Developed Countries

Highlights Dovish Central Banks: Central bankers have successfully talked down bond yields, in an effort to prevent an even deeper pullback in global growth. Government bonds now look overvalued relative to likely outcomes on growth and inflation over the next year. A moderate below-benchmark medium-term duration exposure is warranted on a risk/reward basis, as the next large yield move from current levels is more likely up than down. U.S. Treasuries: The Fed is now signaling no more rate hikes for the rest of 2019, but this newly dovish language merely brings their own interest rate forecasts closer to current market pricing. Lower bond yields and easier financial conditions will help underwrite a recovery in U.S. growth, just as a stabilization of the global economy is starting to materialize. The current downturn in Treasury yields, which is looking technically stretched, should soon begin to bottom out. Feature Another Panic Hits Global Bond Markets The message from central banks to the financial markets is now very loud and clear – global monetary policy is firmly on hold for at least the rest of 2019. Fears over slowing global growth, persistent geopolitical uncertainty and underwhelming inflation have put policymakers on a more cautious footing. The messaging from central banks has become highly synchronized, with even the same buzz words (“patience”, “uncertainty”, “data dependent”) being bandied about in speeches and policy statements. Bond yields have responded to the dovish forward guidance in recent weeks from the Fed, the European Central Bank, the Bank of England, the Bank of Japan and others. Our “Major Countries” measure of 10-year government bond yields in the largest developed economies has fallen to 1.3%, the lowest level since May 2017. The 10-year U.S. Treasury yield now sits at 2.40%, below the fed funds rate and triggering investor angst over the traditionally negative economic message of an inverted yield curve. Global equity markets, however, seem less concerned. The MSCI World Equity Index is only 5% from the 2018 highs after rallying 16% so far from the late 2018 low. This gap between robust equity prices and depressed bond yields is unusual, but not unprecedented. Similar divergences have occurred as recently as 2016 and 2017 (Chart of the Week). During those episodes, central banks responded to uncertainty (the July 2016 Brexit vote followed by currency volatility in China) or sluggish inflation readings (the unexpected 2017 dip in U.S. core inflation) by shifting to an easier monetary stance. This was largely done through delayed interest rate hikes or more dovish forward guidance, with the result being lower bond yields, diminished market volatility and easier financial conditions. Better global growth and more stable inflation expectations soon followed. Chart of the WeekWill Bonds Lose This Battle Once Again? With tentative signs emerging that global growth momentum is bottoming out, the next major move in global bond yields is likely up. Those prior gaps between low bond yields and high stock prices were eventually resolved through higher yields – an outcome that we think will be repeated in the current episode. Already, bond markets have aggressively repriced expectations of future monetary policy with even some rate cuts now discounted in the U.S., Canada and Australia. With tentative signs emerging that global growth momentum will soon bottom out and recover in the latter half of 2019 (Chart 2), the next major move in global bond yields is likely up, not down. Chart 2Global Bond Yields Are Too Pessimistically Priced The decline in yields over the past few months has obviously challenged our recommended strategic below-benchmark global duration stance. The two primary factors that drive our medium-term duration calls on any country can be summed up by the following questions: Do we expect greater or fewer rate hikes than are discounted in money market curves? Do we expect bond yields to rise above or below the current pricing in forward yield curves? In aggregate, we do not expect the major central banks to deliver more monetary easing than is currently priced according to our 12-month discounters, although we think that is most likely in the U.S. where the market is pricing in -21bps of cuts over the next year. Also, the 12-month-ahead forwards for 10-year bond yields in the U.S. (2.51%), Canada (1.69%), Germany (0.13%), Japan (0.02%), U.K. (1.16%) and Australia (1.82%) are not particularly high. Although, once again, we have the greatest confidence that those yield levels will be surpassed in the U.S. The timetable to generate a positive payoff by positioning for higher yields has been stretched out by the renewed dovishness of central banks. By switching their focus from tight labor markets and accelerating wage growth to slowing economies and softening inflation expectations, policymakers are creating a backdrop of lower volatility and more market-friendly stock/bond correlations (Chart 3). Chart 3Stock/Bond Yield Correlation Negative Once Again The goal is to underwrite additional rallies in risk assets to ease financial conditions and stimulate economic activity. This will eventually sow the seeds for a return to a more hawkish bias, but the timing of that switch is uncertain and will most likely coincide with some evidence of faster Chinese economic growth and an end to the downturn in global trade activity – an outcome that is unlikely to occur until the latter half of 2019. Bottom Line: Central bankers have successfully talked down bond yields, in an effort to prevent an even deeper pullback in global growth. Government bonds now look overvalued relative to likely outcomes on growth and inflation over the next year. A moderate below-benchmark medium-term duration exposure is warranted on a risk/reward basis, as the next large yield move from current levels is more likely up than down. The Fed’s more dovish forward guidance only brought the Fed’s rate forecasts down closer to current market pricing. U.S. Treasury Yields Should Soon Bottom Out U.S. Treasury yields moved sharply lower following last week’s Fed meeting, as the FOMC delivered a dovish surprise with its new set of interest rate projections. As of last December, 11 out of 17 Fed members expected to lift rates at least twice in 2019. Now, 11 out of 17 expect to keep rates flat. This was enough to lower the median “dot” by 50bps for 2019, essentially forecasting an unchanged funds rate this year with only one hike expected in 2020. While these are significant dovish changes to the Fed’s forward guidance, it only brought the Fed’s forecasts down to current market pricing on interest rate expectations (Chart 4). Yet bond yields fell sharply in response, tipping the Treasury curve into inversion. The cautious language from Fed Chairman Powell in the post-meeting press conference, which included a reference to Japan-style deflation risks as a threat if the Fed ignored the message from below-target U.S. inflation expectations, likely helped fuel the bullishness of Treasury market participants. Chart 4Fed Is Just Catching Up To Market Pricing It seems clear that the arguments of the more dovish members of the FOMC (John Williams, Richard Clarida, James Bullard, Neil Kashkari) have won over the more pragmatic members of the committee, including Jay Powell. Yet our own Fed Monitor is still not suggesting that rate cuts are necessary (Chart 5), although the growth component of the Monitor is tracking the last downturn seen in 2014/15. More importantly, the inflation elements of the Monitor are not pointing to a need for easier policy, while financial conditions are still in the “tighter money required” zone. Chart 5Markets Pricing In Fed Easing That Is Not Required The Fed is likely to ignore the risks to financial stability stemming from the new dovish slant to its monetary policy, as financial conditions have not yet fully unwound the tightening seen in the risk asset selloff in late 2018. Does that mean that the Fed wants to see U.S. equities hit new highs and U.S. corporate credit spreads return to previous lows? If that means a deeper U.S. economic slowdown can be avoided, the answer is most likely “yes”. They can always return to targeting overvalued asset markets if and when the U.S. and global economy is on more stable footing. In terms of the U.S. economic outlook, we think the current concerns over the recession risks stemming from an inverted Treasury curve are overstated. In a Special Report we published last July, we looked at the relationship between monetary policy, yield curves and economic growth and came to the following conclusions:1 Curve inversion, on a sustained basis, occurs when the Fed lifts the real (inflation-adjusted) funds rate above the neutral rate of interest, “r-star” (Chart 6); Chart 6Too Soon For Sustained U.S. Treasury Curve Inversion Once the Treasury yield curve does invert on a sustained basis, a recession starts seventeen months later, on average; Curve inversion, on a sustained basis, occurs when the Fed lifts the real funds rate above the neutral rate of interest, “r-star” At the moment, the Fed has paused its rate hiking cycle with a real funds rate that is just shy of the Williams-Laubach estimate of r-star, which is 0.5%. Considering that the “Williams” in “Williams-Laubach” is the current president of the New York Fed and Number Two on the FOMC, we should not be surprised that the Fed chose to pause now! The more important point is that it seems too early to look for a classic late-cycle Treasury curve inversion with the Fed on hold – unless, of course, U.S. inflation falls and pushes the real fed funds rate above r-star. That would require a much sharper slowing of U.S. growth to a below-potential pace that is not indicated by current data. Reliable cyclical indicators like the ISM Manufacturing index have fallen from the heady 2018 peaks, but remain at levels consistent at least trend U.S. economic growth (Chart 7). Additionally, the Conference Board’s leading economic indicator, as well as our own models for U.S. employment and capital spending growth, are suggesting that only some cooling of U.S. growth should be expected in the next few quarters (Chart 8), but not to a below-potential pace (i.e. significantly less than 2%). Chart 7UST Yields Should Soon Stabilize Chart 8A Big U.S. Slowdown In 2019 Is Unlikely So how much lower can Treasury yields go in this current rally? Looking at the individual valuation components of yields, the answer is “not much”. The real component of Treasury yields has already fallen sharply since the 2018 peak, and is now approaching 2017 resistance levels. At the same time, 10-year inflation expectations are drifting higher and are now around 25bps below the highs seen in 2018 (Chart 9). At best, we can see real yields and inflation expectations fully offsetting each other and keeping yields unchanged. The more likely outcome, however, is that inflation expectations continue to move higher while real yields stabilize as the U.S. economy moves away from the Q1 growth slowdown, meaning that we are close to the floor in yields now. Chart 9Inflation Expectations Will Lead UST Yields Higher How much lower can Treasury yields go in this current rally? Looking at the individual valuation components of yields, the answer is “not much”. The current downturn in Treasury yields is already looking stretched from a technical perspective (Chart 10). The 26-week total return of the Bloomberg Barclays U.S. Treasury index is now approaching the highs seen during all previous Treasury rallies since the Fed ended its QE program in 2014. The same signal comes from the size of the deviation of the 10-year Treasury yield below its 200-day moving average. Duration positioning is quite long, as well, according to the J.P. Morgan client survey. Chart 10UST Rally Looking Stretched In The Near-Term Not all the technical indicators are as stretched, as the Market Vane Treasury sentiment survey remains depressed and net speculative positioning on 10-year Treasury futures is only neutral (after a very large short position was covered). On balance, however, the indicators suggest that the current Treasury rally is looking over-extended. One other factor to consider is global growth. Much of the current decline in Treasury yields is a result of the prolonged weakness in non-U.S. growth that has pulled down all global bond yields. Yet according to the latest readings from cyclical indicators like the ZEW survey, expectations of future economic growth are now bottoming out, even as current growth continues to slow (Chart 11). This bodes well for a potential bottoming of global growth momentum that could put a floor underneath bond yields. Chart 11Early Signs Of Growth Stabilization? One final note – any signs of stabilization of European growth could also help global bond yields find a floor. Not only are the ZEW surveys in Europe starting to bottom out, the widely-followed German IFO survey is also starting to show modest improvement. If these trends continue, that would help end the drag on global yields from weakening European growth which has pulled German Bunds back to the 0% level (Chart 12). Chart 12Bunds & JGBs Have Been A Drag On Global Yields Any signs of stabilization in European growth could also help global bond yields find a floor. Bottom Line: The Fed is now signaling no more rate hikes for the rest of 2019, but this newly dovish language merely brings their own interest rate forecasts closer to current market pricing. Lower bond yields and easier financial conditions will help underwrite a recovery in U.S. growth, just as a stabilization of the global economy is starting to materialize. The current downturn in Treasury yields, which is looking technically stretched, should soon begin to bottom out. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31st, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy Corporate sector selling price inflation is nil while leading wage inflation indicators signal additional labor cost increases in the coming months. The risk is that profit margins have already peaked for the cycle. We reiterate our tactically cautious overall equity market view. Galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A all signal that it still pays to be bullish software stocks Recent Changes Last Thursday we downgraded the S&P railroads index to underweight. Also last Thursday we trimmed the S&P air freight & logistics index to neutral. Table 1 Feature The SPX stalled last week, digesting the now-complete Fed pivot. Our sense is that the Fed’s dovish turn is now fully reflected in equities. Importantly, the longer and wider the dichotomy between stocks and bonds gets, the more painful the ramifications from the eventual snap will be, likely with equities yielding to the bond market (Chart 1). As we first posited on March 4, short-term equity market caution is still warranted.1 Chart 1Time To Get Back Together While the Fed meeting and sharp decline in Treasury yields dominated headlines last week, it was the NFIB’s latest release that really caught our attention. Importantly, it revealed that taxes and big government are no longer the biggest problems facing small and medium business owners, but labor is: “Twenty-two percent of owners cited the difficulty of finding qualified workers as their Single Most Important Business Problem, only 3 points below the record high. Ten percent of owners find labor costs as their biggest problem, a record high for the 45-year survey.”2 Historically, such extreme tightness in the SME labor market is a precursor of a yield curve inversion (NFIB cost of labor shown inverted, Chart 2). The link is clearer if we show this same NFIB series with the Labor Department’s average hourly earnings monthly release that is currently running at a 3.4%/annum clip (Chart 3). In other words, a tight labor market is conducive to corporations bidding up the price of labor which in turn causes the Fed to raise interest rates, eventually inverting the yield curve. Chart 2Cycle Is Long In The Tooth Chart 3Wage Growth... This macro backdrop is slightly unnerving and our biggest concern is the S&P 500’s profit margins (Chart 4). Q3/2018 marked the all-time peak in SPX quarterly margins according to Standard & Poor’s,3 and in Q4/2018 margins have deflated from a high mark of 12.13% to 10.11%, or a 16.7% q/q drop. Chart 4...Denting Margins Undoubtedly, last year’s fiscal easing-induced all-time highs in SPX margins is unsustainable, and a tight labor market is a warning shot. Using the same NFIB series on cost of labor being the most important problem SMEs face and subtracting it from our corporate pricing power proxy, we constructed an equity market margin proxy, shown as a Z-score in Chart 5. Historically, the y/y change in SPX profit margins move in lockstep with our margin proxy and the current message is grim (Chart 5). Chart 5Margin Trouble Ahead Before getting too bearish though, we want to make three salient points: First, while the NFIB survey’s labor related indicators are disconcerting, unit labor costs – the best measure of wage growth – remain muted as productivity growth has ramped up recently. Second, using empirical evidence dating back to the 1960s, the ultimate SPX profit margin mean reversion occurs during recessions, when EPS suffer a major setback. The implication is that margins can move sideways or grind lower in the coming year. As a reminder, BCA’s review remains that the U.S. will avoid recession in the next 12 months. Third, the most important yield curve slope, the 10/2, has not yet inverted, and even when it does invert, investors will have time to start positioning defensively; we have shown in recent research that the S&P peaks after the yield curve inverts.4 On a related note, we use this opportunity to update our corporate pricing power proxy, and Table 2 summarizes the sectorial results. Table 2Industry Group Pricing Power Corporate sector selling price inflation has ground to a halt at a time when wage inflation is rearing its ugly head. Worrisomely, our pricing power diffusion index’s breadth sunk below the 50% line, whereas our wage growth diffusion index spiked higher; 70% of the 44 industries we track are struggling with rising wages (second & third panels, Chart 6). Taken together, there is evidence that broad-based profit margin pressures are escalating, the mirror image of what our gauges were signaling in our last update late-last year.5 Chart 6Margins Have Likely Peaked Digging beneath the surface of our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. 57% of the industries we cover are lifting selling prices, but only 27% are raising prices at a faster clip than overall inflation. Both figures are lower than our early-November report. Outright deflating sectors increased by eight to twenty four since our last update, fifteen of which are deflating at 1%/annum pace or lower. One third of the industries we cover are experiencing a downtrend in selling price inflation, representing a 43% increase since our most recent report (Table 2). Deep cyclicals/commodity-related industries (ex-oil) continue to dominate the top ranks, occupying the top six slots (Table 2). Despite the ongoing global manufacturing deceleration and still unresolved U.S./China trade tussle, the commodity complex's ability to increase prices remains resilient. On the flip side, energy-related industries occupy the bottom of the ranks as WTI crude oil is still 22% lower than the most recent peak in October 2018. In sum, business sector selling price inflation is nil while leading wage inflation indicators signal additional labor cost increases in the coming months. The risk is that profit margins have already peaked for the cycle. We reiterate our tactically cautious overall equity market view. This week we update a high-conviction overweight tech subgroup and recap our transportation subsurface moves from last Thursday. Buy The Software Breakout Software stocks are on fire and leading profit indicators suggest that more gains are in store in the coming months. Last week, we published a table ranking all the sectors and subsectors by 12-month forward profit growth estimates (please refer to Table 2 from the March 18 Weekly Report). While the broad tech sector is on an even keel with the SPX, software EPS are racing at twice the speed of the broad market, roughly 14%. Keep in mind, when growth gets scarce, investors flock to industries with accelerating profit prospects. The software profit juggernaut is intact and we reiterate our high-conviction overweight recommendation. Sustained capital outlays on software are a key driver of industry profits (bottom panel, Chart 7). In an otherwise muted Q4 GDP release, rising non-residential fixed investment in general and surging investment in software in particular suggest that our bullish software capex thesis is alive and kicking (middle panel, Chart 7). Chart 7Software On A Tear The move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are also in a structural uptrend. Not only private sector software capex is near all-time highs as a share of total outlays, but also government investment in software is reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments are taking such risks extremely seriously the world over (second panel, Chart 8). Chart 8Earnings Led Advance Meanwhile, fear of missing out has rekindled industry M&A and both the dollar amount and number of deals are sky high, with acquirers bidding up premia to the stratosphere (Chart 9). This supply reduction is bullish for industry pricing power. Chart 9M&A Frenzy Granted the M&A frenzy has pushed relative valuations on the expensive side especially on a forward P/E basis, but on EV/EBITDA software stocks are trading below the historical mean and still significantly lower than the late-1990s peak valuation (bottom panel, Chart 8). If our bullish software profit thesis continues to pan out, then software stocks will grow into their pricey valuations. Finally, shareholder friendly activities are ongoing in this key tech subsector and buybacks in particular provide an added layer of artificial EPS growth (bottom panel, Chart 9). Adding it up, galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A, all signal that it still pays to be bullish software stocks. Bottom Line: Buy the software breakout. The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT – MSFT, ORCL, ADBE, CRM, INTU, ADSK, RHT, CDNS, SNPS, ANSS, SYMC, CTXS, FTNT. Tweaking Transport Subgroup Positioning The S&P transports index’s recovery rally has stalled recently and is a cause for concern for the overall market. In more detail, the recent gulf between relative share prices and the SPX has widened and warns that the overall market is at a risk of suffering a pullback (Chart 10). Chart 10Engine Trouble Thus on Thursday last week, we made two subsurface transport changes, downgrading a subgroup to underweight that commands lofty valuations at a time when leading profit indicators are flashing red, and also downgrading to neutral a globally exposed transport sub-index. Get Off The Rails In our downgrade of the S&P railroads index late last year to a benchmark allocation, we highlighted that two of our key industry Indicators, the Railroad Indicator and our Rail Shipment Diffusion Indicator, had turned negative.6 These indicators have continued to deteriorate, including total rail shipments which have now started to contract for the first time since the 2015-16 manufacturing recession (third panel, Chart 11). Intermodal shipments in particular have nosedived, likely a result of weak retail sales, as we highlighted earlier this month.7 Chart 11Downgrade Rails To... This contraction would be far less concerning were it not for the rapid degradation of industry balance sheets as firms have sought to increase relatively cheap leverage in order to retire equity. Railroads are now significantly more indebted than the broad market which itself has not shown an aversion to adding leverage (bottom panel, Chart 11). Such a change in railroad capital structure has kept EPS growth rates artificially high while simultaneously adding an extra measure of equity risk premium that does not yet appear fully reflected in relative share prices. Moreover, when we downgraded the S&P railroads index to neutral last year, deteriorating Indicators were offset by exceptionally healthy pricing power.8 After a multi-year expansion, selling price inflation has now rolled over (second panel, Chart 12), taking away the remaining pillar supporting a neutral view which compelled us to move to an underweight allocation last week. Chart 12...Underweight Pricing power is one of the key determinants in our earnings model that, when combined with the previously noted contracting volumes, is indicating the end to the industry’s above-trend earnings growth is nigh (third panel, Chart 12). With relative earnings growth slowing and rising leverage adding incremental risk, the S&P railroads index’s premium valuation multiple looks increasingly dicey (bottom panel, Chart 12). Bottom Line: Broad based declines in traffic volumes, falling pricing power and high leverage suggest that earnings will underwhelm. Accordingly, last Thursday we moved to an underweight recommendation on the S&P railroads index as we expect a de-rating phase to materialize. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. Air Freight Had Its Wings Clipped We have been offside on the high-conviction overweight call on the S&P air freight & logistics index and the recent FedEx warning suggests that profits will come under pressure for this index for the rest of the year and will trail the SPX. As such, we trimmed exposure to neutral late-last week and removed it from the high-conviction overweight list for a loss of 14%. Chart 13 shows that all the profit drivers we had identified in early December last year have taken a sharp turn for the worse. Energy costs are no longer in deflation as oil prices have jumped from $42/bbl to near $60/bbl. Not only is global growth still decelerating, but also U.S. growth is in a softpatch: the manufacturing shipments-to-inventory ratio is on the verge of contraction, warning that delivery services’ selling prices are in for a turbulent ride (second panel, Chart 13). In addition, definitive news of Amazon becoming a formidable competitor in courier delivery services is structurally negative for the industry. Chart 13Air Freight: Move To The Sidelines Nevertheless, we refrain from turning outright bearish as air freight stocks are technically oversold and valuations are trading at the steepest discount to the broad market since mid-2002. Bottom Line: Last Thursday we downgraded the S&P air freight & logistics index to neutral and also removed it from the high-conviction overweight list. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly” dated March 4, 2019, available at uses.bcaresearch.com. 2https://www.nfib.com/assets/jobs0219hwwd.pdf 3https://ca.spindices.com/documents/additional-material/sp-500-eps-est.xlsx?force_download=true 4 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Weekly Report, “Recuperating” dated November 5, 2018, available at uses.bcaresearch.com. 6 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. 7 Please see BCA U.S. Equity Strategy Weekly Report, “The Good, The Bad And The Ugly“, dated March 4, 2019, available at uses.bcaresearch.com. 8 Please see BCA U.S. Equity Strategy Weekly Report, “Critical Reset“, dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The FOMC managed to surprise investors at its March meeting after all, … : Everyone knew the Fed wasn’t going to hike rates last Wednesday, but the scope of the downward revision in the median dots was unexpected. … as it turns out that the median FOMC participant sees the pause as a lengthy hiatus: Not only does the median voter expect no rate hikes this year, s/he only expects one more in the entire tightening cycle. Rate-hike expectations have dwindled from three to a lonely one. The motivation for the Fed’s pivot is hardly crystal clear, … : The Fed may have turned more dovish because it fears the U.S. is losing momentum or that key major economies may be on the verge of a recession, it succumbed to pressure from the White House or financial markets, and/or it fears being unable to counter the next downturn. … but it looks to us like it has simply decided it can no longer stomach too-low inflation expectations: The zero lower bound will likely come into play when the next recession arrives, and higher inflation expectations will increase the Fed’s maneuverability by giving it the scope to reduce real rates more easily. Feature Wednesday’s FOMC meeting formalized the Fed’s turn to “patient” monetary policy. The dots revealed that the median FOMC participant’s estimates of the appropriate fed funds rate at year-end 2019 and 2020 are now 50 basis points lower than they were at the December meeting. At that meeting, the median participant expected the fed funds rate would be 2⅞% at the end of 2019, and 3⅛% at the end of 2020; the median participant now sees 2⅜% at the end of this year, the midpoint of the current 2.25 – 2.5% range, with a final hike to 2⅝% sometime in 2020. Uber-dovish St. Louis Fed President Bullard crowed in early January that the committee was starting to see things his way, and it seems that he was right. While presumably only Minneapolis President Kashkari voted with Bullard for no 2019 hikes in December, nine more participants came over to his side in the ensuing three months. The shift on the FOMC can be boiled down as follows: in December, two voters called for no hikes in 2019, and eleven called for a minimum of two hikes; in March, eleven voters called for no hikes, and two called for just two (Chart 1). The migration of nine out of seventeen voters from two or three hikes to zero hikes lopped 50 basis points off the FOMC’s median year-end projections through 2021, and has pushed our equilibrium fed funds rate model even further away from the consensus. What happened, and what does it mean for our S&P 500, Treasury and spread-product views? What Made The Fed More Patient? Our real-time view of the Fed’s turn to patience in early January was that it was a logical response to the sharp, sudden tightening of financial conditions imposed by the fourth-quarter sell-off in stocks and corporate bonds (Chart 2). We didn’t create a regression model to try to put a precise number on what the tightening in financial conditions meant, but it seemed fair to assume that it equated to at least one 25-basis-point hike in the fed funds rate. If that was as conservative an estimate as we thought, the Fed’s only rational course was to step aside, given that the financial markets had already done a quarter or two of its work for it. Chart 2Markets Tightened For The Fed In 4Q Slowing momentum in the rest of the world offered another reason for backing off. Chinese deceleration that began with domestic policymakers’ deleveraging drive has been exacerbated by the ongoing trade spat with the U.S. (Chart 3). Chinese imports are the most direct channel by which China impacts the rest of the world, and global trade has slid as China has decelerated (Chart 4). The first contraction in global export volumes since the global manufacturing slump in early 2016 has dragged on Europe, which took its 2018 cue from a soft China, rather than a robust U.S. Chart 3Deleveraging Started China's Slump ... Chart 4... Which Was Felt Around The World Within the U.S., ongoing data releases have fostered the notion that the Fed can well afford to be patient. Despite booming payroll expansion in December and January, which created 538,000 net new jobs, the unemployment rate ticked up to 4% from 3.7%.1 The data raised the possibility that there may be more labor market slack than previously estimated. Headline inflation is hardly alarming, though core measures that back out oil’s drag are hanging around the Fed’s 2% target (Chart 5). Chart 5Core Inflation Is Near Target, But Oil Has Weighed On Headline Inflation Is The Phillips Curve Dead? Is it possible that the Fed could turn away from rate hikes when the unemployment rate is a tenth of a point above its lowest level since 1969? Does the Fed really think the Phillips Curve is so flat that even 50-year lows in unemployment aren’t going to boost wages? Has it abandoned the idea that inflation and the unemployment rate are inversely related once the economy reaches full employment? We don’t think so; as we argued in our recent Special Report on the Phillips Curve,2 we are convinced that the Fed’s belief in the relationship between unemployment and inflation remains intact. Every mainstream macroeconomic inflation model incorporates an inverse relationship with the unemployment rate. We fully accept that the Phillips Curve is kinked, and that the point where it inflects is dependent on estimates of the unobservable natural rate of unemployment (NAIRU), but the economics profession has no widely accepted model that does not take as given the notion that sub-NAIRU unemployment is inflationary. Until the profession develops an alternative framework that achieves wide acceptance, the Phillips Curve will continue to be a keystone element of central bank policy. The path from higher wages to higher consumer prices may be indirect and uncertain, but the link between the unemployment gap and annual wage gains is alive and well, even in the post-Volcker, low-inflation era (Chart 6). Chart 6Wages Rise When Workers Are Hard To Find What Might The Fed See That We Don’t? We have been, and remain, constructive on the U.S. economy. The delayed December retail sales release was lousy, and the uninspiring advance January figure led the Atlanta Fed to knock nearly 40 basis points off of its estimate of consumption’s contribution to first-quarter GDP, but it seems incompatible with a roaring job market, rising wages, and an elevated household savings rate. First-quarter growth projects to be sickly, but it has been for the last few years, and the Atlanta Fed’s GDP Now model projects that real final domestic demand grew by 1.3%, in spite of the government shutdown. The FOMC seemed to err on the side of caution in trimming its growth estimates by 20 and 10 basis points (“bps”) for 2019 and 2020, respectively, and revising its unemployment rate projections 20 bps higher for both years. The global economy has surely slowed; ex-the U.S., its biggest constituents decelerated for nearly all of 2018, as Chair Powell noted. He also noted, however, that Chinese policy makers have taken several steps to support activity. That will help the rest of the world, including Europe, as an accelerating fiscal and credit impulse boosts Chinese imports (Chart 7). Brexit remains a risk the Fed would be irresponsible not to plan for, but given that a do-over referendum would probably lead to the U.K. remaining in the E.U. (Chart 8), it is a risk that may well not come to pass. Chart 7Chinese Policymakers Want To Boost Growth Chart 8Let's Call The Whole Thing Off We do not think that the Fed changed course based on White House pressure. As we have noted before, White House-Fed conflict is nothing new, and while the Arthur Burns-led Fed knuckled under during Nixon’s re-election campaign, pressure from the Johnson, Reagan and G.H.W. Bush Administrations all came to naught. We also do not think that the Fed took its cue from investors, even if its 2019 policy rate outlook now closely resembles the money market’s (Chart 9). If it is wary of inverting the yield curve, however, it may want to see long yields rise