Corporate Bonds

Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities Chart I-13Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com     Footnotes   1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Corporate Bonds: Corporate bond spreads have been slow to price-in the escalation of the U.S./China trade dispute. Nimble investors should take steps to mitigate their near-term (0-3 month) exposure to credit spreads, but remain overweight corporate bonds (both investment grade and high-yield) on a 6-12 month investment horizon. Duration: With 50 bps of rate cuts already priced into the market for the next 12 months, there is very little money to be made from extending duration and potentially a lot of money to be made by keeping duration low. This is especially true given that the Fed has so far done nothing to suggest that rate cuts are on the table. TIPS: Long-maturity TIPS breakeven inflation rates look cheap on our model, and the core PCE deflator’s sharp drop probably overstates the deflationary pressures in the economy. Maintain an overweight allocation to TIPS versus nominal Treasuries in U.S. bond portfolios. Feature Concerns that the ongoing U.S./China trade war will exacerbate the decline in global growth flared again last week, and our geopolitical strategists see high odds of further near-term escalation.1 For starters, China has not yet retaliated to the U.S. Commerce Department’s blacklisting of Huawei and a handful of other Chinese tech firms. Meanwhile, the U.S. stands ready to extend tariffs across the full slate of imported Chinese goods. To cap it all off, there are currently no firm plans for the resumption of talks between the countries’ respective negotiating teams, and no assurance that Presidents Donald Trump and Xi Jinping will speak to each other at the G20 Summit in Japan on June 28-29. Credit Spreads Are Too Complacent Chart 1Corporate Bonds At Risk While Treasury yields responded to the turmoil by dropping for the second consecutive week, the spillover to corporate bond markets has been less severe. Chart 1 on page 1 shows that corporate bond excess returns have de-coupled from the CRB Raw Industrials index during the past 12 months. The CRB Raw Industrials index tracks a broad basket of commodity prices, making it an excellent real-time indicator of the market’s assessment of global growth. Like Treasury yields, the CRB index has fallen sharply during the past two weeks. The wide gulf between corporate bond and commodity returns suggests that we will soon see either a sell-off in the corporate bond market or a positive re-rating of global growth that sends the CRB index higher. Recent history provides examples of both cases (Chart 2). The CRB index rose to meet corporate bond returns in 2012, but dragged corporate bond returns lower in 2014. Given the long list of potential negative trade catalysts, some near-term downside for corporate bond excess returns appears more likely. But it’s not just political headlines that make us cautious about the near-term outlook for credit spreads. The uncertainty created by the U.S./China trade dispute is now finding its way into the economic survey data. Flash Manufacturing PMIs for the U.S., Eurozone and Japan all fell in May, with respondents quick to blame the decline on global trade tensions. Much like the CRB index, PMI readings are sending a starkly different message than credit spreads. Either trade tensions will ease during the next couple of months, sending PMIs higher, or corporate bond spreads will widen. A model of U.S. capacity utilization based on lagged junk spreads predicts that capacity utilization will rise from its current 78% to 80% during the next six months (Chart 3). However, both the Markit and ISM Manufacturing PMIs suggest a further decline is more likely. Once again, either trade tensions will ease during the next couple of months, sending the PMIs higher, or corporate bond spreads will widen. Chart 2Position For Reconvergence Chart 3Capacity Utilization & Junk Spreads   We recommend that investors take measures to limit their near-term (~3-month) exposure to corporate spread risk. Stay Positive On A Cyclical (6-12 Month) Horizon Chart 4Expect More Stimulus From China While near-term caution is warranted, we would still position for positive corporate bond excess returns (both investment grade & high-yield) on a 6-12 month investment horizon. Ultimately, the U.S. and China will navigate toward some sort of truce, and the negative impact from tariffs is unlikely to derail the U.S. economic recovery.2 What’s more, Chinese policymakers will accelerate their stimulus efforts to mitigate the negative impact of higher tariffs. Our China Investment Strategy service tracks a composite of six money and credit growth indicators that lead Chinese economic activity. This leading indicator has already bottomed, and our strategists anticipate a return to stimulus levels reminiscent of mid-2016 (Chart 4).3 As long as a U.S. recession is avoided, corporate bond spreads will eventually settle near levels seen in the late stages of previous economic cycles (Chart 5A & Chart 5B).4 Chart 5AInvestment Grade Spread Targets Chart 5BHigh-Yield Spread Targets   Bottom Line: Corporate bond spreads have been slow to price-in the escalation of the U.S./China trade dispute. Nimble investors should take steps to mitigate their near-term (0-3 month) exposure to credit spreads, but remain overweight corporate bonds (both investment grade and high-yield) on a 6-12 month investment horizon. Risk & Reward In The Treasury Market Unlike credit spreads, Treasury yields have responded aggressively to the negative news flow. The 10-year Treasury yield currently sits at 2.32%, 7 bps lower than at this time last week. Meanwhile, the overnight index swap curve is priced for two full 25 basis point rate cuts over the next 12 months. Interestingly, while market prices imply 50 bps of rate cuts during the next year, the New York Fed’s Survey of Market Participants shows that, as of the May FOMC meeting, investors didn’t actually expect rate cuts any time soon. The shaded region in Chart 6 shows the interquartile range of the surveyed investors’ fed funds rate forecasts, while the dashed black line shows the median forecast. The survey responses convey widespread consensus that the fed funds rate will remain flat until the end of the year – the 25th percentile, median and 75th percentile are all equal until the end of 2019. Then, heading into 2020, the 75th percentile of the distribution starts to forecast rate hikes. The 25th percentile doesn’t move in the direction of rate cuts until Q4 2020, and the median forecaster sees the fed funds rate staying put at least through the second half of 2021. Chart 6Market And Survey Expectations Differ Why would market prices imply a much lower path for the fed funds rate than actual investor survey responses? The most likely reason relates to assessments about the balance of risks. When responding to surveys, investors will usually provide their modal (or most likely) outcome. However, investor bets in financial markets will reflect a dollar-weighted average of different possible scenarios. It’s possible that while investors think a flat fed funds rate is the most likely outcome, they also view rate cuts as a higher probability tail risk than rate hikes. They therefore invest some of their money to hedge that risk, even if it does not reflect their base case view. The intuition that rate cuts remain a “tail risk” is confirmed by another question from the survey. This question asks investors to consider a time period between now and the end of the year, and then attach a probability to the Fed’s next move i.e. whether it will be hike, a cut, or whether there will be no change in the funds rate until the end of 2019 (Chart 7). As of the April/May survey, market participants thought the odds of a hike were 23%, odds of a cut were 17% and the odds of flat rates until the end of the year were 59%. Before the Fed meeting in March, investors saw 50% chance of a hike, 13% chance of a cut, and 37% chance of no change. The overall message is that investors continue to view a 2019 rate cut as a tail risk, but one that’s perceived probability is rising. In any event, for our purposes it doesn’t really matter how investors respond to surveys. According to our Golden Rule of Bond Investing, if the actual change in the fed funds rate over the next 12 months exceeds what is currently priced into the OIS curve for that period, then below-benchmark portfolio duration positions will pay off.5 In fact, the Golden Rule even gives us a framework for translating different rate hike/cut scenarios into expected 12-month Treasury returns (Table 1). Table 1The Golden Rule Of Bond Investing Based on current prices, if the fed funds rate holds steady for the next 12 months – as the median market participant expects – we calculate that the Bloomberg Barclays Treasury Master Index will lose between 1.98% and 2.41% relative to cash. Even in the scenario where the Fed delivers two rate cuts during the next 12 months, we would still expect Treasury index returns to lag cash by 12-13 bps. Negative excess returns in the “two rate cut” scenario are due to the negative carry in the Treasury index. Capital gains/losses would be close to zero in that scenario, since the change in the fed funds rate is exactly equal to the market’s expectations. Investors continue to view a 2019 rate cut as a tail risk, but one that’s perceived probability is rising. What’s evident from those figures is that there is currently very little money to be made betting on rate cuts, and quite a bit to be made betting on rate hikes. The risk/reward balance in the Treasury market clearly favors keeping portfolio duration low. But What Will The Fed Actually Do? The minutes from the last FOMC meeting show broad consensus around the Fed’s current “on hold” policy stance, though it’s notable that “a few” participants thought rate hikes would be appropriate if the economy evolved in line with their expectations. The minutes contain no mention of a possible rate cut. Our sense is that it would require a further sharp tightening of financial conditions or significantly worse economic data before the Fed seriously considers cutting rates. Our Fed Monitor – an aggregate indicator that measures economic growth, inflation and financial conditions – is currently very close to the zero line, a level consistent with the Fed’s “on hold” stance (Chart 8). The ISM Manufacturing PMI is also firmly above the 50 boom/bust line. Historically, Fed rate cuts are usually preceded by a negative reading from our Fed Monitor and a sub-50 PMI. We would be looking for those two signals before expecting the Fed to cut rates. Chart 8Sub-50 ISM Required Before The Fed Cuts Rates Bottom Line: With 50 bps of rate cuts already priced into the market for the next 12 months, there is very little money to be made from extending duration and potentially a lot of money to be made by keeping duration low. This is especially true given that the Fed has so far done nothing to suggest that rate cuts are on the table. Inflation & TIPS Chart 9Adaptive Expectations Model It’s not just nominal Treasury yields that dropped during the past two weeks. Long-maturity TIPS breakeven inflation rates – the spread between nominal Treasury yields and TIPS yields – also fell precipitously. The 10-year TIPS breakeven inflation rate is currently 1.76% and the 5-year/5-year forward breakeven is only 1.9%. These figures suggest that the market does not trust the Fed to meet its inflation target in the long-run. Our main valuation tool for the 10-year TIPS breakeven rate is our Adaptive Expectations Model.6 It derives a fair value for the 10-year breakeven based on: The 10-year rate of change in the core consumer price index The 12-month rate of change in the headline consumer price index The New York Fed’s Underlying Inflation Gauge At present, the 10-year TIPS breakeven rate is 20 bps below the model’s fair value (Chart 9). It shouldn’t be too surprising that TIPS look cheap relative to nominals. Recent inflation data have been weak and the Fed has written off the weakness as “transitory”, leading to doubts about whether it will keep rates low enough to meet its target. For our part, we think investors should take advantage of low breakevens and overweight TIPS versus nominal Treasuries in U.S. bond portfolios. In fact, the Fed’s characterization of low inflation as “transitory” seems correct. Chart 10 shows both the core and trimmed mean PCE deflators. The dramatic fall in the core measure, which strips out food and energy prices from the headline number, is what has caught the market’s attention. But it’s important to note that trimmed mean PCE inflation has not confirmed the decline. In fact, it remains in a multi-year uptrend. Recent inflation data have been weak, but the Fed has written off the weakness as “transitory”. Chart 10Low Inflation Looks "Transitory" This is the third time during this cycle that core PCE inflation has diverged negatively from the trimmed mean. Core eventually rebounded and re-converged with the trimmed mean in both of the prior two episodes. The Fed is banking on the third time playing out the same way, and we think it would be unwise to bet against them. Recently released research from the Federal Reserve Bank of Dallas shows that trimmed mean PCE inflation provides a less-biased real-time estimate of the headline figure than the traditional core measure. The latter tends to run too low. The trimmed mean is also more closely related to labor market slack.7 Bottom Line: Long-maturity TIPS breakeven inflation rates look cheap on our model, and the core PCE deflator’s sharp drop probably overstates the deflationary pressures in the economy. Maintain an overweight allocation to TIPS versus nominal Treasuries in U.S. bond portfolios. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com 1      Please see Geopolitical Strategy Weekly Report, “Is Trump Ready For The New Long March?” dated May 24, 2019, available at gps.bcaresearch.com 2      The potential economic impact from tariffs is discussed in Global Investment Strategy Weekly Report, “Tarrified,” dated May 16, 2019, available at gis.bcaresearch.com 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019, available at cis.bcaresearch.com 4      For details on how we determine the spread targets shown in Charts 5A & 5B, please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 5      Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 6      For details on the model’s construction please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market,” dated November 20, 2018, available at usbs.bcaresearch.com 7      https://www.dallasfed.org/-/media/Documents/research/papers/2019/wp1903… Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global financial markets are currently dealing with a fresh round of uncertainty related to U.S.-China trade tensions. Yet while equities and government bond yields have fallen in response to the U.S. imposition of tariffs and escalation of the trade war with China, corporate bond markets in the developed economies have been relatively well-behaved (so far). Credit spreads have only widened modestly, which perhaps should not be surprising given central bankers’ increasingly dovish bias combined with early signs of a cyclical global growth rebound (Chart 1). Feature Chart 1Global Corporates: Shifting To A Friendlier Growth Backdrop? With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The main conclusion from the latest readings on our CHMs is that slower economic growth over the past year has resulted in some erosion of overall global credit quality. The deterioration was most pronounced in the more economically fragile regions that have suffered the deepest pullbacks in growth: Europe and Japan. The CHMs are currently giving an overall “neutral” signal in the U.S., although there are some worrying trends developing within the sub-components like interest coverage and short-term liquidity. Meanwhile, the CHMs in the U.K. and Canada are showing modest cyclical deterioration from very strong levels. Broadly speaking, the CHMs support our main global corporate bond market investment recommendations: a tactical aggregate overweight versus global government bonds, with a regional bias favoring the U.S. over Europe, and a quality bias tilted towards U.S. high-yield (HY) over investment grade (IG). Renewed U.S.-China trade hostilities represent a threat to that pro-cyclical fixed income asset allocation, although we expect more aggressive responses from policymakers on both sides (more fiscal and monetary stimulus in China, a more dovish bias from the Fed) to offset any tariff-induced weakness in growth. U.S. Corporate Health Monitors: Cyclically OK, But Longer-Term Problems Are Brewing Our top-down U.S. CHM is sending a neutral message on credit quality, sitting right on the threshold separating “deteriorating health” from “improving health” (Chart 2). The indicator, however, has been trending in a direction showing improving credit metrics over the past year. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle.  The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate tax cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. The ratios directly related to corporate profits that go into the top-down CHM – return on capital, profit margins and interest coverage – have all gone up over the past year, generating the bulk of the directional improvement in the top-down CHM. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. That does not mean that all the news is good, however. The short-term liquidity ratio has fallen sharply and is now at levels last seen in the years leading up to the 2008 Financial Crisis. Similar deteriorations can be seen in the short-term liquidity ratios within the bottom-up versions of our U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Coming at a time when interest coverage ratios have been steadily declining for IG, and are already at low levels for HY, declining short-term liquidity would leave U.S. corporates highly vulnerable during the next economic downturn. Chart 2Top-Down U.S. CHM: A Neutral Reading Chart 3Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates. For now, however, the message from our bottom-up U.S. CHMs is the same as that from our top-down U.S. CHM, with all hovering near the zero line suggesting no major deterioration in overall credit quality. We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). Our favored indicators continue to point to a rebound in global growth in the latter half of 2019, and the Fed currently has no desire to push the funds rate into restrictive territory, so the risk/reward over the next six months still favors staying overweight U.S. corporates. The medium-term outlook, however, is far more challenging given the growing body of evidence pointing to the advanced age of the U.S. credit cycle, such as falling interest coverage and liquidity. Chart 4Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY One final point – in Appendix 2 starting on page 17, we present bottom-up CHMs for the main industry sector groupings of companies that go into our overall U.S. IG CHM. Most of the sector CHMs are hovering near the zero line, but two industry groupings stand out as having a rising CHM that is now well within “deteriorating health” territory – Consumer Staples and Utilities. Euro Corporate Health Monitors: Worsened By Weaker Growth The message from our bottom-up CHMs for the euro area shows that there was some damage done to credit quality from last year’s growth slump, evidenced by lower profit margins and interest coverage ratios. Although overall credit quality remains fairly neutral (i.e. the CHMs remain near the zero line). For euro area IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former now slightly in the “deteriorating health” zone (Chart 6). Profit margins have fallen far more sharply for domestic issuers, reflecting the very rapid slowing of euro area growth over the latter half of 2019. Interest coverage for domestic issuers is also lower than for foreign issuers, while short-term liquidity ratios have weakened for both over the past year. For euro area HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, and are now hovering just above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. Despite the lack of a major overall negative signal from the euro area CHMs, we are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates (Chart 9). The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. This will inhibit the ability for spreads to tighten further in the event of a pickup in growth, while also leaving spreads vulnerable to widening pressures if euro area growth continues to languish. Chart 8Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. The gap between the combined IG/HY bottom-up CHMs for the U.S. and euro area has been strongly correlated to the difference in credit spreads between euro area and U.S. issuers (Chart 10).1 The latest trends show a narrowing of the gap between the U.S. and euro area CHMs, suggesting relative corporate health favors U.S. names (middle panel). At the same time, the relatively stronger performance of the U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). U.K. Corporate Health Monitor: Brexit Uncertainty Is Not Helping Our top-down U.K. CHM remains in the “improving health” zone, although the indicator has been drifting towards “deteriorating health” over the past two years. Almost all of the components of the U.K. CHM have contributed to this worsening trend (Chart 11), with only short-term liquidity remaining in a powerful multi-year uptrend. Most worryingly, the interest and debt coverage ratios remain historically depressed, even as the Bank of England has keep interest rates at extraordinarily low levels for the past several years. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits.   The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The persistent uncertainty from Brexit has weighed on business confidence and investment spending by U.K. firms, keeping growth at a below-trend pace. While the immediate deadline of “Brexit Day” came and went back in March, there is still a high degree of uncertainty over the U.K.’s future economic relationship with the European Union. With Prime Minister Theresa May now set to step down, an election will extend the period of politically-driven uncertainty in the U.K. We have maintained a moderate underweight recommendation on U.K. corporates in our model bond portfolio over the past year, despite the lack of an obvious negative signal from our U.K. CHM. Spread widening in 2018 has been followed by spread tightening in 2019 (Chart 12), but the latter has been driven by the global rally in risk assets rather than diminished perceptions of U.K. political risk. Chart 11U.K. Top-Down CHM: Modest Pullback From Healthy Levels Chart 12U.K. Corporates: Stay Modestly Underweight Although there has been some improvement in U.K. economic data of late, leading economic indicators continue to trend lower. In addition, the Bank of England continues to hint that any positive resolution to the Brexit uncertainty could result in a tightening of monetary policy (although that is less of a threat given the synchronized dovish turn by global central bankers over the past few months). Given all the uncertainties, the risk/reward balance continues to favor a modest underweight in U.K. corporates, particularly at current tight spread levels to Gilts. Japan Corporate Health Monitor: A Modest Cyclical Deterioration Our bottom-up Japan CHM has shown a worsening trend over the past year and now sits in the “deteriorating health” zone (Chart 13).2 Interestingly, all of the individual components have contributed to that move in the CHM, and not just the cyclical components (profit margins, return on capital, interest coverage) that reflect the recent slowing of economic growth in Japan. Leverage has increased (albeit from very low levels), while short-term liquidity has also weakened (albeit from very high levels). Strictly looking at the overall level of all the Japan CHM components, the message does not signal a major deterioration in Japanese corporate credit quality. Leverage, defined here as the ratio of total debt to the book value of equity, is still below 100%, well below the 100-140% range seen between 2006 and 2015. The same story applies to the return on capital, which at 5% is still high versus Japan’s history (although very low by global standards). Interest coverage and short-term liquidity both remain high relative to the past decade. The absolute level of Japanese corporate health remains solid, but there has been marginal deterioration from weaker economic growth. On that front, the cyclical momentum in Japan’s economy is not improving. According to the latest Tankan survey, Japanese firms reported that their business outlook was worse than previously expected. Declining confidence has damaged capital spending, as shown by the falling growth of domestic machinery and machine tool orders. Japan’s economy remains highly levered to global growth and export demand and their economy has taken a hit from the slower pace of global trade over the past year. Wage growth has also weakened after finally seeing some positive momentum in 2018, which is weighing on consumer confidence and spending. Japan’s corporate spread has widened slightly (+5bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets (the Bloomberg Barclays Global Corporates index spread has tightened by -33bps year-to-date). This is a sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns versus Japanese Government Bonds (JGBs) with yields held near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitor: Still In Decent Shape Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving health” area over the past few years (Chart 15). The marginal moves have shown some modest deterioration in the cyclically-sensitive components (most notably, return on capital and profit margins for the top-down Canadian CHM). This should not be surprising given how rapidly Canadian economic growth slowed in the final quarter of 2018. There has also been some deterioration in the non-cyclical components. Leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are historically low. This may be building up risks for the next major Canadian economic downturn, but for now, Canadian companies look in decent shape. With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next six months, which will further underpin the health of Canadian oil companies – and should also help support Canadian corporate bond performance. The Bank of Canada is now taking an extended pause from its rate-hiking cycle, with policy rates well below the central bank’s own estimate of neutral (2.25-3.25%). Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have been in a very stable range since the 2009 recession (Chart 16), ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a prolonged deterioration of Canadian economic growth or sharp monetary tightening from the Bank of Canada – neither outcome is likely over the next 6-12 months.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.3 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors       Footnotes 1 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 2 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 3 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.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 Chart 1Is Low Inflation Transitory? Persistent /pə’sıst(ə)nt/ adj. If inflation runs persistently above or below 2 percent, then the Fed would be forced to adjust its policy stance to nudge it back towards target. Transitory /’trænsıtərı/ adj. If inflation’s deviation from target is only transitory, it means that it will return to target even if the Fed maintains its current policy stance. Symmetrical /sı‘metrık(ə)l/ adj. The Fed’s inflation target is symmetrical because the FOMC is as concerned with undershoots as it is with overshoots. More recently, some members are urging the Fed to demonstrate the target’s symmetry by explicitly pursuing an overshoot.  Last week, Chair Powell described recent low inflation readings as transitory (Chart 1). In other words, the Fed believes that interest rates are already low enough to send inflation higher over time. Equally, with downbeat inflation expectations signaling doubts about the symmetry of the Fed’s target (bottom panel), the committee is in no rush to hike. The result is status quo monetary policy for the time being. With the market priced for 25 basis points of rate cuts over the next 12 months, investors should keep portfolio duration low. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 95 basis points in April, bringing year-to-date excess returns up to +365 bps. The corporate bond sector’s strong outperformance has resulted in spread tightening across the credit spectrum. In fact, average index spreads for the Aaa, Aa and A credit tiers are now at or below our fair value targets.1 Only the Baa credit tier, which accounts for about 50% of index market cap, remains attractively valued, with an average spread 11 bps above target (Chart 2). We recommend that investors focus their investment grade credit exposure on Baa-rated bonds. The combination of above-trend economic growth and accommodative Fed policy creates a favorable environment for credit risk. Spreads should continue to tighten in the near-term. However, we will turn more cautious once Baa spreads reach our target. Gross corporate leverage ticked higher in Q4, breaking a year-long downtrend (panel 4). Meantime, while C&I lending standards eased slightly in Q1 after having tightened in Q4 (bottom panel), C&I loan demand contracted for the third consecutive quarter. Weaker loan demand in the Fed’s Senior Loan Officer Survey often precedes tighter lending standards, and tighter lending standards usually coincide with wider corporate bond spreads.    High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 137 basis points in April, bringing year-to-date excess returns up to +710 bps. Junk spreads for all credit tiers remain above our spread targets (Chart 3).2 At present: The Ba-rated option-adjusted spread is 214 bps, 35 bps above target. The B-rated spread is 356 bps, 79 bps above target. The Caa-rated spread is 709 bps, 145 bps above target. An alternative valuation measure, the excess spread available in the junk index after accounting for expected default losses, is currently 267 bps, slightly above average historical levels (panel 4). However, this measure uses the Moody’s baseline default rate forecast of 1.7% for the next 12 months. For that forecast to be realized, it would require a substantial decline from the current default rate of 2.4%. In a previous Special Report, we flagged some reasons why the Moody’s forecast might be too optimistic.3 Among them is the increase in job cut announcements, which remains a concern despite last month’s drop (bottom panel). If we assume that the default rate holds at 2.4% for the next 12 months, the default-adjusted junk spread would fall to 237 bps. Still reasonably attractive by historical standards, and consistent with positive excess returns. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in April, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 5 bps widening in the option-adjusted spread (OAS) was partially offset by a 4 bps drop in the compensation for prepayment risk (option cost). At 42 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains below the pre-crisis mean (Chart 4). In fact, we would assign high odds to MBS outperformance during the next few months. Not only is the OAS attractive, but mortgage refinancings – which have recently caused the nominal MBS spread to widen – have probably peaked (panel 2). Following its sharp decline earlier in the year, the 30-year mortgage rate has now leveled-off. Another downleg is unlikely, given the recent improvements in housing data. New home sales and mortgage purchase applications have both surged in recent months, while homebuilder optimism remains close to one standard deviation above its long-run mean.4 Moreover, even at current mortgage rates we calculate that only about 17% of the conventional 30-year MBS index is refinanceable.  All in all, given that corporate credit offers higher expected returns, we continue to recommend only a neutral allocation to MBS. However, MBS spreads are very likely to tighten during the next few months.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 37 basis points in April, bringing year-to-date excess returns up to +152 bps. Sovereign debt outperformed duration-equivalent Treasuries by 83 bps on the month, bringing year-to-date excess returns up to +420 bps. Local Authorities outperformed the Treasury benchmark by 67 bps and Foreign Agencies outperformed by 40 bps, bringing year-to-date excess returns up to +208 bps and +192 bps, respectively. Domestic Agencies outperformed by 10 bps in April, bringing year-to-date excess returns up to +29 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +23 bps. The Fed’s on-hold policy stance and signs of improvement in leading global growth indicators could set the U.S. dollar up for a period of weakness. All else equal, a softer dollar makes USD-denominated sovereign debt easier to service, benefiting spreads. However, a period of dollar weakness driven by improving global growth would also benefit U.S. corporate bonds, and valuation is heavily tilted in favor of U.S. corporate debt relative to sovereigns (Chart 5). Given that the last period of significant sovereign outperformance versus corporates was preceded by much more attractive valuation (panels 2 & 3), we maintain an underweight allocation to sovereign debt for the time being. We make an exception for Mexican sovereign debt, where spreads are attractive compared to similarly rated U.S. corporates (bottom panel). Our Emerging Markets Strategy service also thinks that the market is taking too dim a view of Mexican government finances.5 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 3% in April, and currently sits at 78% (Chart 6). This is more than one standard deviation below its post-crisis mean and slightly below the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) outperformed short-dated munis (2-year and 5-year) dramatically last month, but yield ratios at the long end remain well above those at the short end of the curve (panel 2). In other words, the best value in the municipal bond space continues to be found at the long-end of the Aaa muni curve. We showed in a recent report that lower-rated and shorter-maturity munis are much less attractive.6 First quarter GDP data revealed that state & local government tax revenues snapped back sharply in Q1, following a contraction in 2018 Q4. Meanwhile, current expenditures actually ticked down. Incorporating an assumption for Q1 corporate tax revenues, we forecast that state & local government interest coverage jumped to 16% in Q1 from 4% in 2018 Q4.7  This is consistent with municipal ratings upgrades continuing to outpace downgrades for the time being (bottom panel). Treasury Curve: Adopt A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in April. The 2/10 Treasury slope steepened 10 bps on the month and currently sits at 21 bps (Chart 7). The 5/30 slope steepened 7 bps on the month and currently sits at 60 bps. In recent reports we have urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.8 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. With recession likely to be avoided this year, the market will eventually price rate hikes back into the curve. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 8 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 5 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, almost all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 81 basis points in April, bringing year-to-date excess returns up to +157 bps. The 10-year TIPS breakeven inflation rate rose 13 bps on the month and currently sits at 1.91% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate rose 12 bps on the month and currently sits at 2.02%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. As we noted in a recent report, the Fed has clearly pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.9 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Year-over-year core PCE inflation dipped to 1.55% in March. However, as Fed Chair Powell went out of his way to mention in last week’s press conference, core PCE was dragged down by one-off adjustments in the ‘Clothing & Footwear’ and ‘Financial Services’ components. In fact, 12-month trimmed mean PCE inflation actually moved up in March. It now sits at 1.96%, just below the Fed’s target (bottom panel). The combination of a dovish Fed and above-trend economic growth should push TIPS breakevens higher over time. Maintain an overweight allocation to TIPS versus nominal Treasuries. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in April, bringing year-to-date excess returns up to +49 bps. The index option-adjusted spread for Aaa-rated ABS narrowed one basis point on the month and, at 32 bps, it remains close to its all-time low (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.     Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 40 basis points in April, bringing year-to-date excess returns up to +187 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 67 bps, below its average pre-crisis level but somewhat higher than levels seen last year (Chart 10). In a recent report, we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.10 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 21 basis points in April, bringing year-to-date excess returns up to +95 bps. The index option-adjusted spread tightened 2 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 25 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of April 30, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of April 30, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 For further details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A High Bar For Rate Cuts”, dated April 30, 2019, available at usbs.bcaresearch.com 5 Please see Emerging Markets Strategy Special Report, “Mexico: The Best Value In EM Fixed Income”, dated April 23, 2019, available at ems.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Corporate tax revenue is not released until the second GDP estimate. We assume that the 2019 Q1 value equals the 2018 Q4 value. 8 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights In Indonesia, investors are ignoring the weakness in global growth, which is an important driver of the country’s financial markets. The Indonesian currency, equities and local currency bonds all remain vulnerable. We continue to recommend underweighting Indonesian assets for now. In Turkey, additional adjustments in the exchange rate and interest rates are unavoidable. Stay put/underweight Turkish financial markets. In the UAE, the economy is set to improve marginally this year. We recommend overweighting UAE equities and corporate spreads within their respective EM portfolios. Feature Indonesia: The Currency And Bank Stocks Are At Risk  Indonesian financial assets have benefited from the Federal Reserve’s dovish turn and corresponding fall in U.S. bond yields (Chart I-1, top panel). Moreover, the market is cheering President Joko Widodo’s lead in the presidential vote tally. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate (Chart I-1, middle panel). Going forward, the Indonesian currency, equities and local currency bonds all remain vulnerable: Falling global growth in general and Chinese imports in particular will intensify Indonesia’s exports contraction and worsen the country’s already wide current account deficit. In turn, the latter will induce currency depreciation, which will then lead to higher interbank rates (Chart I-2). Chart I-1Global Growth Matters For Indonesian Markets Chart I-2Falling Current Account Deficit = Higher Local Rates Upward pressure on local interbank rates will cause a slowdown in domestic private loan growth.   The Indonesian central bank – Bank Indonesia (BI) – has been attempting to lower interbank rates, which have been hovering above the central bank's policy rate (Chart I-3). To achieve this, the central bank has substantially increased excess reserves in the banking system (Chart I-4). It has done so by purchasing central bank certificates from commercial banks, conducting foreign exchange swaps and providing repo lending. Chart I-3A Sign Of Liquidity Strains Chart I-4Bank Indonesia Is Injecting Liquidity   Yet by expanding banking system liquidity so aggressively, BI risks renewed currency depreciation. Like any central bank in a country with an open capital account, BI cannot expect to have full control over the exchange rate while simultaneously targeting local interest rates. The Impossibly Trinity dilemma dictates that a central bank needs to choose between controlling the two. Yet investors are ignoring the budding weakness in industrial metals prices, which has historically been an important driver of Indonesia’s exchange rate. Therefore, if BI continues to inject local currency liquidity to cap or bring down interest rates (interbank rates), the resulting excess liquidity could encourage and facilitate speculation against the rupiah. Scratching below the surface, the recent strong outperformance of Indonesian equities has been entirely due to the surge in the country’s bank share prices (Chart I-5, top panel). Remarkably, the performance of Indonesian non-financial as well as small-cap stocks has been especially dismal (Chart I-5, middle and bottom panels). This is an upshot of poor profitability among Indonesia’s non-financial listed companies (Chart I-6). Chart I-5Indonesian Bank Stocks Are The Only Outperformers Chart I-6Falling Non-Financial Corporate Profitability Furthermore, deteriorating financial health of non-financial corporates, especially small companies, will lead to higher NPLs on banks’ books. Notably, Indonesian banks are more heavily exposed to businesses than to households. As NPLs rise anew, Indonesian commercial banks will need to lift their bad-loan provisioning levels, generating a major profit relapse (Chart I-7). Importantly, Indonesian commercial banks have been boosting their profits by reducing NPL provisions since early 2018. Reversing this will materially affect their earnings. Chart I-7Indonesian Bank Share Prices Are Vulnerable Additionally, bank stocks are vulnerable due to falling net interest income margins. Moreover, their share prices are overbought and not cheap. To be clear, we are not negative on Indonesia’s structural outlook. The above-mentioned alarms are more near-to-medium terms issues. Still, foreign ownership of local currency bonds and stocks – at 38% each – are high, and could be a major source of potential outflows if the rupiah depreciates. This would cause Indonesian stocks and local currency bonds to sell off severely. Bottom Line: The global growth slowdown/commodities downturn and the U.S. dollar upturn are not yet over. Consequently, foreign flows into EM will diminish, which will be particularly negative for Indonesian financial markets. We recommend investors continue underweighting Indonesian equities and avoid Indonesian local currency bonds for now. We continue to recommend a short position in the IDR versus USD. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Turkey’s Foreign Debt Bubble: The Worst Is Not Yet Behind Us Turkish financial assets, and the currency especially, will remain under selling pressure in the coming months. Additional adjustments in the exchange rate and interest rates - as well as in the real economy and current account balance - appear unavoidable. The key imbalance remains the gap between foreign debt obligations (FDOs) and the availability of foreign currency to meet these debt obligations. Turkey’s FDOs in 2019 are equivalent to $180 billion (Chart II-1). FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. This consists of $15 billion in interest payments, $65 billion in debt amortization and $100 billion in maturing short-term (under one year) claims. In theory, these debt obligations can either be rolled over, or the nation should generate current account and capital account surpluses and use these surpluses to pay down FDOs. Even though the current account deficit is shrinking, it is still in a deficit of $18 billion. Net FDI inflows remain weak at US$10 billion. Hence, it appears that Turkey’s only options are either to roll over maturing foreign currency debt or to lure foreign investors into local currency assets and use the surplus in net portfolio inflows to meet these FDOs. The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. However, due to a lack of credibility in the Turkish government’s macro policies - in addition to the ongoing deep economic recession and heightened financial market volatility - external creditors will be unwilling to roll over the debt. In fact, net portfolio flows into government debt and equities have tumbled for the same reason. Typically, when foreign funding dries up temporarily, a country can use its foreign exchange reserves to meet its FDOs. However, Turkey’s foreign exchange reserves have already plummeted to extremely low levels (Chart II-2). The central bank’s foreign currency reserves excluding both commercial banks’ deposits at the Central Bank of Turkey and FX swaps now stand at $13 billion. This is negligible compared with the $180 billion FDO figure due in 2019. Chart II-1Turkey: A Large Foreign Debt Servicing Burden Chart II-2Foreign Exchange Reserves Are Too Small   The recent plunge in the central bank’s net foreign exchange reserves excluding swaps (i.e. net international reserves) has put many pertinent metrics at record lows. In particular, net international reserves are at a precarious level relative to both total imports and external debt (Chart II-3). Finally, the net international reserves-to-broad money supply ratio has fallen to 7% (from 15% in 2014) despite the fact that the massive lira depreciation reduced the U.S. dollar measure of broad money supply (Chart II-4). Chart II-3FX Reserves Do Not Cover Imports Or External Debt Chart II-4Low Coverage Of Broad Money By International Reserves The currency will have to depreciate further and interest rates will have to move higher to shrink domestic demand/imports more. This is needed to generate a current account surplus that could be used to service FDOs, or that otherwise entices foreign creditors to be willing to roll over foreign debt or invest in Turkey. Finally, while the adjustment in the real economy is advanced, it is unlikely to be over, due to the large foreign debt bubble. Importantly, with large foreign and local currency debt obligations coming due for both companies and households - in addition to the deterioration in economic activity and higher interest rates - NPLs are bound to rise (Chart II-5). This is especially likely to occur because a lot of borrowing has been used in the property market both for construction and purchases. Notably, real estate volumes are shrinking, and prices are deflating in real terms (Chart II-6). Chart II-5NPLs Will Rise A Lot Chart II-6Turkey: Real Estate Is In Free Fall     Bottom Line: The macro adjustment in Turkey is not yet complete. The country still lacks foreign currency supply to service its enormous 2019 FDOs. Further currency depreciation and higher interest rates are required to depress domestic demand/imports and push the current account into surplus. Stay put / underweight Turkish financial markets. The authorities are becoming desperate, and the odds of capital control enforcement are not negligible. While such an outcome is not possible to forecast with any certainty or time frame, investors should consider this very real risk. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Overweight UAE Equities And Corporate Bonds Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Chart III-2Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. The UAE economy is set to improve marginally this year. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Chart III-3Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers   Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

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! 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 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 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 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 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 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 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 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.

Highlights Q1/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -17bps in the first quarter of the year. Winners & Losers: The underperformance came from the government side of the portfolio (-40bps), where our below-benchmark duration stance was mainly implemented through underweight positions in long-ends of government bond yield curves. On the other side was a solid outperformance from spread product allocations (+23bps) after our tactical upgrade to global corporates in January. Scenario Analysis For The Next Six Months: An improving global growth backdrop, and benign monetary policy backdrop, should help generate an outperformance of the model bond portfolio – mostly through credit, but also through moderate bear-steepening of government bond yield curves. Feature For fixed income markets, the start of 2019 has been categorized by three main trends: falling bond yields, narrowing credit spreads, and slower global growth. Central bankers have been forced to shift to a much more dovish stance on monetary policy, in response to heightened uncertainties over the global economy, helping trigger rallies in both government bonds and credit. In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the surprisingly eventful first quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2019 Model Portfolio Performance Breakdown: Overweight Credit Pays Off, Below-Benchmark Duration Does Not Chart of the WeekDuration Losses Offset Credit Gains In Q1/2019 Table 1GFIS Model Bond Portfolio Q1/2019 Overall Return Attribution   The total return for the GFIS model portfolio (hedged into U.S. dollars) in the first quarter was 3.1%, underperforming the custom benchmark index by -17bps (Chart of the Week).1 The bulk of the underperformance came from the government bond side of the portfolio (-40bps) - a function of both our below-benchmark duration tilt and underweight stance on sovereign bonds (Table 1). Of course, the flipside of that government bond underweight is a spread product overweight. The tactical upgrade to global corporate debt (favoring the U.S.) that we introduced back on January 15 helped boost the credit piece of the model bond portfolio, which outperformed the custom benchmark by +23bps. The tactical upgrade to global corporate debt (favoring the U.S.) that we introduced back on January 15 helped boost the credit piece of the model bond portfolio, which outperformed the custom benchmark by +23bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. investment grade industrials (+11bps) Overweight U.S. high-yield Ba-rated (+10bps) Overweight U.S. high-yield B-rated (+8bps) Overweight U.S. investment grade financials (+5bps) Overweight Japanese government bonds with maturity of 7-10 years (+4bps) Biggest underperformers Underweight Japanese government bonds with maturity beyond 10+ years (-17bps) Underweight U.S. government bonds with maturity beyond 10+ years (-12bps) Underweight France government bonds with maturity beyond 10+ years (-8bps) Underweight Emerging Markets U.S. dollar denominated corporates (-7bps) Underweight U.S. government bonds with maturity of 7-10 years (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q1/2019 (red for underweight, blue for overweight, gray for neutral). It was a great quarter for global fixed income, as all countries and spread products generated positive total returns. Generally, our allocations did reasonably well. There were more blue bars than red bars on the left side of Chart 4 (i.e. more overweights than underweights where returns were higher), and vice versa on the right side (more underweights than overweights where returns were lower). Some of the hit to performance from below-benchmark duration is already starting to be recouped in the first weeks of Q2 as markets become more comfortable with early signs of improving global growth. The negative overall Q1/2019 result is obviously not satisfactory, but we are still pleased with the positive returns generated from the spread product side after we did our January upgrade. More importantly, some of the hit to performance from below-benchmark duration is already starting to be recouped in the first weeks of Q2 as markets become more comfortable with early signs of improving global growth, pushing bond yields higher. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index in the first quarter of the year. The underperformance came from the government side of the portfolio, where our below-benchmark duration stance was mainly implemented through underweight positions on the long-ends of government bond yield curves. On the other side was a solid outperformance from spread product allocations after our tactical upgrade to global corporates in January. Future Drivers Of Portfolio Returns Chart 6Overall Portfolio Duration: Below-Benchmark Looking ahead, the performance of the model bond portfolio will benefit from two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt (favoring the U.S.) versus government bonds. In terms of the specific high-level weightings in the model portfolio, we are maintaining our tactical overweight tilt, equal to seven percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on global growth, which appears to be bottoming out after the sharp slowdown seen in 2018, to the benefit of corporate bond performance. That faster growth backdrop will also benefit our below-benchmark duration stance through a rebound in government bond yields. This should happen only slowly, however, as global central bankers are likely to keep their newly-dovish policy bias in place for some time until there are more decisive signs of accelerating growth AND inflation. We are maintaining our significant below-benchmark duration tilt (one year short of the custom benchmark), but we recognize that the underperformance from duration seen in Q1 will only be clawed back slowly over the next 3-6 months (Chart 6). As for country allocation, we continue to favor regions where tighter monetary policy is least likely (overweight Japan, the U.K., and Australia, neutral core Europe and Canada). We are staying underweight the U.S., however, as the market’s expectations for the Fed is too dovish, with -25bps of rate cuts now discounted over the next twelve months. We expect to make some changes to those country allocations over the next few months, however - most notably a potential downgrade in core Europe, and upgrade in Peripheral Europe, if the euro area stabilizes on the back of firmer global growth. We expect to make some changes to those country allocations over the next few months, however - most notably a potential downgrade in core Europe, and upgrade in Peripheral Europe, if the euro area stabilizes on the back of firmer global growth. The overall yield from the model bond portfolio is modestly above that of the benchmark (+7bps). That is admittedly a fairly small amount of positive carry (Chart 7) given the overweight credit position. It is a consequence of our below-benchmark duration stance, which is focused on underweights in longer, higher-yielding ends of government bond yield curves (i.e. we have a bear-steepening bias in the U.S., core Europe and even the very long-end in Japan). Chart 7Portfolio Yield: Small Positive Carry Chart 8Portfolio Risk Budget Usage: Cautious   Even though we have decent-sized overall tilts on global duration and spread product allocation, our estimated tracking error (excess volatility of the portfolio versus its benchmark) remains low (Chart 8). This is a function of some of the offsetting country and sector tilts within the overall allocations (i.e. more Japan than Germany, more Spain than Italy, more U.S. corporates than EM corporates). We remain comfortable maintaining a tracking error target range of between 40-60bps, well below our self-imposed 100bps ceiling, as our internal weightings are helping keep overall portfolio volatility at a modest level. Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.2 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, are all driven by what we continue to believe will be the most important driver of market returns in 2019 – the path of U.S. monetary policy. Our Base Case: the Fed stays on hold, the U.S. dollar remains flat, oil prices rise by +10%, the VIX index hovers around 15, and there is a mild bear-steepening of the U.S. Treasury curve. This is the case of a pickup in U.S. and global growth that is strong enough to support higher commodity prices, but not intense enough to rapidly boost U.S. core inflation, allowing the Fed to keep rates unchanged. A Very Hawkish Fed: the Fed does a surprise +25bps rate hike in June or September, the U.S. dollar rises by +3%, oil prices increase +10%, the VIX index climbs to 25 and there is a sharp bear-flattening of the U.S. Treasury curve. This would occur if the U.S. economy reaccelerates alongside improved global growth, U.S. core inflation and inflation expectations move higher, and market volatility increases from a surprisingly hawkish Fed. A Very Dovish Fed: the Fed cuts the funds rate by -25bps, the U.S. dollar falls by -3%, oil prices decline -15%, the VIX index increases to 35 and there is a sharp bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth momentum fades once again, leaving the Fed little choice but to ease monetary policy as market volatility surges alongside elevated recession risks. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are all unchanged from our late portfolio review in early January (Chart 9). The U.S. Treasury yield changes, however, are more moderate than what we used three months ago (Chart 10). That reflects the Fed’s dovish turn since then, which limits the upside for yields from multiple Fed hikes in 2019. Chart 9Risk Factors Assumptions For The Scenario Analysis Chart 10U.S. Treasury Yield Assumptions For The Scenario Analysis     The model bond portfolio is expected to outperform the custom benchmark index by +43bps in our Base Case scenario. This comes from the relative outperformance of credit versus government bonds in an environment of slowly rising bond yields (below-benchmark duration), and tighter credit spreads (overweighting U.S. corporates). In the Very Hawkish Fed scenario, our model portfolio is projected to outperform the benchmark by +29bps. This comes mostly from below-benchmark duration, with more muted credit performance as spreads widen and volatility increases due to the unexpected Fed rate hike. In the Very Dovish Fed scenario, the model bond portfolio is expected to lag the benchmark by -49bps. Performance would get hit from both credit and duration, as government bond yields fall and credit spreads widen sharply against a backdrop of even slower global growth. The overall expected excess return of our model bond portfolio over the benchmark is positive, given that the scenario analysis produces positive excess returns in the Base Case and Very Hawkish Fed scenarios. While we do not place probabilities on our scenarios in this analysis, if we did, the Very Dovish Fed scenario would be far less likely than the Very Hawkish Fed scenario (by definition, the Base Case is our most likely outcome). Global growth is much more likely to rebound than decelerate further over the rest of 2019. Thus, the overall expected excess return of our model bond portfolio over the benchmark is positive, given that the scenario analysis produces positive excess returns in the Base Case and Very Hawkish Fed scenarios. Bottom Line: An improving global growth backdrop, and benign monetary policy backdrop, should help generate an outperformance of the model bond portfolio – mostly through credit, but also through moderate bear-steepening of government bond yield curves.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA, Research Analyst ray@bcaresearch.com   Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.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 Chart 1What’s The Downside? How low can it go? This is the question most investors are asking these days about the 10-year Treasury yield. Our answer is that it can’t go much lower unless the U.S. economy falls into recession, an event we don’t anticipate in 2019. Considering the main macro drivers of the 10-year Treasury yield, we find that the Global Manufacturing PMI (Chart 1), U.S. dollar bullish sentiment (not shown) and Global Economic Policy Uncertainty (not shown) are all close to mid-2016 levels. In other words, the economic growth and policy environment is almost identical to the one that produced a 1.37% 10-year Treasury yield in mid-2016. What’s preventing a return to mid-2016 yield levels is that the Fed has delivered nine rate hikes since then, and rising wage growth confirms that the output gap has closed considerably (bottom panel). In other words, with short-maturity yields much higher than three years ago, we would need to see a much more pronounced growth slowdown, i.e. PMIs well below 50, to re-produce a sub-2% 10-year Treasury yield. If 2019 continues to follow the 2016 roadmap and the Global PMI bottoms-out around 50, then the 10-year Treasury yield has probably already found its floor. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 24 basis points in March, bringing year-to-date excess returns up to +268 bps. The Federal Reserve’s pause opens a window for corporate spreads to tighten during the next few months. We recommend overweight positions in corporate bonds for now, but will be quick to reduce exposure once spreads reach our near-term targets. Aaa spreads are already below target levels and we recommend avoiding that credit tier. Other credit tiers still have room to tighten, though Aa and A-rated bonds are only 3 bps and 5 bps above target, respectively (Chart 2).1 Once spreads reach more reasonable levels for this phase of the cycle, we will be quick to reduce corporate bond exposure because some indicators of corporate default risk are already sending warning signals.2 Most notably, corporate profits grew only 4.0% (annualized) in Q4 2018 while corporate debt rose 5.3% (annualized). The result is that our measure of gross leverage ticked higher for the first time since Q3 2017 (bottom panel). Going forward, with corporate profit growth likely to stabilize in the mid-single digit range, gross leverage will probably stay close to its current level. That would be consistent with a 3% speculative grade default rate, significantly above the 1.7% rate currently projected by Moody’s. Chart 2Investment Grade Market Overview   High-Yield: Overweight High-Yield underperformed the duration-equivalent Treasury index by 23 basis points in March, dragging year-to-date excess returns down to +566 bps. Junk spreads for all credit tiers remain above our near-term spread targets.3 At present, the Ba-rated option-adjusted spread is 235 bps, 55 bps above our target. The B-rated spread is 285 bps, 102 bps above our target. The Caa-rated spread is 802 bps, 244 bps above our target (Chart 3). Chart 3High-Yield Market Overview Elevated spreads mean that investors are currently well compensated for default risk, but that could change later in the year. In a recent report we showed that some leading default indicators – gross leverage, C&I lending standards and job cut announcements (bottom panel) – are showing signs of deterioration.4 Specifically, our model suggests that the speculative grade default rate could be 3% or higher during the next 12 months. Moody’s currently forecasts 1.7%. If the Moody’s forecast is correct, the high-yield default adjusted spread is 306 bps. If the Moody’s forecast turns out to be correct, then investors will take home a default-adjusted spread of 306 bps, well above the historical average of 250 bps. If our 3% forecast is correct, then the default-adjusted spread falls to 230 bps, slightly below the historical average (panel 4). In either case, investors are reasonably well compensated for bearing default risk, but that will change when spreads reach our near-term targets. We will be quick to cut exposure at that time. MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 11 basis points in March, dragging year-to-date excess returns down to +27 bps. The conventional 30-year zero-volatility spread widened 3 bps on the month, driven entirely by an increase in the compensation for prepayment risk (option cost). The option-adjusted spread (OAS) held flat at 40 bps. Falling mortgage rates since the beginning of the year have caused an increase in refinancing activity, leading to some widening in nominal MBS spreads (Chart 4). However, the tepid pace of new issuance in recent years means that the existing mortgage stock is not very exposed to refinancing risk. Consider that, despite an 80 bps drop in the 30-year mortgage rate, the MBA Refinance index has only risen to 1290. The Refi index’s historical average is 1824. Chart 4MBS Market Overview Further, housing starts and new home sales appear to have stabilized, meaning that there is probably not much further downside for mortgage rates. As a consequence, we don’t see much more scope for MBS spread widening. While MBS spreads appear relatively safe, the sector does not offer attractive expected returns compared to the investment alternatives. For example, the index option-adjusted spread for conventional 30-year MBS is well below its average historical level (panel 3) and the sector offers less compensation than normal compared to corporate bonds (panel 4). MBS also offer a poor risk/reward trade-off compared to other Aaa-rated spread products, as we showed in a recent report.5   Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 23 basis points in March, bringing year-to-date excess returns up to +115 bps. Sovereign debt outperformed duration-equivalent Treasuries by 13 bps on the month, bringing year-to-date excess returns up to +334 bps. Local Authorities outperformed the Treasury benchmark by 53 bps and Foreign Agencies outperformed by 42 bps, bringing year-to-date excess returns up to +139 bps and +151 bps, respectively. Domestic Agencies outperformed by 11 bps in March, bringing year-to-date excess returns up to +20 bps. Supranationals outperformed by 4 bps, bringing year-to-date excess returns up to +16 bps. The USD-denominated sovereign debt of most countries continues to look expensive relative to equivalently-rated U.S. corporate credit. However, in a recent report we highlighted that Mexican sovereign debt is an exception (Chart 5).6 Chart 5Government-Related Market Overview Not only is Mexican sovereign debt cheap relative to U.S. corporates, but our Emerging Markets Strategy service has shown that the Mexican peso is cheap.7 The prospect of a stronger peso versus the U.S. dollar makes the spread on offer from Mexican sovereign debt look even more attractive.   Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 39 basis points in March, dragging year-to-date excess returns down to +52 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in March, and currently sits at 82% (Chart 6). This is more than one standard deviation below its post-crisis mean and right around the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview The Municipal / Treasury yield ratio for short maturities (2-year and 5-year) remains well below the yield ratio for longer maturities (10-year, 20-year and 30-year). In other words, the best value in the municipal bond space is at the long-end of the curve, and we continue to recommend that investors favor those maturities. Recently released data from the Bureau of Economic Analysis shows that state & local government revenue growth declined in Q4 2018, for the first time since Q2 2017. As a result, our measure of state & local government interest coverage fell from a lofty 17 all the way down to 5 (bottom panel). Positive interest coverage means that state & local governments are still generating sufficient revenue to cover current expenditures and interest payments, and we therefore don’t anticipate a surge in muni ratings downgrades any time soon. We also continue to note that municipal bonds tend to perform better in the middle-to-late phases of the economic cycle, while corporate credit delivers its best returns early in the recovery.8 Investors should maintain an overweight allocation to municipal debt. Treasury Curve: Adopt A Barbell Curve Positioning Treasury yields fell dramatically in March, as the Fed surprised markets with a larger-than-expected downward revision to its interest rate projections. The result is that the overnight index swap curve is now priced for 34 basis points of rate cuts over the next 12 months (Chart 7). Chart 7Treasury Yield Curve Overview The 2/10 Treasury slope flattened 7 bps to end the month at 14 bps. The 5/30 slope steepened 1 bp to end the month at 58 bps. In recent reports we urged investors to adopt barbell positions along the yield curve. In particular, investors should avoid the 5-year and 7-year maturities and instead focus their allocations at the very short and long ends of the curve.9 There are three main reasons to prefer a barbell positioning. First, the 5-year and 7-year yields are most sensitive to changes in our 12-month discounter. In other words, those yields fall the most when the market prices in rate cuts and rise the most when it prices in rate hikes. As long as recession is avoided, the market will eventually price rate hikes back into the curve. Favor the 2/30 barbell over the 7-year bullet. Second, barbells currently offer a yield pick-up relative to bullets. The duration-matched 2/10 barbell offers 10 bps more yield than the 5-year bullet (panel 4), and the duration-matched 2/30 barbell offers 9 bps more yield than the 7-year bullet. This means that investors will earn positive carry in barbell positions while they wait for rate hikes to get priced back in. Finally, all barbell combinations look cheap according to our yield curve fair value models (see Appendix B). TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 44 basis points in March, dragging year-to-date excess returns down to +76 bps. The 10-year TIPS breakeven inflation rate fell 7 bps to end the month at 1.88% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps to end the month at 1.98%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. Chart 8Inflation Compensation As we noted in last week’s report, with financial conditions no longer excessively easy, the Fed has pivoted to a more dovish stance in an effort to re-anchor inflation expectations at levels more consistent with its 2% target.10 This change should support wider TIPS breakevens, though investors will also need to see evidence of firming realized inflation before meaningful upside materializes. So far, such evidence is in short supply. Note that trimmed mean PCE inflation has rolled over again after having just touched 2% (bottom panel). Trimmed mean PCE is running at 1.84% year-over-year. Nevertheless, we would maintain an overweight allocation to TIPS versus nominal Treasuries. First, our commodity strategists see further upside in the price of oil (panel 2), and second, the 10-year TIPS breakeven inflation rate is 6 bps too low relative to the fair value from our Adaptive Expectations model (panel 4).11 ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in March, bringing year-to-date excess returns up to +40 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month and currently sits at 34 bps, exactly equal to its pre-crisis low (Chart 9). Chart 9ABS Market Overview We showed in a recent report that Aaa-rated consumer ABS offer a relatively poor risk/reward trade-off compared to other U.S. fixed income sectors, a result that is echoed by the Excess Return Bond Map in Appendix C.12 This should not be surprising given that Aaa ABS spreads are close to all-time lows. What is surprising is that ABS spreads are so tight while the consumer delinquency rate is rising (panel 3). Although the delinquency rate remains well below pre-crisis levels, it will likely continue to rise going forward. Household interest payments are rising quickly as a share of disposable income (panel 3) and banks are tightening lending standards for both credit cards and auto loans (bottom panel). We recommend an underweight allocation to consumer ABS, preferring to take Aaa spread risk in MBS and CMBS. Non-Agency CMBS: Neutral Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 5 basis points in March, bringing year-to-date excess returns up to +146 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps to end the month at 73 bps, below its average pre-crisis level but somewhat higher than recent tights (Chart 10). Chart 10CMBS Market Overview In a recent report we noted that non-agency CMBS offer the best risk/reward trade-off of any Aaa-rated U.S. spread product.13 While we remain cautious on the macro outlook for commercial real estate, noting that prices are decelerating (panel 3) and banks are tightening lending standards (panel 4) amidst falling demand (bottom panel), we view elevated CMBS spreads as providing reasonable compensation for this risk for the time being. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 2 basis points in March, dragging year-to-date excess returns down to +74 bps. The index option-adjusted spread widened 2 bps on the month and currently sits at 50 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 34 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +53 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 53 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of March 29, 2019) Table 5Butterfly Strategy Valuation: Standardized Residuals (As of March 29, 2019) Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 For further details on how we arrive at those spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 3 For further details on how we arrive at our spread targets 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 Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 11 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 13 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights U.S. growth remains robust, despite some temporary softness in recent months. Ex U.S., growth continues to fall but, with China probably now ramping up monetary stimulus, should bottom in the second half. Central banks everywhere have turned more dovish, partly in an attempt to push up inflation expectations. The combination of resilient growth and easier monetary policy should be good for global equities. We remain overweight equities versus bonds. Bond yields have fallen sharply everywhere. However, with U.S. inflation still trending up, and central banks unlikely to turn any more dovish this year, yields are unlikely to fall much further in 2019. We recommend a slight underweight on duration. We remain overweight U.S. equities, but are on watch to upgrade the euro zone and Emerging Markets when we have stronger conviction about China’s stimulus. Given structural headwinds in both Europe and EM, this would probably be only a tactical upgrade. We have been tilting our equity sector recommendations in a more cyclical direction, last month raising Industrials and Energy to overweight. We also prefer credit over government bonds within the fixed-income category, though we warn that spreads will not fall much further given weak corporate fundamentals. Feature Recommended Allocation Overview Don’t Fight The Doves The performance of risk assets essentially comes down to a battle between growth and monetary policy/interest rates. Last September, despite the fact that global economic growth was clearly slowing, the Fed sounded hawkish; this triggered an 18% drop in global equities in Q4. But, since late last year, all major developed central banks have turned more dovish, culminating in March’s decision of the ECB to push back its guidance for its first rate hike, and the FOMC’s wiping out its two planned hikes for 2019. But, at the same time, U.S. economic growth is showing resilience, and we see the first “green shoots” of a cyclical pickup in growth outside the U.S. This is an environment in which risk assets should continue to perform well. Why did the Fed back off? The most likely explanation is that it wants to give itself more room to act come the next recession. Inflation expectations have become unanchored, with 10-year breakevens over the past decade steadily below a level that would be consistent with the Fed achieving its 2% core PCE inflation target in the long run. In the period since the Fed formally introduced this (supposedly “symmetrical”) target in 2012, it has exceeded it in only four months (Chart 1). Around recessions over the past 50 years, the Fed has on average cut rates by 655 basis points (Table 1). It sees little risk, therefore, in letting the economy “run a little hot” and allowing inflation to rise somewhat above 2%. This would reanchor expectations, and eventually get nominal short- and long-term rates higher before the next recession. Chart 1Market Doesn’t Believe The Fed’s Target Table 1Fed Won’t Be Able To Cut This Much Next Time   Chart 2Financial Conditions Now Much Easier Chart 3Housing Market Bottoming Out Meanwhile, U.S. growth seems to be stabilizing at a decent level after signs of weakness late last year caused by tighter financial conditions, a slowdown elsewhere in the world, and the six-week government shutdown. An easing of financial conditions since the beginning of the year should help to keep U.S. GDP growth above trend at around 2.0-2.5% this year (Chart 2). Most notably, interest-rate sensitive areas of the economy that were under pressure last year, especially housing, are showing signs of bottoming (Chart 3). Consumption also should be robust, given strong wage growth, consumer confidence close to historic record high levels, and amid no signs of a deterioration in the labor market (Chart 4). Chart 4No Signs Of Weaker Labor Market Chart 5Some 'Green Shoots' For Global Growth   A key question for us over the next few months will be when to shift allocations to more cyclical, higher-beta equity markets such as the euro area and Emerging Markets. These have underperformed year-to-date despite the strong risk-on market. China’s nascent reflationary stimulus will decide the timing and level of conviction of this shift. As we explain in detail on page 6, we think the jury is still out on whether China is injecting liquidity on anything like the same scale as it did in 2016. Even if it is, historically it has taken six to 12 months before the effect showed through via a rebound in global trade, commodity prices, and other China-related indicators. The first early signs of a bottoming are emerging: Chinese fixed-asset investment and the Caixin Manufacturing PMI beat expectations last month, the German ZEW Expectations indicator has started to recover, and the diffusion index of the Global Leading Economic Indicator (which often leads the LEI itself by a few months) has picked up (Chart 5). We are on watch to shift our allocation1 but, given the long-term structural headwinds against both Europe and EM, we need to be more convinced about the strength of Chinese stimulus before doing so. The seeds of recession are sown in expansions. Eventually, we see the newly dovish Fed falling behind the curve. The Fed Funds Rate is still below the range of estimates of the neutral rate – hard though this is to estimate in real time (Chart 6). If the economy remains as strong as we expect, sometime next year inflation could begin rising to uncomfortable levels (and asset bubbles start to be of concern), which would push the Fed back into hiking mode. Given that the market is pricing in Fed rate cuts, not hikes, and that the Fed can hardly sound any more dovish than it does now without moving to an outright easing path, it seems to us that long-term rates are very unlikely to fall from here (Chart 7). Chart 6Fed Still Below Neutral Chart 7Can The Fed Get Any More Dovish Than This? In this environment, therefore, we continue to expect global equities to outperform bonds over the next 12 months. However, a recession is possible in 2021 triggered by the Fed late next year needing to put its foot abruptly on the brake.   What Our Clients Are Asking Chart 8Ex-U.S. Equities Driven By China Stimulus When Is The Time To Switch Allocations To Europe And EM? It is slightly surprising that the 12% rally in global equities this year has been led by the low-beta U.S., up 13%, rather than Europe (up 9%) or emerging markets (up 9% - and much less if the strong Chinese market is excluded). Is it time to switch to these underperforming, more cyclical markets? Our answer is, not yet. Global growth ex-U.S. continues to weaken. It is likely to bottom sometime in the second half, as a result of Chinese growth stabilizing. However, the jury is still out on whether the increase in Chinese credit creation in January was a one-off, or major policy reversal. Even if it is the latter, a revival in global growth (and cyclical markets) has typically lagged Chinese stimulus by 6-12 months (Chart 8, panel 1). There are also significant structural headwinds for both the euro zone and Emerging Markets which make us reluctant to overweight them unless there are clear cyclical reasons to do so. Both have lagged global equities fairly consistently since the Global Financial Crisis, with only brief outperformance during periods of economic acceleration, such as in 2016 and 2012 (panel 2). The euro zone remains challenged by its banking system. Loan growth has been stagnant for years, and banks remain undercapitalized relative to their U.S. peers, and highly fragmented (panels 3 and 4). Emerging markets are hampered by their high level of foreign-currency debt (which makes them highly sensitive to U.S. financial conditions), dependence on China, and lack of structural reform. We could see ourselves shifting our recommendation from the U.S. to the euro area and EM, and becoming outright bearish on the U.S. dollar (a counter-cyclical currency), over the coming months if we find confirmation of a bottoming of global cyclical growth and become more confident in the size of China’s stimulus. But given the structural headwinds, and the steady underperformance of these markets, we need stronger evidence first.   Chart 9Oil, Positioning, And Housing Why Is The 10-Year Bond Yield So Depressed? Despite U.S. equities rallying back to within 4% of a record high, the U.S. Treasury bond yield has fallen further this year (Chart 9, panel 1). Moreover, the 3-month/10-year yield curve has briefly inverted. Besides the Fed’s recent more dovish turn, what has depressed bond yields? We would pin the cause on the following factors: Dampened inflation expectations: Over the past few years the 10-year yield has been closely correlated with the oil price via inflation expectations. A temporary supply shock in Q4 caused oil prices to decline sharply. But tighter supply this year should allow the oil price to recover further. This should cause a rise in inflation expectation (panel 2). Trade positioning: Late last year,  speculative short positions in government bonds were at their highest levels since 2015. However, the Q4 equity selloff pushed investors to cover their positions; these are now close to neutral (panel 3). Home Sales: Housing data has been weak over the past few quarters, with both existing and new home sales declining. But there are now signs of recovery: mortgage applications have started to pick up, which should in turn push home sales higher (panel 4). This should also allow for a rise in bond yields. Our key take-away from March’s FOMC meeting, when the tone turned decidedly dovish, is that the Fed is focusing on re-anchoring inflation expectations, which should push nominal yields higher. We think the market is very pessimistic by pricing in 42 and 56 bps of rate cuts over the next 12 and 24 months respectively. It would take a significant further weakening of economic data to make the Fed’s stance turn even more dovish and for nominal yields to fall even further.   How Will U.S. Corporate Bonds Perform In The Next Recession? Historically high levels of U.S. corporate debt, as well as declining credit quality in the investment-grade space, have started to worry investors (Chart 10). Specifically, investors are worried that, when the next default cycle comes, a large portion of investment-grade debt will be downgraded to junk, forcing fund managers who are constrained to hold certain credit qualities to sell. These worries seem to be justified. Investment-grade bonds of lower credit quality tend to experience large increases in migration to junk status during credit recessions (Chart 11). Given the current composition of the U.S. investment-grade corporate bond universe, a credit recession would imply a downgrade to junk status of 4.6% of the index if we assume similar behavior to previous recessions. Depending on the speed of the selloff, such a downgrade could also have grave consequence for liquidity. According to the Securities Industry and Financial Markets Association (SIFMA), average daily turnover in the U.S. corporate bond market was 0.34% in 2018. Thus, it is not hard to envision a situation where forced selling could surpass normal levels of liquidity. However, it is hard to tell what would be the effect of such a fire-sale on credit spreads, given that they tend to widen in recessions regardless. While this asset class could perform poorly in the next recession, we don’t expect that its weakness will translate to the real economy. Leveraged institutions such as banks hold just 18% of corporate credit. Furthermore, despite being at all-time highs, U.S. nonfinancial corporate debt to GDP is still at a much healthier level than in other countries (Chart 12). Chart 10Declining Quality In Investment Grade Chart 12U.S. Corporate Debt Levels Are Healthy Relative To The Rest Of The World   Chart 13A Value Rebound?   Is It Time To Favor Value Over Growth Again? Since it peaked in May 2007, the ratio of global value to growth has attempted to rebound several times amid a sustained downtrend (Chart 13). Due to the cyclical nature and the neutral relative valuation of the value/growth indexes, we have preferred to use sector positioning (cyclicals vs. defensives) to implement a value/growth style tilt in our global portfolio since March 20162 (Chart 13, panel 1). Lately, we have received many requests on the topic of the value-versus-growth-ratio. After reaching a historical low in August 2018, the  value/growth ratio slightly rebounded in Q4 2018 before reversing some of its gains so far this year. Additionally, the value/growth valuation gap as measured by both price-to-book and forward P/E has reached a historically low level (Chart 13, panel 4). As we have often noted, the sector composition of both the value and growth indexes changes over time.2 Chart 14 shows the current sector weights of S&P Pure Value and Pure Growth Indexes.3 It’s clear that now a bet on Pure Value versus Pure Growth is essentially a bet on Financials (which account for 35% of the Pure Value index) versus Tech and Healthcare (which together account for 38% of the Pure Growth index) - see also Chart 13, panel 2. Given the cyclical nature of the value/growth ratio and also the sector concentration, it’s not surprising that the value/growth play is also a play on euro area versus U.S. equities (Chart 13, panel 3). Currently, we are neutral on Financials and Tech, while overweight Healthcare in our global sector portfolio, and we are putting the euro area on an upgrade watch (see page 14). Therefore, maintaining a neutral stance between value and growth is in line with our sector and country views. However, a close watch for a possible upgrade of value is also warranted given the extreme valuation measures.   Global Economy Overview: U.S. growth has slowed recently, though it remains more robust than in the more cyclical economies in Europe and emerging markets. Central banks almost everywhere have recently turned dovish. However, China’s increased monetary stimulus should help global growth bottom out in H2. This could lead the Fed and central banks in other healthy economies to return to a rate-hiking path. U.S.: The U.S. economy has been weak in recent months. The Citigroup Economic Surprise Index (Chart 15, panel 1) has collapsed, and the Fed NowCasts point to only 1.3-1.7% QoQ annualized GDP growth in Q1 (compared to 2.2% in Q4). But the slowdown is mostly due to the six-week government shutdown (which probably took 1% off growth), some seasonal adjustment oddities (which leave Q1 as the weakest quarter almost every year), and tighter financial conditions in H2 2018 which have now largely reversed. The manufacturing and non-manufacturing ISMs in February were  still healthy at 54.2 and 59.7 respectively. Consumption (propelled by strong employment growth and accelerating wages) and capex remain strong (panel 3). BCA expects GDP growth in 2019 to be around 2.0-2.5%, still above trend. Euro Area: The European economy continues to slow, driven by weak exports to emerging markets, troubles in the banking sector, and political uncertainty. Q4 GDP growth was only 0.8% QoQ annualized, and the manufacturing PMI has fallen to 47.6 (with Germany as low as 44.7). But there are some early signs of an improvement. The ZEW Expectations index for Germany has bottomed (Chart 16, panel 1), fiscal policy should boost euro area growth this year by around 0.5 percentage points, and wage growth has begun to accelerate. The key remains Chinese stimulus, whose positive effects should help European exports recover sometime in H2. Chart 15U.S. Growth Slowing But Still Robust Chart 16Signs Of Bottoming In Global Ex-U.S.? Japan: Japan also remains highly dependent on a Chinese stimulus. Machine tool orders (the best indicator of capex demand from China) fell by 29% YoY in February. Despite stronger wage growth, now 1.2% YoY, inflation shows no signs of moving up towards the Bank of Japan’s target of 2%: ex energy and food CPI inflation is still only 0.4%. The biggest risk in 2019 is October’s planned consumption tax hike from 8% to 10%. Prime Minister Abe has said that he will cancel this only in the event of a shock on the scale of Lehman Brothers’ bankruptcy. The government has put in place measures to soften the impact (most notably a 5% rebate on purchases at small retailers after October 1 paid for electronically), but consumption is still likely to fall significantly. Emerging Markets: China seems to have ramped up its monetary stimulus, with total social financing in January and February combined up 12% over the same months last year. Recent data have shown signs of a stabilization of growth: the manufacturing PMI rebounded to 49.9 in February from 48.3, and fixed-asset investment beat expectations at 6.1% YoY in January and February combined. Nonetheless, the size of liquidity injection is likely to be smaller than in previous episodes such as 2016, since Premier Li Keqiang and the PBOC have warned of the risk of excessive speculation. Elsewhere, some emerging economies (notably Brazil and Mexico) have showed signs of recovery after last year’s deterioration, whereas others (such as South Africa, Indonesia, and Poland) continue to suffer. Interest rates: Central banks worldwide have generally turned more dovish in recent months, with the Fed and ECB both moving to signal no rate hikes this year. This has pushed down long-term rates globally, with 10-year bond yields falling below 0% again in Germany and Japan. However, with global growth likely to bottom over the next few months, rates may not stay at current depressed levels. U.S. inflation, in particular, continues to trend up, and the Fed’s target PCE inflation measure is likely to exceed 2% over coming months. We see the Fed turning more hawkish by year-end, and long rates globally more likely to rise than fall from current levels.   Global Equities Chart 17Watch Earnings Remain Cautiously Optimistic: We added risk in our January Portfolio Update4 by putting cash back to work in global equities, and then in the March Portfolio Update5 we reduced the underweight in EM equities and increased the tilt to cyclicals at the expense of defensives, to hedge against a continuing acceleration in Chinese credit growth. All these came after our risk reduction in July 2018.6 GAA’s portfolio approach has always been to take risks where they are most likely to be rewarded. BCA’s macro view is that global economic growth data is likely to be on the weak side in the coming months, but will pick up in the second half. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. At the asset-class level, our positioning of overweight equities versus bonds while neutral on cash, reflects the “optimistic” side of our allocation. However, the rebound in global equities since the December sell-off has been driven completely by a valuation re-rating, while earnings growth has been revised down sharply. (Chart 17). As such, within global equities, our preference for low-beta countries (favoring DM versus EM, and favoring the U.S over the rest of DM) reflects the “cautious” aspect of our allocation. Our macro view hinges largely on what happens to China. There are signs that China may have abandoned its focus on deleveraging, yet it is too early to tell if it has switched back to a reflationary path. Therefore, our global equity sector overlay has a slight cyclical tilt by overweighting Industrials and Energy, which are among the main beneficiaries of Chinese reflationary policies or a positive resolution to U.S.-China trade negotiations. Chart 18Warming Up To The Euro Area Euro Area Equities: On Upgrade Watch We have favored U.S. equities relative to the euro area since July 2018.7 Since then, the U.S. has outperformed the euro area by 11% in USD terms and by 8% in local currency terms, with the difference being attributed to the weakness of the euro versus the U.S. dollar. Given BCA’s view on the global economy and the U.S. dollar, however, we are watching closely to switch our recommendation between the U.S. and euro area equities, for the following reasons: First, as shown in Chart 18, panel 1, the relative performance between the euro area and the U.S. is highly correlated with the EUR/USD exchange rate. BCA believes that the U.S. dollar is set for a period of weakness starting in the second half of the year,8 which bodes well for the outperformance of euro area equities. Second, relative earnings growth between the euro area and the U.S. is driven by the underlying strength of the economies, as represented by PMIs (panel 2). Both the relative earnings growth and relative PMI have stopped falling and have begun to bottom in favor of the euro area; Third, even though the euro area’s beta has been declining while that of the U.S. has increased, euro area beta is still higher than that in the U.S., making it more of a beneficiary of a global growth recovery; However, the relative valuation of euro area equities to their U.S. counterparts is now  neutral not at the extreme level which historically has been a good entry-point into eurozone  equities (panel 4).   Chart 19Becoming Less Defensive Global Sector Allocation: Gradually Becoming Less Defensive GAA’s sector portfolio took profits on its pro-cyclical positioning and went defensive in July 20189 and remained so until the March Monthly update10 when we upgraded Energy and Industrials to overweight from neutral, while downgrading Consumer Staples two notches to underweight from overweight (Chart 19). The upgrade of Industrials was mainly a hedge against further acceleration in China’s credit growth. But why did we upgrade Energy to overweight yet maintained an underweight in Materials? Long-term GAA clients know that, in terms of global sector allocation, we have structurally favored the oil-related Energy sector to the metals-related Materials sector since October 2016, because oil supply/demand is more global in nature while the supply/demand of metals, especially industrial metals, is closely linked to China (see also the Commodity section of this Quarterly on page 18). From a cyclical perspective, the relative performance of the two sectors has historically closely correlated with the relative prices of oil and metals, as shown in panel 2. This is not surprising because changes in forward earnings for the two sectors are also closely linked to change in the corresponding commodity prices (panels 3 and 4). BCA’s Commodity and Energy Strategy service has an overweight rating on oil and a neutral stance on metals, implying that the growth in the oil price will outpace that of metal prices, which suggests that the Energy sector will outperform the Materials sector (panel 2).   Government Bonds Maintain Slight Underweight On Duration. Global equities have recovered 16% since reaching the low of 2018 on December 24, yet the global bond yield has decreased by 21 bps over the same period. While the directional movement of bond yields is somewhat puzzling given such strong performance in equities (see page 7 for some explanations), it’s evident that the bond markets have been driven by the recent weakness in global growth (Chart 20, panel 3), and are pricing out any expectation of rate hikes over the coming year in major developed economies. Given the surprisingly dovish tone at the March FOMC meeting and BCA’s House View that global economic growth will rebound in the second half, bond yields are now highly exposed to any hawkish shift in central bank policies and any recovery in inflation expectations. As such, it’s still appropriate to maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Depressed inflation expectations have been one reason why global bond yields have decoupled from equities. However, the crude oil price, which closely correlates with inflation expectations, has stabilized. BCA’s Commodity & Energy Strategy service expects Brent crude to end 2019 at US$75 per barrel (Chart 21). This implies a significant rise in inflation expectations in the second half of the year, supporting our preference for inflation-linked bonds over nominal bonds. However, TIPS are no longer cheap. For those who have not already moved to overweight TIPS, we suggest “buying TIPS on dips”. Inflation-linked bonds (ILBs) in Australia and Japan are also still very attractive versus their respective nominal bonds. Overweighting ILBs in those two markets also fits well with our macro themes. Chart 20Rates: Likely More Upside Risk Chart 21Favor Inflation Linkers   Corporate Bonds Chart 22Tactical Upside Remains For Credit In February, we raised credit to overweight within a fixed-income portfolio while underweighting government bonds. So far, this has proven to be the right decision, as corporate bonds have generated excess returns of 90 basis points over duration-matched Treasuries. We based our positioning on the mounting evidence that global growth is turning up: credit impulses are starting to rebound in several major economies, monetary conditions have eased, and our diffusion index of global leading indicators has rebounded sharply, indicating that there remains tactical upside for global credit (Chart 22– panel 1 and 2). When will we close our tactical overweight? Our U.S. Bond Strategy Service has set a target for spreads of U.S. corporate bonds with different credit ratings. According to their targets, which denote the median spread typical of late-cycle environments, there is still some room for further spread compression in non-AAA credits (Chart 22 – panel 3 and 4). However, the upside is limited and, if spreads keep tightening, we will probably close our position by the end of Q2. On a cyclical horizon, the fundamentals of corporate health are still a headwind, with both the interest-coverage and liquidity ratio for U.S. investment-grade corporates standing near 10-year lows.11 Moreover, we expect these ratios to deteriorate further, as corporate profits will likely come under pressure due to increasing wage growth. Finally, we expect that the Fed will turn more hawkish by the end of 2019, turning monetary policy from a tailwind to a headwind. Thus, we recommend investors to remain overweight, but be ready to turn bearish in the back end of the year.   Commodities Chart 23Prefer Oil, Watch Metals Energy (Overweight): Stable demand, declining Venezuelan production due to U.S. sanctions, instability and possible outages in Libya, Iraq, and Nigeria, alongside the GCC’s commitment to cut output through year-end, should support oil prices and allow further upside (Chart 23, panels 1 & 2). While U.S. crude production is on the rise, bottlenecks in its export capabilities should limit market oversupply. Crude supply shocks should outweigh any slowdown in demand, specifically from emerging markets. BCA’s energy strategists expect Brent to average $75 and $80 throughout 2019 and 2020 respectively, and for the gap between WTI and Brent to narrow significantly. Industrial Metals (Neutral): China, the world’s largest consumer, still plays a big role in the direction of industrial metals. Year-to-date, metals prices have been supported partly by a more stable dollar. For now, we maintain a neutral stance until we see confirmation that Chinese stimulus will trigger further upside to metal prices perhaps in the second half. However, a lack of sustained Chinese demand, alongside weaker global growth over the next few months, would weigh down on metal prices (panel 3). Precious Metals (Neutral): Gold has reversed its downslide and rallied by over 10% from its Q4 2018 low. With the market pricing out any Fed rate hikes this year, rising inflation expectations, a weaker USD by year-end, and lower real rates should help gold outperform other commodities in this late-cycle phase. We recommend an allocation to gold as an inflation hedge, as well as a hedge against geopolitical risks (panel 4).     Currencies Chart 24The End Of The Dollar Bull Market U.S. Dollar: Our bullish stance on the dollar has proven to be correct, as the trade-weighted dollar has appreciated by 5% in the past 12-months thanks to the slowdown in global growth. However, the two reasons for the growth slowdown – Fed tightening and Chinese deleveraging – have started to ease. On March 20 the Fed revised its forward guidance to no rate hikes in 2019 and only one rate hike in 2020. Meanwhile, Chinese total social financing relative to GDP has bottomed, indicating that Chinese authorities have opted for a pause in their deleveraging campaign (Chart 24, panel 1). These developments will likely boost global growth and hurt the countercyclical greenback. Therefore, we recommend investors to slowly shift to a cyclical underweight on the dollar. Euro: Most of the factors that dragged the euro down last year are fading: political risk in Italy has eased, fiscal policy is moving from a headwind to a tailwind, and the relative LEI between the EU and the US has started to pick up (panel 2). Moreover, we see little scope for euro area monetary policy to turn any more dovish versus the U.S., since forward rate expectations currently stand near 2014 lows (panel 3). Thus, we expect the euro to be one of the best performing currencies this year. Yen: Easy monetary policy by global central banks will boost asset prices and reduce volatility, creating a risk-on environment that is typically negative for the yen (panel 4). Moreover, the IMF still projects Japan to have a negative fiscal drag of 0.7% this year, which will force the BoJ to prolong its yield curve control regime. As a result, we expect the yen to be one of the worst performing currencies this year.       Alternatives Intro: Investors’ allocation to alternatives is on the rise as we get closer to the end of the business cycle along with increasing realized volatility in traditional assets. In the alternatives assets space, we recommend thinking about allocations through three buckets: 1) return enhancers, means of outperforming traditional equity, fixed income, and mixed-asset strategies; 2) inflation hedges, means of preserving capital throughout periods of elevated inflation; and 3) volatility dampeners, means of reducing drawdowns and portfolio volatility during periods of market drawdowns. Return Enhancers: In our July and October 2018 Quarterly reports, we recommended investors trim back on PE allocations and reallocate towards hedge funds. Growing competition in the PE space has pushed up multiples. Given where the business cycle currently is, we favor macro hedge funds, as they tend to outperform in this sort of environment as well as in downturns and recessions (Chart 25, panel 1). Inflation Hedges: In our July 2018 Quarterly, we recommended investors pare back their real estate allocations, given the backdrop of a slowdown/sideways trend in the sector, and specifically within the retail segment. Given that the end of the current cycle is likely to be accompanied by elevated levels of inflation, we recommend clients to modestly allocate to commodity futures on the likelihood of a softer dollar and rising energy prices (panel 2). Volatility Dampeners: We continue to recommend both farmland and timberland since they have lower volatility than other traditional and alternative asset classes (panel 3). While timberland is more impacted by economic growth via the housing market, farmland has a near-zero correlation with economic growth. We do not favor structured products due to their unattractive valuations. Chart 25Prefer Hedge Funds Over Private Equity   Risks To Our View Our economic outlook is quite sanguine. What would undermine this scenario? Many investors have become nervous about the inversion of the U.S. yield curve. And we have shown in the past that an inversion of the 3-month/10-year yield curve has been a reliable indicator of recessions 12-18 months ahead.12 Its inversion in March, then, is a concern. But note that the indicator works only using a three-month moving average (Chart 26); the curve often inverted for a brief period without signaling recession. We expect long-term rates to rise from here, steepening the curve. But a prolongation of the current inversion would clearly be a worrying signal. The direction of China continues to play a key role in defining the macro picture. Our current allocation is based on the view that China is doing some monetary and fiscal stimulus but that, at the current pace, it will be much smaller than in 2016 (Chart 27). The weak response of money supply growth suggests, as Premier Li Keqiang has complained, that the liquidity is mostly going into speculation (note that A-shares have risen by 20% this year) rather than into the real economy. The March Total Social Financing data, released in mid-April, will give a better read of the degree of the reflation. If it is bigger than we expect, this would suggest a quicker shift into euro area and Emerging Market equities than we currently advocate. The U.S. dollar remains a key driver of asset allocation. The dollar is a counter-cyclical currency and, with global growth slowing, has continued to appreciate moderately this year (Chart 28). We see a weakening of the dollar later this year, when global growth picks up. But if this were to happen more quickly or dramatically than we expect – not impossible given the currency’s over-valuation and crowded long-dollar positions – EM stocks and commodity prices, given their strong inverse correlation with the dollar, could bounce sharply. Chart 26Yield Curve Inversion Chart 27How Much Is China Reflating? Chart 28Dollar Is Counter-Cyclical   Garry Evans, Chief Global Asset Allocation Strategist garry@bcaresearch.com Xiaoli Tang, Associate Vice President xiaolit@bcaresearch.com Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com Amr Hanafy,  Research Associate amrh@bcaresearch.com   Footnotes 1      Please see the Equities Section of this Quarterly on page 14 for more details. 2      Please see Global Asset Allocation “GAA Quarterly,” dated March 31, 2016 available at gaa.bcaresearch.com 3       Please see https://us.spindices.com/documents/methodologies/methodology-sp-us-style.pdf 4       Please see Global Asset Allocation “Monthly - January 2019,” dated January 2, 2019 available at gaa.bcaresearch.com 5     Please see Global Asset Allocation “Monthly - March 2019,” dated March 1, 2019 available at gaa.bcaresearch.com 6       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 7       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 8       Please see Global Investment Strategy Weekly Report, “What’s Next For The Dollar?” dated March 15, 2019  available at gis. bcaresearch.com 9       Please see Global Asset Allocation “Quarterly - July 2018,” dated July 2, 2018 available at gaa.bcaresearch.com 10    Please see Global Asset Allocation “Monthly Portfolio Update,” dated March 1, 2019 available at gaa.bcaresearch.com 11    Based on BCA’s Global Fixed Income Strategy’s bottom-up health monitor. 12   Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?” dated June 15, 2018 available at gaa.bcaresearch.com GAA Asset Allocation