Developed Countries

Highlights The euro area bond yield 6-month impulse recently hit 100 bps, constituting the strongest headwind to growth for three years. Nine times out of ten, the strong headwind to nominal growth pushes the bond yield to a lower level six months later. Downgrade banks and materials to underweight. Downgrade the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225. Upgrade Switzerland to overweight, and upgrade Denmark to neutral. Downgrade Sweden to neutral, and downgrade Spain and Austria to underweight. Fractal trade: short NZD/JPY. Feature Chart of the WeekIf You Get The Bond Yield Right, You'll Get Banks Right Too The analysis in this report differs from the BCA house view which is overweight European versus US equities and expects modestly higher bond yields in the next six months. The euro area 10-year bond yield stands at a miserly 50 bps, though admittedly this does mark a 60 bps increase from its record low of -10 bps last August (Chart I-2).1 However, if you look only at the level or the change in the bond yield you will miss the bigger story. As we explained in Four Impulses, Three Mistakes, the bond yield’s impact on growth accelerations and decelerations comes neither from its level nor from its change – instead, the impact comes from the change in its change, the bond yield impulse.2 Chart I-2The Recent Rise In Bond Yields Followed A Sharp Decline In The Preceding Six Months The Strongest Headwind Impulse For Three Years The euro area bond yield 6-month impulse recently hit 100 bps, its highest mark, and therefore its strongest headwind to growth, for three years. The impulse hit such a high mark because the recent rise in yields followed a sharp decline in yields in the preceding six months. The euro area bond yield 6-month impulse recently hit 100 bps, its highest mark, and therefore its strongest headwind to growth, for three years.  Since the turn of the century, the euro area bond yield 6-month impulse has reached the 100 bps strong headwind mark ten times. Nine times out of the ten, the strong headwind to nominal growth pushed the yield to a lower level six months later. That’s the bigger story. The one exception was in 2006 at the frothy end of the credit bubble which bears no resemblance to today. In any case, nine times out of ten are odds that we wouldn’t want to bet against right now (Chart I-3). Chart I-3Nine Times Out Of Ten, A Strong Headwind Bond Yield Impulse Pushes Yields To A Lower Level Six Months Later Suffice to say, in the vast majority of these cases the lower bond yield also hurt bond yield proxies in the equity market such as banks and materials. The Bond Yield Drives Sector Strategy Investment is complex but it is not complicated. The words complex and complicated are often used interchangeably but they mean different things. Complex means something that is not fully predictable or analysable, whereas complicated means something that is made up of many parts. A car’s movement in traffic is complex, but it is not complicated. A car engine is complicated, but it is not complex. Unlike a car engine, investment is not complicated. This is because investment has just a few key parts that drive everything, albeit these parts are themselves highly complex. The objective of investment is to identify the few key parts that drive everything and to conquer their complexity. One key part is the bond yield. The Chart of the Week and Chart I-4 should leave you in no doubt that if you get the bond yield right, you will also get the relative performance of banks right, whether you are in Europe, Japan, or, for that matter, anywhere. Chart I-4If You Get The Bond Yield Right, You'll Get Banks Right Too The connection between the bond yield and bank performance is twofold. First, to the extent that a higher bond yield reflects higher nominal economic growth, it also likely reflects higher growth in bank credit, which effectively constitutes bank ‘sales’. Second, a higher bond yield also typically signifies a steeper yield curve, which lifts bank net interest (profit) margins. And vice versa for a lower bond yield. Investment is complex but it is not complicated. Likewise, Chart I-5 should also leave you in no doubt that if you get the bond yield right you will also get commodity prices right. Again, this is not surprising. The higher nominal economic growth reflected in a higher bond yield could come from stronger real demand or from higher inflation, either of which would be bullish for commodity prices. And vice versa for a lower bond yield. Albeit the causality can sometimes go the other way, from a commodity price shock via inflation to the bond yield. Chart I-5If You Get The Bond Yield Right, You'll Get Commodity Prices Right Too However, the bond yield’s movement itself is highly complex because it is subject to numerous feedback loops. One feedback loop is that the valuation of equities and other risk-assets depends inversely and exponentially on the bond yield level. A higher yield will ultimately undermine equity and other risk-asset prices and thereby unleash a deflationary impulse, and vice versa. A separate feedback loop comes via the direct impact on economic accelerations and decelerations which, as we have just seen, depends on the bond yield impulse – which is to say, its second derivative. Mathematicians will immediately recognise this setup as a second order differential equation with delayed negative feedback. They will tell you that it describes a complex adaptive system (CAS) which you cannot predict or analyse with any certainty. The best you can do is understand the probabilities that the system goes in one direction or the other. Based on the euro area bond yield impulse at a strong headwind mark, and the previous ten outcomes from this setup, there is a high probability that the post-August burst of outperformance from banks and materials is now over. Accordingly, we are now downgrading both banks and materials to underweight. Sector Strategy Drives Regional And Country Strategy To repeat, investment is highly complex but it is not highly complicated. If you get the bond yield right you will get your equity sector strategy right. And if you get your equity sector strategy right you will automatically get your regional and country allocation right too. This is because each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint which drives relative performance (Table I-1): Table 1The Sector Fingerprints Of Major Regional Stock Markets FTSE 100 = long energy, short technology. Eurostoxx 50 = long banks, short technology. Nikkei 225 = long industrials, short banks and energy. S&P 500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Specifically, the Eurostoxx 50 has an 11 percent overrepresentation to banks and materials versus both the S&P 500 and the Nikkei 225. Against the S&P 500 it is at the expense of technology and against the Nikkei 225 it is at the expense of industrials. It follows that if banks and materials underperform technology and industrials, the Eurostoxx 50 must underperform the S&P 500 and the Nikkei 225. Chart I-6 and Chart I-7 should convince you that there are no ifs, buts, or maybes. Chart I-6Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-7Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Dollars Accordingly we are now downgrading the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225. Exactly the same principle applies to the stock markets within Europe. Relative performance comes from nothing more than the stock market’s long and short sector fingerprint combined with sector performance (Table I-2 and Table I-3). Table I-2The Sector Fingerprints Of Euro Area Stock Markets Table I-3The Sector Fingerprints Of Non Euro Area European Stock Markets Based on the expected underperformance of banks and materials, we are now upgrading Switzerland to overweight, and upgrading Denmark to neutral. Also, we are downgrading Sweden to neutral, and downgrading Spain and Austria to underweight (Chart I-8). Chart I-8Spain = Long Banks Fractal Trading System* This week's recommended trade is short NZD/JPY. Set the profit target at 2.3 percent with a symmetrical stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-9NZD/JPY When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 This is the weighted average of 10-year government bond yields in the euro area, weighted by the stock of government issued debt. 2 Please see the European Investment Strategy Weekly Report “Four Impulses, Three Mistakes” October 31, 2019 available at eis.bcaresearch.com. Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

In this Monday’s Weekly Report we build on our four-factor S&P 500 EPS model by plugging in our base, worse, and best case estimates of the four variables and got as output the model’s EPS growth estimate for the calendar 2020.  We then assigned probabilities to those three outcomes resulting in an EPS forecast of $169/share. Next, we introduced our base, worse and best case forward P/Es (with an equal probability of occurrence) and multiplied them with our $169/share weighted EPS forecast in order to arrive at the SPX 3,049 expected value for end-2020. The Chart on the right depicts results of our analysis, which also suggests that the SPX is currently 8% overvalued. Bottom Line: We remain cautious on the prospects of the broad equity market. For a more detailed discussion of our EPS analysis please refer to this Monday’s Weekly Report.  

