BCA Indicators/Model

Highlights Credit: Credit spreads are widening due to the combination of weakening global growth and perceptions of restrictive Fed policy. Investors should monitor the indicators of global growth and Fed policy outlined in this report to call the peak in spreads. Duration: Financial conditions have not yet tightened enough for the Fed to take a significant dovish turn. Meanwhile, the housing market indicators with the best track records at signaling restrictive monetary policy remain benign. Maintain below-benchmark duration. MBS: Negative excess MBS returns during the past two months are the result of wider option-adjusted spreads, but continued easing in bank lending standards should prevent OAS from widening dramatically. Maintain a neutral allocation to MBS for now, but look to upgrade at the expense of corporate bonds as the credit cycle progresses. Feature The sell-off in credit markets continues to worsen. The average spread of the Bloomberg Barclays High-Yield index is now above 400 bps and the investment grade spread is at its widest level in two years (Chart 1). Chart 1Risk Off In Credit Markets Risk Off In Credit Markets Risk Off In Credit Markets Just like when credit markets sold off in 2014/15, the catalyst for wider spreads is the combination of weakening global economic growth and tight Fed policy. While indicators of global economic growth are sending negative signals, the Fed continues to focus on the sturdier domestic economy. Once again, the end result is a stronger dollar and a sell-off in risk assets.1 In the midst of a downturn, the relevant investment question becomes when to step back into the market. In this case, the question is: How should we go about calling the peak in credit spreads? In this week’s report we identify several catalysts that could signal a peak in credit spreads in the coming months. The catalysts fall into two categories: Signals of rebounding global growth Signals of Fed capitulation We consider each category in turn. Catalyst 1: Global Growth Rebound Chart 2 shows three indicators of global growth that investors should watch closely in the current environment. All three indicators are highly levered to global demand, signaled the peak in credit spreads in early 2016, and most importantly, are updated daily making it possible to track them in real time. Chart 2Signals Of Rebounding Global Growth Signals Of Rebounding Global Growth Signals Of Rebounding Global Growth The first indicator is the CRB Raw Industrials index (Chart 2, panel 2). This index troughed several weeks before the early-2016 peak in credit spreads. It is also currently in an uptrend, albeit a very modest one. The second indicator is the BCA Market-Based China Growth Indicator (Chart 2, panel 3). This indicator was created by our China Investment Strategy team as a broad proxy of investor expectations for Chinese growth.2 It includes 17 different market prices, spanning equity, commodity, fixed income and currency markets. Just like the CRB Raw Industrials index, it also signaled the early-2016 peak in credit spreads and is currently in a shallow uptrend. The third indicator is the price of Global Industrials stocks (Chart 2, bottom panel). These stocks also bottomed in early-2016, and they are currently trending down. On balance, we do not see sufficient evidence from these three indicators to call the peak in credit spreads. Global industrial stocks are collapsing, while the Raw Industrials and China Growth indexes have only put in tentative bottoms. Further, our assessment of economic trends suggests that these indicators may have more near-term downside. Weakness in global demand has largely been a function of slowing growth in China (Chart 3). The Chinese Manufacturing PMI has already collapsed to the 50 boom/bust line and we are still waiting to see the full impact of tariffs in the economic data. It’s true that Chinese policymakers have begun to ease monetary policy: interest rates are lower (Chart 3, panel 3) and the trade-weighted RMB has depreciated (Chart 3, bottom panel). But so far, easier monetary conditions have not passed through to the money and credit growth indicators that tend to lead Chinese economic activity. Our China Investment Strategy team’s Li Keqiang Leading Indicator is an index designed to lead the Li Keqiang index – a widely followed indicator of Chinese economic activity. The leading index is primarily composed of money and credit growth data, and it remains well below the zero line, pointing to further economic weakness ahead (Chart 3, panel 2). Chart 3Keep An Eye On China Keep An Eye On China Keep An Eye On China Catalyst 2: Fed Capitulation If global demand does not improve, then eventually financial conditions will tighten so much that the Fed will downgrade its assessment of future U.S. economic growth and adopt a more dovish policy stance. This is what happened in early 2016, and the Fed’s capitulation signaled the peak in credit spreads at that time (Chart 4). Chart 4Signals Of Fed Capitulation Signals Of Fed Capitulation Signals Of Fed Capitulation Our 12-month Fed Funds discounter tracks the market’s expectation for changes in the fed funds rate during the next 12 months. The discounter plunged sharply in early 2016 from a peak of 75 bps to a trough of 4 bps, signaling the peak in credit spreads (Chart 4, panel 2). At present, the discounter has fallen somewhat during the past few weeks, but hardly by enough to signal capitulation from the Fed on its “gradual” rate hike cycle. The minutes from the November FOMC meeting will be released this week and we will read closely to get a sense for how the Fed is thinking about the current state of financial conditions. However, at this point we view a December rate hike as a done deal. If credit spreads continue to widen between now and the December 19 FOMC meeting, then Chairman Powell’s post-meeting press conference will become critical for markets. Another useful indicator for the perceived stance of monetary policy is the price of gold (Chart 4, panel 3). In prior research we discussed why a higher gold price correlates with perceptions of easier monetary policy, and vice-versa.3 So it should not be surprising that gold rose sharply as the Fed capitulated in early 2016, signaling the peak in credit spreads. Gold has been range-bound during the past few weeks, but a significant upside break-out would signal a potential buying opportunity in credit. Finally, the trade-weighted U.S. dollar will likely be another useful indicator for calling the peak in credit spreads (Chart 4, bottom panel). The dollar is not a pure indicator of the stance of Fed policy like our 12-month discounter or the gold price. Rather, the dollar’s value is determined jointly by the outlooks for the U.S. economy and the rest of the world. However, a peak in the dollar would signal that either the Fed has become more dovish, or that non-U.S. growth has recovered significantly. Credit spreads would benefit in either case. The dollar did in fact roll over prior to the peak in credit spreads in early 2016, and we expect it would do the same again. Thus far we have focused on what to monitor to call the peak in credit spreads. One of the catalysts is an easing of Fed policy that would obviously be accompanied by lower Treasury yields. Therefore, it is worth thinking about how the outlook for credit spreads influences our portfolio duration call, and vice-versa. Chart 5 provides a useful illustration to help us think about the relationship. The chart shows our 12-month Fed Funds Discounter, our BCA Fed Monitor and each its three components lined up with the 2014/15 period. Specifically, this year’s trough in the dollar is lined up with the 2014 dollar trough, denoted in the chart by a vertical line. Chart 5BCA Fed Monitor: Today Vs. 2014/2015 BCA Fed Monitor: Today Vs. 2014/2015 BCA Fed Monitor: Today Vs. 2014/2015 The first key takeaway is that the market expects roughly the same number of rate hikes during the next 12 months as it did this far into the 2014/15 episode of dollar strength (Chart 5, top panel). However, our Fed Monitor is currently well above the zero line, suggesting that further rate hikes are warranted. This far into the 2014/15 dollar uptrend, our Fed Monitor had already dipped below zero (Chart 5, panel 2). The reason for today’s higher Fed Monitor is that U.S. economic growth and inflation are both on much firmer footing than during 2014/15 (Chart 5, panels 3 & 4). In fact, financial conditions have tightened more severely than at a similar stage of the 2014/15 episode, but the impact on the overall Monitor has been offset by stronger economic growth and inflation. What does this all mean? It very likely means that the Fed will need to see tighter financial conditions (i.e. wider credit spreads) before taking a significant dovish turn. In other words, the near-term path of least resistance for credit spreads is probably wider, while Treasury yields may remain close to current levels. Bottom Line: Credit spreads are widening due to the combination of weakening global growth and perceptions of restrictive Fed policy. Investors should monitor the indicators of global growth and Fed policy outlined in this report to call the peak in spreads. Housing Update In prior research we stressed the importance of housing as the most important channel through which monetary policy impacts the real economy.4 This makes the U.S. housing market critical for the portfolio duration call. If the housing market has peaked for the cycle, then it likely means that monetary policy has become overly restrictive and that interest rates have also peaked. Chart 6 shows the three most important indicators of the housing market in this regard. Residential investment as a share of potential GDP, the 12-month moving average in single family housing starts and the 12-month moving average in new home sales. At the moment, only residential investment has flattened off, while the other two indicators have maintained their uptrends. While there’s no denying that the housing data have softened in recent months, the bigger picture suggests it is too soon to sound the alarm. Chart 6Housing: The Three Most Important Indicators Housing: The Three Most Important Indicators Housing: The Three Most Important Indicators Rising rates have taken most of the blame for weaker housing data, best exemplified by these comments from the National Association of Realtors’ Chief Economist Lawrence Yun that accompanied last week’s release of October’s existing home sales data: Rising interest rates and increasing home prices continue to suppress the rate of first-time homebuyers. Home sales could further decline before stabilizing. The Federal Reserve should, therefore, re-evaluate its monetary policy of tightening credit, especially in light of softening inflationary pressures to help ease the financial burden on potential first-time buyers and assure a slump in the market causes no lasting damage to the economy.5 There are certainly structural impediments to first-time homeownership, most notably the lack of supply at the low-end of the market. The most recent annual report from the Joint Center For Housing Studies noted that of 88 metropolitan areas with available data, “virtually all” had more homes for sale in the top third of the market by price than in the bottom third.6 However, we do not see the level of interest rates as the major problem for first-time homebuyers or indeed the overall market. In fact, it is very difficult to see how the level of interest rates could be a large drag on the housing market when the household mortgage debt service ratio is as low as it has been since 1980 (Chart 6, bottom panel). So what exactly is going on with housing? It is likely that the recent slow-down in housing activity is not function of the level of mortgage rates, but of the recent sharp increase in mortgage rates. Chart 7 shows that there have been three periods since the financial crisis when mortgage rates jumped sharply: 2013, late-2016 and 2018. All three episodes were followed by a contraction in residential investment about six months later. The recent contraction fits this pattern nicely, which suggests that it should reverse if mortgage rates simply flatten-off for a time. Chart 7The Culprit: Large Rate Spikes The Culprit: Large Rate Spikes The Culprit: Large Rate Spikes Bottom Line: The housing market indicators with the best track records at signaling restrictive monetary policy remain benign, suggesting it is too soon to fret about the end of the Fed’s rate hike cycle. We suspect that recent housing weakness is a function of the large jump in mortgage rates, and that housing activity will recover once mortgage rates moderate their uptrend. Agency MBS On Upgrade Watch Agency MBS have underperformed duration-matched Treasuries so far this year. While they have outperformed corporate credit, they have also lagged other Aaa-rated securitizations (Chart 8). As the cycle progresses, we think Agency MBS spreads will remain relatively tight even after the credit cycle turns and corporate bond defaults rise. We maintain a neutral allocation to MBS for now, but will likely upgrade the sector when it comes time to downgrade corporate bonds from neutral to underweight. Chart 8Agency MBS: Outperforming Corporate Credit But Lagging Other Aaa-Rated Securitizations Agency MBS: Outperforming Corporate Credit But Lagging Other Aaa-Rated Securitizations Agency MBS: Outperforming Corporate Credit But Lagging Other Aaa-Rated Securitizations We like to model excess MBS returns using the following formula: Monthly Excess Returns = a * (1-month lag in OAS) - b * (change in OAS) + c * (change in yields) - d * (squared change in yields) In the above formula, the change in yields proxies for mortgage refinancing risk. Refinancings tend to increase when yields fall and decline when they rise. The squared change in yields proxies for extension risk, and the lagged OAS approximates the carry in the security. The final risk factor is the change in MBS OAS itself.7 Chart 9 shows a performance attribution of monthly MBS excess returns to each of the risk factors listed above. The model coefficients are estimated using only 2018 data, and the November figures are month-to-date. The message from Chart 9 is that while the squared change in yields was a drag on returns early in the year, widening OAS has been the reason for negative excess returns during the past two months. Refinancing risk has been muted all year, and this will likely continue as the Fed tightens policy. Chart 9Agency MBS Performance Attribution A Checklist For Peak Credit Spreads A Checklist For Peak Credit Spreads While a wider OAS has dragged down MBS returns during the past two months, we do not see this becoming a long-term issue for the sector. The OAS tends to widen when banks are tightening lending standards on residential mortgage loans, and at present, lending standards are already quite restrictive compared to history. The median FICO score for new mortgages is a lofty 758 (Chart 10). This suggests that the most likely way forward is continued gradual easing in bank mortgage lending standards (Chart 10, bottom panel). Chart 10Lending Standards Will Continue To Ease Lending Standards Will Continue To Ease Lending Standards Will Continue To Ease Bottom Line: Negative excess MBS returns during the past two months are the result of wider option-adjusted spreads, but continued easing in bank lending standards should prevent OAS from widening dramatically. Maintain a neutral allocation to MBS for now, but look to upgrade at the expense of corporate bonds as the credit cycle progresses.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 5 https://www.nar.realtor/newsroom/existing-home-sales-increase-for-the-first-time-in-six-months 6 http://www.jchs.harvard.edu/state-nations-housing-2018 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “On The MOVE”, dated February 13, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Feature Asset Allocation Amid Late-Cycle Turbulence BCA today published its 2019 Outlook, Late-Cycle Turbulence,1 our annual discussion with long-time clients Mr X and his daughter, Ms X. Recommendations Monthly Portfolio Update Monthly Portfolio Update This note is simply to update the Global Asset Allocation (GAA) service’s recommended portfolio in the light of our expectations for the next 12 months, as detailed in the 2019 Outlook. The table on the right summarizes our key views, with the full details of recommended weights for a standard portfolio on page 3 of our PDF. Our overall view of markets has not changed significantly. We remain concerned about late-cycle pressures that will ultimately undermine asset prices. However, it is hard to put precise timing on when the U.S. economy will peak. For the next few quarters, it will continue to benefit from loose fiscal policy and still accommodative monetary policy. Although global growth is slowing, a recession is not on the immediate horizon. Therefore, we think it is premature to move underweight on equities. A further sell-off might even present a buying opportunity. Accordingly, we remain neutral on global equities, with a preference for the U.S., underweight global bonds, and overweight cash. The only significant change we make to GAA’s recommended portfolio is to reduce Japanese equities to neutral. Profit margins are at record highs but are vulnerable to narrowing as wage growth picks up and sales to emerging markets come under further pressure. Our model suggests that Japanese profit growth will turn negative in year-on-year terms by the second half of 2019. Barring evidence of more reflationary stimulus from China, Japan will be challenged to outperform global equities. We have used the funds taken from Japan to increase our overweight in U.S. equities. We make two minor changes to our equity sector recommendations, lowering Industrials to underweight and raising Consumer Discretionary to neutral. This is in line with our generally defensive sector tilts. We expect to see a further slowdown in China and, in the U.S. too, capex growth has probably peaked for this cycle. These factors should be negative for capital goods producers. Consumer Discretionary should benefit from a late-cycle rise in wages in developed economies, and contains some structural growth companies in the online commerce space, which are now more attractively valued after the recent sell-off. We will publish our next Monthly Portfolio Update on January 2.   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnote 1 Please see BCA Outlook titled “Late-Cycle Turbulence” dated November 26, 2018 available at bca.bcaresearch.com Recommended Asset Allocation

Highlights The October credit and housing market data present a gloomy picture for Chinese domestic demand. Trade remains buoyant, but exports are set to decline materially over the coming months. Many investors are focused too much on external demand and not enough on Chinese domestic demand. China's old economy has been deteriorating for two years, and it is unlikely that exchange rate depreciation alone will reverse this trend. A review of the drivers of credit growth during China's last mini-cycle upswing underscore that the country's monetary transmission mechanism is impaired. This suggests that investors are exposed to fiscal and regulatory policy inertia, as well as time lags once policymakers decide to aggressively stimulate. Chinese stocks may present an excellent buying opportunity over the coming year, but that point has not yet been reached. Stay neutral for now. Feature China's October trade data (released earlier this month) was a frustrating one for investors, as it revealed that market participants will have to wait even further for clarity on the magnitude and duration of the upcoming shock to exports. The strong October trade data has even led to some market participants questioning whether export growth will decelerate at all, a view that we strongly disagree with. It is true that there is no direct reason to expect that the impact of U.S. import tariffs will affect China's non-U.S. exports. But Chart 1 shows that Chinese exports to the U.S. are currently running above the pace that would be predicted by the overall trend in U.S. non-oil imports, a circumstance that is highly unlikely to continue in the face of mutual tariff imposition. Negative export "alpha" would imply a growth rate materially below the dotted line in Chart 1. As such, even though Chinese exports to the U.S. account for only 20% of total exports, the impact of an eventual "reversion to fundamentals" is likely to substantially effect the overall trend in Chinese export growth. Chart 1Export Frontrunning To The U.S. Continues Export Frontrunning To The U.S. Continues Export Frontrunning To The U.S. Continues Given the integrated nature of global trade, persistently strong export growth is also very likely supporting imports. Chart 2 shows that import growth has been closely correlated with domestic industrial activity since 2010, but is now running approximately 10-12 % above would normally be expected. This implies that China's overall trade momentum will weaken considerably over the coming months, which is likely to reverberate through key trade linkages in emerging markets and commodity-producing developed markets. Chart 2Current Import Growth Appears Unsustainable Current Import Growth Appears Unsustainable Current Import Growth Appears Unsustainable October's credit data was also highly significant, as it validated the view that we espoused in our recent report.1 We noted in response to the September credit release that a surge in the 3-month rate of change of adjusted total social financing (TSF) was driven by front-loaded fiscal spending that would not last. Chart 3 shows that special local government bond issuance in October fell by 650 bn RMB relative to the prior month, suggesting that (net) new fiscal stimulus will be required in order for local government bond issuance to materially boost overall credit growth. Chart 3September Was Not The Start Of A New Trend In LG Bond Issuance September Was Not The Start Of A New Trend In LG Bond Issuance September Was Not The Start Of A New Trend In LG Bond Issuance Finally last week's housing data release highlighted that residential sales and construction momentum is faltering (Chart 4), which was likely triggered in part by prior reductions in the PBOC's pledged supplementary lending (PSL) program. We noted in a September Special Report that the pullback in the PSL would negatively impact the housing market on a cyclical basis,2 and October's data certainly supports this view. Chart 4The Housing Market Slowed In October The Housing Market Slowed In October The Housing Market Slowed In October Don't Pin Any Hopes On A Trade "Ceasefire" Against this gloomy economic backdrop market participants have actually been incrementally positive about China over the past few weeks, in anticipation of a possible détente with the U.S. Last week's flurry of optimism about an apparently meaningful resumption in trade talks were somewhat diminished by comments from President Xi and Vice President Pence at the APEC summit over the weekend, but our geopolitical strategists believe that the odds of a short-term "tariff ceasefire" occurring at the G20 summit later this month are genuinely non-trivial (possibly as high as 30-40%). We define a "ceasefire" in this case as a commitment to refrain from any further protectionist action during a renewed period of negotiations, not an immediate and substantive deal that ends the trade war. We agree that any positive actions on the trade front are likely to lead to a short-term boost to Chinese stock prices (and global risk assets more generally). But the key question for investors is whether this will lead to a durable rally lasting several months. In our opinion, three factors argue against this view: A ceasefire probably will not lead to an agreement: There is no indication that either the U.S. or China has changed their positions concerning the dispute, with China reportedly having simply restated their previous offer in advance of the G20 summit. On the U.S. side, attempts to restart negotiations may reflect the desire to give China "one last chance" before moving to impose tariffs on all Chinese imports, which the administration may be planning as a rhetorical counter to any domestic pushback from rising consumer goods prices (the "Walmart effect"). A ceasefire will not roll back tariffs already in place: It is unlikely that the U.S. would impose tariffs on all remaining imports from China (the "third round") while negotiations are taking place. But a near-term shock to Chinese exports is still likely, because the existing tariffs on the first and second round would not be rolled back until a deal is successfully negotiated. It is even possible (albeit unlikely) that the administration will move ahead with the planned increase in the second round tariff to 25% at the end of the year despite the presence of negotiations. A ceasefire alone will not reverse the ongoing slowdown in Chinese domestic demand: The trade war between the U.S. and China is occurring against a backdrop of weaker Chinese domestic demand, a point that we have highlighted numerous times over the past year. As shown in Chart 2 above, the growth momentum of China's old economy peaked well before the trade war began, and a temporary "stay of execution" on the trade front is unlikely to change the downtrend in domestic activity. This last point is important, as it appears that many global investors are focused almost exclusively on China's negative external demand outlook and not nearly enough on weak domestic demand. Chart 5 vividly illustrates this point, by contrasting our new Market-Based China Growth Indicator with our leading indicator for the Li Keqiang Index. Our market-based China Growth Indicator is very similar to the highly informative China Play Index created by BCA's Foreign Exchange Strategy service to hedge against a possible countertrend correction in the U.S. dollar,3 but it is somewhat broader, has four asset class subcomponents, and has been built on a deviation from trend basis (see Box 1 for a description). Chart 5The Market Has Lagged The Macro Data Over The Past Three Years The Market Has Lagged The Macro Data Over The Past Three Years The Market Has Lagged The Macro Data Over The Past Three Years Box 1 Introducing The BCA Market-Based China Growth Indicator Chart A1 presents the BCA Market-Based China Growth Indicator, along with its four asset class subcomponents: currencies, commodities, equities, and rates/fixed-income. The purpose of the indicator is to act as a broad proxy of investor expectations for Chinese growth, and to illustrate which asset classes are providing the strongest/weakest growth signals. Chart A1Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Investors Are Incrementally Positive, But Rates Caution Against Over Optimism Table A1 presents a list of the series included in each of the asset class subcomponents, all of which were tested to ensure that they were coincident or lead the Bloomberg Li Keqiang index. The indicator is made up of an equally-weighted average of the four asset class subcomponents, and each series is equally-weighted within its respective subcomponent (meaning that the 17 series do not have equal weights in the overall indicator). Table A1Components Of The BCA Market-Based China Growth Indicator Trade Is Not China's Only Problem Trade Is Not China's Only Problem Chart A1 highlights that the commodity and equity subcomponents are currently providing the most positive signals, whereas the currency component is in line with the overall indicator. The rates component, which provided the earliest warning sign this cycle that Chinese growth was likely to decelerate, remains the weakest element of the indicator and has not been rising over the past few weeks (in contrast to the other components). The chart shows that price signals from China-related assets generally followed or even anticipated our LKI leading indicator prior to 2015, but that the reverse has been true over the past three years. The gap between the two indicators became extreme earlier in the year, and only closed once investors began to react to the emergence of the trade war. But the key point from the chart is that trade is not China's only problem, as our LKI leading indicator shows that Chinese monetary conditions, money, and credit growth have been deteriorating for the better part of the past two years. Monetary Policy: Pushing On A String? One bullish China narrative that currently prevails in the marketplace is that the odds of "big bang" stimulus rise materially in lockstep with any further deterioration in the macro data. Most recently, several China analysts have speculated that the PBOC will soon cut its benchmark policy rate, which would be an unmistakable sign that the monetary policy dial has been turned towards "maximum reflation". Ultimately, we agree with the view that investors hold a put option issued by the Chinese government, but we have strenuously argued that the strike price is considerably lower than many think. On top of this, investors face another risk, namely a circumstance where the exercise price of the China put is even lower than the government intends it to be. This situation could arise if the PBOC decides to fire its bazooka, but the resulting decline in interest rates does not materially boost credit growth. Such a scenario prevailed in the U.S. several years following the global financial crisis, when many investors characterized the Fed's efforts to boost (or at least stabilize) credit growth as "pushing on a string". Chart 6 illustrates that this actually occurred in China during its last mini-cycle upswing, raising the odds of a repeat incident that results in a meaningful lag between the approval of big bang stimulus and its reflationary effect on financial markets. The chart shows the annual change in total social financing as a share of 4-quarter trailing GDP, including and excluding local government bond issuance (both measures exclude equity financing). Chart 6No Major Acceleration In "Standard" Credit Growth In 2015-2016... No Major Acceleration In "Standard" Credit Growth In 2015-2016... No Major Acceleration In "Standard" Credit Growth In 2015-2016... While adjusted TSF excluding local government bonds technically accelerated as a share of GDP from 2015 to late last year, the rise was tepid at best (in contrast to the 2012/2013 episode). It is clear from the chart that most of the acceleration in overall credit during the 2015/2016 period came from a surge in local government bond issuance, not from "standard" credit. This is an important observation, given that interest rates declined significantly over the period (Chart 7). Chart 7...Despite A Substantial Easing In Monetary Policy ...Despite A Substantial Easing In Monetary Policy ...Despite A Substantial Easing In Monetary Policy From a theoretical perspective, an atypical divergence between interest rates and credit growth can occur either because of abnormal loan demand or loan supply. Chart 8 suggests that it was the latter in China in 2015/2016: loan demand reportedly rose for small/micro, medium, and large enterprises (particularly among small/micro), but the trend in loan approval barely budged (unlike in 2011/2012 when it rebounded sharply). In short, Chart 8 provides support for the view that Chinese banks did not meaningfully ease lending standards during the 2015/2016 episode, despite a substantial easing in monetary policy and (ultimately) a substantial improvement in economic conditions. Chart 8Loan Demand Responded To Lower Rates, But Lending Standards Did Not Loan Demand Responded To Lower Rates, But Lending Standards Did Not Loan Demand Responded To Lower Rates, But Lending Standards Did Not Chart 9 highlights that this almost certainly occurred because of a sharp deterioration in reported bank asset quality that began in 2014. The chart shows that both the non-performing loan and special mention loan ratios rose significantly during this period, the sum of which has only modestly declined. We highlighted the potential for NPL recognition to weigh on credit growth in our two-part joint Special Report with BCA's Geopolitical Strategy service,4 as long as the ongoing financial regulatory crackdown is even half-heartedly implemented. While Chart 8 shows that loan approval modestly ticked higher in Q3, it provides no evidence of stealth easing in financial regulation. Chart 9Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality Banks Did Not Rush To Lend Because Of Deep Concerns Over Asset Quality The key conclusion for investors from these observations is as follows: while China can certainly decide to stimulate aggressively in response to too-weak economic conditions, an impaired monetary transmission mechanism implies that there may be a lag, possibly a substantial one, between the decision to stimulate and its reflationary impact on financial markets. This is of crucial importance to investors aiming to maximize risk-adjusted returns over a 6-12 month time horizon, and weighs heavily on our recommendations. Investment Strategy Recommendations Chart 10 shows our Li Keqiang leading indicator within its component range, a chart that remains at the core of our efforts to predict China's business cycle. The indicator has been built in such a way that a decision of policymakers to push for more local government bond issuance (like in 2015/2016), or an improvement in the efficacy of China's monetary transmission mechanism, are likely to be captured by one or more of its components. Chart 10Only A Narrow Pickup In Our LKI Leading Indicator Only A Narrow Pickup In Our LKI Leading Indicator Only A Narrow Pickup In Our LKI Leading Indicator As we noted in our November 7 Weekly Report,5 the rise in the indicator has been driven by its two monetary conditions components, which have in turn mostly been driven by the substantial weakness in the RMB over the past four months. Given that the ultimate impact of the U.S. tariffs on Chinese exports remains obscured by trade frontrunning, it is unclear if China's exchange rate depreciation will be sufficiently reflationary even to counter the upcoming export shock, let alone reverse the ongoing domestic demand slowdown. As a result, investors should be closely watching for signs of a pickup in money & credit growth, which for now remain absent. Put differently, macrofundamental support for the equity market is lacking. Despite this, Chart 11 highlights that both Chinese A-shares and the investable market are deeply oversold, which in combination with expectations of further monetary stimulus and the potential for a tariff ceasefire have many investors chafing at the bit to go long either market (or both!) over a 6-12 month time horizon. Chart 11Chinese Stocks Are Quite Oversold... Chinese Stocks Are Quite Oversold... Chinese Stocks Are Quite Oversold... Our advice is simply to wait. A trade ceasefire is unlikely to generate more than a short-term boost to stock prices, and our indicators provide the best bet to monitor whether an impaired banking system is responding to any further easing in monetary policy. Finally, while we agree that stocks have priced in a meaningful decline in earnings, that earnings adjustment process has yet to even begin. Chart 12 illustrates the point where Chinese stocks bottomed in relation to the last major decline in earnings, suggesting that stocks need both a valuation discount and earnings clarity before putting in a durable bottom. The latter is missing and may stay missing for several months, highlighting that an outright long position remains premature. Stay tuned! Chart 12...But We Have Yet To Even Begin The Earnings Adjustment Process ...But We Have Yet To Even Begin The Earnings Adjustment Process ...But We Have Yet To Even Begin The Earnings Adjustment Process Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see China Investment Strategy Weekly Report "Is China Making A Policy Mistake?", dated October 31, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Special Reports "China's Property Market: Where Will It Go From Here?", dated September 13, 2018, available at cis.bcaresearch.com. 3 Pease see BCA Foreign Exchange Strategy Weekly Report "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com. 4 Pease see China Investment Strategy Special Reports "China: How Stimulating Is The Stimulus?", dated August 8, 2018, and "China: How Stimulating Is The Stimulus? Part Two", dated August 15, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report "Checking In On The Data", dated November 7, 2018, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Yields: Global bond yields appear to be settling into a new trading range, with the downside limited by tight labor markets but the upside capped by slowing global growth momentum. 2014/15 Redux?: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Feature Dear Client, There will be no Global Fixed Income Strategy report published next Tuesday, November 27th. Instead, you will be receiving a Special Report this Thursday, November 22nd. The report - authored by BCA's Chief Emerging Markets strategist, Arthur Budaghyan - will discuss the outlook for Emerging Market hard currency debt. Best regards, Rob Robis Chief Strategist On the surface, it appears that uncertainty is increasing in global fixed income markets. Government bond yields have dipped over the past couple of weeks, most notably in the U.S. where the benchmark 10-year Treasury yield is back down to 3.05% as we go to press. Corporate credit spreads have also been drifting wider, especially in the U.S. where there is growing concern that economic momentum has peaked, at least temporarily. The problem for bond markets is that while global growth momentum has clearly slowed, it has not been by enough to alleviate inflation pressures coming from tight labor markets. This story is clearly most visible in the U.S., but also in the majority of major developed market economies. Central bankers are sticking to their guns and focusing on their belief in the Phillips Curve model to forecast inflation. Until there are signs that more turbulent financial markets are feeding into actual weaker economic growth, bond yields will not be able to fall by enough to help bail out flailing equities and corporate credit. There are now 83% of OECD countries with an unemployment rate below the estimated full employment NAIRU. As expected with such a backdrop, our Central Bank Monitors are calling for tighter monetary policy across the developed economies. This is also showing up in an unusual divergence between rising global real bond yields and falling global leading economic indicators (Chart of the Week). Chart of the WeekYields Are Less Responsive To Slowing Growth Yields Are Less Responsive To Slowing Growth Yields Are Less Responsive To Slowing Growth By most conventional measures, monetary policy settings are not restrictive across the major economies. Actual policy interest rates remain below conventional measures of equilibrium like a Taylor Rule, while government bond yields - adjusted for inflation expectations - are less than trend real GDP growth (Chart 2). Those gaps are smallest in the U.S., where the Fed has been raising interest rates for the past three years, but remain wide in other countries. Chart 2Global Interest Rates Are Still Below Equilibrium Levels The Bond Market Is Not Your Friend The Bond Market Is Not Your Friend If global growth is merely shifting from above-trend (falling unemployment) to trend (stable unemployment), then central bankers will not be able to move back to a more dovish posture that could trigger a major fall in bond yields. Trading ranges are more likely to result in such an environment, where yields struggle to break higher because of shaky risk assets but cannot break lower because of low unemployment. We are likely in one of those ranges now, measured by a 3-3.25% range on the 10-year U.S. Treasury. Without a friendly boost from falling bond yields, we continue to recommend a cautious stance on global spread product, while maintaining an overall below-benchmark stance on global duration exposure. Will It Be 2014/15 All Over Again? Watch The USD & China Two months ago, we published a comparison of the current macro backdrop to that of the 2014/15 period.1 Back then, the Fed was forced to alter its plans to deliver a series of rate hikes after the end of its quantitative easing program, thanks to a sharply rising U.S. dollar that triggered major financial market selloffs and, eventually, slower U.S. growth. We concluded that such an outcome could occur again in the next few months, but it would take a much larger tightening of financial conditions to get the Fed to stand down this time given tighter U.S. labor markets and stronger U.S. inflation pressures. The way we presented that comparison between today and four years ago was though "cycle-on-cycle" charts, showing financial and economic data today overlapped with data from that 2014/15 period. The two episodes were indexed to the trough in the U.S. dollar in May 2014 and February 2018. This week, we update a few of those charts, but also add a few new indicators to assess if there has been enough financial and economic damage to trigger a shift to a more dovish Fed. U.S. Economy: The domestic U.S. economy appears healthier today versus the 2014/15 period, judging by the more robust readings from the NFIB Small Business Optimism index and the high level of job openings from the JOLTS data (Chart 3). Yet there are similarities seen in the latest decline in the Conference Board survey of U.S. CEO confidence, and the sharp fall in the ISM Manufacturing New Orders index. We suspect that this divergence in business optimism reflects U.S.-China trade tensions, which should have a greater impact on larger corporations that sell globally compared to smaller companies with a more domestic customer base. Chart 3U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Inflation: U.S. core CPI inflation is much faster now than at the similar point in the 2014/15 cycle, as is the growth in Average Hourly Earnings (Chart 4). This is due to the much lower unemployment rate today in the U.S., which is putting more upward pressure on domestically-generated prices and wages. Yet while the ISM Prices Paid index is also at a higher level today than 2014/15, the upward momentum has peaked and the latest decline in commodity prices is following an ominously similar path to four years ago (bottom panel). Chart 4U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation Emerging Markets (EM): EM economic growth has been decelerating at a similar pace to 2014/15, with the aggregate EM (ex-China) PMI produced by our EM strategists now sitting right at the boom/bust 50 line (Chart 5). China's economic growth appears to be holding up better today when looking at the more elevated Li Keqiang index. A possible reason for that is the much larger and faster easing of Chinese monetary conditions today compared to 2014/15, thanks to the sharp weakening of the yuan. Chart 5EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) Global Financial Markets: Here, the current cycle is sticking very close to the 2014/15 script when looking at the rising U.S. trade-weighted dollar, widening spreads for U.S. investment grade (IG) corporate bonds and EM USD-denominated sovereign debt, and the tightening of U.S. financial conditions (Chart 6). Although it should be noted that the trade-weighted dollar would have to rise another 10% from current levels, and U.S. IG spreads would have to widen another 60bps, to generate similar moves compared to 2014/15. Chart 6Financial Markets Today Vs. 2014/15: Following A Similar Script Financial Markets Today Vs. 2014/15: Following A Similar Script Financial Markets Today Vs. 2014/15: Following A Similar Script U.S. Treasury Yields: Nominal U.S. Treasury yields are at much higher levels today than four years ago, an obvious consequence of the Fed's tightening cycle and more elevated U.S. inflation expectations (Chart 7). Yet the amount of tightening discounted over the next 12-months in the U.S. Overnight Index Swap (OIS) is similar to 2014/15, as is our estimate of the market-implied level of the terminal real fed funds rate (around 0.5%).2 One major difference: there is a large net short position in the Treasury market today, while positioning was fairly neutral during 2014/15 (bottom panel). Chart 7U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing Summing it all up, the broader range of evidence we present here confirms our conclusion from two months ago. There needs to be a much larger tightening of U.S. financial conditions before the Fed can signal a pause on its planned rate hikes, because of a much healthier domestic U.S. economy and a more entrenched acceleration of inflation (especially wage growth). If China's economy can continue to outperform the 2014/15 path - still a big "if" given U.S.-China trade uncertainties and with Chinese policymakers less willing to reflate the domestic credit bubble to boost growth - then the odds of U.S. growth converging down to non-U.S. growth will be reduced. We will continue to monitor these charts and relationships in future Weekly Reports but, for now, we see nothing yet to change our bearish views on U.S. Treasuries and our cautious view on U.S. corporate credit. Bottom Line: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand Update: Fade The Recent Bump In Yields We have been structurally positive on New Zealand (NZ) government bonds for some time, dating back to mid-2017. Our view was based on an assessment that the Reserve Bank of New Zealand (RBNZ) would be unable to make any upward change in policy rates due to sub-par economic growth and inflation that would struggle to meet the RBNZ's target of 2% (the midpoint of the 1-3% target band). So far, that scenario has fully played out, and NZ government bonds have significantly outperformed their global peers as a result (Chart 8). Chart 8Sticking With Our Successful Long NZ Trades Sticking With Our Successful Long NZ Trades Sticking With Our Successful Long NZ Trades Our preferred trades, which are part of our Tactical Overlay shown on page 14, have been yield spread trades for NZ government bonds versus U.S. and German equivalents.3 Specifically, we have been recommending long positions in 5-year NZ bonds vs. 5-year U.S. Treasuries and 5-year German government debt. The trades have performed well, but have given back some of the gains in recent weeks. This has mostly come via a surge in NZ yields (+29bps higher since the recent low on September 7th) that has driven yield spreads wider versus the U.S. and Germany (+23bps and +34bps, respectively, since September 7th). These increases are likely to prove unsustainable, given the sluggish momentum in NZ growth and inflation. The latest read on year-over-year real GDP growth came in at below-potential pace of 2.8% in the 2nd quarter of 2018. The manufacturing and services purchasing managers' indices (PMIs) have both fallen sharply throughout 2018, although the latest data points suggest some stabilization above the 50 level on the PMIs (Chart 9). Similar trends can be seen in the RBNZ surveys of business confidence and capacity utilization, which both remain near the post-2008 lows but may also be stabilizing. Chart 9Sub-Par Growth In New Zealand Sub-Par Growth In New Zealand Sub-Par Growth In New Zealand In the November Monetary Policy Statement (MPS) that was released after the RBNZ meeting earlier this month, a cautious view on growth was outlined.4 The pickup in Q2 GDP growth was dismissed as driven by temporary factors, and policymakers expressed concern that deteriorating business confidence could be signaling a more prolonged period of slowing domestic demand. The central bank did also highlight growth risks coming from slowing exports if U.S.-China trade tensions intensify. It is difficult to find an obvious trigger for faster NZ growth at the moment. Both consumer spending and residential investment were fueled by rising immigration and population growth from 2013 to 2017, but those trends have since begun to reverse. The RBNZ projects net monthly immigration to NZ to slow to levels last seen in 2014 and in line with the current growth rate of consumer spending around 3% (Chart 10). Business investment growth has already stalled (middle panel), while the RBNZ'S Business Outlook surveys indicate a negative outlook for export growth (bottom panel). Chart 10Where Will NZ Growth Come From? Where Will NZ Growth Come From? Where Will NZ Growth Come From? Against this sluggish growth backdrop, the RBNZ must continue to run an accommodative monetary policy to support growth. This can be done given the persistent undershooting of NZ inflation versus the RBNZ target. Headline CPI inflation did accelerate to 1.9% in Q3, but core inflation at 1.2% continued to languish near the bottom end of the RBNZ target range. The gap between the two inflation measures can be attributed to previous increases in global energy prices, which caused a blip up in the tradeables portion of the NZ CPI (Chart 11). Yet the recent decline in oil prices, combined with a bounce in the NZ dollar, suggests that the bump in tradeables inflation is likely to reverse in Q4 (middle panel). Non-tradeables inflation, which is driven by domestic factors such as wage growth, has remained stable at just over 2%, even with the NZ unemployment rate at a 10-year low of 4.5% that is below the OECD's NAIRU estimate. Chart 11Stubbornly Low NZ Inflation Stubbornly Low NZ Inflation Stubbornly Low NZ Inflation With an obvious trigger from higher inflation, the RBNZ will be forced to maintain a highly accommodative policy stance. This is especially true given the RBNZ's mandate, which now includes maximizing sustainable employment alongside keeping inflation between 1-3%. We think that means the RBNZ is more likely to tolerate a move to the upper end of that inflation band if the growth outlook was less certain, as is currently the case. Our RBNZ Monitor sits close to the zero line, indicating no pressure to either hike or cut interest rates. In the November MPS, the RBNZ stuck to its forecast that the Official Cash Rate (OCR) would remain unchanged at 1.75% until mid-2020, consistent with the signal from our RBNZ Monitor. The market is differing on this, with the NZ OIS curve currently discounting almost one full 25bp rate hike by the end of 2019, and a faster pace of hikes after that (Chart 12). Chart 12Market-Priced RBNZ Hikes Will Not Happen Market-Priced RBNZ Hikes Will Not Happen Market-Priced RBNZ Hikes Will Not Happen We continue to recommending fading any pricing of RBNZ rate hikes over the next 6-12 months. Given our still bearish views on U.S. Treasuries, we are maintaining our recommended long NZ 5-year/short U.S. 5-year position (on a currency-hedged basis into U.S. dollars). We have been running our long NZ/short Germany position on an UN-hedged basis - atypical for the Global Fixed Income Strategy service, where our views are almost always currency-hedged into U.S. dollars - since the trade's inception last year, based on a currency view that was more bearish on the euro than the New Zealand dollar. The NZD/EUR cross instead fell substantially, which more than fully eroded the gains on the bond side of the trade until the recent 7.5% pop in that exchange rate. After that move, the return on our unhedged trade is nearly back to flat. We are using that as an opportunity to switch our NZ/Germany trade to a more typical currency-hedged basis, moving the exposure into euros from New Zealand dollars. Bottom Line: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "EM Contagion? Or Just QT On The Q.T.?", dated September 11th 2018, available at gfis.bcarsearch.com. 2 This is calculated by subtracting the 5-year U.S. CPI swap rate, 5-years forward, from the 5-year U.S. OIS rate, 5-years forward. 3 We freely admit that a position held for over one full year should not be described as "tactical", as the name of our overlay portfolio suggests. Yet we have seen no reason to close these trades early given our market views on NZ. 4 The full Monetary Policy Statement can be found here: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2018/mpsnov2018.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Bond Market Is Not Your Friend The Bond Market Is Not Your Friend Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Despite a stellar Q3 earnings print, the S&P 500 had a terrible October as EPS continues to do the hard work in lifting the market (Chart 1). Chart 1EPS Doing The Heavy Lifting EPS Doing The Heavy Lifting EPS Doing The Heavy Lifting We bought the dip,1 consistent with our view of deploying longer term oriented capital were a 10% pullback to occur, given our view of no recession for the next 9 to 12 months.2 Financials and industrials should lead the next leg up and we believe a rotation into these beaten up stocks is going to materialize in the coming months. On the flip side, as volatility is making a comeback and the fed is on a path to lift rates to 3% by June of next year, fixed income proxies and consumer discretionary stocks should be avoided and a preference for large caps over small caps should be maintained (Chart 2). Chart 2The Return Of Vol May Spoil The Party The Return Of Vol May Spoil The Party The Return Of Vol May Spoil The Party Further, a valuation reset has taken hold, pushed by the surprising rise of the equity risk premium over the course of the past two years, representing a surge in negative sentiment from investors, despite the usually tight inverse correlation with the ISM, the core sentiment indicator of the manufacturing economy (Chart 3). Chart 3ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated ERP And The Economy Are Inversely Correlated Nevertheless, while everyone is focusing on the euphoric above trend growth of the U.S. economy, a risk lurking beneath the surface is a domestic economic soft patch.3 We have likely stolen demand from the future and brought consumption forward especially with the stock market related fiscal easing that is front loaded to 2018 and less so for next year. On that front our Economic Impulse Indicator is warning that the U.S. economy cannot grow at such a pace, unless a bipartisan divide can be crossed to deliver enough firepower to rekindle GDP growth (Chart 4). Chart 4Economic Impulse Yellow Flag Economic Impulse Yellow Flag Economic Impulse Yellow Flag Further, at least part of the blame for higher volatility rests with increasing trade uncertainty as the Trump administration has pursued an aggressive trade policy. Still, the evidence so far indicates that any trade weakness has been borne disproportionately by the rest of the world, to the U.S.' benefit (Charts 5 & 6). Chart 5U.S. Is Winning The Trade War U.S. Is Winning The Trade War U.S. Is Winning The Trade War Chart 6U.S. Has The Upper Hand U.S. Has The Upper Hand U.S. Has The Upper Hand We remain cognizant of a few key risks to our sanguine U.S. equity view. Principal among these is the rising U.S. dollar and its eventual infiltration into S&P 500 earnings, which has thus far been muted (Chart 7). Chart 7Watch The U.S. Dollar Watch The U.S. Dollar Watch The U.S. Dollar Further, a softening housing market bodes ill for U.S. economic growth. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters (Chart 8). Chart 8Peak Housing Peak Housing Peak Housing Chris Bowes, Associate Editor chrisb@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Daily Insight, "Time To Bargain Hunt," dated October 26, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "The "FIT" Market," dated October 9, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, "Critical Reset," dated October 29, 2018, available at uses.bcaresearch.com. S&P Financials (Overweight) Unchanged from its trajectory when we updated our cyclical indicators earlier this year, the S&P financials CMI has continued to accelerate. A historically low unemployment rate, combined with unusually resilient economic growth, underpin the surge in the CMI to its highest levels post-GFC. Further goosing the indicator, particularly with respect to the core banks sub-sector, is the recent rise in Treasury yields and a modest steepening in the yield curve both of which bode well for bank profits. However, financials have not responded to this exceptionally bullish data the way we expected, with worries over future loan growth fully offsetting the positive backdrop; financials have been falling throughout 2018. Still, inflation is threatening to rise (albeit gradually) and a selloff looms in the bond market. We highlighted earlier this fall that sectors who benefit from rising interest rates while serving as inflation hedges should outperform against this backdrop. Cue the return of S&P financials. As shown in Chart 10, the S&P financials index has shown a historically strong positive correlation with interest rates and inflation expectations and we expect the recent divergence to be closed via a catch-up in the former. As noted above, bearishness has reigned in 2018 and the result has been a steep fall in our valuation indicator (VI) to more than one standard deviation below normal while our technical indicator (TI) is deep in oversold territory. Chart 9S&P Financials (Overweight) S&P Financials (Overweight) S&P Financials (Overweight) Chart 10Financials Are Trailing Rates Financials Are Trailing Rates Financials Are Trailing Rates S&P Industrials (Overweight) S&P industrials, much like their cyclical brethren S&P financials, benefit from higher interest rates and also serve as hedges against rising inflation. As we have noted in recent research, industrials are levered to the commodity cycle and thus represent an indirect inflation hedge. This hedge only becomes problematic when industrials stocks are unable to pass these rising commodity costs through to the consumer. As shown in Chart 12, pricing power is not yet an issue for these deep cyclicals. Given the positive macro backdrop for S&P industrials, the CMI has risen to new cyclical highs. Despite the forgoing, fears over trade wars and tariff-driven higher input costs, combined with slowing global demand for capital goods, have weighed on the index. The result is that S&P industrials remain deeply oversold on a technical basis while hovering around the neutral line from a valuation perspective. We reiterate our overweight recommendation. Chart 11S&P Industrials (Overweight) S&P Industrials (Overweight) S&P Industrials (Overweight) Cjart 12Resilient Industrials Pricing Power Resilient Industrials Pricing Power Resilient Industrials Pricing Power S&P Energy (Overweight, High-Conviction) Our energy CMI has moved horizontally since our last update of the cyclical macro indicators. However, this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Nevertheless, the S&P energy index has moved sideways in line with the CMI. Energy stocks have significantly trailed crude oil prices since the latter broke out roughly a year ago (Chart 14). Disbelief in the longevity of the increase in oil prices is the likely culprit weighing on the index, along with a bottleneck-induced steep shale oil price discount to WTI. There are high odds that a catch up phase looms, especially if BCA's Commodity & Energy Strategy service's view of a looming oil price spike materializes, and we reiterate our overweight recommendation. Our VI has been hovering at one standard deviation below fair value, while our TI trending into oversold territory. Chart 13S&P Energy (Overweight, High-Conviction) S&P Energy (Overweight, High-Conviction) S&P Energy (Overweight, High-Conviction) Chart 14Crude Prices Are Still Leading The Way Crude Prices Are Still Leading The Way Crude Prices Are Still Leading The Way S&P Consumer Staples (Overweight) Unchanged from our previous update, our consumer staples CMI has moved sideways, near a depressed level. However, share prices have finally been staging the recovery we have anticipated for several years on the back of firm consumer data, solid sector profitability and an overall cyclical rotation into staples. Despite the recent outperformance, both from an earnings and market perspective, consumer staples remain a deeply unloved sector. With respect to the former, earnings growth has outstripped the market's reaction by a wide margin. This is reflected on our VI which only recently rose from one standard deviation below fair value while our TI has only just begun a retreat from oversold territory. Staples' share of retail sales have arrested their steep declines from 2014-2016, which we view as a precursor to a rebound in weak industry sales (top panel, Chart 16). Exports of consumer staples have already been staging a comeback, despite the strengthening of the U.S. dollar which has historically presaged a relative earnings outperformance (middle panel, Chart 16). Considering the already-strong industry return on equity, any relative earnings gains should result in a valuation rerating (third panel, Chart 16). We reiterate our outperform rating on this cyclically defensive index. Chart 15S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) Chart 16Staples Are Making A Comback Staples Are Making A Comback Staples Are Making A Comback S&P Health Care (Neutral) In a mid-summer report , we upgraded the S&P pharma and biotech indexes to neutral which, considering their ~50% weight of the S&P health care index, took our overall recommendation on S&P health care to neutral. In the report, we proffered five reasons why the S&P pharma and biotech indexes were set for a rebound following their precipitous decline from 2016 onwards. These were: firming operating metrics, late cycle dynamics, likelihood of pricing power regulatory relief, the rising U.S. dollar and investor and analyst capitulation. Our timing has proved prescient as the S&P pharma index has been dramatically outperforming since the upgrade (top panel, Chart 18). With respect to pharma's operating metrics, our pharma productivity proxy (industrial production / employment) has been soaring, implying that earnings should surge (second panel, Chart 18). This seems particularly likely as the pace of improvement in drug shipments exceeds inventory growth by a fairly wide margin (third and bottom panels, Chart 18). Despite the upbeat backdrop for pharma, our health care CMI has declined modestly, though remains at a neutral level relative to history. Further, the pharma recovery has taken our VI from undervalued to a neutral position, a reading which is echoed by our TI. Chart 17S&P Health Care (Neutral) S&P Health Care (Neutral) S&P Health Care (Neutral) Chart 18Pharma Strength Is Lifting Health Care Pharma Strength Is Lifting Health Care Pharma Strength Is Lifting Health Care S&P Technology (Neutral) The stratospheric rise of tech profits, particularly in the past two years, have done most of the heavy lifting in pulling the S&P 500's profit margin ever higher (second panel, Chart 20) as well as pushing the index itself to new all-time highs in September. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity - suggests more profit growth is in the offing (third panel, Chart 20), an intimation repeated by our technology CMI. However, we remain cognizant of three material risks to bullishness in tech. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind (bottom panel, Chart 20). Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM economic data would retrench further. Lastly, neither our VI nor our TI send particularly compelling messages, as both are on the expensive side of neutral, despite the recent tech selloff. We sustain a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. Chart 19S&P Technology (Neutral) S&P Technology (Neutral) S&P Technology (Neutral) Chart 20Tech Is King But Beware The U.S. Dollar Tech Is King But Beware The U.S. Dollar Tech Is King But Beware The U.S. Dollar S&P Materials (Neutral) Our materials CMI has recently plumbed new lows, a result of tightening monetary policy and the accompanying selloff in the bond market. As a reminder, the heavyweight chemicals component of the materials index typically sees earnings (and hence stock prices) underperform as real interest rates are moving higher. Despite this negative backdrop, chemicals fundamentals have remained surprisingly resilient. Pricing power has stayed in its multi-year uptrend (second panel, Chart 22) while productivity gains have accelerated, coinciding with an erosion of sell-side bearishness (third panel, Chart 22). Still, chemical production has clearly rolled over (bottom panel, Chart 22) which could lead to a quick reversal of the gains in our productivity proxy and a faltering in rebounding EPS estimates. Combined with BCA's view of rising real interest rates for the next year, this is enough to keep us on the fence. Our VI too shows a neutral reading, though our TI has declined steeply into an oversold position. Chart 21S&P Materials (Neutral) S&P Materials (Neutral) S&P Materials (Neutral) Chart 22Fundamentals In Chemicals Have Improved Fundamentals In Chemicals Have Improved Fundamentals In Chemicals Have Improved S&P Utilities (Underweight) Our utilities CMI is at a 25-year low, driven down by the ongoing backup in interest rates. Such a move is predictable, given that utilities stocks are the closest to perfect fixed income proxies in the equity space. The S&P utilities sector has been enjoying a relative resurgence recently, driven by spiking natural gas prices and a supportive electricity demand backdrop from a roaring economy (ISM survey shown inverted, bottom panel, Chart 24) and, more than anything, a general market retreat into safe haven assets. We recently trimmed our exposure to the sector from neutral to underweight because the S&P utilities sector was yielding 3.5% and the competing risk free asset was near 3.2% and investors would prefer to shed, at the margin, riskier high-yielding equities and park the proceeds in U.S. Treasurys (top panel, Chart 24). Since the run up in S&P utilities without a corresponding decline in Treasury yields, that spread has narrowed. Neither our VI nor our TI send compelling messages as both are in neutral territory, though our bearish thesis on utilities has less to do with their valuation relative to themselves or other equities than to bonds. Chart 23S&P Utilities (Underweight) S&P Utilities (Underweight) S&P Utilities (Underweight) Chart 24Utilities Should Still Be Avoided Utilities Should Still Be Avoided Utilities Should Still Be Avoided S&P Real Estate (Underweight) Our real estate CMI has reversed a recent recovery to set a new decade low; the only time it has shown a lower reading was during the Great Financial Crisis. Excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable (top panel, Chart 26). Much like the S&P utilities sector in the previous section, and in the context of BCA's higher interest rate view, we continue to avoid this sector. The rate-driven downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel, Chart 26). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel, Chart 26). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Our VI suggests that REITs are fairly valued, which is somewhat surprising given the negative backdrop, while our TI echoes a neutral view. Chart 25S&P Real Estate (Underweight) S&P Real Estate (Underweight) S&P Real Estate (Underweight) Chart 26A Bearish Backdrop For REITs A Bearish Backdrop For REITs A Bearish Backdrop For REITs S&P Consumer Discretionary (Underweight) While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. The second panel of Chart 28 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and as a knock off on effect, weigh on discretionary consumer outlays. Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. We show our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices) in the bottom panel of Chart 28. Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. All of this is captured by our CMI which has been sinking since the beginning of the year. Meanwhile, our VI has broken out to nearly its highest level ever which we believe is largely a function of the decreasing diversification of the S&P consumer discretionary index as AMZN now represents more than 30% of its market value following the redistribution of the media indexed to the new S&P communication services index. Our TI has been falling from overbought territory recently and now sends a neutral message. Chart 27S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) Chart 28Higher Rates Spell Declines For Consumer Discretionary Higher Rates Spell Declines For Consumer Discretionary Higher Rates Spell Declines For Consumer Discretionary S&P Communication Services (Underweight) As the newly-minted communication services has little more than a month of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 29 below with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Rather, we refer readers to our still-fresh initiation of coverage on the sector and look forward to being able to deliver something more substantive in the future. Chart 29S&P Communication Services (Underweight) S&P Communication Services (Underweight) S&P Communication Services (Underweight) Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years. Despite the neutral CMI reading, we downgraded small caps earlier this year , and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (top and second panels, Chart 31). We expect the divergence in leverage and stock price to be rationalized as it usually has: via a fall in the latter. Considering the dramatic valuation gap that has opened between large and small caps, particularly on a Shiller P/E (or cyclically adjusted P/E, CAPE) basis (bottom panel, Chart 31), no space remains for any small cap profit mishaps. Our VI is trending towards small caps being undervalued, though without conviction while our TI is hovering in the neutral zone. Chart 30Size Indicator (Favor Large Vs. Small Caps) Size Indicator (Favor Large Vs. Small Caps) Size Indicator (Favor Large Vs. Small Caps) Chart 31Too Much Debt And High Valuations Should Hurt Small Caps Too Much Debt And High Valuations Should Hurt Small Caps Too Much Debt And High Valuations Should Hurt Small Caps

Highlights Did October's equity rout ... : Before bouncing back in its final two sessions, October was the S&P 500's 12th-worst month of the postwar era. ... represent a watershed for financial markets?: Shaken investors have begun asking if the equity bull market is finally over, and if Treasury yields are in the process of making their cyclical highs. Not according to the macro backdrop, which still supports risk assets, ... : There is no recession in sight. An earnings contraction sufficient to induce an equity bear market, or a meaningful pickup in defaults, isn't imminent. ... or our rates checklist, which still supports a bearish take: Inflation may be taking its time, but nothing on our rates checklist calls for increasing duration in a bond portfolio. Feature U.S. equity investors were relieved to close the books on October, which was a notably bad month for the S&P 500. Its 7% loss was good for 33rd-worst in the postwar record books, and just missed being a -2 standard-deviation event. Had the month ended before its robust bounce in the final two sessions, it would have been the 12th-worst, two-and-a-half standard deviations below the mean (Chart 1). At its lowest point, a half-hour before the October 29th close, the index was down a whopping 10.5% for the month. Chart 1Standing Out From The Crowd Standing Out From The Crowd Standing Out From The Crowd The price action understandably unnerved investors. Monthly declines of this magnitude are almost always associated with bear markets; just seven of the thirty-two larger declines occurred outside of bear markets, two of them by the skin of their teeth. Decomposing the equity returns into changes in earnings estimates and changes in forward multiples shows that sharp multiple contraction is a feature of nearly every bad month (Table 1). Table 1Worst Postwar Monthly Declines Checking In On Our Rates View Checking In On Our Rates View It is estimate growth - a robust 0.8% - that makes October something of an outlier among the S&P 500's worst months, and we expect growing forward earnings will keep the S&P out of a bear market for another year, especially now that its multiple is more than 15% off its peak. Earnings growth should also keep spread product out of trouble for the time being. Although we recommend no more than an equal weight in corporate bonds, modest spread widening has boosted their total return prospects. Too Legit To Quit We expect that earnings will keep growing because they rarely contract in a meaningful way outside of recessions. With monetary accommodation likely reinforcing certain fiscal stimulus over the coming year, it is hard to see how the next U.S. recession will occur before 2020. As our U.S. bond strategists pointed out last week, the ongoing market implications of last month's equity decline depend on what precipitated it.1 Was it a simple correction sparked by a valuation reset, or has the market begun to sniff out an economic slowdown? With forward four-quarter earnings growing by an annualized 9.5% in October, it appears that the selloff was nothing more than a valuation reset. As our bond strategists point out, the picture was much different when the S&P 500 corrected in the summer of 2015 and the winter of 2015-16. Those corrections unfolded against the backdrop of a global manufacturing recession (Chart 2). The U.S. economy is not bulletproof, and slowing global growth and tighter financial conditions will eventually bring it to heel, but we think the next recession is still too far down the line for markets to begin selling off in advance of it. Chart 2The Fundamentals Are Much Improved From 2015-16 The Fundamentals Are Much Improved From 2015-16 The Fundamentals Are Much Improved From 2015-16 Checking In With Our Rates Checklist If macro conditions really did change for the worse last month, our bearish rates view may no longer apply, and we would have to rethink our underweight Treasury and below-benchmark-duration calls. We introduced our rates checklist in September to identify and track the key series that could trigger a view change. We review it now to see if perceptions of the Fed, inflation measures, labor-market developments, or financial-market excesses suggest that rates may be at a turning point (Table 2). Table 2Rates View Checklist Checking In On Our Rates View Checking In On Our Rates View Market Perceptions Of The Fed We continue to scratch our head over markets' refusal to take the FOMC's terminal-rate projections seriously. The overnight index swap (OIS) curves are calling for a measly two hikes over the next 12 months ... and the next 18 months ... and the next 24 as well (Chart 3). That would leave the terminal fed funds rate for this tightening cycle at a mere 2.75%. The median projection among FOMC voters is 3 1/8%, and we're looking for anywhere from 3.5 to 4%. We will have to start backing off once the gap between our expectations and the market's expectations begins to close, but it's only widened since we established the checklist. Chart 3Stubbornly Staying Behind The Curve Stubbornly Staying Behind The Curve Stubbornly Staying Behind The Curve We get to our 3.5-4% estimate on the premise that measured inflation will pick up enough to force the Fed to keep hiking beyond its own expectations in a bid to keep inflation from getting out of hand. Client meetings suggest that investors find our inflation call hard to swallow. Some eye-rolling when we mention the Phillips Curve is understandable, but our view is ultimately based on capacity constraints. Tepid investment in the years following the crisis have left the economy's productive potential ill-suited to meet the surge in aggregate demand provoked by tax cuts and fiscal stimulus. An inverted curve would indicate that the bond market has begun to anticipate that rate hikes will soon stifle the economy's momentum. For all the hand-wringing in the media about flattening over the 2-year/10-year segment of the curve, our preferred 3-month/10-year measure remains nowhere near inverting (Chart 4). The yield curve tends to invert way ahead of a recession, so we would look for other indicators to corroborate its message before we changed our big-picture take. We also note that a bear flattening would support below-benchmark-duration positioning. Chart 4The Fed Hasn't Gone Too Far Yet The Fed Hasn't Gone Too Far Yet The Fed Hasn't Gone Too Far Yet Bottom Line: The bond market remains well behind the Fed, and the Fed may well wind up behind the economy. A broad repricing of the Treasury curve awaits. Inflation Measures Inflation's slow creep has gotten a little slower since we initially rolled out the checklist. Headline PCE and CPI have hooked downward, though their uptrends remain intact (Chart 5). Looking forward, continued tightening of the output gap should boost inflation (Chart 6), though long-term expectations have stalled for now (Chart 7). Inflation is the only section of the checklist that has backslid since September, but not by nearly enough to justify checking any of the boxes. Chart 5Two Steps Forward, One Step Back Two Steps Forward, One Step Back Two Steps Forward, One Step Back Chart 6An Economy Running Hot ... An Economy Running Hot ... An Economy Running Hot ... Chart 7... Will Eventually Produce Inflation ... Will Eventually Produce Inflation ... Will Eventually Produce Inflation Labor Market Indicators The first item on our list of labor-market indicators is the unemployment gap, the difference between the unemployment rate and NAIRU. NAIRU (the Non-Accelerating-Inflation Rate of Unemployment), is the estimate of the lowest sustainable unemployment rate. The actual rate fell below NAIRU in early 2017, and the gap has been getting steadily more negative ever since (Chart 8, top panel). A negative gap is associated with higher compensation, but the wage response has been muted so far (Chart 8, bottom panel). Chart 8Supply And Demand Supply And Demand Supply And Demand Friday's October employment report pointed to further downward pressure on the unemployment gap. The three-month moving average of net payroll additions came in at 218,000, keeping job growth for the last seven years at around 200,000/month (Chart 9). If the trend were to continue for another twelve months, and population growth and the labor force participation rate (Chart 10, middle panel) were to remain constant, the Atlanta Fed Jobs Calculator2 projects that the unemployment rate will fall to 3%. Chart 9A Steady, Job-Rich Recovery A Steady, Job-Rich Recovery A Steady, Job-Rich Recovery Chart 10As 'Hidden' Unemployment Shrinks ... As "Hidden" Unemployment Shrinks … As "Hidden" Unemployment Shrinks … We understand investors' impatience with the Phillips Curve. We admit to being surprised that compensation growth hasn't shown more life to this point (Chart 11). Just because wage gains have been sluggish out of the gate, however, doesn't mean they won't speed up in the future. Ancillary indicators like the broader definition of unemployment that includes discouraged and involuntary part-time workers (Chart 10, top panel), and the ratio of workers voluntarily leaving their jobs (Chart 10, bottom panel), reinforce the unemployment rate's signal that the labor market is on its way to becoming as tight as a drum. Chart 11... Wages Should Rise ... Wages Should Rise ... Wages Should Rise Broader Indications Of Instability The final three items on our checklist are meant to flag factors that could bump the Fed off its gradual rate-hiking pace. Overheating would encourage the Fed to move more quickly, but there is nothing in the main cyclical elements of the economy that stirs concern (Chart 12). The Fed might move faster if its third mandate - preserving financial stability - dictated it, but the Fed has been quiet about financial-sector imbalances since Governor Brainard expressed concern about corporate lending two months ago. Finally, the Fed is not oblivious to economic strain in the rest of the world, but conditions in even the most vulnerable emerging markets are far from triggering some sort of "EM put." Chart 12No Sign Of Overheating Yet No Sign Of Overheating Yet No Sign Of Overheating Yet Investment Implications We remain constructive on the economy and markets in the absence of a near-term catalyst to cut off the expansion, the credit cycle and/or the equity bull market. Like our bond strategists, we simply think the U.S. economy is too healthy to merit revising our bearish view on rates. The implication for investors with a balanced mandate is to continue to underweight Treasuries. Within fixed-income portfolios, investors should continue to maintain below-benchmark duration. No investment stance is forever, and we are counting on our checklist to help keep us alert to an approaching inflection point in rates, but the coast is clear for now. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see BCA Research's U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?," published October 30, 2018. Available at usbs.bcaresearch.com. 2https://www.frbatlanta.org/chcs/calculator.aspx?panel=1

Dear Client, Next week, I am on the road in the Middle East visiting clients and teaching the BCA Academy Principles of Global Macro course. There will be no regular Weekly Report on November 9th. Instead, we will be sending you a Special Report on November 6th written by my colleague Rob Robis, who runs BCA's Global Fixed Income Strategy service. In this piece, Rob will be discussing the outlook for Euro Area monetary policy and its implications for rate markets and the euro. This is an especially relevant topic as the end of the ECB's Asset Purchase Program is scheduled to soon materialize. I trust you will find this report both interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. Based on our timing models, the dollar is now fairly valued on short-term basis. However, slowing global growth and robust U.S. activity suggest that the dollar has room to rally further, with our models pointing to a move in the greenback's favor. These conflicting forces suggest the dollar's easy gains are behind us, and any further dollar rally will prove much more volatile. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, thanks to their ability to increase the Sharpe ratio of global equity portfolios vis-Ã -vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-Ã -vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is what will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests that incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Chart 1Interest Rate Parity: Generally Helpful, But... Interest Rate Parity: Generally Helpful, But... Interest Rate Parity: Generally Helpful, But... Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference among investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have a much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. Chart 2Real Rates Work Better Over The Long Run Real Rates Work Better Over The Long Run Real Rates Work Better Over The Long Run It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 3Real And Nominal Rate Spreads Can Differ Real And Nominal Rate Spreads Can Differ Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real - not nominal - long-term rate differentials. Global Risk Aversion And Commodity Prices Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Much literature has focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Chart 4The Dollar Benefits From Global Stresses The Dollar Benefits From Global Stresses The Dollar Benefits From Global Stresses Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resources prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. Currently, there is no evident mispricing in the USD, as it trades near fair value when compared to both the FITM (Chart 5) and ITTM. While this means that the easy part of the dollar rally is behind us, it does not imply that the rally is over. As Chart 6 illustrates, periods of dollar strength tend to end when the dollar trades at a 5% premium to the ITTM. This would imply that a move to 102 on the DXY is likely over the coming months. Moreover, the widening interest rate differential between the U.S. and the rest of the world, as well the bout of rising volatility the world is experiencing, should continue to push the fair values of both the FITM and ITTM higher. Chart 5Fundamentals Continue To Help The Dollar Fundamentals Continue To Help The Dollar Fundamentals Continue To Help The Dollar Chart 6More Upside Is Possible More Upside Is Possible More Upside Is Possible The Euro As a mirror image to the DXY, there is no evident mispricing in EUR/USD. Currently, based on both the FITM and the ITTM, the euro trades at a small premium to fair value (Chart 7). However, the sell signal generated by the deviation from the ITTM in 2017 is still in place, as periods of overvaluation tend to be followed by periods of undervaluation (Chart 8). This indicator will only generate a buy signal for the euro once EUR/USD falls 5% below equilibrium, or to a level of 1.06. Moreover, this target is a moving one. European growth and inflation continue to disappoint, as the euro area feels the drag of a slowing China and decelerating global growth. This means that interest rate differentials are likely to continue to move in a euro-bearish fashion in the coming months. Hence, the flattening in the FITM that materialized in 2018 is at risk of becoming an outright deterioration. Chart 7Fundamentals For The Euro Are Deteriorating Fundamentals For The Euro Are Deteriorating Fundamentals For The Euro Are Deteriorating Chart 8EUR/USD Is Not Cheap EUR/USD Is Not Cheap EUR/USD Is Not Cheap The Yen In an environment of rising global bond yields, the FITM for the yen continues to trend south, as Japanese rates lag well behind U.S. interest rates (Chart 9). This means the yen is once again trading at a small premium to its FITM, implying that even if global risk assets sell off further, the upside for the yen against the dollar may prove limited. However, the picture for the yen against the ITTM is more benign. The yen is at equilibrium on this basis (Chart 10). However, due to the design of the ITTM, previous periods of overvaluations tend to be followed by periods of undervaluation. As a result, on the basis of this model, the yen could continue to experience downside against the dollar over the coming three to six months. This will be even truer if U.S. bond yields can continue to rise. Chart 9Rate Differentials Continue To Hurt The Yen Rate Differentials Continue To Hurt The Yen Rate Differentials Continue To Hurt The Yen Chart 10More Downside Ahead If U.S. Yields Keep Rising More Downside Ahead If U.S. Yields Keep Rising More Downside Ahead If U.S. Yields Keep Rising The British Pound The GBP/USD has deteriorated in recent weeks, a move that was mimicked by cable itself. As a result, the pound does not show any evident mispricing on this basis against the USD (Chart 11). The ITTM corroborates this message, as GBP/USD trades at a marginal 1% discount to this indicator (Chart 12). This upholds our analysis of September 7, which showed there was little risk premium embedded in the pound to compensate investors for the risks associated with the Brexit negotiations and the cloudy British political climate.9 Since British politics remain a minefield, this lack of valuation cushion suggests that the GBP is likely to continue to swing widely. As a result, a strategy to be long volatility in the pound, or to bet on the reversal of both large upside and downside weekly moves in the GBP, remains our preferred approach. Chart 11Cable Is At Equilibrium Cable Is At Equilibrium Cable Is At Equilibrium Chart 12Small Valuation Cushion Could Be Problem If Political Risk Increases Small Valuation Cushion Could Be Problem If Political Risk Increases Small Valuation Cushion Could Be Problem If Political Risk Increases The Canadian Dollar Despite the softening evident in the Loonie's FITM, the Canadian dollar continues to trade at a substantial discount to this fair value model (Chart 13). However, the FITM for the CAD is at risk of weakening further as oil prices have begun to be engulfed in the weakness that has gripped EM and risk assets globally. Mitigating this message, on the eve of the announcement of the USMCA trade deal, which essentially kept in place the trade relationships that existed between the U.S. and Canada under NAFTA, the Loonie was trading at a 1.5 sigma discount to the ITTM, a level normally constituting a buy signal (Chart 14). As a result, we expect the Canadian dollar to not be as sensitive to commodity price weakness as would have been the case had the CAD traded at a premium to its ITTM. This is one factor explaining why the Canadian dollar remains one of our favorite currencies outside the USD for the coming three to six months. The second favorable factor for the CAD is that the Bank of Canada is likely to hike interest rates at the same pace as the Fed. Hence, unlike with other currencies, interest rate differentials are unlikely to move against the CAD. Chart 13Loonie Trades At A Big Discount To Fundamentals... Loonie Trades At A Big Discount To Fundamentals... Loonie Trades At A Big Discount To Fundamentals... Chart 14...Which Will Help The CAD Mitigate A Fall In Oil Prices ...Which Will Help The CAD Mitigate A Fall In Oil Prices ...Which Will Help The CAD Mitigate A Fall In Oil Prices The Swiss Franc Like the euro, the Swiss franc trades in line with both its FITM and ITTM fair values (Chart 15). Moreover, the CHF has been hovering around its fair value for nearly a year now, which means there is less of a case for an undershoot of the ITTM fair value than for currencies that have experienced recent overshoot (Chart 16). Moreover, if volatility in financial markets remains elevated, and volatility within the bond market picks up, the fair value of the Swissie could experience some upside. However, this is where the positives for the Swiss franc end. The Swiss economy remains mired by underlying deflationary weaknesses, reflecting the lack of Swiss pricing power as well as the tepid growth of Swiss wages. As a result, the interest rate differential components of the models are likely to continue to represent a headwind for the CHF, especially as the Swiss National Bank remains firmly dovish and wants to keep real interest rates at low levels in order to weigh on the franc and also stimulate domestic demand. Based on these bifurcated influences, while we remain negative on the CHF against both the dollar and the euro on a cyclical basis, EUR/CHF may remain under downward pressure over the coming three to six months. Chart 15No Valuation Mismatch... No Valuation Mismatch... No Valuation Mismatch... Chart 16...Implies That The CHF Will Be At The Mercy Of Central Banks ...Implies That The CHF Will Be At The Mercy Of Central Banks ...Implies That The CHF Will Be At The Mercy Of Central Banks The Australian Dollar While the Australian dollar continues to trade at a significant premium against long-term models, it now trades at an important discount against both its FITM and ITTM equilibria (Chart 17). However, the problem for the AUD is that the FITM estimates continue to trend lower as Australian interest rates are lagging U.S. rates, especially in real terms. This is a direct consequence of the Reserve Bank of Australia maintaining the cash rate at multi-generational lows, while the Fed keeps hiking its own policy benchmark. With real estate prices sagging in both Melbourne and Sydney, as well as with a lack of wage growth and inflationary pressures, this down-under dichotomy is likely to remain in place and further weigh on the AUD. Meanwhile, while it is true that the AUD is also trading at a discount to its ITTM, historically, the Aussie has bottomed at slightly deeper levels of undervaluation (Chart 18). When all these factors are taken in aggregate, they suggest that for the AUD to fall meaningfully from current levels, we need to see more EM pain, more Chinese economic weaknesses, and commodity prices following these two variables lower. While this remains BCA's central scenario for the coming three to six months, if this scenario does not pan out the AUD could experience a sharp rebound over that timeframe. Chart 17Discount In AUD Emerging... Discount In AUD Emerging... Discount In AUD Emerging... Chart 18...But Not Yet Large Enough ...But Not Yet Large Enough ...But Not Yet Large Enough The New Zealand Dollar The NZD now trades at an even greater discount to both its FITM and ITTM equilibria than the AUD (Chart 19). In fact, so large is this discount that the ITTM is flashing a buy signal for the kiwi (Chart 20). This further confirms the view that we espoused 3 weeks ago that the NZD was set to rebound. As a result, we remain comfortable with our tactical recommendation of buying NZD/USD and selling GBP/NZD. The long NZD/USD position is definitely the riskier one of the two, as the NZD's upside may be limited if EM markets sell off further. In fact, NZD/USD traded at an even greater discount to its ITTM fair value when EM markets were extremely weak in late 2015 and early 2016. However, EM spreads are narrower and EM equities today trade well above the levels that prevail in those days, implying a margin of safety exists for the NZD. Meanwhile, short GBP/NZD is less likely to be challenged by weak EM asset prices, especially as in a post-Brexit environment the U.K. needs global risk aversion to stay low and global liquidity to remain ample in order to finance its large current account deficit of 3.3% of GDP. Chart 19NZD Is Now So Cheap... NZD Is Now So Cheap... NZD Is Now So Cheap... Chart 20...That It Is A Buy ...That It Is A Buy ...That It Is A Buy The Norwegian Krone The Norwegian krone continues to trade at a large discount to its FITM. However, this pair often experiences large and persistent deviations from this model (Chart 21). Nonetheless, it is important to note that as real interest rate differentials between the U.S. and Norway continue to widen, the fundamental drivers of the NOK are set to deteriorate further. By construction, the ITTM has proven to be a more reliable indicator for the Norwegian krone. While the NOK is currently at fair value on this metric, it is concerning that the upward trend in the ITTM has ended and that the equilibrium value for this currency has begun to deteriorate (Chart 22). As such, if oil prices are not able to find a floor at current levels, USD/NOK is likely to experience additional upside. This is because on a three- to six-month basis, there is not enough of a valuation cushion embedded in the NOK at current levels to prevent the Norwegian krone from experiencing deleterious effects in a weak energy price environment. Chart 21The NOK Fundmentals's Are Still Pointing South The NOK Fundmentals's Are Still Pointing South The NOK Fundmentals's Are Still Pointing South Chart 22...And The NOK Remains Vulnerable Versus The USD ...And The NOK Remains Vulnerable Versus The USD ...And The NOK Remains Vulnerable Versus The USD The Swedish Krona The very easy monetary policy conducted by the Riksbank is the key factor explaining why the Swedish krona remains so weak. Indeed, despite a robust economy, Swedish real interest rates are lagging well behind U.S. rates, which is putting strong downward pressure on the SEK's FITM (Chart 23). Meanwhile, despite the SEK's prodigious weakness, this currency only trades at a modest, statistically insignificant discount to its ITTM (Chart 24). This picture suggests that for the SEK to appreciate, the Riksbank needs to become much more aggressive. It is true that the Swedish central bank has flagged an imminent rise in interest rates, but the pace of increase will continue to lag far behind the Fed's own tightening. Moreover, the weakness in global trade is likely to hamper Swedish growth as Sweden is a small, open economy very influenced by gyrations in global industrial activity. As a result, the current slowdown in global trade may well give the Riksbank yet another excuse to only timidly remove monetary accommodation. This suggests that both the FITM and ITTM for the SEK have downward potential. Chart 23The Riskbank Still Hurts The SEK The Riskbank Still Hurts The SEK The Riskbank Still Hurts The SEK Chart 24...And The Krona Needs To Build A Greater Valuation Cushion ...And The Krona Needs To Build A Greater Valuation Cushion ...And The Krona Needs To Build A Greater Valuation Cushion 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report, titled "Assesing The Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of October 31, 2018. The quant model downgraded U.S. and Italy to underweight from overweight while upgrading Canada to a slight overweight from underweight, largely due to changes in technical and valuation conditions. Now the model is overweight 5 countries (Netherland, Germany, Spain, Switzerland and Canada) and underweight 7 countries (Japan, U.S., U.K., France, Australia, Sweden and Italy), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, both Level 1 and Level 2 of the model system outperformed in October by 6bps and 57 bps, respectively, resulting in an outperformance of 24 bps from the overall model. Since going live, the overall model has outperformed its benchmarks by 44 bps, driven by Level 2 outperformance of 121 bps and Level 1 outperformance of 2bps. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA 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 last month, 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 understand will be in December. We thank you for your understanding.

As part of our mandate to make the platform flexible and adaptable to the needs of our clients, we are pleased to announce version 2.7 of ETS. The highlight of this release is a new 'Custom Metrics' feature that allows you to define your own metrics based on transformations to existing ETS metrics. Custom metrics integrate seamlessly into the rest of the platform so that they can be used for screening and comparing stocks, or as part of a Backtest strategy. With this feature in place, you now have the ability to setup useful metrics such as one month change in Global BCA Score, or one year percent change in EPS, for example. Defining Custom Metrics The Settings page is your starting point for defining custom metrics. Using the form provided in the 'Custom Metrics' widget, you will enter the name, base metric, and the operation to apply to the base metric (Figure 1). Currently, there are three operations that can be applied to existing metrics1 - change, percent change, and logarithm. Change metrics will require you to specify the time interval of the change in months.2 For instance, to setup a metric defined as the three month change in Global BCA Score you will enter '3M' into the interval input field. You can also replace the 'M' with 'Y' to denote a time interval in years, e.g., '3Y' equivalent to '36M'. Figure 1Custom Metric Form Version 2.7 - Release Notes Version 2.7 - Release Notes For convenience, you can add multiple metrics at once by clicking the 'Add New' button and then clicking 'Commit Changes' so that your metrics are available for use. All custom metrics are listed under 'My Metrics' within the various dropdown menus throughout the platform. You can delete or edit custom metrics at any time and these changes will be reflected immediately throughout the app. Using Custom Metrics If you are comfortable with using the classic ETS metrics then custom metrics will be a breeze. As mentioned previously, simply find the metric under the category heading 'My Metrics' and proceed as usual. This means that we can use custom metrics wherever filters are permitted (Figure 2A) and wherever we can add custom columns (Figure 2B). In addition, custom metrics are also available on the Compare page. Figure 2ACustom Metric Used As Screener Filter Version 2.7 - Release Notes Version 2.7 - Release Notes Figure 2BAdding Custom Metric As Watchlist Column Version 2.7 - Release Notes Version 2.7 - Release Notes We trust you will find this new feature useful, and as usual, we welcome your feedback so that we can continue to make ETS work for you. Spencer Moran, Senior Analyst Equity Trading Strategy spencerm@bcaresearch.com 1 At the time of writing, all existing metrics, i.e., those from Factor Value, Factor Score, and Factor Component categories are valid base metrics, except for your custom BCA Score, which is excluded for performance reasons. 2 For consistency, we define one month as 21 trading days.