Developed Countries

Neutral Downgrade Alert This Monday we published a summary of our portfolio allocation changes that we made over the past couple of months. They key underlying theme running through most of our recent moves was to reduce our cyclical exposure and pocket in some profits. Today we highlight one of the major moves we are preparing to make: downgrade the S&P technology sector. The downgrade will be executed via the S&P software index. As a reminder, we have a stop at the 27% relative return mark and once it’s triggered, we will go neutral on software pushing the overall tech sector to a below benchmark allocation. Our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a seemingly invincible U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). Bottom Line: We reiterate our defensive stance on the U.S. equity market as the risk/reward remains to the downside. For the full summary of our recent moves, please see this Monday’s Weekly Report.  

Special Report

Highlights A decade after the financial crisis, yield remains scarce: The global count of bonds trading at negative yields seems to grow every week, squeezing a broad swath of investors who are desperate for coupon income. Increasingly accommodative monetary policy is not on income investors’ side, … : Dovish pivots from the Fed and the ECB ensure that low-to-negative yields won’t go away soon. … but it is quite friendly for maturity transformation strategies in the near term: Borrowing short to lend long is far from a fail-safe strategy, but it should dovetail nicely with reflationary Fed policy for at least the rest of the year. The time is ripe for returning to the agency mortgage REITs: Among public securities, agency mortgage REITs offer the most direct exposure to maturity transformation. Feature Economic data and corporate earnings releases remain mixed enough to provide both bulls and bears with ample support for their leanings. The debate within BCA remains spirited, and is emblematic of the debate among investors. Per the financial media, it seems as if the scolds are getting the most attention,1 even as the S&P 500 keeps setting new highs. One thing that both camps agree on, however, is that nothing is cheap. Equities are not terribly expensive, but bonds appear to have little chance of matching their historical return profile. Investors seeking income, from individuals and advisors, to pension funds, life insurers and endowments needing to meet a fixed schedule of liabilities, are under siege a decade into ZIRP and NIRP. With rate cuts on the horizon in the U.S., and the ECB preparing to ramp up accommodation, the pressure on income-seeking investors to throw caution to the wind and ignore credit quality shows no sign of abating. Maturity transformation – borrowing short to lend long – fits the Fed’s reflationary goals like a glove, and offers an alternative to abandoning credit standards. Contrary to popular belief, banks no longer pursue maturity transformation. Chastened by the savings-and-loans’ demise in the ‘80s, they make heavy use of swaps to keep a tight rein on asset-liability mismatches. Maturity transformation is agency mortgage REITs’ raison d’être, however, and aside from some hedging to ensure survival in the face of adverse interest-rate moves, they actively embrace it. The Agency mREIT Formula Mortgage REITs (“mREITs”) finance real estate investment, either by lending directly to property owners or by purchasing mortgages and/or mortgage-backed securities (“MBS”). Agency mREITs invest solely or predominantly in instruments issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. MBS issued by these entities are explicitly backed by the full faith and credit of the United States and bear little to no credit risk. The agency mortgage REITs stumbled ahead of all four of the yield curve inversions they’ve experienced, and six years of flattening has ground down their share prices. Despite the negligible credit risk in their investment portfolios, agency mREITs themselves are far from riskless – leveraged carry trading strategies are not for the faint of heart – but they have performed much better than non-agency mREITs, some of which go bust in every cycle. The agency mREITs are a much purer play on the term structure of rates than their non-agency peers. Their borrow-short-to-lend-long model is intentionally designed to exploit the yield curve’s typical upward slope. Though they stumble ahead of inversions (Chart 1), they are an attractive portfolio component when the fed funds rate outlook is benign and the curve is poised to steepen. Chart 1The Steeper The Better Banks are happy to lend against pristine collateral for short timeframes, allowing agency mREITs to build RMBS portfolios 10 times the size of their equity capital. Figure 1 illustrates the mechanics of building an agency mREIT portfolio. A new mREIT first raises equity in a public offering and uses the proceeds to purchase a portfolio of agency-backed residential MBS (“agency RMBS”). It then uses the portfolio as collateral for a secured repurchase (“repo”) loan, typically with a 30-, 60- or 90-day term, the proceeds of which it recycles into more agency RMBS.  With banks and brokers lending 95 cents on the dollar against agency collateral, an agency mREIT can easily amass asset portfolios several times the value of its equity capital. As long as portfolio income exceeds the sum of repo interest and operating expenses, it will be profitable. Table 1 lists all of the constituents of our Agency Mortgage REIT Index since its 1998 inception, along with the current constituents’ price-to-book multiples, dividend yields, betas versus the S&P 500 and leverage ratios. As a group, the agency mREITs have high dividend yields, low equity betas and considerable leverage. Table 1Agency Mortgage REIT Index Constituents Low beta and high leverage could be a nice mix when the economy is mushy and the Fed and other major central banks are ramping up accommodation. Then And Now The last time we recommended the agency mREITs (June 2011 through September 2012), they handily outperformed the S&P 500 and the Bloomberg Barclays High Yield Index on a total return basis (Chart 2). Uninspiring growth and easy monetary policy proved to be a potent mix for agency mREIT outperformance. The backdrop looks similar to us now, and we expect that the agency mREITs will outdistance high-yield corporate bonds over the rest of the year. They may be hard-pressed to top the S&P 500 under more constructive economic and market scenarios, but they should help protect other equity exposures in the event that economic growth and equities slump. Chart 2The Agency Mortgage REITs Boosted Our Returns In 2011-12, ... The Incredible Shrinking Stock Price Agency mREITs trade on their price-to-book multiples, but REIT rules leave the companies with little chance to grow book value. REITs have to distribute 90% of their annual income to shareholders to maintain their tax-preferred status, and they pay no income tax at the corporate level if they distribute all of it. The upshot is that mREITs have no retained earnings, which stymies them from growing book value.   In exchange for optimal tax efficiency, REITs give up the potential to compound their way to growth. Chart 3...But They've Run Into Headwinds Since Price-to-book multiples swung wildly in the group’s first decade, but have settled into a tight post-crisis range (Chart 3). If book value can’t grow, and multiples are capped around 1, stock price appreciation is unlikely to contribute to total returns. History suggests that investors should actually expect some modest drag from capital losses; all but one of the stocks in our Agency mREIT Index have declined since their inclusion2 (Chart 4). The drag follows from the constraints of the REIT rules; companies that can’t retain earnings and have already reached their borrowing capacity can only grow by issuing stock, but companies only receive about 95% of the proceeds from offerings after underwriting fees.3 The practical takeaway is that the agency mREITs are not a through-the-cycle play, and investors should only add them to their portfolios when they are comfortable that price declines are not likely to undermine dividend distributions. Honey, I Shrunk The Share Price. Agency mREIT Vulnerabilities The agency mREIT model has three inherent vulnerabilities: it relies on maturity transformation, it employs copious amounts of leverage, and it has convexity working against it. None is likely to prove fatal for entities that are reasonably prudent about hedging rate exposures, limiting leverage, and guarding against prepayments, but double-digit annual returns are not pre-ordained. Each management team makes its own hedging choices, but all agency mREITs maintain considerable duration mismatches. Unexpected changes in the term structure of rates have the potential to upend shareholder returns. Chart 5Repo Funding Is Reliable Our index constituents have a considerable amount of leverage. With 5-cent haircuts on agency repo financing, mREITs can theoretically build an agency MBS portfolio equivalent to 20 times the value of its equity capital. Maximal leverage would leave very little room to maneuver under duress, but leverage around ten times has not historically posed a problem. Given that agency MBS is gilt-edged collateral, we expect that the agency mREITs will be able to roll over their repo financings in a stress scenario, just as they were able to amidst the crisis (Chart 5). Interest rate volatility is also a headwind, independent of the level of rates. Under standard U.S. mortgage terms, MBS investors implicitly grant options to borrowers by allowing them the unlimited right to prepay their obligations without penalty (see Box). Options increase in value as the volatility of their underlying reference asset increases, so MBS values move inversely with changes in interest rate volatility. The good news for the mREITs is that increasingly accommodative Fed and ECB policy should act to tamp down rate volatility in the near term. The agency mREIT model proved its resiliency at the height of the crisis. Even in times of peak stress, it’s possible to borrow against the best collateral.   Box An Equity Investor’s Guide To Negative Convexity Even for fixed income lifers, mortgages can be a dauntingly complex product, largely because of borrowers’ ability to prepay their loans, without penalty, at any time.  This prepayment option gives mortgages and MBS what fixed income professionals call “negative convexity.” Long-duration, non-callable bonds are said to be positively convex.  That is, their value increases at an increasing rate as interest rates fall and decreases at a decreasing rate as interest rates rise.  Mortgage borrowers’ prepayment option prevents mortgage lenders from enjoying the full effect of convexity because the more the present value of a mortgage’s future payment stream rises as rates fall, the less likely lenders will realize it as savvy borrowers refinance into one offering a lower interest rate. This effect is called negative convexity and it is why mortgage investors must be compensated with higher yields.  Fannie, Freddie and Ginnie securities therefore yield more than Treasuries, even though both are backed by the full faith and credit of the U.S. Treasury.   With the exception of 2018’s backup, mortgage rates are where they’ve been since late 2014. There may not be many more loans worth refinancing. An unexpected rash of refinancings (“refis”) would squeeze agency mREIT income via mark-to-market losses and unwelcome exposure to reinvestment risk. More borrowers refi when rates decline, squeezing earnings, and cutting into, or even potentially wiping out, the benefit of lower funding costs. Although refi application activity has not always exhibited a tight correlation with agency mREIT returns, refis are a threat to agency mREIT earnings. Although we expect rates to remain in a fairly narrow range consistent with mushy growth and quiescent inflation expectations, it is our sense that they have bottomed and that refi activity, in turn, has already peaked (Chart 6). Chart 6Prepayments May Be Ready To Taper Off   Why Now? An equally-weighted basket of agency mREITs has outperformed both the S&P 500 and the Bloomberg Barclays High Yield Corporate Bond Index by two-and-a-half percentage points (“ppt”) on an annualized total return basis over its 21-plus-year history (Chart 7). They do not always outperform, however, and since we closed our position at the beginning of October 2012, the agency mREITs have lagged large-cap equities and high-yield bonds by ten-and-a-half and three ppt, respectively, on an annualized total return basis. Chart 7The Agency REITs Have Had A Strong Career, But The Last Seven Years Have Been Rough Rising rates and curve-flattening normally spell the end of agency mREIT outperformance, but we feared in the fall of 2012 that the Fed was killing the group with kindness. Ultra-accommodative policy encouraged refis while the Fed itself was actively bidding up agency MBS prices with QE3. Refis impaired the value of the legacy portfolios because they triggered losses on positions that had been marked-to-market above par. Higher prices helped the legacy portfolio holdings but forced the mREITs – in the midst of an epic three-year run of capital raising via secondary equity offerings – to put new capital to work at the top of the market. The policy backdrop appears more conducive to relative agency mREIT outperformance now. Faced with sluggish global growth and stubbornly low inflation expectations, the Fed is poised to cut rates for the first time since 2008. We expect the Fed will deliver a 25-basis-point cut at the conclusion of tomorrow’s FOMC meeting, and another one in September, and then refrain from hiking again until at least the first quarter. Nothing outperforms forever. The agency mREITs make a much better cyclical investment than a structural investment. Reflationary monetary policy should produce a steeper curve as growth and inflation expectations revive (Chart 8). A steeper curve will boost agency mREITs’ earnings by widening their net interest margins, allowing for increased dividend payments and fatter total returns. Given that we expect curve steepening, we do not worry that rate cuts will spark a wave of prepayments. As Chart 6 showed, 2018-vintage mortgages would seem to be the only ones issued over the last five years that are worth refinancing. Chart 8Rate Cuts Typically Promote A Steeper Curve Investment Implications Reflationary policy is a good backdrop for agency mREIT performance because it’s likely to promote a steeper curve. A steeper curve is manna from heaven for maturity transformation strategies, and it would boost mREIT income while reducing the potential for the capital losses that eat away at double-digit dividend yields. We are not counting on capital gains, but if peak inversion is behind us, the group’s multiple has a chance to expand. The bottom line is that several factors may have come together to bring the curtain down on the agency mREITs’ extended underperformance. We recommend that investors stick to the constituents in our index basket if they choose to add agency mREIT exposure to their portfolios. The leading mREIT ETFs, REM and MORT, provide one-stop access to the mREIT universe, but they come with considerable non-agency and commercial exposure. We are constructive on credit performance, but we think the best opportunities reside in the pure-play maturity transformation offered by the agency mREITs. We recommend funding agency mREIT exposure in balanced portfolios by diverting allocations from equities and high-yield positions. We plan on holding the mREITs for six months for now, but we’re open to staying with them longer. We expect that agency mREITs will boost risk-adjusted returns at least until the Fed first hikes again, and possibly even longer if inflation expectations revive. We therefore intend to maintain agency mREIT exposure through the end of the year, and are open to holding onto it for longer if conditions remain supportive. Our initial six-month recommendation in June 2011 remained in place for sixteen months, and we’d be pleased if this one had similar staying power.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com     Footnotes 1      De Aenlle, Conrad, “Is It Time to Fight the Fed?” New York Times, July 14, 2019, p. BU13. The experts quoted in the lead article in the Times’ latest quarterly mutual fund and ETF section were uniformly bearish on U.S. equities, in keeping with the author’s “iffy-to-awful” characterization of the economic backdrop. 2      Dynex (DX) is only included in our index from the beginning of 2001, when it switched to a pure agency strategy after nearly capsizing. Since its 1988 IPO, DX’s stock price has shrunk at an annualized rate of 3.9%. 3      The built-in drag from issuance is exacerbated by the lamentably common industry practice of issuing stock at a discount to book value, which dilutes incumbent shareholders’ investments.

Highlights Fed: The Fed will deliver a 25bp rate cut this week, despite a firmer tone to recent U.S. economic and inflation data, and the door will be left open to an additional “insurance” cut in September. ECB: The ECB will unveil a package of easing measures, from interest rate cuts to restarting asset purchases – including a healthy dose of corporate bond buying – in September. Fixed Income Strategy: The Fed is more likely to disappoint deeply dovish market expectations than the ECB over the next 6-12 months. European fixed income should outperform U.S. equivalents, both for government bonds and corporate debt, especially with the ECB ready to buy bonds again. Stay overweight Bunds vs Treasuries and euro area corporate debt vs U.S. equivalents on a USD-hedged basis. Feature Chart of the WeekData To Satisfy Both The Optimists & Pessimists In normal years, the final days of July are a quiet time for financial markets, with investors focused on preparations for August vacations rather than fretting about the performance of their portfolios. This is not one of those years. Central banks are springing into action to combat a global manufacturing downturn, creating a peculiar divergence of market price signals - elevated stock prices and depressed bond yields. BCA exposed our own internal debate on the growth outlook, and the implications for financial markets, in a recent Special Report.1 Our latest discussions with clients show similar splits within investment committees. While Global Fixed Income Strategy is in the optimist camp at BCA, we do recognize that there is enough news and data at the moment to satisfy both bullish and bearish investors (Chart of the Week). The growth bears can point to the continued deceleration of global trade and manufacturing data, with our global PMI indicator now sitting below the 2015/16 lows. The bulls, on the other hand, can highlight the bottoming of forward-looking data like our global leading economic indicator or the pickup in Chinese credit growth. Most importantly, the bulls are having a very enjoyable summer with interest rate cuts expected from the Fed and ECB, and the latter likely to restart quantitative easing. In this Weekly Report, we focus on monetary policy – specifically, the outlook for the Fed and ECB’s next moves over the next few months – and the implications for financial markets. Our conclusion is that the likely policy choices will benefit the relative performance of European fixed income markets versus U.S. equivalents over a 6-12 month horizon. The ECB’s Next Move: See You In September Chart 2A "Manufacturing-Only" Slump The global trade downturn has hit growth in the U.S. and Europe in a similar fashion, with PMI data showing substantially weaker activity in manufacturing compared to more domestically focused service industries (Chart 2). In Europe, there is an unprecedented divergence, with the services PMI rising and the manufacturing PMI plummeting over the past several months. At his press conference after last week’s monetary policy meeting, ECB President Mario Draghi described the European manufacturing data as “getting worse and worse”. He is right, as evidenced by the downtrends seen in other cyclical data like the ZEW and IFO surveys. European bond markets are betting that the ECB will focus on the manufacturing side of the export-heavy euro area economies and will soon ease monetary policy. Draghi gave strong indications that the ECB will deliver a package of easing measures at the September policy meeting, ranging from interest rate cuts to restarting the Asset Purchase Program (APP) for both government and corporate debt. Bond investors have been making large bets on the ECB delivering a big easing, with European bond yields plummeting to new cyclical lows. Investors remain highly skeptical that robust, inflationary growth – and higher interest rates – will ever return to Europe. The surge in the amount of debt trading at negative yields has gotten the attention of the market. By our count, 53% of all government bonds in the developed economies are now trading with a negative yield, with much of those in Europe (Chart 3). Investors are reaching for anything with a positive yield, including formerly toxic debt like Italian and Greek government bonds, with the benchmark 10-year yields in those markets now down to 1.6% and 2.1%, respectively. The rally has extended into spread product, creating oddities such as shorter-maturity EUR-denominated emerging market bonds – some with credit ratings below investment grade – trading at negative yields.2 From a longer-term perspective, the European bond rally continues a trend seen over the past decade where the relative performance of European equities versus government bonds, a.k.a. the stock-to-bond ratio, has been anemic compared to the similar metric in the U.S. (Chart 4). Investors remain highly skeptical that robust, inflationary growth – and higher interest rates – will ever return to Europe. Chart 3Positive Yields Are Getting Harder To Find Chart 4Structural Market Pessimism On Europe From a cyclical perspective, the case for a comprehensive easing package from the ECB now is a strong one, for several reasons: There is a broad-based slowing of growth and inflation within the euro area. Our diffusion indices of individual country data for real GDP growth and the OECD’s leading economic indicators show that the overwhelming majority of euro area nations are seeing slowing growth (Chart 5). Similar readings coincided with multiple interest rate cuts in 2001, 2008/09 and 2012. Chart 5Good Reasons For An ECB Rate Cut Chart 6Can The ECB Stop A Credit Crunch In Italy? Realized inflation and inflation expectations remain muted. Our diffusion indices for inflation rates among euro area countries are more mixed, with almost all nations actually seeing a slight uptick in core inflation over the past three months (bottom panel). Yet given the plunge in market-based inflation expectations, with the 5-year/5-year forward EUR CPI swap rate now down to 1.35%, the ECB must focus on trying to put a floor under growth to stabilize inflation expectations. Banks are starting to tighten lending standards. The ECB’s latest Bank Lending Survey showed a sharp tightening of lending standards to businesses during Q2/2019 (Chart 6) in France and, more worryingly, Italy where loan growth has been contracting on a year-over-year basis. The ECB already took action back in March to introduce a new targeted bank funding program (TLTRO3), largely to prevent a possible credit crunch in Italy where cheap ECB loans have funded 10% of total Italian bank lending. Yet with Italian banks already tightening lending standards to domestic borrowers, the ECB must take other actions to fight off a deeper contraction in Italian corporate loans. So what can the ECB plausibly do to ease monetary conditions that are already very loose? Cut the deposit rate. Given the ECB’s large balance sheet, swollen by asset purchases, the deposit rate on the excess reserves of banks is now effectively the ECB’s main policy rate. The deposit rate is currently -0.40%, and the ECB is concerned about the impact on European bank profitability by pushing that rate even deeper into negative territory. Draghi noted in his press conference last week that the ECB would consider “tiering” interest rates on excess deposits – essentially, exempting portions of European banks’ excess reserves from being charged negative deposit rates – to help offset the hit to bank profits from negative rates. Chart 7The ECB Can Help Finance European Companies Tiering has been introduced in other countries with negative deposit rates (Japan, Switzerland, Denmark), with limited impacts on bank profitability. The experience of those countries, however, suggests that an introduction of tiering by the ECB could put a floor under interest rate expectations, as it would indicate that additional rate cuts would be too damaging for European bank profitability to be considered by the ECB. For that reason, the ECB could decide to cut rates in September, but without tiering to ensure the maximum effect on European interest rates and bond yields. Restart the Asset Purchase Program (APP). This option is the most intriguing, as it would be a more direct way for the ECB to directly lower the cost of borrowing for European companies where credit conditions are becoming tighter. During the corporate bond buying phase of the APP in 2016-2018, the ECB was not only buying bonds in the secondary market but was buying corporates in the primary (new issue) market. At the peak, the central bank was buying around 18% of all the primary issuance by euro area companies eligible for the APP (Chart 7). This allowed many smaller European companies that relied entirely on bank loans to begin issuing publicly traded corporate bonds to diversify their sources of funding, with the ECB as a guaranteed buyer – in some cases, at interest rates even lower than corporate bank lending rates. With the ECB having fewer constraints on its corporate bond buying (i.e. no Capital Key as in the case of government bond purchases), the big policy surprise in September could be a bigger focus on corporates over sovereigns in the restarted APP. That would be good news for euro area corporate bond performance.  Chart 8Markets Discounting New ECB Corporate Bond Purchases? Investors seem to have already priced in some expectation of a resumption of the ECB’s corporate bond buying program, as euro area credit spreads have tightened sharply despite weakening economic growth (Chart 8). The spread tightening has occurred across all countries and investment grade credit tiers, pushing valuations back to towards the levels seen during the height of the ECB’s last period of corporate bond buying in 2017. The ECB will likely have to start out fairly aggressively with its pace of corporate bond buying, likely with more than €10bn/month, to justify current valuations. With the ECB having fewer constraints on its corporate bond buying (i.e. no Capital Key as in the case of government bond purchases), the big policy surprise in September could be a bigger focus on corporates over sovereigns in the restarted APP. That would be good news for euro area corporate bond performance. Bottom Line: The ECB will unveil a package of easing measures, from interest rate cuts to restarting asset purchases – including a healthy dose of corporate bond buying – in September. The Fed’s Next Moves: Insurance Cuts In July & September, No More After That The latest batch of data from the U.S. suggests that tomorrow’s widely-expected Fed rate cut will not be the start of a full-blown easing cycle. Expect a 25bp cut, with forward guidance suggesting another 25bps in September to protect against the adverse effects on the U.S. from any additional trade policy uncertainty and the associated deterioration of non-U.S. economic growth. Any further easing beyond that is unnecessary given the current state of U.S. growth and inflation. While the year-over-year growth rates of real GDP and core durable goods orders have slowed, the annualized changes over the past six months have shown some reacceleration (Chart 9). Consumer spending has also perked up after the sharp drop fueled by the government shutdown back in January, while the lagged impact of the sharp fall in mortgage rates over the past year should provide a moderate boost to housing activity. A similar dynamic is seen on the inflation front, where the marginal 6-month annualized rate of change of core PCE inflation has picked up to 2% (Chart 10). Less volatile inflation gauges like the Dallas Fed’s trimmed mean core PCE inflation rate are also at 2%. Furthermore, one of the main causes of the unexpected downturn in core PCE inflation in 2018, the Financial Services component, is already rebounding – a trend that will continue given the U.S. equity market’s strong gains in 2019 (bottom panel). Chart 9U.S. Growth Rebounding Chart 10U.S Inflation Rebounding Look for the Fed to signal a cautious tone tomorrow, but without sounding overly pessimistic on U.S. growth prospects. Bottom Line: The Fed will deliver a 25bp rate cut this week, despite a firmer tone to recent U.S. economic and inflation data, and the door will be left open to an additional cut in September. Additional moves after that are unlikely, given signs of reaccelerating momentum in U.S. economic growth and inflation. Investment Implications For The U.S. Versus Europe Over The Next 6-12 Months Looking ahead over the rest of 2019, relative economic performance should continue to favor the U.S. over Europe, creating a backdrop where relative monetary policies will support euro area fixed income returns versus U.S. equivalents.  Looking ahead over the rest of 2019, relative economic performance should continue to favor the U.S. over Europe, creating a backdrop where relative monetary policies will support euro area fixed income returns versus U.S. equivalents. Chart 11Too Soon To See An Export-Led Rebound In Europe The European economic downturn seen over the past year has come almost entirely from the trade side, when looking at the contributions to real GDP growth from net exports and domestic demand (Chart 11). This is also consistent with the manufacturing/services gap discussed earlier in this report, given the large share of manufactured goods in overall euro area exports. China will play a huge role in determining the future path of European economic growth through the trade channel, and already the pickup in Chinese credit growth is heralding a future rebound in European exports to China (third panel). A recovery in euro area exports to other countries besides China is also in store, based on our global leading economic indicator diffusion index (i.e. the net number of countries seeing a rising leading indicator). Yet given the long lead time before changes in those leading European export indicators and the subsequent growth of European exports – between 9-12 months – an improvement in euro area exports will not be visible in the hard data until late in 2019. It will likely be even longer than that given the additional publishing lags of the export data. Importantly, while the recent headlines have provided grounds for more cautious optimism on U.S.-China trade talks, any breakdown on that front would potentially delay any recovery in euro area exports (even if that is met by a bigger policy stimulus from China). At the moment, the U.S. economy is better positioned to withstand a renewed bout of trade uncertainty than the euro area, even though U.S. growth would take a hit through higher market volatility and tighter financial conditions if investors turn more risk averse on another failure of U.S.-China trade talks. Chart 12Not Much Downside Left For Bond Yields So after looking at the relative outlooks for economic growth in the U.S. and Europe, and the likely paths to be taken by the Fed and ECB, we come up with the following fixed income investment recommendations: Maintain below-benchmark overall global duration exposure: At an overall portfolio level, we continue to recommend a moderate below-benchmark global duration stance (Chart 12). Our global leading economic indicator diffusion index suggests that global real yields should soon bottom. At the same time, the annual rate of change of oil prices will accelerate over the rest of the year simply based on comparisons versus the sharp plunge in energy prices in the latter months of 2018. If the bullish oil forecast of BCA’s commodity strategists comes to fruition, the growth rate of oil prices will be even higher (see the “X” in the middle panel of Chart 12). Given the correlations between market-based inflation expectations and oil prices, a rebound in oil on a rate of change basis should put a floor under the inflation expectations component of government bond yields in the developed markets. Expect a rebound in the Treasury/Bund spread: The ECB is more likely to deliver on the policy expectations for the next twelve months discounted in Overnight Index Swap curves (-22bps of rate cuts) compared to the Fed (-89bps of rate cuts). This suggests that the spread between 10-year U.S. Treasury yields and 10-year German Bund yields is likely to widen, but coming first through higher relative market-based U.S. inflation expectations - a trend that is already starting to unfold (Chart 13).   ECB rate cuts, and the return of the ECB as a buyer of euro area non-financial corporate debt, will provide an obvious boost to the relative performance of euro area corporate debt (both investment grade and high-yield) over U.S. equivalents. Favor euro area corporates versus U.S. corporates: ECB rate cuts, and the return of the ECB as a buyer of euro area non-financial corporate debt, will provide an obvious boost to the relative performance of euro area corporate debt (both investment grade and high-yield) over U.S. equivalents. Another factor supporting European corporates is the better state of financial health among euro area companies, according to our Corporate Health Monitors (Chart 14). Chart 13Inflation Expectations Bottoming Out, Led By The U.S. The gap between the “bottom-up” versions of the Monitors tracks the spread differentials of the benchmark corporate bond indices quite closely, and is currently pointing to a more solid fundamental underpinning for euro area corporates on a cyclical (6-12 months) horizon. Chart 14Favor Euro Area Corporates Over U.S. Corporates   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open”, dated July 19, 2019, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2019-07-15/em-succumbs-to-sub-zero-epidemic-as-debt-pile-doubles-in-a-weekD The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Feature This publication’s approach to bond investing is based on an expectations view of the yield curve. We project the future path of Fed policy and compare our forecast to what is priced into the market.1 In other words, we tend to eschew investment approaches that involve forecasting ex-ante supply and demand flows in the Treasury market. That being said, it is still important to understand the details of the markets we study. In this Special Report we get closer to that understanding by looking at the major sources of demand for U.S. Treasuries. We consider what motivates each market actor’s Treasury ownership, and how their presence in the market might evolve in the years to come. The bulk of Treasury ownership is split between six market players (Chart 1):   Foreign official and private entities (aka rest of the world, 36%) Pension funds (14%) The Federal Reserve (13%) Open-ended mutual funds, ETFs & money market funds (12%) Households (12%) Private depositary institutions (aka banks, 4%) We consider each source of Treasury demand in turn. Rest Of The World Foreign Treasury holdings are split between official (i.e. central banks) and private entities, with central banks accounting for roughly two thirds of overall foreign demand. Official foreign entities became a major holder of Treasuries after the abandonment of Bretton Woods in 1971. By ending the U.S. dollar’s convertibility to gold, the former became the global reserve currency and Treasuries the most-demanded foreign reserve in the world. Foreign Treasury holdings then surged a second time in the late 1990s, after a series of financial crises prompted many emerging market economies to shift from being net importers of capital to net exporters. A shift that caused Ben Bernanke to coin the term “global savings glut” in 2005.2  Pension fund Treasury holdings, in the aggregate, are principally determined by demographics and pension plan funded status. Bernanke’s global savings glut refers to the export-oriented growth strategies pursued by many emerging market economies in the 1990s and 2000s. These nations commonly had high domestic savings rates and a lack of internal investment opportunities. This manifested in growing emerging market current account surpluses that were offset by an expanding U.S. current account deficit. The imbalance led to a massive build-up of emerging market foreign-exchange reserves that was funneled back into the U.S. Treasury market (Chart 2). Chart 2Globalization Has Peaked, So Have ##br##Foreign Treasury Holdings Although it is still early in the process, global exports peaked relative to GDP in 2014. Average tariffs have increased since then and, according to the World Trade Organization, the number of new trade restrictions exceeded the number of trade liberalizing initiatives in 2016. As can be seen in Chart 2, the rollback of globalization implies that global current account imbalances will slowly fade during the next few years. Foreigners will therefore have less of a need to own U.S. Treasuries. In other words, foreign holdings of Treasuries have probably already peaked.  Bottom Line: The apex of globalization is likely behind us. Going forward, protectionist trade policies will drive global exports lower as a share of GDP. As a result, foreign holdings of Treasuries have peaked, and although the foreign sector will remain the largest player in the Treasury market for quite some time, its importance will slowly fade. Pension Funds Chart 3Pension Funds Do Not Weigh As Much Pension funds, regardless of their status (private vs. public) or design (defined benefit vs. defined contribution plans), have liability structures that require matched assets on the other side of their balance sheets. In the past, pension funds accomplished this by holding mostly Treasuries and corporate bonds. Then, regulations in the 80s and 90s led to a softening of the constraints placed on pension funds, effectively giving them more latitude to reallocate away from fixed income securities. In the early 2000s, pension funds owned more than 25% of the Treasury market, compared to 14% today (Chart 3). As is explained below, pension fund Treasury holdings, in the aggregate, are principally determined by demographics and pension plan funded status. Funded Status Chart 4It's All About Funded Status For Pension Funds Pension plan funded status represents the difference between the present value of pension fund liabilities and assets. Ideally, funded status should remain close to 100%, but it has deteriorated during the past 20 years. When the funded status is lower, pensions often choose to take more risk in the hopes of “catching up”. “Catching up” means that pensions will decrease their holdings of Treasuries in order to invest more in riskier assets (Chart 4). On the flipside, funded status improvements cause pensions to de-risk their portfolios by moving back into the safety of U.S. Treasuries. Chart 4 shows that pension funded status and pension fund Treasury holdings are positively correlated over time. Interest rates are an important determinant of funded status. Lower (higher) interest rates lead to deteriorating (improving) funded ratios. This correlation holds for two reasons. Low interest rates mean that plans earn less income from their asset portfolios, and they also inflate the present value of plan liabilities. Conversely, high interest rates increase plan investment returns and dampen the present value of plan liabilities. The relationship means that pensions tend to increase their Treasury holdings as rates rise and decrease their holdings as rates fall.  Outside of interest rates, stock market performance is the most important determinant of plan funded status. Pension funds usually maintain something close to a 60/40 split between equities and bonds. As such, equity market outperformance forces pension funds to buy more Treasuries in order to keep these weights balanced. Periods of strong stock market performance also improve plan funded status, leading to even more Treasury buying. Demographics Demographic trends dictate the amount of assets that pension funds have to invest in the first place. Arguably the most important demographic trend is the ratio of retirees to workers. When that ratio is low, many more people are paying into pensions than are withdrawing money, leading to greater pension fund security holdings – including Treasuries. Conversely, a higher ratio of retirees to workers means that pension funds have fewer assets to invest. For many years, the ratio of retirees to workers had been flat, around 15%, before it started to rise rapidly when the first baby boomers started retiring around 2009 (Chart 4, bottom panel). Projections show the ratio continuing to increase through 2050, suggesting that demographics are no longer a tailwind for pension fund Treasury holdings.  The Fed will always be a source of demand for Treasuries. The ratio of retirees to workers also impacts pension plan funded status. The increasing number of retirees relative to workers means pension funds are experiencing more cash outflows, from more individuals tapping into their plans, than inflows from the working population. All else equal, this translates into more underfunded pensions. Notice how the pick-up in old-age dependency ratio coincides with the deterioration in plan funded status (Chart 4, panels 1 & 4). Bottom Line: Pension funds will probably increase their Treasury purchases between now and the end of the economic recovery. The Fed will need to deliver further rate hikes before the next recession hits, and higher interest rates along with continued stock market gains will lead to an improvement in plan funded status on a cyclical horizon. But structurally, demographic trends point to fewer pension fund assets under management and worse plan funded status in the long-run. Pension fund Treasury demand should be lower during the next economic recovery than it is during the present one. Federal Reserve Chart 5Normalization Under Way: Do Not Disturb The Fed has always been an important actor in the Treasury market, though historically it focused mostly on T-bills. But the extraordinary measures taken during the Great Financial Crisis significantly increased the size of the Fed’s balance sheet and made it a major market player. The Fed’s Treasury holdings peaked at 19% of the market in 2015 (Chart 5). In October 2017, the Fed started unwinding its balance sheet by gradually letting its assets – essentially Treasuries and Agency MBS - mature without reinvesting the proceeds. The amount of assets that could leave the balance sheet that way followed predetermined monthly caps, which reached $30 billion for Treasuries and $20 billion for MBS in October 2018. So far, $371 billion of Treasuries and $245 billion of MBS have left the Fed’s balance sheet since the beginning of the runoff. But now, the Fed’s balance sheet run-off is nearly complete, and last March the Fed provided a detailed roadmap for its final stages. Beginning in October 2019, the Fed will maintain its overall assets constant, which we project should be in the vicinity of $3.54 trillion (Table 1).3 Meantime, MBS will continue to run off, but this time, the proceeds will be reinvested into Treasuries. Put differently, the Fed will once again become an active buyer of Treasuries, by the amount of MBS that runs off, which will be no more than $20 billion per month. Table 1Simplied Fed Balance Sheet Projections The policy of keeping its assets constant ensures that the supply of bank reserves will continue to shrink. This is because the Fed’s other non-reserve liabilities – mostly currency in circulation – will continue to grow. If we assume that (i) the Fed allows bank reserves to shrink until the end of 2020, (ii) MBS run off the balance sheet at a pace of $15 billion per month and (iii) currency in circulation grows by 5% per year, then we calculate that the Fed will add close to $200 billion of Treasuries by the end of next year. Alternatively, the Fed could decide much earlier that bank reserves have shrunk to an appropriate level. In that case, Treasury buying would be higher. For example, if the Fed decides to keep the supply of reserves flat as of the end of Q1 2020, we calculate that it would buy $267 billion of Treasuries between now and the end of 2020. In the very long run, the Fed’s balance sheet normalization plan also involves transitioning back to a Treasury-only portfolio. While it will take years to implement, it means that, ultimately, the $1,484 billion of MBS currently on the balance sheet will be converted into Treasuries. Bottom Line: The Fed will always be a source of demand for Treasuries. The normalization process that was initiated back in 2017 is now almost complete, and the Fed will start increasing its Treasury holdings in October. Treasury purchases will be modest at first, limited to the amount of MBS that runs off the Fed’s balance sheet, but they will accelerate once the Fed decides that enough bank reserves have been drained from the system. That decision could come as early as next year. Open-Ended Mutual Funds, ETFs & Money Market Funds Chart 6Growing Presence The combined Treasury holdings of open-ended mutual funds, ETFs and money market funds make them the fourth largest actor in the market, representing 12% of total supply (Chart 6).  Open-Ended Mutual Funds Bond mutual funds make up 28% of open-ended mutual funds total net assets (ex. money market funds). Following the financial crisis, the sustained shift into bond funds from equity funds and the growth of passive investing have been two of the major trends for the sector (Chart 7). According to the Investment Company Institute, actively managed equity mutual funds have experienced negative cumulative flows of $1.4 trillion post-crisis, while bond funds and passive equity funds registered $2.2 billion and $1.6 of inflows over the same period, respectively. Further, net new cash flows to bond mutual funds tend to correlate with bond market total return performance (Chart 7, bottom panel). Chart 7Bond Mutual Funds As Popular As Ever Finally, the fact that fixed-income funds are usually popular with retirees – who are more risk averse and are looking for a steady cash flow – ensures that there is still more upside in the Treasury buying of these funds, based on aging population and the baby boomers retiring. Exchange-Traded Funds (ETFs) The growth of passive investing, driven by lower fees, has benefitted ETFs. They now hold 1% of the Treasury market, driven by bond ETFs’ net assets growing at double digits since the end of the financial crisis. We expect this trend will continue and for ETFs to become a more active Treasury buyer. Money Market Funds Money market funds invest in very short-term assets and are divided into two broad categories: government money market funds that can only invest in government debt, and prime funds that can also invest in high-quality corporate debt. In October 2016, sweeping reforms on liquidity and maturity provisions adopted by the SEC resulted in prime funds becoming much less attractive to investors, leading to an increase in demand for government money market funds and thus indirectly raising the demand for Treasuries (Chart 8, top panel). Chart 8Money Market Funds' Drivers With that information in hand, we can turn to who invests in money market funds to assess what the demand for Treasuries will be. Households own 59% of money market fund shares, with nonfinancial corporations far behind with 15%. Money market funds experience inflows during tightening cycles, as short-term yields become more attractive (Chart 8, bottom panel). Periods of expensive equity valuation also coincide with more inflows, as individual investors put money on the sidelines (not shown). Bottom Line: Open-ended mutual funds, ETFs and money market funds have become major actors in the Treasury market. The rapid growth of ETFs, the shift to bond funds from equity funds and, more structurally, changing demographics, are all contributing trends that should not fade anytime soon;  expect more Treasury buying. Household Sector Chart 9Once Bitten Twice Shy? Household ownership has declined over time. In the early 1950s, households accounted for about 30% of Treasury ownership but that has fallen to a meagre 2% by 2007. Households have been buying Treasuries again since the financial crisis, and now hold 12% of the market (Chart 9). As would be expected, household Treasury ownership is highly correlated with the personal savings rate. A falling savings rate during the 1980s, 1990s and 2000s caused Treasury holdings to decline, but the shock of the financial crisis has led to more conservative household behavior and greater Treasury ownership. We should note that Federal Reserve data on household Treasury ownership includes some institutional investors such as onshore hedge funds. It is conceivable that the financial crisis has permanently shifted household preferences, leading to a much higher savings rate than in prior recoveries. However, high household wealth and elevated consumer sentiment suggest that the savings rate is more likely to fall than rise during the next couple of years (Chart 9, bottom 2 panels). We don’t see much more upside in household Treasury ownership. Bottom Line: Households have added to their Treasury holdings since the financial crisis. But as of today, the savings rate is more likely to fall than rise further. Expect household Treasury ownership to remain low for the next few years. Banks Chart 10Banks Haven't Been Active Buyers...Until Recently In the early 50s, banks accounted for more than 30% of Treasury ownership. Since then, it has steadily declined and now barely amounts to 5% of total securities outstanding (Chart 10). Simply put, banks haven’t been active buyers of Treasuries. But this is starting to change, albeit slowly, due to the regulatory burdens that have been imposed since the Financial crisis. Under Basel III, large U.S. banks are mandated to hold enough high-quality liquid assets (HQLAs) to cover 30 days worth of net cash outflows in a stressed scenario. The ratio between HQLAs and potential net cash outflows is called the Liquidity Coverage Ratio (LCR), and banks must maintain a LCR of at least 100%. HQLAs consist of Level 1 assets and Level 2 assets (which cannot exceed 40% of HQLA). Level 1 assets are bank reserves, cash and Treasury securities, and Level 2 assets are riskier securities such as Agency MBS and corporate bonds. A haircut is applied to level 2 assets for calculating HQLA. With reserves and Treasuries being interchangeable from the perspective of the HQLA calculation, the fact that the Fed is currently shrinking the supply of reserves means that banks might need to increase their Treasury buying to compensate for it. A great deal of Treasury buying will probably not be necessary to compensate for the Fed shrinking the supply of reserves. Based on disclosures from the eight U.S. Systemically Important Financial Institutions (SIFIs) – who have close to $500 billion of reserves held at the Fed – a great deal of Treasury buying is probably not necessary. As shown in Table 2, although these banks display a large degree of heterogeneity in their approaches to meeting their LCR requirements, they all enjoy decent buffers above the 100% minimum requirement. In other words, they can allow the supply of bank reserves to shrink and still maintain LCR compliance with minimal Treasury buying. Table 2 also shows that, on average, reserves represent 19% of the SIFIs’ eligible HQLA, implying these banks are not overly dependent on reserves to comply with Basel III. Table 2Simplied Fed Balance Sheet Projections In a 2017 paper, Ihrig, Kim, Kumbhat and Vohtech4 observed the following: [D]uring the run-up to becoming LCR compliant, banks in aggregate took on a significant quantity of excess reserves. However, after becoming compliant, many such banks adjusted their liquid holdings, reducing their stocks of reserve balances and raising their holdings of other HQLA components, presumably to achieve a more optimal configuration. Table 3Factors Affecting Demand For Reserves This suggests that, subsequent to LCR implementation, decisions regarding reserve holdings for banks may either be tied to daily business operations or rely on a risk-return decision framework. These findings are corroborated by the answers provided by the 51 banks surveyed by the Federal Reserve in the Senior Financial Officer Survey published last September. As shown in Table 3, the factors affecting their respective demand for reserves ranked as “important” or “very important” have to do with self-imposed and internal controls or daily business operations. Only 37% of the respondents ranked the HQLA requirement as an important factor. Bottom Line: The shrinking supply of bank reserves will probably lead to greater Treasury buying from banks, but a surge in bank Treasury demand is unlikely. Banks are already compliant with the Liquidity Coverage Ratio, and their High-Quality Liquid Asset balances are not overly dependent on reserves. Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/boarddocs/speeches/2005/200503102/default.htm  3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcarsearch.com 4 https://files.stlouisfed.org/files/htdocs/publications/review/2019/07/12/how-have-banks-been-managing-the-composition-of-high-quality-liquid-assets.pdf