Corporate Bonds

Highlights Global Spread Product: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios. Feature Stick With A Tactical Overweight To Global Corporates We’ve dedicated our last few Weekly Reports to analyzing the outlook for government bond yields in the developed markets (DM), in light of the recent dovish shift in the policy stance of central banks. We concluded that yields had fully discounted a slower global growth backdrop, through lower inflation expectations and the pricing out of future interest rate hikes. Further declines in bond yields would require a deeper deceleration of activity than we are expecting, thus maintaining a below-benchmark medium-term duration stance is appropriate. That dovish shift by policymakers also took away a major roadblock for risk assets, namely the threat of a continued policy-induced rise in global yields at a time of slowing growth. The result has been sharp rallies in global equity and credit markets, with declining volatility (Chart of the Week). Chart of the WeekSlowing Growth Isn’t Always Bad For Risk Assets Slowing Growth Isn't Always Bad For Risk Assets Slowing Growth Isn't Always Bad For Risk Assets We upgraded global corporate debt, and downgraded global government bonds, on a tactical basis back on January 15 of this year.1 Since then, credit spreads have declined substantially across both DM and emerging markets (EM), most notably in Europe (Chart 2). Within our upgrade to overall global credit, we maintained a relative bias towards U.S. corporates versus non-U.S. equivalents, based on our expectation of relatively faster economic growth in the U.S. In our model bond portfolio, that meant moving U.S. corporates to an above-benchmark weighting, while reducing the size of the underweight in EM debt and only raising European credit to a neutral allocation. Chart 2 Looking at the performance of each of the major credit markets in excess return terms (versus duration-matched government bonds) since January 15, currency-hedged into U.S. dollars, there have not been huge differences between U.S. and non-U.S. returns. The exception is European high-yield which had an excess return of 4.4%, but only represents 0.8% of our custom benchmark index for our model portfolio (and where we are not underweight). Excess returns for investment grade and high-yield corporates in the U.S. have averaged 2.3%, compared to 2.2% for EM credit (averaging hard currency sovereign and corporate debt). We see the global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current overweight allocation to global corporates. With the benefit of hindsight, we know that the decision to upgrade overall global corporate debt versus government bonds has been far more important than adjusting any regional credit allocations. We see that global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current allocations to global corporates. Our cue to reverse our tactical overweight stance on corporates will come from the U.S. Any additional spread tightening and easing of overall financial conditions will keep U.S. economic growth above trend and eventually force the Fed to become more hawkish in the second half of 2019. This will turn global monetary policy from a tailwind for corporate credit to a headwind, justifying a downgrade of corporate allocations. In the meantime, we recommend continuing to earn carry in a policy-induced low volatility environment. Bottom Line: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Upgrade To Neutral Canadian government bonds have been clawing back much of the relative underperformance that occurred in 2017 and 2018 while the Bank of Canada (BoC) was delivering multiple rate hikes. The spread between the yields on the Bloomberg Barclays Canada Treasury index and the overall Global Treasury index has narrowed by -40bps since October 2018, after widening 69bps between May 2017 and October 2018 (Chart 3). Expressed as a relative return (duration-matched and currency-hedged into U.S. dollars), Canadian government debt has lagged the Global Treasury index by -232bps since May 2017. Chart 3Canadian Bonds No Longer Underperforming Canadian Bonds No Longer Underperforming Canadian Bonds No Longer Underperforming That underperformance was driven by the combination of a strong Canadian economy, accelerating inflation and tightening monetary policy. The year-over-year pace of real GDP growth reached 3.8% in mid-2017 and stayed above-trend for the following year. The unemployment rate fell to 5.8%, while core inflation accelerated back to the midpoint of the BoC’s 1-3% target band, alongside faster wage growth. The BoC – devotees of the Phillips Curve, like virtually every other DM central bank – took the message from the combination of tight labor markets and rising inflation and embarked on the long march away from a near-zero (0.5%) policy rate back in July 2017. Now, after 20 months and 125bps of rate hikes, Canada’s economy is weakening sharply. Real GDP only grew at a paltry 0.4% annualized pace in the 4th quarter of 2018, dragging the year-over-year pace to 1.6%. Inflation has followed suit, with headline CPI inflation falling from an early 2018 peak of 3% to 1.4% and the BOC’s median CPI index now growing at only a 1.8% pace. The most concerning part for the BoC is that the economy could be decelerating this rapidly with a policy rate of only 1.75%, which is well below the central bank’s estimated 2.5-3.5% range for the neutral rate. Our own BoC Monitor has rapidly fallen towards the zero line, indicating no pressure to either tighten or ease monetary policy (Chart 4). The more recent rapid decline in the BoC Monitor has been driven by the inflation-focused components of the indicator, while the growth-focused elements have been steadily drifting lower since that 2017 peak in real GDP growth. Chart 4Is The BoC Done, Well South Of Neutral? Is The BoC Done, Well South Of Neutral? Is The BoC Done, Well South Of Neutral? The BoC has been stunned by that shockingly weak Q4/2018 growth outturn. In the official policy statement released following the March 6 BoC meeting, the central bank’s Governing Council was forthright about how the growth uncertainty has put future rate hikes in question: “Governing Council judges that the outlook continues to warrant a policy interest rate that is below its neutral range. Given the mixed picture that the data present, it will take time to gauge the persistence of below-potential growth and the implications for the future inflation outlook. With increased uncertainty about the timing of future rate increases, Governing Council will be watching closely developments in household spending, oil markets and global trade policy.” Rising interest rates may be the big reason why growth has slowed so dramatically in Canada. The BoC’s economic projections for 2019 had already factored in some slowing global growth, as well a hit to business confidence and capital spending from global trade conflicts and last year’s decline in energy prices (a big deal for Canada’s huge oil industry). BoC officials, including Governor Stephen Poloz, have noted that a resolution of the U.S.-China trade tensions could therefore be a positive for the Canadian economy by removing a critical drag on Canadian business confidence and export demand. Yet when looking at the contribution to Canadian real GDP growth from the main components, there have been large drags on growth from consumer spending, capital spending and housing (Chart 5). That suggests that there is something more fundamental than just a series of external shocks at work here. Chart 5Broad-Based Weakness In Canadian Domestic Demand Broad-Based Weakness In Canadian Domestic Demand Broad-Based Weakness In Canadian Domestic Demand A look at the more interest-sensitive components of the Canadian economy suggests that rising interest rates may be a big reason why growth has slowed so dramatically. Consumer Durables Real consumer spending growth has plunged from a 4% pace in 2018 to 1.3% in Q4/2018, driven by a collapse in demand for consumer durables which contracted -1.2% year-over-year terms (Chart 6). Car sales plunged 7.5% on a year-over-year basis in Q4, suggesting that rising interest rates on auto loans may have been a major factor driving the weakness in durables spending. Softer incomes have also played a role, with wage growth rolling over even with the majority of evidence pointing to a very tight Canadian labor market that is getting even tighter (third panel). The fact that the drop was so focused on durables, however, suggests that higher interest rates were the more likely reason for the plunge in overall consumer spending. Chart 6Weak Canadian Consumption Concentrated In Durables Weak Canadian Consumption Concentrated In Durables Weak Canadian Consumption Concentrated In Durables Housing The overheated Canadian housing market has endured the double-whammy of rising mortgage interest rates and increasing macro-prudential changes to mortgage lending. House prices in the hottest Toronto and Vancouver markets – which should be most impacted by the changes in mortgage regulations – have stopped increasing, helping bring the growth in national house prices to only 1.9% (Chart 7). Yet the sharp deceleration of mortgage credit growth, alongside a contraction in housing starts and overall residential investment, suggests that higher mortgage rates could be the bigger driver of the housing weakness. Chart 7Some Long-Needed Cooling Of Canadian Housing Some Long-Needed Cooling Of Canadian Housing Some Long-Needed Cooling Of Canadian Housing The BoC has noted that it is difficult to disentangle the impact of regulatory changes in Canadian mortgages from that of rising interest rates. Yet the impact of higher mortgage rates on Canadian consumer spending power can be seen in the rising debt service ratio for Canadian households. As of Q4/2018, Canadians must now pay 14.5% of their household income to service their debts, an 0.53 percentage point increase over the past two years (Chart 8). For highly indebted Canadian households, who have mortgage debt equal to 107% of disposable income, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Chart 8Leveraged Canadian Consumers Pinched By Higher Rates Leveraged Canadian Consumers Pinched By Higher Rates Leveraged Canadian Consumers Pinched By Higher Rates Does the fact that consumer spending has fallen so rapidly mean that the interest sensitivity of the Canadian economy is far greater than the BoC has assumed? If so, then the neutral range of 2.5-3.5% for the BoC policy rate may be too high, and the central bank could be closer to, if not already at, the end of its hiking cycle. The low level of the household savings rate – currently only 1.1%, a product of the housing bubble and the associated wealth effects on spending activity – makes Canadian consumers even more vulnerable to rate increases that diminish their spending power. For highly indebted Canadian households, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Capital Spending Canadian companies have seen a steady decline in corporate profit growth over the past couple of years, decelerating from a 23% pace in 2017 to 2% late in 2018 on a top-down basis. Yet even allowing for that, the -8% contraction in year-over-year real non-residential investment spending in Q4/2018 is a shock. Particularly since the BoC’s Senior Loan Officer Survey showed that credit conditions have been easing, and our own Canadian Corporate Health Monitor is flashing that Canadian companies are in solid financial condition (Chart 9). Chart 9An Unusually Sharp Fall In Canadian Capex An Unusually Sharp Fall In Canadian Capex An Unusually Sharp Fall In Canadian Capex Business surveys from the BoC and the Conference Board did both show a sharp plunge in confidence and future sales expectations (bottom panel). This suggests that worries about global trade tensions and diminished trade activity may have weighed on Canadian business confidence and capital spending – especially coming alongside a big drop in oil prices as was seen last year, which hinders the ability of Canadian energy producers to ramp up investment. Canadian exports accelerated over the final half of 2018 while business confidence was falling. However, oil prices have now stabilized and, more importantly, Canadian exports accelerated over the final half of 2018 while business confidence was falling (Chart 10). That acceleration was seen for both energy and non-energy exports, but was also heavily concentrated in exports to China, which are now growing 24% on a year-over-year basis (a pace that is wildly at odds with the overall growth in Chinese imports, suggesting that Canadian exporters have increased their market share in China). Chart 10Should Canadian Companies Be Worried About Global Trade? Should Canadian Companies Be Worried About Global Trade? Should Canadian Companies Be Worried About Global Trade? Could higher corporate borrowing rates, rather than worries about plunging export demand, be the true reason why Canadian companies have so drastically cut back on capital spending? It is no surprise that the BoC has chosen to take a pause on its rate hiking cycle, given all those conflicting messages from the Canadian economic data. The growth slump could be related to global trade uncertainty, or regulatory changes in the housing market, or past declines in oil prices, or previous interest rate increases. Or all of the above. The BoC can also take some time before considering its next interest rate move given cooling inflation and wage growth (Chart 11). The central bank has reduced its estimate of the Canadian output gap to -0.5%, based off the downside surprises already seen in Canadian economic growth. A closed output gap, combined with accelerating inflation, was the main argument the BoC had been using to justify its interest rate increases over the past two years. Now, neither of those conditions is currently in place, and the BoC can take its time to assess the underlying trend of economic growth without having to worry about above-target inflation. Chart 11Slowing Inflation = More Dovish BoC Slowing Inflation = More Dovish BoC Slowing Inflation = More Dovish BoC The Governing Council next meets in April, when a new Monetary Policy Report and updated economic projections will be published. The 2019 growth and inflation forecasts will surely be downgraded, perhaps heavily as the European Central Bank just did in response to the sharp growth slowdown in Europe – which led to a new round of monetary easing measures. What will be more interesting from the point of view of Canadian bond investors will be the Bank’s assessment of the size of Canada’s output gap, the pace of trend growth and, perhaps, even the appropriate neutral range for the BoC policy rate. The lowering of any of those three elements would be supportive of Canadian bond yields staying lower for longer. We have maintained an underweight in Canadian government bonds since July 2017, based on our view that the BoC would follow in the Fed’s footsteps and attempt to normalize interest rates. A strong economy and rising inflation would allow them to do that. Now, both the Fed and BoC are on hold, with small probabilities of rate cuts now priced into Overnight Index Swap (OIS) curves (Chart 12). Chart 12BoC Now Less Likely To Follow The Fed BoC Now Less Likely To Follow The Fed BoC Now Less Likely To Follow The Fed Given the BCA view that Fed rate hikes will resume later this year on the back of a rebound in U.S. and global growth, we had been sticking with the bearish view on Canadian government bonds as well. Yet given the stunning drop in Canadian growth that startled the BoC, the odds now favor the BoC staying on hold for longer, even once the Fed begins to hike again. This would also provide additional easing of Canadian financial conditions through a soft Canadian dollar (bottom two panels). We are upgrading our recommended allocation to Canadian bonds to neutral(3 out of 5) this week from underweight (2 out of 5).  In light of this uncertainty over the BoC’s next move given the weak economy, the underlying rationale for our underweight Canada position is no longer applicable. Thus, we are upgrading our recommended allocation to Canadian bonds to neutral (3 out of 5) this week from underweight (2 out of 5). The excess return of Canadian government bonds versus the Global Treasury index since we went to underweight back in July 2017 was -0.83%, so our bearish recommendation did generate positive alpha. In our model bond portfolio, we are funding that additional Canadian allocation from a reduction of the overweight in Japanese government bonds. We are also closing our tactical trade of being long 10-year Canadian Real Return Bonds versus nominal 10-year government debt, at a loss as 10-year inflation breakevens are now 1.6%, or 16bps below the entry level on our trade (Chart 13). Chart 13Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We will contemplate any additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey and Senior Loan Officer Survey on April 15 and the new BoC Monetary Policy Report and economic projections at the April 24 monetary policy meeting. Bottom Line: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index March Calmness March Calmness Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Corporate Default Rate: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. Corporate Bond Valuation: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy: Corporate spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth. However, tighter Fed policy and a higher-than-expected corporate default rate could pressure spreads wider in the second half of 2019. We will be quick to back off our overweight corporate bond stance when our near-term spread targets are met. Feature Investors should remain overweight corporate bonds within U.S. fixed income portfolios, but be conscious that the window for outperformance may close quickly. While the Fed’s dovish turn and signs of global growth stabilization will allow spreads to tighten during the next few months, corporate default risk is rising in the background. This week’s report focuses on corporate default risk. We assess where the default rate is headed during the next 12 months and discuss the implications for investment strategy. Default Rate Near A Bottom Chart 1 shows that the trailing 12-month speculative grade default rate has been steadily falling since early 2017. However, it also shows that the fair value reading from our macro-driven default rate model has not fallen as much. The actual trailing 12-month default rate came in at 2.7% in February, the fair value reading from our model stands at a loftier 3.6%. Chart 1Corporate Default Rate Near A Bottom? Corporate Default Rate Near A Bottom? Corporate Default Rate Near A Bottom? Our default rate model is based on two factors, Commercial & Industrial bank lending standards and gross corporate leverage. The latter is defined as total nonfinancial corporate debt divided by pre-tax profits. With that in mind, our model provides a framework for assessing where the default rate is headed under different scenarios for corporate profit and debt growth. We consider each of these two factors in turn. Corporate Profit Growth Will Moderate Nonfinancial corporate pre-tax profits grew an astonishing 17% during the four quarters ending in Q3 2018, but all leading indicators point to deceleration in Q4 2018 and beyond. On the revenue side of the ledger, leading indicators are in universal agreement that growth is poised to slow (Chart 2): Chart 2Corporate Revenues Will Soften Corporate Revenues Will Soften Corporate Revenues Will Soften The ISM Manufacturing index has fallen to 54.2 from a recent peak above 60. The year-over-year growth rate in total business sales came in at 2% in December, down from a recent peak of 8.4%. The year-over-year growth rate in industrial production fell to 3.5% in February, from a September peak of 5.7%. The year-over-year growth rate in the U.S. Leading Economic Indicator is down to 3.2% as of January, from a September peak of 6.8%. Clearly, the global growth slowdown has migrated to the U.S. and the impact is being seen in the leading U.S. economic data. Some slowdown in corporate revenue growth is all but assured. All leading indicators point to deceleration in corporate profit growth in Q4 2018 and beyond. Corporate profit growth and investment spending are tightly linked in the sense that firms are more likely to take on new projects when they feel better about their future cash flow prospects. The upshot is that we can infer trends in corporate profits by looking at data on investment spending and firms’ investment plans. That data paint a similar picture of widespread deceleration (Chart 3): Chart 3Investment Indicators Investment Indicators Investment Indicators The year-over-year growth rate in core durable goods orders is down to 4% from a recent peak close to 9%. An average of firms’ capital spending plans as reported in regional Fed surveys remains elevated, but has declined markedly in recent months. Small business capital spending plans, as reported to the NFIB, have fallen sharply during the past few months. Periods of tightening lending standards coincide with decelerating corporate debt. Wage growth is another important driver of corporate profits. In particular, we can get a read on profit growth by looking at the difference between corporate selling prices and unit labor costs, aka our Profit Margin Proxy (Chart 4). Our Profit Margin Proxy remains at a high level because growth in unit labor costs has been tepid. Even though top-line wage growth has improved, this has been matched by an acceleration in productivity growth (Chart 4, bottom panel). The latter has kept unit labor costs low, even as nominal wages have risen. Chart 4Wage Growth A Drag On Profits Wage Growth A Drag On Profits Wage Growth A Drag On Profits Extremely tight labor markets will lead to a continued acceleration in wage growth during the next few quarters.1 Meanwhile, the prospect for continued rapid productivity growth is much more uncertain. It seems reasonable to expect that corporate profits will come under some downward pressure from rising unit labor costs during 2019. Finally, we can get a sense of the corporate profit outlook by looking at equity analyst net earnings revisions (Chart 5). Analyst earnings per share (EPS) upgrades outpaced downgrades for most of 2018, but that trend reversed sharply near the end of last year. Analysts are once again lowering EPS forecasts more often than they are raising them. Chart 5More EPS Downgrades Than Updgrades More EPS Downgrades Than Updgrades More EPS Downgrades Than Updgrades Debt Growth Should Also Slow Fortunately, some of the balance sheet impact from decelerating profits will likely be offset by slower debt growth during the next few quarters. Corporate debt growth has been robust and fairly stable since 2012, but C&I lending standards tightened slightly in the fourth quarter of last year. Typically, periods of tightening lending standards coincide with decelerating corporate debt (Chart 6). Chart 6Tighter Lending Standards Implies Slower Debt Growth Tighter Lending Standards Implies Slower Debt Growth Tighter Lending Standards Implies Slower Debt Growth Anecdotally, several high profile firms have recently taken steps to curtail debt growth. Most notably, General Electric just announced a major asset divestment to pay down debt, and the stock market rewarded them for doing so. If our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. More broadly, we observe that firms with low debt/asset ratios have been outperforming firms with high debt/asset ratios, a dynamic that tends to occur when lending standards are tightening and corporate debt growth is falling (Chart 7). Chart 7Low Leverage Firms Are Outperforming Low Leverage Firms Are Outperforming Low Leverage Firms Are Outperforming For a sense of scale, nonfinancial corporate debt grew 6.5% in the four quarters ending Q4 2018 and has averaged 6.3% since 2012. Some mild deceleration from these growth rates is likely during the next few quarters. Putting It All Together Table 1 shows that trailing 12-month profit growth of 17% and debt growth of 6.5% led to gross corporate leverage of 6.95, which translates to a fair value default rate of 3.6%. Table 1 also shows where the fair value default rate will head during the next 12 months based on different scenarios for profit and debt growth. Table 1Default Rate Scenarios Assessing Corporate Default Risk Assessing Corporate Default Risk For example, if profits grow by 5% and debt growth is between 0% and 8%, then the fair value default rate will be between 3.5% and 4.1% one year from now. This seems like a reasonable scenario based on our macro forecast. A scenario that would result in a default rate that is much higher than the current Moody’s baseline forecast of 1.7%. And One More Thing Though they are not included in our model, job cut announcements are a fairly reliable coincident indicator of corporate defaults. Recently, job cut announcements have clearly bottomed even as the default rate has continued to fall (Chart 8). This is a clear warning sign that the default rate might head higher in the coming months. Chart 8Warning Sign From Job Cuts Warning Sign From Job Cuts Warning Sign From Job Cuts Bottom Line: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. It increasingly looks like the second half of 2019 will be more challenging for corporate credit. Are Investors Adequately Compensated For Default Risk? Forecasting the default rate is important, but it is only one side of the coin when it comes to corporate bond investing. The other relevant question is whether current spreads offer adequate compensation for expected defaults. At present, the average option-adjusted spread (OAS) on the Bloomberg Barclays High-Yield index is 388 bps. If we assume that defaults occur in line with the Moody’s baseline forecast during the next 12 months, then we would expect default losses of approximately 90 bps (assuming a 49% recovery rate).2 That translates to an excess junk spread of 298 bps, well above the historical average realized excess spread of 250 bps. In other words, investors should expect better than average excess junk returns if the Moody’s baseline default rate forecast turns out to be correct. However, our analysis suggests that the default will be significantly higher during the next 12 months. If we assume a 3.5% default rate, more in line with our macro forecast, and a slightly lower recovery rate of 45%, then the excess spread available in the high-yield index falls to 198 bps. This number is still positive, so unless there is significant spread widening investors should still earn a positive excess return versus Treasuries, but it is considerably below average historical levels. Another factor to consider is the historical correlation between junk spreads and the Moody’s baseline default rate forecast. We find that the average high-yield OAS has the strongest positive correlation with the 9-month forward Moody’s baseline default rate expectation (Chart 9). In other words, if our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. Chart 9Default Rate Revisions Will Lead To Wider Spreads Default Rate Revisions Will Lead To Wider Spreads Default Rate Revisions Will Lead To Wider Spreads Bottom Line: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy While this report has focused on detecting early warning signs of default risk, that is not the only thing that matters for corporate spreads. We continue to believe that spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth.3 The purpose of this report is to stress that our current overweight stance on corporate bonds is unlikely to last through to the end of the year. First, if spreads tighten during the next few months leading to an easing in overall financial conditions, then the Fed will probably turn more hawkish in the second half of 2019 and monetary policy will shift from being a tailwind for corporate credit to a headwind. This shift could occur at around the same time that corporate defaults start to exceed current expectations. As a matter of strategy, we have published spread targets for each corporate credit tier based on average spread levels seen during similar stages of past economic cycles (Charts 10A & 10B).4 We will be quick to move off our overweight stance once these spread targets are achieved. Note that Aaa spreads are already below target. We recommend that investors avoid Aaa-rated corporate bonds. Chart 10AInvestment Grade Spread Targets Investment Grade Spread Targets Investment Grade Spread Targets Chart 10BHigh-Yield Spread Targets High-Yield Spread Targets High-Yield Spread Targets While the current environment remains positive, it increasingly looks like the second half of 2019 will be more challenging for corporate credit. Stay tuned. Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further details on the amount of labor market slack in the economy please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 We forecast the recovery rate based on its inverse historical relationship with the default rate. A higher default rate implies a lower recovery rate, and vice-versa. 3 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 For more details on our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com

Highlights Chart 1Track The CRB/Gold Ratio Track The CRB/Gold Ratio Track The CRB/Gold Ratio Earlier this year the Fed signaled a dovish policy shift in response to slowing global growth and tighter financial conditions. In large part due to the Fed’s move, financial conditions are now easing and the CRB Raw Industrials index – a timely proxy for global growth – is starting to perk up. But when will this improvement translate to higher Treasury yields? The CRB/gold ratio offers some clues. Gold moves higher when monetary policy eases. Then with a lag, that easier policy spurs stronger global growth and a rising CRB index. Eventually, that stronger growth puts rate hikes back on the table. A more hawkish Fed limits the upside in gold and sends Treasury yields higher. In fact, we find that the 10-year Treasury yield only starts to rise when the CRB index outpaces the gold price (Chart 1). The recent jump in the CRB index is a positive sign, but we shouldn’t expect Treasury yields to rise until the CRB/gold ratio heads higher. In the meantime, investors should maintain below-benchmark portfolio duration and initiate positive-carry yield curve trades (see page 10) to boost returns while we wait for the next upward adjustment in yields. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 59 basis points in February, bringing year-to-date excess returns up to +243 bps. The Federal Reserve’s pause opens a window for corporate spreads to tighten during the next few months. We recommend overweight positions in corporate bonds for now, but will be quick to reduce exposure once spreads reach our near-term targets (Chart 2). Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview In last week’s report we published option-adjusted spread targets for each corporate credit tier.1 The targets are based on the median 12-month breakeven spreads during prior periods when the slope of the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.2 Currently, the Aa-rated spread of 59 bps is 3 bps above our target (panel 2). The A-rated spread of 91 bps is 6 bps above our target (panel 3). The Baa-rated spread of 156 bps is 28 bps above our target (panel 4). The Aaa-rated spread is already below our target. We advise investors to avoid the Aaa-rated credit tier. With profit growth poised to moderate during the next few quarters, it is unlikely that gross corporate leverage will continue to decline at its current pace (bottom panel). As such, we will be quick to reduce corporate bond exposure when spreads reach our targets. Renewed Fed hawkishness will be another headwind for corporate bonds in the second half of the year. Chart Chart High-Yield: Overweight High-Yield outperformed the duration-equivalent Treasury index by 175 basis points in February, bringing year-to-date excess returns up to +590 bps. In last week’s report we published near-term spread targets for each high-yield credit tier.3 The targets are based on the median 12-month breakeven spreads seen during periods when the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.4 At present, the Ba-rated option-adjusted spread is 224 bps, 37 bps above our target. The B-rated spread is 376 bps, 81 bps above our target. The Caa-rated spread is 780 bps, 208 bps above our target. Our default-adjusted spread is an alternative measure of high-yield valuation. It represents the excess spread available in the High-Yield index after accounting for expected default losses. It is currently 243 bps, very close to the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast during the next 12 months, high-yield bonds will return 243 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview The Moody’s baseline forecast calls for a default rate of 2.4% during the next 12 months. This appears a touch too optimistic, as our own macro model is calling for a default rate closer to 3.5%.5 In either case, junk bonds currently offer adequate compensation for default risk. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in February, bringing year-to-date excess returns up to +39 bps. The conventional 30-year zero-volatility spread tightened 2 bps on the month, driven by a 5 bps decline in the compensation for prepayment risk (option cost). The fall in option cost was partially offset by a 3 bps widening in the option-adjusted spread (OAS). The recent drop in the 30-year mortgage rate led to a jump in mortgage refinancings from historically low levels, putting some temporary upward pressure on MBS spreads (Chart 4). However, the relatively tepid pace of new issuance during the past few years means that the existing MBS stock is not very exposed to refinancing risk, even if mortgage rates fall further. All in all, we view agency MBS as one of the safest spread products in the current macro environment. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The problem with MBS is that valuation remains unattractive. The index option-adjusted spread for conventional 30-year MBS is well below its average pre-crisis level (panel 3) and the sector offers less compensation than normal compared to corporate bonds (panel 4). We continue to recommend a neutral allocation to agency MBS. An upgrade will only be appropriate when value in the corporate sector is no longer attractive relative to expected default risk. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 38 basis points in February, bringing year-to-date excess returns up to +92 bps. Sovereign debt outperformed duration-equivalent Treasuries by 97 bps on the month, bringing year-to-date excess returns up to +320 bps. Local Authorities outperformed the Treasury benchmark by 54 bps in February, bringing year-to-date excess returns up to +86 bps. Foreign Agencies outperformed by 44 bps in February, bringing year-to-date excess returns up to +109 bps, while Domestic Agencies outperformed by 12 bps on the month, bringing year-to-date excess returns up to +9 bps. Supranationals outperformed by 10 bps in February, bringing year-to-date excess returns up to +13 bps. The USD-denominated sovereign debt of most countries continues to look expensive relative to equivalently-rated U.S. corporate credit. However, in a recent report we highlighted that Mexican sovereign debt is an exception (Chart 5).6 Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Not only is Mexican sovereign debt cheap relative to U.S. corporate credit, but our Emerging Markets Strategy service highlights that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs.7 This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite real interest rates being much higher in Mexico than in the U.S. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 85 basis points in February, bringing year-to-date excess returns up to +92 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 5% in February, and currently sits at 81% (Chart 6). This is more than one standard deviation below its post-crisis mean and right at the average level that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview In other words, municipal bonds on average are no longer cheap. Rather, they appear fairly valued compared to similar prior macro environments. But a pure focus on the average yield ratio across the curve hides an important distinction. The yield ratio for short maturities (2-year and 5-year) is very low relative to history, while the yield ratio for long maturities (10-year, 20-year and 30-year) remains quite cheap (panel 2). Investors should continue to focus on long-maturity municipal debt to add yield to U.S. bond portfolios. In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of +3 bps. In contrast, municipal bonds have delivered annualized excess returns of +64 bps (before adjusting for the tax advantage).8 Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields rose in February, led by the long-end of the curve. The 2/10 Treasury slope steepened 3 bps on the month and currently sits at 21 bps. The 5/30 slope steepened 1 bp on the month and currently sits at 57 bps. Our 12-month fed funds discounter remains below zero, meaning that the market is priced for rate cuts during the next year (Chart 7). We continue to view rate hikes as more likely than cuts on this time horizon, and therefore recommend yield curve trades that will profit from a move higher in our discounter. In prior research we found that the 5-year and 7-year Treasury maturities are most sensitive to changes in our discounter, so any trade where you sell the 5-year or 7-year bullet and buy a duration-matched barbell consisting of the long and short ends of the curve will provide the appropriate exposure.9 Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview An added benefit of implementing a barbell over bullet strategy in the current environment is that barbells currently offer higher yields than bullets, meaning that you earn positive carry as you wait for the market to price rate hikes back into the curve (bottom 2 panels).10 Not surprisingly, barbell strategies also look attractively valued on our yield curve models, the output of which is found in Appendix B. TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 36 basis points in February, bringing year-to-date excess returns up to +120 bps. The 10-year TIPS breakeven inflation rate rose 11 bps on the month and currently sits at 1.96%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps on the month and currently sits at 2.07%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. After last month’s increase, the 10-year TIPS breakeven inflation rate is currently very close to the fair value reading from our Adaptive Expectations model (Chart 8).11 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ inflation expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value will trend steadily higher as long as core CPI inflation remains above 1.84%. The 1.84% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in the model. Chart 8Inflation Compensation Inflation Compensation Inflation Compensation On that note, core CPI has increased at an annual rate of 2.58% during the past four months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 3), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Cut To Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in February, bringing year-to-date excess returns up to +38 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 8 bps on the month and currently sits at 31 bps, 3 bps below its pre-crisis low (Chart 9). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Our excess return Bond Map, shown in Appendix C on page 18, shows that Aaa-rated ABS offer a relatively poor risk/reward trade-off compared to other U.S. bond sectors. Aaa-rated auto loan ABS in particular offer greater risk and lower potential return than the Aggregate Plus index (the Bloomberg Barclays Aggregate index plus high-yield).  Tight spreads look even more unattractive when you consider that the delinquency rate for consumer credit is rising, and according to the uptrend in household interest expense, will continue to march higher in the coming quarters (panel 4). Lending standards are also tightening for both credit cards and auto loans, a dynamic that often coincides with a rising delinquency rate and wider ABS spreads (bottom panel). Given the recent spread tightening, we advise investors to reduce consumer ABS exposure in U.S. bond portfolios. Other sectors, such as Agency CMBS, offer a more attractive risk/reward trade-off within high-rated spread product. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in February, bringing year-to-date excess returns up to +142 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 13 bps on the month and currently sits at 93 bps, below the average pre-crisis level but somewhat higher than the recent tights (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (bottom 2 panels). This, coupled with decelerating CRE prices paints a relatively negative picture for non-agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Teasury index by 49 basis points in February, bringing year-to-date excess returns up to +77 bps. The index option-adjusted spread tightened 8 bps on the month and currently sits at 48 bps. The excess return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. 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. At present, the market is priced for 2 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the change in the fed funds rate. 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. 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 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. 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 +55 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 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of February 28, 2019) The Sequence Of Reflation The Sequence Of Reflation Table 5Butterfly Strategy Valuation: Standardized Residuals (As of February 28, 2019) The Sequence Of Reflation The Sequence Of Reflation Table 6Discounted Slope Change During Next 6 Months (BPs) The Sequence Of Reflation The Sequence Of Reflation 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, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 9  Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018 available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Fed: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again in the second half of this year. The best way to position for the resumption of rate hikes is to sell the 5-year or 7-year part of the Treasury curve and buy a duration-matched barbell consisting of the short and long ends of the curve. These sorts of positions currently offer positive carry, meaning you get paid as you wait for the market to price rate hikes back in. Corporate Spreads: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economy: Tracking estimates for 2018 Q4 and 2019 Q1 real GDP have fallen significantly during the past two weeks. The decline in tracking estimates is heavily influenced by an abnormal December retail sales report. That impact will reverse in 2019. Feature The Federal Reserve’s “on hold” strategy is now well known and has been completely discounted in the market. In fact, the overnight index swap curve is priced for 9 bps of rate cuts during the next 12 months and 21 bps of cuts during the next 24 months (Chart 1). Chart 1Primary Dealers Still Looking For Hikes Primary Dealers Still Looking For Hikes Primary Dealers Still Looking For Hikes At this point, the only thing that’s unclear is how the Fed will respond to the economic data going forward. Will it be eager to re-start rate hikes at the first sign of calm? Or perhaps the Fed is leaning toward a strategy where the next move will be a rate cut in the face of flagging economic growth? Survey Says Unfortunately, last month’s FOMC meeting was not accompanied by an updated Summary of Economic Projections. We therefore don’t know how policymakers have revised their rate hike expectations since December. However, the New York Fed’s Survey of Primary Dealers was updated in January, and it shows that the median primary dealer still expects two rate hikes this year. The only change between the December and January surveys is that the median primary dealer now expects one of the 2019 rate hikes in June and the other in December. In the December survey, both 2019 rate hikes were anticipated before the end of June (Chart 1). Typically, the median primary dealer and the median FOMC participant have very similar views on the future interest rate trajectory. Counting The Minutes The next stop on our search for clarity is the minutes from the January FOMC meeting, which were released last week. The January minutes provide a lot of insight into the thought processes of different FOMC participants. Unfortunately, they also reveal a serious lack of cohesion amongst the group. All in all, the document might confuse more than it clarifies. A few key excerpts from the document drive this point home. Referring to “global economic and financial developments”: Many participants observed that if uncertainty abated, the Committee would need to reassess the characterization of monetary policy as “patient” and might then use different language. This suggests that many Fed participants view the pause in rate hikes as a result of slower non-U.S. growth and tighter financial conditions. They also suggest that if global growth improves and financial conditions ease it would be appropriate to abandon a “patient” stance. … several […] participants argued that rate increases might prove necessary only if inflation outcomes were higher than in their baseline outlook. This second statement is much more dovish than the first. It suggests that several participants think that even improving global growth and an easing of financial conditions would not be sufficient to re-start rate hikes. They would also need to see inflation come in stronger than expected. Several other participants indicated that, if the economy evolved as they expected, they would view it as appropriate to raise the target range for the federal funds rate later this year. Finally, this last statement reveals that several other participants disagree with the view that an unexpected rise in inflation is a pre-condition for further rate hikes. What can we make of all this mess? The first thing that seems clear is that all Fed members view easier financial conditions as a pre-condition for further rate hikes. In this regard, we are already well on our way. Financial conditions have eased considerably since the start of the year, with the stock-to-bond total return ratio up sharply and credit spreads, the VIX and the dollar all off their highs (Chart 2). Chart 2Financial Conditions Are Easing Financial Conditions Are Easing Financial Conditions Are Easing Second, all FOMC participants need more confidence that inflation will return to target before re-starting rate hikes, but this bar seems higher for some than for others. Year-over-year core and trimmed mean CPI are currently running at 2.15% and 2.19%, respectively. This is slightly below the 2.4% level that is consistent with the Fed’s inflation target (Chart 3).1 The minutes suggest that some FOMC participants would be comfortable re-starting rate hikes as long as core inflation moves higher in the next few months and approaches the Fed’s target from below. Some others, however, may need to see an overshoot of the Fed’s inflation target before recommending rate hikes. Chart 3Core Inflation Needs To Move Higher Core Inflation Needs To Move Higher Core Inflation Needs To Move Higher Depressed inflation expectations, as seen in the TIPS market or the Michigan Consumer Sentiment survey, are a related issue (Chart 3, bottom 2 panels). The Fed will probably want to see upward movement in both of these measures before resuming rate hikes. In fact, New York Fed President John Williams warned last week that the “persistent undershoot of the Fed’s [inflation] target risks undermining the 2 percent inflation anchor.” He added that “the risk of the inflation expectations anchor slipping toward shore calls for a reassessment of the dominant inflation targeting framework.”2 Williams has long been an advocate for a monetary policy framework where the Fed targets an overshoot of its inflation target in the future to “make up” for undershooting its target in the past, i.e. some form of price level targeting. The Fed is currently conducting a year-long investigation into whether it should switch to this sort of regime and we learned last week that the Fed will announce the results of its investigation in the first half of 2020. Our own sense is that the Fed will eventually adopt some sort of “history dependent” inflation target as a way to avoid continuously bumping up against the zero-lower bound on interest rates. But this change will not occur this year and maybe not even next year. Of course, the more immediate concern for bond investors is whether inflation pressures will be meaningful enough in the next few months for the Fed to resume rate hikes in 2019. We expect they will be. We have previously shown that base effects alone will pressure year-over-year core CPI higher as we head toward mid-year.3 Meanwhile, other signs also point toward rising core inflation (Chart 4): Chart 4Inflation Pressures Building Inflation Pressures Building Inflation Pressures Building The New York Fed’s Underlying Inflation Gauge is running close to 3% (Chart 4, top panel). The ISM Manufacturing PMI is off its highs, but is still consistent with rising year-over-year core CPI (Chart 4, panel 2). Our CPI Diffusion Index is deep in positive territory, pointing to further near-term upside in the core measure (Chart 4, bottom panel). Bottom Line: With financial conditions easing and core inflation more likely to rise than fall, the majority of Fed officials will feel justified lifting rates again this year. January’s FOMC minutes imply that several Fed members want to see an overshoot of the inflation target before advocating for the resumption of rate hikes, but until the Fed changes its inflation targeting regime they will likely be out-voted. The Best Way To Trade The Fed We continue to recommend a below-benchmark duration bias in U.S. bond portfolios, on the view that rate hikes will exceed depressed market expectations on a 12-month horizon. However, this is not the most attractive way to position for the resumption of Fed rate hikes. The best way to trade the Fed in the current environment is by initiating a duration-neutral yield curve trade where you buy a barbell consisting of the long and short ends of the curve, and sell the 5-year or 7-year maturity. In a prior report we demonstrated that the 5-year and 7-year Treasury yields are most sensitive to changes in our 12-month fed funds discounter.4 That is, when the market starts to price-in more Fed rate hikes, the 5-year and 7-year Treasury yields increase more than other maturities. Similarly, the 5-year and 7-year yields fall the most when our discounter declines. Clearly, this means that if you are short the 5-year/7-year part of the curve versus the wings, you will make money as rate hikes are priced back into the market. Usually the problem with implementing such a trade is that it has negative carry. That is, the 5-year or 7-year bullet typically offers a greater yield than what you would earn on a duration-matched 2/10 or 2/30 barbell. If you don’t time the trade properly, you end up losing money waiting for Fed rate hike expectations to move. However, this is not a problem at the moment. In fact, duration-matched barbells are now positive carry propositions relative to 5-year and 7-year bullets (Chart 5). Chart 5 Barbell Yields Greater Than Bullet Yields Barbell Yields Greater Than Bullet Yields Barbell Yields Greater Than Bullet Yields In other words, if you think rate hikes will resume at some point, you are currently getting paid to wait for the market to catch on. The only way to lose money in this sort of trade is if our 12-month fed funds discounter falls further from its current -9 bps level. We view that as an unlikely scenario. Bottom Line: The best way to position for the resumption of Fed rate hikes is to sell the 5-year or 7-year part of the Treasury curve, and buy a barbell consisting of the long and short ends of the curve. We currently recommend being short the 7-year and long the 2/30 barbell. This trade has positive carry, meaning that you will earn money as you wait for rate hikes to get priced back in.  Corporate Spread Targets As we have discussed in prior reports, we think the Fed’s pause opens up a window where corporate bond spreads have room to tighten during the next few months.5 However, we also acknowledge that the window for outperformance is limited. Once financial conditions ease and the Fed resumes rate hikes, the environment will quickly become more difficult for corporate bonds. For this reason, in last week’s report we presented Chart 6. The diamonds in Chart 6 show where corporate 12-month breakeven spreads are today relative to past “Phase 2” periods, which are environments similar to today when the yield curve is quite flat but still positively sloped.6 We argued that we would be quick to reduce corporate bond exposure when the breakeven spreads reach the historical median for Phase 2 periods, i.e. when the diamonds fall to the 50% line in Chart 6. Chart 6 However, we acknowledge that this is not a helpful guide for investors who don’t have timely access to our valuation metrics. So this week we present Charts 7A and 7B. These charts estimate the option-adjusted spread (OAS) levels for each credit tier of the Bloomberg Barclays corporate bond indexes that would be consistent with the 50% line in Chart 6. To make these estimates we need to assume that the average duration of each index remains constant. The results show the following spread targets: For Aa we target 55 bps. The current OAS is 61 bps. For A we target 84 bps. The current OAS is 94 bps. For Baa we target 128 bps. The current OAS is 161 bps. For Ba we target 186 bps. The current OAS is 236 bps. For B we target 298 bps. The current OAS is 391 bps. For Caa we target 571 bps. The current OAS is 813 bps. We do not recommend an overweight allocation to Aaa-rated corporate bonds, where spreads are already expensive relative to past Phase 2 periods (Chart 7A, top panel). Chart 7aInvestment Grade Spread Targets Investment Grade Spread Targets Investment Grade Spread Targets Chart 7BHigh-Yield Spread Targets High-Yield Spread Targets High-Yield Spread Targets   Bottom Line: Maintain an overweight allocation to corporate bonds (both investment grade and high-yield) with the exception of the Aaa credit tier. But be prepared to reduce exposure when spreads reach our target levels. Economic Update We will finally receive GDP data for the fourth quarter of 2018 on Thursday, and investors should ready themselves for a weak number. In fact, the most recent tracking estimates from the New York Fed have real GDP coming in at 2.35% in Q4 and a mere 1.20% in 2019 Q1 (Chart 8). Chart 8Poor GDP Tracking Estimates ... Poor GDP Tracking Estimates ... Poor GDP Tracking Estimates ... It will come as no surprise that the trend in GDP growth is vital to our interest rate call. In fact, we showed in a recent report that when year-over-year nominal GDP growth falls below the 10-year Treasury yield it is often a good signal that monetary policy has turned restrictive and that interest rates have peaked for the cycle.7 With that in mind, if we add 1.2% expected real growth in Q1 to the 1.7% average growth rate of the GDP deflator (Chart 8, bottom panel), we can roughly estimate nominal GDP growth of 2.9% in Q1. This remains above the current 10-year Treasury yield, suggesting that monetary conditions would still be accommodative, but just barely. However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York Fed’s model, the weak December retail sales report trimmed 0.41% from its Q1 growth forecast and this report increasingly looks like an aberration. In contrast to the retail sales number, the Johnson Redbook index of same-store sales is growing at a rate close to 5%, and indexes of consumer confidence remain elevated (Chart 9). Chart 9...Driven By Abnormal Retail Sales ...Driven By Abnormal Retail Sales ...Driven By Abnormal Retail Sales Even the Fed staff’s economic report, as presented in the January FOMC minutes, suggests that December should have been a good month for consumer spending: The release of the retail sales report for December was delayed, but available indicators – such as credit card and debit card transaction data and light motor vehicle sales – suggested that household spending growth remained strong in December. Bottom Line: However, we expect the Q1 tracking forecast to improve as new data come in. According to the New York it seems likely that the partial government shutdown influenced the collection of the December retail sales data and led to an abnormal print. Since the retail sales data feed directly into GDP, the impact will be felt in the next GDP report. But the impact will prove fleeting.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 The Fed’s target is for 2% PCE inflation. CPI tends to run about 0.4% above PCE. 12-month core PCE is currently 1.88%, but data only go to November. This is why we refer to CPI in this report, which has data through January. 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190222 3 Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 For more detail on the different phases of the economic cycle please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Spread Product Valuation: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Corporate Defaults: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Mexican Sovereign Bonds: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Feature Corporate bonds have been on fire since the start of the year. High-yield excess returns have already made back all of their lost ground from 2018, and investment grade credits are on their way (Chart 1). With the Fed’s rate hike cycle on hold and some signs of credit easing in China, the near-term backdrop is amenable to further spread compression. Especially from current elevated levels. Chart 1Corporate Bonds Having A Good Run In 2019 Corporate Bonds Having A Good Run In 2019 Corporate Bonds Having A Good Run In 2019 On the flipside, some indicators of corporate default risk are starting to deteriorate and we can easily envision a more difficult environment for corporate spreads in the second half of this year. Especially if the Fed re-starts rate hikes, as we expect.1 In this week’s report we illustrate the extent of undervaluation in corporate spreads, and also detail our concerns related to budding default risk. We conclude that investors should maintain an overweight allocation to corporate bonds (both investment grade and high-yield) for now, but be prepared to trim exposure once spreads reach more reasonable levels. Finally, we identify an opportunity in USD-denominated Mexican sovereign bonds. Too Cheap For Phase 2 In our Special Report from mid-December that laid out our key themes for 2019, we described how we split the economic cycle into different phases based on the slope of the yield curve (Chart 2).2 We define the three phases of the cycle as follows: Chart 2Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Phase 1: From the end of the prior recession until the 3-year / 10-year Treasury slope flattens to below 50 bps Phase 2: When the 3/10 slope is between 0 bps and 50 bps Phase 3: From when the 3/10 slope inverts until the start of the next recession Dividing the cycle this way reveals a reliable pattern in corporate bond excess returns versus Treasuries. Excess returns tend to be highest in Phase 1. They tend to be quite low but still positive in Phase 2, and they tend not to turn negative until Phase 3. We argued in December that we are currently in Phase 2 and that we will probably stay there for most, if not all, of 2019. The main reason that excess returns are lower in Phase 2 than in Phase 1 is that corporate bond spreads are much tighter in Phase 2. Most of the cyclical spread compression occurs in Phase 1, in the immediate aftermath of the recession. With that in mind, consider the data presented in Chart 3. The chart shows 12-month breakeven spreads for each corporate bond credit tier as a percentile rank relative to history.3 For example, a percentile rank of 50% means that the breakeven spread has been tighter than its current level half of the time throughout history. Chart 3 also divides the historical data into two samples, showing how breakeven spreads rank relative to the entire history of available data, and also how they rank relative to other Phase 2 periods only. Chart 3 When the full historical sample is considered, only the B-rated and Caa-rated credit tiers have breakeven spreads above their historical medians. However, when we focus exclusively on Phase 2 environments we see that spreads for every credit tier other than Aaa look extremely cheap. Essentially, Chart 3 shows that today’s spread levels are more consistent with periods when the economy is either just exiting or entering a recession. Absent that sort of macro environment, there would appear to be an obvious buying opportunity in corporate bonds. Interestingly, other spread products don’t look nearly as cheap as corporate bonds. Chart 4 shows the same data as Chart 3 but for all non-corporate U.S. spread products with available data prior to 2000. It shows that Agency MBS and Consumer ABS spreads are close to median Phase 2 levels. USD-denominated Sovereign debt looks somewhat cheap. Meanwhile, Domestic Agencies and Supranationals both look expensive. What’s clear is that right now corporate credit offers the most attractive opportunity in U.S. fixed income. Chart 4 Bottom Line: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Default Cycle At A Turning Point?  Another valuation tool in our arsenal is the High-Yield default-adjusted spread. This is the excess spread available in the high-yield index after accounting for expected 12-month default losses. It can also be thought of as the 12-month return earned by the High-Yield index in excess of a position in duration-matched Treasuries, assuming that default losses match expectations and that there are no capital gains (losses) from spread tightening (widening). Expected default losses are calculated using the Moody’s baseline default rate forecast and our own forecast of the recovery rate. Combining the Moody’s baseline default rate forecast of 2.4% and our recovery rate forecast of 45% gives expected 12-month default losses of 1.3%. Those expected default losses are then subtracted from the average High-Yield index option-adjusted spread to get a default-adjusted spread of 274 bps. This is slightly above the historical average of 250 bps (Chart 5). In other words, junk investors are currently being compensated at slightly above average levels to bear default risk. Chart 5A Look At The Default-Adjusted Spread A Look At The Default-Adjusted Spread A Look At The Default-Adjusted Spread Another way to conceptualize the default-adjusted spread is to ask what default rate would have to prevail over the next 12 months for junk investors to earn average historical excess compensation. This spread-implied default rate is denoted by the ‘X’ in the second panel of Chart 5. It is currently 2.8%, slightly above Moody’s baseline expectation. Is The Baseline Default Rate Forecast Reasonable? If we view the Moody’s 2.4% default rate forecast as reasonable, then we should conclude that junk bonds are attractively valued. However, some macro indicators suggest that 2.4% might be too optimistic. Chart 6 shows a model of the 12-month trailing speculative grade default rate based on gross leverage, which we define as total debt over pre-tax profits, and C&I lending standards. Chart 6A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate Gross leverage has improved during the past few quarters as profit growth has outpaced corporate debt growth (Chart 6, panel 2). This has acted to push down the fair value reading from our default rate model. On the other hand, commercial & industrial (C&I) lending standards tightened in the fourth quarter of last year (Chart 6, bottom panel). A net tightening in C&I lending standards is consistent with a higher default rate. Overall, the fair value reading from our default rate model is currently 3.5%, above the current 12-month trailing default rate of 2.6%. For the purposes of valuation, where the default rate will be 12 months from now is more important than where it is currently. To get a sense of where the fair value from our model is headed we need forecasts for corporate profit and debt growth. Profit growth will almost certainly moderate from its current lofty levels (Chart 7). Pressures on revenues and expenses both point in that direction. Total business sales and the ISM Manufacturing PMI have both fallen sharply from their recent highs (Chart 7, panel 2), suggesting lower corporate revenue growth going forward. Meanwhile, wages continue to accelerate (Chart 7, bottom panel). Chart 7Forecasting Profit Growth Forecasting Profit Growth Forecasting Profit Growth Using a model based on nominal GDP growth, wage growth, industrial production and the trade-weighted dollar, if we forecast that nominal GDP growth slows to the same rate as wage growth over the next 12 months, then the model predicts that profit growth will fall into the mid-single digits (Chart 7, top panel). This would be more or less consistent with the recent growth rate in corporate debt, meaning that gross leverage would flatten-off and the fair value reading from our default rate model would stabilize near 3.5%. In summary, if profit growth moderates in line with our expectations during the next 12 months, then it is likely that the corporate default rate will be somewhat higher than the current Moody’s forecast of 2.4%, possibly as high as 3.5%. But even a 3.5% default rate would still translate to a default-adjusted junk spread of 211 bps. Positive compensation for default risk, though less than average historical levels. In that case we would still expect solid positive excess returns from junk bonds. However, it will be important to monitor our default-adjusted spread during the next few months. If junk spreads tighten in the near-term, as we anticipate, then the excess compensation for default risk will evaporate quickly. Bottom Line: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Buy Mexican Bonds While most spread products have benefited from the Fed’s pause, delivering excellent year-to-date returns. We notice that the spreads on Mexico’s USD-denominated sovereign debt have not tightened alongside other comparable credits (Chart 8). This presents an attractive opportunity. Chart 8Mexican Bonds: An Attractive Opportunity Mexican Bonds: An Attractive Opportunity Mexican Bonds: An Attractive Opportunity When we compare 12-month breakeven spreads between the USD-denominated sovereign debt of different emerging market countries versus the spreads on equivalently-rated U.S. corporate bonds, we see that Mexico has now joined Argentina, Saudi Arabia, Qatar, UAE and Poland as the only countries that offer attractive compensation relative to the U.S. corporate sector (Chart 9). Chart 9 Why has this happened? Our Emerging Markets Strategy service postulates that many investors fear that the new political regime will bring fiscal profligacy, but in fact, the AMLO administration is proving to be less populist and more pragmatic than expected.4 The 2019 budget, for example, targets a primary surplus of 1% of GDP, and envisages a decline in nominal expenditures in 29 out of 56 categories. This commitment to sound fiscal policy should benefit Mexican sovereign bond spreads. More fundamentally, our Emerging Markets strategists note that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs. This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite interest rates being much higher in Mexico than in the U.S. The Mexican 10-year real yield is currently 4.1%, well above real GDP growth which was 2.6% during the past four quarters (Chart 10). Contrast that with the U.S., where the 10-year real yield is a meagre 0.8% versus real GDP growth of 3% during the past four quarters. In other words, interest rate differentials favor a stronger peso, which is positive for USD-denominated sovereign spreads. Chart 10Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Though the Mexican/U.S. interest rate differential remains wide, it is likely to compress going forward. Elevated Mexican interest rates relative to growth signal that monetary policy is restrictive. A fact that is already evident in decelerating Mexican money supply (Chart 10, bottom panel). Meanwhile, low U.S. real yields relative to GDP suggest that further Fed tightening is necessary before U.S. rates are similarly restrictive. Bottom Line: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 2      Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3      The 12-month breakeven spread is the spread widening required over the next 12 months for the corporate bond to break even with a duration-matched position in Treasury securities. We use the breakeven spread instead of the average index spread because it takes into account the changing duration of the bond indexes. 4      Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1Look For Rate Hikes In H2 2019 Look For Rate Hikes In H2 2019 Look For Rate Hikes In H2 2019 First things first: The Fed’s rate hike cycle is not over. Last week’s FOMC statement told us that the Fed will be “patient” and Chairman Powell cited slower global growth and tighter financial conditions as reasons to keep the funds rate steady. However, both of those reasons could soon evaporate. With the market now priced for 8 bps of rate cuts during the next 12 months and the dollar off its highs, there is scope for financial conditions to ease and global growth to improve in the first half of the year. According to our Fed Monitor, only tight financial conditions warrant a pause in rate hikes (Chart 1). The economic growth and inflation components of our Monitor (not shown) continue to recommend a tighter policy stance. The message is that if risk assets rally during the next six months causing financial conditions to ease, then all else equal, the Fed will have the green light to re-start rate hikes in the second half of the year. Investors should maintain below-benchmark duration in U.S. bond portfolios. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 183 basis points in January. The index option-adjusted spread tightened 25 bps on the month and currently sits at 127 bps. We upgraded our recommended allocation to corporate bonds three weeks ago because spreads had become too wide given the current phase of the credit cycle.1 Presently, we observe that the 12-month breakeven spread for Baa-rated corporate bonds has been tighter 43% of the time since 1989 (Chart 2). In the phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps, corporate breakeven spreads are typically in the lower third of their distributions.2 Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Baa-rated bonds currently offer better value than higher-rated credits. The 12-month breakeven spread for A-rated debt has been tighter 29% of the time since 1989 (panel 2). Aa and Aaa-rated credits clock in at 25% and 4%, respectively. With the Fed in a holding pattern, we are comfortable taking credit risk for the next six months and recommend that investors move down in quality to capture the extra return. The Fed’s Q4 Senior Loan Officer Survey, released yesterday, showed that a net 3% of banks reported tightening lending standards on C&I loans. Tighter lending standards correlate with higher defaults and wider spreads, so this tentative development bears close monitoring going forward. Chart   Chart High-Yield: Overweight High-yield outperformed the duration-equivalent Treasury index by 408 basis points in January. The index option-adjusted spread tightened 103 bps, and currently sits at 416 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 224 bps, slightly below the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 224 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Moody’s revised its baseline 12-month default rate forecast higher last month, from 2.6% to 3.4%, and as was discussed in last week’s report, the revised forecast looks reasonable given our economic outlook.3 Specifically, our measure of nonfinancial corporate sector gross leverage – calculated as total debt over pre-tax profits – is roughly consistent with a 4% default rate. This leverage measure improved rapidly during the past year, but should start to stabilize during the next few quarters as profit growth decelerates. All in all, baseline default rate expectations have moved higher in recent months, but junk spreads still offer adequate compensation for that risk. In fact, if we assume excess compensation equal to the historical average, then junk spreads embed an expected default rate of 3% (panel 4), not far from the Moody’s base case. While junk spreads offer adequate compensation given our 12-month default outlook, the near-term outlook for excess returns is somewhat brighter as the Fed’s dovish turn should lead to spread compression during the next few months. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The conventional 30-year zero-volatility spread tightened 3 bps on the month, driven by a 3 bps decline in the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The drop in the 30-year mortgage rate to 4.46%, from 4.94% in November, led to a sharp spike in mortgage refinancings. However, refi activity remains very low relative to history (Chart 4). With the longer-run uptrend in mortgage rates still intact, the recent spike in refinancings is bound to reverse in the coming months. This will keep MBS spreads capped near historically low levels. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Outside of refi activity, MBS spreads are also influenced by changes in mortgage lending standards. The Federal Reserve’s Senior Loan Officer Survey showed no change in residential mortgage lending standards in Q4 2018 (bottom panel), while reported mortgage demand took a significant dip. Periods of tightening lending standards tend to coincide with MBS spread widening, but faced with weaker demand banks are much more likely to ease standards going forward. This is particularly true because very little progress has been made easing lending standards since the financial crisis. The median FICO score for new mortgages peaked at 781 in Q1 2011, but had only fallen to 758 as of Q3 2018. With relatively little risk of spread widening we are comfortable with a neutral allocation to Agency MBS, though tight spreads make the sector less appealing than corporate bonds from a return perspective. Later in the cycle, when the risk of corporate spread widening is more pronounced, MBS will likely warrant an upgrade. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 53 basis points in January. Sovereign debt led the way, outperforming the Treasury benchmark by 221 bps. Foreign Agencies outperformed by 65 bps, Local Authorities outperformed by 32 bps, and Supranationals outperformed by 3 bps. Domestic Agency bonds were the sole laggard, underperforming Treasuries by 3 bps on the month. The Fed’s pause and the accompanying weakness in the dollar spurred last month’s outperformance of USD-denominated Sovereign debt. But given the current attractiveness of U.S. corporate credit, we are not eager to chase the outperformance in Sovereigns. The option-adjusted spread advantage in Baa-rated U.S. corporate credit relative to the Sovereign index is as wide as it was in mid-2016 (Chart 5), a period when corporate bonds outperformed Sovereigns by a significant margin. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview At the country level, our analysis of USD-denominated Emerging Market Sovereign spreads shows that only Argentina, Mexico, Saudi Arabia, Qatar, UAE and Poland offer excess spread compared to equivalently-rated U.S. corporates.4 We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 7 basis points in January (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 2% in January, and currently sits at 84% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of -14 bps. In contrast, municipal bonds have delivered annualized excess returns of +47 bps (before adjusting for the tax advantage).5  Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Long maturity municipal debt continues to offer a substantial yield advantage relative to the short-end of the curve. For example, a muni investor needs an effective tax rate of 35% to equalize the after-tax yields between a 5-year Aa-rated municipal bond and the equivalent-duration U.S. credit index. For a 20-year muni the same breakeven tax rate is between 10% and 17%. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields declined in January, with the 5-year and 7-year maturities falling more than the short and long ends of the curve. The 2/10 slope flattened 3 bps on the month, from 21 bps to 18 bps. The 5/30 slope steepened 5 bps on the month, from 51 bps to 56 bps. In a recent report we looked at the correlations between different yield curve slopes and our 12-month Fed Funds Discounter.6 We found that the 5-year and 7-year maturities are most sensitive to changes in the discounter, while the short and long ends of the curve tend to be more stable. In other words, a decline in our 12-month discounter, like the one seen during the past two months (Chart 7), will tend to flatten the curve out to the 5-year/7-year maturity point and steepen the curve beyond that point. An increase in the discounter has the opposite effect. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview We expect the market to price some Fed rate hikes back into the curve as financial conditions ease during the next few months. Based on that view, we recommend adopting a yield curve strategy that benefits from a rise in our 12-month discounter. A position short the 7-year bullet and long a duration-matched 2/30 barbell provides the appropriate exposure and is attractively valued by our yield curve models (panel 4).7 TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 84 basis points in January. The 10-year TIPS breakeven inflation rate rose 14 bps on the month, and currently sits at 1.88%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps, and currently sits at 2.04%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. The 10-year TIPS breakeven inflation rate also remains below the fair value reading from our Adaptive Expectations Model (Chart 8).8 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value reading will trend steadily higher as long as core CPI inflation remains above 1.83%. The 1.83% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in our model.   Chart 8Inflation Compensation Inflation Compensation Inflation Compensation On that note, core CPI has increased at an annual rate of 2.48% during the past 3 months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 4), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Asset-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 8 bps on the month, and currently sits at 40 bps, 6 bps above its pre-crisis low. The Excess Return Bond Map in Appendix C shows that consumer ABS offer greater expected return than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The Fed's Senior Loan Officer Survey for Q4 2018 showed that banks tightened lending standards slightly for both credit cards and auto loans. This is consistent with a continued gradual uptrend in consumer credit delinquencies (Chart 9). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Rising household interest expense further confirms that the consumer credit delinquency rate is biased higher, albeit from a low starting point (panel 4). All in all, ABS still offer a reasonable risk/reward trade-off but could warrant a downgrade in the coming quarters as credit quality worsens. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 67 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 11 bps on the month and currently sits at 105 bps. The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (Chart 10). This is a typical negative environment for CMBS spreads. Decelerating CRE prices are also a cause for concern (panel 3). Investors should maintain an underweight allocation to non-Agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The index option-adjusted spread tightened 4 bps on the month and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview 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 8 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. 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 yield curve. The models are explained in detail in the following two Special Reports: 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 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of January 31, 2019) On Pause But Not Forgotten On Pause But Not Forgotten   Table 5Butterfly Strategy Valuation: Standardized Residuals (As of January 31, 2019) On Pause But Not Forgotten On Pause But Not Forgotten   Table 6Discounted Slope Change During Next 6 Months (BPs) On Pause But Not Forgotten On Pause But Not Forgotten 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, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 2 For further details on how we divide the credit cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearh 6 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 7 The output from all of our yield curve models is shown in Appendix B of this report. 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations Monthly Portfolio Update Monthly Portfolio Update True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? How Worrying Is The U.S. Slowdown? How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive U.S. Data Surprisingly Positive U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize Housing Market Should Stabilize Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming Consumption Booming Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 5 Chart 6Tighter Conditions Mean More Cautious Fed Tighter Conditions Mean More Cautious Fed Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Trump Won't Be Reelected In A Recession Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Analysts Have Overdone Downward Revisions Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Inflation Expectations Should Recover Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Corporate Leverage Is A Concern Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Can ECB Really Hike In 2019? Can ECB Really Hike In 2019? Chart 12 Chart 13...U.S. Loan Growth Accelerating... ...U.S. Loan Growth Accelerating... ...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further ... Which Will Tighten Liquidity Further ... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months.  Chart 15Oil Balance In Deficit This Year Oil Balance In Deficit This Year Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown China Sticking To Credit Crackdown China Sticking To Credit Crackdown   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   GAA Asset Allocation Footnotes 1      Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2      Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3      For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com

Highlights Global equity markets have managed to recoup some of last year’s plunge since we upgraded stocks to overweight in late December. The equity rally has been tentative, however, and so far feels more like a technical bounce from oversold levels than a resumption of the bull market. One driving factor behind last year’s market swoon was that policy uncertainty spiked at a time when the last pillar of global growth, the U.S., was showing signs of cracking. Investors thus welcomed the Fed’s signal that it would pause in March. Nonetheless, shrinkage in the Fed’s balance sheet is proving to be troublesome. Quantitative tightening does not necessarily imply permanently higher risk premia, but it will be a source of volatility. There are hopeful but tentative signs that a U.S. slowdown is not the precursor to a recession. The hit to GDP from the U.S. government shutdown will be reversed next quarter. The FOMC has also signaled that policymakers are attuned to the economic risks associated with tightening financial conditions, and that the calm inflation backdrop provides room to maneuver. The FOMC will stand pat in March, but should restart rate hikes in June as the economic soft patch ends. We still see only a modest risk of a U.S. recession this year. In contrast, our outlook for growth outside the U.S. remains downbeat for at least the first half of the year. Among the advanced economies, Japan and Europe are being the most affected by the Chinese economic slowdown and global trade tensions. This means that monetary policy divergence will continue to be a tailwind for the dollar. China continues to stimulate at the margin, but efforts so far have been insufficient to put a floor under growth. The contraction in Chinese exports has just begun. It is still too early to upgrade EM assets or base metals. Despite the cloud still surrounding Brexit, sterling is beginning to look attractive as a long-term punt. Our decision to upgrade corporate bonds to overweight this month, similar to our reasoning for upgrading equities in December, is based on improved value and a sense that investor pessimism had become excessive. Just as the selloff in risk assets was overdone, so too was the rally in government bonds. It is highly unlikely that the Fed is done tightening, as is currently discounted in the money market curve. A resumption of Fed rate hikes around mid-year means that the 10-year Treasury yield will move back above 3% by year end. Feature Global equity markets have managed to recoup some of last year’s plunge since we upgraded the asset class back to overweight in the latter half of December. A decline in the VIX and high-yield bond spreads are also positive signs that global risk appetite is recovering, following an overdone investor ‘panic attack’ last quarter. The equity rally has been tentative, however, and so far feels more like a simple technical bounce from oversold levels than a resumption of the bull market. One problem is that policy uncertainty has spiked at a time when the last pillar of global growth, the U.S., is showing signs of cracking (Chart I-1). Investors are skittish while they await a clear de-escalation of U.S./China trade tensions, an end to the U.S. economic soft patch, an end to the U.S. government shutdown, and signs that global growth is bottoming (especially in China). There has only been some modestly positive news on a couple of these issues. Chart I-1Policy Uncertainty Has Spiked Policy Uncertainty Has Spiked Watch Policy Uncertainty Policy Uncertainty Has Spiked Watch Policy Uncertainty Another factor that appeared to play a role in last quarter’s market swoon is the fear that the end of asset purchases by the European Central Bank and the normalization of the Fed’s balance sheet necessarily imply a structural de-rating for all risk assets. A related worry is that the de-rating might intensify the global economic slowdown, resulting in a self-reinforcing negative feedback loop. Does QT Imply Lower Multiples? The question of balance sheet normalization is a difficult one because there is widespread disagreement on how, or even whether, quantitative easing (QE) works. We have always maintained that QE was not about creating a wave of central bank liquidity that flowed into asset prices. Central banks did not “print money” – they created bank reserves. These reserves did not result in a major acceleration in broader measures of money growth, including M1 and M2, largely because there was little demand for loans and because banks tightened lending standards. In other words, the credit channel of monetary policy was broken. The implication is that investors should not worry that quantitative tightening (QT) implies a withdrawal of central bank liquidity that must mechanically come from the sale of risk assets. Rather, we believe that QE operates mostly through the portfolio balance effect. There are two ways to think about this channel. First, the central bank forced investors to move into riskier assets by purchasing large amounts of “safe” assets, such as government bonds. Investors had little choice but to redeploy the capital into other riskier areas, pushing up asset prices. The second perspective is that central bank purchases of government bonds depressed both the yield curve and bond volatility. Volatility fell because investors could forecast the policy rate with certainty – it would be glued to zero (or negative) for the foreseeable future in most of the advanced economies. This is akin to strong forward guidance that flattened the yield curve. Aggressive monetary stimulus, such as QE, also helped to reduce the perceived risk that the economy would succumb to secular stagnation or fall back into recession. Reduced bond volatility, lower bond yields, and less economic risk all increased the attractiveness of the riskier asset classes. These explanations represent two sides of the same coin. Either way, QE boosted a broad array of asset prices. If this is true, then unwinding QE must be bearish for risk assets, all else equal. In the case of the U.S., the fed funds rate is much more difficult to forecast than was the case when the Fed was buying bonds. Higher yields and bond volatility imply a lower equilibrium multiple in the equity market and wider equilibrium corporate bond spreads. Nonetheless, all else is not equal. If interest rates and bond volatility are rising in the context of healthy economic and profit growth, then it is likely that the perceived risk of secular stagnation is falling. It would be a sign that the economy has finally put the financial crisis firmly in the rear-view mirror. It could be the case that the upgrade in economic confidence overwhelms the negative impact of the reverse portfolio balance effect related to quantitative tightening, allowing risk assets to rise. No one can prove this thesis one way or the other and we are not making the case that unwinding the Fed’s balance sheet will necessarily go smoothly, especially since interest rates are rising at the same time. The problem is that both investors and the Fed are trying to figure out where the neutral fed funds rate lies. If the so-called level of R-star is still very low, then the Fed might have already made a policy mistake by raising rates too far. We discussed in last month’s Overview the market implications of four scenarios for the level of R-star and the Fed’s success in correctly guessing it. If the economy holds up and the economic soft patch ends in the coming months as we expect, then investors will revise their estimate of the neutral rate higher and risk assets will rally even as bond yields rise. The Doom Loop One risk to our base-case scenario is the so-called financial conditions “doom loop”. Irrespective of whether or not QT is playing a role, the doom loop scenario involves a shock to investor confidence that leads to a tightening in financial conditions and market liquidity as stock prices fall and credit spreads widen. More onerous financial conditions, in turn, undermine economic activity, which then feeds back into even tighter financial conditions. One could make the argument that risk assets are even more exposed to this type of negative feedback loop today than in past monetary tightening cycles because of program trading, the Fed’s balance sheet shrinkage and investors’ lingering shell shock from the Great Recession and financial crisis. Nonetheless, there are a few mitigating factors to consider. We believe that a doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. On a positive note, unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart I-2). The highly cyclical parts of the U.S. economy are not stretched to the upside as a share of GDP, reducing the risk that overspending in one part of the economy will required a deep contraction to correct the imbalance (Chart I-3). Chart I-2U.S. Private Sector: A New Saver U.S. Private Sector: A New Saver The U.S. Private Sector Is A Net Saver U.S. Private Sector: A New Saver The U.S. Private Sector Is A Net Saver Chart I-3U.S. Cyclical Spending Not Extended U.S. Cyclical Spending Not Extended U.S. Cyclical Spending Not Extended In terms of financial excesses, the good news is that the U.S. household sector is in its best shape in decades. Our main concern is debt accumulation in the corporate sector. We reviewed the related risks in a Special Report published in the November 2018 issue.1 We concluded that corporate leverage will not cause the next U.S. recession, because high levels of debt will only become a problem when profits begin to contract (i.e. when the economic downturn is already underway). Nonetheless, when a recession does occur, corporate spreads will widen by more than in the past for any given degree of economic contraction (see below). ‘Fed Put’ Still In Play Another factor that tempers the risk of a doom loop is that the so-called ‘Fed Put’ is still operating. The December FOMC Minutes and comments by various FOMC members communicated to investors that the Fed is attuned to the economic risks associated with tightening financial conditions, and that the calm inflation backdrop provides policymakers with room to maneuver. Chair Powell even said he was willing to adjust the Fed’s balance sheet run-off if necessary. One important reason for policymakers’ willingness to be flexible is that the fed funds rate is still not far from the zero-lower-bound, making it potentially more difficult for the FOMC to respond adequately in the event of a recession this year because the fed funds rate can only be cut by 250 basis points. Several U.S. data releases have been delayed due the government shutdown, but what has been released has been mixed. The downdraft in the January reading of the manufacturing ISM was eye-opening, highlighting that the global manufacturing slowdown has reached U.S. shores. The good news is that the non-manufacturing ISM and the small business survey, although off their peaks, remain consistent with solid underlying growth. The December U.S. payroll report revealed that wage growth continued to accelerate on the back of gangbusters job creation at the end of the year. There have also been some recent hints that the soft patch in capital spending and housing is ending (Chart I-4). Existing home sales fell sharply in December, but extremely low inventories suggest that it is more of a supply than a demand problem. The impressive bounce in home mortgage applications for purchases is a hopeful sign. U.S. commercial and industrial loan growth is also accelerating. Chart I-4Some Tentative Signs Some Tentative Signs Some Tentative Signs These tentative signs that the economic soft patch is close to an end will not be enough to get the FOMC to tighten in March, after so many members have gone out of their way to signal a pause in recent weeks. Nonetheless, we believe the economy will remain strong enough for the Fed to resume hiking in June. The U.S. government shutdown will complicate interpreting incoming economic data. Ultimately, while its impact on Q1 real GDP growth will be non-trivial, it will be reversed the following quarter and we do not expect any permanent damage to be done. U.S. inflation should edge higher by mid-year, supporting our view that the Fed will resume tightening in June. The decline in oil prices will continue to feed into a lower headline inflation rate in the coming months, but that does not mean that the core rate will fall. Indeed, core CPI has increased by roughly 0.2% in each of the past three months, translating into an annualized rate of approximately 2.4%. Base effects will depress annual core inflation in February but, thereafter, this effect will begin to reverse. The acceleration in wage growth according to measures such as average hourly earnings and the Employment Cost Index highlights that underlying inflationary pressures continue to percolate (Chart I-5). The implication is that the Treasury bond market is overly complacent in discounting that the fed funds rate has peaked for the cycle. Chart I-5U.S. Wage Pressure Is Percolating U.S. Wage Pressure Is Percolating U.S. Wage Pressure Is Percolating Looking further ahead, our base case remains that the next U.S. recession will not occur until 2020, and will be the result of tighter fiscal policy and further Fed tightening that takes short-term rates a step too far. No Bottom Yet For Global Growth Our outlook for growth outside the U.S. remains downbeat for at least the first half of the year. Our global economic indicators still show no sign of a turnaround, except for a bottoming in the diffusion index based on BCA’s Global Leading Economic Indicator (Chart I-6). The global ZEW economic sentiment index continued to fall in January, while business and consumer confidence readings in the advanced economies eroded heading into year end. Chart I-6Global Leading Indicators Still Deteriorating Global Leading Indicators Still Deteriorating Global Growth Is Still Moderating... Global Leading Indicators Still Deteriorating Global Growth Is Still Moderating... A better global growth dynamic awaits more serious policy stimulus in China. Real GDP growth decelerated further to 6.4% year-over-year in the last quarter of 2018. This is no disaster, but the point is that there are still no signs of stabilization. The Chinese authorities continue to tweak the policy dials at the margin, most recently providing some tax cuts and a liquidity injection into the banking system. Nonetheless, the central government has so far abstained from stimulating the property market due to existing speculative excesses. This is very different from the previous two policy easing episodes, including 2015/16 (Chart I-7). Chart I-7China: No Property Market Stimulus... China: No Property Market Stimulus... China: No Property Market Stimulus... The stimulus undertaken so far has been insufficient in terms of putting a floor under growth according to our 12-month Credit Impulse (Chart I-8). It is a hopeful sign that broad money growth is trying to bottom, but this does not guarantee that the credit impulse is about to turn. The latter is required to confirm that Chinese import demand will accelerate, providing a lift to EM exporters, EM asset prices and commodity prices. Without a positive credit impulse, China’s investment and construction activity will continue to moderate, leading to lower imports of machinery and raw materials. Chart I-8...And No Credit Impulse ...And No Credit Impulse ...And No Credit Impulse The economic situation in China is likely to get worse before it gets better. Dismal trade figures in December confirmed that the trade war is beginning to bite. The period of export ‘front-running’ related to higher U.S. tariffs is over as total exports fell by 4.4% year-over-year. Last year’s collapse in export orders indicates that the woes are just beginning. In turn, moderating production related to the Chinese export sector will bleed into domestic consumption and imports, suggesting that it is too early to expect a durable rally in EM assets or commodity prices. Lackluster Chinese demand and growing trade concerns have weighted on global business confidence, contributing to the pullback in capital goods orders, manufacturing PMIs and industrial production in the advanced economies (Chart I-9). Even the average service sector PMI and consumer confidence index in the advanced economies have fallen in recent months, although both remain at a high level. Chart I-9The Fallout From Trade The Fallout From Trade The Fallout From Trade Europe and Japan, in particular, are feeling the pinch. German GDP only grew 1.5% in 2018, implying that Q4 GDP growth was in the vicinity of just 0.2% QoQ. Meanwhile, European industrial production contracted by 3.3% year-over-year in December. The German Ifo and ZEW surveys do not point to any significant improvements in this trend. A few idiosyncratic factors explain some of this poor performance, including new emissions testing standards that have weighted on the German auto industry, a tightening in financial conditions in Italy, and the ‘gilets jaunes’ protests in France. Nonetheless, the euro area slowdown cannot be fully explained by one-off factors. The economy is highly sensitive to global trade fluctuations given that 18% of the euro area’s gross value added is generated in the manufacturing sector. Hence, China’s poor economic health has been painful for Europe, and the trend in Chinese credit does not bode well for the near term (Chart I-10). The European Central Bank (ECB) is likely to stay on the defensive as a result, especially as euro area core inflation, which has been stuck near 1% for three years, is unlikely to pick up if growth remains on the back foot. The ECB stuck with the view that the economic soft patch is temporary after the January policy meeting, but policymakers will consider providing more stimulus in March if the economy does not pick up (using forward guidance or a new TLTRO). This will weigh on the euro. Chart I-10China's Woes Are Infecting Europe China's Woes Are Infecting Europe China's Woes Are Infecting Europe Japan is suffering from similar ills. Exports are no longer growing, and foreign machinery and factory orders are contracting at a 4.1% and 4.3% pace, respectively. This weakness is not mimicked in domestic growth, but the disproportionate contribution of the external sector to Japan’s overall economic health means that this country is also falling victim to the malaise witnessed in China and emerging markets, the destination of 19% and 45% of Japanese shipments, respectively (Chart I-11). Collapsing oil prices and a firming trade-weighted yen have amplified this deflationary backdrop. It is therefore far too early to bet that the Bank of Japan will tighten the monetary dials. Chart I-11Japan Hit By The Chinese Cold As Well Japan Hit By The Chinese Cold As Well Japan Hit By The Chinese Cold As Well If we are correct that the U.S. economic soft patch will soon end, then the dollar will once again look to be the best of a bad lot. Interest rate expectations will move in favor of the dollar. We expect the dollar to rise by about 6% this year on a trade-weighted basis, appreciating most strongly against the AUD and SEK. As for sterling, it is beginning to look attractive as a long-term punt. Brexit Deadlock We are a month closer to the end-March deadline and a Brexit deal seems even farther out of reach. It could play out in one of three ways: (1) a “no deal” where the U.K. leaves the EU with no alternative in place; (2) a “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; or (3) a decision to reverse the results of the original referendum and stay in the EU. There is no support for the “no deal” option in Parliament, which means that it won’t happen. We do not have a strong view on which of the latter two scenarios will occur. The odds of another referendum are rising and the polls are swinging away from any sort of Brexit, suggesting that the original referendum result may be over-turned via another referendum (Chart I-12). Nonetheless, for investors, it does not matter much whether it is scenario 2 or 3; either outcome would be welcomed by markets. Overweight sterling positions are attractive as a long-term play, although it could be some time before the final solution emerges. Chart I-12Brexit Result May Be Overturned Brexit Result May Be Overturned Brexit Result May Be Overturned Upgrade Corporate Bonds To Overweight Given the recent global economic dynamics, it is perhaps surprising that U.S. corporate financial health actually improved in 2018 according to our Corporate Health Monitors (CHM). We highlighted in the aforementioned Special Report the risks facing U.S. corporate bonds when the economic expansion ends. High levels of corporate leverage mean that the interest coverage ratio for the median corporation in the Barclays-Bloomberg index will plunge to near or below all-time historic lows. The potential for a large wave of fallen angels implies that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds. Moreover, poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Rapid debt accumulation is reflected in our bottom-up Corporate Health Monitors (CHM) for the U.S. investment-grade and high-yield sectors (Chart I-13). The CHMs are constructed from six financial ratios that the rating agencies use when rating individual companies. The companies in our bottom-up sample were chosen so as to mimic the sector and quality distribution in the Bloomberg-Barclay’s corporate bond index. Chart I-13U.S. Corporate Health U.S. Corporate Health U.S. Corporate Health The debt-to-book-value of equity ratio for both the U.S. IG and HY sample of companies has risen to nose-bleed levels, although the ratio appears to have flattened off for the latter. Despite rising leverage, the HY CHM has shifted into “improved health” territory and the IG CHM is on the verge of doing the same. Last year’s upturn in the profitability measures, such as the return on capital, overwhelmed the deteriorating leverage trend. In Europe, where we distinguish between domestic and foreign issuers, rising leverage has been concentrated among the latter until recently (Chart I-14). In any event, the CHM for both types of issuers is close to the neutral zone. Chart I-14Euro Area Corporate Health Euro Area Corporate Health Euro Area Corporate Health Improving U.S. corporate health on its own would not justify increasing exposure to corporate bonds within balanced portfolios or moving down in quality. Profit growth is likely to moderate this year, especially in Europe, such that last year’s improvement in corporate health is likely to reverse. And, as previously discussed, the economic cycle is well advanced and this sector is particularly vulnerable to a recession. Nonetheless, value has improved enough to warrant a tactical upgrade to overweight within fixed-income portfolios, at a time when the FOMC has signaled a pause and the next recession is at least a year away. Implied volatility should continue to moderate and spreads should narrow, similar to dynamics in 2016, the last time that the Fed signaled patience following a period of market turmoil (Chart I-15). Chart I-15Fed Patience To Narrow Spreads Fed Patience To Narrow Spreads Fed Patience To Narrow Spreads Spreads have already narrowed from the peak in late December, but 12-month breakeven spreads for most credit tiers are all still close to or above their historical means, except for AA-rated issues (Chart I-16). For example, the 12-month breakeven spread2 for the Baa credit tier is 46%. This means that the spread has been tighter than its current level 46% of the time since 1988 and wider than its current level 54% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart I-16Value Restored In IG Corporates... Value Restored In IG Corporates... Value Restored In IG Corporates... For U.S. high yield, our estimate of the spread adjusted for expected defaults has risen to 237 bps (Chart I-17). This implies that investors are discounting a 2019 default rate of 3.2%, in line with Moody's forecast. Since we do not foresee recession this year, high-yield bonds are not expensive enough to be avoided within a portfolio. Chart I-17...And In HY Too ...And In HY Too ...And In HY Too Value has also improved in the European corporate bond market, but our global fixed-income team still recommends favoring the U.S. market for global credit investors. Leverage is higher in the U.S., especially relative to domestic issuers in Europe, but the U.S. economic and profit outlook for 2019 is better. Conclusions Our decision to upgrade corporate bonds this month, similar to our reasoning for upgrading equities to overweight in December, is based on improved value and a sense that investor pessimism had become excessive. For the equity market, the S&P 12-month forward P/E is an attractive 15.4 as we go to press, and bottom-up estimates for 2019 EPS have been slashed to a very reasonable 8%. Just as the selloff in risk assets late last year was overdone, so too was the rally in government bonds. It is highly unlikely that the Fed is done tightening. A resumption of Fed rate hikes, probably in June, means that the 10-year Treasury yield will move back above 3% by year end. Across the major countries, market expectations for yields 5-10 years from now are close to current levels, which is extremely complacent (Chart I-18). Investors should keep duration short of benchmark. Chart I-18Forward Rates Far Too Low Forward Rates Far Too Low Forward Rates Far Too Low Our shift to overweight in both equities and corporate bonds is tactical in nature. We fully expect to move back to neutral and then to underweight later this year or into 2020, as the peak in U.S. GDP draws nearer. Timing will be difficult as always, which means that investors should be prepared to trim risk exposure earlier than implied by our base-case economic timeline.  The tactical upgrade does not imply that we have become more sanguine on the economic and geopolitical risks for 2019. We do not believe that quantitative tightening or U.S. corporate leverage will truncate the U.S. expansion prematurely. Nonetheless, there is a plethora of other risks to keep us up at night. These include a Fed policy mistake, a hard economic landing in China, a full-blown financial crisis in Italy and an escalation in U.S./China trade tensions. The last one has diminished marginally in probability. We have a sense that the recent equity market downdraft unnerved President Trump, such that he now has a diminished appetite for upsetting investors with talk of an escalating trade war ahead of next year’s election. Outside of these well-known risks, our geopolitical team has recently published its “Black Swans” report for 2019. These are deemed to be risks that are off of most investors’ radar screens, but that would have profound implications if they were to occur: It is premature to expect armed conflict over Taiwan, but an outbreak of serious tensions between China and Taiwan is possible as Sino-American strategic distrust continues to build. Russia and Ukraine may have a shared incentive to renew hostilities this year. Saudi Arabia has received a “blank cheque” from Donald Trump, and thus it may continue to be provocative. This could boost the geopolitical risk premium in oil prices. Tensions are building in the Balkans. A renewed conflict on Europe’s doorstep could be the next great geopolitical crisis. A “Lame Duck” Trump could stage a military intervention in Venezuela. We encourage interested readers to see our Special Report for details.3 As for emerging market assets and base metals, we continue to shy away until we receive confirmation that China is aggressively stimulating. We expect better news on this front by mid-year, but watch our China Credit Impulse indicator for timing. In contrast, investors should be overweight oil and related assets now because our commodity specialists still see the price of Brent rising above US$80/bbl sometime this year. Recent political turmoil in Venezuela buttresses our bullish oil view. Finally, this month’s fascinating Special Report, penned by BCA’s Chief Global Strategist, Peter Berezin, examines the long-term implications of the peaking in the average IQ in the advanced economies. Average intelligence is falling for both demographic and environment reasons. The impact will be far from benign, potentially leading to lower productivity growth, lower equity multiples, larger budget deficits and higher equilibrium bond yields. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy January 31, 2019 Next Report: February 28, 2019   II. The Most Important Trend In The World Has Reversed And Nobody Knows Why After rising for thousands of years, human intelligence has begun to decline in developed economies. This can be seen in falling IQ scores and a decline in math and science test scores. Environmental factors appear to account for the bulk of this decline, but no one knows what these factors are. If left unchecked, falling intelligence will severely undermine productivity growth. This could lead to lower equity multiples, larger budget deficits, and ultimately, much higher government bond yields. Technological advances, particularly in the genetic realm, promise to radically raise IQs. In a complete abandonment of its one-child policy, China will combine these controversial technologies with pro-natal measures in order to boost sagging birth rates. The coming Eugenic Wars will be one of the most important economic and geopolitical developments of the 21st century. Part 1: What The Tame Fox Says In 1959, a Soviet scientist named Dmitry Belyaev embarked on an ambitious experiment: to domesticate the silver fox. A geneticist by training, Belyaev wanted to replicate the process by which animals such as cats and dogs came to live side-by-side with humans. It was a risky endeavor. The Soviets had essentially banned the study of Mendelian genetics in favor of the blank slate ideology that is popular in progressive circles today. Belyaev persevered. Working under the guise of studying vulpine physiology, he selected foxes based on only one trait – tamability. Less than 10% of foxes made it to the subsequent generation, with the other 90% being sent off to fur farms. By the fourth generation, the changes were undeniable. Rather than fleeing humans, the foxes sought out their attention with no prompting whatsoever. They even wagged their tails and whined and whimpered like dogs do. The tame foxes also displayed physical changes. Their ears flopped over. Their snouts became shorter and their tails stood upright. "By intense selective breeding, we have compressed into a few decades an ancient process that originally unfolded over thousands of years," wrote Lyudmila Trut, who began as Belyaev’s assistant and took over the project when her boss died in 1985.  Genetically Capitalist? Evolution can broadly proceed in two ways. The first way is through random mutations. This form of evolution, which scientists sometimes refer to as genetic drift, can take thousands of years to yield any discernable changes. The second way is through natural selection, a process that exploits existing variations in genetic traits. As the Russian fox experiment illustrates, evolution driven by selective pressures (either natural or artificial) can occur fairly quickly. Did selective pressures manifest themselves in human evolution in the lead up to the Industrial Revolution? Did humans, in some sense, domesticate themselves? In his book, A Farewell To Alms, economic historian Gregory Clark argued in the affirmative. Clark documented that members of skilled professions in Medieval England had twice as many surviving children as unskilled workers (Chart II-1). Indeed, the fledgling middle class of the time had even more surviving children than the aristocracy, who were often out fighting wars. As a result, the wages of craftsmen declined by a third relative to laborers between 1200 and 1800, implying that the supply of skilled labor was growing more quickly than the demand for skilled workers over this period. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why In subsequent work, Clark and Neil Cummins argued that the spread of bourgeois values across pre-industrial England was more consistent with a model of genetic transmission than a cultural one (see Box II-1 for details). Similar developments occurred in other parts of the world. For example, in China, the gateway into the bureaucracy for a thousand years was the highly competitive imperial exam. Xi Song, Cameron Campbell, and James Lee showed that high-status men had more surviving children during the eighteenth- and nineteenth-centuries (Chart II-2).4 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why The 10,000 Year Explosion Stephen Jay Gould famously said that “There’s been no biological change in humans in 40,000 or 50,000 years. Everything we call culture and civilization we’ve built with the same body and brain.” Gould was wrong. Data from the International HapMap Project show that human evolution accelerated by 100-fold starting around 10,000 years ago (Chart II-3). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why In their book The 10,000 Year Explosion: How Civilization Accelerated Human Evolution, Gregory Cochran and the late Henry Harpending explained why evolution sped up so rapidly.5 The advent of agriculture led to a surge in population levels. This, in turn, increased the absolute number of potentially beneficial genetic mutations that could be subject to selection effects. Farming and the rise of city states also completely reshaped the environment in which people lived. Basic biology teaches us that environmental dislocations of this kind tend to generate selective pressures that cause evolution to accelerate. John Hawks, professor of anthropology and genetics at the University of Wisconsin-Madison, put it best: “We are more different genetically from people living 5,000 years ago than they were different from Neanderthals.” Many of the changes to our genomes relate to diet and diseases. The various genetic resistances that people have built up to malaria are all less than 10,000 years old. Mutations to the LCT gene, which confers lactose tolerance into adulthood, occurred independently in three different geographical locations: one in East Asia, one in the Middle East, and one in Africa. The Middle Eastern variant was probably responsible for the rapid enlargement of the Indo-European language group, which now stretches from India to Ireland. The African variant likely facilitated the Bantu expansion, which started near the present-day border of Nigeria and Cameroon, and then spread out across almost all of sub-Saharan Africa. Evolution Of The Human Brain About half of the genes in the human genome regulate some aspect of brain function. Given the rapid acceleration in evolution, it would be rather surprising if our own brains had not been affected. And indeed, there is plenty of evidence that they were. The frontal lobe of the brain has increased in size over the past 10,000 years. This is the part of the brain that regulates such things as language, memory, and long-term planning. Testosterone levels have also declined. That may explain the steady reduction in violent crime rates (Chart II-4). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why We know that certain genes that are associated with higher intelligence have been under recent selective pressure. For example, the gene that leads to torsion dystonia – a debilitating movement disorder – appears to have increased in frequency. Why would a gene that causes a known disease become more widespread? The answer is that individuals who have this particular mutation tend to have IQs that are around 10-to 20-points above the population average. Why IQ Matters IQ has a long and contentious history. Yet, despite numerous efforts to jettison the concept, it has endured for one simple reason: It has more predictive power than virtually anything else in the psychological realm. A simple 30-minute IQ test can help predict future educational attainment, job performance, income, health, criminality, and fertility choices (Table II-1 and Chart II-5). IQ even predicts trader performance!6 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why   The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Like most physiological traits, IQ is highly heritable.7 The genetic contribution to IQ increases from 20% in early childhood to as high as 80% by one’s late teens and remains at that level well into adulthood.8 This makes IQ almost as heritable as height (Chart II-6). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Although there is a great deal of variation among individuals, on average, more intelligent people earn higher incomes (Chart II-7). If the same relationship existed in the pre-industrial era, as seems likely, then human intelligence probably increased in a way that facilitated the economic explosion that we associate with the Industrial Revolution. The stunning implication is that the emergence of the modern era was a question of “when, not if.” The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Part 2: The Flynn Effect By the late-19th century, it had become clear that the rich were no longer having as many children as the poor. This realization, together with the growing popularity of Darwin’s theories, helped galvanize the eugenics movement. Contrary to popular belief, this movement was not a product of the far-right. In fact, the most vocal proponents of eugenics were among the progressive left. John Maynard Keynes, for example, served as the Director of the British Eugenics Society between 1937 and 1944. Yet, a funny thing happened on the road to idiocracy: The concerns of eugenicists did not come to pass. Rather than becoming dimmer, people became smarter. This phenomenon is now known as the Flynn Effect, named after James Flynn, a psychologist who was among the first to document it. Chart II-8 shows the evolution of IQ scores in a sample of countries between 1940 and 1990. The average country recorded IQ gains of three points per decade over this period, a remarkably large increase over such a relatively short period of time. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Explaining The Flynn Effect The Flynn Effect must have been entirely driven by environmental factors since genetic factors – namely the tendency of less-educated people to have more children, and to have them at an earlier age – would have reduced average IQs over the past two hundred years. But how could environmental factors have played the dominant role in light of the strong role of genes discussed above? The answer was proposed by geneticist Richard Lewontin in the 1970s. Lewontin suggested imagining a genetically-diverse sack of seed corn randomly distributed between two large identical fields. One field had fertilizer added to it while the other did not. Genetic variation would explain all of the differences in the height of corn stalks within each field, while environmental factors (the addition of fertilizer) would explain all of the difference in the average height of corn stalks between the two fields. This logic explains why genes can account for the bulk of the variation in IQs within any demographic group, while environmental effects may explain most of the variation across groups, as well as why average scores have changed over time. And what environmental effects are these? The truth is that no one really knows. Plenty of theories have been advanced, but so far there is still little consensus on the matter. Bigger, Healthier Brains It has long been known that learning increases the amount of grey matter in the brain. For example, a recent study showed that the hippocampi of London taxi drivers tend to be larger due to the need for drivers to memorize and navigate complex routes.9 The emergence of modern societies likely kicked off a virtuous circle where the need to solve increasingly complex tasks forced people to hone their learning skills, leading to higher IQs and further technological progress. The introduction of universal primary education amplified this virtuous circle. Better health undoubtedly helped as well. Early childhood diseases reduce IQ by diverting the body’s resources away from mental development towards fighting off infections. There is a strong correlation between measured IQ and disease burden across countries (Chart II-9). A number of studies have documented a strong relationship between the timing of malaria eradication in the U.S. and other parts of the world and subsequent observed gains in childhood IQs.10 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Brain size and IQ are positively correlated. Forensic evidence from the U.S. suggests that the average volume of adult human skulls has increased by 7% since the late 1800s, or roughly the size of a tennis ball.11 Part 3: The End Of A 10,000 Year Trend The problem with environmental effects is that they eventually run into diminishing returns. This appears to have happened with the Flynn Effect. In fact, not only does the recent evidence suggest that the Flynn Effect has ended, but the data suggest that IQs are starting to decline. Chart II-10 shows that average math and science test scores fell in the OECD’s Program For International Scholastic Achievement (PISA) between 2009 and 2015, the latest year of the examination. The drop in math and science test scores has been mirrored in falling IQ scores. Flynn observed a decade ago that IQs of British teenagers were slipping.12 Similar results have been documented in France, the Netherlands, Germany, Denmark, and most recently, Norway. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why The Norwegian results, published last year, are particularly noteworthy.13 Bernt Bratsberg and Ole Rogeberg examined three-decades worth of data on IQ tests of Norwegian military conscripts. Military duty has been mandatory for almost all men in Norway since 1814, which means that the study’s authors were able to collect comprehensive data on most Norwegian men and their fathers.  Their paper clearly shows that IQ peaked with the generation born in the mid-1970s and declined by about five points, or one-third of a standard deviation, for the one born in 1990 (Chart II-11). For the first time in recorded history, Norwegian kids today are not scoring as well as their parents. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why A Mystery What caused the sudden reversal of the Flynn Effect in Norway and most other developed economies? Nobody knows. We can, however, offer three possible theories: New Technologies For much of human history, rising intelligence and technological innovation were complementary processes, meaning that the smartest people were the ones who could best exploit the new technologies that were coming their way. Moreover, as noted above, even those who were less gifted benefited from the mental stimulation that a technologically advanced society provided. It remains to be seen how future technological advances such as generalized AI will affect human intelligence, but recent technological advances seem to have had a dumbing down effect.14 For example, the GPS has obviated the need for people to navigate unfamiliar locations, thus blunting the development of their visuospatial skills. Modern word processors have made spelling skills less important. Having all the information in the world just a click away is a wonderful thing, but it has reduced the need for our brains to retain and codify what we learn. Meanwhile, the constant bombardment of information to which we are subject has made it difficult to concentrate on anything for long. How many youth today can read a report of this length without checking their Facebook feed multiple times? My guess is not many. Diminishing Returns To Education The ability to take young bright minds, who would have otherwise spent their lives doing menial labor, and provide them with an education was probably the greatest tailwind to growth that the 20th century enjoyed. There is undoubtedly still scope to continue this process, but the low-hanging fruits have been picked. Educational attainment has slowed dramatically in most of the world (Chart II-12). Economist James Heckman estimates that U.S. high-school graduation rates, properly measured, peaked over 40 years ago.15 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Despite billions of dollars spent, efforts to improve school performance have generally fallen flat. A recent high-level report by the U.S. Department of Education concluded that “The panel did not find any empirical studies that reached the rigor necessary to determine that specific turnaround practices produce significantly better academic outcomes.”16 This gets to a point that most parents already know, which is that when people talk about “bad schools," they are really talking about “bad students.” Deteriorating Health Better health probably contributed to the Flynn Effect. But is it possible to have too much of a good thing? More calories are welcome when people are starving, but today’s calorie-rich, nutrient-poor diets have led to a surge in obesity rates. A clean environment reduces the spread of germs, but it also makes children hypersensitive to foreign substances. Following German reunification, researchers observed that allergies were much more common among West German children than their Eastern peers, presumably because of the West’s more salubrious environment.17 All sorts of weird and concerning physiological changes are occurring. Sperm counts have fallen by nearly 60% since the early 1970s.18 Testosterone levels in young men are dropping. Among girls, the age of first menarche has declined by two years over the past century.19 Are chemical agents in the environment responsible? If they are, what impact are they having on cognitive development? Nobody knows. Reported mental illness is also on the rise. The share of U.S. teenagers with a reported major depressive episode over the prior year surged by over 60% between 2010 and 2017 (Chart II-13). The fraction of young adults that made suicide plans nearly doubled.20 More than 20% of U.S. women over the age of 40 are on antidepressants.21 Five percent of U.S. children are receiving ADHD medication.22 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Implications For Economic Growth And Asset Markets So far, the reversal of the Flynn Effect has been largely confined to the developed economies. Test scores are still rising in the developing world, albeit from fairly low levels. For example, two recent studies have documented significant IQ gains in Kenya and Brazil.23 In the poorest countries, opportunities for improving health abound. Even small steps such as fortifying salt with iodine (which costs about five cents per person per year) have been shown to boost IQ by nearly one standard deviation.24 Measures to reduce inbreeding are also likely to boost IQ scores.25 Yet, we should not underestimate the importance of falling cognitive skills in developed economies. Chart II-14 shows that there is a clear positive correlation between student score on math and science and per capita incomes. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Most technological innovation still takes place in developed economies. There is an extremely tight relationship between visuospatial IQ and the likelihood of becoming an inventor (Chart II-15). Since IQ is distributed along a bell curve, a 0.1 standard deviation drop in IQs across the entire distribution will result in an 8% decline in the share of people with IQs over 100, a 14% decline in those with IQs over 115, and a 21% decline in those with an IQ over 130 (by convention, each standard deviation on an IQ test is worth 15 points). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Falling IQs could result in slower productivity growth, which could further strain fiscal balances. Lower IQs are also associated with decreased future orientation.26 People who live for the moment tend to save less. A decline in savings would push up real rates, leading to less capital accumulation. History suggests that a deceleration in productivity growth and higher real rates will put downward pressure on equity multiples (Chart II-16). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Part 4: Generation E For 200 years, the environmentally-driven Flynn Effect disguised the underlying genetically-driven decline in IQs that began not long after the dawn of the Industrial Revolution. Flynn has acknowledged this himself, noting at the 2017 International Society For Intelligence Research Conference that “I have no doubt that there has been some deterioration of genetic quality for intelligence since the late Victorian times.”27 Now that the Flynn Effect has reversed, both genes and the environment are working together to reduce cognitive abilities in developed economies. This means that the most important trend in the world – a trend that allowed the human population to increase during the Malthusian era and later allowed output-per-worker to soar following the Industrial Revolution – has broken down. Yet, there may be another twist in the story – one that began just a few months ago: the first members of Generation E were born. E Is For Edited ... Or Eugenics Lulu and Nana will be like most other children, but with one key difference: They will be the first humans ever to have their genomes edited through a procedure know as CRISPR-Cas9. Rogue Chinese scientist He Jiankui deactivated their CCR5 gene, which the HIV virus uses as a gateway into the body. His actions were rightfully condemned around the world for endangering the twins’ health by using a procedure that has not yet been fully vetted in animal studies, let alone in human trials (Lulu and Nana’s father is HIV+ but it is debatable whether the children were at an elevated risk of infection). He Jiankui remains under house arrest at the university where he worked. But whatever his fate, the dam has been broken. For better or for worse, the era of personal eugenics has arrived. The Return Of The Silver Fox It is easier to delete a gene than to add one. It is even more difficult to swap out a large number of genes in a way that achieves a predictable outcome. Thus, the successful manipulation of highly polygenic traits such as intelligence — traits that are linked to hundreds of different genes – may still be decades away.28 Predicting a trait is much simpler than modifying it, however. The cost of sequencing a human genome has fallen by more than 99% since 2001 (Chart II-17). Start-up company Genomic Prediction has already developed a test for fertilized embryos for IVF users that predicts height within a few centimetres and IQ with a correlation of 0.3-to-0.4, roughly as accurate as standardized tests such as the SAT or ACT.29 Other companies are following suit.30 The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why Some will recoil in horror at the prospect of selecting prospective children in this manner. They will argue that such technologies, beyond being simply immoral, will widen social inequality between those who can afford them and those who cannot. Others will counter that screening embryos for certain traits is not that dissimilar to what people already do with prospective romantic partners. They will also point out that mass usage of these technologies will drive down prices to the point that even poor people will be able to access them, thus giving low IQ parents the chance to have high IQ kids. They might also note that such technologies may be the only way to reverse the ongoing accumulation of deleterious mutations within the human germline that has been the unintended by-product of the proliferation of life-saving medicines.31 We will not wade into this thorny debate, other than to note that there will be huge incentives for people to avail themselves of these technologies. The Coming Eugenic Wars And not just individuals either – governments too. While the initial impact of eugenic technologies will be small, the effects will compound over time. Carl Shulman and Nick Bostrom estimate that genetic screening could boost average IQs by up to 65 points in five generations (Table II-2). The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why China has been investing heavily in genetic technologies. As Geoffrey Miller has argued, China’s infatuation with eugenics spans into the modern day.32 Like most other countries, fertility in China is negatively correlated with IQ. Mingrui Wang, John Fuerst, and Jianjun Ren estimate that China is currently losing nearly one-third of a point in generalized intelligence per decade, with the loss having accelerated rapidly between the 1960s and mid-1980s.33 The decline in the genetic component of Chinese IQs is coming at a time when the population itself is about to shrink. According to the UN’s baseline forecast, China will lose 450 million working-age people by the end of the century (Chart II-18). Meanwhile, the country is saddled with debt, the result of an economic model that has, for decades, recycled copious household savings into debt-financed fixed-investment spending in an effort to shore up domestic demand. The Most Important Trend In The World Has Reversed And Nobody Knows Why The Most Important Trend In The World Has Reversed And Nobody Knows Why The authorities may be tempted to tackle all three problems simultaneously by adopting generous pro-natal measures – call it the “at least one-child policy”– which increasingly harnesses emerging eugenic technologies. The resulting baby boom would strengthen domestic demand, thus making the economy less dependent on exports, while ensuring China’s long-term geopolitical viability. The Eugenic Wars are coming, and they will be unlike anything the world has seen before. BOX II-1 The Diffusion Of Bourgeois Values: Culture Or Genes? Higher-income people had more surviving children in the centuries leading up to the Industrial Revolution. Real per capita income was broadly stable during this period. This implies that there must have been downward social mobility, with sons, on average, being less wealthy than their fathers. This downward mobility, in turn, spread the characteristics of higher-income people across the broad swathe of society. What were these characteristics? Cultural values that emphasized thrift, diligence, and literacy were undoubtedly part of what was passed on to future generations. But surprisingly, it also appears that genetic transmission played an important, and perhaps pivotal, role. Models of genetic transmission make very concrete predictions about the correlations in economic status that one would expect to see among relatives. Biological brothers share 50% of their genes, as do fathers and sons. Likewise, first cousins share 25% of their genes, the same as grandfathers and sons. These facts yield two testable predictions: The first is that the correlation coefficient on status measures such as wealth, occupation, and education should be the same for relatives that share the same fraction of genes such as sibling pairs and father-son pairs. Box Chart II-1 shows that this is borne out by the data. The second prediction is that the correlation between status and genetic distance should follow a linear trend so that, for example, the correlation in wealth among brothers is twice that of first cousins and four times that of second cousins. Box Chart II-2 shows that this is also borne out by the data. Image   Image Other evidence supports the importance of genes in the transmission of status across generations. The correlation in measures such as wealth, education, and occupation is much higher among identical twins than fraternal twins. Adopted children turn out to be more similar to their biological parents on these measures when they reach adulthood than their adopted parents, even when the children have never met their biological parents. The parent-child correlation also remains the same regardless of family size, suggesting that spreading the same resources over more children may not harm life outcomes to any discernible degree, at least on the measures listed above. Peter Berezin Chief Global Strategist Global Investment Strategy III. Indicators And Reference Charts Our tactical equity upgrade to overweight last month has still not been confirmed by most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicator for the U.S. is falling fast. It is also eroding for Europe, although it has ticked higher in Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors have clearly moved funds away from the U.S. equity market and there is no sign yet that this is reversing. Our Revealed Preference Indicator (RPI) for stocks continued to issue a ‘sell’ signal in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. While the RPI is still cautious, value has improved significantly according to BCA’s composite valuation indicator. It is a composite of 11 different valuation measures. This indicator almost reached the fair value line in December. Moreover, our Monetary Indicator has suddenly shifted out of negative territory for stocks, rising to the neutral line in December. Calming words from the Fed has improved the monetary backdrop by removing expected rate hikes from the money market curve. Given the improvement in both value and the monetary backdrop, the RPI could generate a ‘buy’ signal next month. Our Composite Technical indicator for stocks broke down last month, providing a clear ‘sell’ signal, and has not yet delivered a ‘buy’. However, sentiment is now washed out and earnings expectations have been revised heavily downward. These signals are bullish from a contrary perspective.  The 10-year Treasury yield is in the neutral range according to our valuation model. Bonds are not overbought, despite the rally in December, because they were still working off oversold conditions. Contrary to the bond valuation model, the 10-year term premium moved further into negative territory in January, suggesting that yields are unsustainably low. Our bond-bearish bias is consistent with the view that the Fed rate hike cycle is not over. The U.S. dollar is somewhat overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator   Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals   Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators   Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst   Footnotes 1       Please see The Bank Credit Analyst Special Report "The Long Shadow Of The Financial Crisis," dated October 25, 2018, available at bca.bcaresearch.com 2       The amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon. 3       Please see Geopolitical Strategy Special Report "Five Black Swans In 2019," dated January 16, 2019, available at gps.bcaresearch.com 4       Xi Song, Cameron Campbell, and James Lee, "Descent Line Growth and Extinction From A Multigenerational Perspective, Extended Abstract," American Sociological Review 80:3, (April 21, 2015): 574-602. 5       Gregory Cochran and Henry Harpending, "The 10,000 Year Explosion: How Civilization Accelerated Human Evolution," Basic Books, (2009). 6       Mark Grinblatt, Matti Keloharju, and Juhani T. Linnainmaa, “IQ, Trading Behavior, and Performance,” Journal of Financial Economics, 104:2, (May 2012): 339-362. 7       Thomas Bouchard, "Genetic Influence On Human Psychological Traits - A Survey," Current Directions in Psychological Science 13:4, (August 2004): 148-151. 8      The tendency for the genetic contribution to IQ to increase until early adulthood and then to remain at high levels until old age is known as the Wilson Effect. There is no consensus on what causes it, but it probably reflects a number of factors: 1) It may take some children longer than normal to reach full intellectual maturity. Testing their IQs at a young age will result in scores that are lower than those expected based on their parents’ IQs. The opposite is true for children whose IQs increase relatively quickly in young age, but possibly top out earlier; 2) Environmental effects are probably more important in young age when a child’s brain is still quite malleable; 3) Self-reinforcing gene-environment interactions tend to increase with age. Children do not have much control over their environment, but as they get older, they will seek out activities that are more in keeping with their genetic predispositions. For example, a studious child may pursue a career that reinforces their love of learning. 9       "Cache Cab: Taxi Drivers' Brains Grow to Navigate London's Streets," Scientific American, (December 2011). 10       Atheendar Venkataramani, "Early Life Exposure to Malaria and Cognition in Adulthood: Evidence from Mexico," Journal of Health Economics 31:5, (July 2012): 767-780; Hoyt Bleakley, "Health, Human Capital and Development," Annual Review of Economics 2, (March 2010): 283-310; Hoyt Bleakley, "Malaria Eradication in the Americas: A Retrospective Analysis of Childhood Exposure," American Economic Journal: Applied Economics 2, (April 2010): 1-45. 11       "Anthropologists Find American Heads Are Getting Larger," ScienceDaily, (May 2012). 12       "British Teenagers Have Lower IQs Than Their Counterparts Did 30 Years Ago," The Telegraph, (February 2009). 13     Bernt Bratsberg and Ole Rogeberg, "Flynn Effect And Its Reversal Are Both Environmentally Caused," Proceedings of the National Academy of Sciences 115:26, (June 2018): 6674-6678. 14     On the face of it, artificial intelligence would appear to be a substitute for human intelligence. Many applications of AI would undoubtedly have this feature, especially those that allow computers to perform complex mental tasks that humans now must do. However, there are several ways that AI may eventually come to complement human intelligence. First, and most obviously, AI could be used to augment human capabilities either directly by hardwiring it into our brains, or indirectly through the development of drugs or genetic techniques which improve cognition. Second, looking further out, the benefits of highly intelligent AI systems would be limited if humans did not possess the requisite intelligence to understand certain concepts that are currently beyond our mental reach. No matter how well intentioned, trying to explain string theory to a mouse is not going to succeed. There are probably a multitude of ideas that AI could reveal that we simply cannot comprehend at current levels of human intelligence. 15     James Heckman and Paul La Fontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 16     "Turning Around Chronically Low-Performing Schools," The Institute of Education Sciences (IES), (May 2008). 17     E. von Mutius, F.D. Martinez, C. Fritzsch, T. Nicolai, G. Roell, and H. H. Thiemann, "Prevalence Of Asthma And Atopy In Two Areas Of West Germany And East Germany," American Journal of Respiratory and Critical Care Medicine 149:2, (February 1994): 358-64. 18     "Sperm Counts In The West Plunge By 60% In 40 Years As ‘Modern Life’ Damages Men’s Health," Independent, (July 2017). 19     Kaspar Sørensen, Annette Mouritsen, Lise Aksglaede, Casper P. Hagen, Signe Sloth Mogensen, and Anders Juul, "Recent Secular Trends in Pubertal Timing: Implications for Evaluation and Diagnosis of Precocious Puberty," Hormone Research in Paediatrics 77:3, (May 2012): 137-145. 20     “Results from the 2017 National Survey On Drug Use And Health: Detailed Tables,” Substance Abuse and Mental Health Services Administration, Center for Behavioral Health Statistics and Quality, Rockville (Maryland), (September, 2018). 21     Laura A. Pratt, Debra J. Brody, and Qiuping Gu, "Antidepressant Use Among Persons Aged 12 and Over: United States, 2011–2014," NCHS Data Brief No. 283, Centers for Disease Control and Prevention, (August 2017). 22     Some, but not all, of the increase in reported rates of mental illness may be due to more aggressive diagnosis by health practitioners. For example, a recent study revealed that children born in August were 30% more likely to receive an ADHD diagnosis than those born in September, simply because they were less mature compared to other kids in the first few years of elementary school. See: Timothy J. Layton, Michael L. Barnett, Tanner R. Hicks, and Anupam B. Jena, "Attention Deficit-Hyperactivity Disorder and Month of School Enrollment," New England Journal of Medicine 379:22, (November 2018): 2122-2130. 23     Tamara C. Daley, Shannon E. Whaley, Marian D. Sigman, Michael P. Espinosa, and Charlotte Neumann, "IQ On The Rise: The Flynn Effect In Rural Kenyan Children," Psychological Science 14:3, (June 2003): 215-9; Jakob Pietschnig and Martin Voracek, "One Century of Global IQ Gains: A Formal Meta-Analysis of the Flynn Effect (1909-2013)," Perspectives on Psychological Science 10:3, (May 2015): 282-306. 24     N. Bleichrodt and M. P. Born, “Meta-Analysis of Research on Iodine and Its Relationship to Cognitive Development,” In: ed. J. B. Stanbury, "The Damaged Brain of Iodine Deficiency," Cognizant Communication Corporation, New York, (1994): 195-200; "Iodine status worldwide: WHO Global Database on Iodine Deficiency," World Health Organization, Geneva, (2004). 25     Mohd Fareed and Mohammad Afzal, "Estimating the Inbreeding Depression on Cognitive Behavior: A Population Based Study of Child Cohort," PLOS ONE 9:12, (October 2015): e109585. 26     H. de Wit, J. D. Flory, A. Acheson, M. McCloskey, and S. B. Manuck, "IQ And Nonplanning Impulsivity Are Independently Associated With Delay Discounting In Middle-Aged Adults," Personality and Individual Differences 42:1, (January 2007): 111-121; W. Mischel and R. Metzner, "Preference For Delayed Reward As A Function Of Age, Intelligence, And Length Of Delay Interval," Journal of Abnormal and Social Psychology 64:6, (July 1962): 425-31. 27     James Flynn, “IQ decline and Piaget: Does the rot start at the top?” Lifetime Achievement Award Address, 18th Annual meeting of ISIR, (July 2017). 28     For a good discussion of these issues, please see Richard J. Haier, “The Neuroscience of Intelligence,” Cambridge Fundamentals of Neuroscience in Psychology, (December 2016). 29     "The Future of In-Vitro Fertilization and Gene Editing," Psychology Today, (December 2018). 30     "DNA Tests For IQ Are Coming, But It Might Not Be Smart To Take One," MIT Technology Review, (April 2018). 31     Michael Lynch, "Rate, Molecular Spectrum, And Consequences Of Human Mutation," Proceedings of the National Academy of Sciences 107:3, (January 2010): 961-968. 32     Geoffrey Miller, "What *Should* We Be Worried About?" Edge, (2013). 33     Mingrui Wang, John Fuerst, and Jianjun Ren, "Evidence Of Dysgenic Fertility In China," Intelligence 57, (April 2016): 15-24. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: