Economy

Highlights We recently upgraded our recommended investment stance on global corporate bonds to overweight on a tactical (3 to 6 months) basis.1 Feature That change was mostly based on our view that global financial conditions had tightened enough in late 2018 – both through lower equity prices and wider corporate credit spreads – to force central banks (most notably, the Fed) to shift to a less hawkish policy bias. Our opinion that global growth expectations had grown too pessimistic, particularly in the U.S., also played a role in the upgrade (Chart 1). Chart 1Global Corporates: Too Much Bad News Now Discounted One other supporting factor for the upgrade to corporates: the prior bout of spread widening was not justified by a significant worsening of the underlying financial health of companies. With that in mind, this week we are presenting our latest update of the BCA 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 Pages 15-16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement, but with divergences starting to open up among individual regions. The U.S. has delivered the biggest improvement in corporate health, thanks largely to the boost to profitability from the Trump corporate tax cuts. Euro area corporates still appear to be in decent health, but are now exposed to the sharp slowing of European growth and the end of the ECB’s buying of corporates through its Asset Purchase Program. Meanwhile, corporate health in the U.K. and Japan is showing some strain from weaker growth in both countries. Given those regional divergences, we continue to prefer U.S. corporates over non-U.S. equivalents, even within that tactical overweight recommendation on global corporate exposure. Beyond that tactical timeframe, however, there are growing risks for corporate bond performance. Our base case scenario is that resilient U.S. growth and inflation will prompt the Fed to restart the rate hike cycle later in the year, creating a more challenging backdrop for corporates from U.S. growth uncertainty and rising volatility. Yet if the U.S. (and global) economy surprises to the downside, that is even worse for corporate bond returns given how the only real improvements in our global CHMs have come from cyclical variables like profit margins and interest coverage. U.S. Corporate Health Monitors: Strong Profits “Trump” High Leverage Our top-down CHM for the U.S. has ever so slightly flipped into the “improving health” zone, after flashing “deteriorating health” since mid-2014 (Chart 2). The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. Chart 2Top-Down U.S. CHM: Supported By Cyclically Strong Profits There are clear uptrends in the ratios that go into the top-down CHM that are directly related to corporate profits – return on capital, profit margins, interest coverage and debt coverage. 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. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also shown meaningful cyclical progress, with the HY indicator now firmly in “improving health” territory. This confirms that the signal from our top-down CHM is being reflected in both higher rated and lower quality companies. Yet the longer-term issues related to high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. Chart 3Bottom-Up U.S. IG CHM: Steady, But Have Margins Peaked?   Chart 4Bottom-Up U.S. High-Yield CHM: Only A Cyclical Improvement Interest coverage remains the key ratio to watch in both the IG and HY bottom-up U.S. CHMs. For IG, the fact that interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates, is worrisome. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate revenues, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or if U.S. earnings growth slows sharply – likely from rising labor costs eroding high profit margins. For HY, interest coverage remains depressed by historical standards, with the liquidity ratio down to levels last seen prior to the 2009 recession. This suggests that U.S. HY companies are at risk of a severe default cycle when the current U.S. economic expansion ends, with fewer liquid assets available to meet current liabilities. Given these more medium-term fundamental concerns, we do not plan on overstaying our current tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). We anticipate cutting our recommended exposure once the Fed begins signaling a need to restart the rate hikes, likely around mid-year. For those with an investment horizon beyond the next six months, the more prudent decision may be to sell into the corporate bond outperformance that we are expecting. The medium-term outlook for U.S. corporates is far more challenging given the advanced age of the U.S. monetary, business and credit cycles. Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY Euro Corporate Health Monitors: Stable, But Slowing Growth Is A Problem The CHMs remain a core part of our suite of bond market indicators, reliably proving their usefulness in helping evaluate the fundamental risks in owning corporate bonds. That does not, however, mean that there is no room for improvement in the CHM methodology from time to time. This is the case for our top-down CHM for the euro area, which has been behaving in a manner inconsistent with our bottom-up CHMs for the region – which are based on actual reported financial data from publicly traded companies – for some time. This is not the case in the U.S., where our bottom-up and top-down CHMs continue to move broadly in lockstep. Thus, we are taking our top-down euro area CHM “into the garage” for repairs. We will revisit all aspects of the methodology, from calculations to data sources, to try and improve the signal from the top-down euro area CHM. We plan on introducing a new and (hopefully) improved indicator sometime in the next few months. The message from our bottom-up CHMs for euro area IG and HY is still generally positive for overall European corporate health. Yet there are noticeable divergences within the sub-components of those individual CHMs that paint a more worrisome picture. For IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former worsening on the margin (Chart 6). While interest/debt coverage has improved for domestic issuers, operating margins and return on capital remain low and leverage has been inching higher. These trends have not been matched by foreign issuers. Perhaps most ominously, the short-term liquidity ratio has fallen quite sharply for domestic IG issuers in the euro area. Chart 6Bottom-Up Euro Area IG CHMs: Stable, But Watch Liquidity Ratios For HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined and operating margins have improved for both sets of issuers, but interest/debt coverage and liquidity are worse for domestic issuers. Chart 7Bottom-Up Euro Area High-Yield CHMs: Cyclically Healthier Within the euro area, our bottom-up IG CHMs for Core and Periphery countries show that both remain in the “improving health” zone (Chart 8). Yet the CHM for the Core now sits on the edge of the “deteriorating health” zone, led by higher leverage, lower debt coverage and a sharply falling liquidity ratio. Notably, there is no gap between the profitability metrics of the Core and Peripheral companies used in our bottom-up CHMs. Chart 8Bottom-Up Euro Area IG CHMs: Trending In Wrong Direction Peripheral European issuers continue to have much higher leverage and much lower interest coverage, the latter suggesting that Core issuers have benefitted more from the ECB’s super-easy monetary policies that have lowered borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Despite the lack of a major negative signal from the CHMs, we are concerned that the combination of slowing euro area economic growth and the end of ECB corporate bond buying will negatively impact the performance of euro area corporates (Chart 9). We are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates. 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. Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Euro area corporates have not enjoyed the same rally that U.S. corporates have seen so far in 2019, and for good reasons. In Chart 10, we show an overall bottom-up CHM for the U.S. and euro area, combining both IG and HY are combined into a single measure for each region.2 The obvious visible trend is that U.S. corporate health has been steadily improving, while it is starting to worsen in the euro area. The gap between those two CHMs is strongly correlated to the difference in credit spreads between European and U.S. issuers (middle panel), suggesting that relative corporate health is favoring U.S. names. At the same time, the relatively stronger U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe U.K. Corporate Health Monitor: A Brexit-Fueled Deterioration Our top-down U.K. CHM indicates that U.K. companies remain in the “improving health” zone, but just barely as the indicator has been drifting towards “deteriorating health” over the past two years. All the components of the U.K. CHM have contributed to this worsening trend (Chart 11). Even short-term liquidity, which has been in a powerful uptrend for almost a decade, has started to roll over. Chart 11U.K. Top-Down CHM: Cyclical Hit From Brexit Worries The cause for this deterioration can be reduced to six letters: B-R-E-X-I-T. Two years of political uncertainty over the details of the U.K.’s future relationship with the European Union have eroded confidence among U.K. businesses and consumers. The result is slowing economic growth and diminished corporate profitability that has hit all earnings-related ratios in the U.K. CHM. Perhaps most disturbingly for U.K. credit performance, even the interest coverage ratio has rolled over – at a historically low level – despite the Bank of England keeping U.K. interest rates at deeply depressed levels. The toxic combination of political uncertainty and weaker economic growth has resulted in a substantial widening of U.K. credit spreads. The spread on U.K. HY corporates has widened by 293bps since September 2017 and now sits at the widest level since September 2012. U.K. IG has not seen the same degree of spread widening, but has underperformed even more on an excess return basis versus duration-matched U.K. Gilts (Chart 12). Chart 12U.K. Corporates: Brexit Uncertainty = Stay Underweight We are currently recommending an underweight stance on U.K. corporates, even as we have become more tactically positive on overall global corporate exposure. While credit spreads have widened to levels that appear to offer value, U.K. economic momentum is fading steadily and leading economic indicators are pointing to even slower growth in 2019. With Conservative Prime Minster Theresa May now in a dramatically weakened position after losing the recent vote on her Brexit deal with the EU, there are no immediate options that will solve the Brexit uncertainty in a way that will provide a lasting boost to U.K. business confidence. In fact, the only realistic options – postponing Brexit, fresh U.K. elections, even a second Brexit referendum – all involve a period of even more uncertainty that will weigh on the performance of U.K. corporate debt.  Japan Corporate Health Monitor: A Negative Signal Our bottom-up Japan CHM3 has consistently stayed in the “Improving health” zone since 2010; however, the most recent data shows that the health of Japanese corporates has started to deteriorate as the last data point from Q3/2018 is just above the zero line (Chart 13). The overall Japanese economy has generally performed well (by Japanese standards) over the past few years, boosted by “Abenomics” economic stimulus combined with the extraordinarily easy monetary policies of the Bank of Japan. Yet the slowing of global growth momentum seen in 2018 has weighed on the performance of the Japanese corporate sector, which is still heavily geared to exports and global growth. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Looking at the components of the CHM, there was a modest deterioration of all the ratios last year, except for profit margins which have been virtually unchanged since 2015. On an absolute basis, the CHM components do not suggest any major problems with Japanese credit quality. Japanese companies are not highly levered and liquidity remains near the highest level seen since at least the mid-2000s. Interest coverage is still high on a historical basis and is much higher than the ratios seen in the other major developed markets. Yet at the same time, return on capital and profit margins remain very low compared to those same other major economies. Japanese companies remain cash-rich with low debt levels – a sharp contrast to the other countries show in this report. There are many potential cyclical risks for Japanese corporates in 2019: even weaker demand for Japanese exports, the drag on Japanese capital spending from firms worried about slowing global growth and the spillover effects from the U.S.-China trade war, even a possible hike in the consumption tax that the Abe government is still considering for October of this year. Yet these all would prevent any adjustment of the interest rate policy of the Bank of Japan, which remains the biggest factor to consider when looking at the investment prospects of Japanese corporate bonds. Japanese corporate spreads did not widen much compared to other countries’ corporate spreads in the 2018 selloff, due to their relative illiquidity and the extreme low level of interest rates in Japan. As the central bank is under no pressure to move off its current hyper-easy monetary policy settings, government bond yields and corporate spreads will remain low, even if the Japanese economy continues to slow. Therefore, for those investors who have access to the relatively small Japanese corporate debt market, we continue to recommend an overweight stance on Japanese corporates vs Japanese government bonds (Chart 14). Chart 14Japan Corporates: Stay Overweight Vs JGBs Canada Corporate Health Monitor: Now Even Healthier Both our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health (Chart 15). Steady above-trend economic growth, combined with some increases in realized inflation, have helped boost the profitability and interest/debt coverage ratios. Yet not all the news is good - leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are low. This may be building up risks for the next Canadian economic downturn but, for now, Canadian companies look in decent shape. Chart 15Canada CHMs: Supported By Solid Growth 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 6-9 months, which will further underpin the health of Canadian oil companies. Canadian corporates were not immune to the period of global spread widening seen at end of 2018, but the magnitude of the move was modest (Chart 16). This is a function of the still-low interest rate environment in Canada, where the Bank of Canada has not yet lifted policy rates to its own estimate of neutral (2.5-3.5%). Easy monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds on a tactical basis. Spreads have been in a very stable range since the 2009 recession, 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 sharp deterioration of Canadian economic growth or several more rate hikes from the Bank of Canada – neither outcome is likely over at least the next six months. Yet given how closely the Bank of Canada has been tracking the Fed’s current tightening cycle, we anticipate downgrading Canadian corporates at the same time do the same for U.S. corporates, likely around mid-2019.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy 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.4 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 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th, 2019, available at gfis.bcaresearch.com. 2 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. 3 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 4 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 Duration: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428  4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve 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 Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

In a report published early last August, I wrote that: “The perfect time for equity investing is when markets are cheap, earnings expectations are overly pessimistic and the monetary environment is highly accommodative. Currently, the opposite conditions exist: valuations are stretched, earnings expectations are euphoric and the Fed is in tightening mode. It does not seem a propitious time to be aggressive.” By the end of the year, the MSCI All-Country Index had declined by around 12%, with the S&P 500 down by a similar amount. Against that background, valuations improved, earnings expectations moderated and the Fed adopted a less hawkish tone. And, not surprisingly, investors and traders became much less bullish about the outlook, a positive development from a contrary perspective. As a result, BCA’s equity stance was upgraded to overweight from both a 3- and 12-month perspective. With no recession imminent and the Fed likely to raise rates by less than previously feared, we took the view that the path of least resistance for equities was up. There is no requirement at BCA for strategists to agree on the outlook. In fact, the opposite is true in that we encourage independent thinking and diverse ways of looking at the world. I have no strong reasons to disagree with the view that equities will end this year higher, and thus outperform bonds and cash. However, my concerns about the longer-run outlook, coupled with the potential for further late-cycle volatility, temper my comfort with an overweight position. Of course, this merely cements my reputation amongst colleagues as the resident BCA bear! What Troubles Me There rarely is a shortage of economic, financial or political issues to worry about. Even in the best of times, one can always find some problems and potential threats to the outlook. Contrary to my current reputation within BCA, I am not always bearish – I turned more positive on equities in the spring of 2009 and embraced the rally for most of the subsequent decade. However, notwithstanding the potential for equity prices to move higher this year, I perceive three particular challenges to an optimistic view of the outlook: The outlook for U.S. corporate earnings given the likelihood that labor’s share of income will rise from current unusually low levels. The financial markets’ addiction to easy money and low interest rates that may delay the normalization of monetary policy and encourage financial imbalances and excessive risk-taking. The unprecedented rise in U.S. federal deficits at a time of strong economic growth. There will be a price to pay down the road. Notably absent from this list is any mention of trade wars, Brexit, China, U.S. political dysfunction, recession risks and the many other issues that feature in news headlines. I do care about these things, but the three topics mentioned above are enough reason to be concerned, without piling on other problems. The Extraordinary Performance Of U.S. Profits, But… One of the most remarkable features of the past decade’s economic environment has been the impressive performance of U.S. corporate earnings. Despite the weakest economic recovery on record, profit margins have soared to an all-time peak (Chart 1). How on earth did companies manage that? Let’s start by noting what strong earnings growth did NOT reflect. Chart 1An Impressive Margin Performance First, there has not been above-trend growth in top-line revenues. The top panel of Chart 2 shows that S&P 500 sales have grown broadly in line with nominal U.S. corporate GDP over the past two decades. Second, related to the above point, there has not been a great environment for corporate pricing power. The corporate sector inflation rate has averaged a measly 1.2% during the past decade. Third, despite ongoing technological innovations, earnings have not benefited from a revival in productivity growth. Corporate sector productivity has grown at only a moderate 1.1% pace during the past 10 years, far below its historical average (third panel of Chart 2). Chart 2No Major Improvements Here! Finally, one other popular explanation – low interest rates - also can be ruled out as a major driver of the profit cycle. The large decline in interest rates since the Great Recession has clearly benefited some companies, but interest payments as a share of pre-tax profits have not shown much net change in the decade (final panel of Chart 2). In recent years, the lower level of rates has been offset by an increase in outstanding debt. We are left with two major drivers of the rise in margins: lower tax rates and, more importantly, tight control over labor costs. The effective tax rate paid by domestic non-financial companies averaged 21.7% between 2010 and 2017 compared with 26.7% between 2000 and 2007 (Chart 3). And the rate plunged further in 2018 in response to the large cut in the federal corporate tax rate from 35% to 21%. Had the effective tax rate continued to average 26.7% after 2010, after-tax profits of domestic non-financial companies would have grown at a much-reduced pace during the past eight years. Chart 3Corporate Tax Burdens Have Declined We finally come to the main explanation of remarkable earnings growth: the corporate sector’s success in capturing much of the benefits of higher productivity, rather than sharing it with labor. Historically, real employee compensation in the corporate sector rose in line with productivity, allowing both employees and the employers to enjoy the rewards of increased efficiencies. As a result, the shares of income going to capital and labor were among the most mean-reverting series in the economy (Chart 4). Chart 4A Major Divergence in Income Shares Everything changed around 2000 when real compensation began to stagnate, even as productivity continued to rise (Chart 5). Labor’s bargaining power was eroded by the combination of globalization and technological innovations, allowing companies to keep a tight grip on wage costs. The returns to capital soared while those to labor collapsed, with both moving to more than four standard deviations away from historical averages – an extraordinary divergence. If real employee compensation had continued to rise in line with productivity after 2000, then EBITD margins1 would be at their historical mean, rather than at a high extreme. Chart 5Labor Gets Left Behind The corporate sector’s ability to expand at the expense of labor has now come to an end. Wage growth has started to rise against the backdrop of an increasingly tight labor market. As a result, the labor share of income bottomed at the end of 2017 and the capital share peaked. Populist pressures against globalization also argue for an increased labor share.  The payoff to earnings growth from the drop in the corporate tax rate also will end this year. It was a one-off event with no further cuts in prospect. The bottom line is that the major tailwind (weak wage growth) behind strong U.S. earnings has turned into a headwind, while the secondary one (lower taxes) is ending. When it comes to S&P earnings (as opposed to the national income measure of profits), an additional supporting factor has been the decline in outstanding share balances that has boosted earnings per share. Many companies have taken advantage of low interest rates to raise debt and use the proceeds to buy back shares. However, with leverage now high and interest rates off their lows, the incentive for such financial engineering is diminishing. Debt growth has slowed and so should the pace of share buybacks (Chart 6). Chart 6Lots Of Financial Engineering The ever-optimistic analyst community remains unfazed about the above trends. According to IBES data, analysts’ individual company estimates imply long-run earnings growth of more than 16% a year for the S&P 500 universe (Chart 7). That is more than double average historical earnings growth. It was exceeded only by the insane optimism at the peak of the tech bubble in the late 1990s/early 2000, and we know how that ended! There can only be disappointment and an eventual marked downgrading of these earnings expectations. In my view, earnings will be lucky to grow at 3% a year over the long run from current elevated levels. Chart 7Euphoric Long-Run Earnings Estimates Some may argue that these long-term earnings estimates are irrelevant because investors pay them little attention. But there is a loose correlation between valuations and these earnings estimates, and while the price-earnings ratio (PER) has declined from its peak, it remains above its historical average. If long-term earnings estimates come down that should undermine the PER. Perhaps the causality is the other way: high valuations encourage analysts to inflate their earnings projections, but that would not be any more encouraging. Either way, it is a bearish chart. The Addiction To Easy Money The Fed’s gradual retreat from its hyper-easy policy stance was well telegraphed, but still unsettled the markets. That is the problem with addictions – the withdrawal period is always difficult. That has put the Fed in a tricky position as it must balance the need to prevent an overheated economy with the need to maintain financial stability. History suggests that the odds of the Fed getting it just right are slim. Adopting a cautious approach to tightening risks the worst of both worlds: falling behind the curve on inflation while encouraging financial speculation and imbalances. The Fed embraced an extended period of easy policy in the first half of the 2000s after the tech bubble burst, with the fed funds rate kept far below the growth in nominal GDP (Chart 8). If money is unusually cheap, then speculation and financial excesses are inevitable. The easy money period of the 1990s helped fuel the tech bubbles and the more extended period of easy money in the 2000s fueled the housing bubble. Once again, we have interest rates far below the growth in GDP and, not surprisingly, this has fed financial euphoria. Chart 8Monetary Policy Still Looks Accomodative The Fed has raised the federal funds rate by 225 basis points over the past three years, with nine increases of 25 basis points each. Four of the moves occurred in 2018 and have been blamed for financial problems in emerging economies and volatility in developed equity markets. Yet, all the Fed has done is bring the real fed funds rate out of negative territory. If a real funds rate of only 0.5% is enough to trigger extreme market volatility and threaten the economic expansion, then the system is much more vulnerable than generally assumed. There is much discussion in economic circles about the level of the real equilibrium interest rate – the rate consistent with the economy growing at trend, currently estimated to be around 2% a year. In the past, a simple rule of thumb was that real rates, over time, would have some approximation to the real growth in the economy. However, some studies (including by the Fed) argue that the real equilibrium rate may now be close to zero, far below the trend growth of the economy. If real rates close to zero are all that the economy can tolerate then that raises interesting questions. Does it mean that the economy’s growth potential could be much lower than 2%? Does it mean that if real rates have to be kept close to zero, then speculative activities in the markets will continue to build, ultimately threatening financial stability? Either way, it does not seem to be a positive story. Some worry that the Fed is making a mistake in both raising rates and unwinding its bloated balance sheet (aka QT or quantitative tightening). I believe this concern is hugely overstated. Contrary to popular opinion, the expansion in the Fed’s balance sheet did not lead to a surge of liquidity that drove asset prices sharply higher. Of course, the Fed’s bond purchases lowered yields and that forced money into riskier assets. However, there was no increased flood of money in the broader financial system. Quantitative easing (QE) led to a dramatic rise in bank reserves at the Fed, but there was no corresponding sustained surge in M2 – the measure of money supply that is more reflective of money available for economic and/or financial transactions. In other words, the money multiplier (the ratio of M2 to the narrow money) collapsed (Chart 9). This is because the credit system was impaired after the 2007-09 meltdown and the Fed was largely pushing on a string in its attempts to bring it back to life. The main way that Fed policy drove asset prices higher was keeping short rates close to zero because that gave investors a massive reason to take on more risk. Chart 9The Monetary Plumbing Has Blockages If QE was not the driving factor behind the bull market in stocks, then we should not be overly concerned about QT. Yes, investors will be forced to absorb more bond issuance as the Fed ceases to be a buyer. However, it is interesting to note that the current 10-year Treasury yield of 2.7% is no higher than five years ago, even though the Fed’s balance sheet has begun to shrink and the Fed has hiked rates nine times over the period (Chart 10). Chart 10Monetary Policy And Bond Yields The bottom line is that the Fed should continue on its path of reducing its balance sheet and not be timid about raising rates if the economy continues to grow in excess of a 2% pace. At some point there will be another recession and the Fed may well be blamed. But that is a lesser evil than feeding the addiction to easy money by prolonging the period of excessively low rates. Fiscal Profligacy The federal deficit is expected to reach around $1 trillion this year, around 5% of GDP. There is no precedent for such a large peacetime deficit during the late stage of an economic expansion (Chart 11). And, assuming current policies remain in place, the Congressional Budget Office (CBO) expects the deficit to rise rather than fall over the next few decades given the aging population’s impact on entitlement programs. Chart 11Fiscal Policy Has Become Pro-Cyclical There is no strong support for fiscal discipline in Congress. Neither party has the stomach to tackle the problem of entitlements, those on the right want more spending on defense, while those on the left want more spending on social programs. One should never be surprised that politicians prefer fiscal profligacy to austerity. It is no fun and is injurious to re-election prospects to advocate spending cuts and tax increases. When things start to get of hand, the burden of imposing fiscal discipline falls on the markets. Currently, markets do not appear fazed by fiscal trends. The 10-year Treasury bond yield remains below 3% and the gap between 30- and 10-year yields is low. If markets are worried about government finances, that gap tends to widen as investors demand a fiscal premium to hold longer-duration bonds (Chart 12). Chart 12Bond Investors Unfazed By The Deficit...For Now Presumably, investor complacency about the grim fiscal picture reflects a list of other more important economic and financial concerns that are suppressing yields. There will be a limit to this fiscal tolerance, but we just don’t know exactly where it is. Japan’s gross government debt has exceeded 200% of GDP throughout the past decade without a financial crisis, but that is a poor model for what the U.S. can manage. Japan does not need to borrow from abroad and thus finances its deficits internally. In contrast, the U.S. current account deficit is still running at around $500 billion a year and the country is, by far, the world’s largest international debtor. Yes, the dollar is the international reserve currency of choice and the U.S. receives the exorbitant privilege from that. However, that will not protect the U.S. currency or markets from an eventual loss of investor confidence. I accept that a fiscal-related bond/currency market crisis could be years away, and timing is everything! Nonetheless, the current lack of fiscal discipline does pose a threat to markets because it could limit the authorities’ room to enact stimulus in the next recession. How I Could Be Wrong I have strong convictions about the views I expressed, but that does not mean I will be proved right. Let’s examine some counter arguments. On earnings, my pessimism will be unfounded if the corporate sector manages to keep a tight grip on wages and/or there is a sustained marked improvement in productivity. Of course, we need to exclude subdued wages that arise because of an economic slowdown as that would undermine sales growth. It would be remarkable if the nascent upturn in wage growth suddenly reverses without a renewed rise in unemployment so I would put low odds on that. As far as productivity is concerned, there are lots of interesting innovations these days, but none seem to be game changers within a five-year horizon. Autonomous vehicles will certainly be huge for several sectors but widespread adoption is still some time away. However, it is important to keep an open mind on this and I will certainly change my view if the data improve meaningfully. Turning to monetary policy, I suppose it is possible that the Fed will miraculously calibrate policy to achieve a soft economic landing and maintain financial stability. They have never been able to do this in the past but there is a first time for everything. Needless to say, I am hugely skeptical but time will tell. Finally, on fiscal policy, you would have to be an extreme optimist to believe that politicians will suddenly enact the politically painful measures required to restore order to government finances. The current Administration has shown no signs of fiscal responsibility and the opposition have not raised this as an issue. If anything, there are calls for even more spending. History shows that governments generally skirt to the edge of a severe crisis before they reluctantly embrace austerity. In other words, I do not see much case to be optimistic here. Concluding Thoughts On average, the stock market is more likely to rise than fall. Since 1950, the S&P has recorded monthly gains 60% of the time. In other words, it generally has paid to be bullish. This was particularly true between end-1982 and end-2018 with the S&P 500 delivering above-average compound annual returns of around 11% a year (8% a year in real terms), despite two 50%+ market declines during the period. This was the greatest 36-year period for financial assets in history, driven by falling inflation and interest rates, major corporate restructuring that boosted profit margins, rising equity multiples and a huge expansion in credit growth. Looking ahead, the environment will be very different. Inflation and interest rates are more likely to rise than fall, profit margins will be under pressure, it would imprudent to expect sustained gains in multiples, and broad credit growth will not return to its earlier rapid pace. Thus, future returns will be a pale shadow of the past performance. Against the above background, I don’t think I am being overly pessimistic. However, I understand that many investors do not have the luxury of taking a long-term view. For those who are in a competition to beat their peers, it can be disastrous to stand on the sidelines while the market marches higher. Moreover, if returns are going to be modest by past standards, it puts a premium on market timing, as difficult as that may be. So I do not recommend ignoring the BCA view that equities will outperform bonds and cash this year. My concerns are for the long run. The obvious question is: how should one invest in a world of low returns? I doubt that piling into alternative investments will be the solution as these assets will be affected by the same macro forces as conventional assets. The answer is a rather boring and obvious one. In the absence of being a market-timing and stock/sector-selection genius or investing with such a person, capital preservation has become more important. When returns are low, it takes longer to recover from market losses. This means one should maintain a conservative portfolio bias with higher-than-normal levels of cash.   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com Footnotes 1 EBITD = earnings before interest, taxes and depreciation. This measure best reflects the performance of earnings as it relates to output, wages, prices and productivity.

Highlights We believe 2019 and 2020 will be a tale of two markets; … : The latter stages of the long post-crisis party may be rewarding, but the inflection points that will herald a bear market and a recession are not too far off. … the first will be broadly favorable for investors in risk assets, … : The combination of ample monetary accommodation and the indiscriminate fourth-quarter markdown in risk assets provides the springboard for one last advance. … but the second will mark the end of the post-crisis bull market, … : Nothing lasts forever, and we wouldn’t be overweight risk assets at this stage were it not for last quarter’s selloff. … as the Fed pulls the plug on the expansion: Our base-case scenario does not call for a deep or lengthy recession, but once Fed policy transits from accommodative to restrictive, the going will become much rougher for stocks, corporate bonds and the economy. Feature We spent the week of January 14th meeting with clients in South Africa. It is always good to exchange views with investors, especially when they are at a distant remove from the echo chamber which inevitably colors our perspective, no matter how much we try to resist it. It was also a pleasure to swap a week of winter at home for summer abroad, where our clients’ golf talk helped boil our views down to a simple analogy. We see the next twelve to twenty-four months as a double-breaker putt. 2019-20’s Double Breaker The undulating terrain of some golf-course greens sets up putts that break one way and then the other on their path to the hole. That is the way we view the next twelve-plus months, following the fourth quarter’s sharp, sudden tightening in financial conditions (Chart 1). The selloff pulled hard on the financial-condition reins, checking some of the pressure on the economy to overheat, and allowing the Fed to pause its rate-hiking campaign. Relieved investors immediately bid stocks higher, and corporate-bond spreads tighter, retracing nearly half of the tightening in financial conditions, but we expect the Fed to remain on the sidelines until June anyway. Chart 1A Swift Tightening In Financial Conditions A Fed pause delays the date when monetary policy will turn restrictive by a few months. We see the monetary policy inflection point as the key event presaging all of the inflection points that matter most to investors: the transition from an equity bull market to a bear market; the point at which credit performance deteriorates, and spreads widen, in earnest; and the transition from expansion to recession. The delay, and the lower entry points provided by the selloff, set the stage for a last hurrah in risk assets over the next six to nine months. With the Fed in the background, investors will be able to focus on the above-trend growth driven by the remaining fiscal thrust (Chart 2) and what we expect will be better calendar 2019 S&P 500 earnings than investors currently anticipate. Chart 2Fiscal Fuel Will Keep 2019 Growth Above Trend Better-than-expected conditions will ultimately prove to be self-limiting, however. The more momentum the economy gathers while the Fed is on hold, the more budding inflation pressures will become evident. The more that inflation pressures reveal themselves, the more forcefully the Fed will have to act to counter them. The upshot for investors is that the last burst of the good times will necessarily bring forth a slowdown, and they therefore confront a putt that will break twice over the next year or two: equities and spread product will outperform Treasuries and cash over the first stretch, but underperform over the next.1 Inflation Pressure Our oft-repeated view that the fiscal stimulus will promote inflation pressures is not at all controversial. Force-feeding stimulus into an economy already operating at capacity should lead to inflation. Businesses and other investors, recognizing that the above-trend boost in aggregate demand is temporary and unsustainable, will not expand capacity to meet it. Imports may relieve some of the pressure, but prices should nonetheless rise as aggregate demand exceeds aggregate supply. Inflation pressures emanating from the labor market provoke much more pushback. Investors, tired of hearing that a pickup in wages is right around the corner, harbor considerable doubts about the Phillips Curve, which posits that there is an inverse relationship between the unemployment rate and wage growth. We acknowledge that the 1960s belief in a mechanical tradeoff between inflation and unemployment – policymakers could have lower inflation if they were willing to tolerate higher unemployment, or lower unemployment if they were willing to tolerate higher inflation – was shattered by the stagflation of the 1970s. We further acknowledge that the relationship between unemployment and compensation is not linear. We continue to believe, however, that the laws of supply and demand apply, and that the relationship between compensation and unemployment has been slow to assert itself this time around because the Phillips Curve is kinked. That is to say that the sensitivity of wage growth to a drop in unemployment is a function of the level of the unemployment rate itself. A decline in unemployment from 10% to 9%, 9% to 8%, or 8% to 7% does not exert upward pressure on wages because there are many more qualified candidates than there are openings at such elevated unemployment rates (Chart 3, top panel). When the unemployment rate is 5% or less, on the other hand, wages do respond to unemployment declines because the lack of labor market slack ensures that employers have to compete to attract qualified candidates (Chart 3, bottom panel). Estimates of the United States’ natural rate of unemployment in recent years have typically hovered around 5%. Over the 50-plus years covered by the average hourly earnings (AHE) series, real AHE growth has tended to peak (Chart 4, bottom panel) following unemployment’s sub-natural-rate trough (Chart 4, top panel). It has not yet reached an elevated level, but wages did begin accelerating sharply a year after the unemployment gap turned negative in early 2017. With the unemployment rate on track to continue to fall throughout 2019 (it only takes about 110,000 net new jobs a month to hold it in place), we expect that real AHE growth has further to run. Chart 4Don't Count Dr. Phillips Out Just Yet Taking the analysis a step further to consider real wage growth relative to productivity growth exhibits an even stronger link with the unemployment gap. From the early ‘70s through 2001, when productivity and real wages grew at the same rate (Chart 5, middle panel), real wages fell behind productivity when the unemployment gap was positive and caught up when it was negative (Chart 5, bottom panel). Capital has seized a disproportionate share of the gains in productivity since 2002, with the real-wages-to-productivity ratio able to stabilize only when the unemployment gap turned negative from 2006 to 2008. Chart 5Productivity-Adjusted Real Wages Rise When Unemployment Bottoms We expect that the coming cyclical trough in the unemployment gap will be consistent with past troughs, which have been associated with cyclical peaks in compensation gains. The linkage between compensation and consumer prices isn’t firmly established, but investors don’t have to sweat it. As long as the Fed perceives a connection, which it clearly does, it can be counted upon to respond to higher wages by tightening policy. A swift recovery in oil prices – our Commodity & Energy Strategy service sees Brent crude averaging $80/barrel, and WTI averaging $74, across 2019 – will also help keep the Fed’s attention squarely focused on price stability after ten years of full-employment fixation. Bottom Line: Unnecessary fiscal stimulus will continue to exert upward pressure on prices, while an extremely tight labor market will place steady upward pressure on wages. The Fed will respond by removing accommodation, pushing the fed funds rate above the neutral level, and bringing down the curtain on the record-long expansion sometime in 2020. Upgrading Corporate Bonds We noted two weeks ago that the spread-widening in high-yield corporate bonds was extreme, and that overweighting spread product would mesh well with our renewed equity overweight. Our U.S. Bond Strategy colleagues have since upgraded credit,2 and we are following their lead. We now recommend that investors overweight equities, underweight fixed income and equal-weight cash. Within fixed income, we recommend that investors significantly underweight Treasuries while overweighting both investment-grade and high-yield corporate bonds. Consistent with our above-consensus inflation expectations, we prefer TIPs to nominal Treasuries. We harbor no illusions that a new credit cycle has begun. It is late in an already lengthy cycle, and we view the projected near-term decline in high-yield default rates as a final unwind of the default spike that accompanied the shale-drilling rout in 2016 (Chart 6). We do not expect a recession in 2019, but the next one is likely not too far off, and defaults begin to pick up well ahead of a recession. Our spread-product upgrade is an opportunistic short-term move, not a change in our cyclical view. Chart 6A New Credit Cycle Has Not Begun High-yield spreads widened so much in the fourth quarter, relative to their history, that their capital-gain prospects have flipped. We had been at equal weight, anticipating an eventual move to underweight, because spreads were unusually tight. The capital-gain stretch of the cycle was long gone, and excess returns over Treasuries were limited to coupon spreads that were likely to be eroded by capital losses as spreads widened ahead of an approaching recession. The lurch in spreads from the 25th percentile to the 75th percentile in double-B, B and triple-C bonds (Chart 7) restores potential capital gains as a cushion that should protect the coupon spread against unanticipated economic weakness. Chart 7Irrational Gloom The Fed’s newly conciliatory stance should support spread product just as it should support equities. All three monetary-policy elements of our bond strategists’ peak-spread checklist are issuing the all-clear signal: twelve-month fed funds rate hike projections have collapsed (Chart 8, second panel), gold has revived (Chart 8, third panel), and the dollar’s relentless upward march has finally been halted (Chart 8, bottom panel). Chart 8Monetary Policy Argues For Lower Spreads ... The jury is still out on the global-growth elements of our bond team’s peak-spread checklist. Our China Investment Strategy service’s Market-Based China Growth Indicator looks spry3 (Chart 9, third panel), and industrial mining stocks may be in the midst of bottoming (Chart 9, bottom panel), but the CRB raw industrials index is still scuffling (Chart 9, second panel). A blowout in spreads accompanied by a less-hawkish Fed and rebounding global growth would be a no-brainer reason to own spread product, but two out of three ain’t bad, and spreads would not have blown out in the first place if global growth were poised to surge. The biggest threat to our constructive economic and market views is a slowdown in China, and its uncertain direction is a risk to overweighting credit. On balance, though, we believe the current level of option- and default-adjusted spreads adequately compensate credit investors over the next three to six months, especially after factoring in the Fed’s benign turn. Chart 9... But The Jury's Still Out On Global Growth Bottom Line: We are upgrading spread product to take advantage of its fourth-quarter selloff and a Fed pause that may last until June, despite uncertainty around the global growth outlook.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 The wise men and women gathered at the Barron’s annual roundtable foresee a similar setup, but with the direction reversed. They expect markets and the U.S. economy to encounter rough going in the first half of 2019 before conditions become more hospitable in the second half and in 2020, ahead of the next election. “Goodbye to Gloom,” Rublin, Lauren R., Barron’s, January 14, 2019, pp. 21-34. 2 Please see the January 15, 2019 U.S. Bond Strategy Weekly Report, “Buy Corporate Credit,” available at usbs.bcaresearch.com. 3 Please see the November 21, 2018 China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem,” available at cis.bcaresearch.com.

Special Report

Venezuela’s stability is deteriorating rapidly along the lines of our projections in recent years. Regime failure is at this point a high probability and poses immediate risks to global oil production. Our conviction is high because of the unprecedented combination of internal and external factors working against the regime: Economic collapse: Economic collapse has translated into total social collapse, as indicated by the large-scale emigration from the country (Chart 1). The current mass protests are the largest ever and are gaining momentum, while the opposition movement is coalescing into a single force against the regime as a whole for the first time. Political illegitimacy: What remained of the Maduro administration’s political legitimacy has eroded with his decision to ignore the results of the 2015 election and rig the election of 2018. The President of the National Assembly, Juan Guaidó, has declared himself President of the Republic based on an interpretation of the Venezuelan constitution and his leadership of the democratically elected National Assembly.1 International opposition: The erosion of Maduro’s legitimacy is reinforced by a rapidly changing international environment, with several countries becoming more assertive in opposing the regime. The United States and Colombia, on January 23, formally recognized Guaidó as president. They are joined by Canada and several other Latin American states, including Brazil, which is taking a more confrontational posture under the newly inaugurated President Jair Bolsonaro. This marks a rare coordination of North and South American states in pursuing a harder policy toward Venezuela. U.S. intervention: The United States, in particular, is taking a more interventionist stance through tighter sanctions. Indeed a limited U.S. military intervention is one of our top five geopolitical “Black Swans” for this year. Such an intervention could be further motivated by President Donald Trump’s need to distract from his domestic woes (Chart 2). His weak popular approval is comparable to that of President Ronald Reagan at this stage in Reagan’s first term, when he intervened in the small island state of Grenada. Venezuela is not Grenada, but the U.S. is also not considering outright invasion. Trump is facing a serious risk of becoming a “lame duck” due to the fall in his popularity amid the government shutdown and gridlock in Congress. A foreign policy response to a humanitarian crisis is an obvious way for him to try to increase his influence over the remainder of his term. Moreover, the U.S. diplomatic and defense establishment may agree on the need to reinforce the Monroe Doctrine against anti-democratic politics and growing Chinese (and Russian) influence in Venezuela. Chart 2Trump May Distract From His Woes What remains is to see whether the U.S. adds force (tougher sanctions) to its more aggressive diplomatic posture, and whether the Venezuelan opposition remains mobilized and unified in rejecting anything except a transition to a new government. The U.S. is already considering expanding sanctions, including a likely deathblow that would involve sanctioning Venezuelan oil imports and the export of diluents necessary to process Venezuela’s heavy sour crude. Within Venezuela, the opposition’s momentum and the role of the National Bolivarian Armed Forces will be decisive: so far there are small signs of fracture (Table 1), but no sign of a substantial turn against the Maduro regime.Sufficient popular pressure can create a “tipping point,” however, after which the military and security forces are no longer effective in executing the government’s writ and the socio-political situation declines beyond the ability of the regime to stay in power. Persistent large-scale protests concentrating on Maduro’s departure and/or a split in the security forces could precipitate the final stage of transition to a new interim government in the short to medium term. Table 1Military Insurgencies Have Been Small And Unsuccessful … So Far Impact On The Oil Market In this context, we are raising the likelihood of a collapse of that state to an 80% probability, from our prior assessment (33%). We use the word “collapse” to stand for Venezuela’s production falling to 250k b/d to feed domestic refineries, from ~ 1mm b/d at present. In our simulation of how a collapse could affect oil prices, we make the following assumptions based on recent history – i.e., the run-up to the re-imposition of U.S. sanctions against Iranian oil exports. These assumptions are driven by our prior belief that the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, which we’ve dubbed OPEC 2.0, and the Trump administration will attempt to hold Brent crude oil prices at or below $80/bbl in the event of a collapse in Venezuela’s oil production. Here are our assumptions: Venezuela collapses next month; OPEC 2.0 responds with a one-month lag, and increases production by 500k b/d in March 2019. If Brent spot prices trade to $85/bbl, OPEC 2.0 raises production an additional 100k b/d. If prices continue to rise toward $100/bbl, OPEC 2.0 adds another 300k b/d to global supply. Further increases lead to the U.S. Strategic Petroleum Reserve (SPR) releasing 100k b/d as needed to reduce Brent prices to $80/bbl or less. If spot Brent prices rise toward $100/bbl, we assume there will be 200k b/d of demand destruction globally. Chart 3 shows how Brent and WTI prices would evolve per these assumptions. Because Venezuela’s production has fallen so much, we believe the collapse of that country’s oil industry can be managed by OPEC 2.0, and, if necessary, via U.S. SPR releases. Of course, a similar trajectory likely would occur in the event Venezuela’s oil industry collapses later.2 Chart 3A Venezuela Collapse Would Trigger OPEC 2.0 and U.S. Supply Responses In our simulation, the Brent spot price trades to $85/bbl in December 2019, and OPEC 2.0 adds an additional 100k b/d to global supply. Prices continue to rise, and we assume OPEC 2.0 member states release a combined 300k b/d in March 2020. The U.S. release 100k b/d of SPR in 2020. In addition, we do see demand destruction of 200k b/d in 2020, as prices reach close to $100/bbl. With all of this, prices are contained and start decreasing in mid-2020. Of course, whether these surges can be maintained indefinitely – i.e., until Venezuela comes back on line, or comparable crude grades can be shipped south from Canada – is an open question. Even so, there is no doubt that the leaders of OPEC 2.0 silenced more than a few critics by means of their 4Q18 production surge. KSA stands out in this regard, taking its November 2018 production over 11mm b/d from ~ 10mm b/d in 1H18 (Table 2). Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) As a practical matter, we have no way of knowing how OPEC 2.0 or the U.S. SPR would respond to a collapse in Venezuela’s oil industry. In these simulations, we’re making a call on how and when OPEC 2.0 might choose to release its spare capacity once again, as they did in the run-up to the U.S.’s Iran oil export sanctions last year (Chart 4). As the members of OPEC 2.0 – mostly KSA, when it’s all said and done – dig deeper into spare capacity, less is available to meet another unplanned outage – e.g., Libya or Nigeria lose significant barrels to civil unrest. That is, we are sure, a discussion OPEC 2.0 is and will be having among its members, and with the U.S. SPR. The global oil market still is exposed to a sharp loss of Iranian barrels on top of the loss of Venezuela’s supplies in the event that country’s oil industry collapses. This argues strongly for an extension of the waivers granted by the Trump administration in November for anywhere from 90 to 180 days, depending on how the Venezuela situation evolves. These waivers expire at the end of May. This would require us to change our balances assessment, should it occur.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com   Footnotes 1 Please see Articles 233, 333, 350 of the Venezuelan constitution. The domestic and international legal debate is beside the point: the effective power of the people, the security forces, and the international community will determine the outcome. 2 For more information on global supply and demand balances, and our most recent oil price forecasts, please see “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone,” published by BCA Research’s Commodity & Energy Strategy today. It is available at ces.bcaresearch.com.