Economy

Special Report

Dear Client, We will not be publishing a report next week as we take an end-of-summer break. Our next report will be published on Tuesday, September 10th. Best regards, Robert Robis  Highlights Canadian Corporates: The small but growing Canadian corporate bond market has delivered performance comparable to other developed market credit over the past decade, with less duration risk and higher average credit quality compared to the larger U.S. corporate debt market. Returns: Our new regression model for Canadian corporate bond excess returns is calling for modest positive gains for Canadian corporate debt over the next year.  Corporate Health: Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability are longer-term concerns. Allocation: We recommend overweight allocations into Canadian investment grade corporates, versus both Canadian government bonds and U.S. investment grade corporates. Amid elevated global policy uncertainty, favor the moderate spread volatility and attractive valuation in Canadian corporates. Feature Canadian corporate bonds do not get much attention from global fixed income investors due to the relatively small size of the market. Yet Canadian corporates have delivered returns in line with their global peers over the past decade, delivering an average excess return over Canadian government bonds (hedged into U.S. dollars) of 2.8% (Chart  of the Week). Looking ahead, Canadian corporates may present an opportunity for diversification in what is becoming an increasingly challenging environment for corporate bond investors, offering relatively higher yields and better credit quality with an economy that has held up well relative to the current weakening trend in global growth. In this Special Report, we outline the contours of the Canadian corporate bond market, assess the macroeconomic factors driving Canadian corporate bond returns, and survey the current overall financial health of Canadian companies. We also take a high-level look at the state of Canadian corporate debt at the sector level, while offering our recommendations on which ones to favor over the next 6-12 months. A Brief Overview The bulk of outstanding Canadian corporate debt is rated investment grade (IG), but this represents only 5% of the global IG market (Chart 2), using the Bloomberg Barclays Global Corporates Index as a proxy.1 However, the total market capitalization of Canadian corporate bonds is 30% of Canadian GDP – a ratio as large as seen in other major developed countries like the U.S., U.K. and Switzerland (Chart 3).  Like those other markets, Canadian companies have taken advantage of historically low borrowing rates and increased demand for income-generating assets to add leverage to their balance sheets.   On the demand side, Canadian corporates have traditionally been more of an institutional investment product, although domestic retail investor interest has picked up in recent years (mostly through mutual funds and exchange traded funds). The buy-and-hold nature of those local institutional investors reduces liquidity, particularly in comparison to the more widely-traded debt of Canadian federal and provincial governments. Yet according to a September 2018 Bank of Canada (BoC) report, domestic investor concerns over a perceived deterioration of Canadian corporate bond market liquidity appeared overstated.2 The report concluded that corporate bond market liquidity had generally been improving since 2010, with only short-lived bouts of illiquidity around events such as the 2011 European Debt Crisis and the 2014/15 collapse in oil prices. That medium-term improvement in liquidity was especially concentrated in high-grade corporate debt and bonds issued by banks, although the BoC concluded that liquidity and trading activity in low-grade and non-bank bonds have generally been stable. Issuance is dominated by financials, utilities, and energy companies. Unsurprisingly, the defensive utilities sector, which has high borrowing requirements, has been the top-performing industry group in 2019 (total return of +14% year-to-date) against a backdrop of falling bond yields and increased investor nervousness about future global growth (Chart 4). Yet all Canadian corporate bonds have generally performed well, with the overall Bloomberg Barclays Canadian Corporate Index delivering a total return of +8.2% so far in 2019, compared to 11.4% for Canadian equities and 5.6% for Canadian government bonds. Canadian corporate credit spreads have been remarkably stable since the 2008 Global Financial Crisis.  The overall index option-adjusted spread (OAS) has stayed in a range between 100-200bps, while both total and excess (duration-matched versus government debt) returns exhibiting fairly low volatility since 2008 (Chart 5). Canadian corporate credit spreads have been remarkably stable since the 2008 Global Financial Crisis.  The overall index option-adjusted spread (OAS) has stayed in a range between 100-200bps, while both total and excess (duration-matched versus government debt) returns exhibiting fairly low volatility since 2008 The duration of the benchmark Canadian IG corporate index is now 6.4 years, well below the equivalent level for U.S IG (7.9 years) even though it has steadily increased over the past decade.  Over that same period, the average credit quality has deteriorated, with 40% of the Canadian corporate index now rated BBB (Chart 6). This is below the BBB share seen in the U.S. (50%) and euro area (52%), though, making Canadian IG relatively less exposed to potential downgrades to junk bond status. Chart 5Low Volatility Of Spreads & Returns Since 2008 Chart 6Lower Share Of BBBs Compared To The U.S. & Europe Bottom Line: The small but growing Canadian corporate bond market has delivered performance comparable to other developed market credit over the past decade, with less duration risk and higher average credit quality compared to the large U.S. corporate debt market. A Fundamental Model To Forecast Canadian Corporate Bond Returns In order to help forecast Canadian corporate bond performance, we have developed a factor-based regression model of Canadian IG excess returns (in local currency terms). We first determined the independent variables in the regression by compiling a list of potential drivers of bond returns which map to four factor groups: growth, inflation, financial variables, and other miscellaneous factors. After statistically testing those factors, the insignificant and unrelated ones were dropped. The final result of this analysis is shown in Table 1. Table 1Regression Details Of The Fundamental Canadian Corporate Bond Return Model We concluded that five variables explain the bulk of Canadian corporate bond returns:  the annual percentage change in oil prices (using the Canadian benchmark, Western Canadian Select), non-residential fixed investment growth, the M3 measure of money supply growth, the Canadian dollar trade-weighted index (CAD TWI), and the level of Canadian industrial capacity utilization. We concluded that five variables explain the bulk of Canadian corporate bond returns:  the annual percentage change in oil prices (using the Canadian benchmark, Western Canadian Select), non-residential fixed investment growth, the M3 measure of money supply growth, the Canadian dollar trade-weighted index (CAD TWI), and the level of Canadian industrial capacity utilization. Chart 7A Fundamental Model Of Canadian Corporate Bond Returns Looking at recent excess return history (Chart 7), it is not surprising that oil prices significantly affect returns given the importance of Canada’s energy sector to the overall Canadian economy.  Moreover, growth in non-residential fixed asset investment also positively influences excess returns as faster capital spending can potentially increase the profitability of Canadian firms. In contrast, the inflation factors - money supply and capacity utilization – are detrimental to returns. Increases in both of those factors can result in higher inflation and rising bond yields as the BoC is forced to tighten monetary policy, which often results in rising risk premiums and wider corporate credit spreads (falling excess returns). Finally, the CAD TWI is (weakly) positively correlated to corporate bond excess returns. A stronger currency is a reflection of a strong domestic economy, but it also helps lower imported input costs for Canadian companies – both of which boost corporate profits and corporate bond returns. We now turn to the outlook for these factors over the next 6-12 months, which remain generally supportive for moderate positive excess returns for Canadian corporates: Oil prices: BCA’s commodity strategists expect global oil prices to increase moderately over the next year as global inventory drawdowns outpace expectations (Iran sanctions, Venezuela production collapsing and OPEC 2.0 production discipline are likely sources of supply restraint). In addition, if global growth starts to rebound from the end of this year, as we expect, oil demand will also rise. Non-residential fixed investment: According to the BoC’s most recent Business Outlook Survey of Canadian companies, investment spending plans of firms remain healthy – although that survey was taken at the end of June before the latest increase in uncertainty over global trade and economic growth.3  Moreover, relatively easy credit conditions have made it easier for firms to finance capex. Therefore, our baseline scenario is still to expect moderate growth in non-residential fixed capital investment, although risks are to the downside given the global macro uncertainties. Money supply: The most recent reading of the annual growth of Canadian M3 from June was a solid +7.5%. The BoC is expected to maintain an accommodative monetary policy stance, keeping the current policy rate on hold until the end of 2020. Therefore, money supply growth is likely to remain firm – a negative for Canadian corporate bond returns in our model, although perhaps less so than in the past since rapid money growth will not generate the same type of monetary tightening response from the BoC. Capacity utilization: The Canadian capacity utilization rate is currently at 81%, a meaningful pullback from the 84% level seen in early 2018. According to the latest BoC Monetary Policy Report, the Canadian economy is operating below potential (the output gap in Q1 was estimated to be between -1.25% to -0.25% of potential GDP) and that gap is only expected to close over the next two years.  Thus, capacity utilization is not expected to have a major impact on corporate excess returns over the next 6-12 months. Canadian Dollar: The CAD TWI has shown no change over the past year, and will likely remain near current levels in the short term. Although we do not expect the BoC to cut interest rates as much as currently discounted by markets (-40bps over the next twelve months), Canadian monetary policy will still remain accommodative and will likely keep the CAD relatively soft until global manufacturing growth and trade activity stabilize and begin to revive. The CAD is likely to be a neutral factor for Canadian corporate returns over the next year. Bottom Line: Our new regression model for Canadian corporate bond excess returns is calling for modest positive gains for Canadian corporate debt over the next year.  Canadian Corporate Balance Sheet Health: OK For Now, But At Risk If The Economy Weakens Chart 8The BCA Canadian Corporate Health Monitors Regular readers of our work will be familiar with our Corporate Health Monitor (CHM) framework. In this approach, we combine financial ratios that are most important for corporate creditworthiness of the entire non-financial corporate sector of a given country into a summary indicator that is designed to track corporate credit spreads. We introduced a Canadian CHM in April 2018, both using top-down national accounts data and aggregated bottom-up ratios from actual company financial statements.4  The latest reading from our top-down and bottom-up Canadian CHMs suggest that the overall health of Canadian corporates is decent, with the CHMs both below the zero line (Chart 8).5  Digging into the individual ratios, however, does reveal some potential signs of future weakness.  Leverage is relatively high, while profitability metrics and interest coverage ratios are at the low end of the historical range.  However, in our CHM framework, how the latest data compares to the medium-term trend – rather than the absolute level of the ratios - is most relevant for corporate bond performance. On that front, the latest data points for the CHM ratios do represent modest improvements versus the levels seen in 2014 and 2015, which is why our CHMs remain in the “improving health” zone. The more cyclically-driven ratios (profit margins, return on capital, interest coverage) declined amid the sharp plunge in Canadian economic growth at the end of 2018. However, given the recent reacceleration visible in some Canadian economic data, those cyclically-driven ratios may end up showing signs of stabilization, if not improvement, once the underlying CHM data for Q2/2019 and Q3/2019 are available. Looking ahead, Canadian corporate debt would be vulnerable to spread widening (rising risk premiums) in the event of a sustained slowing of the Canadian economy, given the poor absolute levels of the CHM component ratios. With the BoC maintaining an accommodative monetary policy stance, however, and the Canadian economy likely to continue growing at a trend-like pace supported by consumer spending, we think the backdrop will remain conducive to credit spread stability in Canada over the next 6-12 months. With the BoC maintaining an accommodative monetary policy stance, however, and the Canadian economy likely to continue growing at a trend-like pace supported by consumer spending, we think the backdrop will remain conducive to credit spread stability in Canada over the next 6-12 months. Bottom Line: The financial health of Canadian companies remains a positive for corporate bond returns on a cyclical basis, but there are longer-term concerns given high leverage and mediocre profitability. Canadian Corporate Bond Sector Valuation For IG corporate sectors in the U.S., euro area and the U.K., we utilize a relative value framework to rank credit spreads within the benchmark corporate universe.  We can apply that same approach to assess valuations of Canadian corporate bond sectors. In our sector relative value model, the “fair value” option-adjusted spread (OAS) for each sector within the Bloomberg Barclays Canadian IG Corporate index is estimated based on a panel regression. The explanatory variables in the regression are the modified duration, convexity and credit rating of each industry sub-sector within the index. The regression produces a set of common coefficients for all sectors that can be used to estimate a fair value OAS for each industry group as a function of its own interest rate duration, convexity and credit quality – all important drivers of corporate bond returns. The Risk-Adjusted Valuation is the difference between each sector’s current OAS and the model estimate of the sector’s fair value OAS.  A positive Risk-Adjusted Valuation implies undervaluation for the sector in question, and a negative reading implies overvaluation. Table 2 shows the recommended positioning of the Canadian IG industry sectors based on our relative value model. Sectors with positive Risk-Adjusted Valuations have overweight allocations versus the benchmark, with the opposite holds true for sectors with negative valuations. Sectors with spreads that are very close to fair value (within a range of +5bps to -5bps) have only a neutral recommended weighting versus the benchmark. Table 2Canada Investment Grade Corporate Bond Aggregate: Sector Relative Valuation* Chart 9 depicts the risk/reward tradeoff between the valuation metric and the riskiness of each sector as measured by its duration-times-spread (DTS).  Valuation is measured along the vertical axis of the chart, while DTS is measured along the horizontal axis. Sectors with higher DTS exhibit greater excess return volatility and are thus riskier. In the current environment of heightened uncertainty and slowing global growth, but with the BoC and other global central banks responding with a more dovish monetary policy stance, targeting cheap sectors that are less risky (i.e. DTS scores close to or below the average DTS of all sectors) is a prudent strategy.  Those would be sectors that appear in the upper left quadrant of Chart 9, like Metals & Mining, Finance Companies and Office REITs. Chart 10Positive Support For Canadian Consumer Cyclicals We also see a case for overweighting the cheap Consumer Cyclical Services sector, even with a DTS that is modestly higher than the overall index, given the continued strength in the Canadian labor market which supports consumer confidence through rising earning power (Chart 10). Recommended underweights are in the bottom right quadrant of Chart 9, with expensive valuations and high DTS scores, like Utilities: Natural Gas, Utilities: Electric, Supermarkets and Food & Beverage. Bottom Line: Favor Canadian corporate bond sectors with cheap valuations and spread volatility close to that of the overall benchmark index. Investment Conclusions Chart 11Canadian Corporates Outperformance Vs U.S. Will Continue Canadian IG corporates now offer a potential opportunity to diversify corporate bond exposure away from the larger markets in the U.S. and Europe.  The Canadian economy remains resilient despite slowing global growth, while the fundamental drivers of Canadian corporate bond returns are stabilizing or even improving. At the same time, the economic weakness abroad and heightened trade/political uncertainty will ensure that the BoC maintains an accommodative monetary stance over the next 6-12 months. That is not to say that Canadian corporates are not without risk. Canada is not a low-beta market - spreads do widen during “risk-off” periods in global financial markets. Also, underlying Canadian corporate credit fundamentals look poor on a long-term basis; Canadian private sector debt levels are high (especially for households); and the export-intensive Canadian economy is vulnerable to any incremental deceleration of global growth in particular, and the US more specifically.  Yet as a relative value trade versus the much larger corporate bond market to the south, Canadian corporates are well positioned to continue their recent bout of outperformance versus U.S. equivalents over the next 6-12 months, for the following reasons (Chart 11): While markets are priced for rate cuts from both the Fed and the BoC, the starting point for monetary conditions is easier in Canada than in the U.S. given the much weaker level of the Canadian dollar compared to the U.S. dollar. There is a wide gap between the corporate credit fundamentals in Canada and the U.S. according to our top-down Corporate Health Monitors for both countries, such that Canadian balance sheets are more robust. There is a wide gap between the corporate credit fundamentals in Canada and the U.S. according to our top-down Corporate Health Monitors for both countries, such that Canadian balance sheets are more robust. Bottom Line: We recommend that domestic Canadian investors continue to stay overweight Canadian corporates versus Canadian government bonds, while keeping an overall level of spread risk close to benchmark. Global credit investors that have access to the Canadian corporate bond market should consider allocations out of U.S. investment grade corporates into Canadian equivalents. Ray Park, CFA, Research Analyst ray@bcaresearch.com Robert Robis, CFA,  Chief Fixed Income Strategist rrobis@bcaresearch.com  Footnotes 1 Throughout this report, we solely use data on Canadian corporate debt from the Bloomberg Barclays bond indices, which is the main index data we use in all our global bond research. Comprehensive data is also available from other providers such as FTSE Russell and S&P Global. 2 Bank of Canada September 2018 Staff Analytical Note 2018-31, “Have Liquidity and Trading Activity in the Canadian Corporate Bond Market Deteriorated?” 3 https://www.bankofcanada.ca/2019/06/business-outlook-survey-summer-2019/ 4 Please see BCA Global Fixed Income Strategy Weekly Report, “BCA Corporate Health Monitor Chartbook Update: Growth Is Papering Over The Cracks”, dated April 24, 2018, available at gfis.bcaresearch.com 5 A CHM below zero implies improving financial health, while a CHM above zero indicates deteriorating financial health. Thus, the direction of the CHM is designed to be positively correlated with corporate credit spreads.

Special Report

Feature According to the official reported growth rate, Chinese industrial profit growth ticked slightly back into positive territory in July, after having fallen into modestly negative territory earlier this year. However, market participants have increasingly noted the gaping difference between the reported year-over-year (YoY) growth rate and the YoY growth rate of the reported level, with the latter having shown a much weaker profile over the past two years (Chart I-1). Chart I-1Will The Real Profit Trend Please Stand Up? The profile in the growth of overall earnings per share of listed companies does not match that of the reported level of industrial profit growth (either in the domestic or investable markets), and it remains unclear whether this is due to changes in shares outstanding or other factors. But the divergence between the two series shown in Chart I-1 has certainly focused investor attention on China’s profit outlook, which has deteriorated over the past year regardless of the data series used. This deterioration in earnings has raised the risk of a bullish cyclical position towards Chinese stocks for two reasons: 1) it makes an eventual uptrend in stock prices conditional on a rebound in EPS and, 2) it had led to a deterioration in corporate health in what has become a highly-leveraged economy. The latter is particularly notable, given the backdrop of serious investor concern over rising (although still low) onshore corporate defaults. To investigate the impact of declining/decelerating profit growth on Chinese corporate health, this week we are updating our China Industry Watch thematic chartpack. The charts shown on pages 6 - 27 present our corporate health monitor (CHM) and its components across multiple industries (see below for our CHM methodology).1 Several observations are noteworthy: Although our aggregate CHM for all industrials hasn’t yet fallen back to levels seen in 2008 or during the early-2000s, the deceleration in profit growth has clearly caused a meaningful deterioration in corporate health (Chart I-2). To underscore the point, our aggregate CHM suggests that Chinese industrial sector health is presently the worst that it has been since the global financial crisis (Chart I-3). While we acknowledge that Chinese authorities remain reluctant to prompt a large rise in the macro leverage ratio, this core finding of our report raises the stakes for policymakers in terms of their ability to tolerate significant further weakness in economic activity. Chart I-2In China, Profit Growth Drives Corporate Health Chart I-3Chinese Corporate Health Now The Worst Since the Global Financial Crisis Our sub-industry CHMs shed some light on what has driven the deterioration in our overall CHM. The monitors show a particularly marked decline in corporate health for the steel, non-ferrous metals, construction materials, autos, and information technology sectors. Three of these sectors (steel, non-ferrous metals, and IT) are particularly sensitive to exports, suggesting that the trade war with the U.S. is at least partially responsible for the worsening corporate health of industrial enterprises. However, the auto and construction materials sectors tend to be domestically-oriented, underscoring that some of the weakness in these sectors is purely homegrown. Corporate health for energy-related sub-industries (oil & gas and coal) continues to improve from a poor starting point, and the incredible two-decade improvement in health for the food & beverage sector has continued, which shows that Chinese demand for consumer staples remains robust. Measured either by debt-to-assets or interest coverage, China’s industrial enterprises have experienced a broad-based worsening of leverage. To the extent that “deleveraging” has happened, it has occurred in some of China’s “old industries” such as coal, steel, and non-ferrous metals. On the efficiency front, coal and steel have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign; besides this, inventory, asset, and receivable turnover has deteriorated in nearly every other sub-industry. Similarly, profit growth has decelerated and/or fallen into negative territory broadly across sub-industries along with a meaningful deceleration in revenue growth. Utilities and food & beverage are the notable outliers, where profit growth has moderately recovered due to a combination of positive revenue growth and wider margins. Chart I-4Non-SOE Profits: A Leading Indicator For Overall Profit Growth? Finally, Chart I-4 provides an interesting perspective about overall profit growth. A breakdown of profit growth by ownership (state-owned vs. non-state-owned enterprises), shows that non-SOE industrial profits led the decline in overall profit growth in 2017-2018. While it has not yet occurred, a significant pickup in non-SOE profit growth may herald a durable bottom for industrial sector profits, which could act as a meaningful outperformance catalyst for Chinese stocks over the coming 6-12 months. To us, the significant decline in corporate health noted in this report reinforces both our tactically bearish and cyclically bullish recommendations towards Chinese stocks. In the near-term, the risks facing Chinese stocks are high, as the combination of the reluctance of policymakers to stimulate aggressively, weaker corporate health, and the likelihood of negative near-term economic and profit momentum is a perfect storm for stock prices. We recommend an underweight position relative to global stocks for the remainder of the year. However, over the cyclical time horizon (i.e. 6-12 month), these circumstances also suggest high odds in favor of Chinese policymakers soon accepting the need to ease meaningfully further. Barring a major episode of earnings dilution among publicly-listed stocks, significant further easing along with controlled currency depreciation makes a strong case for an overweight stance towards Chinese stocks versus the global benchmark in local currency terms.2 We recommend that investors who are not yet invested in Chinese assets to remain on the sidelines until clearer signs of materially stronger stimulus emerge. However, intermediate-term investors who are already positioned in favor of Chinese equities should stay long, as the relative performance trend of Chinese stocks will likely be higher a year from now than it is today.   Qingyun Xu, CFA, Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   BCA's China Industry Watch The BCA China Industry Watch includes four categories of financial ratios to monitor a sector’s leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators   Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Chart II-36Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Chart III-54Food & Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators   Footnotes 1      Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch”, dated February 10, 2016, available at cis.bcaresearch.com. 2      We continue to recommend that investors hedge the currency exposure of a long Chinese equity position by being long USD-CNH. Cyclical Investment Stance Equity Sector Recommendations

There will be no U.S. Bond Strategy report next week. Our regular publication schedule will resume on September 10th, with our Portfolio Allocation Summary for September. Highlights Fed: Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it. Expect another 25 basis point rate cut in September. Duration: Stronger economic data will eventually lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. Yield Curve & Recessions: An inverted yield curve signals that the market views monetary policy as restrictive. Restrictive policy should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. Feature Chart 1Markets Want More Easing And The Fed Should Accommodate Bond investors had their hands full last week, as comments from Fed officials produced an unusually wide range of views. The hawks were most vocal early in the week as Boston Fed President Eric Rosengren, Kansas City Fed President Esther George and Philadelphia Fed President Patrick Harker all made the case for leaving rates at current levels, even as the market continues to price-in another 25 basis point rate cut in September, followed by an additional 50 basis points of cuts between October and February (Chart 1). Fed Chairman Jerome Powell, however, did not try to shift market expectations one way or the other during his Jackson Hole speech on Friday. This suggests that he is probably comfortable with current bond market pricing. In our opinion, we will see another 25 basis point rate cut in September and the Fed is justified in doing so. The Fed Can’t Fight The Markets, And It Shouldn’t Chart 2Keep Financial Conditions Supportive In the current environment, monetary policy exerts its greatest influence on the economy via its impact on broad financial conditions. Easier financial conditions lead to stronger growth and higher inflation in the future (Chart 2), and the Fed must ensure that financial conditions remain accommodative during the current global slowdown. This means that the Fed’s most important job is to ensure that investors perceive Fed policy as supportive for equities and corporate credit. In other words, unless Chairman Powell wants to slow the economy, he must bow down to the markets and deliver enough monetary easing to keep broad financial conditions accommodative. The minutes from the July FOMC meeting, released last week, suggest that the Fed understands this dynamic and will act as appropriate. In their discussion of financial market developments, participants observed that financial conditions remained supportive of economic growth, with borrowing rates low and stock prices near all-time highs. Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks. Chart 3No Sign Of Rising Inflation Expectations... Simply, if the market expects another rate cut in September, the Fed would be wise to deliver. Otherwise, broad financial conditions could tighten sharply, making it more difficult for economic growth to recover. It is not always the case that the Fed should act to ensure that financial conditions remain accommodative. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations.1 However, neither of those conditions are in place today. The cost of inflation compensation priced into long-maturity TIPS has collapsed, and it is well below the 2.3% - 2.5% range that would be consistent with well-anchored inflation expectations near the Fed’s target (Chart 3). Survey measures of long-dated inflation expectations have been more stable, but are not threatening to move significantly higher (Chart 3, bottom panel). Equally, financial asset valuations are nowhere near “bubbly” (Chart 4). The risk premium priced into corporate bonds after accounting for expected default losses is above levels seen early last year, while the S&P 500’s 12-month forward Price/Earnings ratio is below its early-2018 peak. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations. Further, the 2-year/10-year Treasury slope recently inverted and the broad trade-weighted dollar continues to appreciate (Chart 5). Both of these factors suggest that the market views Fed policy as insufficiently accommodative. St. Louis Fed President James Bullard bluntly summed up the situation in an interview last week, saying that it is “our job to get the yield curve to be un-inverted”. Chart 4...Or Excessive Financial ##br##Asset Valuation Chart 5The Case For More Accommodative Monetary Policy We agree with this sentiment. Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it, in an effort to un-invert the yield curve. The Economy Must Lead Chart 6Still Waiting For A Rebound In Global Growth But the Fed can’t un-invert the yield curve all on its own. The Fed can pull down the short-end of the curve, but it needs to economy to cooperate if it wants to boost long-end yields. In fact, if the global economic data improve, then the market will no longer require Fed rate cuts to keep financial conditions accommodative. If the economic data improve a lot, then the market might even be able to live with rate hikes and still maintain supportive broad financial conditions. We haven’t yet seen much evidence of improvement in the global economic data, but we remain confident that a rebound will take hold before the end of the year.2 Flash PMI data for August were released last week and showed a drop in the U.S. figure to below the 50 boom/bust line (Chart 6). The Flash data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. In contrast with the weaker PMI data, Leading Economic Indicators (LEI) are showing some signs of strength. Although both the U.S. and Global (excluding U.S.) LEIs remain at below-average levels relative to their trailing 12-month trends (Chart 7), the Global (ex. U.S.) index bottomed several months ago and the U.S. index ticked higher last month. Troughs in the LEIs tend to precede troughs in both the Global PMIs and bond yields.  Chart 7Leading Economic Indicators Suggest The Rebound Might Be Soon Bottom Line: The Fed must keep financial conditions accommodative, and this means satisfying the bond market’s expectations for further rate cuts. Eventually, stronger economic data will lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. The Inverted Yield Curve And Recession Risk We have received a lot of client questions on the topic of using the yield curve to forecast recessions. In this week’s report we explain our views about how the inverted yield curve should be interpreted. In short, we think an inverted yield curve should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. The Flash PMI data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. We start by recognizing that many variables have strong track records at forecasting recession, and those variables can be grouped into two broad categories: Financial market indicators (including the yield curve, stock market, oil price, etc…) Economic indicators (including initial jobless claims, unemployment rate, housing starts, etc…) In general, financial market indicators give more advance warning of recession but they are also prone to sending false signals. Economic indicators, on the other hand, are less prone to false signals, but often provide little (if any) advance notice. With this in mind, we turn to Chart 8. The top panel of which shows the New York Fed’s popular Recession Probability Indicator, an indicator derived purely from the 3-month/10-year Treasury slope. We also calculate the same model using the 2-year/10-year slope, but the results are not materially different. Chart 8Recession Probability Indicators The top panel of Chart 8 shows the strengths and weaknesses of using financial market data to forecast a recession. The New York Fed’s model started to rise about 3 years prior to the last recession and 5 years prior to the 2001 recession. The model also fluctuated up and down several times in the late 1990s, suggesting that recession risk was lower in 1998 than in 1996 even though the recession was actually 2 years closer. In general, the model clearly illustrates that the yield curve flattens as the economic recovery ages, but also that the yield curve can provide a recession signal far in advance of the actual recession. The model’s signal can also reverse if the yield curve re-steepens. The bottom panel of Chart 8 shows the New York Fed’s yield curve-based Recession Probability Indicator alongside our own recession indicator, one that is based on several different variables (including the yield curve). Our model is designed to give less lead time than a pure yield curve model, but also fewer false signals. Once again, the late-1990s are instructive. The yield curve-only model was sending a recession signal of varying magnitudes for 5 years before our multi-factor model shot higher in 2001. What can we conclude from looking at these different recession models? Essentially, we should view an inverted yield curve as a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. Policy could remain restrictive for several years before the recession takes hold, or policy could move from restrictive to accommodative and the yield curve’s recession signal could vanish. Incorporating The Term Premium, Is This Time Different? Some publications at BCA have made the case that the yield curve’s recession signal is distorted in this cycle because of the deeply negative term premium. While this could be true in theory, in practice, we think it would be unwise to dismiss what the yield curve is telling us about the current stance of monetary policy. Chart 9Uncertainty Around The Term Premium Bond yields consist of two components, short rate expectations and a term premium. The yield curve’s power as a recession indicator comes from the rate expectations component. Assuming a constant term premium, an inverted yield curve means that the bond market expects the overnight rate to fall in the future. This is more likely to happen in a recession. However, if the term premium were deeply negative at the long-end of the yield curve, then an inverted yield curve might simply reflect the negative term premium and not an expectation that the fed funds rate will decline. In theory, this could be the case if, for example, the equity hedging value of Treasury bonds is perceived to be much higher now than in the past. In that case, investors might be willing to pay to take duration risk in order to gain the perceived diversification benefits. That is a plausible story. The problem is that we cannot verify it in the data because bond term premia cannot be accurately estimated. For example, one popular term premium estimate, the New York Fed’s Adrian, Crump and Moench (ACM) estimate, placed the 10-year zero coupon term premium at -84 bps on July 22. On that same date, the spot 10-year Treasury yield was 2.06%. This implies that the market’s 10-year average fed funds rate expectation was (206 bps – (-84 bps)) = 2.9%. In other words, the ACM estimate tells us that on July 22 the market expected the fed funds rate to average 2.9% over the next 10 years. This seems highly implausible, given that the New York Fed’s Survey of Market Participants, taken that same day, shows that the median market participant expected the fed funds rate to average 2% over the next 10 years (Chart 9). According to that median survey response, the 10-year term premium was +6 bps on July 22, not -84 bps! The point is not that survey measures of term premia are preferable to more sophisticated models of the ACM variety. We simply wish to point out that term premia estimates are highly uncertain, and the actual term premium on any given day is impossible to pin down. Once we recognize this fact, then we should at least be skeptical of claims that a negative term premium is distorting the recession signal from the yield curve. Given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value. Bottom Line: The proper interpretation of an inverted yield curve is that it is a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. It is conceivable that a deeply negative term premium is currently distorting the yield curve’s signal about the stance of monetary policy. But given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 We have made the case that inflation expectations and financial conditions are the two most important factors to monitor when tracking Fed policy. For further details please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 2  We elaborated on the reasons to expect a rebound in global growth in the U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?” dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy The sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. Weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index, all signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index.   Waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P electrical components & equipment (EC&E) index.  Recent Changes There are no changes to the portfolio this week. Table 1 Feature The S&P 500 traded in an uncharacteristically tight range last week before falling apart on Friday on the back of a re-escalation in the U.S./China trade war. Worries of recession also resurfaced. Not only did the MARKIT flash manufacturing PMI break below the 50 expansion/contraction line, but it also pulled down the MARKIT flash services PMI survey that barely held above the boom/bust line. Adding insult to injury, the 10/2 yield curve slope inverted anew last week further fanning these recession fears. Worrisomely, consumer sentiment took a hit recently according to the University of Michigan survey (top panel, Chart 1). Importantly, what caught our attention was the following commentary: “The main takeaway for consumers from the first cut in interest rates in a decade was to increase apprehensions about a possible recession. Consumers concluded, following the Fed’s lead, that they may need to reduce spending in anticipation of a potential recession.” While the consumer is the last and most significant pillar standing for the U.S. economy, reflexivity may spoil the party and a recession may become a self-fulfilling prophecy. This is the message the bond market is sending and it is warning that the path of least resistance is a lot lower for stocks (bottom panel, Chart 1). Chart 1“The First Cut Is The Deepest” Economists are also downgrading their U.S. real GDP growth estimates and that forecast now stands at 2.3% for the current year according to Bloomberg. While the recession alarm bells are not sounding off, these downward revisions bode ill for stocks (Chart 2)  Chart 2Watch Out Down Below Moving to another part of the fixed income market, stress is slowly building in the high yield market especially given the recent tick up in bankruptcies and the blind sides that cove-lite loans now pose to bond investors. As a reminder, the U.S. high yield option adjusted spread (OAS) troughed last September and continues to emit a distress signal for the broad equity market (junk OAS shown inverted, top panel, Chart 3). Chart 3Mind The Gaps With regard to global growth, it is still missing in action, and given that Dr. Copper is on the verge of a breakdown, a global growth recovery is a Q1/2020 story at the earliest. This week we update a consumer discretion­ary subindex and also highlight an industrials sector subgroup. Chart 4SPX: The Next Shoe To Drop? Chart 5Risk To View Other financial market variables concur that global growth is elusive. J.P. Morgan’s EM FX index has broken down and EM equities are also hanging from a thread. The EM high yield OAS has broken out signaling that the risk off phase has yet to fully run its course (EM junk OAS shown inverted, bottom panel, Chart 4). Finally, there is a short-term risk to our cautious equity market view. Indiscriminate buying in U.S. Treasurys has now pushed the 10-year yield down almost 180bps from last November’s peak deeply in overvalued territory. While such a move is not unprecedented, buying may be exhausted and in need of at least a short-term breather (Chart 5).     Netting it all out, the sustained global growth slowdown, widening junk spreads, along with the risk of a U.S. recession becoming a self-fulfilling prophecy suggest that caution is still warranted in the broad equity market on a 3-12 month time horizon. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. This week we update a consumer discretionary subindex and also highlight an industrials sector subgroup. Empty Spaces When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. The latest University of Michigan consumer sentiment survey made for grim reading and such souring in confidence will continue to weigh on lodging equities (Chart 6). As a result, we remain underweight the niche S&P hotels, resorts & cruise lines consumer discretionary subgroup. When the consumer is worried about a possible recession as the latest survey revealed, the knee jerk reaction is to tighten the purse strings and marginally retrench. Chart 6Stay Checked Out Of Hotels   Already discretionary retail sales have taken the back seat and non-discretionary retail sales are in the driver’s seat. In fact, the top panel of Chart 7 shows that the relative retail sales backdrop has plunged to levels last seen during the GFC, warning that relative share prices have ample room to fall. Drilling deeper in the consumption data is instructive. Lodging outlays are decelerating and are also trailing overall PCE. The implication is that relative profits will likely underwhelm sustaining the 18-month long de-rating phase (middle & bottom panels, Chart 7). On the operating front the news is equally dour. While selling prices are expanding, the relentless construction binge will lead to a mean reversion sooner rather than later (bottom panel, Chart 8).   Chart 7De-rating Phase To Gain Steam Chart 8Margin Squeeze Looming   Tack on the ongoing assault from the new sharing economy unicorns like Airbnb, and industry pricing power will remain in check in coming quarters. Similarly, the ISM non-manufacturing price subcomponent is warning that a deflation scare is looming in the lodging industry (second panel, Chart 8). Not only are selling prices under attack, but also labor-related input costs are on fire. The sector’s wage inflation is climbing at a 3.9%/annum pace or roughly 120bps higher that the overall employment cost index (third panel, Chart 8). Taken together, there are high odds that a profit margin squeeze will weigh on profits and on relative share prices (top panel, Chart 8). Importantly, the overall ISM services survey best encapsulates the bearish backdrop of the S&P hotels, resorts & cruise lines index. Historically, relative share prices have been moving in tandem with the ISM non-manufacturing survey and the current message is that selling pressures on relative share prices will persist in the coming months (Chart 9). Chart 9Heed The Message From The ISM Services Survey In sum, weakening consumer sentiment, softening hotel industry operating metrics that point to a margin squeeze, anemic relative outlays on lodging and a decelerating ISM non-manufacturing index signal that more pain lies ahead for the S&P hotels, resorts & cruise lines index. Bottom Line: Continue to avoid the S&P hotels, resorts & cruise lines index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, RCL, CCL, NCLH. Short Circuited The S&P EC&E index broke down recently (top panel, Chart 10) and we reiterate our underweight recommendation in this industrials sector subgroup. While it is tempting to bottom fish here especially given oversold technical and bombed out valuations (bottom panel, Chart 11), a number of the indicators we track suggest that more losses are around the corner. Chart 10Sell The Weakness Chart 11Good Reasons For Valuation Discount   First the trade-weighted dollar has broken out to fresh cyclical highs despite the collapse in the 10-year yield. Historically, relative share prices and the greenback are tightly inversely correlated and the current weak global growth message the U.S. dollar is emitting is bearish for the S&P EC&E index (U.S. dollar shown inverted, middle panel, Chart 10). This global growth soft patch is not only negative for new orders owing to deficient foreign demand, but the appreciating currency also makes EC&E exports less competitive in the global market place (U.S. dollar shown inverted, bottom panel, Chart 10). Second, while industry new orders have been resilient, the massive inventory buildup dwarfs new order growth and warns that a deflationary liquidation phase is looming (middle panel, Chart 11). In fact, the recent drubbing in the ISM manufacturing prices paid subcomponent portends a deflationary industry phase (third panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Other operating metrics are also warning that EC&E profits will underwhelm. Industry weekly hours worked have plunged and sell-side analysts have been aggressively cutting EPS estimates (bottom panel, Chart 13). On the productivity front, executives have not adjusted labor cost structures to lower running rates yet (second panel, Chart 13) and, thus, our EC&E productivity gauge (industrials production versus employment) is contracting which bodes ill for industry earnings (third panel, Chart 13). Chart 12Weak Profit Backdrop Chart 13Deteriorating Operating Metrics   Finally, our S&P EC&E EPS growth model does an excellent job in encapsulating all these moving parts and is signaling that the path of least resistance is lower for EPS growth in the coming months (bottom panel, Chart 12). Adding it all up, waning industry operating metrics, a bearish signal from our EPS growth model along with the mighty U.S. dollar warns against bottom fishing in the S&P EC&E index. Bottom Line: Stay underweight the S&P EC&E index. BLBG: S5ELCO – AME, EMR, ETN, ROK.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps