Fixed Income

Highlights Dovish Central Banks: Central bankers have successfully talked down bond yields, in an effort to prevent an even deeper pullback in global growth. Government bonds now look overvalued relative to likely outcomes on growth and inflation over the next year. A moderate below-benchmark medium-term duration exposure is warranted on a risk/reward basis, as the next large yield move from current levels is more likely up than down. U.S. Treasuries: The Fed is now signaling no more rate hikes for the rest of 2019, but this newly dovish language merely brings their own interest rate forecasts closer to current market pricing. Lower bond yields and easier financial conditions will help underwrite a recovery in U.S. growth, just as a stabilization of the global economy is starting to materialize. The current downturn in Treasury yields, which is looking technically stretched, should soon begin to bottom out. Feature Another Panic Hits Global Bond Markets The message from central banks to the financial markets is now very loud and clear – global monetary policy is firmly on hold for at least the rest of 2019. Fears over slowing global growth, persistent geopolitical uncertainty and underwhelming inflation have put policymakers on a more cautious footing. The messaging from central banks has become highly synchronized, with even the same buzz words (“patience”, “uncertainty”, “data dependent”) being bandied about in speeches and policy statements. Bond yields have responded to the dovish forward guidance in recent weeks from the Fed, the European Central Bank, the Bank of England, the Bank of Japan and others. Our “Major Countries” measure of 10-year government bond yields in the largest developed economies has fallen to 1.3%, the lowest level since May 2017. The 10-year U.S. Treasury yield now sits at 2.40%, below the fed funds rate and triggering investor angst over the traditionally negative economic message of an inverted yield curve. Global equity markets, however, seem less concerned. The MSCI World Equity Index is only 5% from the 2018 highs after rallying 16% so far from the late 2018 low. This gap between robust equity prices and depressed bond yields is unusual, but not unprecedented. Similar divergences have occurred as recently as 2016 and 2017 (Chart of the Week). During those episodes, central banks responded to uncertainty (the July 2016 Brexit vote followed by currency volatility in China) or sluggish inflation readings (the unexpected 2017 dip in U.S. core inflation) by shifting to an easier monetary stance. This was largely done through delayed interest rate hikes or more dovish forward guidance, with the result being lower bond yields, diminished market volatility and easier financial conditions. Better global growth and more stable inflation expectations soon followed. Chart of the WeekWill Bonds Lose This Battle Once Again? With tentative signs emerging that global growth momentum is bottoming out, the next major move in global bond yields is likely up. Those prior gaps between low bond yields and high stock prices were eventually resolved through higher yields – an outcome that we think will be repeated in the current episode. Already, bond markets have aggressively repriced expectations of future monetary policy with even some rate cuts now discounted in the U.S., Canada and Australia. With tentative signs emerging that global growth momentum will soon bottom out and recover in the latter half of 2019 (Chart 2), the next major move in global bond yields is likely up, not down. Chart 2Global Bond Yields Are Too Pessimistically Priced The decline in yields over the past few months has obviously challenged our recommended strategic below-benchmark global duration stance. The two primary factors that drive our medium-term duration calls on any country can be summed up by the following questions: Do we expect greater or fewer rate hikes than are discounted in money market curves? Do we expect bond yields to rise above or below the current pricing in forward yield curves? In aggregate, we do not expect the major central banks to deliver more monetary easing than is currently priced according to our 12-month discounters, although we think that is most likely in the U.S. where the market is pricing in -21bps of cuts over the next year. Also, the 12-month-ahead forwards for 10-year bond yields in the U.S. (2.51%), Canada (1.69%), Germany (0.13%), Japan (0.02%), U.K. (1.16%) and Australia (1.82%) are not particularly high. Although, once again, we have the greatest confidence that those yield levels will be surpassed in the U.S. The timetable to generate a positive payoff by positioning for higher yields has been stretched out by the renewed dovishness of central banks. By switching their focus from tight labor markets and accelerating wage growth to slowing economies and softening inflation expectations, policymakers are creating a backdrop of lower volatility and more market-friendly stock/bond correlations (Chart 3). Chart 3Stock/Bond Yield Correlation Negative Once Again The goal is to underwrite additional rallies in risk assets to ease financial conditions and stimulate economic activity. This will eventually sow the seeds for a return to a more hawkish bias, but the timing of that switch is uncertain and will most likely coincide with some evidence of faster Chinese economic growth and an end to the downturn in global trade activity – an outcome that is unlikely to occur until the latter half of 2019. Bottom Line: Central bankers have successfully talked down bond yields, in an effort to prevent an even deeper pullback in global growth. Government bonds now look overvalued relative to likely outcomes on growth and inflation over the next year. A moderate below-benchmark medium-term duration exposure is warranted on a risk/reward basis, as the next large yield move from current levels is more likely up than down. The Fed’s more dovish forward guidance only brought the Fed’s rate forecasts down closer to current market pricing. U.S. Treasury Yields Should Soon Bottom Out U.S. Treasury yields moved sharply lower following last week’s Fed meeting, as the FOMC delivered a dovish surprise with its new set of interest rate projections. As of last December, 11 out of 17 Fed members expected to lift rates at least twice in 2019. Now, 11 out of 17 expect to keep rates flat. This was enough to lower the median “dot” by 50bps for 2019, essentially forecasting an unchanged funds rate this year with only one hike expected in 2020. While these are significant dovish changes to the Fed’s forward guidance, it only brought the Fed’s forecasts down to current market pricing on interest rate expectations (Chart 4). Yet bond yields fell sharply in response, tipping the Treasury curve into inversion. The cautious language from Fed Chairman Powell in the post-meeting press conference, which included a reference to Japan-style deflation risks as a threat if the Fed ignored the message from below-target U.S. inflation expectations, likely helped fuel the bullishness of Treasury market participants. Chart 4Fed Is Just Catching Up To Market Pricing It seems clear that the arguments of the more dovish members of the FOMC (John Williams, Richard Clarida, James Bullard, Neil Kashkari) have won over the more pragmatic members of the committee, including Jay Powell. Yet our own Fed Monitor is still not suggesting that rate cuts are necessary (Chart 5), although the growth component of the Monitor is tracking the last downturn seen in 2014/15. More importantly, the inflation elements of the Monitor are not pointing to a need for easier policy, while financial conditions are still in the “tighter money required” zone. Chart 5Markets Pricing In Fed Easing That Is Not Required The Fed is likely to ignore the risks to financial stability stemming from the new dovish slant to its monetary policy, as financial conditions have not yet fully unwound the tightening seen in the risk asset selloff in late 2018. Does that mean that the Fed wants to see U.S. equities hit new highs and U.S. corporate credit spreads return to previous lows? If that means a deeper U.S. economic slowdown can be avoided, the answer is most likely “yes”. They can always return to targeting overvalued asset markets if and when the U.S. and global economy is on more stable footing. In terms of the U.S. economic outlook, we think the current concerns over the recession risks stemming from an inverted Treasury curve are overstated. In a Special Report we published last July, we looked at the relationship between monetary policy, yield curves and economic growth and came to the following conclusions:1 Curve inversion, on a sustained basis, occurs when the Fed lifts the real (inflation-adjusted) funds rate above the neutral rate of interest, “r-star” (Chart 6); Chart 6Too Soon For Sustained U.S. Treasury Curve Inversion Once the Treasury yield curve does invert on a sustained basis, a recession starts seventeen months later, on average; Curve inversion, on a sustained basis, occurs when the Fed lifts the real funds rate above the neutral rate of interest, “r-star” At the moment, the Fed has paused its rate hiking cycle with a real funds rate that is just shy of the Williams-Laubach estimate of r-star, which is 0.5%. Considering that the “Williams” in “Williams-Laubach” is the current president of the New York Fed and Number Two on the FOMC, we should not be surprised that the Fed chose to pause now! The more important point is that it seems too early to look for a classic late-cycle Treasury curve inversion with the Fed on hold – unless, of course, U.S. inflation falls and pushes the real fed funds rate above r-star. That would require a much sharper slowing of U.S. growth to a below-potential pace that is not indicated by current data. Reliable cyclical indicators like the ISM Manufacturing index have fallen from the heady 2018 peaks, but remain at levels consistent at least trend U.S. economic growth (Chart 7). Additionally, the Conference Board’s leading economic indicator, as well as our own models for U.S. employment and capital spending growth, are suggesting that only some cooling of U.S. growth should be expected in the next few quarters (Chart 8), but not to a below-potential pace (i.e. significantly less than 2%). Chart 7UST Yields Should Soon Stabilize Chart 8A Big U.S. Slowdown In 2019 Is Unlikely So how much lower can Treasury yields go in this current rally? Looking at the individual valuation components of yields, the answer is “not much”. The real component of Treasury yields has already fallen sharply since the 2018 peak, and is now approaching 2017 resistance levels. At the same time, 10-year inflation expectations are drifting higher and are now around 25bps below the highs seen in 2018 (Chart 9). At best, we can see real yields and inflation expectations fully offsetting each other and keeping yields unchanged. The more likely outcome, however, is that inflation expectations continue to move higher while real yields stabilize as the U.S. economy moves away from the Q1 growth slowdown, meaning that we are close to the floor in yields now. Chart 9Inflation Expectations Will Lead UST Yields Higher How much lower can Treasury yields go in this current rally? Looking at the individual valuation components of yields, the answer is “not much”. The current downturn in Treasury yields is already looking stretched from a technical perspective (Chart 10). The 26-week total return of the Bloomberg Barclays U.S. Treasury index is now approaching the highs seen during all previous Treasury rallies since the Fed ended its QE program in 2014. The same signal comes from the size of the deviation of the 10-year Treasury yield below its 200-day moving average. Duration positioning is quite long, as well, according to the J.P. Morgan client survey. Chart 10UST Rally Looking Stretched In The Near-Term Not all the technical indicators are as stretched, as the Market Vane Treasury sentiment survey remains depressed and net speculative positioning on 10-year Treasury futures is only neutral (after a very large short position was covered). On balance, however, the indicators suggest that the current Treasury rally is looking over-extended. One other factor to consider is global growth. Much of the current decline in Treasury yields is a result of the prolonged weakness in non-U.S. growth that has pulled down all global bond yields. Yet according to the latest readings from cyclical indicators like the ZEW survey, expectations of future economic growth are now bottoming out, even as current growth continues to slow (Chart 11). This bodes well for a potential bottoming of global growth momentum that could put a floor underneath bond yields. Chart 11Early Signs Of Growth Stabilization? One final note – any signs of stabilization of European growth could also help global bond yields find a floor. Not only are the ZEW surveys in Europe starting to bottom out, the widely-followed German IFO survey is also starting to show modest improvement. If these trends continue, that would help end the drag on global yields from weakening European growth which has pulled German Bunds back to the 0% level (Chart 12). Chart 12Bunds & JGBs Have Been A Drag On Global Yields Any signs of stabilization in European growth could also help global bond yields find a floor. Bottom Line: The Fed is now signaling no more rate hikes for the rest of 2019, but this newly dovish language merely brings their own interest rate forecasts closer to current market pricing. Lower bond yields and easier financial conditions will help underwrite a recovery in U.S. growth, just as a stabilization of the global economy is starting to materialize. The current downturn in Treasury yields, which is looking technically stretched, should soon begin to bottom out. 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 31st, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Corporate sector selling price inflation is nil while leading wage inflation indicators signal additional labor cost increases in the coming months. The risk is that profit margins have already peaked for the cycle. We reiterate our tactically cautious overall equity market view. Galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A all signal that it still pays to be bullish software stocks Recent Changes Last Thursday we downgraded the S&P railroads index to underweight. Also last Thursday we trimmed the S&P air freight & logistics index to neutral. Table 1 Feature The SPX stalled last week, digesting the now-complete Fed pivot. Our sense is that the Fed’s dovish turn is now fully reflected in equities. Importantly, the longer and wider the dichotomy between stocks and bonds gets, the more painful the ramifications from the eventual snap will be, likely with equities yielding to the bond market (Chart 1). As we first posited on March 4, short-term equity market caution is still warranted.1 Chart 1Time To Get Back Together While the Fed meeting and sharp decline in Treasury yields dominated headlines last week, it was the NFIB’s latest release that really caught our attention. Importantly, it revealed that taxes and big government are no longer the biggest problems facing small and medium business owners, but labor is: “Twenty-two percent of owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem, only 3 points below the record high. Ten percent of owners find labor costs as their biggest problem, a record high for the 45-year survey.”2 Historically, such extreme tightness in the SME labor market is a precursor of a yield curve inversion (NFIB cost of labor shown inverted, Chart 2). The link is clearer if we show this same NFIB series with the Labor Department’s average hourly earnings monthly release that is currently running at a 3.4%/annum clip (Chart 3). In other words, a tight labor market is conducive to corporations bidding up the price of labor which in turn causes the Fed to raise interest rates, eventually inverting the yield curve. Chart 2Cycle Is Long In The Tooth Chart 3Wage Growth... This macro backdrop is slightly unnerving and our biggest concern is the S&P 500’s profit margins (Chart 4). Q3/2018 marked the all-time peak in SPX quarterly margins according to Standard & Poor’s,3 and in Q4/2018 margins have deflated from a high mark of 12.13% to 10.11%, or a 16.7% q/q drop. Chart 4...Denting Margins Undoubtedly, last year’s fiscal easing-induced all-time highs in SPX margins is unsustainable, and a tight labor market is a warning shot. Using the same NFIB series on cost of labor being the most important problem SMEs face and subtracting it from our corporate pricing power proxy, we constructed an equity market margin proxy, shown as a Z-score in Chart 5. Historically, the y/y change in SPX profit margins move in lockstep with our margin proxy and the current message is grim (Chart 5). Chart 5Margin Trouble Ahead Before getting too bearish though, we want to make three salient points: First, while the NFIB survey’s labor related indicators are disconcerting, unit labor costs – the best measure of wage growth – remain muted as productivity growth has ramped up recently. Second, using empirical evidence dating back to the 1960s, the ultimate SPX profit margin mean reversion occurs during recessions, when EPS suffer a major setback. The implication is that margins can move sideways or grind lower in the coming year. As a reminder, BCA’s review remains that the U.S. will avoid recession in the next 12 months. Third, the most important yield curve slope, the 10/2, has not yet inverted, and even when it does invert, investors will have time to start positioning defensively; we have shown in recent research that the S&P peaks after the yield curve inverts.4 On a related note, we use this opportunity to update our corporate pricing power proxy, and Table 2 summarizes the sectorial results. Table 2Industry Group Pricing Power Corporate sector selling price inflation has ground to a halt at a time when wage inflation is rearing its ugly head. Worrisomely, our pricing power diffusion index’s breadth sunk below the 50% line, whereas our wage growth diffusion index spiked higher; 70% of the 44 industries we track are struggling with rising wages (second & third panels, Chart 6). Taken together, there is evidence that broad-based profit margin pressures are escalating, the mirror image of what our gauges were signaling in our last update late-last year.5 Chart 6Margins Have Likely Peaked Digging beneath the surface of our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. 57% of the industries we cover are lifting selling prices, but only 27% are raising prices at a faster clip than overall inflation. Both figures are lower than our early-November report. Outright deflating sectors increased by eight to twenty four since our last update, fifteen of which are deflating at 1%/annum pace or lower. One third of the industries we cover are experiencing a downtrend in selling price inflation, representing a 43% increase since our most recent report (Table 2). Deep cyclicals/commodity-related industries (ex-oil) continue to dominate the top ranks, occupying the top six slots (Table 2). Despite the ongoing global manufacturing deceleration and still unresolved U.S./China trade tussle, the commodity complex's ability to increase prices remains resilient. On the flip side, energy-related industries occupy the bottom of the ranks as WTI crude oil is still 22% lower than the most recent peak in October 2018. In sum, business sector selling price inflation is nil while leading wage inflation indicators signal additional labor cost increases in the coming months. The risk is that profit margins have already peaked for the cycle. We reiterate our tactically cautious overall equity market view. This week we update a high-conviction overweight tech subgroup and recap our transportation subsurface moves from last Thursday. Buy The Software Breakout Software stocks are on fire and leading profit indicators suggest that more gains are in store in the coming months. Last week, we published a table ranking all the sectors and subsectors by 12-month forward profit growth estimates (please refer to Table 2 from the March 18 Weekly Report). While the broad tech sector is on an even keel with the SPX, software EPS are racing at twice the speed of the broad market, roughly 14%. Keep in mind, when growth gets scarce, investors flock to industries with accelerating profit prospects. The software profit juggernaut is intact and we reiterate our high-conviction overweight recommendation. Sustained capital outlays on software are a key driver of industry profits (bottom panel, Chart 7). In an otherwise muted Q4 GDP release, rising non-residential fixed investment in general and surging investment in software in particular suggest that our bullish software capex thesis is alive and kicking (middle panel, Chart 7). Chart 7Software On A Tear 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 also in a structural uptrend. Not only private sector software capex is near all-time highs as a share of total outlays, but also government investment in software is reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments are taking such risks extremely seriously the world over (second panel, Chart 8). Chart 8Earnings Led Advance Meanwhile, fear of missing out has rekindled industry M&A and both the dollar amount and number of deals are sky high, with acquirers bidding up premia to the stratosphere (Chart 9). This supply reduction is bullish for industry pricing power. Chart 9M&A Frenzy Granted the M&A frenzy has pushed relative valuations on the expensive side especially on a forward P/E basis, but on EV/EBITDA software stocks are trading below the historical mean and still significantly lower than the late-1990s peak valuation (bottom panel, Chart 8). If our bullish software profit thesis continues to pan out, then software stocks will grow into their pricey valuations. Finally, shareholder friendly activities are ongoing in this key tech subsector and buybacks in particular provide an added layer of artificial EPS growth (bottom panel, Chart 9). Adding it up, galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A, all signal that it still pays to be bullish software stocks. Bottom Line: Buy the software breakout. The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ORCL, ADBE, CRM, INTU, ADSK, RHT, CDNS, SNPS, ANSS, SYMC, CTXS, FTNT. Tweaking Transport Subgroup Positioning The S&P transports index’s recovery rally has stalled recently and is a cause for concern for the overall market. In more detail, the recent gulf between relative share prices and the SPX has widened and warns that the overall market is at a risk of suffering a pullback (Chart 10). Chart 10Engine Trouble Thus on Thursday last week, we made two subsurface transport changes, downgrading a subgroup to underweight that commands lofty valuations at a time when leading profit indicators are flashing red, and also downgrading to neutral a globally exposed transport sub-index. Get Off The Rails In our downgrade of the S&P railroads index late last year to a benchmark allocation, we highlighted that two of our key industry Indicators, the Railroad Indicator and our Rail Shipment Diffusion Indicator, had turned negative.6 These indicators have continued to deteriorate, including total rail shipments which have now started to contract for the first time since the 2015-16 manufacturing recession (third panel, Chart 11). Intermodal shipments in particular have nosedived, likely a result of weak retail sales, as we highlighted earlier this month.7 Chart 11Downgrade Rails To... This contraction would be far less concerning were it not for the rapid degradation of industry balance sheets as firms have sought to increase relatively cheap leverage in order to retire equity. Railroads are now significantly more indebted than the broad market which itself has not shown an aversion to adding leverage (bottom panel, Chart 11). Such a change in railroad capital structure has kept EPS growth rates artificially high while simultaneously adding an extra measure of equity risk premium that does not yet appear fully reflected in relative share prices. Moreover, when we downgraded the S&P railroads index to neutral last year, deteriorating Indicators were offset by exceptionally healthy pricing power.8 After a multi-year expansion, selling price inflation has now rolled over (second panel, Chart 12), taking away the remaining pillar supporting a neutral view which compelled us to move to an underweight allocation last week. Chart 12...Underweight Pricing power is one of the key determinants in our earnings model that, when combined with the previously noted contracting volumes, is indicating the end to the industry’s above-trend earnings growth is nigh (third panel, Chart 12). With relative earnings growth slowing and rising leverage adding incremental risk, the S&P railroads index’s premium valuation multiple looks increasingly dicey (bottom panel, Chart 12). Bottom Line: Broad based declines in traffic volumes, falling pricing power and high leverage suggest that earnings will underwhelm. Accordingly, last Thursday we moved to an underweight recommendation on the S&P railroads index as we expect a de-rating phase to materialize. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Air Freight Had Its Wings Clipped We have been offside on the high-conviction overweight call on the S&P air freight & logistics index and the recent FedEx warning suggests that profits will come under pressure for this index for the rest of the year and will trail the SPX. As such, we trimmed exposure to neutral late-last week and removed it from the high-conviction overweight list for a loss of 14%. Chart 13 shows that all the profit drivers we had identified in early December last year have taken a sharp turn for the worse. Energy costs are no longer in deflation as oil prices have jumped from $42/bbl to near $60/bbl. Not only is global growth still decelerating, but also U.S. growth is in a softpatch: the manufacturing shipments-to-inventory ratio is on the verge of contraction, warning that delivery services’ selling prices are in for a turbulent ride (second panel, Chart 13). In addition, definitive news of Amazon becoming a formidable competitor in courier delivery services is structurally negative for the industry. Chart 13Air Freight: Move To The Sidelines Nevertheless, we refrain from turning outright bearish as air freight stocks are technically oversold and valuations are trading at the steepest discount to the broad market since mid-2002. Bottom Line: Last Thursday we downgraded the S&P air freight & logistics index to neutral and also removed it from the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 2https://www.nfib.com/assets/jobs0219hwwd.pdf 3https://ca.spindices.com/documents/additional-material/sp-500-eps-est.xlsx?force_download=true 4 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, “Recuperating” dated November 5, 2018, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. 7 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly“, dated March 4, 2019, available at uses.bcaresearch.com. 8 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Analysis on Turkey is published below. The key reason why we believe the ongoing EM rally will falter is that EM corporate earnings have begun to contract. When EPS growth turns negative, low interest rates typically do not prevent share prices from selling off. The recent pick-up in China’s credit and fiscal spending impulse suggests the bottom in EM corporate profit growth will only occur toward the end of 2019. There are several key differences between the economic backdrops and financial markets signposts between now and 2016. The current profiles of both EM and DM share prices are a close match to those in 2011-2012 when the strong rally in the first quarter was followed by a major selloff in the second quarter. Feature The common narrative in the market is that the current policy backdrop – a pause by the Fed and policy stimulus from China – is a repeat of early 2016. As such, market participants expect moves in global risk assets to be analogous to those during that period. We too could easily adopt this simple narrative, and recommend investors to chase EM higher. Instead, we have chosen to take on the very difficult task of expounding why 2019 is not a repeat of 2016 in EM and China-related financial markets. Based on this, our view remains that investors should not be chasing the current EM rally. The essential pillar of our negative thesis on EM is that their corporate profits will contract this year. This will be bad news not only for EM share prices but also for EM credit markets and currencies. Chart I-1 illustrates that during the past 10 years, EM stock prices plunged every time profit contraction commenced. Having rallied meaningfully in the past three months, EM financial markets will sell off as EM corporate earnings begin to shrink. Chart I-1EM EPS Is Beginning To Contract The basis for EM profit contraction is the continued slowdown in China. Chart I-2 illustrates that China’s credit and fiscal spending impulse leads EM EPS growth by about 12 months. Hence, the recent pick-up in the former entails the bottom in the latter only toward the end of 2019. Chart I-2EM EPS Growth Will Bottom Only Toward The End Of 2019 In brief, even assuming China’s credit and fiscal spending impulse has bottomed and will improve going forward, EM EPS contraction will deepen for now. EM share prices are unlikely to embark on a cyclical bull market until EM EPS growth bottoms. Earnings Versus Interest Rates Lower interest rates are typically bullish for both equity and credit markets so long as corporate profits do not contract. However, when EPS growth turns negative, low interest rates usually do not prevent share prices from selling off. In general, when discussing the effect of interest rates on equities, one should differentiate between economic and financial linkages. Given the cornerstone narrative of this EM rally has been declining U.S. interest rate expectations, we examine the nexus between EM risk assets and U.S. interest rates. The economic link refers to the impact of borrowing costs on aggregate spending, and hence corporate profits. The pertinent question is as follows: Was the Fed tightening responsible for the growth deceleration in EM/China in 2018? The short answer is not really. Chart I-3 illustrates that as of the end of February, while Korean, Taiwanese, Japanese and Singaporean exports to the U.S. expanded by 10% from a year ago, their shipments to China contracted by 10%. Chart I-3Global Trade Slowed Due To China Not The U.S Hence, the slowdown in EM corporate profits has not been caused by Fed policy. U.S. domestic demand in general and imports in particular have so far been expanding at a healthy pace and they have not been instrumental to EM corporate earnings cycles (Chart I-4). This signifies that lower U.S. interest rates should not have a material impact on EM growth, and thereby corporate profits. Chart I-4EM EPS Growth Has Not Been Driven By Sales To U.S. Notably, one can argue that the economic and financial market dynamics that prevailed in 2018 worked in the opposite direction: It was China’s slowdown that ultimately imperiled U.S. manufacturing growth, causing U.S. equity and credit markets to sell off, thereby forcing a reversal in the Fed’s stance. The financial link refers to a declining discount rate for EM risk assets as U.S. interest rates drop. A drop in the discount rate lifts the present value of future cash flows and boosts risk asset prices. However, EM equity multiples have not been historically negatively correlated with U.S. bond yields, as shown on the top panel of Chart I-5. Besides, EM credit spreads do not always positively correlate with U.S. borrowing costs, as widely expected (Chart I-5, middle panel). Chart I-5U.S. Bond Yields And EM: No Stable Relationship Further, EM currencies have not been negatively correlated with either U.S. bond yields or with the interest rate differential between the U.S. and EM (Chart I-5, bottom panel). As to EM local bond yields, especially in high-yielding markets, it is EM exchange rates that drive EM domestic bond yields and their differential over U.S. Treasurys. When EPS growth turns negative, low interest rates usually do not prevent share prices from selling off. Finally, Chart I-6 illustrates the relationship between the returns on EM assets on one hand and U.S. bond yields on the other. This chart corroborates the evidence from Chart I-5 – that the relationship between U.S. interest rates and EM asset markets is not stable. Chart I-6U.S. Bond Yields And EM Risk Assets: No Stable Relationship Even though in the short term financial markets in developing countries seem to react to changes in U.S. interest rates, in the medium and long run there is no stable relationship between EM risk assets and U.S. Treasury yields. In short, lower U.S. interest rate expectations is not a sufficient condition to be positive on EM risk assets. How do we explain the absence of a strong relationship between these financial and economic variables? Our take is as follows: When EPS growth turns negative, low interest rates typically do not prevent share prices and credit markets from selling off. That is why there is no clear and strong relationship between EM risk assets and U.S. interest rates. Was the Fed tightening responsible for the growth deceleration in EM/China in 2018? The short answer is not really. Corporate earnings are the key to sustaining this EM rally. What is needed for EM corporate profits to recover is a revival in Chinese demand. The latter is not yet imminent, implying that EM assets will likely hit an air pocket before a more durable bottom occurs. Are lower interest rates in China a justification for the latest EM equity rebound? Chart I-7 demonstrates that both EM and Chinese investable stock indexes positively correlate with interest rates in China. The reason is because all of them are driven by Chinese growth: When growth accelerates, these share prices and Chinese local bond yields rise, and vice versa. Chart I-7Chinese Interest Rates And EM / China Share Prices: Positive Correlation Bottom Line: Lower interest rates in the U.S. or in China in and of themselves do not constitute sufficient conditions for a cyclical rally in EM share prices. The primary driver of EM share prices in the past 10 years has been Chinese growth, because the latter has a considerable bearing on EM corporate profits. For now, there have been no substantive signs of a growth revival in China. How 2019 Is Different From 2016 We elaborated in detail on how the current round of policy stimulus in China differs from the one in 2015-‘16 in our report titled, Dissecting China’s Stimulus, and will not discuss it here. Instead, we offer several economic and financial signposts illustrating how the EM/China outlook and financial market dynamics in 2019 will differ from those of 2016: Presently, there is no meaningful policy stimulus for the real estate market in China, and property sales will continue to shrink (Chart I-8). This is the opposite of what occurred in 2015-‘16 when the Chinese central bank literally monetized excessive housing inventories by financing residential real estate via its Pledged Supplementary Lending (PSL) facility. The ensuing surge in property demand substantially contributed to the business cycle recovery on the mainland in 2016-‘17. Chart I-8A Downbeat Outlook For Chinese Housing EM share prices have been underperforming the DM equity index since late December. In contrast, EM began outperforming DM in January 2016 (Chart I-9). Chart I-9EM Equities Have Been Underperforming DM Ones Since Late December In early 2016, the pace of EM profit contraction stabilized after 18 months of deepening shrinkage (Chart I-1 on page 1). What’s more, investor sentiment on EM was very downbeat in early 2016. Presently, the EM profit contraction is just commencing, and its rate of change will bottom only in late 2019, as per Chart I-2 on page 2. In the meantime, investors are ill prepared for bad news, as their sentiment on EM is extremely buoyant. Finally, the broad trade-weighted U.S. dollar began selling off in early 2016, corroborating the EM rally. This year the broad measure of the trade-weighted dollar has not sold off. Hence, the dollar has not yet confirmed the EM rebound (Chart I-10). Chart I-10The U.S. Dollar And EM Share Prices Is 2019 Akin To 2012? In terms of share-price patterns, the current profiles of both EM and DM are a close match to those in 2011-2012 (Chart I-11). Following a major plunge in the second half of 2011, share prices bottomed in December 2011 and rallied sharply in the following three months. Not only is the duration similar to what transpired with share prices in 2011-’12, but also the magnitude (Chart I-11). Chart I-11Is 2018-19 Akin To 2011-12? As to the economic backdrop in 2011-‘12, the euro area was in the midst of a credit crisis and China/EM growth was slowing due to the preceding Chinese policy tightening. After the strong rally in January-March 2012, both EM and DM bourses sold off sharply in the second quarter of 2012, re-testing their late 2011 lows. Critically, like the present and unlike early 2016, EM stocks were underperforming DM ones during the early 2012 rally. Lower U.S. interest rate expectations is not a sufficient condition to be positive on EM risk assets. On the surface, it appears that the magic words of the European Central Bank President Mario Draghi that “…the ECB is ready to do whatever it takes to preserve the euro” that halted the global selloff. Yet, in reality, Draghi’s speech was the trigger for – not the cause of – the markets’ reversal. In retrospect, the primary reason for a major bottom in global risk assets in June 2012 was the bottom in the global business cycle in the second half of 2012 (Chart I-12, top panel). Chart I-12Global Growth Has Not Yet Bottomed As can be seen on this panel, global equity prices are often coincident with “soft” economic data like global manufacturing PMI. Global stocks typically lead “hard” economic data and corporate profits but do not always lead “soft” data. Presently, the bottom in global manufacturing and trade is not yet in sight. The bottom panel of Chart I-12 shows that Taiwanese exports of electronics products parts are still nose-diving, and they typically lead global manufacturing PMI by a few months. These electronics parts are inputs into final goods; when producers of these goods plan to increase production they first order these parts. As a result, trade in these electronics parts lead the broader trade/manufacturing cycle. Taiwanese exports of electronics products parts are still nose-diving, and they typically lead global manufacturing PMI by a few months. On the whole, odds are that China’s business cycle as well as global trade and manufacturing have not yet hit a durable bottom and are not about to recover. Countries/industries leveraged to China will experience a meaningful profit contraction. Hence, there is a significant probability that EM stocks re-test their recent lows akin to what transpired in 2012. Investment Considerations There is no meaningful evidence indicating that China’s business cycle and global trade and manufacturing have bottomed. Global cyclical equity sectors have rebounded but have not yet decisively broken above their 200-day moving averages (Chart I-13). Crucially, their relative performance to the overall global index has been rather sluggish (Chart I-14). This corroborates the lack of global growth tailwinds behind this global equity rally. Chart I-13Global Cyclical Equity Sectors: Absolute Performance Chart I-14Global Cyclical Equity Sectors: Relative Performance Asset allocators should continue to underweight EM stocks and credit markets within their global equity and credit portfolios, respectively. Without an improvement in the global business cycle, the rebound in EM currencies is not durable. As China’s growth disappoints, EM currencies will depreciate versus the dollar, the euro and the yen. Renewed currency depreciation will erode returns on EM local currency bonds for international investors. For dedicated EM local bond portfolios, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea (Chart I-15). Our underweights are South Africa, Indonesia, India and today we are downgrading Turkish local bonds to underweight (please refer to section on Turkey starting on the next page). Chart I-15Favor These Local Currency Bond Markets Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Turkey: Brewing Policy Reversal? The odds of a policy reversal in Turkey are rising. The government’s patience with tight monetary policy may be running thin. The nation’s GDP contracted by 3% in the final quarter of 2018 from a year ago. Further contraction is in the cards. Chart II-1 signifies that monetary policy is indeed tight: Lira-denominated bank loan growth is at zero, and in real (inflation-adjusted) terms bank lending has shrunk by about 18% from a year ago. The ongoing painful economic retrenchment (Chart II-2) and rising unemployment may lead the authorities to loosen monetary policy/liquidity conditions via “backdoor” liquidity easing – something the Turkish central bank has done often over the current decade. Specifically, the central bank’s liquidity provisions to the banking system will likely begin to rise (Chart II-3). The severe liquidity tightening, underway since October 2018 via reduced lending to banks, has been partially responsible for the stability in the exchange rate. As the central bank augments liquidity provisions to the banking system, the lira will again come under renewed selling pressure. Rising unemployment may lead the authorities to loosen monetary policy/liquidity conditions via “backdoor” liquidity easing. The goal of liquidity provisioning would be to bring down interbank rates and, ultimately, lending rates. Presently, the spread between commercial banks’ lending rates and the interbank rate is negative (Chart II-4, top panel). This is unsustainable. The authorities have forced banks to bring down their lending rates in recent months. As a result, the gap between banks’ lending and deposit rates has also narrowed considerably (Chart II-4, bottom panel). This will weigh on the banks’ profitability. Consequently, we are closing our tactical long Turkish banks / short EM banks trade. The government cannot force banks to reduce their lending rates further without reducing their cost of funding. Hence, the central bank might opt to inject excess reserves into the system to bring down interbank rates. Thereafter, the authorities could “guide” banks to further lower their lending rates. Policy easing might not be in the form of outright policy rate cuts to avoid a negative reaction from financial markets. Instead, the central bank could push down inter-bank rates by way of obscure liquidity injections into the banking system. To be sure, the odds of the currency reacting poorly to such loosening of liquidity are non-trivial. This, along with the ongoing recession, the shrinking bank net interest margins and the slow pace of bank loan restructuring, are leading us to downgrade the Turkish bourse that is heavy in bank stocks. Investment Recommendations Downgrade Turkish stocks and local currency bonds back to underweight. We closed our short/underweight positions in the Turkish currency, bonds and equities on August 15, 2018. For details, please see the report Turkey: Booking Profits On Shorts. This has proved to be a timely move as Turkish markets have rebounded notably and outperformed their EM peers (Chart II-5). In our opinion, it is now time to downgrade it again. ​​​​​​​ We are also closing our tactical long Turkish banks / short EM banks trade. This position has netted a modest 2.3% gain since its initiation on November 29, 2018. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Investors should use the following dynamic for tactical asset allocation: 1. Sum the 10-year yields on the T-bond, German bund, and JGB. 2. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. 3. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways. 4. When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities (Chart of the Week). 5. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds. Right now, with the sum near 3 percent, it is still appropriate to be overweight equities versus bonds, and our preferred expression is overweight the DAX versus the German long bund. Feature Chart of the WeekThe Rule Of 4 Becomes The Rule Of 3 The global long bond yield recently hit a two-year low (Chart I-2). This is the direct result of central banks’ pivot to dovish – a commitment to keep policy rates at current levels, rather than to hike, for the foreseeable future. Chart I-2The Global Long Bond Yield Recently Hit A Two-Year Low One consequence is that high-quality bonds have become riskier. Consider a German bund or a JGB which is yielding zero percent. The short-term potential for capital appreciation – nominal or real – has almost vanished, while the potential for vicious losses has increased dramatically. The technical term for this negative asymmetry is negative skew. Years of research in a field of behavioural economics called Prospect Theory concludes that negative skew is the metric that best encapsulates investment risk. The Correct Way Of Thinking About Investment Risk A great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional sense. After all, who minds when their asset price goes up sharply? Risky assets are risky because they have the propensity to experience much larger short-term losses than short-term gains – captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. High-quality bonds have become riskier. Another great misunderstanding of finance is the idea that bonds offer a diversification benefit and, therefore, that investors should accept a lower return from them. This argument is also flawed. The bond market is bigger than the equity market, and just as bonds are a diversifier for equity investments, equities are a diversifier for bond investments. Indeed, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump’s shock victory in 2016. So we could equally argue that equities offer a diversification benefit. In fact, the correct way of thinking about investment risk is as follows: An investment’s risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns (Chart I-3). This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher (Chart I-4). But when bond yields normalize, equities regain their excess riskiness versus bonds – and their valuations must suffer a phase transition sharply lower. The phase transition in equity valuations is most pronounced when the global 10-year bond yield goes up or down through 2 percent (Chart I-5). This dynamic proved to be the biggest driver of asset allocation in 2018, and is likely to be a big driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse. The unsurprising response from central banks is to pivot back to dovish, pulling back bond yields to previous lows. These lower bond yields then push up equity (and other risk-asset) valuations back to previous highs. An investment’s risk depends on the negative asymmetry of its short-term returns. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or decline further. But the longer-term danger is that these rich valuations are hyper-sensitive to rising bond yields. The Bubble In Everything The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets. Extraordinary monetary policy has boosted the valuations of all risk-assets across all geographies and all asset-classes. By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes – equities (Chart I-6), credit (Chart I-7), and real estate (Chart I-8). This makes it considerably more dangerous, because we estimate that the total value of global risk-assets including real estate is $400 trillion, equal to about five times the size of the global economy.1 Chart I-6Equities Remain Richly Valued Chart I-7Credit Remains Richly Valued Chart I-8The EM Real Estate Boom Happened After 2008 Let’s say you had a risk-asset that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today’s price must surge by 63 percent.2 If you were prudent, you might amortise today’s windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. The total value of global risk-assets equals five times the size of the global economy. Now let’s imagine a valuation derating moves the risk-asset’s returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The Rule Of 4 Becomes The Rule Of 3 How can we sense the crucial 2 percent level in the global 10-year bond yield? The answer is that it broadly equates to when the sum of the 10-year yields on the T-bond, German bund and JGB is at a 4 percent level (Chart I-9). This is the genesis of our very successful ‘Rule of 4’. In 2019, just as in 2018, investors should use the following dynamic for tactical asset allocation. The rule of 4 identifies when the global 10-year bond yield is at 2 percent. Chart I-9When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent  Sum the 10-year yields on the T-bond, German bund, and JGB. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways.  When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds (Chart I-10). Overweight equities versus bonds. With the sum of the three 10-year yields now near 3 percent, the rule of 4 has, in a sense, become the rule of 3. It is still appropriate to be tactically overweight equities versus bonds, and our preferred expression is to overweight the DAX versus the German long bund. Chart I-10Use The 65-Day Fractal Dimension To Pinpoint The Precise Transition Points Between Asset-Classes   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Trapped: Have Equities Trapped Bonds?”, September 13, 2018 available at eis.bcaresearch.com. 2 5 percent compounded over ten years.

Highlights Global Spread Product: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios. Feature Stick With A Tactical Overweight To Global Corporates We’ve dedicated our last few Weekly Reports to analyzing the outlook for government bond yields in the developed markets (DM), in light of the recent dovish shift in the policy stance of central banks. We concluded that yields had fully discounted a slower global growth backdrop, through lower inflation expectations and the pricing out of future interest rate hikes. Further declines in bond yields would require a deeper deceleration of activity than we are expecting, thus maintaining a below-benchmark medium-term duration stance is appropriate. That dovish shift by policymakers also took away a major roadblock for risk assets, namely the threat of a continued policy-induced rise in global yields at a time of slowing growth. The result has been sharp rallies in global equity and credit markets, with declining volatility (Chart of the Week). Chart of the WeekSlowing Growth Isn’t Always Bad For Risk Assets We upgraded global corporate debt, and downgraded global government bonds, on a tactical basis back on January 15 of this year.1 Since then, credit spreads have declined substantially across both DM and emerging markets (EM), most notably in Europe (Chart 2). Within our upgrade to overall global credit, we maintained a relative bias towards U.S. corporates versus non-U.S. equivalents, based on our expectation of relatively faster economic growth in the U.S. In our model bond portfolio, that meant moving U.S. corporates to an above-benchmark weighting, while reducing the size of the underweight in EM debt and only raising European credit to a neutral allocation. Looking at the performance of each of the major credit markets in excess return terms (versus duration-matched government bonds) since January 15, currency-hedged into U.S. dollars, there have not been huge differences between U.S. and non-U.S. returns. The exception is European high-yield which had an excess return of 4.4%, but only represents 0.8% of our custom benchmark index for our model portfolio (and where we are not underweight). Excess returns for investment grade and high-yield corporates in the U.S. have averaged 2.3%, compared to 2.2% for EM credit (averaging hard currency sovereign and corporate debt). We see the global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current overweight allocation to global corporates. With the benefit of hindsight, we know that the decision to upgrade overall global corporate debt versus government bonds has been far more important than adjusting any regional credit allocations. We see that global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current allocations to global corporates. Our cue to reverse our tactical overweight stance on corporates will come from the U.S. Any additional spread tightening and easing of overall financial conditions will keep U.S. economic growth above trend and eventually force the Fed to become more hawkish in the second half of 2019. This will turn global monetary policy from a tailwind for corporate credit to a headwind, justifying a downgrade of corporate allocations. In the meantime, we recommend continuing to earn carry in a policy-induced low volatility environment. Bottom Line: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Upgrade To Neutral Canadian government bonds have been clawing back much of the relative underperformance that occurred in 2017 and 2018 while the Bank of Canada (BoC) was delivering multiple rate hikes. The spread between the yields on the Bloomberg Barclays Canada Treasury index and the overall Global Treasury index has narrowed by -40bps since October 2018, after widening 69bps between May 2017 and October 2018 (Chart 3). Expressed as a relative return (duration-matched and currency-hedged into U.S. dollars), Canadian government debt has lagged the Global Treasury index by -232bps since May 2017. Chart 3Canadian Bonds No Longer Underperforming That underperformance was driven by the combination of a strong Canadian economy, accelerating inflation and tightening monetary policy. The year-over-year pace of real GDP growth reached 3.8% in mid-2017 and stayed above-trend for the following year. The unemployment rate fell to 5.8%, while core inflation accelerated back to the midpoint of the BoC’s 1-3% target band, alongside faster wage growth. The BoC – devotees of the Phillips Curve, like virtually every other DM central bank – took the message from the combination of tight labor markets and rising inflation and embarked on the long march away from a near-zero (0.5%) policy rate back in July 2017. Now, after 20 months and 125bps of rate hikes, Canada’s economy is weakening sharply. Real GDP only grew at a paltry 0.4% annualized pace in the 4th quarter of 2018, dragging the year-over-year pace to 1.6%. Inflation has followed suit, with headline CPI inflation falling from an early 2018 peak of 3% to 1.4% and the BOC’s median CPI index now growing at only a 1.8% pace. The most concerning part for the BoC is that the economy could be decelerating this rapidly with a policy rate of only 1.75%, which is well below the central bank’s estimated 2.5-3.5% range for the neutral rate. Our own BoC Monitor has rapidly fallen towards the zero line, indicating no pressure to either tighten or ease monetary policy (Chart 4). The more recent rapid decline in the BoC Monitor has been driven by the inflation-focused components of the indicator, while the growth-focused elements have been steadily drifting lower since that 2017 peak in real GDP growth. Chart 4Is The BoC Done, Well South Of Neutral? The BoC has been stunned by that shockingly weak Q4/2018 growth outturn. In the official policy statement released following the March 6 BoC meeting, the central bank’s Governing Council was forthright about how the growth uncertainty has put future rate hikes in question: “Governing Council judges that the outlook continues to warrant a policy interest rate that is below its neutral range. Given the mixed picture that the data present, it will take time to gauge the persistence of below-potential growth and the implications for the future inflation outlook. With increased uncertainty about the timing of future rate increases, Governing Council will be watching closely developments in household spending, oil markets and global trade policy.” Rising interest rates may be the big reason why growth has slowed so dramatically in Canada. The BoC’s economic projections for 2019 had already factored in some slowing global growth, as well a hit to business confidence and capital spending from global trade conflicts and last year’s decline in energy prices (a big deal for Canada’s huge oil industry). BoC officials, including Governor Stephen Poloz, have noted that a resolution of the U.S.-China trade tensions could therefore be a positive for the Canadian economy by removing a critical drag on Canadian business confidence and export demand. Yet when looking at the contribution to Canadian real GDP growth from the main components, there have been large drags on growth from consumer spending, capital spending and housing (Chart 5). That suggests that there is something more fundamental than just a series of external shocks at work here. Chart 5Broad-Based Weakness In Canadian Domestic Demand A look at the more interest-sensitive components of the Canadian economy suggests that rising interest rates may be a big reason why growth has slowed so dramatically. Consumer Durables Real consumer spending growth has plunged from a 4% pace in 2018 to 1.3% in Q4/2018, driven by a collapse in demand for consumer durables which contracted -1.2% year-over-year terms (Chart 6). Car sales plunged 7.5% on a year-over-year basis in Q4, suggesting that rising interest rates on auto loans may have been a major factor driving the weakness in durables spending. Softer incomes have also played a role, with wage growth rolling over even with the majority of evidence pointing to a very tight Canadian labor market that is getting even tighter (third panel). The fact that the drop was so focused on durables, however, suggests that higher interest rates were the more likely reason for the plunge in overall consumer spending. Chart 6Weak Canadian Consumption Concentrated In Durables Housing The overheated Canadian housing market has endured the double-whammy of rising mortgage interest rates and increasing macro-prudential changes to mortgage lending. House prices in the hottest Toronto and Vancouver markets – which should be most impacted by the changes in mortgage regulations – have stopped increasing, helping bring the growth in national house prices to only 1.9% (Chart 7). Yet the sharp deceleration of mortgage credit growth, alongside a contraction in housing starts and overall residential investment, suggests that higher mortgage rates could be the bigger driver of the housing weakness. Chart 7Some Long-Needed Cooling Of Canadian Housing The BoC has noted that it is difficult to disentangle the impact of regulatory changes in Canadian mortgages from that of rising interest rates. Yet the impact of higher mortgage rates on Canadian consumer spending power can be seen in the rising debt service ratio for Canadian households. As of Q4/2018, Canadians must now pay 14.5% of their household income to service their debts, an 0.53 percentage point increase over the past two years (Chart 8). For highly indebted Canadian households, who have mortgage debt equal to 107% of disposable income, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Chart 8Leveraged Canadian Consumers Pinched By Higher Rates Does the fact that consumer spending has fallen so rapidly mean that the interest sensitivity of the Canadian economy is far greater than the BoC has assumed? If so, then the neutral range of 2.5-3.5% for the BoC policy rate may be too high, and the central bank could be closer to, if not already at, the end of its hiking cycle. The low level of the household savings rate – currently only 1.1%, a product of the housing bubble and the associated wealth effects on spending activity – makes Canadian consumers even more vulnerable to rate increases that diminish their spending power. For highly indebted Canadian households, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Capital Spending Canadian companies have seen a steady decline in corporate profit growth over the past couple of years, decelerating from a 23% pace in 2017 to 2% late in 2018 on a top-down basis. Yet even allowing for that, the -8% contraction in year-over-year real non-residential investment spending in Q4/2018 is a shock. Particularly since the BoC’s Senior Loan Officer Survey showed that credit conditions have been easing, and our own Canadian Corporate Health Monitor is flashing that Canadian companies are in solid financial condition (Chart 9). Chart 9An Unusually Sharp Fall In Canadian Capex Business surveys from the BoC and the Conference Board did both show a sharp plunge in confidence and future sales expectations (bottom panel). This suggests that worries about global trade tensions and diminished trade activity may have weighed on Canadian business confidence and capital spending – especially coming alongside a big drop in oil prices as was seen last year, which hinders the ability of Canadian energy producers to ramp up investment. Canadian exports accelerated over the final half of 2018 while business confidence was falling. However, oil prices have now stabilized and, more importantly, Canadian exports accelerated over the final half of 2018 while business confidence was falling (Chart 10). That acceleration was seen for both energy and non-energy exports, but was also heavily concentrated in exports to China, which are now growing 24% on a year-over-year basis (a pace that is wildly at odds with the overall growth in Chinese imports, suggesting that Canadian exporters have increased their market share in China). Chart 10Should Canadian Companies Be Worried About Global Trade? Could higher corporate borrowing rates, rather than worries about plunging export demand, be the true reason why Canadian companies have so drastically cut back on capital spending? It is no surprise that the BoC has chosen to take a pause on its rate hiking cycle, given all those conflicting messages from the Canadian economic data. The growth slump could be related to global trade uncertainty, or regulatory changes in the housing market, or past declines in oil prices, or previous interest rate increases. Or all of the above. The BoC can also take some time before considering its next interest rate move given cooling inflation and wage growth (Chart 11). The central bank has reduced its estimate of the Canadian output gap to -0.5%, based off the downside surprises already seen in Canadian economic growth. A closed output gap, combined with accelerating inflation, was the main argument the BoC had been using to justify its interest rate increases over the past two years. Now, neither of those conditions is currently in place, and the BoC can take its time to assess the underlying trend of economic growth without having to worry about above-target inflation. Chart 11Slowing Inflation = More Dovish BoC The Governing Council next meets in April, when a new Monetary Policy Report and updated economic projections will be published. The 2019 growth and inflation forecasts will surely be downgraded, perhaps heavily as the European Central Bank just did in response to the sharp growth slowdown in Europe – which led to a new round of monetary easing measures. What will be more interesting from the point of view of Canadian bond investors will be the Bank’s assessment of the size of Canada’s output gap, the pace of trend growth and, perhaps, even the appropriate neutral range for the BoC policy rate. The lowering of any of those three elements would be supportive of Canadian bond yields staying lower for longer. We have maintained an underweight in Canadian government bonds since July 2017, based on our view that the BoC would follow in the Fed’s footsteps and attempt to normalize interest rates. A strong economy and rising inflation would allow them to do that. Now, both the Fed and BoC are on hold, with small probabilities of rate cuts now priced into Overnight Index Swap (OIS) curves (Chart 12). Chart 12BoC Now Less Likely To Follow The Fed Given the BCA view that Fed rate hikes will resume later this year on the back of a rebound in U.S. and global growth, we had been sticking with the bearish view on Canadian government bonds as well. Yet given the stunning drop in Canadian growth that startled the BoC, the odds now favor the BoC staying on hold for longer, even once the Fed begins to hike again. This would also provide additional easing of Canadian financial conditions through a soft Canadian dollar (bottom two panels). We are upgrading our recommended allocation to Canadian bonds to neutral(3 out of 5) this week from underweight (2 out of 5).  In light of this uncertainty over the BoC’s next move given the weak economy, the underlying rationale for our underweight Canada position is no longer applicable. Thus, we are upgrading our recommended allocation to Canadian bonds to neutral (3 out of 5) this week from underweight (2 out of 5). The excess return of Canadian government bonds versus the Global Treasury index since we went to underweight back in July 2017 was -0.83%, so our bearish recommendation did generate positive alpha. In our model bond portfolio, we are funding that additional Canadian allocation from a reduction of the overweight in Japanese government bonds. We are also closing our tactical trade of being long 10-year Canadian Real Return Bonds versus nominal 10-year government debt, at a loss as 10-year inflation breakevens are now 1.6%, or 16bps below the entry level on our trade (Chart 13). Chart 13Upgrade Canadian Government Bonds To Neutral We will contemplate any additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey and Senior Loan Officer Survey on April 15 and the new BoC Monetary Policy Report and economic projections at the April 24 monetary policy meeting. Bottom Line: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Corporate Default Rate: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. Corporate Bond Valuation: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy: Corporate spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth. However, tighter Fed policy and a higher-than-expected corporate default rate could pressure spreads wider in the second half of 2019. We will be quick to back off our overweight corporate bond stance when our near-term spread targets are met. Feature Investors should remain overweight corporate bonds within U.S. fixed income portfolios, but be conscious that the window for outperformance may close quickly. While the Fed’s dovish turn and signs of global growth stabilization will allow spreads to tighten during the next few months, corporate default risk is rising in the background. This week’s report focuses on corporate default risk. We assess where the default rate is headed during the next 12 months and discuss the implications for investment strategy. Default Rate Near A Bottom Chart 1 shows that the trailing 12-month speculative grade default rate has been steadily falling since early 2017. However, it also shows that the fair value reading from our macro-driven default rate model has not fallen as much. The actual trailing 12-month default rate came in at 2.7% in February, the fair value reading from our model stands at a loftier 3.6%. Chart 1Corporate Default Rate Near A Bottom? Our default rate model is based on two factors, Commercial & Industrial bank lending standards and gross corporate leverage. The latter is defined as total nonfinancial corporate debt divided by pre-tax profits. With that in mind, our model provides a framework for assessing where the default rate is headed under different scenarios for corporate profit and debt growth. We consider each of these two factors in turn. Corporate Profit Growth Will Moderate Nonfinancial corporate pre-tax profits grew an astonishing 17% during the four quarters ending in Q3 2018, but all leading indicators point to deceleration in Q4 2018 and beyond. On the revenue side of the ledger, leading indicators are in universal agreement that growth is poised to slow (Chart 2): Chart 2Corporate Revenues Will Soften The ISM Manufacturing index has fallen to 54.2 from a recent peak above 60. The year-over-year growth rate in total business sales came in at 2% in December, down from a recent peak of 8.4%. The year-over-year growth rate in industrial production fell to 3.5% in February, from a September peak of 5.7%. The year-over-year growth rate in the U.S. Leading Economic Indicator is down to 3.2% as of January, from a September peak of 6.8%. Clearly, the global growth slowdown has migrated to the U.S. and the impact is being seen in the leading U.S. economic data. Some slowdown in corporate revenue growth is all but assured. All leading indicators point to deceleration in corporate profit growth in Q4 2018 and beyond. Corporate profit growth and investment spending are tightly linked in the sense that firms are more likely to take on new projects when they feel better about their future cash flow prospects. The upshot is that we can infer trends in corporate profits by looking at data on investment spending and firms’ investment plans. That data paint a similar picture of widespread deceleration (Chart 3): Chart 3Investment Indicators The year-over-year growth rate in core durable goods orders is down to 4% from a recent peak close to 9%. An average of firms’ capital spending plans as reported in regional Fed surveys remains elevated, but has declined markedly in recent months. Small business capital spending plans, as reported to the NFIB, have fallen sharply during the past few months. Periods of tightening lending standards coincide with decelerating corporate debt. Wage growth is another important driver of corporate profits. In particular, we can get a read on profit growth by looking at the difference between corporate selling prices and unit labor costs, aka our Profit Margin Proxy (Chart 4). Our Profit Margin Proxy remains at a high level because growth in unit labor costs has been tepid. Even though top-line wage growth has improved, this has been matched by an acceleration in productivity growth (Chart 4, bottom panel). The latter has kept unit labor costs low, even as nominal wages have risen. Chart 4Wage Growth A Drag On Profits Extremely tight labor markets will lead to a continued acceleration in wage growth during the next few quarters.1 Meanwhile, the prospect for continued rapid productivity growth is much more uncertain. It seems reasonable to expect that corporate profits will come under some downward pressure from rising unit labor costs during 2019. Finally, we can get a sense of the corporate profit outlook by looking at equity analyst net earnings revisions (Chart 5). Analyst earnings per share (EPS) upgrades outpaced downgrades for most of 2018, but that trend reversed sharply near the end of last year. Analysts are once again lowering EPS forecasts more often than they are raising them. Chart 5More EPS Downgrades Than Updgrades Debt Growth Should Also Slow Fortunately, some of the balance sheet impact from decelerating profits will likely be offset by slower debt growth during the next few quarters. Corporate debt growth has been robust and fairly stable since 2012, but C&I lending standards tightened slightly in the fourth quarter of last year. Typically, periods of tightening lending standards coincide with decelerating corporate debt (Chart 6). Chart 6Tighter Lending Standards Implies Slower Debt Growth Anecdotally, several high profile firms have recently taken steps to curtail debt growth. Most notably, General Electric just announced a major asset divestment to pay down debt, and the stock market rewarded them for doing so. If our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. More broadly, we observe that firms with low debt/asset ratios have been outperforming firms with high debt/asset ratios, a dynamic that tends to occur when lending standards are tightening and corporate debt growth is falling (Chart 7). Chart 7Low Leverage Firms Are Outperforming For a sense of scale, nonfinancial corporate debt grew 6.5% in the four quarters ending Q4 2018 and has averaged 6.3% since 2012. Some mild deceleration from these growth rates is likely during the next few quarters. Putting It All Together Table 1 shows that trailing 12-month profit growth of 17% and debt growth of 6.5% led to gross corporate leverage of 6.95, which translates to a fair value default rate of 3.6%. Table 1 also shows where the fair value default rate will head during the next 12 months based on different scenarios for profit and debt growth. Table 1Default Rate Scenarios For example, if profits grow by 5% and debt growth is between 0% and 8%, then the fair value default rate will be between 3.5% and 4.1% one year from now. This seems like a reasonable scenario based on our macro forecast. A scenario that would result in a default rate that is much higher than the current Moody’s baseline forecast of 1.7%. And One More Thing Though they are not included in our model, job cut announcements are a fairly reliable coincident indicator of corporate defaults. Recently, job cut announcements have clearly bottomed even as the default rate has continued to fall (Chart 8). This is a clear warning sign that the default rate might head higher in the coming months. Chart 8Warning Sign From Job Cuts Bottom Line: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. It increasingly looks like the second half of 2019 will be more challenging for corporate credit. Are Investors Adequately Compensated For Default Risk? Forecasting the default rate is important, but it is only one side of the coin when it comes to corporate bond investing. The other relevant question is whether current spreads offer adequate compensation for expected defaults. At present, the average option-adjusted spread (OAS) on the Bloomberg Barclays High-Yield index is 388 bps. If we assume that defaults occur in line with the Moody’s baseline forecast during the next 12 months, then we would expect default losses of approximately 90 bps (assuming a 49% recovery rate).2 That translates to an excess junk spread of 298 bps, well above the historical average realized excess spread of 250 bps. In other words, investors should expect better than average excess junk returns if the Moody’s baseline default rate forecast turns out to be correct. However, our analysis suggests that the default will be significantly higher during the next 12 months. If we assume a 3.5% default rate, more in line with our macro forecast, and a slightly lower recovery rate of 45%, then the excess spread available in the high-yield index falls to 198 bps. This number is still positive, so unless there is significant spread widening investors should still earn a positive excess return versus Treasuries, but it is considerably below average historical levels. Another factor to consider is the historical correlation between junk spreads and the Moody’s baseline default rate forecast. We find that the average high-yield OAS has the strongest positive correlation with the 9-month forward Moody’s baseline default rate expectation (Chart 9). In other words, if our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. Chart 9Default Rate Revisions Will Lead To Wider Spreads Bottom Line: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy While this report has focused on detecting early warning signs of default risk, that is not the only thing that matters for corporate spreads. We continue to believe that spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth.3 The purpose of this report is to stress that our current overweight stance on corporate bonds is unlikely to last through to the end of the year. First, if spreads tighten during the next few months leading to an easing in overall financial conditions, then the Fed will probably turn more hawkish in the second half of 2019 and monetary policy will shift from being a tailwind for corporate credit to a headwind. This shift could occur at around the same time that corporate defaults start to exceed current expectations. As a matter of strategy, we have published spread targets for each corporate credit tier based on average spread levels seen during similar stages of past economic cycles (Charts 10A & 10B).4 We will be quick to move off our overweight stance once these spread targets are achieved. Note that Aaa spreads are already below target. We recommend that investors avoid Aaa-rated corporate bonds. Chart 10AInvestment Grade Spread Targets Chart 10BHigh-Yield Spread Targets While the current environment remains positive, it increasingly looks like the second half of 2019 will be more challenging for corporate credit. Stay tuned. Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further details on the amount of labor market slack in the economy please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 We forecast the recovery rate based on its inverse historical relationship with the default rate. A higher default rate implies a lower recovery rate, and vice-versa. 3 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 For more details on our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com