before it hikes again.3 Chart 9Seeing It The Markets' Way (At Least For 2019) Don’t Fence Me In Q: [B]elow-target inflation is a … phenomenon … across advanced economies, and I’d … like to … hear your thoughts about what kind of challenges that poses to policy makers like yourself and the global economy in general. Chair Powell: It’s a major challenge. It’s one of the major challenges of our time, really, to have … downward pressure on inflation[.] It gives central banks less room … to respond to downturns[.] [I]f inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to … keep inflation at two percent, which gives us some room to cut, … when it’s time to cut rates when the economy weakens. … It’s … one of the things we’re looking into as part of our strategic monetary policy review this year. The proximity to the zero lower bound calls for more creative thinking about ways we can … uphold the credibility of our inflation target, and … we’re open-minded about ways we can do that. Our best guess is that the Fed has become frustrated by moribund inflation expectations ten years into a recovery. Now that it sees the potential for a recession in the not-so-distant future, it would prefer not to have to confront it with the zero lower interest-rate bound tying one hand behind its back. It would be reasonable if it would also prefer not to have to rely too heavily on asset purchases, given all the headaches that even a modest shrinking of the balance sheet has occasioned. The Fed’s ongoing monetary policy review may therefore turn out to be more than an academic exercise. It might be awfully nice to have strategies aiming to reverse past misses of the inflation objective in place before the next recession arrives. Those strategies would provide the Fed with more flexibility to reduce real interest rates via moves in the fed funds rate. Powell discussed the potential appeal of these sorts of strategies at Stanford University just a week and a half before the FOMC meeting,4 and despite all the times they’ve been bandied about, they just might come to something this time around. Investment Implications The Fed has made a significant pivot since October’s “long way from neutral,” and December’s post-FOMC press conference, when the chair seemed to be disconnected from the markets’ agita. We don’t think a 2019 rate hike is completely out of the question, but there is no doubt that the Fed’s reaction function has changed. We don’t yet see a reason to revise our terminal rate estimate down from 3.25%-3.5%, even if it’s evident that it will take a good bit longer for the Fed to get there than we initially expected. It seems to be more willing to let inflation get ahead of it – it may end up actively encouraging inflation to do so – before it completes its meandering journey to the terminal rate. Allowing the economy to run a little hotter should be equity-friendly. It’s hard to get earnings contraction without a recession, and recessions don’t occur when monetary policy is accommodative. If the Fed requires more evidence of improvement before it resumes hiking rates, the economy and corporate earnings should be able to build up more momentum than they otherwise would. The Fed’s newfound patience should also be spread-product-friendly, as borrowers become better credits as an expansion rolls along. The Treasury outlook is more nuanced. Yields fell as the Fed committed to remaining on hold for longer, but the Fed now seems to have exhausted its capacity for dovish surprises. Short of a recession or near-recession, it’s hard to see how yields can go much lower. Given markets’ seeming conviction that inflation is as dead as a doornail, however, Treasury bond yields may do no more than drift higher at the margin until the Fed’s efforts to put a floor underneath inflation expectations begin to bear some fruit. We still think risk-friendly positioning makes sense, and we reiterate our equity and spread-product overweights, our Treasuries underweight, and our below-benchmark-duration recommendation. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 At the other end of the spectrum, the unemployment rate fell two ticks in February, to 3.8%, despite a meager net increase of 20,000 jobs. Short-term disconnects can be explained by the fact that the unemployment rate (household) and net payrolls additions (business establishments) are calculated from separate surveys, but no one knows exactly how many people who aren’t working are available to work when they decide the time is ripe. 2 Please see the February 26, 2019 U.S. Investment Strategy Special Report, “The Phillips Curve: Science Or Superstition?” Available at usis.bcaresearch.com. 3 The Fed may not care a whit about the yield curve, but may simply want to hold its fire until it is convinced that the economy requires less accommodation so as not to overheat, which would get it to the same place: not hiking until long yields begin to price in the potential for overheating. 4 Please see the March 18, 2019 U.S. Investment Strategy Weekly Report, “Kinder, Gentler Central Banking.” Available at usis.bcaresearch.com.