Highlights 2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -38bps for all of 2019. Winners & Losers: The underperformance of our model bond portfolio in 2019 was concentrated in the government bond side of the portfolio (-103bps), a result of below-benchmark duration positioning and underweights to US Treasuries and Italian government bonds. On the other side was a solid outperformance from spread product allocations (+65bps), mostly driven by an overweight to US high-yield corporate bonds. Q4/2019 Performance: The year ended strongly, however, as the portfolio outperformed by +28bps in Q4, split equally between government bonds and spread product. Scenario Analysis For The Next Six Months: We are targeting a moderately aggressive level of overall portfolio risk, with below-benchmark duration exposure alongside meaningful overweight allocations to global corporate credit. In our base case scenario, global growth will continue to recover supported by accommodative monetary policies, thus opening a window for another year of global corporates outperforming sovereign bonds in 2020. Feature Last week, we published the Global Fixed Income Strategy (GFIS) model bond portfolio strategy for the coming year, in which we translated our 2020 global fixed income Key Views into recommended investment positioning for the next 6-12 months.1 In this week’s report, take a final look back to review the performance of the model portfolio for both the fourth quarter of 2019 and the entire calendar year. We also present our updated scenario analysis, and return projections, for the portfolio over the next six months, incorporating the new recommended allocations introduced last week. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. 2019 Performance: A Short Summary Of A Long Year Chart of the Week2019 Performance: Credit Good, Duration Bad, But A Solid Q4 The 2019 performance of the model portfolio can be summarized by duration dominating credit. Government bond yields rapidly fell in the first three quarters of the year due to weakening global growth and growing political uncertainty, to the detriment of our below-benchmark stance on overall portfolio duration. At the same time, global credit markets performed strongly in 2019, even as risk-free government bond yields plunged, which benefited our overweight stance on global spread product. The 2019 performance of the model portfolio can be summarized by duration dominating credit.  All in all, the overall portfolio return in 2019 was +7.9% (hedged into USD), underperforming our custom benchmark index by -38bps (Chart of the Week).2 That underperformance was more pronounced before the strong rebound in global bond yields witnessed at the beginning of the fourth quarter, at which point the portfolio was underperforming the custom benchmark by -68bps (Table 1). Table 1GFIS Model Bond Portfolio Q4/2019 Overall Return Attribution Looking at the breakdown of underperformance in 2019, our recommended positioning on government bonds (duration and country allocation) dragged the overall performance by -104bps, while our credit tilts (by country and broadly defined credit sectors) provided a partial offset, contributing +65bps. The details of the full year 2019 performance can be found in the Appendix on pages 14-16. In terms of specifics, the biggest sources of underperformance were underweights in US Treasuries (-66bps) and Italian government bonds (-28bps). Those positions, however, were used to “fund” corporate bond overweights in US investment grade (+28bps) and US high-yield (+46bps), as well as euro area corporate debt (+6bps) – allocations that performed well and helped offset the underperformance in US and Italian sovereign debt. More generally across the government bond portion of the portfolio, the drag on returns was concentrated in the 10+ year maturity buckets. This was a consequence of combining our below-benchmark duration stance with a curve-steepening bias that was hurt severely by the bullish flattening of global yield curves in the first three quarters of the year. The drag on returns from curve positioning was particularly acute in Japan and France, where the 10+ year maturity buckets underperformed by -27bps and -13bps, respectively. On a more positive note with regards to country selection, three of our favorite overweights for 2020 – Germany (+10bps), Australia (+7bps) and the UK (+5bps) – all outperformed versus the model portfolio benchmark. Q4/2019 Model Portfolio Performance Breakdown: Winning On Both Sides The GFIS model bond portfolio performed well at the end of 2019, as fixed income markets began to discount stabilizing global growth and reduced central bank easing expectations. The total return for the GFIS model portfolio (hedged into US dollars) in Q4/2019 was only +0.1%, but this managed to outperform the custom benchmark index by a solid +28bps. The GFIS model bond portfolio performed well at the end of 2019, as fixed income markets began to discount stabilizing global growth and reduced central bank easing expectations.  In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +14bps of outperformance versus our custom benchmark index while the latter outperformed by +15bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q4/2019 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q4/2019 Spread Product Performance Attribution By Sector The most significant movers were: Biggest outperformers Underweight US government bonds with maturity beyond 10+ years (+8bps) Overweight US Ba-rated high-yield corporates (+5bps) Overweight US B-rated high-yield corporates (+5bps) Underweight Italian government bonds with maturity beyond 10+ years (+4bps) Underweight German government bonds with maturity beyond 10+ years (+3bps) Biggest underperformers Underweight US government bonds with maturity of 1-3 years (-2bps) Overweight Japanese government bonds with maturity of 5-7 years (-2bps) Overweight Japanese government bonds with maturity of 7-10 years (-1bp) Overweight UK government bonds with maturity of 5-7 years (-1bp) Underweight German government bonds with maturity of 7-10 years (-1bp) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q4/2019. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q4/2019 (red for underweight, green for overweight, gray for neutral).3 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The Model Bond Portfolio In Q4/2019 Global spread product dominates the left half of the chart. EM corporates and EM sovereigns denominated in US dollars turned to be the best performers in Q4, followed by US and European corporate bonds. This was a boon for our model portfolio performance, given our overweight stances on global corporate bonds. This was due to credit spread narrowing, supported by accommodative monetary policy and fading fears of slower global growth. On the other hand, the right side of Chart 4 is predominantly occupied by government bonds. The worst performers in Q4 were German, New Zealand and UK governments bonds – three markets where we have been overweight, although we did take profits on our long-held bullish view on New Zealand in mid-November.4 Bottom Line: Our recommended model bond portfolio outperformed the custom benchmark index during the fourth quarter of the year. The outperformance came both from the government and spread product sides of the portfolio, driven by a smaller exposure to the long-ends of government bond yield curves and our recommended overweight position on US high-yield corporate bonds. Future Drivers Of Portfolio Returns Chart 5Overall Portfolio Allocation: Significantly Overweight Credit Looking ahead, the performance of the model bond portfolio will be driven by three main factors: our below-benchmark duration bias, our overweight stance on corporate debt versus global government bonds, and last week’s upgrade of EM USD-denominated sovereigns and corporates to overweight. In terms of specific weightings in the GFIS model bond portfolio, we now have a more pronounced bias favoring global spread product over government debt, with a relative overweight of fifteen percentage points versus the benchmark index (Chart 5). We also remain modestly below-benchmark on duration, with an overall exposure equal to 0.5 years short of the benchmark (Chart 6). While we do not expect a major surge in bond yields this year, global yield curves discount inflation expectations that are too low and monetary policy easing in 2020 that is unlikely to be delivered (especially in the US). With global growth showing signs of bottoming out, and leading indicators pointing to continued improvement in the next 6-12 months, the risk/reward bias is tilted in favor of global yields moving higher, justifying reduced duration exposure. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: our below-benchmark duration bias, our overweight stance on corporate debt versus global government bonds, and last week’s upgrade of EM USD-denominated sovereigns and corporates to overweight. Chart 6Overall Portfolio Duration: Moderately Below Benchmark Chart 7Portfolio Yield: Significant Positive Carry From Credit Chart 8Portfolio Risk Budget Usage: Moderately Aggressive To better position the model bond portfolio to this backdrop of slowly rising global yields, we adjusted our government bond country allocations last week in favor of lower-beta markets such as Japan, Germany, France, Spain, Australia and the UK, while maintaining underweight positions in higher-beta markets such as the US, Canada and Italy.5 Our decision to upgrade global credit exposure helps boost the yield of our model portfolio to around 3%, or +43bps in excess of the benchmark index yield (Chart 7). Further, these changes represent an increase in the usage of the “risk budget” of our model bond portfolio, which is now running a tracking error (or excess volatility versus that of the benchmark) of 73bps (Chart 8). This is slightly higher than the 58bps prior to last week’s changes, but is still below the maximum allowable tracking error of 100bps that we have imposed on the model portfolio since its inception. More importantly, this is consistent with our view that investors should maintain a “moderately aggressive” level of risk in fixed income portfolios in 2020. Scenario Analysis & Return Forecasts