Financial Markets

Highlights Risk assets have had a rough go of it since we last published on December 17th: Equities have been through the wringer, spreads have widened sharply, and the 10-year Treasury yield has tumbled to an 11-month low. We don’t put much stock in the talk that the Fed is about to go too far, … : We still judge that the fed funds rate is comfortably shy of its equilibrium level. The economy will decelerate this year, but fiscal stimulus will keep it growing above trend. … and even if market-unfriendly policies merit a lower equity multiple, … : A bull market in Washington uncertainty is a recipe for a lower multiple, and there are no signs that policy uncertainty will ebb any time soon. … we think the time has come to put our cash overweight to work: Equities priced in a lot of bad news when the forward multiple fell below 14. If earnings hold up like we think they will, a recovery to the mid-15s would deliver a double-digit gain, and that merits an equity overweight relative to cash and bonds. Feature Thanks to Christmas Eve and New Year’s Eve falling on Mondays, we haven’t published since December 17th. A lot has happened in those three weeks, starting with the FOMC’s final 2018 meeting. As we’ve gathered our bearings and tried to set a course forward through the volatility, we’ve asked ourselves several questions about markets, policy and the economy. This week’s report reviews those questions, including the ones the clients we met three weeks ago might want to ask now. Is the expansion coming to an end? Not just yet; we still think it has at least a year to run. Following several uninspiring releases, the Atlanta Fed’s GDPNow forecast of real final domestic demand has slipped to 3.3% from 3.8%, but it’s still 3.3%. That may seem too good to be true this late in the cycle, but that’s what 100 basis points of fiscal stimulus can do when injected into an economy already operating at full capacity. The IMF estimates there’s still another 40 basis points of stimulus coming in 2019, and we expect that that infusion will be enough to stave off the next recession until 2020 or beyond. Is the Fed about to make a policy mistake? We do not think so. Although the neutral, or equilibrium, policy rate is only observable after the fact, research from the head of the New York Fed holds that the FOMC is not on the verge of breaching the neutral threshold. The widely-followed Laubach-Williams model estimates that the real neutral rate is between 0.75 and 0.875%, or 2.75-2.875% in nominal terms.1 Our internal equilibrium fed funds rate model sees even more breathing room – it estimates that the (nominal) equilibrium rate is around 3%, and that it will rise to around 3⅜% by the end of the year. U.S. equities have been hypersensitive to perceived inflection points in monetary policy throughout the sell-off, which began roughly after Jay Powell said in an October 3rd interview that interest rates were “a long way from neutral.” Interestingly, though, the money market’s expectations never really budged. At the time of the Powell interview, it was pricing in a December hike to 2.50%, and a 40% chance of one more hike to 2.75%. It would take the probability of a 2.75% terminal rate up to 80% in early November, but it was again calling for a 40% chance of 2.75% when we were on the road during the two-day December meeting. It now puts the odds of an additional hike at just 4%, and says the Fed will have cut rates once by the middle of next year (Chart 1). Chart 1According To The Money Market, The Fed's Done We do not know what is behind the money market’s obstinacy, but we see an economy that has far more accommodation than it needs. While we think it’s inevitable that the Fed will tighten into a recession – that’s life with a blunt monetary policy instrument that works with long and uncertain lags – we don’t think it is on the verge of doing so. Fiscal stimulus will ensure that the U.S. economy grows above trend again this year, and there are no imbalances in housing2 or the other cyclical segments of the economy that would make the expansion particularly vulnerable (Chart 2). Elevated rates of job openings (Chart 3, middle panel) and job quits (Chart 3, bottom panel) indicate that the labor market will continue drawing in workers (Chart 3, top panel), supporting consumption and growth. Chart 2No Signs Of Overheating, ...   Chart 3... And The Jobs Outlook Is Strong You aren’t still calling for four rate hikes this year, are you? Let’s call it three, now that the market-driven tightening in financial conditions (Chart 4) has already done some of the work of cooling off the economy. We take the Fed at its word when it says its actions are data-driven, and we don’t think that it will pile on when credit spreads have shot up to their 2015 oil-collapse/shale-patch-distress levels (Chart 5) and equity prices have swooned. If credit spreads retraced meaningfully, and equities went back to making new highs, four hikes might come back into play. Conversely, if spreads continued to widen and took aim at their 2016 peaks, two hikes might become more likely than three. Given our expectations for spreads (they will not approach 2015-6’s quasi-recession levels, but corporate leverage is too high to support material narrowing), and equities (the S&P 500 will be hard-pressed to eclipse September’s high), our base case is three hikes. Chart 4Tighter, Yes; Tight, No   Chart 5Spreads Say It's 2015-6, ... Have the economic fundamentals really deteriorated that much over the last three months? Not that we can tell. There have been some high-profile data disappointments here and there, like the punk manufacturing ISM release last Thursday, but the overall message has been positive, and Friday’s jobs report was consistent with an economy growing above trend. The economic surprise indexes have been declining since November, but they’re not at levels that are anywhere out of the ordinary (Chart 6). Our earnings-per-share model still sees robust growth for corporate earnings (Chart 7). Chart 6... But The Data Beg To Differ   Chart 7Earnings Will Decelerate, But They Won't Contract We are as discomfited by the prospect of new trade barriers as any other economists, and we have eyed the divergence between U.S. acceleration and rest-of-the-world deceleration with increasing wariness. Even for an economy as comparatively closed as the U.S., decoupling is only a temporary phenomenon. We tend to equate global activity with global trade, and generally view developing economies as especially dependent on trade. It is still early days, but we have found it mildly encouraging that EM activity and EM equities have been outpacing their DM equivalents. The growth backdrop can’t be that bad if the emerging markets are perking up. Do you still think the S&P 500 has yet to make its highs? Maybe, but we wouldn’t bet on it. We view stock prices, P, as the product of expected earnings, E, and the multiple investors are willing to pay for those earnings, P/E. If our confidence in the expansion is not misplaced, and corporate earnings match analysts’ consensus bottom-up expectations of $174, topping September 20th’s 2,930.75 closing high will require a multiple approaching 17. If analysts project year-over-year EPS gains across all of 2020’s quarters, E will rise over the course of the year, reducing the P/E expansion needed to make a new high, but an assault on the peak cannot succeed without a meaningful re-rating from today’s multiple in the 14s. Although multiple expansion has played second fiddle to earnings growth (Chart 8, middle panel) across the nine-and-a-half year bull market, it declined nearly 30% peak-to-trough in 2018, and was entirely responsible for the fourth-quarter sell-off (Chart 8, bottom panel). While we think the de-rating has gone too far, the last three months have persuaded us that a return to the 18.8 peak is too much to ask. Our working hypothesis is that the equity market has decided that Washington has become enough of an impediment that the market multiple has to come off a couple of points. Markets hate uncertainty, and the policy climate is flat-out unsettled: the principal architect and guarantor of the international postwar order repeatedly threatens to topple that order; the U.S.-China showdown does not appear to be nearing a resolution; and both political parties seem willing to sacrifice the economy to gain an advantage in 2020. In the absence of new deregulatory initiatives or tax cuts to balance out the broadly investment-unfriendly instincts of several of D.C.’s power players, a poisonous partisan climate and a dysfunctional administration can no longer be ignored. Chart 8Earnings Built The Bull Market; De-Rating Almost Wrecked It Okay, so what do you do now? We upgrade equities to overweight with the cash we raised in mid-June when we downgraded them from overweight to neutral. Although we wouldn’t bet on the S&P 500 topping 2,931, it doesn’t have to do so to generate alluring prospective returns. From a 2,500 starting point, a target of 2,750, or $174 earnings at a 15.75 multiple, would generate a 10% capital gain. If the economy holds up in line with our base-case expectation, it’s hard not to like U.S. equities at current levels. We were eager to put our cash overweight to work as we watched equities gyrate in October and November, but the combination of December’s valuation reset and the improved equity outlook from our Global Investment Strategy colleagues’ MacroQuant model encourages us to pull the trigger now. More money is made when conditions, or perceptions, go from terrible to bad than when they go from good to great. As the approaching earnings season redirects attention to the solid fundamental outlook, and the Treasury secretary stops taking actions that make investors wonder if conditions are far worse than they feared, there is a path for perceptions to improve. Chart 9Spreads Have Overreacted We continue to hold to our view that markets are underestimating the potential for inflation, making Treasuries vulnerable, especially at longer maturities. We reiterate our recommendation to underweight bonds via an underweight in Treasuries, and to hold interest-rate duration below benchmark in all fixed-income categories. We continue to recommend a neutral weighting in credit-sensitive fixed income, as the spread widening is incompatible with projected defaults (Chart 9), but we are not counting on meaningful spread compression this late in the cycle.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 From the spreadsheet containing updated estimates of the baseline model described in “Measuring the Natural Rate of Interest,” by Thomas Laubach and John C. Williams, published in the November 2003 Review of Economics and Statistics, located at https://www.newyorkfed.org/research/policy/rstar, and accessed January 3, 2019. 2 We discussed housing at length in the November 19 and December 3, 2018 U.S. Investment Strategy Special Reports, “Housing: Past, Present And (Near) Future,” and “Housing Seminar,” respectively, available at usis.bcaresearch.com.

Highlights The yen’s sharp rally this week reflected a liquidation of carry trades. EUR/JPY has hit our target of 120, it is time to close our longstanding bearish recommendation on this pair. The downside in AUD/JPY is limited. The Bank of Japan will not stand idly by in front of the deflationary impact of a stronger yen. The coming weeks could witness some dollar softness, but this should prove temporary. Feature The FX market started the year with a bang. The yen rallied massively Thursday morning, during the so-called “witching hour” between the New York close and the Tokyo open. As is now usual, algorithms have been blamed. We agree that poor liquidity and automatized trading accentuated the speed of the move, but ultimately, the strength of the yen is rooted in fundamental reasons. As we have been arguing, the yen should be strong in the current environment, especially against the euro, the Australian dollar and high-yielding EM currencies. When global growth weakens and safe heaven yields fall, the yen benefits. Not only do Japanese domestic savers, who park their funds abroad in hope of higher yields, repatriate there money when growth slows, but also, carry-traders, who fund their purchases of high-yielding assets by selling the yen, buy back the JPY once volatility rises. The above-dynamics have driven the yen’s eye-catching move. The yen has been strong, but the AUD, the EUR, the TRY and the ZAR have also been weak, suggesting that investors who bought the yen also sold these currencies. This was a carry-trade reversal. What should we do with our long-held negative biases on EUR/JPY and AUD/JPY? Last night, EUR/JPY and AUD/JPY moved below 119 and 71, respectively. Our target for these pairs were EUR/JPY 120 and AUD/JPY 72. We are inclined to close these recommendations. As we have repeatedly highlighted, EUR/JPY is a function of global bond yields (Chart I-1). As a firm, BCA sees upward pressure on yields. Currently, the futures market is pricing in potential rate cuts in 2019 and 2020. We think that the U.S. economy is strong enough that the Fed will not cut rates over this timeframe. However, the Fed is likely to pause for one or two quarters, something made even more likely after the fall in the ISM manufacturing this week. Such a pause should create upward pressure on U.S. 10-year inflation breakevens, which currently trade at 1.7%, while also supporting risk asset prices. All these developments would be consistent with higher yields and thus, a stronger EUR/JPY. Chart I-1EUR/JPY Should Now Find Support Regarding AUD/JPY, this pair is now trading in line with the lows experienced in 2016, and at its worst Thursday morning, it traded at levels last recorded in the first half of 2009. We do anticipate continued weakness in the global economy, but not a recession. Hence, at current levels, the downside for AUD/JPY is limited. Beyond the global dynamics, we also need to take into account Japanese dynamics. The JPY may be cheap, but Japan’s core inflation remains well below the Bank of Japan’s objective, and shows little sign of hitting 2% within a reasonable period. The recent strength in the yen only re-enforces the inability of the BoJ to hit its target. In fact, the yen’s strength was met by a large rally in JGBs, with 10-year Japanese yields falling back to zero. We agree with the market’s assessment of the combined impact of a higher yen and slowing global growth: the BoJ will have to fight this deflationary impulse. How, though, is still unclear. The BoJ could cut rates while continuing to target a positive yield curve slope, something we think is likely. Also, Japan still sports a current account surplus as well as the largest positive net international investment position in the word. This means that this country has little to fear from a falling exchange rate. This raises the likelihood that the Ministry of Finance decides to intervene in the FX market in order to push the yen lower. The only constraint here is the U.S. Treasury, which could balk at such a move. Finally, the U.S. dollar has been losing momentum this December, and weaker U.S. economic data is likely to prompt the Fed to openly message that it will pause its hiking campaign for at least one quarter. This should cause a period of softness in the greenback. However, we continue to expect such softness to be temporary. The market anticipates rate cuts from the Fed, but this is not BCA’s baseline scenario. Thus, any pause along the hiking campaign should only have a transitory impact on the dollar, as the U.S. economy is likely to continue to grow above trend, preventing the need for lower rates. Bottom Line: Poor liquidity conditions may have facilitated the yen’s massive move this week, but its true driver was the weakness in global growth, which forced a massive liquidation of carry trades. As EUR/JPY has hit our 120 target, we are removing our long-standing negative bias on this pair. Staying short AUD/JPY at current levels does not make sense either, unless one expects a global recession, which is not our base case. Finally, the strength in the yen is hurting the Japanese economy, which will force the Bank of Japan to ease monetary conditions.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com

Getting right to the point: Oil fundamentals are, and could remain, disconnected from benchmark prices, as they were in the waning days of 2018, when markets were forced to recalibrate global supply-demand balances in the dark. Four factors will drive this disconnect and keep volatility elevated (Chart of the Week): Chart of the WeekPrice-Fundamentals Disconnect Will Persist Continuing uncertainty over how much oil Iran will export this year; A lack of precise information about individual production cuts from OPEC 2.0; Uncertainty over EM demand; and Illiquid markets, brought about by a diminution of speculators’ risk-bearing capacity, which is largely the result of the price-fundamentals disconnect. Nonetheless, we do not believe markets are responding to an as-yet undetected collapse in demand or run-away supply, which recent price action would suggest. To the contrary, we expect OPEC 2.0 and Canadian production cuts of ~ 1.4mm b/d, continued decline-curve losses and slower U.S. shale growth resulting from price-induced capex declines, will face off against stout demand to rebalance markets in 1H19. We are, therefore, getting long spot WTI, and long July 2019 Brent vs. short July 2020 Brent as a spread at today’s close. Highlights Energy: Overweight. We ended 2018 with an average gain of 24% on recommendations we closed or were stopped out of. Open positions going into 2019 – mostly Brent call spreads with stop-losses of -$1.00/bbl – were down 49%. Base Metals: Neutral. Chile’s national statistics agency INE reported copper output was 5.3mm MT over the January – November 2018 period, its highest level since December 2005, and 6% higher than year-ago levels.1 Precious Metals: Neutral. Gold markets appear to be pricing less than the four rate hikes we’re expecting this year from the Fed. We remain long as a portfolio hedge. Ags/Softs: Underweight. U.S. negotiators head to Beijing next week to continue trade talks. We remain bearish soybeans all the same, given our expectation the current crop year will end with record-high stocks-to-use ratios worldwide. Feature The last time WTI oil futures traded this close to $40/bbl, OECD crude and products inventories stood at ~ 3.1 billion barrels, and OPEC 2.0 had just begun its output cuts in Jan17 (Chart 2). OECD inventories now stand under 2.9 billion barrels, and are on course to fall to ~ 2.5 billion by year-end, as the physical surplus is drained by a combination of falling production and still-strong demand (Chart 3). Chart 2OECD Inventories Will Draw, Taking Crude Prices Higher Chart 3Supply Cuts, Demand Strength Will Rebalance Markets Brent and WTI prices have fallen 39% and 41% from their October 2018 highs, following the about-face by the U.S. on Iranian oil-export sanctions in November. On the back of this, we expect OPEC 2.0 to follow through on its 1.2mm b/d production cuts – possibly even exceed them, as they did over the 2017 – 1H18 period. OPEC 2.0’s track record on production discipline is strong, hence our expectation the group’s 2019 output will fall to 31.14mm b/d vs. 2018’s 32.40mm b/d level.2 The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as unlikely the administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and expect they will be extended at least for 90 days. We expect Iranian production to fall from ~ 2.80mm b/d in 1H19 to an average 2.60mm b/d from June – December 2019, resulting in the loss of 1.25mm b/d of exports. We expect Saudi Arabia to raise production from 10.15mm b/d to 10.30mm b/d to offset most of this incremental loss of Iranian production. Government-mandated production cuts of 325k b/d in Alberta, Canada – undertaken to drain a persistent inventory overhang and loosen the flow of oil pipeline-transport-constrained production – also will remove actual production from the market this year.3 In addition, we continue to model the loss of 190k b/d of decline-curve losses in OPEC 2.0 member states that are incapable of maintaining or lifting output due to low prices and a lack of investment (Chart 4). The contribution of these states to the OPEC 2.0 cuts is to “manage” their depletion rates per their November 2016 accord (Table 1). Chart 4Production Outside Gulf OPEC Continues Decline, Led By VenezuelaTable 1Table 1 BCA Global Oil Supply - Demand Balances (MMb/d) (Base Case Balances) Net, we have world supply growth at 0.5mm b/d this year vs. the 1.4mm b/d estimated by the EIA. Most of this again comes from the U.S., where we expect 1.3mm b/d growth. Due to the price rout following Iranian import waivers, we lowered our rig count projections – the main input of our U.S. production forecast – which took our Lower 48 U.S. (i.e., ex GOM) production growth to 1.2mm b/d from the 1.4mm b/d rate we estimated last month. Despite pipeline bottlenecks in the Permian Basin, which will be fully alleviated by 4Q19 when the last of ~ 2mm b/d of new takeaway capacity comes on line, U.S. shales still account for most of the net growth in U.S. ouput (Chart 5).4 If WTI prices remain in the mid- to low-$40/bbl range, however, rig counts will be driven lower, which will, all else equal, lower U.S. shale-oil output this year. Chart 5Lower WTI Prices Slow U.S. Shale Growth Lower Prices Will Support Demand The price collapse since October will keep global oil demand from breaking down, leading us to expect consumption to grow ~ 1.40mm b/d this year. This is down slightly from our previous estimate of 1.45mm b/d of growth, and falls 200k b/d short of the ~ 1.6mm b/d of growth we expect for 2018.5 Forecasting demand is notoriously difficult. This is particularly true for forecasting EM demand, the source of most of the growth in the world. We have non-OECD demand – our proxy for EM oil consumption – growing 1.0mm b/d this year, down from 2018’s rate of 1.2mm b/d. This reflects our expectation the IMF will lower its growth expectation for EM GDP to 4.6% this year, from its October 2018 estimate of 4.7% growth. This will take global GDP growth to 3.6% to 3.7% previously estimated. EM demand continues to be led by China and India, which we expect will grow 450k b/d and 210k b/d, respectively, this year, again accounting for more than half of EM growth. China’s oil consumption is expected to average 14.3mm b/d, while India’s will average just over 5mm b/d. We continue to expect modest stimulus coming from China in 2H19, which will support oil demand and consumer spending. However, this could surprise to the upside, with the 100th anniversary of the Chinese Communist Party coming up in 2021. Our colleagues at BCA Research’s Geopolitical Strategy (GPS) noted that if China’s government is to launch another large-scale stimulus package (not a foregone conclusion), then the likeliest time frame is 2H19 or 2020. Indeed, this is more probable than anytime earlier, due to the desire of Chinese policymakers to dispel any doubts about stability in 2021 for the Party’s centenary. GPS’s Matt Gertken observed the average gap between the bottom of China’s credit impulse and the top of nominal GDP growth is ~ 1.5 to 2 years. Policymakers will not want to stimulate too aggressively in early 2019 and risk having a flagging economy in the midst of 2021 celebration.6 Investment Implications Over the short term, oil prices could remain disconnected from market fundamentals, which we believe remain broadly supportive. Indeed, the balance of risks still favors the upside, despite the epic volatility over the past 3 months brought about by the larger-than-expected waivers to importers of Iranian oil just before U.S.-imposed sanctions were due to kick in in November (Chart 6). Chart 62019 Brent, WTI Price Forecasts: Slightly Lower at And /bbl We have lowered our average 2019 Brent forecast to $80 this year from $82/bbl, and our WTI forecast to $74 from $76/bbl, given our assessments of production and consumption.7 Markets continue to re-calibrate supply and demand balances largely in the dark, and will continue to do so until greater clarity is gained on actual OPEC 2.0 production cuts and the state of EM demand. On the supply side, we expect sharp production cuts from OPEC 2.0 and Canadian producers of ~ 1.4mm b/d; falling output in non-Gulf OPEC states from continuing decline-curve losses; and slower U.S. shale growth resulting from lower capex in the wake of the price collapse. On the demand side, we lowered our EM growth estimate slightly ahead of an expected downgrade of EM growth this year, but we still expect consumption to show relatively strong growth of 1.4mm b/d. Net, the combination of supply cuts plus still-strong demand will remove the current global surplus, and rebalance the market by the end of 1H19. Thus, in our view, the balance of risks – as seen in our ensemble scenarios – still is to the upside (Chart 7). Chart 7Balance of Risks Favors Upside In line with our expectation for higher prices, we are getting long spot WTI, believing prices in the low- to mid-$40s extending beyond 1Q19 will cause a 5 – 10% slowdown in U.S. production growth later this year, which will set up a rally later in the year. We also are getting long July 2019 Brent vs. short July 2020 Brent as a spread at today’s close, in the expectation of a return to backwardation by the end of 1H19, as OECD inventories draw. We have touched on 3 of the 4 drivers of volatility in this week’s research. Next week we will examine the effect of this volatility on speculators’ risk-bearing capacity, and the implications for price discovery. Contrary to popular and received political opinion, speculation is a necessary and vital activity for the efficient functioning of commodity markets, particularly those used by commercial participants to hedge untoward price risks.   Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Footnotes 1      Please see “UPDATE 1-Chile monthly copper output highest in 13 years,” published December 31, 2018, by reuters.com. 2      Our estimates include continued production declines ex OPEC Gulf states and in other non-OPEC members like Mexico that are covered by the OPEC 2.0 agreement (Table 1). Under the production-cutting accord agreed at OPEC 2.0’s December meeting in Vienna, October 2018 is the benchmark against which new quotas – yet to by made public – are assessed. We note here that OPEC 2.0 has not published any official quota schedule following its December 2018 meeting, where it agreed to the 1.2mm b/d of production cuts.  Our supply estimates use data from the U.S. EIA, IEA and OPEC, along with trade press reports. 3      We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the Alberta government is attempting to draw down by its action over the course of 2019 at a rate of ~ 96k b/d.  4      By year-end, we expect U.S. crude oil production of 12.6mm b/d, which will keep the U.S. the largest crude oil producer in the world. U.S. crude oil exports can be expected to continue to grow as a result, after hitting 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data. U.S. product exports likely will run ~ 6mm b/d this year. 5      The IEA and OPEC are expecting 2019 demand growth of 1.3mm and 1.29mm b/d, respectively, while the U.S. EIA is expecting consumption will grow 1.5mm b/d. 6      Please see “China Sticks To The ‘Three Battles’,” published by BCA Research’s Geopolitical Strategy October 24, 2018. It is available at gps.bcaresearch.com. 7      This puts us above the consensus Brent forecast of $69.13/bbl reported by Reuters. Please see “Oversupply, faltering growth to weigh on oil prices in 2019: Reuters poll,” published by reuters.com December 31, 2018. Investment Views and Themes Recommendations Strategic Recommendations Trade Recommendation Performance In 3Q18 Commodity Prices and Plays Reference Table Trades Closed in 2018 Summary of Trades Closed in 2017

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 31, 2018.  The quant model reduced Spain’s large overweight to a slight overweight, and further downgraded the U.S. allocation. As a result, the model now has assigned overweight allocations to Germany, Switzerland, the Netherlands, Canada and Italy, with underweight allocations to the U.S., Japan, France and U.K.  Australia and Sweden are now in the neutral zone, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the overall model outperformed the MSCI world benchmark by 38 bps in December, with a 48 bps of outperformance from Level 1 model offset by a 21 bps of underperformance from Level 2. Since going live, the overall model has outperformed by 96 bps, with Level 2 outperforming by 120 bps and level 1 outperforming by 57 bps. Table 2Performance (Total Returns In USD %)   Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2)     Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.     GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com

Feature No Recession – Add To Risk Again Markets have been notably weak and volatile since we published our 2019 Outlook1 in late November. Over the past couple of months, global equities have fallen by more than 10%, the 10-year U.S. Treasury yield has dipped from above 3.2% to below 2.7%, and high-yield bond spreads have risen by more than 200 basis points. The market is sniffing out the risk of recession on the near-term horizon. We think the market has got this wrong, and so we move back to overweight global equities (from neutral, to where we lowered our recommendation last June). Recommendations Last year, U.S. growth was much stronger than growth in the rest of the world (Chart 1). Markets are implying that the global slowdown will soon infect the U.S., with the stock market pointing to the manufacturing ISM, currently at 59.3, falling back to 50 in very short order (Chart 2). Chart 1Will U.S. Growth Also Fall Back? Chart 2Stocks Imply ISM At 50 It is, indeed, probable that growth will slow this year: the FOMC’s median forecast suggests a slowdown in real GDP growth from 3.0% in 2018 to 2.3%. And it may take the market a little longer to digest that deceleration. However, growth is likely to remain above trend (currently estimated at 1.8%). Higher interest rates have begun to take their toll on the housing market (with a noticeable deterioration in new housing starts and builder confidence). But residential investment is now only 4% of GDP, compared to 7% in 2006, so the impact of the slowdown will be limited. Moreover, consumption is likely to remain buoyant, with wage growth accelerating, consumer confidence strong, and the savings rate with room to fall (Chart 3). Additionally, though fiscal stimulus will not be as powerful in 2019, the IMF estimates that it will add a further half of one percentage point to U.S. GDP growth. Chart 3Consumption Likely To Remian Buoyant The Fed is reacting very pragmatically to the evolving circumstances. Chair Jerome Powell emphasized in his post-FOMC press conference in December that “some cross currents have emerged” and that “policy decisions are not on a pre-set course”. The FOMC cut its forecast for hikes in 2019 from three to two and lowered its estimate of the terminal rate from 3.0% to 2.8% (currently the fed funds rate is at 2.4%). This implies that it will take approximately two more 25 basis point rate hikes before the Fed gets rates back to neutral. As we have often shown, risk assets tend to outperform bonds until monetary policy is restrictive (Chart 4). Meanwhile, market sentiment has turned excessively bearish. Our sentiment index is at a level that has historically pointed to a good buying opportunity (Chart 5). The AAII survey shows that recently only 25% of U.S. retail investors expect the market to rise over the next six months, compared to 47% who expect it to fall. Valuations are cheap again: the forward PE for the MSCI All Country World Index (ACWI) is now back to the range it traded at in 2013 (Chart 6). The classic indicators of recession, such as the yield curve, are not yet flashing warning signals: the 3-month/10-year curve, which we have shown has historically been the most reliable,2 remains at +20 basis points (Chart 7). It needs to invert to signal recession – and, typically, it does that as much as 18-24 months in advance. Chart 5Sentiment Is Very Bearish   Chart 6Global PE Back To To 2013 Level Chart 7Yield Curve Has Not Inverted Certainly, there are risks (we would highlight a reignition of the trade war after March 1, Brexit, U.S. government shutdown, the possibility that falling stock and house prices hurt consumer and business sentiment, and China’s reluctance to implement a massive 2016-style reflationary stimulus). But our analysis suggests there is significantly more upside than downside risk for equities over the next 12 months. If earnings growth, particularly in the U.S., comes in close to our top-down forecasts (Chart 8), it is hard to imagine – given the current depressed multiples – equities underperforming bonds this year. Accordingly, we recommend raising global equities to overweight in a multi-asset portfolio on a 12-month horizon, and lowering cash to neutral. For now, we have not changed our other tilts, and continue to recommend an overweight on U.S. equities and defensive sectors, a preference for equities over credit, and a high degree of caution towards emerging market assets. Chart 8Earnings On Track To Grow Healthily In 2019 Currencies: With growth likely to remain stronger in the U.S. than in the rest of the world, we expect appreciation of the dollar over the next six months. BCA’s Central Bank Monitors point to the need for the Fed to tighten policy further, but for the ECB to remain dovish. The gap between these two monitors has done a good job at forecasting EUR/USD over the past 10 years (Chart 9). However, speculative positions are already quite long dollar (Chart 10) and so the upside might be limited to around 5% in trade-weighted terms. If global growth begins to reaccelerate midway through 2019, the dollar might weaken again. Chart 9Relative Policy Suggests Stronger USD Equities: We prefer DM equities over EM. Further rises in the dollar and long-term U.S. interest rates, combined with continuing slowdown in global trade and Chinese growth, will remain headwinds for EM equities even if the market moves into a more risk-on phase. Valuations in EM do not look attractive either, with forward PE relative to DM in line with recent averages, and earnings growth forecasts likely to be revised down into negative territory over the coming months given the challenges facing developing economies (Chart 11). Within DM, we have a preference for the U.S., given its stronger growth and likely currency appreciation, over the euro zone and Japan, which are more sensitive to the global manufacturing cycle. Europe, in particular, will continue to be held back by the travails of its banks, which have been a major determinant of relative equity market performance in recent years (Chart 12). In a recent Special Report, we concluded that the long-term outlook for euro zone bank profitability remains lackluster.3 Chart 11EM Equities Are Not Cheap Chart 12Banks Will Weigh On Euro Zone Stocks Fixed Income: We see further upside for long-term rates in 2019, driven by a combination of above-trend economic growth, more Fed hikes than the market is pricing in, a moderate pick-up in inflation, and the unwinding of the Fed’s balance-sheet. We do not see rates being an impediment to growth until they reach the level of trend nominal GDP growth, currently 3.8% (which was the crunch point in both 1999 and 2006 – Chart 13). Despite our more positive view on equities, we remain more cautious on credit. Spreads have widened recently to more attractive levels (Chart 14). However, we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009 (Chart 15). Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019.  At this stage of the cycle, credit spreads are unlikely to tighten much, even with an equity market rally. Furthermore, given the high leverage, credit is an asset class that is likely to perform particularly poorly in the next recession. Chart 13Only At 3.8% Do Rates Become A Risk Chart 14Credit Spreads Not More Attractive Chart 15U.S. Corporate Leverage Is A Problem Commodities: The sell-off in crude oil over the past two months was due to short-term supply-side shocks, most notably the U.S.’s agreeing to 180-day exceptions on Iranian sanctions. But supply is likely to tighten in coming months (Chart 16). Saudi Arabia and Russia intend to reduce production by 1.2 million barrels/day, and U.S. shale oil supply growth is likely to slow since one-year forward WTI is now around $49, slightly below the average breakeven level for shale oil producers. With global oil demand set to remain strong, our energy strategists see Brent oil rebounding to around $80 a barrel in 2019, with WTI $6 below that.4 Industrial commodities will continue to face headwinds from a stronger dollar and slowing China. Only when the effects of China’s moderate reflation measures start to come through in 2H 2019 would we expect to see a recovery in metals prices. Chart 16Oil Supply Set To Tighten   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1      Please see “Outlook 2019: Late-Cycle Turbulence,” dated 27 November 2018, available at bca.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Can Asset Allocators Rely On Yield Curves?”, dated 15 June 2018, available at gaa.bcaresearch.com 3      Please see Global Asset Allocation Special Report, “Euro Area Banks: Value Play Or Value Trap?”, dated 14 December 2018, available at gaa.bcaresearch.com 4      For the detailed rationale of their forecast, please see Commodity & Energy Strategy Weekly Report, “2019 Key Views Policy-Induced Volatility Will Drive Markets,” dated 13 December 2018, available at ces.bcaresearch.com GAA Asset Allocation