Developed Countries

Highlights Investors should use the following dynamic for tactical asset allocation: 1. Sum the 10-year yields on the T-bond, German bund, and JGB. 2. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. 3. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways. 4. When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities (Chart of the Week). 5. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds. Right now, with the sum near 3 percent, it is still appropriate to be overweight equities versus bonds, and our preferred expression is overweight the DAX versus the German long bund. Feature Chart of the WeekThe Rule Of 4 Becomes The Rule Of 3 The global long bond yield recently hit a two-year low (Chart I-2). This is the direct result of central banks’ pivot to dovish – a commitment to keep policy rates at current levels, rather than to hike, for the foreseeable future. Chart I-2The Global Long Bond Yield Recently Hit A Two-Year Low One consequence is that high-quality bonds have become riskier. Consider a German bund or a JGB which is yielding zero percent. The short-term potential for capital appreciation – nominal or real – has almost vanished, while the potential for vicious losses has increased dramatically. The technical term for this negative asymmetry is negative skew. Years of research in a field of behavioural economics called Prospect Theory concludes that negative skew is the metric that best encapsulates investment risk. The Correct Way Of Thinking About Investment Risk A great misunderstanding of finance is to equate risk with volatility. Risky assets, such as equities, are risky not because they are volatile in the conventional sense. After all, who minds when their asset price goes up sharply? Risky assets are risky because they have the propensity to experience much larger short-term losses than short-term gains – captured in the saying: equities climb up the stairs on the way up, but they jump out of the window on the way down. High-quality bonds have become riskier. Another great misunderstanding of finance is the idea that bonds offer a diversification benefit and, therefore, that investors should accept a lower return from them. This argument is also flawed. The bond market is bigger than the equity market, and just as bonds are a diversifier for equity investments, equities are a diversifier for bond investments. Indeed, equities have protected bond investors during vicious sell-offs in the bond market such as after Trump’s shock victory in 2016. So we could equally argue that equities offer a diversification benefit. In fact, the correct way of thinking about investment risk is as follows: An investment’s risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns (Chart I-3). This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher (Chart I-4). But when bond yields normalize, equities regain their excess riskiness versus bonds – and their valuations must suffer a phase transition sharply lower. The phase transition in equity valuations is most pronounced when the global 10-year bond yield goes up or down through 2 percent (Chart I-5). This dynamic proved to be the biggest driver of asset allocation in 2018, and is likely to be a big driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, triggering a plunge in the stock market and other risk-assets which threatens a disinflationary impulse. The unsurprising response from central banks is to pivot back to dovish, pulling back bond yields to previous lows. These lower bond yields then push up equity (and other risk-asset) valuations back to previous highs. An investment’s risk depends on the negative asymmetry of its short-term returns. The good news is that record high valuations of risk-assets are fully justified if bond yields remain at current levels or decline further. But the longer-term danger is that these rich valuations are hyper-sensitive to rising bond yields. The Bubble In Everything The current episode of elevated risk-asset valuations is not unprecedented, but there is a crucial difference. Previous episodes of elevated risk-asset valuations tended to be localised, either by geography or sector: 1990 was focussed in Japan; 2000 was focussed in the dot com related sectors; 2008 was focussed in the U.S. mortgage and credit markets. Extraordinary monetary policy has boosted the valuations of all risk-assets across all geographies and all asset-classes. By comparison, the post-2008 global experiment with quantitative easing, and zero and negative interest rate policy has boosted the valuations of all risk-assets across all geographies and all asset-classes – equities (Chart I-6), credit (Chart I-7), and real estate (Chart I-8). This makes it considerably more dangerous, because we estimate that the total value of global risk-assets including real estate is $400 trillion, equal to about five times the size of the global economy.1 Chart I-6Equities Remain Richly Valued Chart I-7Credit Remains Richly Valued Chart I-8The EM Real Estate Boom Happened After 2008 Let’s say you had a risk-asset that was priced to generate 5 percent a year over the next decade. Now imagine that the valuation boost from ultra-accommodative monetary policy capitalises all of those future returns to today. For those future returns to drop to zero, today’s price must surge by 63 percent.2 If you were prudent, you might amortise today’s windfall to generate the original 5 percent a year over the next decade. But if you were imprudent, you might spend a large amount of the windfall today. The total value of global risk-assets equals five times the size of the global economy. Now let’s imagine a valuation derating moves the risk-asset’s returns back to the future. For those that had prudently amortised the original windfall, nothing has really changed and future spending patterns would not be impacted. But not everybody is prudent. For those that had imprudently spent the original windfall, future spending would inevitably suffer a nasty recession. The Rule Of 4 Becomes The Rule Of 3 How can we sense the crucial 2 percent level in the global 10-year bond yield? The answer is that it broadly equates to when the sum of the 10-year yields on the T-bond, German bund and JGB is at a 4 percent level (Chart I-9). This is the genesis of our very successful ‘Rule of 4’. In 2019, just as in 2018, investors should use the following dynamic for tactical asset allocation. The rule of 4 identifies when the global 10-year bond yield is at 2 percent. Chart I-9When The Sum Of 10-Year Yields On The T-Bond, Bund, And JGB Equals 4 Percent, The Global 10-Year Yield Equals 2 Percent  Sum the 10-year yields on the T-bond, German bund, and JGB. When the sum is near 4 percent, it is prudent to de-risk portfolios and sit aside, at least for a while. It is a good level to buy a mixed portfolio of high-quality 10-year government bonds. Just below this level, a sum in the 3-4 percent range defines a kind of ‘no man’s land’ in which equities drift sideways.  When the sum is near 3 percent, the seemingly rich valuations of equities versus bonds is fully justified. And it is appropriate to redeploy tactically from bonds to equities. Use the 65-day fractal dimension to pinpoint the precise transition points between asset-classes: as for example, successfully achieved for the DAX versus German bunds (Chart I-10). Overweight equities versus bonds. With the sum of the three 10-year yields now near 3 percent, the rule of 4 has, in a sense, become the rule of 3. It is still appropriate to be tactically overweight equities versus bonds, and our preferred expression is to overweight the DAX versus the German long bund. Chart I-10Use The 65-Day Fractal Dimension To Pinpoint The Precise Transition Points Between Asset-Classes   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Weekly Report “Trapped: Have Equities Trapped Bonds?”, September 13, 2018 available at eis.bcaresearch.com. 2 5 percent compounded over ten years.

Special Report

Highlights So What? A major antitrust suit could happen within the next couple of years, paradoxically ushering in a rewarding investment opportunity.  Why? The current environment of corporate overreach, protectionism and popular discontent has often preceded large antitrust suits. An outcome other than a breakup would likely be benign for the stock price, while the announcement of a breakup would be negative. However, the completion of the breakup could present a great buying opportunity. Feature “No wonder that Wall Street’s prayer now is ‘Oh Merciful Providence, give us another dissolution’” - Former U.S. President Theodore Roosevelt, 1912   The investment community has been increasingly worried about the possibility of regulatory action against America’s biggest technology companies (the so-called “FAANG” stocks). We addressed the mounting probability of such action in a mid-2018 report. In this report, we focus on the market reaction post-dissolution, by examining some of the biggest antitrust cases in the history of the U.S. Specifically, this report complements our work on the U.S. antitrust framework (please see Appendix A) by looking for potential signs indicating that a monopolization suit could be likely. Moreover, we analyze the stock prices of the companies alleged to have committed antitrust violations to understand the implications for investors’ portfolios. To build our sample of U.S. monopolization cases, we set the following criteria: 1.  Non-merger cases: Antitrust cases blocking mergers between two or more companies are common, and most investors are familiar with them. However, we choose to examine the much rarer cases involving a single firm. 2.  Large-cap companies: A large number of anti-monopoly suits are directed towards small or private companies. We select only companies that had a large market capitalization at the time of the suit, in order to closely match the profile of FAANG stocks. 3.  The Department of Justice sought dissolution: We decided against considering monetary fines, as they are generally not big enough to meaningfully affect the stock price of large companies.1 By focusing on cases where dissolution was sought, we narrow our scope to the most severe cases in antitrust history. Table 1 shows the seven companies that we selected, as well as the final verdict, the timeline of the process, and other details. While our sample may seem small, it is important to remember that since the passing of the Sherman Act in 1890, non-merger anti-monopoly cases against large public companies have been incredibly rare in the U.S., even in the periods with the strictest regulatory enforcement.2  The increasing economic and political power of corporations acted as a catalyst for antitrust enforcement. Our sample includes a variety of outcomes: from cases where the accused won the suit or where the suit was dropped (U.S. Steel and IBM), to cases where there was ultimately no dissolution but a different remedy was imposed (Alcoa and Microsoft), to cases where the accused was broken up (Standard Oil, American Tobacco and AT&T). Power, Protectionism, And Discontent: The Causes Of Anti-Monopoly Suits The economic and political context surrounding the cases in our sample share some common features. 1.  Corporate overreach The issue of power was central to the original intent of the Sherman Act,3 with the U.S. Congress understanding that the concentration of economic power will ultimately result in concentration of political power, “breeding antidemocratic political pressures.”4 The data confirms that the increasing economic and political power of corporations acted as a catalyst for enforcement. With the exception of AT&T, every single one of our examined cases occurred following a period where the earnings of the biggest corporations in the U.S. were increasing at a rate faster than worker compensation (Chart 1, top panel). This dynamic likely increased the feeling of distrust towards big business, as corporations were perceived to be getting a disproportionate amount of the national wealth. The prices in the industries of the accused companies were generally decreasing relative to inflation in the period prior to the beginning of their case. Concern regarding corporate power also arose for different reasons. In 1965, Ralph Nader published the book “Unsafe at Any Speed,” accusing the large American automakers of hiding their safety record. Nader’s work coincided with the origin of the modern anti-tobacco movement. The two would mark the beginning of the consumer movement and would increase scrutiny on the power that companies yielded (Chart 1, bottom panel), providing the political impetus behind the antitrust movement.5  Chart 1Antitrust Action Seeks To Curb Corporate Power 2.  Domestic protectionism Traditional economic theory would suggest that monopoly firms can charge “monopoly prices,” i.e. prices much higher than what would exist in a competitive market. However, the data tells a different story, as the prices in the industries of the accused companies were generally decreasing relative to inflation in the period prior to the beginning of their case (Chart 2). Chart 2AAccused Monopolies Were Cutting Prices (I) Chart 2BAccused Monopolies Were Cutting Prices (II) How to explain this? In contrast to the stereotypical monopoly, most of the accused companies were ruthlessly efficient and competitive, having the ability to substantially lower costs relative to their competitors. Some did this through genuine innovation. The Standard Oil corporation, for example, invented the oil tanker, dramatically reducing loading time and associated risk. As a result, it was able to secure lower transportation costs from the railway companies.6 Others did it through economies of scale. An example is Alcoa, which vertically integrated all four stages of aluminum production.7 Moreover, while being responsible for 90% of the supply of U.S. primary aluminum, it produced it all in a single plant, minimizing overhead costs.8  Due to their ability to charge drastically lower prices, the corporations in our sample were accused of using predatory prices in six out of the seven cases.9 This was despite the fact that these claims often fell flat in court, largely because distinguishing between predatory pricing and price competition is extremely difficult in practice.10 But if these companies were lowering prices through innovation and economies of scale, why were they charged in the first place? At its core, regulation of monopolies has broader policy objectives.11 This ranges from protectionism against foreign competition to protectionism against large domestic corporations. This protectionist streak dates all the way back to John Sherman himself, an advocate of tariffs during his entire political career.12 Thus, the efficiency of major companies accused of forming trusts was often their downfall, as struggling domestic rivals applied political pressure to bring the suit forward.13 The timing of antitrust suits suggests that the government was looking to deflect the blame of the bust phase. 3.  Late cycle, recessions, inflation Finally, with the exception of the Microsoft case in 1998, the government filed the antitrust complaints against the companies in our sample in recessionary or late-cycle periods (within a year of a recession). Additionally, rising and relatively high inflation tended to precede these periods (Chart 3). Although we have no outright evidence, the timing suggests that the government was looking to deflect the blame of the bust phase or general economic mismanagement. Chart 3Are Antitrust Suits A Distraction From Economic Mismanagement? Antitrust Cases And Stock Prices  The length of the cases in our sample range from roughly three years in the Microsoft case to more than 13 years in the Alcoa case. Moreover, the number and type of judicial decisions varied widely between cases. To make for a better comparison we look at only three events in each case: 1.  The Accusation: the date when the suit was first filed by the Department of Justice. 2.  The Decision: the date of the effective end of the case; when the case was either dropped or settled, or when the “last resort” court arrived at a final remedy. 3.  The Breakup: for the cases ending in dissolution, the date when shares of the new companies were distributed to investors; when the breakup was consummated. For all the charts in this section, we denote month “t” as the relevant event month. For information on the stock price movement following other important judicial events, please see Appendix B. The filing of a suit was generally negative for the stock price of the accused company. The Accusation The filing of a suit was generally negative for the stock price of the accused company (Chart 4). The stock price of every one of the companies suffered relative to the appropriate benchmark in the month of the accusation. The effect seems to have been more dramatic for the cases before the 1920’s with an average underperformance of 13% in the month of the event, although they were able to recover from the initial hit within six months. The impact on the more recent cases was more muted, with an average underperformance of 3.7%. The Decision When analyzing the last judicial event of the suit, we separate our cases into three different outcomes: cases where the suit was dropped or won (U.S. Steel and IBM), cases where there was a remedy other than dissolution (Alcoa and Microsoft), and cases concluding in dissolution (Standard Oil, American Tobacco, and AT&T). Both U.S. Steel and IBM outperformed the market in the year following the positive announcement (Chart 5), though the effect seems to have been more muted for U.S. Steel. On the other hand, the effect was much more pronounced for IBM, which found some relief from regulators after famously spending a fortune defending itself. Alcoa, on the other hand, suffered a 4.3% underperformance once its stock disposal remedy was announced, although it managed to recover the losses within seven months (Chart 6). Meanwhile, Microsoft finished the year following the announcement outperforming the market by 12%. For the cases in which dissolution was the result, we look at the performance of the stock from the decision of the breakup until the month before the new shares were distributed. The month of the announcement was negative for both Standard Oil and particularly American Tobacco (Chart 7). AT&T, on the other hand, managed to rally slightly following the settlement. However, the months leading to the breakup involved a significant amount of volatility for all companies, most likely as investors slowly got to know the terms that were being agreed upon for the dissolution. In the AT&T case, the two-year period in which the dissolution was arranged proved to be particularly negative, with the stock underperforming the market by more than 20%. Every single one of the companies outperformed the market on the date of the breakup. The Breakup To analyze the performance following the breakup we look at the portfolios that were given to investors in exchange for their pre-dissolution shares. The AT&T case resulted in the simplest portfolio: for every 10 shares of old AT&T, the investor received 10 shares of new AT&T, plus one share of each of the other seven companies. The Standard Oil portfolio involved varying amounts of shares of 34 companies. The American Tobacco portfolio was slightly more complex, as the stock for two of the post-breakup companies was not given away for free but instead offered at a discount. Given that shareholders might not have had the funds available for this purchase we show the portfolio without the investment (LOWER BOUND) and fully invested up to the amount permitted (UPPER BOUND). Every single one of the companies outperformed the market on the date of the breakup (Chart 8). Furthermore, they all managed to outperform by large amounts over the following year, with AT&T outperforming by 14%, American Tobacco outperforming by 47% (10% for the lower bound), and Standard Oil outperforming by a gargantuan 66%.14 While this sample size is small, the large positive market effect from the breakup of companies from such disparate industries has drawn the interest of academics.15 Overall, it seems that the fear that competition might bring about earnings erosion is misguided. Rather, earnings growth outperformed the market following the dissolution (Chart 9). Investment Implications The previous analysis provides us with some answers to the following questions: When will one or more of the FAANGs be accused of monopolization? The current political environment is ripe for significant antitrust enforcement, particularly for the high-flying FAANG stocks. Whether it is election meddling, data privacy issues, perceived ideological bias, or large accumulation of wealth, Americans across the political spectrum are wary of the power of tech companies (Chart 10). Moreover, BCA expects the next recession by 2021 with inflation trending to the upside. Thus, we expect that antitrust action against a large tech company is likely to occur in the next couple of years. Which of the FAANGs is the most likely target? Among all FAANG stocks, no company has crushed its rivals more than Amazon (Chart 11). This makes it particularly vulnerable to antitrust enforcement, and it is thus not surprising that President Trump most often singles it out, entirely aside from any personal issues with CEO Jeff Bezos.16 Chart 11Amazon Is Devastating Small Retailers How will the stock of an accused company react? A monopoly suit will likely be negative for the stock. If recent history is any guide, the underperformance on the event could be relatively mild (2% to 5%), although the stock could underperform by up to 15%, if similar to older cases. However, investors must remember that monopoly cases have historically developed across multi-years periods. Thus, while individual court decisions will influence the stock through the process, other factors will determine the overall trend of these stocks throughout the duration of the case. The date when the breakup is complete could prove to be a fantastic buying opportunity, as competition is unlikely to erode earnings. How will the stock price react when the case is decided? Outcomes in which the accused wins the suit, or there is a remedy other than dissolution will ultimately be benign for the stock within a one-year period. Thus, investors should fade any selloff in this situation. In the case of a breakup, investors should try to sell the stock of the accused on or before the announcement, as the agreement of the terms of the dissolution will likely bring a substantial amount of volatility and negative performance to the share price. However, the date when the breakup is complete could prove to be a fantastic buying opportunity, as competition is unlikely to erode earnings.   Juan Manuel Correa Ossa, Senior Analyst juanc@bcaresearch.com     APPENDIX A A Brief History Of Monopoly Regulation Interest in monopolies started in the late nineteenth century with the emergence of the business trust. It increased markedly in the earlier years of the twentieth century (Appendix A Chart 1, top panel). Soon breaking up powerful companies became a popular bipartisan goal for many voters. Appendix A Chart 1Monopoly Regulation Throughout The Years Politicians reacted accordingly. In 1890, Congress passed the Sherman Act, the first federal legislation regulating competition. This piece of legislation served as the basis for prosecuting the first few cases  in our sample: Standard Oil in 1906, American Tobacco in 1907, and U.S. Steel in 1911. After a brief respite in the roaring 1920’s, monopoly regulation rose throughout the New Deal, with the 1937 Alcoa case being the landmark case of this era. Regulation continued to tighten and peak in the 1950’s – the era with the strictest enforcement of monopoly laws in the history of the Unites States (Appendix A Chart 1, middle panel). No cases from our sample fall in this period, probably because intense antitrust regulation made it difficult for large monopolies to exist in the first place. Nevertheless, as the 1960’s passed, interest started to dwindle. While regulation of monopolies was a staple talking point of the State of the Union address for Republicans and Democrats alike throughout the first half of the twentieth century, no president would again feature it after 1962.17  Amid this decline in enforcement, the IBM and AT&T cases were the last monopoly cases for many years, as the “Chicago School”, and its free market paradigm, rose in popularity in the 1970’s and 1980’s (Appendix A Chart 1, bottom panel). Monopoly enforcement would continue to decline throughout the 1990’s and into the present, with the Microsoft case being the only one from our sample that developed during the past three decades. Appendix B   Footnotes 1      The largest monetary fine ever imposed by the Department of Justice on an antitrust case was the $925 million fine against Citicorp. This amounts to roughly 0.6% of the market cap of Netflix, the smallest of the FAANGs. Even larger fines imposed in the EU, like the €4.34 billion fine imposed against Google had little effect on the stock price. 2      Please see Spencer Weber Waller, ”The Past, Present, and Future of Monopolization Remedies,” Antitrust Law Journal, 76:11 (2008), pp. 14-15, available at lawecommons.luc.edu 3      Please see Lina M. Khan, "Amazon's Antitrust Paradox," The Yale Law Journal 126:710 (2017), pp. 739. 4      Khan 740. 5      Please see Steve Coll, The Deal of The Century: The Break Up of AT&T (New York, NY: Open Road Media, 2017). 6      Please see Werner Troesken, “The Letters of John Sherman and the Origins of Antitrust”, The Review of Austrian Economics 15:4 (2002), pp. 279, available at www.gmu.edu 7      Please see Don E. Waldman and Elizabeth J. Jense, Industrial Organization: Theory and Practice: Fourth Edition (Routledge, 2016). 8      Please see Robert W. Crandall, ”The Failure of Structural Remedies in Sherman Act Monopolization Cases”, AEI-Brookings Joint Center For Regulatory Studies, Working Paper No. 01-05 (March 2001). 9      Ironically, U.S. Steel, the only case won in court and without a predatory pricing allegation, was the only company that fit the definition of a stereotypical monopoly. Its need to coordinate with more efficient competitors to set prices was ultimately used as key evidence to prove that U.S. Steel did not have monopoly power. Please see William H. Page, “Standard Oil and U.S. Steel: Predation and Collusion in the Law of Monopolization and Mergers”, Southern California Law Review 85:3 (2012), pp. 112, available at scholarship.law.ufl.edu 10     Please see Federal Trade Commission, “Predatory or Below-Cost Pricing”, available at www.ftc.gov 11     Please see Christopher Grandy, “Original Intent and The Sherman Antitrust Act: A Re-examination of the Consumer-Welfare Hypotheses,” The Journal of Economic History 53:2 (1993), pp. 360, available at www.jstor.org 12     Please see William Kolasky, “Trustbusters: Senator Sherman And The Origin of Antitrust”, Antitrust Magazine of the ABA Section of Antitrust Law 24:1 (2009), pp. 86. 13     Some examples include the Ohio Oil lobby in the Standard Oil case, MCI in the AT&T case, and Netscape in the Microsoft case. 14     The explosive performance of the trusts after their breakup would anger Theodore Roosevelt, who would bitterly joke that people in Wall Street prayed: ‘Oh Merciful Providence, give us another dissolution’”. Please see Steve Weinberg, Taking on the Trust: The Epic Battle of Ida Tarbell and John D. Rockefeller (Norton & Company, 2009). 15     Please see Malcolm R. Burns, “The Competitive Effects of Trust-Busting: A Portfolio Analysis,” Journal of Political Economy 85:4 (1977), pp. 719, available at www.jstor.org 16     Please see AXIOS, “Trump Hates Amazon, not Facebook,” dated March 28, 2018, available at www.axios.com. 17     Please see The Atlantic, “The Rise And Fall of the Word ‘Monopoly’ In American Life,” dated June 20, 2017, available at www.theatlantic.com

Underweight (High-Conviction) Shares in Facebook, a heavyweight component of the S&P interactive media & services index, have been falling recently as an exodus of executives, including the founders of the Instagram platform, have shaken investor confidence. This adds to our core concern over pending privacy regulation which may further dampen the company’s prospects, as highlighted in our initiation of the index last year.1 Facebook is not alone in facing regulatory struggles as anti-trust legislation against the other index heavyweight Alphabet seems ever more likely to gain traction; at least one presidential contender has made tech break-up part of her election platform. Beyond the headline risks faced by the S&P interactive media & services index, we remain concerned by the growth and valuation prospects. The sector’s forward earnings growth has collapsed to just above the zero line and fallen below the broad market (middle panel). Meanwhile, the slower-growing S&P interactive media & services index trades at an enormous premium to the S&P 500 (bottom panel). Bottom Line: We continue to think a mismatch exists between valuation, growth and regulatory headwinds and reiterate our high-conviction underweight in the S&P interactive media & services index. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. 1       Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?," dated August 1, 2018, available at uses.bcaresearch.com.

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