Corporate Bonds

Highlights We update our long-range forecasts of returns from a range of asset classes – equities, bonds, alternatives, and currencies – and make some refinements to the methodologies we used in our last report in November 2017. We add coverage of U.K., Australian, and Canadian assets, and include Emerging Markets debt, gold, and global Real Estate in our analysis for the first time. Generally, our forecasts are slightly higher than 18 months ago: we expect an annual return in nominal terms over the next 10-year years of 1.7% from global bonds, and 5.9% from global equities – up from 1.5% and 4.6% respectively in the last edition. Cheaper valuations in a number of equity markets, especially Japan, the euro zone, and Emerging Markets explain the higher return assumptions. Nonetheless, a balanced global portfolio is likely to return only 4.7% a year in the long run, compared to 6.3% over the past 20 years. That is lower than many investors are banking on. Feature Since we published our first attempt at projecting long-term returns for a range of asset classes in November 2017, clients have shown enormous interest in this work. They have also made numerous suggestions on how we could improve our methodologies and asked us to include additional asset classes. This Special Report updates the data, refines some of our assumptions, and adds coverage of U.K., Australian, and Canadian assets, as well as gold, global Real Estate, and global REITs. Our basic philosophy has not changed. Many of the methodologies are carried over from the November 2017 edition, and clients interested in more detailed explanations should also refer to that report.1 Our forecast time horizon is 10-15 years. We deliberately keep this vague, and avoid trying to forecast over a 3-7 year time horizon, as is common in many capital market assumptions reports. The reason is that we want to avoid predicting the timing and gravity of the next recession, but rather aim to forecast long-term trend growth irrespective of cycles. This type of analysis is, by nature, as much art as science. We start from the basis that historical returns, at least those from the past 10 or 20 years, are not very useful. Asset allocators should not use historical returns data in mean variance optimizers and other portfolio-construction models. For example, over the past 20 years global bonds have returned 5.3% a year. With many long-term government bonds currently yielding zero or less, it is mathematically almost impossible that returns will be this high over the coming decade or so. Our analysis points to a likely annual return from global bonds of only 1.7%. Our approach is based on building-blocks. There are some factors we know with a high degree of certainly: such as the return on U.S. 10-year Treasury yields over the next 10 years (to all intents and purposes, it is the current yield). Many fundamental drivers of return (credit spreads, the small-cap premium, the shape of the yield curve, profit margins, stock price multiples etc.) are either steady on average over the cycle, or mean revert. For less certain factors, such as economic growth, inflation, or equilibrium short-term interest rates, we can make sensible assumptions. Most of the analysis in this report is based on the 20-year history of these factors. We used 20 years because data is available for almost all the asset classes we cover for this length of time (there are some exceptions, for example corporate bond data for Australia and Emerging Markets go back only to 2004-5, and global REITs start only in 2008). The period from May 1999 to April 2019 is also reasonable since it covers two recessions and two expansions, and started at a point in the cycle that is arguably similar to where we are today. Some will argue that it includes the Technology bubble of 1999-2000, when stock valuations were high, and that we should use a longer period. But the lack of data for many assets classes before the 1990s (though admittedly not for equities) makes this problematic. Also, note that the historical returns data for the 20 years starting in May 1999 are quite low – 5.8% for U.S. equities, for example. This is because the starting-point was quite late in the cycle, as we probably also are now.   We make the following additions and refinements to our analysis: Add coverage of the U.K., Australia, and Canada for both fixed income and equities. Add coverage of Emerging Markets debt: U.S. dollar and local-currency sovereign bonds, and dollar-denominated corporate credit. Among alternative assets, add coverage of gold, global Direct Real Estate, and global REITs. Improve the methodology for many alt asset classes, shifting from reliance on historical returns to an approach based on building blocks – for example, current yield plus an estimation of future capital appreciation – similar to our analysis of other asset classes. In our discussion of currencies, add for easy reference of readers a table of assumed returns for all the main asset classes expressed in USD, EUR, JPY, GBP, AUD, and CAD (using our forecasts of long-run movements in these currencies). Added Sharpe ratios to our main table of assumptions. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in U.S. dollars). Table 1BCA Assumed Returns Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Unsurprisingly, given the long-term nature of this exercise, our return projections have in general not moved much compared to those in November 2017. Indeed, markets look rather similar today to 18 months ago: the U.S. 10-year Treasury yield was 2.4% at end-April (our data cut-off point), compared to 2.3%, and the trailing PE for U.S. stocks 21.0, compared to 21.6. If anything, the overall assumption for a balanced portfolio (of 50% equities, 30% bonds, and 20% equal-weighted alts) has risen slightly compared to the 2017 edition: to 4.7% from 4.1% for a global portfolio, and to 4.9% from 4.6% for a purely U.S. one. That is partly because we include specific forecasts for the U.K., Australia, and Canada, where returns are expected to be slightly higher than for the markets we limited our forecasts to previously, the U.S, euro zone, Japan, and Emerging Markets (EM). Equity returns are also forecast to be higher than 18 months ago, mainly because several markets now are cheaper: trailing PE for Japan has fallen to 13.1x from 17.6x, for the euro zone to 15.5x from 18.0x, and for Emerging Markets to 13.6x from 15.4x (and more sophisticated valuation measures show the same trend). The long-term picture for global growth remains poor, based on our analysis, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. We include Sharpe ratios in Table 1 for the first time. We calculate them as expected return/expected volatility to allow for comparison between different asset classes, rather than as excess return over cash/volatility as is strictly correct, and as should be used in mean variance optimizers. Chart 1Volatility Is Easier To Forecast Than Returns Volatility Is Easier To Forecast Than Returns Volatility Is Easier To Forecast Than Returns For volatility assumptions, we mostly use the 20-year average volatility of each asset class. As discussed above, historical returns should not be used to forecast future returns. But volatility does not trend much over the long-term (Chart 1). We looked carefully at volatility trends for all the asset classes we cover, but did not find a strong example of a trend decline or rise in any. We do, however, adjust the historic volatility of the illiquid, appraisal-based alternative assets, such as Private Equity, Real Estate, and Farmland. The reported volatility is too low, for example 2.6% in the case of U.S. Direct Real Estate. Even using statistical techniques to desmooth the return produces a volatility of only around 7%. We choose, therefore, to be conservative, and use the historic volatility on REITs (21%) and apply this to Direct Real Estate too. For Private Equity (historic volatility 5.9%), we use the volatility on U.S. listed small-cap stocks (18.6%). Looking at the forecast Sharpe ratios, the risk-adjusted return on global bonds (0.55) is somewhat higher than that of global equities (0.33). Credit continues to look better than equities: Sharpe ratio of 0.70 for U.S. investment grade debt and 0.62 for high-yield bonds. Nonetheless, our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. Over the past 20 years a global balanced portfolio (defined as above) returned 6.3% and a similar U.S. portfolio 7.0%. We expect 4.7% and 4.9% respectively in future. Investors working on the assumption of a 7-8% nominal return – as is typical among U.S. pension funds, for example – need to become realistic. Below follow detailed descriptions of how we came up with our assumptions for each asset class (fixed income, equities, and alternatives), followed by our forecasts of long-term currency movements, and a brief discussion of correlations. 1. Fixed Income We carry over from the previous edition our building-block approach to estimating returns from fixed income. One element we know with a relatively high degree of certainty is the return over the next 10 years from 10-year government bonds in developed economies: one can safely assume that it will be the same as the current 10-year yield. It is not mathematical identical, of course, since this calculation does not take into account reinvestment of coupons, or default risk, but it is a fair assumption. We can make some reasonable assumptions for returns from cash, based on likely inflation and the real equilibrium cash rate in different countries. After this, our methodology is to assume that other historic relationships (corporate bond spreads, default and recovery rates, the shape of the yield curve etc.) hold over the long run and that, therefore, the current level reverts to its historic mean. The results of our analysis, and the assumptions we use, are shown in Table 2. Full details of the methodology follow below. Table 2Fixed Income Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Projected returns have not changed significantly from the 2017 edition of this report. In the U.S., for the current 10-year Treasury bond yield we used 2.4% (the three-month average to end-April), very similar to the 2.3% on which we based our analysis in 2017. In the euro zone and Japan, yields have fallen a little since then, with the 10-year German Bund now yielding roughly 0%, compared to 0.5% in 2017, and the Japanese Government Bond -0.1% compared to zero. Overall, we expect the Bloomberg Barclays Global Index to give an annual nominal return of 1.7% over the coming 10-15 years, slightly up from the assumption of 1.5% in the previous edition. This small rise is due to the slight increase in the U.S. long-term risk-free rate, and to the inclusion for the first time of specific estimates for returns in the U.K., Australia, and Canada. Fixed Income Methodologies Cash. We forecast the long-run rate on 3-month government bills by generating assumptions for inflation and the real equilibrium cash rate. For inflation, in most countries we use the 20-year average of CPI inflation, for example 2.2% in the U.S. and 1.7% in the euro zone. This suggests that both the Fed and the ECB will slightly miss their inflation targets on the downside over the coming decade (the Fed targets 2% PCE inflation, but the PCE measure is on average about 0.5% below CPI inflation). Of course, this assumes that the current inflation environment will continue. BCA’s view is that inflation risks are significantly higher than this, driven by structural factors such as demographics, populism, and the advent of ultra-unorthodox monetary policy.2 But we see this as an alternative scenario rather than one that we should use in our return assumptions for now. Japan’s inflation has averaged 0.1% over the past 20 years, but we used 1% on the grounds that the Bank of Japan (BoJ) should eventually see some success from its quantitative easing. For the equilibrium real rate we use the New York Fed’s calculation based on the Laubach-Williams model for the U.S., euro zone, U.K., and Canada. For Japan, we use the BoJ’s estimate, and for Australia (in the absence of an official forecast of the equilibrium rate) we take the average real cash rate over the past 20 years. Finally, we assume that the cash yield will move from its current level to the equilibrium over 10 years. Government Bonds. Using the 10-year bond yield as an anchor, we calculate the return for the government bond index by assuming that the spread between 7- and 10-year bonds, and between 3-month bills and 10-year bonds will average the same over the next 10 years as over the past 20. While the shape of the yield curve swings around significantly over the cycle, there is no sign that is has trended in either direction (Chart 2). The average maturity of government bonds included in the index varies between countries: we use the five-year historic average for each, for example, 5.8 years for the U.S., and 10.2 years for Japan. Spread Product. Like government bonds, spreads and default rates are highly cyclical, but fairly stable in the long run (Chart 3). We use the 20-year average of these to derive the returns for investment-grade bonds, high-yield (HY) bonds, government-related securities (e.g. bonds issued by state-owned entities, or provincial governments), and securitized bonds (e.g. asset-backed or mortgage-backed securities). For example, for U.S. high-yield we use the average spread of 550 basis points over Treasuries, default rate of 3.8%, and recovery rate of 45%. For many countries, default and recovery rates are not available and so we, for example, use the data from the U.S. (but local spreads) to calculate the return for high-yield bonds in the euro zone and the U.K. Inflation-Linked Bonds. We use the average yield over the past 10 years (not 20, since for many countries data does not go back that far and, moreover, TIPs and their equivalents have been widely used for only a relatively short period.) We calculate the return as the average real yield plus forecast inflation. Chart 2Yield Curves Yield Curves Yield Curves Chart 3Credit Spreads & Default Rates Credit Spreads & Defaykt Rates Credit Spreads & Defaykt Rates     Bloomberg Barclays Aggregate Bond Indexes. We use the weights of each category and country (from among those we forecast) to derive the likely return from the index. The composition of each country’s index varies widely: for example, in the euro zone (27% of the global bond index), government bonds comprise 66% of the index, but in the U.S. only 37%. Only the U.S. and Canada have significant weightings in corporate bonds: 29% and 50% respectively. This can influence the overall return for each country’s index. Table 3Emerging Market Debt Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Emerging Market Debt. We add coverage of EMD: sovereign bonds in both local currency and U.S. dollars, and USD-denominated EM corporate debt. Again, we take the 20-year average spread over 10-year U.S. Treasuries for each category. A detailed history of default and recovery is not available, so for EM corporate debt we assume similar rates to those for U.S. HY bonds. For sovereign bonds, we make a simple assumption of 0.5% of losses per year – although in practice this is likely to be very lumpy, with few defaults for years, followed by a rush during an EM crisis. For EM local currency debt, we assume that EM currencies will depreciate on average each year in line with the difference between U.S. inflation and EM inflation (using the IMF forecast for both – please see the Currency section below for further discussion on this). After these calculations, we conclude that EM USD sovereign bonds will produce an annual return of 4.7%, and EM USD corporate bonds 4.5% – in both cases a little below the 5.6% return assumption we have for U.S. high-yield debt (Table 3).   2. Equities Our equity methodologies are largely unchanged from the previous edition. We continue to use the return forecast from six different methodologies to produce an average assumed return. Table 4 shows the results and a summary of the calculation for each methodology. The explanation for the six methodologies follows below. Table 4Equity Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined The results suggest slightly higher returns than our projections in 2017. We forecast global equities to produce a nominal annual total return in USD of 5.9%, compared to 4.6% previously. The difference is partly due to the inclusion for the first time of specific forecasts for the U.K., Australia and Canada, which are projected to see 8.0%, 7.4% and 6.0% returns respectively. The projection for the U.S. is fairly similar to 2017, rising slightly to 5.6% from 5.0% (mainly due to a slightly higher assumption for productivity growth in future, which boosts the nominal GDP growth assumption). Japan, however, does come out looking significantly more attractive than previously, with an assumed return of 6.2%, compared to 3.5% previously. This is mostly due to cheaper valuations, since the growth outlook has not improved meaningfully. Japan now trades on a trailing PE of 13.1x, compared to 17.6x in 2017. This helps improve the return indicated by a number of the methodologies, including earnings yield and Shiller PE. The forecast for euro zone equities remains stable at 4.7%. EM assumptions range more widely, depending on the methodology used, than do those for DM. On valuation-based measures (Shiller PE, earnings yield etc.), EM generally shows strong return assumptions. However, on a growth-based model it looks less attractive. We continue to use two different assumptions for GDP growth in EM. Growth Model (1) is based on structural reform taking place in Emerging Markets, which would allow productivity growth to rebound from its current level of 3.2% to the 20-year average of 4.1%; Growth Model (2) assumes no reform and that productivity growth will continue to decline, converging with the DM average, 1.1%, over the next 10 years. In both cases, the return assumption is dragged down by net issuance, which we assume will continue at the 10-year average of 4.9% a year. Our composite projection for EM equity returns (in local currencies) comes out at 6.6%, a touch higher than 6.0% in 2017. Equity Methodologies Equity Risk Premium (ERP). This is the simplest methodology, based on the concept that equities in the long run outperform the long-term risk-free rate (we use the 10-year U.S. Treasury yield) by a margin that is fairly stable over time. We continue to use 3.5% as the ERP for the U.S., based on analysis by Dimson, Marsh and Staunton of the average ERP for developed markets since 1900. We have, however, tweaked the methodology this time to take into account the differing volatility of equity markets, which should translate into higher returns over time. Thus we use a beta of 1.2 for the euro zone, 0.8 for Japan, 0.9 for the U.K., 1.1 for both Australia and Canada, and 1.3 for Emerging Markets. The long-term picture for global growth remains poor, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. Growth Model. This is based on a Gordon growth model framework that postulates that equity returns are a function of dividend yield at the starting point, plus the growth of earnings in future (we assume that the dividend payout ratio stays constant). We base earnings growth off assumptions of nominal GDP growth (see Box 1 for how we calculate these). But historically there is strong evidence that large listed company earnings underperform nominal GDP growth by around 1 percentage point a year (largely because small, unlisted companies tend to show stronger growth than the mature companies that dominate the index) and so we deduct this 1% to reach the earnings growth forecast. We also need to adjust dividend yield for share buybacks which in the U.S., for tax reasons, have added 0.5% to shareholder returns over the past 10 years (net of new share issuance). In other countries, however, equity issuance is significantly larger than buybacks; this directly impacts shareholders’ returns via dilution. For developed markets, the impact of net equity issuance deducts 0.7%-2.7% from shareholder returns annually. But the impact is much bigger in Emerging Markets, where dilution has reduced returns by an average of 4.9% over the past 10 years. Table 5 shows that China is by far the biggest culprit, especially Chinese banks. Table 5Dilution In Emerging Markets Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined BOX 1 Estimating GDP Growth We estimate nominal GDP growth for the countries and regions in our analysis as the sum of: annual growth in the working-age population, productivity growth, and inflation (we assume that capital deepening remains stable over the period). Results are shown in Table 6. Table 6Calculations Of Trend GDP Growth Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined For population growth, we use the United Nations’ median scenario for annual growth in the population aged 25-64 between 2015 and 2030. This shows that the euro zone and Japan will see significant declines in the working population. The U.S. and U.K. look slightly better, with the working population projected to grow by 0.3% and 0.1% respectively. There are some uncertainties in these estimates. Stricter immigration policies would reduce the growth. Conversely, greater female participation, a later retirement age, longer working hours, or a rise in the participation rate would increase it. For emerging markets we used the UN estimate for “less developed regions, excluding least developed countries”. These countries have, on average, better demographics. However, the average number hides the decline in the working-age population in a number of important EM countries, for example China (where the working-age population is set to shrink by 0.2% a year), Korea (-0.4%), and Russia (-1.1%). By contrast, working population will grow by 1.7% a year in Mexico and 1.6% in India. For productivity growth, we assume – perhaps somewhat optimistically – that the decline in productivity since the Global Financial Crisis will reverse and that each country will return to the average annual productivity growth of the past 20 years (Chart 4). Our argument is that the cyclical factors that depressed productivity since the GFC (for example, companies’ reluctance to spend on capex, and shareholders’ preference for companies to pay out profits rather than to invest) should eventually fade, and that structural and technical factors (tight labor markets, increasing automation, technological breakthroughs in fields such as artificial intelligence, big data, and robotics) should boost productivity. Based on this assumption, U.S. productivity growth would average 2.0% over the next 10-15 years, compared to 0.5% since 1999. Note that this is a little higher than the Congressional Budgetary Office’s assumption for labor productivity growth of 1.8% a year. Chart 4AProductivity Growth (I) Productivity Growth (I) Productivity Growth (I) Chart 4BProductivity Growth (II) Productivity Growth (II) Productivity Growth (II) Our assumptions for inflation are as described above in the section on Fixed Income. The overall results suggest that Japan will see the lowest nominal GDP growth, at 0.9% a year, with the U.S. growing at 4.4%. The U.K. and Australia come out only a little lower than the U.S. For emerging markets, as described in the main text, we use two scenarios: one where productivity grow continues to slow in the absence of reforms, especially in China, from the current 3.2% to converge with the average in DM (1.1%) over the next 10-15 years; and an alternative scenario where reforms boost productivity back to the 20-year average of 4.1%.   Growth Plus Reversion To Mean For Margins And Profits. There is logic in arguing that profit margins and multiples tend to revert to the mean over the long term. If margins are particularly high currently, profit growth will be significantly lower than the above methodology would suggest; multiple contraction would also lower returns. Here we add to the Growth Model above an assumption that net profit margin and trailing PE will steadily revert to the 20-year average for each country over the 10-15 years. For most countries, margins are quite high currently compared to history: 9.2% in the U.S., for example, compared to a 20-year average of 7.7%. Multiples, however, are not especially high. Even in the U.S. the trailing PE of 21.0x, compares to a 20-year average of 20.8x (although that admittedly is skewed by the ultra-high valuations in 1999-2000, and coming out of the 2007-9 recession – we would get a rather lower number if we used the 40-year average). Indeed, in all the other countries and regions, the PE is currently lower than the 20-year average. Note that for Japan, we assumed that the PE would revert to the 20-year average of the U.S. and the euro zone (19.2), rather than that of Japan itself (distorted by long periods of negative earnings, and periods of PE above 50x in the 1990s and 2000s).  Earnings Yield. This is intuitively a neat way of thinking about future returns. Investors are rewarded for owning equity, either by the company paying a dividend, or by reinvesting its earnings and paying a dividend in future. If one assumes that future return on capital will be similar to ROC today (admittedly a rash assumption in the case of fast-growing companies which might be tempted to invest too aggressively in the belief that they can continue to generate rapid growth) it should be immaterial to the investor which the company chooses. Historically, there has been a strong correlation between the earnings yield (the inverse of the trailing PE) and subsequent equity returns, although in the past two decades the return has been somewhat higher that the EY suggested, and so in future might be somewhat lower. This methodology produces an assumed return for U.S. equities of 4.8% a year. Shiller PE. BCA’s longstanding view is that valuation is not a good timing tool for equity investment, but that it is crucial to forecasting long-term returns. Chart 5 shows that there is a good correlation in most markets between the Shiller PE (current share price divided by 10-year average inflation-adjusted earnings) and subsequent 10-year equity returns. We use a regression of these two series to derive the assumptions. This points to returns ranging from 5.4% in the case of the U.S. to 12.5% for the U.K. Composite Valuation Indicator. There are some issues that make the Shiller PE problematical. It uses a fixed 10-year period, whereas cycles vary in length. It tends to make countries look cheap when they have experienced a trend decline in earnings (which may continue, and not mean revert) and vice versa. So we also use a proprietary valuation indicator comprising a range of standard parameters (including price/book, price/cash, market cap/GDP, Tobin’s Q etc.), and regress this against 10-year returns. The results are generally similar to those using the Shiller PE, except that Japan shows significantly higher assumed returns, and the U.K. and EM significantly lower ones (Chart 6). Chart 5Shiller PE Vs. 10-Year Return Shiller PE Vs. 10-Year Return Shiller PE Vs. 10-Year Return Chart 6Composite Valuation Vs. 10-Year Return Composite Valuation Vs. 10-Year Return Composite Valuation Vs. 10-Year Return     3. Alternative Investments We continue to forecast each illiquid alternative investment separately, but we have made a number of changes to our methodologies. Mostly these involve moving away from using historical returns as a basis for our forecasts, and shifting to an approach based on current yield plus projected future capital appreciation. In direct real estate, for example, in 2017 we relied on a regression of historical returns against U.S. nominal GDP growth. We move in this edition to an approach based on the current cap rate, plus capital appreciation (based on forecasts of nominal GDP growth), and taking into account maintenance costs (details below). We also add coverage of some additional asset classes: global ex-U.S. direct real estate, global ex-U.S. REITs, and gold. Table 7 summarizes our assumptions, and provides details of historic returns and volatility. Table 7Alternatives Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined It is worth emphasizing here that manager selection is far more important for many alternative investment classes than it is for public securities (Chart 7). There is likely to be, therefore, much greater dispersion of returns around our assumptions than would be the case for, say, large-cap U.S. equities. Chart 7For Alts, Manager Selection Is Key For Alts, Manager Selection Is Key For Alts, Manager Selection Is Key Hedge Funds Chart 8Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge Fund Return Over Cash Hedge fund returns have trended down over time (Chart 8). Long gone is the period when hedge funds returned over 20% per year (as they did in the early 1990s). Over the past 10 years, the Composite Hedge Fund Index has returned annually 3.3% more than 3-month U.S. Treasury bills. But that was entirely during an economic expansion and so we think it is prudent to cut last edition’s assumption of future returns of cash-plus-3.5%, to cash-plus-3% going forward. Direct Real Estate Our new methodology for real estate breaks down the return, in a similar way to equities, into the current cash yield (cap rate) plus an assumption of future capital growth. For the cap rate, we use the average, weighted by transaction volumes, of the cap rates for apartments, office buildings, retail, industrial real estate, and hotels in major cities (for example, Chicago, Los Angeles, Manhattan, and San Francisco for the U.S., or Osaka and Tokyo for Japan). We assume that capital values grow in line with each’s country’s nominal GDP growth (using the IMF’s five-year forecasts for this). We deduct a 0.5% annual charge for maintenance, in line with industry practice. Results are shown in Table 8. Our assumptions point to better returns from real estate in the U.S. than in the rest of the world. Not only is the cap rate in the U.S. higher, but nominal GDP growth is projected to be higher too. Table 8Direct Real Estate Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined REITs We switch to a similar approach for REITs. Previously we used a regression of REITs against U.S. equity returns (since REITs tend to be more closely correlated with equities than with direct real estate). This produced a rather high assumption for U.S. REITs of 10.1%. We now use the current dividend yield on REITs plus an assumption that capital values will grow in line with nominal GDP growth forecasts. REITs’ dividend yields range fairly narrowly from 2.9% in Japan to 4.7% in Canada. We do not exclude maintenance costs since these should already be subtracted from dividends. The result of using this methodology is that the assumed return for U.S. REITs falls to a more plausible 8.5%, and for global REITs is 6.2%. Private Equity & Venture Capital Chart 9Private Equity Premium Has Shrunk Around Private Equity Premium Has Shrunk Around Private Equity Premium Has Shrunk Around It makes sense that Private Equity returns are correlated with returns from listed equities. Most academic studies have shown a premium over time for PE of 5-6 percentage points (due to leverage, a tilt towards small-cap stocks, management intervention, and other factors). However, this premium has swung around dramatically over time (Chart 9). Over the past 10 years, for example, annual returns from Private Equity and listed U.S. equities have been identical: 12%. However, there appears to be no constant downtrend and so we think it advisable to use the 30-year average premium: 3.4%. This produces a return assumption for U.S. Private Equity of 8.9% per year. Over the same period, Venture Capital has returned around 0.5% more than PE (albeit with much higher volatility) and we assume the same will happen going forward.   Structured Products In the context of alternative asset classes, Structured Products refers to mortgage-backed and other asset-backed securities. We use the projected return on U.S. Treasuries plus the average 20-year spread of 60 basis points. Assumed return is 2.7%. Farmland & Timberland Chart 10Farm Prices Grow More Slowly Than GDP Farm Prices Grow More Slowly Than GDP Farm Prices Grow More Slowly Than GDP As with Real Estate and REITs, we move to a methodology using current cash yield (after costs) plus an assumption for capital appreciation linked to nominal GDP forecasts. The yield on U.S. Farmland is currently 4.4% and on Timberland 3.2%. Both have seen long-run prices grow significantly more slowly than nominal GDP growth. Since 1980, for example, farm prices have risen at a compound rate of 3.9% per acre, compared to U.S. nominal GDP growth of 5.2% and global GDP growth of 5.5% (Chart 10). We assume that this trend will continue, and so project farm prices to grow 1.5 percentage points a year more slowly than global GDP (using global, not U.S., economic growth makes sense since demand for food is driven by global factors). This produces a total return assumption of 6%. For timberland, we did not find a consistent relationship with nominal GDP growth and so assumed that prices would continue to grow at their historic rate over the past 20 years (the longest period for which data is available). We project timberland to produce an annual return of 4.8%. Commodities & Gold For commodities we use a very different methodology (which we also used in the previous edition): the concept that commodities prices consistently over time have gone through supercycles, lasting around 10 years, followed by bear markets that have lasted an average of 17 years (Chart 11). The most recent super-cycle was 2002-2012. In the period since the supercycle ended, the CRB Index has fallen by 42%. Comparing that to the average drop in the past three bear markets, we conclude that there is about 8% left to fall over the next nine years, implying an annual decline of about 1%. Our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. We add gold to our assumptions, since it is an asset often held by investors. However, it is not easy to project long-term returns for the metal. Since the U.S. dollar was depegged from gold in 1968, gold too has gone through supercycles, in the 1970s and 2002-11 (Chart 12). We find that change in real long-term interest rates negatively affects gold (logically since higher rates increase the opportunity cost of owning a non-income-generating asset). We use, therefore, a regression incorporating global nominal GDP growth and a projection of the annual change in real 10-year U.S. Treasury yields (based on the equilibrium cash rate plus the average spread between 10-year yields and cash). This produces an assumption of an annual return from gold of 4.7% a year. We continue to see this asset class more as a hedge in a portfolio (it has historically had a correlation of only 0.1 with global equities and 0.24 with global bonds) rather than a source of return per se.  Chart 11Commodities Still In A Bear Market Commodities Still In A Bear Market Commodities Still In A Bear Market Chart 12Gold Also Has Supercycles Gold Also Has Supercycles Gold Also Has Supercycles   4. Currencies Chart 13Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP Currencies Tend To Revert To PPP All the return projections in this report are in local currency terms. That is a problem for investors who need an assumption for returns in their home currency. It is also close to impossible to hedge FX exposure over as long a period as 10-15 years. Even for investors capable of putting in place rolling currency hedges, GAA has shown previously that the optimal hedge ratio varies enormously depending on the home currency, and that dynamic hedges (i.e. using a simple currency forecasting model) produce better risk-adjust returns than a static hedge.3  Fortunately, there is an answer: it turns out that long-term currency forecasting is relatively easy due to the consistent tendency of currencies, in developed economies at least, to revert to Purchasing Power Parity (PPP) over the long-run, even though they can diverge from it for periods as long as five years or more (Chart 13). We calculate likely currency movements relative to the U.S. dollar based on: 1) the current divergence of the currency from PPP, using IMF estimates of the latter; 2) the likely change in PPP over the next 10 years, based on inflation differentials between the country and the U.S. going forward (using IMF estimates of average CPI inflation for 2019-2024 and assuming the same for the rest of the period). The results are shown in Table 9. All DM currencies, except the Australian dollar, look cheap relative to the U.S. dollar, and all of them, again excluding Australia, are forecast to run lower inflation that the U.S. implying that their PPPs will rise further. This means that both the euro and Japanese yen would be expected to appreciate by a little more than 1% a year against the U.S. dollar over the next 10 years or so. Table 9Currency Return Calculations Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined PPP does not work, however, for EM currencies. They are all very cheap relative to PPP, but show no clear trend of moving towards it. The example of Japan in the 1970s and 1980s suggests that reversion to PPP happens only when an economy becomes fully developed (and is pressured by trading partners to allow its currency to appreciate). One could imagine that happening to China over the next 10-20 years, but the RMB is currently 48% undervalued relative to PPP, not so different from its undervaluation 15 years ago. For EM currencies, therefore, we use a different methodology: a regression of inflation relative to the U.S. against historic currency movements. This implies that EM currencies are driven by the relative inflation, but that they do not trend towards PPP. Based on IMF inflation forecasts, many Emerging Markets are expected to experience higher inflation than the U.S. (Table 10). On this basis, the Turkish lira would be expected to decline by 7% a year against the U.S. dollar and the Brazilian real by 2% a year. However, the average for EM, which we calculated based on weights in the MSCI EM equity index, is pulled down by China (29% of that index), Korea (15%) and Taiwan (12%). China’s inflation is forecast to be barely above that in the U.S, and Korean and Taiwanese inflation significantly below it. MSCI-weighted EM currencies, consequently, are forecast to move roughly in line with the USD over the forecast horizon. One warning, though: the IMF’s inflation forecasts in some Emerging Markets look rather optimistic compared to history: will Mexico, for example, see only 3.2% inflation in future, compared to an average of 5.7% over the past 20 years? Higher inflation than the IMF forecasts would translate into weaker currency performance. Table 10EM Currencies Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined In Table 11, we have restated the main return assumptions from this report in USD, EUR, JPY, GBP, AUD, and CAD terms for the convenience of clients with different home currencies. As one would expect from covered interest-rate parity theory, the returns cluster more closely together when expressed in the individual currencies. For example, U.S. government bonds are expected to return only 0.8% a year in EUR terms (versus 2.1% in USD terms) bringing their return closer to that expected from euro zone government bonds, -0.4%. Convergence to PPP does not, however, explain all the difference between the yields in different countries. Table 11Returns In Different Base Currencies Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined 5. Correlations Chart 14Correlations Are Hard To Forecast Correlations Are Hard To Forecast Correlations Are Hard To Forecast We have not tried to forecast correlations in this Special Report. As discussed, historical returns from different asset classes are not a reliable guide to future returns, but it is possible to come up with sensible assumptions about the likely long-run returns going forward. Volatility does not trend much over the long term, so we think it is not unreasonable to use historic volatility data in an optimizer. But correlation is a different matter. As is well known, the correlation of equities and bonds has moved from positive to negative over the past 40 years (mainly driven by a shift in the inflation environment). But the correlation between major equity markets has also swung around (Chart 14). Asset allocators should preferably use rough, conservative assumptions for correlations – for example, 0.1 or 0.2 for the equity/bond correlation, rather than the average -0.1 of the past 20 years. We plan to do further work to forecast correlations in a future edition of this report.  But for readers who would like to see – and perhaps use – historic correlation data, we publish below a simplified correlation matrix of the main asset classes that we cover in this report (Table 12). We would be happy to provide any client with the full spreadsheet of all asset classes . Table 12Correlation Matrix Return Assumptions – Refreshed And Refined Return Assumptions – Refreshed And Refined Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Special Report, “What Returns Can You Expect?”, dated 15 November 2017, available at gaa.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated 22 May 2019, available at gaa.bcaresearch.com 3      Please see GAA Special Report, “Currency Hedging: Dynamic Or Static? A Practical Guide For Global Equity Investors,” dated 29 September 2017, available at gaa.bcaresearch.com  

Highlights Fed: The Fed will cut rates in July, and possibly once more this year. This extra stimulus will help boost global growth in the second half of 2019. Credit: With inflation expectations low, the Fed will not risk upsetting financial markets by striking a hawkish tone. This will be a boon for corporate bonds. We no longer advocate a cautious near-term allocation to corporate credit. Spreads have likely peaked. Duration: The economic environment bears a greater resemblance to prior mid-cycle slowdowns than to prior pre-recession periods. As such, the Fed will not deliver more than the 89 basis points of rate cuts that are already discounted for the next 12 months. Maintain below-benchmark portfolio duration. Feature More Houdini Than Bullwinkle When Fed Chair Jay Powell reached into his hat at last week’s FOMC meeting, most – including us – thought he might emerge looking like Bullwinkle the cartoon moose.1 Instead, he pulled a rabbit, delivering a dovish surprise to markets that already expected a lot. The yield curve was discounting 80 basis points of rate cuts over the next 12 months heading into last Wednesday’s announcement. Then, the Fed’s statement and Powell’s press conference pushed our 12-month discounter all the way down to -94 bps (Chart 1). The 10-year Treasury yield also dropped 8 bps post-FOMC, while the 2-year yield fell a whopping 14 bps. The Fed will go to great lengths to signal that monetary conditions remain accommodative. The Fed communicated its dovish pivot through both the post-meeting statement and its interest rate projections. In the post-meeting statement, the Fed replaced its pledge to be “patient” with a promise to “act as appropriate to sustain the expansion”. A re-phrasing that is clearly designed to signal a rate cut in July. FOMC participants also revised their interest rate projections sharply lower (Chart 2). In March, 11 out of 17 participants expected the Fed to stay on hold for the balance of 2019, while 4 participants called for one rate hike and 2 called for two rate hikes. Now, 8 out of 17 participants continue to expect a steady fed funds rate, but 7 are calling for two rate cuts this year. Only one participant is still looking for a 2019 hike. Chart 1A Dovish Magic Show Dovish Magic Show Dovish Magic Show Chart 2Dots Revised Lower Dots Revised Lower For 2020 Dots Revised Lower For 2020   In his press conference, Chair Powell explicitly linked the Fed’s dovish pivot to “trade developments” and “concerns about global growth”. Bond investors will undoubtedly heed this message, and Treasury yields will be extra sensitive to any trade-related news that comes out of this weekend’s G20 summit, as well as to any fluctuations in the global growth data (see section titled “No PMI Recovery Yet” below). Ultimately, our baseline expectation is that there will be enough progress in trade negotiations at the G20 summit to keep the U.S. from imposing a further $300 billion in tariffs on Chinese imports. However, an all-encompassing deal, which rolls back existing tariffs, is not in the cards. Table 1Fed Funds Futures: What's Priced In? The Fed’s Got Your Back The Fed’s Got Your Back But even such a muddle-though scenario, when combined with a Fed rate cut in July and continued credit easing out of China, will be sufficient to support global growth in the second half of this year. This will prevent the Fed from delivering the 79 bps of rate cuts that are priced-in for between now and next February (Table 1). We remain short the February 2020 fed funds futures contract. And Now Here’s Something We Hope You’ll Really Like Our main takeaway from the FOMC meeting is that the Fed will go to great lengths to signal that monetary conditions remain accommodative. We posited back in March that the new battleground for monetary policy is between inflation expectations and financial conditions.2 That is, the Fed will only move to a restrictive policy stance in response to above-target inflation expectations or “bubbly” financial asset prices. While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. At present, long-maturity TIPS breakeven inflation rates remain well below target levels and financial markets are far from “bubbly” (Chart 3): The Financial Conditions component of our Fed Monitor is close to neutral (Chart 3, panel 2). The S&P 500 12-month forward P/E ratio has rebounded this year, but is not close to the highs seen in late-2017/early-2018 (Chart 3, panel 3). The GZ measure of the excess premium in corporate bond spreads after accounting for expected default losses is low, but above where it traded throughout most of the 2000s (Chart 3, bottom panel). The upshot is that the Fed will continue to act as a tailwind for risk assets, and we therefore remove our prior recommendation to stay cautious on credit spreads in the near-term. It is now likely that credit spreads have peaked, a message confirmed by our list of “peak credit spread” indicators (Chart 4): Chart 3No Rush For Fed To Tighten No Movement On The Fed's Battleground No Movement On The Fed's Battleground Chart 4Credit Spreads Have Likely Peaked Credit Spreads Have Likely Peaked Credit Spreads Have Likely Peaked   The price of gold has decisively broken-out to the upside, a sign that the market views monetary policy as reflationary (Chart 4, panel 2). Such a breakout has preceded the last two peaks in corporate bond spreads. The dollar’s uptrend has abated, signaling that the market views U.S. monetary policy as less out of step with the rest of the world (Chart 4, panel 3). Global industrial mining stocks have rebounded (Chart 4, panel 4). The CRB Raw Industrials index is the sole holdout (Chart 4, bottom panel). A rebound in this index would confirm our intuition that credit spreads have peaked. Chart 5Waiting For Improving Global Growth Waiting For Improving Global Growth Waiting For Improving Global Growth While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. The ratio between the CRB Raw Industrials index and Gold correlates very tightly with the 10-year yield, and it continues to plummet (Chart 5). The CRB/Gold ratio will only rise when gains in the CRB index start to outpace gains in Gold. In other words, the Fed’s reflationary policy stance needs to translate into an improving global growth outlook. This could take a few months, though we ultimately continue to think that Treasury yields will be higher on a 6-12 month horizon. As explained in the next section, as long as the U.S. economy avoids recession, mid-cycle rate cuts tend to be followed by higher Treasury yields. A History Of Rate Cuts Part 2 In last week’s report we looked at every Fed rate cut since 1995 and showed how the 10-year Treasury yield reacted during the subsequent 21-day, 65-day, 130-day and 261-day periods.3 Our main conclusion was that the 10-year Treasury yield tended to rise following mid-cycle rate cuts, such as those that occurred in 1995-98 and 2003, and decline following rate cuts that led into a U.S. recession. For reference, we have attached last week’s analysis as an Appendix to this report, along with a new table showing how the Bloomberg Barclays Treasury Master index performed relative to cash following each post-1995 rate cut. The 2/10 Treasury slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. This week, we delve a little deeper and look at the market’s interest rate expectations around each prior cut, and also at how the 2/10 Treasury slope responded in each case. Rate Expectations At The Time Of Fed Rate Cuts Table 2 shows the 12-month change in the fed funds rate that the market was discounting prior to each Fed rate cut announcement since 1995. It also shows the actual change in the fed funds rate that occurred over the subsequent 12-month period, and the difference between what occurred and what was expected – the 12-month fed funds surprise. Table 2A History Of Rate Cuts: Rate Expectations The Fed’s Got Your Back The Fed’s Got Your Back According to our Golden Rule of Bond Investing, a dovish surprise (actual change < expectations) should coincide with a falling 10-year Treasury yield, and a hawkish surprise (actual change > expectations) should coincide with a rising 10-year yield.4 The table shows that this indeed occurred in 26 out of 29 episodes. As was the case last week, the mid-1990s rate cuts immediately capture our attention. We have previously noted the resemblance between today’s economic environment and that of the mid-1990s.5 It’s interesting that the market is currently priced for a similar number of rate cuts as at that time. Once again, we expect those expectations will be disappointed. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield. Yield Curve: Steeper Now = Flatter Later Another interesting trend is that the 2/10 Treasury slope steepened dramatically in the run-up to, and following, last week’s FOMC meeting. It is now back up to 29 bps after having troughed at 11 bps near the end of last year (Chart 6). It is also worth noting that the 2/10 Treasury slope has yet to invert this cycle. Such an inversion has occurred prior to every U.S. recession since at least 1960. Table 3 shows how the 2/10 Treasury slope has responded to Fed rate cuts in the past, and it reveals an interesting pattern. The slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. The 2003 episode is a prime example. The 2/10 slope steepened by 62 bps in the month following the rate cut, but a year later it was 14 bps below where it started. Chart 6The Fed Steepens The Curve On Track: Steeper Now... On Track: Steeper Now... Table 3A History Of Rate Cuts: 2/10 Treasury Slope The Fed’s Got Your Back The Fed’s Got Your Back   In contrast, the 2/10 steepening that immediately follows a “pre-recession” rate cut tends to be milder, but the steepening then accelerates as time passes and the Fed eases further.  The observed yield curve patterns line up well with theory. We would expect rapid curve steepening immediately following a mid-cycle rate cut, as the market prices in a quick return to tighter policy settings. Then, the curve should eventually flatten as the Fed reverses its initial cuts. In contrast, a rate cut that precedes a recession should not lead to much initial steepening, because the market would not be expecting a quick recovery. The steepening would then accelerate as more rate cuts are eventually delivered. The fact that the 2/10 slope has steepened a lot in recent weeks is another datapoint in favor of “mid-cycle” rather than “pre-recession” market behavior. No PMI Recovery Yet We remain confident that the combination of a July Fed rate cut and Chinese credit stimulus will put a floor under global growth in the second half of the year. However, no such global growth rebound is yet evident in the crucial manufacturing PMI data. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield, and it remains in a free-fall, even breaking below the 50 boom/bust line in May (Chart 7). Flash PMI data paint an equally dim picture for June: The Euro Area Manufacturing PMI is expected to tick up in June, but only to 47.8 from 47.7 in May (Chart 7, panel 2). The U.S. Manufacturing PMI is expected to fall to 50.1 in June, from 50.5 in May (Chart 7, panel 3). The Japanese Manufacturing PMI is expected to fall to 49.5 in June, from 49.8 in May (Chart 7, bottom panel). There is no Flash PMI data for China, but the Chinese index stood at 50.2 in May, only a hair above the 50 boom/bust line. On the bright side, financial markets are starting to price-in the beginnings of a reflation trade. Gold is rallying strongly, as we noted above, and an index of high-beta currency pairs (RUB/USD, ZAR/USD and BRL/USD) is off its lows. Both of these moves signal that the policy backdrop is becoming more supportive, and both have led upswings in the Global Manufacturing PMI in the past (Chart 8). Chart 7No Rebound In Sight Yet... No Rebound In Sight Yet... No Rebound In Sight Yet... Chart 8...But Financial Markets Are Already Looking Ahead ...But Financial Markets Alread Are Looking Ahead ...But Financial Markets Alread Are Looking Ahead   Bottom Line: Treasury yields will probably need to see a rebound in the Global Manufacturing PMI before moving higher, but a few reflationary indicators suggest that such a rebound will occur in the second half of the year. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com     Appendix Table 4A History Of Rate Cuts: 10-Year Treasury Yield The Fed’s Got Your Back The Fed’s Got Your Back Table 5A History Of Rate Cuts: Treasury Excess Returns The Fed’s Got Your Back The Fed’s Got Your Back   Footnotes 1      https://www.youtube.com/watch?v=kx3sOqW5zj4 2      Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 3      Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com 4      Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 5      Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights June FOMC Meeting: To appease markets, the Fed will at least have to signal that it stands ready to cut rates in July. While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit spreads in the near-term (0-3 months). Rate Cuts: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates in June or July. Treasury Yields: Yields have fallen a lot since the beginning of November, but the move isn't terribly anomalous relative to history. We use statistics to place recent price action in its appropriate historical context. Feature The Fed This Week Chart 1Credit Spreads At Risk Credit Spreads At Risk Credit Spreads At Risk Tomorrow’s FOMC meeting is the main event in financial markets this week, with investors of all stripes eager to learn whether the Fed will deliver on the rate cut expectations that have already been priced into bond yields. As we’ve written in prior reports, our immediate concern is that the Fed may not sound dovish enough to appease markets, leading to further near-term widening in corporate bond spreads.1 Corporate bond excess returns have far outpaced commodity prices of late (Chart 1), leaving the sector vulnerable to any hawkish surprise. What’s Priced In, And Can The Fed Deliver? How dovish must the Fed be to prevent a sell-off in corporate credit? A look at current fed funds futures pricing shows that the market is looking for nearly three 25 basis point rate cuts spread over the next six FOMC meetings (Table 1). Roughly, the market expects one rate cut at either the June or July meeting, a second rate cut in either September or October, and a third rate cut in either December or January. To appease markets, the Fed will at least have to revise its 2019 funds rate projections down and signal that it stands ready to cut rates in July (Chart 2). While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit markets in the near-term (0-3 months). Table 1Fed Funds Futures: What's Priced In? Track Records Track Records Chart 2Watch For Dot Plot Revisions Watch For Dot Plot Revisions Watch For Dot Plot Revisions   Fed Rate Cuts: A Track Record While we are cautious on corporate spreads in the near-term, we are also not willing to chase Treasury yields lower from current levels. Our view is that while the Fed might deliver a rate cut at one of the next few meetings, it is unlikely to lower rates by more than the 84 bps that are priced into the yield curve for the next 12 months. Ultimately, we expect Treasury yields to be higher on a 6-12 month horizon, even if the Fed cuts rates during the next few months. In response to this outlook, a few clients have asked whether it is possible for Treasury yields to rise so soon after a Fed rate cut. While we see no theoretical reason why it shouldn't be possible, it is always a good idea to stress test a theory against the historical track record. We therefore compiled a list of every Fed rate cut since 1995, and looked at how the 10-year Treasury yield reacted to each event. The results are displayed in Tables 2A-2D. Chart Chart Chart   Chart Table 2A shows the rate cuts that the Fed delivered in the mid-1990s, in response to persistently low U.S. inflation and slowing growth in the rest of the world. At the time, overall U.S. economic growth was quite solid and the U.S. economy didn’t fall into recession until 2001. The divergence between relatively strong U.S. economic growth and slower growth in the rest of the world makes the period look very similar to today, and we have long argued that the current cycle should be viewed in the context of the mid-1990s.2 Table 2A reveals that, on average, the 10-year Treasury yield tended to rise in the months following a rate cut, often even in the first 21 days. The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. Table 2C shows the rate cuts that were delivered during the economic recovery of the mid-2000s, and it paints a similar picture as Table 2A. In particular, the 10-year Treasury yield rose dramatically following the 2003 rate cut, and the Fed actually started to hike interest rates almost exactly one year after the 2003 cut. Tables 2B & 2D show the rate cuts that led into the 2001 and 2008 recessions. Not surprisingly, yields were much more likely to fall after the Fed cut rates in those episodes. Bottom Line: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. The yield is much more likely to fall if the cut occurs in the run-up to a recession. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates at one of the next few FOMC meetings. Treasury Yield Moves: A Track Record In recent weeks a BCA client who had been shaking his head at the large drop in Treasury yields reached out to see if we could put the recent moves in historical context. Specifically, he wondered how often such large yield moves have occurred in the past, and whether there is a tendency for moves of this magnitude to mean-revert. Our U.S. Investment Strategy team took a stab at answering these questions. The below analysis first appeared in last week's U.S. Investment Strategy report, but is re-printed here for the interest of U.S. bond clients.3 The ongoing decline in bond yields has felt like a big deal in real time, but it isn’t historically. The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 3). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 3). Chart 3The Path To 2.07% The Path To 2.07% The Path To 2.07% Table 3A Lower 10-Year Treasury Yield In Three Steps Track Records Track Records Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 4). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 4Standardized Values Of Nominal 10-Year Treasury Yield Declines Track Records Track Records The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 4). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 5). Chart 4No Historical Anomaly In The Current Market No Historical Anomaly In The Current Market No Historical Anomaly In The Current Market Chart 5Little Impact In Terms Of Real Yields Little Impact In Terms Of Real Yields Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.4 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The standardized moves in real yields and Treasury index returns haven’t been a big deal. Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 6). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 6Little Impact In Terms Of Treasury Total Returns, ... Little Impact In Terms Of Treasury Total Returns, ... Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 7). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 8). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. Chart 7... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... ... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... ... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 8... And Long-Maturity Returns Have Been Elevated ... And Long-Maturity Returns Have Been Elevated ... And Long-Maturity Returns Have Been Elevated The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, and history suggests it will be partially unwound over the next six to twelve months. Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 5). Table 5Standardized Values Of Future Long-Maturity Treasury Index Returns Track Records Track Records Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 6). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. Table 6Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns Track Records Track Records Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2      Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com 3      Please see U.S. Investment Strategy Weekly Report, “Context”, dated June 10, 2019, available at usis.bcaresearch.com 4      If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%). Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Fed: The large divergence between Treasury yields and risk assets means that the Fed will almost certainly cut rates during the next few months. The only question is whether a large sell-off in risk assets will be required to force the Fed’s capitulation. Maintain a cautious near-term (0-3 month) allocation to corporate credit. Duration: The economic data and shape of the yield curve do not suggest that the economy is heading into recession. Rather, they suggest that the economy is experiencing an external shock – akin to 1998 or 2015/16 – that can be offset by a relatively minor pivot in Fed policy. Investors should keep portfolio duration low. Corporate Balance Sheets: Growth rates for both corporate profits and debt should settle into the mid-single digits during the next few quarters. This will keep gross leverage and the default rate roughly stable. A sustained period of negative profit growth and tighter C&I lending standards would challenge this outlook. Feature Chart 1Markets Taking The Rate Cut For Granted Markets Taking The Rate Cut For Granted Markets Taking The Rate Cut For Granted Markets aren’t begging for a rate cut. Rather, they are behaving as though one has already occurred. This sort of set-up could lead to wider credit spreads and lower equity prices in the near-term. To elaborate, notice that the S&P 500 is only 3% off its late-2018 peak, but is down an alarming 8% relative to the Bloomberg Barclays Treasury Master Index. Meanwhile, the 10-year Treasury yield had fallen all the way to 2.06% as we went to press last Friday (Chart 1, bottom panel). The overall message from financial markets is that investors expect the Fed to cut rates very soon, but also think that a small number of cuts will be enough to forestall recession and keep risk assets supported. As we see it, the divergence between risk assets and Treasuries makes a rate cut during the next few months a near certainty. If the Fed does not appear sufficiently dovish at next week’s FOMC meeting, then risk assets will sell off. The resulting tightening of financial conditions will then force the Fed’s hand, leading to a rate cut in July or September. The alternative is that the Fed tries to get ahead of market sentiment by delivering a rate cut next week, even if such a move is not easily justified by the economic data. A New Trade In last week’s report, we recommended adding a fed funds futures calendar spread trade to take advantage of these near-term policy moves (Chart 2).1 Specifically, we advised investors to go long the August 2019 fed funds futures contract and short the February 2020 contract. Chart 2Exit Long Aug 2019 / Stay Short Feb 2020 Exit Long Aug 2019 / Stay Short Feb 2020 Exit Long Aug 2019 / Stay Short Feb 2020 We recommended buying the August 2019 fed funds futures contract to hedge the risk that the Fed tries to get ahead of market sentiment by cutting rates in June or July. As of last week, this contract would have earned a positive return in a scenario where the Fed delivered one 25 basis point rate cut in either June or July, and a negative return in a scenario where rates are unchanged. But as of last Friday, the contract’s risk/reward profile had shifted dramatically. The contract is now priced for a loss in both the “one rate cut” and “no rate cut” scenarios. We therefore exit our long position in the August 2019 fed funds futures contract for a gain of 8 bps.  .  The second leg of our proposed trade was to short the February 2020 fed funds futures contract. This remains an excellent bet. As of last Friday, a short position in the February 2020 contract will earn a positive return as long as three or fewer rate cuts occur between now and next February (Chart 2, bottom panel). In last week’s report, we recommended adding a fed funds futures calendar spread trade to take advantage of these near-term policy moves. Table 1 displays the expected returns from our proposed spread trade (long Aug 2019/short Feb 2020) as of last Friday, the most recent pricing available at the time of publication. Because of the rapid gains in the August 2019 contract price, an outright short position in the February 2020  contract now dominates the expected returns from the calendar spread trade in all likely scenarios. We therefore advise investors to exit the long position in the August 2019 contract, but to remain short the February 2020 contract. Table 1Expected Returns From Long Aug 2019 / Short Feb 2020 Fed Funds Futures Calendar Spread Trade Tracking The Mid-1990s Tracking The Mid-1990s Bottom Line: The large divergence between Treasury yields and risk assets means that the Fed will almost certainly cut rates during the next few months. The only question is whether a large sell-off in risk assets will be required to force the Fed’s capitulation. We advise near-term caution on credit spreads. While a near-term rate cut is likely, we also doubt that the Fed will deliver more than the 76 bps of rate cuts priced into the curve for the next 12 months. We therefore recommend that investors keep portfolio duration low and maintain a short position in the February 2020 fed funds futures contract.  More 1998 Than 2001 In the last section we reiterated our view that the Fed will deliver fewer than the 76 bps of rate cuts that are priced into the yield curve for the next 12 months. Our main justification is that such a large number of rate cuts will only occur if the economy enters recession. At present, the pre-conditions for an economic recession are simply not in place. Rather, the economy is experiencing an external shock – akin to 2015/16 and 1998 – that will require only a modest shift in Fed policy. In other words, if we use the mid-1990s cycle as a roadmap, today looks much more like 1998 than 2001. The divergence between manufacturing and services PMIs is exactly what occurred in 1998 and 2015/16. In a recent Special Report, we observed that every single post-WWII recession was preceded by either high inflation or rapid private debt growth (Chart 3).2 At present, inflation is muted and private debt growth is low. The economy is unlikely to experience a recession if there hasn’t been a prior build-up of excess demand. Chart 3Private Debt Growth, High Inflation & Recessions Private Debt Growth, High Inflation & Recessions Private Debt Growth, High Inflation & Recessions Second, economic indicators are much more consistent with the 2015/16 and 1998 episodes than with “pre-recession” conditions. The ISM Manufacturing PMI has fallen sharply, though it remains above 50, but the ISM Non-Manufacturing PMI looks much healthier. This divergence between manufacturing and services is exactly what occurred in 1998 and 2015/16 (Chart 4). It is consistent with a shock to global demand and trade that has relatively little impact on the U.S. consumer and the domestic economy’s large service sector. Chart 4Divergence Between Services And Manufacturing Divergence Between Services And Manufacturing Divergence Between Services And Manufacturing Granted, the PMIs compiled by Markit do not mirror the divergence between the ISM Manufacturing and Non-Manufacturing surveys. In fact, the Markit Services PMI has dropped sharply alongside its manufacturing counterpart (Chart 5). However, the Markit surveys also showed no divergence between manufacturing and services in 2015/16 and have no available data for 1998. We are therefore inclined to downplay the weakness in the Markit Services PMI for the time being. Chart 5MARKIT PMIs MARKIT PMIs MARKIT PMIs Third, employment growth usually starts to slow at least one year before the economy heads into recession. But it showed relatively little weakness in 1998 and 2015/16 (Chart 4, bottom panel). If May’s downbeat payrolls number turns out to be the start of a trend, then we will have to reconsider our view. But for now, even after last week’s report, employment growth remains solid. Finally, not only do the economic data suggest an episode similar to 1998 and 2015/16, but the slope of the yield curve does as well. While many have focused on the inversion of the 3-month/10-year Treasury slope, the 2-year/10-year slope remains above zero, and has indeed steepened in recent weeks. A more comprehensive look at the entire yield curve, adjusting for changes in the overall level of yields, shows that it looks very similar to the yield curve seen just ahead of the first 1998 rate cut. In contrast, the yield curve seen just before the first 2001 rate cut was more heavily inverted at the front-end, and long-dated yields priced-in much less of a rebound (Charts 6A & 6B). Chart 6 Chart 6 Bottom Line: The economic data and shape of the yield curve do not suggest that the economy is heading into recession. Rather, they suggest that the economy is experiencing an external shock – akin to 1998 or 2015/16 – that can be offset by a relatively minor pivot in Fed policy. Investors should keep portfolio duration low on the view that the Fed will cut rates by less than 76 bps during the next 12 months. Corporate Health Update Chart 7Weak Profit Growth In Q1 Weak Profit Growth In Q1 Weak Profit Growth In Q1 The full slate of first quarter corporate balance sheet data have now been released, and as expected, corporate profit growth cooled significantly compared to the rapid gains seen in 2018. As a result, our Corporate Health Monitor – an equal-weighted composite of six important financial ratios – ceased its recent improvement and jumped firmly back into “deteriorating health” territory (Chart 7). Our preferred measure of pre-tax profits contracted at an annualized rate of 17% in Q1, dragging the year-over-year growth rate down to 7%, from 15% in 2018 Q4 (Chart 7, bottom panel). The crucial relationship for corporate bond investors is between pre-tax profit growth and debt growth. If profit growth exceeds debt growth, then gross leverage will decline over time taking the default rate with it. Conversely, defaults tend to rise whenever profit growth fails to keep pace with debt growth.3 Corporate debt has been growing at an annualized pace of about 6-8%. This means that profit growth would have to slow to below those levels for us to become concerned about an increase in defaults. This could occur for the next quarter or two, as the weak global growth environment weighs on revenues (Chart 8). But our Profit Margin Proxy – corporate selling prices less unit labor costs – is in a strong uptrend, suggesting that the weakness may not be that dire. The crucial relationship for corporate bond investors is between pre-tax profit growth and debt growth.  There is also some reason to think that corporate debt growth might slow during the next few quarters. According to the Fed’s Senior Loan Officer Survey, C&I loan demand has weakened significantly in recent months, while lending standards remain approximately unchanged. Historically, it is extremely rare for loan demand to weaken without a simultaneous tightening in bank lending standards (Chart 9). However, if the current unusual situation were to persist, it would be quite positive from the perspective of corporate balance sheet health. It would suggest that firms are adding less debt to balance sheets, even though banks continue to make credit readily available. Chart 8Profit Margins Still Strong Profit Margins Still Strong Profit Margins Still Strong Chart 9Is Corporate Sector On A Debt Diet? Is Corporate Sector On A Debt Diet? Is Corporate Sector On A Debt Diet? Bottom Line: Growth rates for both corporate profits and debt should settle into the mid-single digits during the next few quarters. This will keep gross leverage and the default rate roughly stable. A sustained period of negative profit growth and tighter C&I lending standards would challenge this outlook.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, “When Expectations Are Self-Fulfilling”, dated June 4, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy/Global Fixed Income Strategy  Special Report, “The Risk From Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The May official PMI shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. The divergence between H-shares and both A-shares and the domestic fixed-income market suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, April’s activity data provided early evidence that the trajectory of the economy was beginning to turn prior to the breakdown in U.S./China trade talks, in response to a meaningful credit improvement in Q1. The May Caixin manufacturing PMI was stable, but the official PMI fell and the experience of last year clearly shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Assuming that the Trump administration follows through with its threat, investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, the most notable development is the contrast between the relative performance of investable Chinese stocks on the one hand, and domestic equities and the Chinese fixed-income market on the other. The recent performance of investable stocks confirms that they have been driven nearly exclusively by trade war developments for the better part of the past year, whereas the somewhat better relative performance of A-shares and the calm in the government bond, corporate bond, and sovereign CDS markets suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock Both Bloomberg’s and our alternative calculation of the Li Keqiang index (LKI) rose in April, albeit only fractionally in the case of the latter. Still, as we noted in last week’s report,1 the Q1 rebound in credit appears to have halted the decline in investment-relevant Chinese economic activity (Chart 1). This suggests that the trajectory of the economy was beginning to change in April prior to the breakdown in U.S./China trade talks, implying that an aggressively stimulative response from Chinese authorities to counter a full 25% tariff scenario has good odds of succeeding. This supports our cyclically overweight stance towards Chinese stocks. Our leading indicator for the LKI declined slightly in April, but remains in a very modest uptrend. The gap between accelerating credit growth and the sluggishness of our leading indicator is explained by the fact that growth in Chinese M2 and M3 has been slow to rise. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, but we cannot reasonably envision an outcome where credit growth continues to trend higher and growth in the money supply does not meaningfully accelerate. The incoming Chinese housing data continues to provide conflicting signals. The annual change of the PBOC’s pledged supplementary lending injections declined further in April, which since 2015 has done an excellent job explaining weak housing demand. However, both floor space started and sold picked up in April (Chart 2), and house price growth remained steady despite a significant decline in the breadth of house price appreciation across 70 cities. Policymakers are likely to allow aggregate credit growth to accelerate significantly over the coming 6-12 months in order to counter the deflationary impact of a trade war with the U.S., but our sense is that policymakers will then refocus their financial stability efforts on the household sector (i.e. they will work to prevent another significant reacceleration in household debt growth). Given this, we continue to expect that housing demand will remain weak, although we will be closely watching floor space sold over the coming few months. The new export orders component of the official manufacturing PMI is signaling an external outlook that is as negative as the 2015/2016 episode. The May official manufacturing PMI fell back into contractionary territory, led by a very significant decline in the new export orders component (Chart 3). The Caixin manufacturing PMI was stable, but the outlook for manufacturing in China is clearly negative unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Chart 2Surprising Resilience In China's Housing Market (For Now) Surprising Resilience In China's Housing Market (For Now) Surprising Resilience In China's Housing Market (For Now) Chart 3A Clearly Negative Outlook For Manufacturing A Clearly Negative Outlook For Manufacturing A Clearly Negative Outlook For Manufacturing There has been a sharp contrast in the behavior of the Chinese investable and domestic equity markets over the past month, which in our view confirms that the former has been driven nearly exclusively by trade war developments for the better part of the past year. Chart 4 shows that the relative performance of investable stocks (versus global) has nearly fallen back to its late-October low, whereas A-shares technically remain in an uptrend despite having sold off. Some investors have attributed the relative support of A-shares to aggressive buying by the “national team”, state-related financial market participants that the government has relied on since 2015 to manage volatility in the domestic equity market. Chart 4Are A-Shares Acting More Rationally Than The Investable Market? Are A-Shares Acting More Rationally Than The Investable Market? Are A-Shares Acting More Rationally Than The Investable Market? However, it is also possible that the A-share market is acting more rationally than the investable market, by focusing on the possibility of a major reflationary response to the Trump tariffs. This contrast in behavior between the investable and domestic markets was also observed pre- and post-February 15th, when the January credit data was released. Prior to this point, the A-share market was (rightly) not confirming the relative uptrend in investable stocks; following February 15th, A-shares exploded higher in response to tangible evidence that a upcycle in credit had arrived. If it is true that the A-share market is better reflecting the prospect of a reflationary response from Chinese policymakers, the relative performance trend for domestic stocks supports our decision to remain cyclically overweight Chinese stocks versus the global benchmark.   Chinese utilities and consumer staples have outperformed in both the investable and domestic equity markets over the past month, which is not surprising given that these sectors typically outperform during risk-off phases. Within the investable market, the sharp underperformance of the BAT (Baidu, Alibaba, and Tencent) stocks has been the most interesting (Chart 5). To the extent that the selloff in BAT stocks reflects trade war retaliation risk (through, for example, delisting from U.S. exchanges), then the selloff is rational. But the fact that Tencent (which also trades in Hong Kong) has also declined so sharply suggests that investors are blanket selling Chinese technology-related stocks out of concern that the sector will be heavily implicated by punitive action from the Trump administration. The BAT stocks are domestically oriented, meaning that “Huawei risk” appears to be minimal. Chart 5A Potential (Future) Opportunity In The BAT Stocks A Potential (Future) Opportunity In The BAT Stocks A Potential (Future) Opportunity In The BAT Stocks Beyond the near-term risk from deteriorating sentiment, the selloff in BAT stocks may present a cyclical opportunity for investors. Unlike Huawei, whose export-oriented business model relied on the U.S. as part of its supply chain, Alibaba and Tencent are largely domestically-driven businesses whose earnings will depend mostly on the outlook for Chinese consumer spending. We agree that reflationary efforts by Chinese policymakers will attempt to avoid stoking a significant acceleration in residential mortgage credit, but it is difficult to envision a scenario in which China stimulates aggressively and consumer spending growth does not accelerate. As such, investors should closely watch the performance of BAT stocks in response to reflationary announcements and developments on the credit front; we would strongly consider an outright long stance favoring BAT stocks if a technical breakout occurs alongside the release of data that is consistent with a significant improvement in the macro outlook. There has been little movement in the Chinese government bond market over the past month, with the Chinese 10-year government bond yield having fallen merely 10 basis points since late-April. This is in contrast to what has occurred in the U.S., with yields on 10-year Treasurys having come in roughly three times as much over the past month (Chart 6). The relative calm in the Chinese government bond market is echoed by the relative 5-year CDS spread between China and Germany, a component of our BCA Market-Based China Growth Indicator. While the spread has certainly moved higher in response to the breakdown in trade talks and President Trump’s full imposition of tariffs on the second tranche of imports from China, it remains below its 2018 average and well below levels that prevailed in 2015 and 2016 (Chart 7). Similarly, Chinese onshore corporate bond spreads have not reacted negatively to the resumption in the trade war, with the spread on the aggregate ChinaBond Onshore Corporate Bond Index up one basis point over the past month. Taken together with the relative performance of A-shares as well as Charts 6 and 7 we see this as evidence that China’s financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. Chart 6Relative Calm In China's Fixed-Income Market Relative Calm In China's Fixed-Income Market Relative Calm In China's Fixed-Income Market Chart 7China's Sovereign CDS Spread Is Rising, But The Level Remains Low China's Sovereign CDS Spread Is Rising, But The Level Remains Low China's Sovereign CDS Spread Is Rising, But The Level Remains Low A decline in the RMB is necessary to stabilize China’s economy (and is thus reflationary), but global investors will not act like it is until the economy visibly improves. Global financial market commentary on the RMB has been focused almost exclusively over the past month on the USD-CNY exchange rate, but Chart 8 shows that the decline in the currency has been broad-based. The RMB has fallen roughly 1.4% versus the euro over the past month, and over 2% versus an equally-weighted basket of Asian currencies. We highlighted in our May 15 Weekly Report that a 25% increase in tariffs affecting all U.S.-China trade would cause economic conditions in China to deteriorate to 2015/2016-like levels, and that currency depreciation was essential in order to generate a 2015/2016-magnitude policy response.2 However, to the extent that the decline in the RMB will contribute to a period of greater volatility in the global foreign exchange market, China-related assets are not likely to respond positively to this form of stimulus until “hard” activity data clearly shows a meaningful rise. Chart 8The RMB Has Declined Against Everything, Not Just The Dollar The RMB Has Declined Against Everything, Not Just The Dollar The RMB Has Declined Against Everything, Not Just The Dollar   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes   1 Please see China Investment Strategy Weekly Report, “Waiting For The Pain”, dated May 29, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, “Simple Arithmetic”, dated May 15, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Bond Rally Supports Stocks Bond Rally Supports Stocks Bond Rally Supports Stocks Financial markets are pricing-in an intensifying global growth slowdown, but not all assets are responding equally. U.S. Treasuries have rallied strongly, while equities and credit spreads remain resilient. Case in point, the S&P 500 is only 5.9% off its Q3 highs in absolute terms, but is down 11.3% versus bonds (Chart 1). The markets are pricing-in that the Fed will react to slower growth by cutting rates and that easier Fed policy will keep risk assets supported. But consider what will happen if, at the June FOMC meeting, the Fed doesn’t seem as eager to cut rates as the market would like. The perception of less monetary support could prompt a sharp sell-off in equities and credit spreads. That tightening of financial conditions could then be enough to force the Fed’s hand, ultimately leading to the rate cut that the market has already come to expect. The odds of the above scenario are rising by the day, especially since the President’s decision to expand the trade war to Mexico. We recommend a cautious near-term (0-3 month) stance on credit spreads as a hedge against this mounting risk.  Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 139 basis points in May, dragging year-to-date excess returns down to +221 bps. As we noted in last week’s report, corporate bond spreads have not responded as aggressively as some other assets – commodities and Treasuries – to the escalating trade war and the deteriorating global growth data.1 This leaves the sector vulnerable to a near-term sell-off, especially if the Fed doesn’t validate the market’s dovish expectations at this month’s FOMC meeting. We advise investors to hedge their exposure to credit spreads on a 0-3 month horizon. Beyond that, assuming that the U.S. government’s tariff announcements eventually reach a plateau, the outlook for corporate bond excess returns is positive on a 6-12 month investment horizon. Spreads are comfortably above levels typically seen at this stage of the economic cycle (Chart 2) and, tariffs aside, the U.S. economy is growing at a reasonable clip. As for balance sheets, corporate profit growth contracted in the first quarter, dragging the year-over-year growth rate down to 7%. That is roughly equivalent to the trend rate in corporate debt growth, meaning that if profit growth stabilizes near that level our measure of gross leverage will stay flat (panel 4). We are also keeping a close eye on C&I lending standards. While the most recent data showed an easing in Q1, the continued contraction in loan demand poses a risk (bottom panel). Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 250 basis points in May, dragging year-to-date excess returns down to +443 bps. As with investment grade corporates, the risk of near-term spread widening is high. We noted in last week’s report that excess junk returns versus Treasuries outpaced the CRB Raw Industrials index by 9% during the past 12 months, a historically wide divergence that is bound to fade.2 Looking further out, high-yield bonds still look like a good bet on a 6-12 month investment horizon. Spreads are comfortably above typical levels from past cycles and the excess spread available in the junk index after accounting for expected default losses has risen to 325 bps, well above its historical average (Chart 3). Assuming historically average excess compensation and a 50% recovery rate, current junk spreads discount an expected 12-month default rate of 3.1%. This is well above the Moody’s baseline projection of 1.5% and even above the 2.7% default rate seen during the past 12 months. The spread-implied default rate should be easy to beat, though a persistent increase in job cut announcements could pose a risk (bottom panel). MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in May, dragging year-to-date excess returns down to -13 bps. The conventional 30-year zero-volatility spread widened 6 bps on the month, the combination of a 4 bps widening in the option-adjusted spread (OAS) and a 2 bps increase in the compensation for prepayment risk (option cost). At 49 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains slightly below its pre-crisis mean (Chart 4). Nonetheless, we see high odds that the MBS/Treasury basis will contract going forward. Falling mortgage rates and an uptick in refinancing activity led to the recent widening in MBS spreads. But with the housing activity data showing signs of improvement, we anticipate that mortgage rates are close to a trough and that refis will soon peak (panel 2). If the “risk off” sentiment in financial markets prevails in the near-term, then MBS will outperform corporate credit. But expected 6-12 month excess returns remain higher for corporate bonds than for MBS. We therefore maintain only a neutral allocation to MBS, despite increasingly attractive valuations. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to +107 bps. Sovereign debt underperformed duration-equivalent Treasuries by 205 bps on the month, dragging year-to-date excess returns down to +206 bps. Local Authorities outperformed the Treasury benchmark by 11 bps, bringing year-to-date excess returns up to +219 bps. Meanwhile, Foreign Agencies underperformed by 61 bps, dragging year-to-date excess returns down to +130 bps. Domestic Agencies underperformed by 1 bp in May, bringing year-to-date excess returns up to +28 bps. Supranationals outperformed by 4 bps on the month, bringing year-to-date excess returns up to +27 bps. Sovereign debt remains expensive relative to equivalently rated U.S. corporate credit (Chart 5), and the dollar’s relentless march higher presents a further headwind for the sector. We continue to recommend an underweight allocation. Previously, we made an exception for Mexican sovereign bonds, which trade cheap relative to U.S. corporates (bottom panel). However, with the U.S. government now threatening tariffs on imported Mexican goods, the peso will likely see heightened volatility in the coming months. We recommend standing aside on Mexican sovereigns for the time being. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 75 basis points in May, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in May, and currently sits at 80% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, but close to the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) have outperformed short-dated munis (2-year and 5-year) by a wide margin since the beginning of the year, but long-end yield ratios remain relatively attractive. 20-year and 30-year Aaa-rated municipal bonds are particularly alluring. Yield ratios for those bonds remain above their pre-crisis averages, whereas 10-year, 5-year and 2-year Aaa yield ratios are close to one standard deviation below their respective pre-crisis means. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.3 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in May, with yields falling by more than 30 basis points for all maturities beyond 1 year. The 2/10 Treasury slope flattened 5 bps on the month and currently sits at 19 bps. The 5/30 slope was unchanged on the month and currently sits at 65 bps (Chart 7). The belly (5-year/7-year) of the curve looks particularly expensive relative to the wings (see Appendix B) and we continue to recommend a barbell curve positioning: Investors should overweight the long and short ends of the curve and avoid the belly.4 Further, this week we recommend an additional fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract. The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if 3 or more rate cuts occur between now and then. We would expect our spread trade to return +48 bps in a scenario where the Fed keeps rates flat until next March and +23 bps in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 116 basis points in May, dragging year-to-date excess returns down to +39 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.74%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps on the month and currently sits at 1.90%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.5 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 3% (annualized) clip in April, but has only risen 1.6% during the past year. 12-month trimmed mean PCE inflation has been higher, and actually just moved above the Fed’s target following last week’s April data release (Chart 8). In last week’s report we noted that core PCE inflation has a track record of converging toward the trimmed mean.6 As such, we recommend that investors remain overweight TIPS versus nominal Treasuries in U.S. bond portfolios. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +64 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and actually hit a new all-time low of 26 bps in mid-May, before settling at 28 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +195 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 69 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst waning demand (bottom panel) and decelerating prices (panel 3). However, CMBS still offer reasonable compensation for this risk. Especially compared to other similarly-rated fixed income sectors.7 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in May, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread widened 3 bps on the month and currently sits at 51 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread product. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 75 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Image Image Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of May 31, 2019) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of May 31, 2019) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12 Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 4 We have specifically been recommending a position short the 7-year bullet and long a duration-matched 2/30 barbell. 5 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Reflation Indicator And EM Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Asian Exports To China And To U.S Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities bca.ems_wr_2019_05_30_s1_c12 bca.ems_wr_2019_05_30_s1_c12 Chart I-13Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle bca.ems_wr_2019_05_30_s1_c16 bca.ems_wr_2019_05_30_s1_c16 Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). Chart I-18 This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Facing Resistance? Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Business Cycle Is Weak Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Domestic Demand Is Fragile Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Less Provisions = More Paper Profit Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth Very Weak Equity Breadth Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices India Versus EM & Oil Prices India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com     Footnotes   1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

Highlights Global financial markets are currently dealing with a fresh round of uncertainty related to U.S.-China trade tensions. Yet while equities and government bond yields have fallen in response to the U.S. imposition of tariffs and escalation of the trade war with China, corporate bond markets in the developed economies have been relatively well-behaved (so far). Credit spreads have only widened modestly, which perhaps should not be surprising given central bankers’ increasingly dovish bias combined with early signs of a cyclical global growth rebound (Chart 1). Feature Chart 1Global Corporates: Shifting To A Friendlier Growth Backdrop? Global Corporates: Shifting To A Friendlier Growth Backdrop? Global Corporates: Shifting To A Friendlier Growth Backdrop? With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The main conclusion from the latest readings on our CHMs is that slower economic growth over the past year has resulted in some erosion of overall global credit quality. The deterioration was most pronounced in the more economically fragile regions that have suffered the deepest pullbacks in growth: Europe and Japan. The CHMs are currently giving an overall “neutral” signal in the U.S., although there are some worrying trends developing within the sub-components like interest coverage and short-term liquidity. Meanwhile, the CHMs in the U.K. and Canada are showing modest cyclical deterioration from very strong levels. Broadly speaking, the CHMs support our main global corporate bond market investment recommendations: a tactical aggregate overweight versus global government bonds, with a regional bias favoring the U.S. over Europe, and a quality bias tilted towards U.S. high-yield (HY) over investment grade (IG). Renewed U.S.-China trade hostilities represent a threat to that pro-cyclical fixed income asset allocation, although we expect more aggressive responses from policymakers on both sides (more fiscal and monetary stimulus in China, a more dovish bias from the Fed) to offset any tariff-induced weakness in growth. U.S. Corporate Health Monitors: Cyclically OK, But Longer-Term Problems Are Brewing Our top-down U.S. CHM is sending a neutral message on credit quality, sitting right on the threshold separating “deteriorating health” from “improving health” (Chart 2). The indicator, however, has been trending in a direction showing improving credit metrics over the past year. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle.  The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate tax cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. The ratios directly related to corporate profits that go into the top-down CHM – return on capital, profit margins and interest coverage – have all gone up over the past year, generating the bulk of the directional improvement in the top-down CHM. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. That does not mean that all the news is good, however. The short-term liquidity ratio has fallen sharply and is now at levels last seen in the years leading up to the 2008 Financial Crisis. Similar deteriorations can be seen in the short-term liquidity ratios within the bottom-up versions of our U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Coming at a time when interest coverage ratios have been steadily declining for IG, and are already at low levels for HY, declining short-term liquidity would leave U.S. corporates highly vulnerable during the next economic downturn. Chart 2Top-Down U.S. CHM: A Neutral Reading Top-Down U.S. CHM: A Neutral Reading Top-Down U.S. CHM: A Neutral Reading Chart 3Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates. For now, however, the message from our bottom-up U.S. CHMs is the same as that from our top-down U.S. CHM, with all hovering near the zero line suggesting no major deterioration in overall credit quality. We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). Our favored indicators continue to point to a rebound in global growth in the latter half of 2019, and the Fed currently has no desire to push the funds rate into restrictive territory, so the risk/reward over the next six months still favors staying overweight U.S. corporates. The medium-term outlook, however, is far more challenging given the growing body of evidence pointing to the advanced age of the U.S. credit cycle, such as falling interest coverage and liquidity. Chart 4Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY U.S. Corporates: Stay Tactically Overweight IG & HY U.S. Corporates: Stay Tactically Overweight IG & HY One final point – in Appendix 2 starting on page 17, we present bottom-up CHMs for the main industry sector groupings of companies that go into our overall U.S. IG CHM. Most of the sector CHMs are hovering near the zero line, but two industry groupings stand out as having a rising CHM that is now well within “deteriorating health” territory – Consumer Staples and Utilities. Euro Corporate Health Monitors: Worsened By Weaker Growth The message from our bottom-up CHMs for the euro area shows that there was some damage done to credit quality from last year’s growth slump, evidenced by lower profit margins and interest coverage ratios. Although overall credit quality remains fairly neutral (i.e. the CHMs remain near the zero line). For euro area IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former now slightly in the “deteriorating health” zone (Chart 6). Profit margins have fallen far more sharply for domestic issuers, reflecting the very rapid slowing of euro area growth over the latter half of 2019. Interest coverage for domestic issuers is also lower than for foreign issuers, while short-term liquidity ratios have weakened for both over the past year. For euro area HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, and are now hovering just above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. Despite the lack of a major overall negative signal from the euro area CHMs, we are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates (Chart 9). The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. This will inhibit the ability for spreads to tighten further in the event of a pickup in growth, while also leaving spreads vulnerable to widening pressures if euro area growth continues to languish. Chart 8Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Euro Area Corporates: Stay Tactically Neutral IG & HY Euro Area Corporates: Stay Tactically Neutral IG & HY Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. The gap between the combined IG/HY bottom-up CHMs for the U.S. and euro area has been strongly correlated to the difference in credit spreads between euro area and U.S. issuers (Chart 10).1 The latest trends show a narrowing of the gap between the U.S. and euro area CHMs, suggesting relative corporate health favors U.S. names (middle panel). At the same time, the relatively stronger performance of the U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). U.K. Corporate Health Monitor: Brexit Uncertainty Is Not Helping Our top-down U.K. CHM remains in the “improving health” zone, although the indicator has been drifting towards “deteriorating health” over the past two years. Almost all of the components of the U.K. CHM have contributed to this worsening trend (Chart 11), with only short-term liquidity remaining in a powerful multi-year uptrend. Most worryingly, the interest and debt coverage ratios remain historically depressed, even as the Bank of England has keep interest rates at extraordinarily low levels for the past several years. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits.   The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The persistent uncertainty from Brexit has weighed on business confidence and investment spending by U.K. firms, keeping growth at a below-trend pace. While the immediate deadline of “Brexit Day” came and went back in March, there is still a high degree of uncertainty over the U.K.’s future economic relationship with the European Union. With Prime Minister Theresa May now set to step down, an election will extend the period of politically-driven uncertainty in the U.K. We have maintained a moderate underweight recommendation on U.K. corporates in our model bond portfolio over the past year, despite the lack of an obvious negative signal from our U.K. CHM. Spread widening in 2018 has been followed by spread tightening in 2019 (Chart 12), but the latter has been driven by the global rally in risk assets rather than diminished perceptions of U.K. political risk. Chart 11U.K. Top-Down CHM: Modest Pullback From Healthy Levels U.K. Top-Down CHM: Modest Pullback From Healthy Levels U.K. Top-Down CHM: Modest Pullback From Healthy Levels Chart 12U.K. Corporates: Stay Modestly Underweight U.K. Corporates: Stay Modestly Underweight U.K. Corporates: Stay Modestly Underweight Although there has been some improvement in U.K. economic data of late, leading economic indicators continue to trend lower. In addition, the Bank of England continues to hint that any positive resolution to the Brexit uncertainty could result in a tightening of monetary policy (although that is less of a threat given the synchronized dovish turn by global central bankers over the past few months). Given all the uncertainties, the risk/reward balance continues to favor a modest underweight in U.K. corporates, particularly at current tight spread levels to Gilts. Japan Corporate Health Monitor: A Modest Cyclical Deterioration Our bottom-up Japan CHM has shown a worsening trend over the past year and now sits in the “deteriorating health” zone (Chart 13).2 Interestingly, all of the individual components have contributed to that move in the CHM, and not just the cyclical components (profit margins, return on capital, interest coverage) that reflect the recent slowing of economic growth in Japan. Leverage has increased (albeit from very low levels), while short-term liquidity has also weakened (albeit from very high levels). Strictly looking at the overall level of all the Japan CHM components, the message does not signal a major deterioration in Japanese corporate credit quality. Leverage, defined here as the ratio of total debt to the book value of equity, is still below 100%, well below the 100-140% range seen between 2006 and 2015. The same story applies to the return on capital, which at 5% is still high versus Japan’s history (although very low by global standards). Interest coverage and short-term liquidity both remain high relative to the past decade. The absolute level of Japanese corporate health remains solid, but there has been marginal deterioration from weaker economic growth. On that front, the cyclical momentum in Japan’s economy is not improving. According to the latest Tankan survey, Japanese firms reported that their business outlook was worse than previously expected. Declining confidence has damaged capital spending, as shown by the falling growth of domestic machinery and machine tool orders. Japan’s economy remains highly levered to global growth and export demand and their economy has taken a hit from the slower pace of global trade over the past year. Wage growth has also weakened after finally seeing some positive momentum in 2018, which is weighing on consumer confidence and spending. Japan’s corporate spread has widened slightly (+5bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets (the Bloomberg Barclays Global Corporates index spread has tightened by -33bps year-to-date). This is a sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns versus Japanese Government Bonds (JGBs) with yields held near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Japan Corporates: Stay Overweight Vs JGBs For Carry Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitor: Still In Decent Shape Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving health” area over the past few years (Chart 15). The marginal moves have shown some modest deterioration in the cyclically-sensitive components (most notably, return on capital and profit margins for the top-down Canadian CHM). This should not be surprising given how rapidly Canadian economic growth slowed in the final quarter of 2018. There has also been some deterioration in the non-cyclical components. Leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are historically low. This may be building up risks for the next major Canadian economic downturn, but for now, Canadian companies look in decent shape. With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next six months, which will further underpin the health of Canadian oil companies – and should also help support Canadian corporate bond performance. The Bank of Canada is now taking an extended pause from its rate-hiking cycle, with policy rates well below the central bank’s own estimate of neutral (2.25-3.25%). Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Canada CHMs: Still Healthy, Despite Slower Growth Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have been in a very stable range since the 2009 recession (Chart 16), ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a prolonged deterioration of Canadian economic growth or sharp monetary tightening from the Bank of Canada – neither outcome is likely over the next 6-12 months.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: Growth Powdering Over Some Warts BCA Corporate Health Monitor Chartbook: Growth Powdering Over Some Warts Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.3 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Image Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR   APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR     Footnotes 1 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 2 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 3 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: Growth Powdering Over Some Warts BCA Corporate Health Monitor Chartbook: Growth Powdering Over Some Warts Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns