Recession-Hard/Soft Landing

Crude oil price volatility surged over the past week, and likely will remain elevated. Underlying prices continue to reflect heightened policy risk ranging from continuing Sino – U.S. trade-war tensions; new tariff threats against Mexico from the Trump administration; global growth concerns, which are fuelled by rising oil inventories in the U.S.; and the continued threat of war in the Persian Gulf (Chart of the Week). These factors are exacerbating recession fears in the U.S., where the yield curve is pricing in a greater than one-in-three chance of a recession one year forward (Chart 2). Given the above-trend performance of the American economy relative to other DM economies, this is disconcerting re global growth generally, and re EM GDP prospects in particular. EM GDP drives EM commodity demand. Given EM commodity demand is the principal driver of global commodity demand, it is especially important in our modeling. Chart of the WeekVolatility Surges on Policy-Risk Concerns Volatility Surges on Policy-Risk Concerns Volatility Surges on Policy-Risk Concerns   Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. Chart 2Bond Market Pricing High Odds of U.S. Recession Bond Market Pricing High Odds of U.S. Recession Bond Market Pricing High Odds of U.S. Recession To be conservative, our oil-demand assumptions for EM GDP have followed World Bank estimates, which means they’ve been below post-Global Financial Crisis (GFC) trend (Chart 3). Chart 3 Cutting right to the chase: Reducing EM GDP growth from 4.2% and 4.5% this year and next to 3.8% and 4.1% shaves ~ $2/bbl off our 2019 Brent price expectation and $3/bbl off our 2020 expectation. This brings our Brent forecast to $73/bbl and $77/bbl for this year and next.1 We continue to expect WTI to trade $7/bbl and $5/bbl below Brent this year and next. Highlights Energy: Overweight. We expect OPEC 2.0 – the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia – to extend its production cuts to year end when it meets later this month or next month. This will still allow OPEC 2.0 to raise production in 2H19 over 1H19 if needed, due to the group's current over-compliance with the agreed cuts. KSA's production is currently close to ~500k b/d below its output target. We believe Wednesday’s inventory report released by the U.S. EIA showing a 22.4mm-barrel increase in commercial crude oil and refined products inventories all but assures OPEC 2.0’s production cuts will be extended when the producer coalition meets. Base Metals: Neutral. Union members who voted to strike a Codelco copper mine over the weekend remain on the job, after Chilean government officials joined to mediate negotiations, according to Fastmarkets MB. Precious Metals: Neutral. Gold rallied above $1,340/oz – up 4% over the past week – as global trade tensions and other factors riling equity, bond and commodity markets intensified. Ags/Softs: Underweight. The USDA reported corn plantings were running at 67% this week, vs. an average of 96% percent over the 2014 – 18 period. The department surveyed 18 states, which account for 92% of all 2018 corn acreage. Feature Global oil demand concerns are manifesting themselves in the almost-relentless selling of futures seen in the past two weeks. This coincided with an increasing risk premium noted in our price decomposition, and with rising concerns over the health of the global economy generally.2 Markets are becoming increasingly concerned U.S. and Chinese trade and foreign policy will spill into the larger global economy and result in a full-blown global trade war. Already, Mexico and Canada have been drawn into this vortex once again – the former is being threatened with U.S. tariffs once more, after presumably having agreed to a revised NAFTA treaty, the latter via increased inspection of meat imports into China.3 On Wednesday, the World Bank lowered its global growth forecast, taking 0.3 percentage points off its 2019 growth estimate – lowering it to 2.6% in 2019 – and reducing its 2020 forecast to 2.7% from 2.8% earlier.4 The Bank noted, “Emerging and developing economy growth is constrained by sluggish investment, and risks are tilted to the downside. These risks include rising trade barriers, renewed financial stress, and sharper-than-expected slowdowns in several major economies.” Assessing Lower EM Growth Prospects We follow the World Bank’s GDP growth estimates closely, largely because the Bank’s forecasts tend to be lower than those of the IMF, which induces a measure of conservatism to our forecasts. We use the Bank’s EM GDP estimates (levels and growth rates) to estimate oil demand in our modelling. Prior to the Bank’s updated forecast released on June 4, we re-estimated EM oil consumption, by shaving 0.4 percentage points from our earlier EM GDP forecast. This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate. Using the World Bank's revised forecasts as inputs to our fundamental model – and leaving all other assumptions unchanged – the lower EM GDP estimate for 2019 would take our average Brent expectation to $71/bbl. Averaging this with our existing expectation of $75/bbl leads us to change our 2019 forecast to $73/bbl. To hit this new estimate of $73/bbl would require 2H19 Brent prices to average ~ $79/bbl, which we believe is not unreasonable. For 2020, the slowdown in EM GDP we used gives an expectation of $73/bbl for Brent, versus our previous estimate of $80/bbl. We average these as well, and change our estimate for 2020 Brent to $77/bbl. OPEC 2.0 Remains Focused On Lower Inventories Our lower EM GDP estimates take growth rates to those roughly prevailing during the 2015 – 16 oil-price collapse. This episode was a true global shock, particularly for commodity exporters, which was not offset by higher growth in the GDPs of commodity importers (Chart 4). This go-round is different, however: The 2015 – 16 oil price collapse was a self-inflicted shock, occasioned by OPEC’s decision to launch an all-out market-share war in 2014. This had a devastating effect on EM commodity-exporting countries, particularly the oil exporting countries. We expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition. This time, the global backdrop is considerably different. For one thing, the oil-price collapse laid the foundation for the formation of OPEC 2.0, which has shown remarkable production discipline since it was founded in November 2016, and took on the mission of reducing the massive unintended inventory accumulation brought on by the combination of the OPEC market-share war and surging U.S. shale production (Chart 5). The nominal target for this mission is OECD inventories. Chart 4EM Oil Demand vs. GDP EM Oil Demand vs. GDP EM Oil Demand vs. GDP Chart 5Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing Commercial Oil Inventories Will Resume Drawing We continue to stress this founding principal of OPEC 2.0, because its leadership continues to make it a focal point when engaging with the press and guiding the market. It is for this reason we expect OPEC 2.0 to extend production cuts, even though we believe the market will need an additional 900k b/d of production from the producer coalition to keep prices below $85/bbl. KSA’s Energy Minister, Khalid al-Falih, this week said, “We will do what is needed to sustain market stability beyond June. To me, that means drawing down inventories from their currently elevated levels.”5 Fiscal, Monetary Policy Support EM Demand The other noteworthy aspect of the current market is central banks globally are more accommodative than they were during the 2015 – 16 oil-price collapse. In addition, fiscal stimulus is being deployed globally, and likely will be increased. Against this backdrop, it is difficult to see monetary or fiscal policy being the sort of headwind it has shown it can be post-GFC. As our colleague Peter Berezin noted in last week’s Global Investment Strategy, “politicians will pursue large-scale fiscal stimulus” to avoid a slide into deflation.6 U.S. – Iran Tensions High, But Ebbing Lastly, oil markets seem to have reduced their concern over U.S. – Iran tensions in the Persian Gulf. This may be due to the fact that U.S. Secretary of State Mike Pompeo said the U.S. was “prepared to engage in a conversation (with Iran) with no pre-conditions. We are ready to sit down.”7 All the same, the U.S. recently deployed an aircraft carrier strike group to the Persian Gulf, where it now is on station, and B52 bombers. From the oil market’s perspective, any thawing in the potential military standoff in the Gulf would require the U.S. to abandon its stated goal of reducing Iran’s oil exports to zero. In and of itself, a resumption of official Iranian oil exports would simply re-distribute production cuts and the make-up production OPEC 2.0 is providing markets in the wake of Venezuela’s collapse, where oil production has fallen to ~ 850k b/d from ~ 2mm b/d when OPEC 2.0 was formed. Bottom Line: Wednesday’s massive 22.4mm-barrel build in U.S. crude and refined product inventories shocked the global oil market, and pushed Brent prices toward $60/bbl as we went to press. Almost surely, this will harden KSA’s and OPEC 2.0’s resolve to maintain production cuts into 2H19 to drain oil inventories globally. The lower prices also will act as a headwind to U.S. shale producers, a topic we will take up in a two-part Special Report next week and the following week. We’ve established rig counts in the U.S. shales are closely tied to WTI price levels and curve shape: Lower prices and a flattening forward curve will restrain drilling in the shales, and the rate of growth in U.S. output. Lastly, fiscal and monetary policy globally will be supportive of commodity demand, and EM oil demand in particular, as this stimulus is deployed. We continue to expect prices to rally from here, but have lowered our forecasts slightly to $73 and $77/bbl for Brent this year and next. We continue to expect WTI to trade $7 and $5/bbl below these levels in 2019 and 2020.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      Please note, we ran our simulations earlier this week, prior to the World Bank’s most recent forecast released June 4.  This means our simulation is 0.1 percentage point below the Bank’s most recent estimate for EM GDP this year, and 0.3 percentage points below the Bank’s 2020 estimate.  2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 3      The amounts involved in the stepped up meat inspections in China are small. However, they can be read as an extension of the foreign-policy imbroglio involving the possible extradition of Huawei Technologies’ CFO from Canada to the U.S. to face trial on charges she and the company allegedly conspired to commit bank and wire fraud to avoid U.S. sanctions on Iran.  Chinese officials deny there is any connection.  Please see “Canada says China plans more meat import inspections, industry fears disaster,” published by reuters.com June 4, 2019. 4      Please see Global growth to Weaken to 2.6% in 2019, Substantial Risks Seen , published by the World Bank June 4, 2019. 5      This quote came from a reuters.com report that relayed what al-Falih told Arab News. Please see “Saudi’s Falih says OPEC+ consensus emerging on output deal in second half,” published June 3, 2019. 6      Please see Global Investment Strategy Weekly Report titled “MMT And Me,” dated May 31, 2019, which discusses the prospects for large-scale fiscal stimulus and accommodative monetary policy globally.  It is available at gis.bcaresearch.com.  Peter also expects a détente in the Sino – U.S. trade war, arguing both sides would benefit from reducing trade tensions and tariffs. 7      Please see U.S. prepared to talk to Iran with 'no preconditions', Iran sees 'word-play' published by reuters.com June 2, 2019.  This followed news that Iran’s President Hassan Rouhani said his country is willing to speak with the U.S. if it shows respect. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Image Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Image

Highlights Inverted Curves & Recessions: While an inverted U.S. Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today compared to past recessions. The Role Of The Term Premium: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. The Stance Of Monetary Policy: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Feature The rush into the safety of government debt accelerated rapidly last week, after another Trump Tariff Tweet targeted Mexican exports to the U.S. Investor confidence, already shaken by the escalation of the U.S.-China trade war, was further eroded by the news that the U.S. was willing to broaden the use of blunt economic tools like tariffs to deal with national security issues like illegal immigration. Global equity and credit markets sold off sharply, adjusting to both higher uncertainty and lower growth expectations. The biggest moves, however, came in the U.S. Treasury market. The 2-year Treasury yield fell -14bps to 1.92% after the Mexico tariff announcement and ended -34bps lower for the entire month of May – the largest monthly decline since November 2008 during the depths of the financial crisis. The 10-year Treasury yield fell -37bps on the month to 2.13%, below the fed funds target range of 2.25-2.5% and 22bps lower than the 3-month U.S. Treasury bill rate. This triggered the dreaded “inversion” signal that has preceded the majority of post-WWII U.S. recessions. The current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Given the well-known predictive properties of an inverted Treasury curve, investors are right to be more nervous about the outlook for U.S. economic growth and the potential for a recession. Multiple Fed rate cuts are now discounted in shorter-maturity Treasury yields. At the same time, the intense flight-to-quality bid for duration exposure has driven the term premium on longer-maturity Treasuries – and all other developed market government bonds – down to unprecedentedly negative territory (Chart of the Week). This can potentially alter the meaning of an inverted yield curve with regards to future economic growth and expected changes in monetary policy. Chart of the WeekUST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? UST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? UST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? In this Weekly Report, we discuss the typical drivers of yield curve inversions and conclude that the current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Could The Treasury Curve Be Wrong This Time? Chart 2This Is A GLOBAL Bond Rally This Is A GLOBAL Bond Rally This Is A GLOBAL Bond Rally The current sharp fall in government bond yields is not only occurring in the U.S. Treasury market. Yields are hitting new cyclical lows in many countries, with the 10-year German Bund yield ending May at an all-time low of -0.2%. Yield curves have bull-flattened during this move, with 10-year yields trading below 3-month Treasury bill rates not only in the U.S., but even in places like Canada and Australia (Chart 2). Global yields have been falling steadily since late in 2018, seemingly with little regard to the performance of risk assets in either direction. This suggests a more fundamental driver – like deteriorating growth expectations or perceptions of overly-tight monetary policy – rather than simple asset allocation decisions by investors. In July 2018, we published a Special Report discussing the drivers of yield curve shape in the major developed markets and the potential economic implications.1 For the U.S., we concluded that when the 10-year U.S. Treasury yield traded below the 3-month U.S. Treasury bill rate for an extended period of time (i.e. more than just a few days), the U.S. subsequently entered recession within twelve months, on average (Table 1). With the 10-year yield now trading below the 3-month rate, the clock may have already started counting down to a recession sometime in the next year. Table 1U.S. Curve Flattening, Inversions & Recessions Since 1960 The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. The New York Fed has a model that determines the probability of a U.S. recession one year ahead based on the slope of the 10-year/3-month Treasury curve.2 The current curve level translates into a 36% probability of a recession one year from now, which is in line with the probabilities seen before the three previous U.S. recessions (Chart 3). Chart 3New York Fed's Yield-Curve Based Recession Probability Model Flashing Red New York Fed's Yield-Curve Based Recession Probability Model Flashing Red New York Fed's Yield-Curve Based Recession Probability Model Flashing Red Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. In Chart 4, we show a “cycle-on-cycle” analysis of selected U.S. economic data series, comparing the current backdrop to past U.S. business cycles. For all panels, the solid line represents the current cycle, while the dotted line is the average of the past five U.S. business cycles. The data is lined up such that the vertical line in the chart represents the start date of past U.S. recessions as determined by the National Bureau of Economic Research. Shown this way, we can look how the data is evolving today and see how it compares to the way the data typically moves in the run-up to a recession. Based on the data, we can make the following conclusions: The current weakness in the U.S. manufacturing sector is in line with the start of past recessions, based on the depressed level of the ISM Manufacturing New Orders-to-Inventories ratio. The Conference Board’s U.S. leading economic indicator is usually contracting in the year prior to the onset of recession; today, the year-over-year growth rate is slowing but remains positive at 2.6%. The U.S. consumer is in much better shape today - initial jobless claims are not rising and consumer confidence is not falling, as typically happens in the run-up to an economic downturn. Non-financial corporate profits also typically start to contract about one year before a recession begins; today, profit growth has slowed from the tax cut fueled surge of 2018, but has not yet downshifted into negative territory on a year-over-year basis. We can apply the same cycle-on-cycle analysis to the U.S. Treasury curve to see how today compares to past pre-recessionary periods (Chart 5). Typically, the 2-year Treasury yield falls below the fed funds rate about one full year before the start of a recession, and ends up around 150bps below the funds rate when the downturn actually begins. In the current cycle, the 2-year dipped below the funds rate back in March of this year, and now sits 58bps below the funds rate. Both of those curve relationships, however, are influenced by the changing nature of the Treasury term premium. Chart 4Only A Manufacturing Recession Only A Manufacturing Recession Only A Manufacturing Recession Chart 5Mixed Messages From The Curve Mixed Messages From The Curve Mixed Messages From The Curve The New York Fed produces estimates of the Treasury term premium for all maturities, from one year up to ten years, which allows us to see how the term premium looks different today than prior to past U.S. recessions.3 As can be seen in the bottom two panels of Chart 5, the 10-year term premium has averaged between 100-150bps in the year prior to U.S. recessions, while the 2-year term premium has averaged between 25-50bps over the same period. Today, the term premia for 10-year and 2-year yields are now both deeply negative. This suggests that the current inversion of the 2-year/fed funds curve, and the 10-year/3-month curve, is likely giving too pessimistic a signal about future U.S. growth – a fact corroborated by the cycle-on-cycle analysis of U.S. economic data. Bottom Line: While an inverted Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today versus past recessions. The Message From Depressed Bond Term Premia Today, the estimated term premium for 10-year Treasuries and 2-year Treasuries is -88bps and -70bps, respectively. This means that not only are bond investors willing to accept yields below the expected path of interest rates over the life of a bond (i.e. a negative term premium), they are accepting an even lower term/risk premium for bonds with longer maturities and durations – bonds that are more risky strictly in terms of price volatility. Why would that be? Typically, bond term premia are driven by the following factors: The volatility of inflation The volatility of bond yields and returns The volatility of economic growth Investor risk aversion Proxies for the first three factors are presented in Chart 6, alongside the estimate of the 10-year Treasury term premium dating back to the early 1960s. Broadly speaking, bond term premia have been higher when realized inflation is more volatile (second panel), unemployment is high (third panel) and Treasury yield volatility is elevated. Today, all of those factors are at, or very close to, the lowest levels seen over the past 50 years. No wonder term premia are so depressed. Chart 6Term Premia Are Depressed For Structural Reasons ... Term Premia Are Depressed For Structural Reasons ... Term Premia Are Depressed For Structural Reasons ... Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve.  Investor risk aversion does not exhibit the same type of broad multi-decade trends as growth and inflation, but it is safe to assume that investors become more risk averse when the economic backdrop is more uncertain. Periods of stable growth, categorized by low variability of U.S. nominal GDP growth or a rising trend in the global leading economic indicator, are associated with narrow term premiums and low measures of market-implied bond volatility like the MOVE index of U.S. Treasury option prices (Chart 7). Chart 7... And Cyclical Reasons ... And Cyclical Reasons ... And Cyclical Reasons This result does seem counter-intuitive – more economic uncertainty should make bonds safer, not riskier! The key to remember here is that it is only the term premium component of yields that rises during periods of greater volatility. Actual bond yields fall during those same periods, but because of more fundamental drivers like falling inflation expectations and a lower expected path of interest rates as the Fed eases policy. Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve. Bottom Line: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. So Is The Fed Actually Running A Tight Monetary Policy? As we discussed in our yield curve Special Report last July, curve inversions typically occur during periods when monetary policy is considered restrictive. For example, every time the real fed funds rate (actual fed funds minus core PCE inflation) has been above the Fed’s estimate of the neutral r* real rate, the 10-year/3-month Treasury curve has inverted (Chart 8). Currently, the real funds rate is essentially equal to the Fed’s latest r* estimate, suggesting that monetary policy is neutral and not restrictive. Chart 8Too Soon For Sustained, Policy-Induced Yield Curve Inversion Too Soon For Sustained, Policy-Induced Yield Curve Inversion Too Soon For Sustained, Policy-Induced Yield Curve Inversion Other measures like the Taylor Rule can also provide an indication of whether monetary policy is too tight relative to real interest rates and measures of economic spare capacity. If policy was too restrictive, with a fed funds rate above the Taylor Rule, this would imply a more “fundamental” Treasury curve inversion. The Atlanta Fed’s interactive Taylor Rule tool provides estimates of a variety of Taylor Rules, using differing measures of the neutral real fed funds rate and measures of spare capacity.4 We show the results of those Taylor Rules in Table 2. Only one of twenty rules shown is currently producing a fed funds rate below the current 2.25-2.5% range, with fifteen rules indicating that a higher funds rate is still required. Table 2Taylor Rule Fed Funds Prescription Heat Map For 2019: Q2 The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Chart 9Our Fed Monitor Is Close To Calling For Rate Cuts Our Fed Monitor Is Close To Calling For Rate Cuts Our Fed Monitor Is Close To Calling For Rate Cuts Yet despite the more traditional indicators suggesting that the current level of the fed funds rate is not too high, that does not mean that there are not potential pressures on the Fed to cut rates. Our own Fed Monitor remains near the zero line, suggesting that no change in the Fed’s stance is warranted (Chart 9). Yet when looking at the individual components of the Fed Monitor, there has been enough softening of U.S. growth and inflation momentum to justify Fed rate cuts. Only the Financial Conditions component is preventing the overall Monitor from moving into the “easier policy required” zone. In other words, if equity and credit markets continue to sell off and the U.S. dollar continues to rally, a Fed rate cut becomes a higher probability outcome. Investment Conclusions Summing it all up, it does not appear that the current inverted Treasury yield curve is signaling a risk of a U.S. recession within the next 6-12 months. A very flat Treasury curve is appropriate with a Fed policy stance that is appropriately neutral. On a cyclical perspective, we still think that a small below-benchmark stance on overall portfolio duration for global bond investors is warranted, along with a modest underweight in U.S. Treasuries in currency-hedged global bond portfolios. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. Those cuts are largely discounted in the current level of yields, though. Our 12-Month Discounter now indicates that -75bps of rate cuts over the next year are priced into the U.S. Overnight Index Swap curve. A good tactical way to play for Fed cuts in 2019 is to implement a fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract – a position we are adding to our Tactical Overlay (see the table on page 15). The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if three or more rate cuts occur between now and then. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. We would expect our spread trade to return +45bps (unlevered) in a scenario where the Fed keeps rates flat until next March and +19bps (unlevered) in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. Bottom Line: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Go long an August 2019/February 2020 fed funds futures calendar spread trade to profit from near-term “insurance’ Fed rate cuts.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. 2 Details of the NY Fed’s probit model of U.S. recession probability based on the slope of the Treasury curve can be found here: https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3 There are several methodologies used to estimate term premia for government bond yields; the one used by the New York Fed is the Adrian, Crump and Moench (ACM) approach, details of which can be found here: https://www.newyorkfed.org/research/data_indicators/term_premia.html 4 The Atlanta Fed’s interactive Taylor Rule tool can be found here: https://www.frbatlanta.org/cqer/research/taylor-rule.aspx?panel=1 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights We’ve searched in vain for imminent domestic weakness in the U.S. economy, … : Much of our work this spring has focused on trying to poke holes in our view that the equilibrium fed funds rate remains above the target fed funds rate, but we haven’t found any evidence of overheating in the real economy, or worrisome excesses in financial markets. … but an exogenous shock could well precipitate a recession if it were serious enough: The U.S. is a comparatively closed economy, but there’s no such thing as full-on decoupling. The U.S. may react more slowly than other major economies to what’s going on in the rest of the world, but it’s not immune to it. A trade war would threaten global growth, … : U.S.-China trade negotiations have taken center stage over the last couple weeks, and escalating tension between the world’s two largest standalone economies will surely cast a pall over the global outlook. … but there are other potential threats that bear monitoring: Tensions with Iran could be the catalyst for an oil price shock, while a significant rollback of globalization could crimp corporate profit margins. Either would hasten the end of the equity bull market and the expansion. Feature Tight monetary policy is a necessary, if not sufficient, condition for a recession. We deem policy to be tight if the fed funds rate exceeds our estimate of the equilibrium fed funds rate, and easy if it is below our estimate of equilibrium. Over the six decades for which we compute an estimate of the equilibrium fed funds rate, the U.S. has only ever experienced recessions when the fed funds rate has exceeded our estimate of equilibrium (Chart 1). Tight policy isn’t always tantamount to a recession – nothing came of tight settings in 1984 or 1995 – but recessions don’t occur without it. Chart 1Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight Recessions Only Occur When Monetary Conditions Are Tight We currently estimate that the equilibrium fed funds rate, a.k.a. the neutral rate, is about 3⅛%, and we continue to project that it will be around 3⅜% by the end of the year. Those estimates leave the Fed with plenty of headroom before it materially slows the economy. If our estimate is on the money, it will take four more rate hikes to induce an inflection in the business cycle. We have not seen anything in the ongoing flow of macro data, or evidence of excesses in the financial markets, that would suggest a recession is already under way or is lurking around the corner. Internal dynamics should continue to support the expansion, but threats from outside the U.S. are growing. We therefore conclude that the next recession may well not arrive for another two years, in the absence of a significantly adverse exogenous event. This week, we extend our focus beyond the U.S. to try to uncover the external threats that could stop the U.S. economy, and the bull markets in risk assets, in their tracks. Beyond the tariff fireworks, we also contemplate the possibility that conflict with Iran could lead to an oil price shock, and the impact of a significant rollback of globalization. It is not our base case that any of the various external threats will tip the U.S. into a recession, but investors should keep tabs on the biggest ones. Tariffs The U.S.-China trade saga has unfolded in three pairs of moves and counter-moves (Diagram 1). While the aggregate $50bn worth of Chinese goods tariffed in the first two salvos mostly targeted industrial equipment and machinery, the third installment, covering $200bn worth of imports, extended the tariffs’ reach to consumer products. Major categories included not only commodities such as base metals, chemical products and mineral fuels and oils, but also a broad swath of foods, textiles, electronics, vehicles and spare parts. After a three-month cease-fire, the developments of the last two weeks arguably marked the most significant escalation of tensions on both sides. The U.S. is now threatening to levy tariffs on the remaining $325bn of Chinese goods that have so far been spared. Diagram 1Anything You Can Do External Threats External Threats Our colleagues at BCA’s Geopolitical Strategy service suggest that recent foreign policy initiatives indicate that the White House does not feel any particular pressure to minimize economic risk this far ahead of the election. The risk of market-disruptive measures has therefore increased, and they see a 50-50 chance that the U.S. and China will fail to reach an accord (Table 1). Although the administration has delayed any action on autos and auto parts for now, Europe could be the next trade partner in its cross hairs. The odds that Section 232 (national-security-threat) tariffs will be levied on European auto imports is rising (Chart 2). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 External Threats External Threats Chart 2 These heightened trade tensions may delay the global growth recovery that we were expecting to bloom in the summer, and they may also allow the dollar to keep advancing. The greenback is a countercyclical currency, moving inversely with global activity (Chart 3), and a bump in the road for global growth would likely extend its upward run. Chart 3The Countercyclical Dollar The Countercyclical Dollar The Countercyclical Dollar Although a strong dollar would be a headwind for exporters, the U.S. economy is comparatively closed. Tariffs are likely to exert the greatest pressure on the economy via softer consumption and investment. So far, the available evidence suggests that U.S. consumers and corporations have borne the brunt of higher tariffs in the form of higher retail prices and lower profit margins.1 Iran Our geopolitical strategists contend that investors have underrated conflict with Iran as a market risk for a while. Now that the contentiousness of U.S.-Iran relations has ratcheted higher upon the administration’s decision not to extend the import waivers on Iranian oil, the issue is back in the spotlight. Our strategists caution that managing the dispute may require more delicacy than the more hawkish elements of the administration realize. In their view, the potential for a misstep increases the odds of a recession and poses a significant risk to the equity bull market. In a joint Special Report by our Commodity and Energy Strategy and Geopolitical Strategy services at the beginning of the month, our in-house experts stressed that there are multiple moving parts driving the supply-demand balance in the global oil market.2 Investors should realize that the world faces the prospect of the loss of Venezuelan production (approximately 600,000 barrels per day (b/d)) and significant outages in Libya (~600,000 to 800,000 b/d), in addition to our strategists’ base-case estimate of 700,000 b/d from Iran’s current 1.3 million b/d output. BCA does not expect that all of that output will be lost, but the key point is that Iran is not the only potential source of a supply shortfall. Our energy strategists believe that OPEC 2.0 – the producer coalition led by Saudi Arabia and Russia, and supported by Saudi Arabia’s OPEC allies – has the capacity to make up for even their larger shortfall scenarios (Chart 4). The problem is that OPEC 2.0 may not have the will to do so in a timely fashion. Saudi Arabia and the rest of the OPEC 2.0 coalition were caught completely off guard by the administration’s issuance of import waivers in November, after they had ramped up production at its request to limit the market disruptions that would have ensued when Iran’s output was taken off the market. The last-minute waiver decision caused oil prices to crater in the wake of a supply glut that OPEC 2.0 has been working to sop up ever since (Chart 5). Chart 4 Chart 5... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight ... But The Oil Market Is Pretty Tight   OPEC 2.0’s members may feel that they were badly used last fall, and may not be inclined to move proactively now. Russia is managing its own low-grade conflict with the U.S., and all of the coalition should bear in mind that the U.S. could release over a million b/d from its Strategic Petroleum Reserve (SPR) for a solid six to nine months, according to our energy team’s estimates. If rising oil prices are often viewed as a tax on American consumers, a late summer/early fall release of holdings could be viewed as an election rebate, courtesy of the skilled economic managers in the White House. Our team expects that OPEC 2.0 will likely guard against an oversupply-driven swoon in oil prices by managing its production on something akin to a just-in-time inventory strategy. Our energy and geopolitical strategists caution that there are two other ways the administration may overplay its hand. First, it might overestimate U.S. shale drillers’ ability to export their production. While new pipeline construction will relieve the transportation bottleneck limiting the Permian Basin output that reaches the Gulf of Mexico, oil exports from the Gulf are limited by a shortage of deep-water harbor facilities. If global trade tensions do worsen, both the dollar and U.S. equities may attract safe-haven flows. There is also the possibility that Iran might strike at Iraq, putting some of its 3.5 million b/d output at risk. It could also make good on its repeated threat to close the Straits of Hormuz, through which nearly a fifth of global oil supplies travel daily. Either of these options would dramatically escalate the conflict, but a desperate Iran might pursue them if it felt cornered. The bottom line is that the probability of an oil price shock is not negligible. Brinkmanship with Iran could upset a delicate supply-demand balance in global oil markets, and a delicate geopolitical balance in the Middle East. If the Volcker double-dip is treated as a single event, a surge in oil prices has preceded every recession in the last 45 years, except for the 2001 recession precipitated by the bursting of the dot-com bubble (Chart 6). Chart 6Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Significant Rollback Of Globalization Our Geopolitical Strategy and Global Asset Allocation services have cited peak globalization as an important long-term investment theme for the last several years. The tariff tensions between the U.S. and its trading partners would seem to have borne out their predictions, especially if one views them as having been inspired by unskilled workers’ losses from globalization. Taking on foreign exporters is likely to play well in the electorally decisive Rust Belt states, where manufacturing job losses have hit especially hard. We fully subscribe to the theory of comparative advantage as formulated by David Ricardo in the early 19th century. By allowing individual countries to specialize in what they do best, free trade increases the size of the global economic pie. Empirical evidence suggests that globalization also re-slices the pie, however. In the developed world, outsourcing manufacturing has operated to the benefit of investors and the detriment of less-skilled workers. For U.S.-based multinationals, tariffs are a minor irritant compared to the prospect of having to reroute supply chains around China. The modest headwinds to globalization observed before the U.S. began engaging in serial bilateral trade conflicts did not undermine corporate profit margins in any material way. A bigger anti-globalization push that forced global supply chains to be rerouted or partially unwound would have much more negative effects. The U.S. is a comparatively closed economy, but the multinationals that dominate equity market capitalization rely heavily on interactions with the rest of the world. Unwinding the global supply chains that have been carefully constructed over the last 30 years would be disruptive and costly. The worst-case scenario envisioned by our geopolitical strategists, in which U.S.-China relations dramatically worsen and the tariff back-and-forth escalates in a major way, would hit equities hard, especially if supply chains had to be rebuilt. As a proxy for what globalization has meant for investors’ and blue-collar workers’ share of the pie, we consider the path of real wages relative to productivity over the last 50 years. From 1970 through 2001, U.S. wages generally kept pace with productivity gains, observing a fairly narrow, well-defined range (Chart 7). Once China entered the WTO (as denoted by the vertical line on the chart), productivity-adjusted wages fell precipitously, and even their periodic bounces have fallen well short of the level that marked the lower end of the previous range. Chart 7The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk The Pie Has Grown, But Unskilled Labor's Slice Has Shrunk Bottom Line: Temporary barriers to free trade, implemented as a negotiating tactic, are not a big deal for equities. A significant rollback of globalization would be, however, and a need to divert global supply chains away from China could stop the bull market in its tracks. Investment Implications Along with our Global Investment Strategy colleagues, we are somewhat more sanguine than our Geopolitical Strategy service that a worst-case outcome between the U.S. and China can be averted. We therefore continue to believe that the U.S. expansion, and the bull markets in risk assets, will persist until the Fed tightens monetary conditions enough to spark the next recession. We reiterate our recommendations that investors should maintain at least an equal weight position in equities and spread product. Enough is at stake in the conflicts with China and Iran, however, that a worsening of either could cause us to change our view, and we will be watching developments on each front closely. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com   Footnotes 1      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 2      Please see Commodity & Energy Strategy/Geopolitical Strategy Special Report, “U.S.-Iran: This Means War?,”dated May 3, 2019, available at ces.bcaresearch.com.

Highlights Corporate Debt In Theory: Conventional theory holds that high levels of corporate debt pose a risk to the economy because they make the corporate sector more vulnerable to exogenous economic shocks. Corporate Debt In Practice: The conventional theory is contradicted by empirical evidence that links rapid private debt growth to negative economic outcomes, but shows no relationship between high debt levels and slow economic growth. The empirical evidence also links measures of credit market sentiment – such as corporate bond spreads – to future economic outcomes. We present an alternative theory of the corporate credit cycle that better aligns with the observed empirical results. The Current Risk: At present, the corporate debt measures that have historically been linked to weaker economic growth paint a fairly benign picture. We see no immediate risk to the U.S. economy from elevated corporate debt. Feature In our interactions with clients we are often asked whether corporate debt poses a risk to the U.S. economy. It’s easy to see why, U.S. nonfinancial corporate debt as a percent of GDP is higher than at any time since 1936 (Chart 1). Chart 1U.S. Corporate Debt: Highest Since 1936! U.S. Corporate Debt: Highest Since 1936! U.S. Corporate Debt: Highest Since 1936! This Special Report investigates the issue by looking at what recent academic theory and empirical evidence have to say about the relationship between corporate debt and economic growth. We then apply that evidence to today’s corporate debt situation to assess the economy’s current level of risk. We should note that this report focuses on potential risks stemming from the amount of outstanding debt, how quickly it is growing and how it is valued in financial markets. In a follow-up report, we will consider whether the ownership structure of the corporate bond market imparts additional risks to the economy and financial system. The Risk From Corporate Debt In Theory Conventional economic theory tells us that we should be concerned about elevated private sector debt because high debt makes the economy more vulnerable in the face of future shocks. Case in point, here is how the Federal Reserve’s Financial Stability Report describes the mechanism through which private sector debt impacts the economy: Excessive borrowing by businesses and households leaves them more vulnerable to distress if their incomes decline or the assets they own fall in value. In the event of such shocks, businesses and households with high debt burdens may need to cut back spending sharply, affecting the overall level of economic activity.1 This theory raises a few issues that we will consider in the remainder of this report: The theory suggests that the absolute amount of private sector debt matters more than its rate of growth. The theory suggests that elevated debt leads to a more severe economic downturn, but doesn’t necessarily cause the downturn. In other words, high debt simply makes the economy more vulnerable to exogenous shocks. The theory suggests that household debt and corporate debt are equally important. The Empirical Record Level Versus Growth While conventional theory implies that the crucial variable to monitor is the level of private sector debt, recent empirical evidence challenges this view. For example, a 2017 Bank of England paper considered a sample of 130 recessions across 26 countries and found that the rate of private debt growth matters much more.2 Please note that in the remainder of this report we define “debt growth” as the 3-year change in the debt-to-GDP ratio. Specifically, the researchers found a statistically and economically significant link between the severity of the recession – defined as the drawdown in per capita GDP – and the 3-year change in private debt-to-GDP that immediately preceded the downturn. They found no similar relationship using the level of private debt-to-GDP. In fact, the researchers found that the level of private debt to GDP only helped explain the severity of the recession when it was interacted with the rate of private debt growth. To quote from the paper: It appears that the level of credit before a recession matters for the severity of the downturn only when it is accompanied by a credit boom. By contrast, periods of fast credit growth appear to be associated with more severe recessions whether or not the level of credit is elevated.3 These findings suggest that the conventional theory presented above – that high debt levels make the private sector more vulnerable to exogenous shocks – is not the principle mechanism at work. We need an alternative theory to explain why the rate of debt growth is the more important variable to monitor. We discuss a possible alternative theory in the section titled “Toward A Better Theory” below. But for now, let’s consider the current state of the U.S. economy in light of the Bank of England’s findings. Chart 2 shows that the level of U.S. private sector debt-to-GDP is elevated compared to history. In fact, using data beginning in 1955, it was only higher in the run-up to the 2008 financial crisis. However, the second panel of Chart 2 shows that private sector debt growth is only 2.5%, a far cry from what was seen prior to the last three recessions. Chart 2Recession Watch: Private Debt Growth And Inflation Recession Watch: Private Debt Growth And Inflation Recession Watch: Private Debt Growth And Inflation We don’t mean to imply that a recession cannot occur with low private debt growth, but the track record of post-WWII U.S. recessions shows that every single one was preceded either by elevated private debt growth – 8% or above – or high inflation. At present, the U.S. economy shows very little risk on either front. Household Debt Versus Corporate Debt So far we’ve looked at private sector debt in total, i.e. we have combined household debt and nonfinancial corporate debt. This arguably masks the true instability in the U.S. economy, which is concentrated in the corporate sector. Chart 3 shows that low overall private sector debt growth of 2.5% is split between relatively quick corporate debt growth of 4.2% and household debt that is contracting at a rate of 1.8%. If we ignore the household sector’s persistent deleveraging, we see that current corporate debt growth of 4.2% is not that far below the peaks of 6.9%, 7.9% and 8% seen prior to each of the last three recessions. Chart 3U.S. Private Debt Growth Is Driven By Corporate Sector U.S. Private Debt Growth Is Driven By Corporate Sector U.S. Private Debt Growth Is Driven By Corporate Sector This raises two interesting questions. First, are corporate debt and household debt equally de-stabilizing for the economy? And relatedly, when tracking the U.S. economy should we focus on overall private sector debt, or should we monitor household and corporate sector debt individually? The track record of post-WWII U.S. recessions shows that every single one was preceded either by elevated private debt growth or high inflation. On the first question, we can turn back to the Bank of England paper. That paper presented the results from several regressions where the researchers looked at household debt growth and corporate debt growth individually. The results showed that elevated household debt growth and elevated corporate debt growth were both associated with more severe recessions, and with roughly equal coefficients. In the words of the researchers: Rapid credit growth continues to be an important predictor of the severity of a recession whether we look at lending to non-financial companies or to households, suggesting that the role of lending to businesses should not be ignored. Interestingly, this result stands in contrast to some other recent empirical work. Most notably, a 2016 paper by Atif Mian, Amir Sufi and Emil Verner (MSV). That paper looked at a panel of 30 countries between 1960 and 2012 and found that while higher household debt growth is associated with lower subsequent GDP growth, no such correlation is found with corporate debt.4 MSV summarize their basic result as follows: There is a significant negative correlation between changes in private debt and future output growth. Moreover, this negative correlation is entirely driven by the growth in household debt. The magnitude of the negative correlation is large, with a one standard deviation increase in the change in household debt to GDP ratio (6.2 percentage points) associated with a 2.1 percentage point lower growth rate during the subsequent three years. The main difference between the MSV methodology and that used by the Bank of England is that the MSV paper looks at GDP growth unconditional on whether there is a recession. In contrast, the Bank of England paper looks only at recessionary periods. A look back at past U.S. recessions makes us reluctant to ignore corporate debt growth completely. Table 1 lists every post-WWII U.S. recession, showing the peak-to-trough drawdown in GDP as a measure of the recession’s severity along with prior peaks in private debt growth, household debt growth, corporate debt growth and inflation. Table 1A History Of Post-WWII U.S. Recessions The Risk From U.S. Corporate Debt: Theory And Evidence The Risk From U.S. Corporate Debt: Theory And Evidence Table 1 confirms what we already stated above, that every post-WWII U.S. recession has been preceded by either rapid private sector debt growth or high inflation. If we dig deeper and look at the breakdown between household debt growth and corporate debt growth we find that there have only been two recessions where peak corporate debt growth exceeded peak household debt growth. Current corporate debt growth of 4.2% is not that far below the peaks of 6.9%, 7.9% and 8% seen prior to each of the last three recessions. The first such recession occurred in 1973-75, but that recession was clearly driven by high inflation. Both household and corporate debt growth were quite low during that period. The second example is the 2001 recession. Private debt growth was elevated prior to the 2001 recession, and more heavily concentrated in the corporate sector. However, it’s important to note that the 2001 recession was also the mildest post-WWII U.S. recession. Main Takeaways We draw several conclusions from our review of the empirical research: First, we should pay attention to the rate of growth in private debt-to-GDP and downplay the level of private debt-to-GDP. The latter has very little predictive power on its own. Second, a U.S. recession is unlikely to occur in the absence of elevated private sector debt growth (above ~8%) or high inflation. At the moment, neither factor suggests that the U.S. economy is on the cusp of a downturn. Third, we should not ignore corporate debt growth. However, the MSV research suggests it might be less economically important than household debt growth. Further, the Bank of England paper shows that the severity of any future downturn is equally sensitive to both household and corporate debt, suggesting that it is reasonable to combine the two and use overall private sector debt growth as our key metric when assessing risks to the economy. Finally, the empirical research suggests that the theory of how corporate debt relates to the economy that was presented in the first section of this report is at best incomplete. That theory cannot explain why the rate of debt growth is associated with weaker economic activity, but the level of debt is not. Fortunately, some recent research proposes a few alternative theories that better align with the empirical results. These theories also suggest a few other measures of corporate credit risk that are important for investors to monitor. Looking Beyond Debt Growth So far we have focused on the difference between the level of corporate debt and the rate of corporate debt growth, but recent empirical research has also linked several other measures of ebullient credit market sentiment to future slow-downs in economic activity. Assessing Credit Market Sentiment For example, a 2016 paper by David Lopez-Salido, Jeremy Stein and Egon Zakrajsek (LSZ) shows, using U.S. data from 1929 to 2013, that “when corporate bond spreads are narrow relative to their historical norms and when the share of high-yield bond issuance in total corporate bond issuance is elevated, this forecasts a substantial slowing of growth in real GDP, business investment, and employment over the subsequent few years. Thus buoyant credit-market sentiment today is associated with a significant weakening of real economic outcomes over a medium-term horizon.”5 Before getting into the possible reason for this finding, let’s quickly look at how the U.S. economy stacks up with regard to credit market sentiment. First, the spread between Baa-rated corporate bonds and the 10-year U.S. Treasury yield – the spread measure used in the LSZ paper – is slightly above its historical average, and does not look stretched compared to history (Chart 4). Chart 4U.S. Credit Spreads Aren't Stretched U.S. Credit Spreads Aren't Stretched U.S. Credit Spreads Aren't Stretched Second, even a more conventional spread measure like the average option-adjusted spread from the Bloomberg Barclays Investment Grade Corporate Bond index remains fairly wide (Chart 5). Chart 5Junk Share Of New Issuance Is Falling Junk Share Of New Issuance Is Falling Junk Share Of New Issuance Is Falling Third, the high-yield share of new corporate bond issuance was elevated early in the recovery, especially compared to last cycle, but has declined in recent years (Chart 5, panel 2). Relatedly, the par value of outstanding junk debt as a proportion of the total par value of corporate debt has been falling since 2015 (Chart 5, bottom panel). Does Elevated Credit Market Sentiment Cause Slower Economic Growth? Of course, the empirical finding that tight credit spreads predict slower economic growth could simply reflect the fact that credit spreads respond to swings in the economic data. If our goal is to forecast economic growth, then this would suggest that we don’t need to pay much attention to credit spreads, because they are simply reflecting swings in the economy rather than causing them. However, the empirical evidence increasingly suggests that there is a causal mechanism at play. To test this, the LSZ paper employs a two-step regression procedure. In the first step, researchers model the future change in credit spreads based on the lagged level of credit spreads and the junk share of new issuance. In the second step, they use the fitted value from the first regression to predict changes in economic activity. The fact that the fitted value is significantly related to changes in economic activity implies that there is some predictable mean reversion in credit market sentiment, unrelated to economic fundamentals, that actually exerts an influence on future economic growth. LSZ suggest the following causal mechanism: Heightened levels of sentiment in credit markets today portend bad news for future economic activity. This is because mean reversion implies that when sentiment is unusually positive today, it is likely to deteriorate in the future. Moreover, a sentiment-driven widening of credit spreads amounts to a reduction in the supply of credit, especially to lower credit-quality firms. It is this reduction in credit supply that exerts a negative influence on economic activity. It follows from this analysis that if we could show that corporate bond spreads are tight relative to their “economic fair value”, then the economy would be at even greater risk from a mean reversion in credit market sentiment. While it’s difficult to identify a true “fair value” for credit spreads, Simon Gilchrist and Egon Zakrajsek (GZ) have calculated an Excess Bond Premium that measures the excess spread available in a sample of corporate bonds after removing a bottom-up estimate of expected default losses.6 Expected default losses are estimated using the Merton model and each firm’s market value of equity and face value of debt.7 Using this new measure, GZ find that “over the past four decades, the predictive power of credit spreads for economic downturns is due entirely to the Excess Bond Premium”. This stunning result is the most compelling evidence yet that swings in credit market sentiment actually cause shifts in economic activity, rather than simply reflect them. Looking at the GZ Excess Bond Premium today, we see that while it had been negative for most of the current cycle, it recently ticked above zero and has yet to recover (Chart 6). For the time being, there is no evidence of excessively optimistic credit market sentiment. Chart 6U.S. Credit Spreads Are High Relative To Fundamentals U.S. Credit Spreads Are High Relative To Fundamentals U.S. Credit Spreads Are High Relative To Fundamentals Toward A Better Theory So far we’ve seen that rapid debt growth is a better predictor of future economic weakness than high debt levels. We’ve also seen evidence that optimistic credit market sentiment (tight credit spreads, especially relative to fundamentals, and an elevated junk share of new issuance) forecasts, and likely causes, future economic weakness. Clearly, we need a better theory for why corporate debt matters for the economy than the one provided by the Federal Reserve in the first section of this report. In our view, the theory that most closely aligns with the empirical data is Nicola Gennaioli and Andrei Shleifer’s theory of Diagnostic Expectations, as detailed in their 2018 book A Crisis Of Beliefs.8 In the book, the author’s demonstrate how investors systematically overreact to new economic information. A tendency that makes forecast errors highly predictable. For example, Chart 7 shows that forecasts for what the Baa/Treasury spread will be in one year’s time are tightly linked with today’s actual spread. This means that investors inevitably expect too much future spread widening when spreads are high, and too much future tightening when spreads are low. Chart 7Forecast Errors Are Predictable Forecast Errors Are Predictable Forecast Errors Are Predictable Gennaioli and Shleifer integrate this systematic behavioral bias into a model that, from our perspective, better aligns with the empirical data on the relationship between corporate debt and the real economy. According to Gennaioli and Shleifer: Good economic news […] makes right-tail outcomes representative. This leads investors to both overestimate average future conditions and to neglect the unrepresentative downside risk, causing overexpansion of both leverage and real investment. When good news stops coming, investors revise their expectations down, even without adverse shocks. These revisions cause credit spreads to revert, the lenders to perform poorly, and economic and financial conditions to deteriorate, leading to deleveraging and cuts in real investment. A severe crisis occurs if arriving news is sufficiently bad as to render left-tail outcomes representative and hence overstated. This theory would seem to explain all of the key empirical findings. Investors form their expectations based on an overreaction to recent news. During an economic recovery this causes credit spreads to tighten and debt to grow rapidly. Eventually, investors realize that expectations have become unrealistically optimistic, credit spreads mean-revert and debt growth plunges. Crucially, in this model a severe economic shock is not required for credit spreads to mean-revert, only a lack of further good news to confirm investor over-optimism. Based on this theory, if we are concerned about the impact of corporate debt on the real economy we should predominantly track measures of credit market sentiment and the rate of debt growth. The theory helps reveal why the level of corporate debt has little informational value. Concluding Thoughts Conventional theory tells us that high corporate debt levels could pose a risk to the economy because they make the corporate sector more vulnerable in the face of exogenous economic shocks. However, empirical evidence suggests that this theory is of little practical value. A better theory is one where investors and corporate managers overreact to positive economic news, leading to overvaluation in credit markets and rapid debt growth. Then, when sentiment is revealed to be overly optimistic, it leads to a mean-reversion in credit spreads and a tightening of credit supply that actually causes a period of weaker economic growth. Investors inevitably expect too much future spread widening when spreads are high, and too much future tightening when spreads are low. It follows from this theory that if we are concerned about the impact of corporate debt on the real economy we should predominantly track debt growth and measures of credit market sentiment such as credit spreads and the junk share of new issuance. The U.S. economy currently looks quite stable by these measures. Overall private sector debt growth is only 2.5%. Historically, it has been above 8% prior to recessions that weren’t caused by high inflation. The GZ Excess Bond Premium also shows that credit market sentiment is not currently stretched relative to fundamentals. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com   Footnotes 1      https://www.federalreserve.gov/publications/files/financial-stability-report-201811.pdf 2      https://www.bankofengland.co.uk/working-paper/2017/down-in-the-slumps-t… 3      Please note that the Bank of England paper uses the term “credit” in place of “debt”. In this report we use both terms interchangeably. 4      https://chicagounbound.uchicago.edu/cgi/viewcontent.cgi?article=1050&co… 5      https://www.nber.org/papers/w21879 6      https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/recession-risk-and-the-excess-bond-premium-20160408.html 7      Merton, Robert C., “On The Pricing Of Corporate Debt: The Risk Structure of Interest Rates”, The Journal of Finance, Vol. 29, No. 2, May 1974. 8      Nicola Gennaioli and Andrei Shleifer, A Crisis Of Beliefs: Investor Psychology And Financial Fragility, Princeton University Press, 2018.

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road 10 Most FAQs From The Road 10 Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display Fed’s Pivot On Display Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks 10 Most FAQs From The Road 10 Most FAQs From The Road Chart 2 Chart 3…And Then The SPX Peaks …And Then The SPX Peaks …And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak 10 Most FAQs From The Road 10 Most FAQs From The Road While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late 10 Most FAQs From The Road 10 Most FAQs From The Road Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Mind The Excess Supply Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert 10/2 Y/C Has Yet To Invert 10/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble Margin Trouble Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates 10 Most FAQs From The Road 10 Most FAQs From The Road Chart 7Bad Breadth Bad Breadth Bad Breadth Chart 8Too Complacent Too Complacent Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Growth Green Shoots Growth Green Shoots Chart 10Chineasing… Chineasing… Chineasing… Chart 11...On All… ...On All… ...On All… Chart 12…Fronts …Fronts …Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown U.S. Debt Profile Breakdown U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Hide In Pristine Balance Sheets Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag CRE Excesses Are A Yellow Flag CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over 10 Most FAQs From The Road 10 Most FAQs From The Road   Chart 17Bonds Are In A Bubble Bonds Are In A Bubble Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing The Fed Has Engineered A Soft Landing The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Stimulative Real Rates Stimulative Real Rates Chart 20There Is Always A First Time There Is Always A First Time There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Buy The Software Breakout Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy Defense Stocks Remain A Long-term Buy Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Highlights The yield curve has inverted: The 10-year Treasury bond yield fell below the 3-month T-bill rate following the March FOMC meeting and has remained there since. We never say it’s different this time, but there is not yet sufficient evidence to change course: The yield curve is almost always early as a standalone signal, and the depressed term premium may make it less sensitive right now. Monetary policy still looks decidedly accommodative to us, … : Our estimate of the equilibrium fed funds rate says policy’s easy, and that it’ll stay that way until the Fed gets serious about hiking rates again. … so asset allocation should continue to favor risk assets: There are global forces restraining Treasury yields, but the fed funds rate cycle is only partway through a stretch that has been uniformly unfavorable for Treasuries. Feature Last week’s data were soft, as the U.S. economy continues to show signs of decelerating. The consumer confidence survey disappointed hopes for an extended bounce back from January’s shutdown-shadowed release, housing starts were uninspiring, and the Case-Shiller index revealed that home-price gains continue to sag. Beyond the U.S., the message from manufacturing PMIs is glum, although the services sector seems to be holding up just fine. Our traveling colleagues report that investors around the world have developed a decided aversion to European assets. We remind our clients that deceleration is nothing new. It’s been the story so far this year, as the incremental decline in fiscal thrust ensured it would be. The inversion of the yield curve is new, however, and it’s commanding attention from the financial media and from investors drawn to a leading indicator that consistently works. We like the yield curve, too, and it’s one of the three components of our recession indicator, but it’s only one. The other two components have yet to confirm its message, and the way things look now, it may well be awhile before they do. The Yield Curve Has Inverted, The Yield Curve Has Inverted The 3-month-to-10-year segment of the yield curve inverted after the March FOMC meeting, and it dipped a little further into negative territory last week as the 10-year Treasury yield continued to melt. An inverted curve is one of the three components of our simple recession indicator,1 and we believe it can send an important signal about the economy’s vigor and the state of monetary policy. By itself, however, an inverted curve is not a sufficient precondition for a recession. It has also been something less than a timely guide to asset allocation, inverting a year ahead of a recession, on average, and six months before the S&P 500 peaks (Table 1). The yield curve has been a reliable recession warning signal, but it tends to be too early to serve as a practical guide to money management and asset allocation. Table 1Inverted Yield Curves, 1968 - 2018 Keep Calm And Carry On Keep Calm And Carry On   An inverted yield curve has called eight of the seven recessions that have occurred over the last 50 years, making it a dependable leading indicator (Chart 1). Year-over-year contraction in the Conference Board’s Leading Economic Index (LEI) has compiled the same enviable track record, calling all seven of the last half-century’s recessions with just one false positive (Chart 2). LEI tends to be timelier, however, sounding the alarm an average of five months after the curve inverts (Table 2). For our recession indicator, we also add a comparison of the fed funds rate to our estimate of the equilibrium fed funds rate, because recessions have only occurred when the fed funds rate has exceeded our estimate of the equilibrium rate (Chart 3). Chart 1The Yield Curve Has Been Reliable, Albeit Early The Yield Curve Has Been Reliable, Albeit Early The Yield Curve Has Been Reliable, Albeit Early Chart 2LEI Has Been Timelier LEI Has Been Timelier LEI Has Been Timelier Table 2LEI Contractions, 1968 - 2018 Keep Calm And Carry On Keep Calm And Carry On   The cycle is extended, and the inverted curve has made us even more alert for trouble in the economy and financial markets, but we do not think trouble is imminent. The LEI is clearly decelerating, but it has yet to contract. We currently peg the equilibrium fed funds rate at about 3⅛%, and project that it will rise to 3⅜% by the end of the year. We can’t know the equilibrium rate with exact precision in real time, but our estimate has been a reliable guide to financial market performance, and the fact that the fed funds rate is four 25-basis-point hikes from crossing the line gives us some comfort that neither a recession nor a bear market is waiting just around the corner. Chart 3Recessions Only Occur When Policy Is Tight Recessions Only Occur When Policy Is Tight Recessions Only Occur When Policy Is Tight Bottom Line: We are not dismissing the inverted yield curve, but our other recession-indicator inputs are not confirming its warning. Given the Fed’s new guidance, we expect that the next recession will not arrive before mid-to-late 2020. It’s A Little Bit Anomalous This Time At its best, an inverted yield curve is a signal from the bond market that the Fed has tightened monetary policy too much, heralding future rate cuts and a sharp slowdown. Anything affecting yields at the long end, however, has the potential to skew the curve’s signal. If long yields were somehow inflated, the curve would be less prone to invert and the signal would be delayed. If long yields were restrained, the curve would be prone to invert sooner and the signal might come especially early. Rate hikes invert the curve once the bond market decides they’re unnecessary, or expects that they’re going to be reversed soon. We believe that the yield curve currently has a bias to invert even earlier than it otherwise would. The question of how much the Fed’s asset purchases have affected the term premium,2 if at all, is far from settled within either the Fed or BCA, and is beyond the scope of this report. Nonetheless, we do think that QE1, QE2, and QE3 must have made some contribution to the decline in the term premium on long-term bonds (Chart 4). The bottom line is that we think the curve was disposed to invert earlier this time around. Its signal is still worth incorporating into our analysis, but we will seek confirmation from our other recession indicators before revamping our asset-allocation recommendations in line with an approaching inflection point in the business cycle. Chart 4The Curve Inverts More Easily When The Term Premium Is Negative The Curve Inverts More Easily When The Term Premium Is Negative The Curve Inverts More Easily When The Term Premium Is Negative The Fed And The Yield Curve We subscribe to the idea that the Fed induces recessions by removing monetary accommodation in an attempt to keep the economy from overheating. It’s simply too difficult to achieve a soft landing with policy tools that influence activity indirectly and with long and variable lags, given that the dual-mandate metrics are themselves lagging indicators. Compared to the path by which the Fed influences the economy, the path by which it inverts the curve is simple and straightforward. It raises short rates, and the long end rises as well, as the bond market discounts higher inflation and/or stronger growth, until investors no longer believe that inflation or growth prospects merit tighter policy, and long rates fall behind short rates. We reviewed moves in 10-year yields and 3-month rates across the different phases of the fed funds rate cycle (Chart 5) to see how the process has unfolded empirically. As the mechanics of yield curve inversion imply – short rates rise, long rates rise less or fall – the curve bear flattens when the Fed hikes the fed funds rate, and bull steepens when it cuts it (Table 3). The outcome fits the intuition: if the Fed’s attempt to slow the economy with higher short rates is successful, real interest rates will decline, inflation pressure will ease and bond yields should fail to keep pace with bill rates, especially if investors associate tightening campaigns with recessions. Conversely, if the Fed successfully boosts the economy with lower short rates, bond yields should fall less than short rates as the real component of rates rises, and the curve should steepen. Chart 5 Table 3The Yield Curve And The Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Depicting our stylized fed funds rate as a bell curve makes for an appealing picture, but it obscures the fact that the Fed often pauses for a while after hiking rates to their cyclical peak, or cutting them to their cyclical trough. Phase II doesn’t end until the beginning of the next rate-cutting campaign, and Phase IV doesn’t end until the beginning of the next series of rate hikes. A stricter representation of the fed funds rate cycle would have two phases of active hiking, followed by a state of limbo between the last hike and the first cut, then two phases of active cutting, followed by a lull during which the Fed waits for signs that it should remove accommodation. The expanded fed funds rate cycle is therefore composed of active hiking in Phase I and Phase II(a), pre-easing in Phase II(b), active easing in Phase III and Phase IV(a), and pre-hiking in Phase IV(b). Table 4 shows the average monthly changes in the yield curve and its components in the expanded fed funds rate cycle. There is quite a difference between Phase II(a), when the curve aggressively bear flattens, and Phase II(b), when the curve modestly bull flattens. Phase IV(a) features a sharp bull steepening, while the long end drifts higher in Phase IV(b) and short rates barely budge. Ultimately, the real action happens when the Fed is actively adjusting monetary policy, and the duration positioning implications are quite sensitive to the transitions into and out of the active phases. Table 4The Yield Curve And The Expanded Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Bonds And The Fed Funds Rate Cycle An inverted yield curve has provided a reliable early-warning signal about recessions, but it can be too early to drive asset-allocation decisions for a manager judged on relative returns. The curve moves in Tables 3 and 4 offer more timely implications for duration positioning within fixed-income portfolios across the fed funds rate cycle. It comes as no surprise that Treasuries perform better when the Fed is cutting rates (Phases III and IV) than they do when the Fed is hiking them (Phases I and II). Their returns should be inversely correlated with the direction of rates, and longer-maturity instruments should exhibit greater sensitivity to changes in the fed funds rate (Table 5). Table 5Treasuries And The Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Overweight duration within bond portfolios from when the Fed stops hiking rates until it stops cutting them; underweight duration when it’s actively hiking. Expanding the fed funds rate cycle to account for active hiking, active easing, and the pre-hiking/pre-cutting limbo periods makes the duration-positioning road map clearer. Treasuries lose ground in real terms when the Fed is actively hiking, with longer-maturity instruments bearing the brunt (Table 6). They deliver in a big way when the Fed is actively easing (Phase III and Phase IV(a)), with the Barclays Bloomberg Long Treasury Index posting double-digit annualized total returns. Longer Treasuries shoot out the lights once the Fed stops hiking (Phase II (b)), and they generate real total returns that compare favorably with bull-market equities when aggregating Phase II(b)’s pre-easing results with active-easing Phases III and IV(a). Table 6Treasuries And The Expanded Fed Funds Rate Cycle Keep Calm And Carry On Keep Calm And Carry On Our terminal and equilibrium fed funds rate estimates are admittedly far from the consensus. Markets are skeptical of the FOMC’s one-more-hike projection, much less our three, four, or more terminal-rate call. With “secular stagnation” searches ascendant on Google Trends (as of Friday morning, the partially complete March 24-30 period already had the most searches of any week over the last twelve months), our equilibrium estimate is also surely out of step with the herd. If the Fed is not done, however, history says it’s not yet time to overweight duration. If we’re right, Treasuries still have the full Phase II(a) ahead of them, and won’t be a buy until the Fed desists, sometime in 2020 or beyond. Investment Implications We have taken note of the inverted yield curve, but we will not overreact to it. While it has been a reliable recession indicator for the last half-century, it consistently sounds the alarm too early to merit immediate investment action. Neither the LEI nor our equilibrium fed funds rate model has yet corroborated its warning, and the bombed-out term premium may have biased it to inverting even sooner than it otherwise would. There’s no need for Paul Revere to ready his horse just yet. We did not anticipate that the 10-year Treasury yield would decline as much as it has. The extent of the Fed’s dovishness caught us off guard, and the 10-year Treasury is having a very hard time escaping the gravity of the decline in major-economy sovereign yields around the world. Our Global Fixed Income Strategy service (GFIS) points out that the global yield decline has become extended (Chart 6), and it contends that global bond prices incorporate too much pessimism about global economic momentum. The GFIS team also notes that there’s no guarantee stock prices will fall to align with bond yields – over the last couple years, stocks and bonds have recoupled following yield scares via bond, not equity, sell-offs (Chart 7). Chart 6Enough Is Enough Enough Is Enough Enough Is Enough Chart 7Equities Have Been Smarter Than Bonds The Last Few Years Equities Have Been Smarter Than Bonds The Last Few Years Equities Have Been Smarter Than Bonds The Last Few Years We therefore remain constructive on the economy and financial markets, and advise that balanced portfolios should still maintain exposure to riskier assets. Much of that view depends on Chinese authorities relaxing their deleveraging campaign, global trade tensions easing, and some hint of green shoots appearing in the rest of the world. If those elements of our base-case scenario fail to materialize, we will likely become more cautious. We are not happy that the vindication of our high-conviction view on the terminal fed funds rate has been indefinitely delayed, but the silver lining of the Fed’s dovish surprise is that the bull market in equities and other risk assets has been granted an open-ended extension.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Special Report, “How Much Longer Can The Bull Market Last?,” published August 13, 2018. Available at usis.bcaresearch.com. 2 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument.

Highlights We are asked nearly everywhere we go about the Fed’s independence, … : The Fed’s independence is an especially popular topic overseas, and it typically takes some persuasion to bring clients around to our view that it’s not at risk. … and Jay Powell shed some light on how the Fed intends to protect it: Since Bernanke, the Fed has fought back against criticism by attempting to open a window on its operations, and showing how they benefit all Americans. Powell’s Stanford speech and 60 Minutes appearance continued the transparency and charm offensive. The housing debate remains unresolved, but year-to-date activity has supported our sanguine outlook: Demand came back smartly following the decline in mortgage rates, and there is still no sign of overheating or oversupply on the horizon. Coincident indicators have a place, too: We do not include the three-month moving average of the unemployment rate in our recession indicator because it’s only a coincident indicator, but it does help to validate the leading indicators we follow. Feature BCA was established on our founder’s insight that tracking money flows through the banking system informs the future direction of the economy and financial markets. Monetary policy is of the utmost importance to BCA as a firm, and the fed funds rate cycle is a pillar of our U.S. Investment Strategy asset-allocation framework. That said, spending time parsing Fed speeches can be unavailing and tedious. Although we continually monitor comments from the Fed governors and regional bank presidents, we don’t often write about them. Since last summer, when the President first began expressing his displeasure with the Fed 140 characters at a time, we have been inundated with questions about the Fed’s independence, especially from overseas clients. We have noted repeatedly that conflicts between the White House and the Fed are nothing new. They are largely inevitable, and highlight the importance of insulating central banks from political pressure. A recent television interview and speech by Fed Chair Powell illustrated how the Fed hopes to safeguard its independence. The speech also sketched out some of the arguments supporting a potential re-interpretation of the Fed’s price stability mandate. If the Fed really were to pursue some sort of price-level targeting, the implications could be profound. TRIGGER ALERT: The following sections may promote cardiac distress among Austrian School devotees and other hard-money types. An Open, Friendly Fed Fed Chair Jerome Powell sat for an extended interview with venerable U.S. television news magazine 60 Minutes, broadcast in prime time Sunday March 10th. His comments carried no new information for Fed watchers, but appearances on 60 Minutes are not intended for Fed watchers, any more than Janet Yellen’s stop to watch community college students welding on her first official trip as Chair was. Powell appeared briefly alongside Yellen and Ben Bernanke in the 60 Minutes segment, and his appearance followed his predecessors’ public-relations game plan closely: defend the Fed’s independence, and explain the Fed’s role in managing the economy, so as to dispel some of the mystery about its mission and modus operandi. It was Bernanke who first sat for 60 Minutes, in 2009 and 2010, attempting to broadcast the Fed’s aims to the general public. Yellen extended the public outreach, as we noted in these pages five years ago, following her debut appearance:1 Not only did she make her first major outside appearance at a community development conference, she placed the plight of three locals grappling with unemployment and/or underemployment at the center of her remarks. She dined at a community-college training restaurant on the night before the speech, and went to another community college after delivering it, where she visited a shop floor and watched students weld. One could easily have mistaken her for a candidate for public office, given the photo ops and her dogged efforts to drive home the message that the labor market heads the Fed’s list of concerns. A New Take On Price Stability Powell’s 60 Minutes interviewer occasionally went out of his way to express skepticism about the Fed and its pre-crisis performance. A voiceover pointed to Powell’s academic record and Wall Street experience as signs of privilege, rather than evidence of aptitude or acumen. As Powell noted in a speech at Stanford University two days before the 60 Minutes interview aired, the current climate is one of “intense scrutiny and declining trust in public institutions” globally. Outwardly welcoming the scrutiny, and seeking to shore up the public’s trust, the Fed plans to hold a series of town-hall-style “Fed Listens” events around the country. The post-crisis Fed has tried to protect its independence by becoming more transparent. The Fed’s listening tour will be a part of its year-long review of monetary policy strategy, tools and communication practices, but we were most interested in Powell’s comments on strategy as it relates to the Fed’s price-stability mandate. Concerned that the secular decline in rates will regularly make the zero lower bound a binding policy constraint, the Fed is exploring the potential for some sort of price-level-targeting strategy. As a part of its review, it is asking, “Can the Federal Reserve best meet its statutory objectives with its existing monetary policy strategy, or should it consider strategies that aim to reverse past misses of the inflation objective?” When targeting the inflation rate, the Fed hasn’t much sweated inflation undershoots. Price-level targeting would represent a significant change from managing to the 2% annual inflation target on a non-cumulative basis. As shown in Chart 1, the Fed has executed its price-stability mandate by aiming for 2% annual inflation, as measured by the headline PCE price index. In theory, each year-over-year change is an independent event, considered without regard to prior overshoots or undershoots. The post-crisis shortfalls have no explicit bearing on the price-stability goal going forward, though perhaps they have made the Fed a little more inclined to wait until it sees the whites of inflation’s eyes before it removes accommodation in earnest. Chart 1Traditional Policy Has Been Directed At Keeping Prices From Rising Too Fast ... Traditional Policy Has Been Directed At Keeping Prices From Rising Too Fast ... Traditional Policy Has Been Directed At Keeping Prices From Rising Too Fast ... A price-level-targeting framework, on the other hand, would take its cues directly from past overshoots and undershoots. Whereas the Fed simply aimed at 2% every year in the old regime, under price-level targeting, it would be attempting to stay in continual contact with the 2% trend-growth line in Chart 2. Had price-level targeting been in place since the crisis began, the cumulative misses from 2008 on would eventually have to be made up. If the price-level target were to be reached by the end of this year, 2019 inflation would have to be 8.1%; by the end of next year, annualized inflation would have to be 5%; in five years, 3.2%; and in ten years, 2.6% (Table 1). Chart 2... Price-Level Targeting Seeks To Ensure They've Risen Enough ... Price-Level Targeting Seeks To Ensure They've Risen Enough ... Price-Level Targeting Seeks To Ensure They've Risen Enough Table 1Price-Level Targeting Kinder, Gentler Central Banking Kinder, Gentler Central Banking Higher inflation rates would presumably push Treasury bond volatility higher (Chart 3, top panel), along with the term premium (Chart 3, bottom panel). The increased uncertainty inherent in hitting a moving target would also help stoke interest-rate volatility, which would ripple out into the rest of financial markets. The Fed wouldn’t deliberately pursue a policy that stokes volatility unless it delivers other significant benefits. By boosting inflation expectations, price-level targeting could help stave off a deflationary mindset like the one that has crippled Japan since the bursting of its bubble three decades ago. More immediately, it could help combat the secular stagnation effects Larry Summers has been warning about for the last several years by making it easier for the Fed to reduce real rates. Chart 3Lower Inflation Has Helped Tamp Down Treasury Volatility And The Term Premium Lower Inflation Has Helped Tamp Down Treasury Volatility And The Term Premium Lower Inflation Has Helped Tamp Down Treasury Volatility And The Term Premium There is no sign that a change in the Fed’s monetary policy strategy, as it relates to price stability, is coming. The Fed performs a great deal of research and develops hypothetical game plans for a wide range of hypothetical economic outcomes. Discussions about price-level targeting are only conceptual for now, and the Fed will not necessarily adopt it. If price-level targeting were to become mainstream policy, it might better equip central banks with a tool for counteracting disinflationary impulses and could turn out to be marginally equity-friendly and bond-unfriendly. If it were to shift to a price-level-targeting framework, the Fed would be equally concerned about undershoots and overshoots. Housing Update We were unperturbed by the softness in the U.S. housing market when we published our housing Special Reports late last year. Three months into 2019, the data have supported our view, and we remain confident that the housing market does not represent the leading edge of an imminent downturn. We expect price-level targeting would increase financial-market volatility, at least when it’s first implemented. We highlighted in those Special Reports2 that the share of residential investment as a percentage of GDP has been steadily decreasing over the past 70 years, and is down to just 3% today. Although housing remains an important component of the U.S. economy and large fluctuations in the space will surely impact other segments of the economy, it is unlikely to exert a powerful drag. Home values also comprise a sizable portion of households’ net worth, and a decline in house prices will affect consumption patterns, but investors probably exaggerate the impacts. Housing now accounts for less than 15% of household equity – well below its 1980s and 2006 peaks – whereas pension entitlements and direct and indirect equity holdings account for 25% each. The rate at which mortgage rates change can exert a powerful impact on home sales and residential construction activity. 2018’s soft housing data was likely the byproduct of the yearlong rise in mortgage rates. Home sales and construction tend to decline in the six-month period after mortgage rates rise (Chart 4). Although higher mortgage rates took a toll on housing affordability last year, it remained at comfortable levels relative to history, and has already regained a good bit of ground now that the 30-year mortgage rate has declined by half a percentage point since its November peak. Mortgage applications have duly picked up since the end of last year. Chart 4Mortgage Rates Hurt Housing Last Year, But Are Poised To Help It This Year Mortgage Rates Hurt Housing Last Year, But Are Poised To Help It This Year Mortgage Rates Hurt Housing Last Year, But Are Poised To Help It This Year Most importantly for the overall economy, there is no evidence of construction excess. In contrast to the decade preceding the crisis, there is still plenty of room for new supply as housing starts still lag the pace of new household formations. New-home inventories have increased, but only back to their pre-housing boom range, and they amount to no more than a fraction of existing-home inventories, which are bumping around 30-year lows (Chart 5). The aggregate supply of homes for sale is not at all a matter for concern. Chart 5Housing Inventory Levels Are Low Housing Inventory Levels Are Low Housing Inventory Levels Are Low Bottom Line: The outlook for the housing market has improved since the end of the year. Homes remain affordable relative to history, and the aggregate inventory of homes for sale is the lowest it’s been since the mid-‘90s. The housing market still looks okay to us. Unemployment Is A Coincident Indicator We received a question from a client following last week’s review of our bond-upgrade and equity-downgrade checklists. Why do we include the three-month moving average of the unemployment rate in the equity checklist, but not our recession indicator? The simple answer is that the recession indicator is meant to be forward-looking.3 The unemployment measure has a sterling track record of coinciding with recessions, but it does not lead them (Chart 6). Chart 6A Coincident Indicator A Coincident Indicator A Coincident Indicator The three components of our recession indicator – an inverted yield curve, year-over-year contraction in the Leading Economic Indicator (LEI), and an above-equilibrium fed funds rate – have all consistently preceded recessions (Table 2). When combined into a single indicator, they’ve done so an average of just over six months before the onset of recessions, in line with the S&P 500’s average peak. The unemployment rate has been a coincident indicator, sending its signal an average of just under a month after recessions begin (Table 3). Table 2Lead Times For Indicator Components And Bear Markets Kinder, Gentler Central Banking Kinder, Gentler Central Banking Table 3Unemployment And Postwar Recessions Kinder, Gentler Central Banking Kinder, Gentler Central Banking The unemployment rate’s three-month moving average has a perfect record of coinciding with recessions, but indicators have to lead to be included in our recession alarm system. Tacking on an extra month to account for the lag in the data release, the unemployment rate alerts an investor to a recession two months after it’s begun. That’s too late to help sidestep the brunt of the S&P 500’s bear-market declines, so we leave it out of our recession indicator. Unemployment’s recession signal is nonetheless a good bit more timely than the NBER’s official recession declaration, which has come an average of eight months after the start of the last five recessions. The three-month moving average of the unemployment rate provides reliable confirmation that recessions have begun, and that has earned it a place in our equity checklist. Doug Peta, CFA   Chief U.S. Investment Strategist dougp@bcaresearch.com Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com Footnotes 1      Please see the April 7, 2014 U.S. Investment Strategy Weekly Report, “Fed To America: We Care.” Available at usis.bcaresearch.com. 2      Please see the November 19, 2018 and December 3, 2018 U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar.” Available at usis.bcaresearch.com. 3      Please see the August 13, 2018 U.S. Investment Strategy Special Report, “How Much Longer Can the Bull Market Last?” Available at usis.bcaresearch.com.

Highlights Global equities will remain rangebound for the next month or so, but should move decisively higher as economic green shoots emerge in the spring. A revival in global growth will cause the recent rally in the U.S. dollar to stall out and reverse direction, setting the stage for a period of dollar weakness that could last until the second half of next year. Rising inflation will force the Fed to turn considerably more hawkish in late-2020 or early-2021. This will cause the dollar to surge once more. The combination of a stronger dollar and higher interest rates will trigger a recession in the U.S. in 2021, which will spread to the rest of the world. Investors should maintain a bullish stance towards global equities for the next 12 months, but look to reduce exposure at some point next year. Feature Stocks Temporarily Stuck In The Choppy Trading Range We argued at the end of February that global equities and other risk assets would likely enter a choppy trading range in March as investors nervously awaited the economic data to improve.1 Recent market action has been consistent with this thesis, with the MSCI All-Country World Index falling nearly 3% at the start of the month, only to recoup its losses over the past few days. We expect stocks to remain in a holding pattern over the coming weeks, as investors look for more evidence that global growth is bottoming out. The U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 1). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. This makes the U.S. a low-beta play on global growth (Chart 2). As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. Chart 1The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 2The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth The U.S. Is A Low-Beta Play On Global Growth Given the dollar’s countercyclical nature, it is not surprising that the slowdown in global growth over the past 12 months has given the greenback a lift. The broad trade-weighted dollar has strengthened by almost 8% since February 2018, putting it near the top of its post 2015-range (Chart 3). Chart 3The Dollar Has Gotten A Lift From Global Growth Disappointments The Dollar Has Gotten A Lift From Global Growth Disappointments The Dollar Has Gotten A Lift From Global Growth Disappointments Stocks Will Rally And The Dollar Will Weaken Starting In The Spring We expect the U.S. dollar to strengthen over the coming weeks as global economic data continues to underwhelm. However, an improvement in leading economic indicators in the spring will set the stage for a reacceleration in global growth and a decline in the dollar in the second half of this year. The combination of stronger growth and a weaker dollar later this year should be highly supportive of global equities. Equity investors with a 12-month horizon should overlook any near-term weakness and maintain a bullish bias towards stocks. We do not have a strong view on U.S. versus international equities at the moment, but expect to upgrade the latter once we see more confirmatory evidence that global growth is bottoming out. Equity investors with a 12-month horizon should overlook any near-term weakness and maintain a bullish bias towards stocks.   A Stronger China Will Lead To A Weaker Dollar Our expectation that the dollar will weaken in the second half of this year hinges on what happens to China. The deceleration in global growth in 2018 was largely the consequence of China’s deleveraging campaign. China’s slowdown led to a falloff in capital spending throughout the world. Weaker Chinese growth also put downward pressure on the yuan, pulling other EM currencies lower with it (Chart 4). All this occurred alongside an escalation in trade tensions, further dampening business sentiment. Chart 4EM Currencies Are Off Their Early 2018 Highs EM Currencies Are Off Their Early 2018 Highs EM Currencies Are Off Their Early 2018 Highs While it is too early to signal the all-clear on the trade front, the news of late has been encouraging. A recent Bloomberg story described how Trump watched approvingly as Asian stocks rose and U.S. futures rallied following his decision to delay the scheduled increase in tariffs on Chinese goods.2 As a self-professed master negotiator, Trump needs to secure a deal with China before next year‘s presidential election, while also convincing American voters that the deal was concluded on favorable terms for the United States. Reaching a deal with China early on in his term would have been risky if the agreement had failed to bring down the bilateral trade deficit — an entirely likely outcome given how pro-cyclical U.S. fiscal policy currently is.  At this point, however, Trump can crow about making a great deal with China while reassuring voters that the product of his brilliance will be realized after he has been re-elected. This means that we are entering a window over the next 12 months where Trump will want to strike a deal. For their part, the Chinese want as much negotiating leverage with the Trump administration as they can muster. This means being able to convincingly demonstrate that their economy is strong enough to handle the repercussions from turning down a trade deal that fails to serve their interests. Since the credit cycle is the dominant driver of Chinese growth, this requires putting the deleveraging campaign on the backburner. Admittedly, credit growth surprised on the downside in February. However, this followed January’s strong showing. Averaging out the two months, credit growth appears to be stabilizing on a year-over-year basis. Conceptually, it is the change in credit growth that correlates with GDP growth.3 Thus, merely going from last year’s pattern of falling credit growth to stable credit growth would still imply a positive credit impulse and hence, an uptick in GDP growth. In practice, we suspect that the Chinese authorities will prefer that credit growth not only stabilize but increase modestly. In the past, this outcome has transpired whenever credit growth has fallen towards nominal GDP growth (Chart 5). The prospect of a rebound in credit growth in March was hinted at by the PBOC, which spun the weak February data as being caused by “seasonal factors.” Chart 5Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Historically, China Has Scaled Back On Deleveraging When Credit Growth Has Fallen Close To Nominal GDP Growth Europe: Down But Not Out Stronger growth in China will help European exporters. Euro area domestic demand will also benefit from a rebound in German automobile production, the winding down of the “yellow vest” protests in France, and incrementally easier fiscal policy. In addition, the ECB’s new TLTRO facility should support credit formation, particularly in Italy where the banks remain heavily reliant on ECB funding. Our expectation that the dollar will weaken in the second half of this year hinges on what happens to China. Euro area financial conditions have eased significantly over the past three months, which bodes well for growth in the remainder of the year. It is encouraging that the composite euro area PMI has rebounded to a three-month high. The expectations component of the euro area confidence index has also moved up relative to the current situation component, which suggests further upside for the PMI in the coming months (Chart 6). Chart 6Easing Financial Conditions Bode Well For Euro Area Growth Easing Financial Conditions Bode Well For Euro Area Growth Easing Financial Conditions Bode Well For Euro Area Growth The selloff in EUR/USD since last March has been largely driven by a decline in euro area interest rate expectations (Chart 7). If euro area growth accelerates in the back half of the year, the market will probably price back in a few rate hikes in 2020 and beyond. Chart 7EUR/USD Sell-Off Has Been Driven By Falling European Rate Expectations EUR/USD Sell-Off Has Been Driven By Falling European Rate Expectations EUR/USD Sell-Off Has Been Driven By Falling European Rate Expectations What Will The Fed Do? Of course, the degree to which a steeper Eonia curve benefits EUR/USD will depend on what the Fed does. The 24-month discounter has fallen from over +100 bps in March 2018 to -25 bps today, implying that investors now believe that U.S. short rates will fall over the next two years (Chart 8). Chart 8The Fed's Dovish Messaging Has Worked... Almost Too Well The Fed's Dovish Messaging Has Worked... Almost Too Well The Fed's Dovish Messaging Has Worked... Almost Too Well We expect the Fed to raise rates more than what is currently priced into the curve, thus justifying a short duration position in fixed-income portfolios. However, the Fed’s newfound “baby step” philosophy will probably translate into only two hikes over the next 12 months. Such a gradual pace of Fed rate hikes is unlikely to prevent the euro from appreciating against the dollar starting in the middle of this year, especially in the context of a resurgent global economy. We do not expect any major inflationary pressures to emerge in the near term. In contrast to the euro, the yen should depreciate against the dollar in the back half of this year. The yen is a “risk-off” currency and thus tends to weaken whenever global risk assets rally (Chart 9). The government is also about to raise the sales tax again in October, a completely unnecessary step that will only hurt domestic demand and force the Bank of Japan to prolong its yield curve control regime. We would go long EUR/JPY on any break below 123. Chart 9The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency The Yen Is A Risk-Off Currency A Blow-Off Rally In The Dollar Starting In Late-2020 What could really light a fire under the dollar is if the Fed began raising rates aggressively while the global economy was slowing down. In what twisted parallel universe could that happen? The answer is this one, provided that inflation rose to a level that evoked panic at the Fed. We do not expect any major inflationary pressures to emerge in the near term. The growth in unit labor costs leads core inflation by about 12 months (Chart 10). Thanks to a cyclical pickup in productivity growth, unit labor cost inflation has been trending lower since mid-2018. However, as we enter late-2020, if the labor market has tightened further by then, wage growth will likely pull well ahead of productivity growth, causing inflation to accelerate. Chart 10Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being All things equal, higher inflation is bearish for a currency because it implies a loss in purchasing power relative to other monies. However, if higher inflation spurs a central bank to hike policy rates by more than inflation has risen – thus implying an increase in real rates – the currency will tend to strengthen. Chart 11 shows the “rational expectations” response of a currency to a scenario where inflation suddenly and unexpectedly rises by one percent relative to partner countries and stays at this higher level for five years while nominal rates rise by two percent. The currency initially appreciates by 5%, but then falls by 2% every year, eventually finishing down 5% from where it started.4 Chart 11 The yen should depreciate against the dollar in the back half of this year. The real world is much messier of course, but we suspect that the dollar will stage a final blow-off rally late next year or in early-2021 (Chart 12). Since the Fed will be hiking rates in a stagflationary environment at that time, global growth will weaken, further boosting the dollar. The resulting tightening in both U.S. and global financial conditions will likely trigger a global recession and a bear market in stocks. Investors should maintain a bullish stance towards global equities for the next 12 months, but look to reduce exposure at some point next year. Chart 12   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Gretzky’s Doctrine,” dated March 1, 2019. 2      Jennifer Jacobs and Saleha Mohsin, “Trump Pushes China Trade Deal to Boost Markets as 2020 Heats Up,” Bloomberg, March 6, 2019. 3      Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. 4      The 2% annual decline in the currency is necessary for the real interest parity condition to be satisfied. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Image Tactical Trades Strategic Recommendations Closed Trades

Highlights Duration: With rate hikes more likely than cuts over the next 12 months, it makes sense to maintain below-benchmark duration in U.S. bond portfolios. However, timing the next up-move in Treasury yields is difficult. We recommend that investors initiate positive carry yield curve trades to boost returns while we wait for Treasury yields to bottom alongside the CRB/Gold ratio. Corporates: The Fed’s pause is leading to improvement in our global growth indicators. The end result is a window where corporate spreads will tighten during the next few months. Remain overweight corporate bonds, but be prepared to downgrade when spreads reach our targets. CMBS: We upgrade our allocation to non-agency CMBS from underweight to neutral, due to elevated spreads relative to other Aaa-rated sectors. While spreads are currently attractive, the macro back-drop is also fairly bleak. If spreads tighten to more reasonable levels or CMBS delinquencies start to rise we will be quick to downgrade. Feature Green Shoots For Global Growth Since 1994 the Global (ex. U.S.) Leading Economic Indicator (LEI) has contracted relative to its 12-month trend six times. In all six episodes it eventually dragged the U.S. LEI down with it (Chart 1). As we predicted last August, the U.S. economy cannot remain an oasis of prosperity when the rest of the world is in turmoil.1 However, to focus on the weakening U.S. data right now is to miss the bigger picture. Chart 1U.S. Follows The Rest Of The World U.S. Follows The Rest Of The World U.S. Follows The Rest Of The World Corporate bond spreads already reacted to the global slowdown by widening near the end of last year. Then, the Federal Reserve reacted to tighter financial conditions by signaling a pause in its rate hike cycle. We took that opportunity to turn more bullish on spread product, and now, there are budding signs of improvement in the global growth outlook. While the Global LEI (including the U.S.) remains in a downtrend, our Global LEI Diffusion Index is well off its lows (Chart 2). Historically, the Diffusion Index has a good track record leading changes in the overall indicator. Chart 2Global LEI Diffusion Index Is Back Above 50% Global LEI Diffusion Index Is Back Above 50% Global LEI Diffusion Index Is Back Above 50% Similarly, the timeliest indicators of global growth that called the early-2016 peak in credit spreads are starting to improve (Chart 3). The CRB Raw Industrials index is breaking out, the BCA Market-Based China Growth Indicator has recovered and Global Industrial Mining Stock prices are heading up. Chart 3Global Growth Checklist Global Growth Checklist Global Growth Checklist All told, it appears that the Fed’s pause and related dollar weakness, along with less restrictive fiscal and monetary policies in China, are starting to pay dividends.2 The end result is a window where leading global growth indicators will improve and financial conditions will ease. We recommend that investors maintain an overweight allocation to corporate bonds during this supportive window, though we also note that the continued rapid pace of corporate re-leveraging is a cause for concern. We will be quick to downgrade our recommended allocation to corporate bonds when our near-term spread targets are hit. Our spread target for Aa-rated corporates is 57 bps, the current spread level is 61 bps. Our spread target for A-rated corporates is 85 bps, the current spread level is 92 bps. Our spread target for Baa-rated corporates is 128 bps, the current spread level is 159 bps. Our spread target for Ba-rated corporates is 188 bps, the current spread level is 243 bps. Our spread target for B-rated corporates is 297 bps, the current spread level is 400 bps. Our spread target for Caa-rated corporates is 573 bps, the current spread level is 827 bps. We recommend avoiding Aaa-rated corporate bonds, which already look expensive. We explore the universe of Aaa-rated spread product in more detail below. Implications For Treasury Yields The Fed’s pause and the nascent improvement in global growth are both obvious positives for corporate spreads. The impact on Treasury yields is somewhat less obvious. We contend that once financial conditions ease sufficiently, the market will start to price-in further Fed rate hikes and this will pressure Treasury yields higher at both the short and long ends of the curve. The ratio between the CRB Raw Industrials index and the gold price can help clarify this concept. Chart 4 shows that the 10-year Treasury yield tends to rise when the CRB index outpaces gold, and vice-versa. The rationale for this correlation is that the CRB index is a proxy for global growth and gold is a proxy for the stance of monetary policy. Chart 4Timing The Next Treasury Sell-Off Timing The Next Treasury Sell-Off Timing The Next Treasury Sell-Off A rising gold price suggests that monetary policy is becoming increasingly accommodative. This eventually leads to an improvement in global growth and a rising CRB index. But Treasury yields do not rise alongside the CRB index. They only increase once the improvement in global growth is sufficient for the market to discount a tighter monetary policy. That moment occurs when the CRB index rises more quickly than the gold price. The bottom line is that with rate hikes more likely that cuts over the next 12 months it makes sense to maintain below-benchmark duration in U.S. bond portfolios. However, timing the next up-move in Treasury yields is difficult. We recommend that investors initiate positive carry yield curve trades to boost returns while we wait for Treasury yields to bottom alongside the CRB/Gold ratio.3 Checking In On The Labor Market Based on the number of emails we’ve received on the topic, the last two U.S. employment reports have stoked some confusion among investors. This is not surprising given the volatility in the headline numbers: Nonfarm payrolls increased +311k in January and only +20k in February. The U3 unemployment rate jumped to 4% in January, then fell back to 3.8% in February. The U6 unemployment rate jumped to 8.1% in January, then fell back to 7.3% in February. Much of the volatility is likely explained by data collection issues related to the partial government shutdown, which makes it useful to look through the noise and focus on a few important trends. Trend #1: Slow Growth In Q1 The employment data clearly point to a U.S. growth slowdown in the first quarter of 2019. Real GDP growth can be proxied by looking at the sum of the growth rate in aggregate hours worked and the growth rate in labor force productivity (Chart 5). The recent steep decline in hours worked suggests that first quarter growth is going to be weak. Chart 5Employment Data Point To Slow Growth In Q1 Employment Data Point To Slow Growth In Q1 Employment Data Point To Slow Growth In Q1 But as was noted in the first section of this report, weak Q1 GDP is the result of the global growth slowdown dragging the U.S. lower. Crucially, the market has already discounted this eventuality and the budding improvement in leading global growth indicators suggests that the U.S. slowdown will prove temporary. Trend #2: No More Slack A broad set of indicators now all point to the fact that the U.S. economy is at full employment (Chart 6). The implication is that we should expect wage growth to accelerate and payroll growth to decelerate as we move deeper into the cycle. Chart 6At Full Employment At Full Employment At Full Employment Some investors may retain the belief that a rising labor force participation rate will keep wage growth capped, but even here the prospects are dim. The participation rate for people of prime working age (25-54) has risen rapidly during the past few years, but that has only led to a small bounce in overall participation (Chart 7). This is because the aging of the population has pushed more and more people out of that prime working age demographic bucket. Chart 7Labor Force Participation Labor Force Participation Labor Force Participation The dashed line in the top panel of Chart 7 shows where the labor force participation rate would be, based on current demographics, if the participation rate for each narrow age cohort reverted to its July 2007 level. The message is that the scope for a further increase in labor force participation is limited. Trend #3: No Recession Risk Yet The full employment state of accelerating wage growth and decelerating employment growth can last for some time before a recession hits. In our research we have noted that, from a financial markets perspective, one of the best leading indicators is the change in initial jobless claims. Typically, a bottom in initial jobless claims coincides with an inflection point in Treasury excess returns (Chart 8). Chart 8Jobless Claims Have Called Troughs In Treasury Returns Jobless Claims Have Called Troughs In Treasury Returns Jobless Claims Have Called Troughs In Treasury Returns Initial jobless claims have risen somewhat during the past few weeks, and while this trend is worth monitoring, it is premature to flag it as a concern. The 4-week moving average in claims has already fallen back to 226k from a recent high of 236k, and next week an elevated print of 239k will roll out of the 4-week average. Any initial claims print below 239k next week will cause the 4-week average to decline further. Bottom Line: The U.S. labor market has reached full employment. Going forward we should expect a continued acceleration in wage growth and deceleration in payroll growth. This situation can persist without causing a recession until initial jobless claims start to head higher. We see no evidence of this as of yet. Aaa-Rated Spread Products In this week’s report we consider the risk/reward trade-off on offer from the major Aaa-rated spread products. Specifically, we consider corporate bonds, agency and non-agency CMBS, conventional 30-year residential MBS and consumer ABS (both credit cards and auto loans). Focusing purely on expected returns, we find that non-agency CMBS offer the highest option-adjusted spread of 73 bps. This is followed by 65 bps from corporates, 50 bps from Agency CMBS, 41 bps from MBS, 35 bps from auto ABS and 31 bps from credit card ABS. But this is just one side of the equation. Chart 9 shows each sector’s spread relative to the likelihood that it will experience losses versus Treasuries. To measure the risk of losses we use our measure of Months-To-Breakeven. This is defined as the number of months of average spread widening that each sector requires before it starts to lose money relative to a duration-matched position in Treasury securities. Essentially, the Months-To-Breakeven measure is each sector’s 12-month breakeven spread adjusted by its spread volatility since 2014. We only calculate spread volatility since 2014 because that it is when data for Agency CMBS start. Chart 9 Chart 9 shows that while Aaa corporate bonds offer elevated expected returns compared to the other sectors, they also offer a commensurate increase in risk. Similarly, consumer ABS offer lower expected returns than the other sectors but with considerably less risk. According to Chart 9, the only sector that offers an attractive risk/reward trade-off is non-agency CMBS. This warrants further investigation. Looking at spreads throughout history, we see that non-agency CMBS spreads also look relatively attractive. While Aaa-rated consumer ABS spreads are near all-time lows, non-agency CMBS spreads are still not quite one standard deviation below the pre-crisis mean (Chart 10). Chart 10CMBS Spreads Have Room To Narrow CMBS Spreads Have Room To Narrow CMBS Spreads Have Room To Narrow We noted in last week’s report that consumer ABS look even worse when we incorporate the macro environment.4 All-time tight ABS spreads currently coincide with tightening consumer lending standards and a rising consumer credit delinquency rate. This is why we downgraded consumer ABS from neutral to underweight last week. The macro environment for CMBS is also fairly bleak (Chart 11). Commercial real estate lending standards are tightening, loan demand is waning and prices are decelerating. The one saving grace is that, so far, this has not translated into a rising CMBS delinquency rate (Chart 11, bottom panel). It is probably only a matter of time before CMBS delinquencies start to trend higher, but with spreads so attractive relative to the investment alternatives, the sector warrants better than an underweight allocation. Chart 11Delinquencies Biased Higher? Delinquencies Biased Higher? Delinquencies Biased Higher? Bottom Line: We upgrade our allocation to non-agency CMBS from underweight to neutral. Spreads are currently attractive relative to other Aaa-rated sectors, but we will keep a close eye on the evolving macro backdrop. If spreads tighten to more reasonable levels or if CMBS delinquencies start to rise, we will be quick to downgrade.   Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity”, dated August 21, 2018, available at usbs.bcaresearch.com 2 For further details on recent shifts in Chinese policy please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com 3 For more details on the attractiveness of positive carry yield curve trades please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights All the U.S. data look broadly similar to us, …: The data series are decelerating, one by one, but they generally remain at a fairly high level relative to history. … and we have begun sounding like a broken record in our morning meetings, … : “There’s no doubt that [insert data series name here] is slowing, but it’s still nowhere close to heralding a recession. As a matter of fact, it remains at a level consistent with above-trend growth. That’s what we should expect given the pattern of fiscal thrust across last year and this year, combined with still-accommodative monetary policy.” … so we’re revisiting our checklists to see if we should change our bearish rates and bullish equities views: We periodically review our checklists, which we rolled out in the fall, to assess whether or not our positioning rationale still applies. Our recommendations may still be the same, but at least we put them to the test: The business cycle, the inflation outlook, the Fed’s reaction function, the corporate profit outlook, and valuations have not changed enough to dictate changing our views. We continually seek out evidence that we’re getting it wrong, but we haven’t found any in the current data. Feature We have become a bit self-conscious about offering our take on the latest U.S. economic data releases at BCA’s daily morning meetings. It’s one thing to be out of step with the prevailing view, or to offer a novel theory that fails to achieve much traction in the room. (Strategists who don’t get shot down by their peers every once in a while aren’t pushing the conventional wisdom enough.) It’s quite another to keep recycling the same narrative, and we’re at something of a loss for a way to maintain our colleagues’ interest. Beep. You’ve reached the voicemail box of the U.S. Investment Strategy team. We believe today’s (insert series name here) release indicates that while the U.S. economy is decelerating, it continues to be on a path to grow at, if not above, trend in 2019. This is consistent with the 60-basis-point decline in fiscal thrust from 2018 to 2019. That decline is large enough to ensure deceleration in 2019, but the 40 bps that’s still going to be deployed this year is also sufficient to ensure that the economy will be able to grow above its 2% trend rate, provided the rest of the world does not fall apart. Thank you for your call, and please do not hesitate to call again if we can be of any further assistance. Beep. We created our bond upgrade and equity downgrade checklists last fall to help guard against sticking with our views beyond their sell-by date. Both checklists have a negative bias, in that they’re meant to help reveal the points at which the underpinnings of our views no longer apply. The bond checklist is broadly geared to identifying either, one, the presence of slack in the economy that might call for easier policy, or, two, a convergence of the fixed-income markets’ views with ours that would limit the potential payoff from maintaining below-benchmark duration positioning.1 Our equity downgrade checklist looks out for signs of an approaching recession, pressure on corporate earnings, inflation pressures that might inspire the Fed to remove accommodation in a hurry, or signs of euphoria that can’t be sustained.2 Reviewing the data series that comprise the checklists did not lead us to change our views. The exercise does help us adhere to a process, however, and we think they help keep us from falling into an analytical rut. We will revisit them with increasing frequency as the cycles we’re trying to track approach their inflection points, while keeping an eye out for any new indicators that might broaden their insights. Is A Bearish Rates View Still Appropriate? The first section of our bond checklist (Table 1) focuses on market perceptions of the Fed. Following our U.S. Bond Strategy service’s golden rule, if the Fed hikes more than it is expected to hike, long-duration positions will underperform. If it hikes less than expected, long-duration positions will outperform. As implied by the overnight index swap (OIS) curves, the money market now expects that the fed funds rate has peaked at 2.5%, and that a rate cut will likely bring it down to 2.25% by the end of 2020 (Chart 1). Table 1Bond Upgrade Checklist Status Quo Status Quo Chart 1Markets Are Pricing In A Rate Cut Markets Are Pricing In A Rate Cut Markets Are Pricing In A Rate Cut We beg to differ. With little to no slack remaining in the economy as a whole (the output gap is closed), and unemployment well below its natural level and poised to fall further, we think inflation pressures are percolating below the surface. Once they begin to reveal themselves, we expect the Fed will have no choice but to resume its tightening campaign. Our estimate of the equilibrium rate (3% now, rising to about 3⅜% by year-end) appears to be well above the financial markets’ estimate, and we therefore believe the Fed has plenty of room to hike without capsizing the economy. An inverted yield curve has historically been a reliable sign that the Fed has gone too far in its efforts to prevent overheating, and we are watching it now for hints that the fed funds rate may be done rising. Though the curve flattened considerably as the 10-year Treasury yield plunged in the fourth quarter (Chart 2), we think it’s very unlikely to invert while the Fed is on hold. An on-hold Fed implies that the 3-month bill rate will remain in the mid-to-high 2.40s and that the 10-year Treasury yield would have to dip below 2.5% for the curve to invert. Such an outcome would be completely incompatible with below-target inflation and above-trend economic growth. Chart 2The Yield Curve Has Flattened, But Inversion Is A Stretch The Yield Curve Has Flattened, But Inversion Is A Stretch The Yield Curve Has Flattened, But Inversion Is A Stretch Inflation is not yet an issue on most investors’ radar screens because it has been conspicuously missing in action around the developed world for the last ten years. In the U.S., headline measures rolled over upon oil’s slide, masking the fact that the core measures are hovering around 2% and remain in uptrends (Chart 3). Inflation break-evens have plunged, and are well below the 2.3-2.5% level that is consistent with the Fed’s 2% inflation target, but their decline was nearly entirely a function of the decline in oil prices (Chart 4). Our Commodity & Energy Strategy service is calling for higher crude prices across the rest of this year, so even though we’ve checked the break-evens box, we expect we’ll be unchecking it as the break-evens reverse in step with oil. Chart 3Headline Inflation's Decline ... Headline Inflation's Decline ... Headline Inflation's Decline ... Chart 4... Is An Oil Story ... Is An Oil Story ... Is An Oil Story The labor market remains quite tight. Although the unemployment rate ticked up in December and January, it came down again in February and remains below the estimated natural rate of unemployment where upward wage pressures typically begin to take hold (Chart 5, top panel). Unemployment ticked higher in December and January, despite robust job gains, because the share of working-age Americans participating in the labor force rose. The exodus of the baby boomers from the work force will make it very difficult for the participation rate to keep rising, however (Chart 5, middle panel), and the elevated level of workers quitting their jobs (Chart 5, bottom panel) indicates that employers are poaching workers from one another, driving wages higher. Chart 5The Labor Market Is Tight And Getting Tighter The Labor Market Is Tight And Getting Tighter The Labor Market Is Tight And Getting Tighter Instability is a double-edged sword as it relates to monetary policy. The Fed is likely to return to hiking rates if it believes it can cut off rising instability before it goes too far. If instability is far enough advanced that it threatens the economy, however, the Fed may well ease policy to try to counteract it. For now, it appears to us that the key cyclical segments of the economy are on track to keep warming up, but are nowhere near overheating (Chart 6). We are not overly concerned about the frisky lending climate that Governor Brainard called out in September, but ongoing anecdotal reports of bond-market froth will presumably keep the Fed alert to the need to dial back accommodation. Acutely bad conditions elsewhere in the global economy would make the Fed consider rate cuts, but if the rest of the world perks up by mid-year, in line with BCA’s base case, the Fed will feel less urgency to indemnify the U.S. against foreign distress. Chart 6Cyclical Segments Are Warming Up Cyclical Segments Are Warming Up Cyclical Segments Are Warming Up Should We Still Be Constructive On Equities? Every box in our equity downgrade checklist remains unchecked, starting with our silent recession alarms (Table 2). The yield curve has not inverted, and as we noted in the review of our rates checklist, we do not believe it will while the Fed remains on hold. Growth has come off the boil, but the LEI is not close to contracting on a year-over-year basis (Chart 7). The fed funds rate remains below our estimate of equilibrium, as we expect it will for the rest of the year, and the three-month moving average of the unemployment rate has not risen by a third of a percentage point from its current cyclical bottom. Table 2Equity Downgrade Checklist Status Quo Status Quo Chart 7The LEI May Be Decelerating, But It's Still A Ways From Contracting The LEI May Be Decelerating, But It's Still A Ways From Contracting The LEI May Be Decelerating, But It's Still A Ways From Contracting Labor market tightness will eventually manifest itself in higher wages, which will squeeze corporate profit margins, but until real wage gains begin to outstrip productivity growth (i.e., until labor starts capturing a bigger piece of the pie), corporate earnings will not be at risk (Chart 8). The dollar has spent the last several months going sideways, and BBB corporate yields are now below their level when we rolled out the equity checklist in mid-October (Chart 9). The savings rate has backed up to near the top of its six-year range, and we would check the box if it were to break out of it (Chart 10). There have been no blowups in EM or anywhere in the rest of the world that cast a shadow over U.S. corporate earnings. Chart 8Wage Growth Doesn't Cut Into Profits Until It Outstrips Productivity And Inflation Wage Growth Doesn't Cut Into Profits Until It Outstrips Productivity And Inflation Wage Growth Doesn't Cut Into Profits Until It Outstrips Productivity And Inflation Chart 9Round Trip Round Trip Round Trip Chart 10The Savings Rate Has Risen, But Not Enough To Check The Box The Savings Rate Has Risen, But Not Enough To Check The Box The Savings Rate Has Risen, But Not Enough To Check The Box As noted in our bond checklist comments, above, core inflation measures have dipped below 2% but remain in an uptrend. Both headline CPI and the inflation break-evens relapsed with oil prices, but we expect that a crude recovery will help restore inflation expectations. Bull markets tend to end amid a general feeling of euphoria, and we therefore continue to keep an eye out for signs of over-exuberance. Valuations are elevated but hardly extreme, and we don’t see anecdotal indications of widespread silliness, or suspension of disbelief. Investment Implications From our perspective, overheating in the U.S. remains a very real possibility. Since that is a distinctly minority view, the potential reward for underweighting Treasuries and holding all bond exposures below benchmark duration is alluring. We reiterate our recommendations that investors underweight Treasuries and maintain below-benchmark-duration across their fixed-income portfolios. We expect we will continue to do so until the U.S. economy weakens, or the Treasury curve begins to price in some of our bearish rates view. We reiterate our cyclical recommendation to overweight equities despite the tactical caution we expressed last week.3 We simply expect that the S&P 500 will have to consolidate some of its rapid year-to-date gains before moving on to an eventual new cycle high at 3,000 or above. Stocks don’t go straight up, even if they did for nearly all of January and February, and it is reasonable to expect elevated volatility in the latter stages of a bull market. We thought that the 2,800 level might provide some technical resistance, offering tactically oriented sellers an attractive point to reduce equity exposures, while tactically oriented buyers were likely to find better entry points going forward.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?,” published September 17, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Investment Strategy Weekly Report, “Introducing Our Equity Downgrade Checklist,” published October 15, 2018. Available at usis.bcaresearch.com. 3 Please see the U.S. Investment Strategy Weekly Report, “How Much Do U.S. Equities Have Left?,” published March 4, 2019. Available at usis.bcaresearch.com.