To help provide some insight as to the potential excess returns from our model bond portfolio tilts, we use a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors. For credit, returns are estimated as a function of changes in the US dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-US yield changes are estimated using historical betas to changes in US Treasury yields (Table 2B). We take yield forecasts for US Treasuries that are translated to shifts in non-US yields using these yield betas.6 Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries In Tables 3A and 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, all revolve around our expectation that the most important drivers of future market returns will continue to be the momentum of global growth and the path of US monetary policy. Base Case (Global Growth Recovery): The Fed stays on hold, the US dollar weakens by -2%, oil prices rise by +10%, the VIX hovers around 13, and there is a bear-steepening of the UST curve. This is a scenario where global growth keeps recovering, alongside a US dollar which slightly weakens. The model bond portfolio is expected to beat the benchmark index by +90bps in this case. Global Growth Accelerates: The Fed stays on hold, the US dollar weakens by -5%, oil prices rise by +15%, the VIX declines to 10, and there is a more pronounced bear-steepening of the UST curve. Under this scenario, the pickup in global growth is faster than anticipated, causing the US dollar to weaken substantially as global capital flows move into more growth-sensitive markets outside the US. Both of these forces support EM economies and support oil prices. The model bond portfolio is expected to beat the benchmark index by +125bps in this case. Global Growth Upturn Fails: The Fed cuts rates by -25bps, the US dollar appreciates by +3%, oil prices fall by -20%, the VIX rises to 25; there is a parallel shift down in the UST curve. This is a scenario where global growth merely stabilizes at weak levels but fails to rebound. The Fed finds itself delivering one more rate cut in order to support the US economy. Meantime, the US dollar appreciates as capital flows out of growth-sensitive regions into the safe-haven greenback, particularly as global recession fears result in increased financial market volatility. The model portfolio will underperform the benchmark by -38bps in this scenario. Table 3AScenario Analysis For The GFIS Model Bond Portfolio For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the US dollar and the VIX index) are shown visually in Chart 9, while the US Treasury yield scenarios are in Chart 10. Chart 9Risk Factor Assumptions For The Scenario Analysis Chart 10US Treasury Yield Assumptions For The Scenario Analysis In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are confident that global growth is much more likely to rebound than decelerate further over the course of 2020. This will allow our increased spread product allocation to be the main driver of the portfolio returns. Thus, the overall expected excess return of our model bond portfolio over the benchmark is positive, given that the scenario analysis produces positive excess returns in the Base Case and “Global Growth Accelerates” outcomes. We are confident that global growth is much more likely to rebound than decelerate further over the course of 2020. This will allow our increased spread product allocation to be the main driver of the portfolio returns. Bottom Line: We are targeting a moderately aggressive level of overall portfolio risk, with below-benchmark duration exposure alongside meaningful overweight allocations to global corporate credit. In our base case scenario, global growth will continue to recover supported by accommodative global monetary policy, thus opening a window for another year of global corporates outperforming sovereign bonds in 2020.   Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Our Model Bond Portfolio Strategy For 2020: Selectively Aggressive”, dated January 7, 2020, available at gfis.bcarsearch.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Note that sectors where we made changes to our recommended weightings during Q4/2019 will have multiple colors in the respective bars in Chart 4. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, “When In Doubt, Trust The Leading Indicators”, dated November 19, 2019, available at gfis.bcaresearch.com. 5 We are defining “beta” here in terms of yield beta, or the sensitivity to changes in an individual country's bond yield to changes the overall level of global bond yields. 6 We are making a change in the betas used in our scenario analysis this week, using trailing 3-year yield betas to US Treasuries in place of the longer-term post-crisis yield betas that were measured over a full 10 years. Appendix Appendix Table 1GFIS Model Bond Portfolio Full Year 2019 Overall Return Attribution Appendix Chart 1GFIS Model Bond Portfolio Full Year 2019 Government Bond Performance Attribution Appendix Chart 2GFIS Model Bond Portfolio Full Year 2019 Spread Product Performance Attribution By Sector   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns