Developed Countries

Highlights The delay to the U.K. parliamentary vote on the current Brexit deal has edged up our assessed probability of no-deal to 20 percent. Our probability-weighted value of the GBP is still around 5 percent higher than today. Nevertheless, the optimal moment to buy the GBP lies ahead, as the Brexit catharsis cannot properly begin until the U.K. parliament expresses its will. Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade in the coming months, but this fading is going to be less pronounced in Europe than in the United States. These relative inflation dynamics should give EUR/USD a leg up in 2019. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Chart of the WeekThe Pound Has Decoupled From British Public Opinion On Brexit Feature Please note this report was written before the outcome of Conservative MPs vote of no confidence in Theresa May held on the evening of December 12. To assess the impact of Brexit on the financial markets, we are going to turn to a fundamental concept in physics – the concept of a ‘phase transition’. In physics, a phase transition is a disruptive tipping point at which a body transforms from one state into another. The classic example is when water transforms into ice. If the temperature drops from 10 degrees (Celsius) to a degree or so lower, you will experience no discernible difference in water. Even if the temperature drops to 2 degrees, the difference is only slight. But if the temperature drops to minus 2 degrees, water transforms into ice – and you will experience a huge difference as roads freeze over, pipes burst, and so on… Beware A Sudden Phase Transition We can draw a powerful analogy for how the various forms of Brexit would impact the British economy and financial markets. If the current membership of the EU equates to water at 10 degrees, a ‘Norway plus’ arrangement – European Economic Area (EEA) plus a customs union – might be a temperature only a degree or so lower, a barely noticeable difference. The Brexit deal negotiated by Theresa May (or an amended version of it) might be a temperature of 2 degrees, so a somewhat discernible change. But crashing out of the EU to WTO trading rules would equate to minus 2 degrees, or lower. This Brexit would be hard (Chart I-2). Its properties would be very different. Chart I-2Goods Still Dominate U.K. Exports Also important is the speed of the phase transition. If winter arrives gradually, over the course of several weeks, we can generally prepare, and adapt our behaviour and habits. Thereby, we can even enjoy and thrive in a new climate. But if winter arrives overnight, it causes severe disruption and suffering.1 As Brexit reaches its denouement, the options for the future EU/U.K. relationship – full membership of the EU, a ‘Norway plus’ arrangement, the Brexit deal negotiated by Theresa May, or complete and overnight detachment – are each quite differentiated from the perspective of politics and law. For example, EEA plus a customs union is politically sub-optimal compared with the U.K.’s current full membership of the EU which includes the bonus of precious legal opt-outs. However, from the perspective of an investor in the markets, the first three types of arrangement are not really that different (Chart I-3). Only the last type – complete and overnight detachment from the EU – constitutes a severely disruptive phase transition. Chart I-3For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome We can simplify the various Brexit possibilities into a binary investment outcome: The complete and overnight detachment ‘no-deal’ outcome – in which GBP/EUR would collapse to below parity. All other outcomes – in which GBP/EUR would initially rally through 1.20, by liberating the BoE to remove its precautionary monetary policy (Chart I-4 and Chart I-5). Chart I-4U.K. Economic Fundamentals... Chart I-5...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit This makes the key question: what is the probability of no-deal? No-deal is the default outcome if a deal or extension to the Article 50 process is not agreed (by both sides) before March 29 2019. Therefore no-deal can happen either if: The U.K. parliament cannot coalesce a majority around a course of action that is also acceptable to the EU27. Or if: The Prime Minister and government – the executive branch – ignores the will of parliament and runs down the clock to no-deal regardless. Looking at the parliamentary arithmetic, it is conceivable that a majority could exist for either ‘Norway plus’, or a new referendum, or no confidence in the current government leading to a general election. As for the Prime Minister ignoring the will of parliament, this is legally possible though politically improbable. Nevertheless, the Article 50 clock is running down. The delay to the parliamentary vote on the current deal, possibly until January 21, has edged up our assessed probability of no-deal to 20%, slightly reducing our probability-weighted value of GBP/EUR to 1.175.2 On a one year horizon, this still offers respectable upside for the GBP versus the EUR or the USD (Chart of the Week). But the Brexit catharsis cannot properly begin until parliament gets a chance to express its will, meaning that the optimal moment to buy the pound still lies ahead. Explaining Central Banks’ Obsession With 2 Percent Inflation Back in 1979, Daniel Kahneman and Amos Tversky formalized a new branch of behavioural finance called Prospect Theory, which would ultimately win Kahneman the Nobel Prize for Economics. One of the key findings of Prospect Theory is that we are incapable of distinguishing the meaning of very small numbers. In the case of price inflation, we cannot really distinguish inflation rates between 0 percent and 2 percent. Anything within this range is indistinguishably perceived as ‘price stability’. Given that we cannot distinguish inflation rates between 0 percent and 2 percent, it is impossible for monetary policy to fine-tune our inflation expectations to a point-target such as 2 percent. And given that it is impossible to fine-tune our inflation expectations, it is also impossible to fine-tune inflation itself to a point-target such as 2 percent. Prospect Theory says it is much wiser to define price stability in terms of an inflation range such as 0-2 percent, because this is how we actually perceive price stability (Chart I-6). But despite this compelling Nobel Prize winning academic evidence, central banks remain obsessed with an inflation point-target, most commonly 2 percent. Why? Chart I-6Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target The reason is that central banks have created a rod for their own back. Once a central bank has staked its credibility in terms of impossibly precise ‘data-dependency’ – such as an inflation point-target – it becomes extremely difficult to move the goalposts without risking accusations of bias, partiality and exceptionalism. Future generations will judge the inflation point-target as one of the monumental errors of early twenty-first century economic policy. But for the time-being this flawed policy will nonetheless govern central bank behaviour, and as investment strategists we must see it in that light.  Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade. But this fading is going to be less pronounced in Europe compared with the United States (Chart I-7 and Chart I-8). The main reason is that tax rates on fuel are much higher in Europe compared with the United States, and this attenuates the proportionate pass-through into European retail fuel prices from lower (or higher) oil prices. Chart I-7The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... Chart I-8...But Strong In The U.S The ECB has, in any case, committed to keep its policy rates on hold for most of 2019. By contrast, the Fed has been on a one hike per quarter tightening path. Hence, relative to this behaviour, the surprise could be that the Fed indicates an open-ended pause in its tightening. Even if this is discounted to some extent, weak prints on reported inflation in the coming months could still move the rates and currency markets. After a spectacular gain for the EUR in 2017, our stance turned broadly neutral in early 2018 by adding a short position in EUR/JPY to counterbalance a 50:50 long position in EUR/USD and SEK/USD. Overall, this has proved to be a successful strategy (Chart I-9). Chart I-9The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 Looking ahead to the first half of 2019, the aforementioned relative inflation dynamics should give EUR/USD another leg up. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week, we have spotted an excellent tactical opportunity in EUR/NZD which is at a technical level that has signaled several previous tuning points. On this basis, the recommended trade is long EUR/NZD setting a profit target of 2.5% with a symmetrical stop-loss. In other trades, long EM versus DM achieved its profit target while long banks versus healthcare reached the end of its 65 day holding also in profit. Against this, long nickel versus palladium and short Australian telecoms versus insurance both reached their stop-losses. This leaves two open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 This analogy can also apply to the arrival of spring. If the spring thaw arrives in one day, the consequent severe flooding can also cause terrible disruption and suffering. 2 1.225*0.8 + 0.98*0.2 Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Highlights Late-cycle pressures will keep pushing bond yields higher. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay benign through 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. Feature BCA’s annual Outlook report, outlining the main investment themes that will drive global asset markets in 2019, was sent to all clients in late November.1 In this Weekly Report, we discuss the four broad implications of those themes for global fixed income. In a follow-up report to be published next week, we will translate those themes into strategic investment recommendations and allocations within our model bond portfolio framework. Key View #1: Late-Cycle Inflation Pressures Will Keep Pushing Bond Yield Higher The main theme from last year’s BCA Outlook was that markets and policy would collide in 2018. This year’s Outlook concluded that those same frictions would persist in 2019, and for similar reasons. The global economy is likely to see another year of above trend growth, after the current deceleration phase bottoms out in the first half of the year. Tight labor markets will continue to force developed market central banks, who still strongly believe in the Phillips Curve relationship as the best way to forecast inflation, to move toward less dovish monetary policies, putting steady upward pressure on global bond yields. Our own Central Bank Monitors signal a need for tighter monetary policy (Chart of the Week), most notably in the U.S. That may sound strange given the recent softening of global growth momentum and plunge in oil prices. Yet economic survey data (like the global ZEW index) show a huge divergence between actual and expected growth, with real bond yields responding more to the former than the latter (Chart 2). Chart of the WeekStill A Bearish Bond Backdrop   Chart 2Global Yields Will Remain Resilient In 2019 The fear of a global economic downturn appears greater than the current reality - a trend likely magnified by the ongoing U.S.-China trade tensions and the sharp fall in oil prices which some are interpreting to be a sign of weaker demand. BCA’s commodity strategists view the oil decline as purely supply driven, and expect that a tighter demand/supply balance will result in oil prices recovering recent losses and rising smartly in 2019. This should lead to a rebound in the inflation expectations component of global bond yields later next year (bottom panel). As was argued in the 2019 BCA Outlook, the conditions for a deep pullback in global growth are not yet in place, especially in the U.S. where consumer fundamentals remain solid (strong income growth, booming net worth and a low debt service ratio). China, where growth is currently slowing, remains the biggest wild card for the world economy, especially given the degree to which emerging market economies are levered to Chinese growth. Yet the most likely outcome is that Chinese authorities will make enough policy adjustments to stabilize the economy in the first half of 2019, which will help put a floor under global growth. With over 80% of OECD economies now with an unemployment rate below estimates of “full employment”, the backdrop today is more conducive to sustained higher inflation than at any point since the 2008 Global Financial Crisis (Chart 3). This means that actual inflation readings are likely to be stickier to the upside, especially for domestically focused measures like wages and services which are accelerating in many countries. Chart 3Tight Labor Markets Will Prevent A Sharp Drop In Inflation From the point of view of global central bankers, this means that as long as global growth does not slow sustainably below trend, then unemployment rates are unlikely to begin to rise. For policymakers who slavishly follow the Phillips Curve when forecasting inflation, that will make it difficult to shift to a more dovish policy bias, even if inflation remains below target for a time thanks to the recent pullback in oil prices (Chart 4). Chart 4Central Banks Who Believe In The Phillips Curve Can’t Turn Dovish The degree of policy bias in 2019 will not be uniform, though, which was also the case in 2018. Central banks in countries with core inflation rates closer to policymaker targets (the U.S., Canada, the U.K. if the Brexit uncertainty fades, Sweden) will be more likely to raise rates than those where inflation is still well below target (Japan, the euro area, Australia). Relative government bond market performance over the course of 2019 should reflect those trends. U.S. Treasury yields will still most likely to see the largest increase from current levels as the Fed will lift rates over the full 2019 calendar by more than markets are currently discounting (only 33bps are currently priced in the U.S. Overnight Index Swap curve – a low hurdle to beat). Key View #2: The Unwind Of Crisis-Era Global Monetary Policies Will Continue Quantitative easing (QE) – central banks buying huge amounts of bonds to help keep yields low enough to sustain economic growth amid weak inflation expectations – has been a dominant feature of global bond markets since the 2009 recession. Policymakers have been forced to engage in such unusual activities to try and boost weak inflation expectations even after policy interest rates have been cut to 0% (and even lower in some cases). Now, a decade later, inflation expectations are more stable and much closer to central bank targets in most countries (except, as always, Japan). That means government bond returns are no longer negatively correlated to equity returns (Chart 5), reducing the value of bonds as a hedge to stocks. Chart 5Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation In the 2019 BCA Outlook, several other reasons were given as to why that correlation has been weakening, including a shift towards more consumption and less savings from aging populations entering their retirement years. The biggest change, however, has been the move from QE to “QT” (quantitative tightening) as central banks buy fewer bonds or, in the case of the U.S. Fed, actually letting bonds run of its massive balance sheet. The new year will bring an end to the net new buying phase of the European Central Bank (ECB) Asset Purchase Program. That represents a loss of €180 billion of liquidity into European bond markets compared to 2018 (twelve months at €15bn per month), both for government debt and investment grade corporates which are also part of the ECB’s program. This will come on top of reduced purchases from the Bank of Japan (BoJ), who will likely buy at a reduced ¥30 trillion pace in 2019 (down from around ¥40 trillion in 2018), and from the Fed who will let $600bn of maturing bonds run off its balance sheet ($360bn of which will be Treasuries). That slowing pace of central bank asset accumulation means that private investors must absorb an even greater supply of government bonds next year. The BCA Outlook estimated that the change in the supply of government bonds available to private investors would equal $1.2 trillion in 2019, a huge increase from the $400bn seen in 2018 (Chart 6). This will come at a time when new government bond issuance is set to increase once again thanks to wider U.S. budget deficits, further worsening the global supply/demand balance for government debt from the major developed economies. Chart 6Private Sector To Absorb More Bonds The reduction in the pace of central bank bond buying will continue to put gentle upward pressure on government bond yields, as has been the case since the pace of ECB purchases peaked in 2016 (Chart 7). More importantly, the diminished central bank liquidity expansion means there will be less money going into risky assets via the portfolio balance channel (i.e. private investors taking the funds earned from selling bonds to central banks and placing that in equity and credit markets). Chart 7Upward Pressure On Yields & Vol From 'QT' This creates a backdrop where volatility spikes will be more frequent, as has been the case in 2018 (bottom panel). Risky asset valuations will also be impacted from reduced inflows from yield-seeking investors who have sold government bonds to central banks. This suggests wider credit spreads and lower equity price/earnings multiples, all else equal (Chart 8). Chart 8Risk Asset Valuations Will Continue To Suffer From QT In 2019 Of course, all is not equal. A rebound in global growth could trigger a new wave of inflows into global equity and credit markets with valuations having cheapened in recent months. The important point is that, without central bank liquidity propping up asset prices, global risk assets will trade more off fundamentals in 2019 than has been the case during the past couple of years. Key View #3: Too Soon To Worry About Inverted Yield Curves “Yield curve inversions lead to recessions” is a well-known (if not well understood) relationship that has gained almost mythical status among investors. As the widely-watched spread between 2-year and 10-year U.S. Treasury yields (the 2/10 curve) has melted away during the course of 2018 – now sitting at a mere 13bps – the prognosticating power of the curve has many worried that a U.S. recession could be just around the corner. Especially after the Fed has raised the fed funds rate by 200 basis points over the past three years. Those fears are misguided, for several reasons: 1. The Treasury curve segment with the most successful track record in heralding U.S. recessions is the spread between the 10-year U.S. Treasury bond yield and the 3-month U.S. Treasury bill rate (Chart 9). That spread is still a firmly positive 42bps. We showed in a Special Report published last July that, on average, the length of time between the inversion of the 3-month/10-year Treasury curve and the beginning of a recession is seventeen months.2 Chart 9UST Curve Not Close To A True Recessionary Inversion Signal 2. The slope of the Treasury curve is unusually flat given the level of the fed funds rate measured in real (inflation-adjusted) terms. The previous three episodes where the 2-year/10-year Treasury curve has inverted over the past thirty years have occurred when the real fed funds rate was between 300-400bps (Chart 10). The current level of the real funds rate (deflated by headline CPI inflation) is near zero which, in the past, has occurred alongside a 2-year/10-year Treasury curve that had a positive slope between 150-200bps. Chart 10Global Yield Curves Look Too Flat Vs Real Policy Rates... 3. The depressed level of bond term premia is weighing on longer-dated Treasury yields and dampening the slope of the curve. This is happening not only in the U.S., but also in other major bond markets in Germany, the U.K. and Japan (Chart 11). The impact of global QE programs is the most likely common factor. Chart 11...With Global Term Premia Depressed 4. The 2-year/10-year U.S. Treasury curve has never been inverted without the real fed funds rate being above the neutral real rate, also known as R-star (Chart 12). Chart 12No 2/10 UST Inversion Before Real Rates Exceed R* The implication for fixed income investing for 2019 is that it is too soon in the Fed’s monetary tightening cycle to expect an inverted yield curve driven by an overly tight monetary policy. That outcome is more likely by late 2019 after inflation expectations pick up and the Fed delivers at least another 75bps over the course of the year, pushing the funds rate into restrictive territory. Key View #4: Poor Corporate Returns From The Aging Credit Cycle The other major fixed income implication of the 2019 BCA Outlook is that global corporate bond markets are likely to see another year of poor returns (both in absolute terms and relative to government bonds). Spreads remain near historically tight levels across most spread product sectors, suggesting that credit risk premia will need to be repriced higher as the endgame of the multi-year credit cycle draws nearer (Chart 13). Both investors and policymakers have grown increasingly worried about the risks to the U.S. corporate bond market from high corporate leverage. However, as was discussed in the Outlook, U.S. corporate interest coverage remains well above levels that have preceded the end of previous credit cycles and BCA’s models suggest U.S. corporate profit growth will remain solid (albeit much slower than the rapid +20% growth seen in 2018). Chart 13Fading Support For Corporate Bonds From Growth & Policy That does not mean that corporate bonds are without risk. With 50% of global investment grade bond indices now rated BBB (one notch above junk), the greater threat to corporates may come from downgrades. While those are less likely in a growing economy, investors in lower-rated investment grade bonds may require higher yields and spreads to compensate for the future risk of losses as those bonds could become “fallen angel” high-yield debt in the next economic downturn. This impact would be magnified as how many large fixed income managers have mandates that forbid investment in bonds rated below investment grade, thus creating forced selling in the event of downgrades. More fundamentally, the outlook for global corporate bonds, with spreads still much closer to historical tights than long-run averages, remains reliant on strong economic growth momentum and supportive monetary policy. On the former, we do not anticipate a move to sub-trend global growth, as discussed earlier, and corporate bond returns could stabilize once the current downtrend in the world economy subsides (Chart 14). This would likely represent a final period of calm, however. Tightening global monetary policies – both Fed hikes and diminished asset purchases – will create a more bearish backdrop for credit in the latter half of 2019 as markets begin to discount slower economic growth in 2020. Chart 14Fading Support For Corporate Bonds From Growth & Policy   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see the December 2018 edition of The Bank Credit Analyst, “Outlook 2019 – Late Cycle Turbulence”, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31st 2018, available at gfis.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

Overweight After reaching their post-GFC highs in the middle of 2017, the S&P homebuilders index put in a seven-year bottom in October, though has since recovered to roughly the level where we upgraded to overweight.1 The fall came as homebuilder sentiment gave up some of its optimism (second panel), driven largely by higher mortgage rates and the resulting lower affordability (third panel). However, we believe the market priced in faltering homebuilder optimism well before the industry itself. Anecdotally, Toll Brothers (TOL, notably not a member of the S&P homebuilders index but a major homebuilder nonetheless) recently delivered quarterly results where new orders fell for the first time in four years, including a precipitous 39% decline in California, their biggest market, and offered guidance below analyst expectations. This glum news was met by a market that took the stock higher that day. Our inference is that negativity is fully priced in to this index and with the overall housing market index squarely above the 50 boom/bust line (second panel) and earnings growth expectations coming back to reality (bottom panel), the S&P homebuilders index is set to continue its recovery. We reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM.   1      Please see BCA U.S. Equity Strategy Weekly Report, “Indurated” dated September 24, 2018, available at uses.bcaresearch.com.

The SPX had a significant reversal earlier this week and washed out technical conditions likely signal that the recent triple bottom formation will pave the way for a rebound. The CBOE VIX index of volatility also stayed below the February intraday peak, and suggests that a trough may already be in place. Importantly, taking a cue from Sweden is interesting. Sweden is a small open economy driven by net exports and a slew of economic indicators are currently springing higher. Could Sweden’s exporters sniff out an end to the global trade slowdown and a likely de-escalation in the U.S./China trade tussle? The short answer is yes. The Swedish manufacturing PMI is on fire and a visible exception compared with grim prints throughout Europe (third panel). Keep in mind that Sweden’s PMI troughed mid-year, leading even the hyper-sensitive EM FX index (bottom panel). Financial markets also corroborate the healthy Swedish PMI signal; relative Swedish stock performance is in a V-shaped recovery (second panel). This is significant given that industrials stocks comprise over 30% of the MSCI Sweden index. Bottom Line: Across the board improvement in Swedish data suggests that global export growth is likely at a turning point. Sweden may also be sniffing out that the trade dispute between the U.S. and China will take a turn for the better. The upshot is that the SPX may have already put in a trough.

Special Report

Highlights So What? The tech war will continue to disrupt the trade truce. Why? The U.S. and China have legitimate national security concerns about each other’s tech policies. The 90-day trade talks cannot succeed without some compromises on tech issues. Chinese structural reforms could also reduce U.S. concerns over tech transfer. Feature The fanfare over President Donald Trump’s tariff ceasefire, agreed at the G20 summit on December 1, has already proved short-lived. We know now that on the same day President Trump sat down with Chinese President Xi Jinping to negotiate the truce, Canadian authorities arrested Meng Wanzhou, the chief financial officer of Huawei, under a U.S. warrant. Huawei is the world’s biggest telecoms equipment maker, second-biggest smartphone maker, and one of China’s high-tech champions. So far the controversial arrest – which prompted Beijing to make representations to the U.S. ambassador – has not derailed the trade truce. China’s Commerce Ministry has announced that tariffs will be eased and imports of American goods will increase. The CNY-USD has climbed upwards despite a rocky global backdrop in financial markets (Chart 1). Chart 1Currency Part Of The Trade Truce? Nevertheless, Meng’s arrest calls attention to our chief reason for skepticism about the ability of the U.S. and China to conclude a substantive trade deal. In essence, “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance. Trade War? Tech War! The historian Paul Kennedy, in his bestselling The Rise and Fall of the Great Powers, argued that the history of competition between nations is determined by economic and technologically advanced industrial production.1 Eighteenth-century Britain defeated France; Ulysses S. Grant defeated Robert E. Lee; and the U.S., the allies, and Russia defeated Nazi Germany and Imperial Japan. This thesis helps to explain why China’s recent technological acceleration has provoked a more aggressive reaction from the U.S. than its general economic rise over the past four decades. For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart 2). If it comes to match the U.S.’s ratio then it will overwhelm it in real R&D investment, at least in dollar value. And R&D is just one of many factors showing that China is eroding the U.S.’s global dominance. Chart 2The U.S. Has Some Competition In September, an inter-agency U.S. government task force initiated by President Trump’s Executive Order 13806 sought to assess the strength of the U.S. defense industrial base and resilience of its supply chains.2 The conclusion was that the U.S.’s military-industrial base is suffering from a series of macro headwinds that need to be addressed urgently. The report cited key domestic issues, such as the erosion of the U.S. manufacturing sector (Chart 3). It argued that the country is rapidly losing the ability to source its defense needs from home, develop human capital for future needs, and surge capabilities in a national emergency. Chart 3Decline Of The U.S. Manufacturing Base However, foreign competition, specifically “Chinese economic aggression,” also holds a central place in the report. The obvious risk is U.S. overreliance on singular Chinese sources for critical inputs, as highlighted during the 2010 rare earth embargo, when Beijing halted exports of these metals to Japan during a flare-up of their maritime-territorial dispute in the East China Sea (Chart 4). Chart 4China’s Rare Earth Supply Chain Leverage The authors’ point is not simply that China’s near-monopoly of rare earths remains a threat to the U.S. supply chain, but that Beijing’s willingness to leverage its advantageous position in the supply chain to coerce its neighbors could be used in other areas. After all, Washington’s reliance on China is rapidly extending to industrial goods that are critical for U.S. defense supply chains, such as munitions for missiles. But Washington’s greatest fear is China’s move into higher-end manufacturing and information technology – and hence the flare-up in tensions over ZTE and Huawei this year. Bottom Line: Technological sophistication and economic output determine which nations rise and which fall over the course of history. While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Semiconductors: The Next Battlefront While the U.S. lacks a national industrial policy, Beijing has made a concerted effort to promote indigenous production and innovation. The obvious example is Beijing’s state-backed ascent to the top of the global solar panel market. More broadly, China’s export growth has been fastest in the categories of goods where the U.S. has the greatest competitive advantage (Chart 5). Again, the U.S. concern is not market share in itself, but China’s ability to compete as an economically advanced “great power.” Chart 5China’s Comparative Advantage Threatens U.S. Global Market Share Semiconductors are rapidly becoming the next major battleground, as China is trying to build its domestic industry and the U.S. is considering a new slate of export controls that could constrict the flow of computer chips to China.3 Semiconductors are critical as the building blocks of the next generation of technologies. The semiconductor content of the world’s electronic systems is ever rising. Breakthroughs such as artificial intelligence and the Internet of Things (IoT) promise to create a huge boost in demand for chips in the coming decades. China’s predicament is that the U.S. and its allies control 95% of the global semiconductor market (Chart 6), and yet China is the world’s largest importer, making up about a third of all imports, and its largest consumer (Chart 7). This is a dangerous vulnerability that China has been working to mitigate. Back in 2014 Beijing launched a $100-$150 billion semiconductor development program and has more or less stuck with it. The Made in China 2025 program projects that China will produce 70% of its demand for integrated circuits by 2030 (Chart 8). Chart 6China’s Chip Makers Are Still Small FryChart 7China Accounts For 60% Of Global Semiconductor Demand While China-domiciled chip companies have a long way to go, they are rising rapidly, and China has already become a big player in global semiconductor equipment manufacturing (18% market share to the U.S.’s 11%). Chart 8Made In China 2025 Targets The problem for the U.S. is that semiconductors are one area where China runs a large trade deficit. Indeed, the U.S.’s share of China’s market is somewhat larger than the U.S. share of the global market, suggesting that the U.S. has not yet gotten shut out of the market (Chart 9). Chart 9U.S. Chips Still Have An Edge In China Moreover, 60% of U.S. semi imports from China and 70% of exports are with “related parties,” i.e. U.S. corporate subsidiaries operating in China. The U.S.’s highly competitive semiconductor industry is the most exposed to the imposition of tariffs (Chart 10). This may explain why so many exemptions were granted to the U.S. Trade Representative’s third tariff schedule: out of $37 billion in semi-related Chinese imports to face tariffs, $22.9 billion were given waivers.4 Chart 10Tariffs Are Harmful To U.S. Chip Makers The Barack Obama administration, initially faced with China’s disruptive entrance into this sector, determined that the U.S.’s best response would be to “win the race by running faster.” A council on science and technology warned that the U.S. would have to make extensive investments in STEM education, job retraining, manufacturing upgrades, research and development, international collaboration, and export promotion in order to stay ahead.5 However, these initiatives proved to be either too rhetorical (due to policy priorities and gridlock in Washington) or too slow-in-coming to make a difference in light of China’s rapid state-directed investments under the Xi Jinping administration. The Trump administration has obviously taken a more punitive approach. Trump originally focused on China’s alleged currency manipulation and criticized its large trade surpluses with the United States, but his focus has evolved since taking office. Under the influence of U.S. Trade Representative Robert Lighthizer – who is now heading up the 90-day talks – Trump’s complaints have given way to a Section 301 investigation into forced technology transfers, intellectual property theft, and indigenous innovation. This investigation eventually provided the justification for imposing tariffs on $250 billion worth of Chinese imports. Over this time period, it has become clear that there is considerable consensus across the U.S. government, on both sides of the aisle, to take a more aggressive approach with China that includes tariffs, sanctions, foreign investment reviews, and potentially new export controls. Significantly, the high-tech conflict has escalated separately from the trade war: it operates on a different timeline and according to a different set of interests. For example: The ZTE affair: The Commerce Department’s denial order against telecoms equipment maker ZTE came on April 15, even as the U.S. and China were trying (ultimately failing) to negotiate a trade deal to head off the Section 301 tariffs. CFIUS reforms: The U.S. Congress proceeded throughout the summer on its efforts to modernize the Committee on Foreign Investment in the United States, culminating in the Foreign Investment Risk Review Modernization Act (FIRRMA). The Treasury Department released its implementing rules for the law in October, which will take effect even as trade negotiations get underway. The secretive body’s major actions have always been to block deals with China or related to China (Table 1). Table 1U.S. Foreign Investment Reviews Usually Hit China Chipmaker sanctions: The U.S. Department of Justice indicted Chinese chipmaker Fujian Jinhua Integrated Circuit despite the November diplomatic “thaw” between the two countries in preparation for the G20 summit.6 This action occurred even as top American and Chinese diplomats and generals engaged in talks intended to simmer down strategic tensions in the South China Sea and elsewhere. New export controls: Despite the 90-day trade talks scheduled through March 1, the U.S. government is currently holding public hearings on whether to expand U.S. export controls to cover a range of emerging technologies. These hearings, to conclude on December 19, are being held pursuant to the Export Control Reform Act signed into law in August along with the CFIUS reform. Most recently, the arrest of Meng Wanzhou, the CFO of Huawei, falls into this trend – casting doubt on the viability of the tariff ceasefire and forthcoming trade talks. The incident highlights how the pace, scale, and momentum of the tech conflict are substantial and will be difficult to reverse. Furthermore, the U.S. is building alliances with like-minded Western countries in order to encourage a unified embargo of Huawei, ZTE, and potentially other Chinese tech companies. In particular the U.S. and its allies are trying to block Chinese companies out of their upcoming 5G networks. The U.S. banned Huawei back in 2012, but it fears that allied countries – particularly those that host U.S. military bases – will have their commercial networks compromised by Huawei.7 5G will enable superfast connections that form the basis of the Internet of Things. If Huawei is embedded in 5G networks, it could theoretically gain unprecedented penetration into Western society and industry. Since China’s Communist Party has prioritized the “fusion” of civilian capabilities with military,8 and since the country’s security forces and cyber regulators are authorized to have access to Chinese companies’ critical infrastructures and data at will, American government departments have been soliciting allied embassies not to adopt Huawei as a supplier despite its competitive pricing and customizability. Australia, New Zealand, and Japan have effectively banned Huawei from 5G for their own reasons; the U.K. and others are considering doing the same. The expansion of this coalition creates a difficult backdrop for negotiating a final trade deal by March 1. And yet the G20 ceasefire clearly improved the odds of such a deal. So what will break first, the tech war or the trade ceasefire? Bottom Line: The tech war is intensifying even as the trade war takes a pause. The large-scale U.S. mobilization of a coalition of states opposed to China’s growing presence is a bad sign for the 90-day talks, though so far they are intact. What A Deal Might Look Like To get a sense of whether the tech war will upend the trade talks, or vice versa, we need to consider what a final trade deal that includes the U.S.’s technological demands would look like. It is significant that on November 20, the eve of the G20 summit, U.S. Trade Representative Lighthizer released a report updating the findings of his Section 301 investigation.9 Lighthizer’s position matters because he is leading the 90-day talks and a critical swing player within the administration.3 Lighthizer’s report is essentially the guideline for the U.S. position in the 90-day talks. It makes the following key claims: China has not altered its abusive and discriminatory trade practices since the Section 301 investigation was concluded. These practices include grave accusations of cyber-theft and industrial espionage. The report also argues that China’s state-driven campaign to acquire tech through mergers and acquisitions is ongoing, despite the drop in Chinese mergers and acquisitions in the United States over 2017-18 (Chart 11). The reason, the USTR alleges, is that China tightened controls on investment in real estate and other non-strategic sectors (essentially capital flight from China), whereas Chinese investment to acquire sensitive technology in Silicon Valley is still intense and is being carried out increasingly through venture capital deals (Chart 12). Chart 11M&A No Longer China’s Best Way To Get Tech...Chart 12...Now Venture Capital Deals Offer A Better Way China’s concessions so far are “incremental” and in some cases deceptive. For instance, China’s propaganda outlets have de-emphasized the “Made in China 2025” program even though the government is continuing apace with this program, as well as other state-subsidized industrial programs that utilize stolen tech, such as the “Strategic Emerging Industries” (SEI) policy. Not only has China maintained certain targets for domestic market share in key technologies, but modifications to the program have in some cases increased these targets, such as in the production of “new energy vehicles” (Chart 13). Other concessions, such as on foreign investment equity caps, are similarly unsatisfactory thus far, according to the USTR. For instance, China’s pledge gradually to allow foreigners to operate wholly owned foreign ventures in the auto sector is said to arrive too late to benefit foreign car manufacturers, who have already spent decades building relationships under required joint ventures. Chart 13The Opposite Of U.S.-China Compromise Trade partners share the U.S.’s concerns and are taking actions to address the same problems. In addition to the aforementioned actions on the 5G, the EU is developing foreign investment review procedures for the first time. Foreign industry groups share the U.S. business lobby’s fear of China’s forced tech transfers. Ultimately, Lighthizer’s report shows both that a trade deal is possible and that it will be extremely difficult to achieve: Possible, because while the report touches on deep structural factors underlying China’s practices, it emphasizes technical issues. Since these issues can often be adjusted by degree, there is ostensibly room to bargain. Difficult, because the main takeaway of the report is that the U.S. is giving China an ultimatum to stop cyber theft and industrial espionage. At minimum, the U.S. will demand assurances that China’s military, intelligence, and cyber agencies will rein in their hacking, spying, and tech acquisition campaigns. Other disputes are more susceptible to tradeoffs, but it will be hard for the U.S. to compromise on a list of grievances that so plainly enumerates national security violations. Can China really compromise on aspects of its Made in China 2025 industrial plan? Possibly. What China cannot compromise on is technological advancement in general, since its future economic sustainability and prosperity depend on it. So China may not accept getting shut out of investment opportunities in Silicon Valley. But if the 2025 plan provokes foreign sanctions, then it interferes with China’s technological advance, and hence can be compromised in order to achieve China’s true end. It makes sense for China and the U.S. to focus on the above tech issues – that is, for the “structural” part of the trade talks – as opposed to any macroeconomic structural demands that are more difficult to pull off at a time when China’s credit cycle is exceedingly weak and the economy is slowing. For instance, on China’s currency, while the U.S. will have to have some kind of agreement, and China has already shown it will allow some appreciation to appease the U.S., China is highly unlikely to agree to a dramatic, Plaza Accord-style currency appreciation. Therefore the negotiators will have to accept a nominal agreement on currency practices, perhaps as an addendum as was done with the U.S.-Korea trade renegotiation. As for other strategic tensions, China is continuing to support the Trump administration’s diplomatic efforts with North Korea. Therefore the U.S. is unlikely to get much traction on its demand that China remove missiles from the South China Sea. But unlike cyber theft and corporate hacking, the South China Sea could conceivably be set aside for the purposes of a short-term trade deal and left for later rounds of negotiations, much as Trump’s border wall with Mexico was set aside during the NAFTA renegotiation. Bottom Line: The U.S. is demanding that China (1) rein in its hacking and spying (2) shift its direct investment to less tech-sensitive sectors (3) adjust its Made in China targets to allow for more foreign competition (4) lower foreign investment equity restrictions. Our sense, from looking at these demands, is that a trade deal is possible. But given the underlying strategic rivalry, and the intensity of the tech conflict, we think it is more likely that the tech war will ultimately derail the trade talks than vice versa. China’s Reform And Opening Up Turns 40 Finally, a word about China’s reforms, which are no longer discussed much by investors, given that many of the ambitious pro-market reforms outlined at the 2013 Third Plenum flopped. This month marks the 40th anniversary of China’s “Reform and Opening Up” policies under Deng Xiaoping. The original Third Plenum, the third meeting of the 11th Central Committee at which Deng launched his sweeping policy changes, occurred on December 18-22, 1978. In the coming days, General Secretary Xi Jinping will commemorate the anniversary with a speech. Various party media outlets have been celebrating reform and opening up over the past few months. We have no interest in adding to the hype. But we do wish to highlight the interesting overlap in the deadline for the trade talks, March 1, with the annual meeting of China’s legislature, when new policy initiatives are rolled out. To conclude a substantive trade deal, China needs to make at least a few structural concessions. And to satisfy the Trump administration, these concessions will have to be implemented, not merely promised, since the administration has argued consistently that past dialogues have gone on forever without tangible results. The surest way to achieve such a compromise would be to strike a trade deal and then begin implementation at the appropriate time in China’s own political calendar, which would be the March NPC session – right after the 90-day negotiation period ends. What kind of structural changes might China make? Of the four points outlined above, the one that is likely to get the most traction is lifting foreign venture equity caps (Table 2). This would be substantive because it would remove an outstanding structural barrier to foreign market access – China’s prohibitive FDI environment – while depriving China of a means of pressuring firms into conducting technology transfers. It would also have the added benefit of attracting investment that could push up the renminbi. Table 2China’s Foreign Investment Equity Caps In this context, we will watch very carefully both for progress in the 90-day talks and for any new and concrete proposals within President Xi’s upcoming economic statements. This includes the annual Central Economic Work Conference as well as the 40th anniversary of the historic Third Plenum. Bottom Line: The basis for a substantial U.S.-China trade deal would be Chinese structural changes to grant the U.S. (and others) greater market access for investment and a safer operating environment for foreign intellectual property. While we remain pessimistic, the reform agenda is important to watch. Investment Conclusions We continue to believe that a final trade deal between the U.S. and China is not likely forthcoming – at least not in the 90-day timeframe. The difficulty of working out a deal with the tech issues above should support this baseline view. Nevertheless, given that there is a possible path forward, and given that Chinese tech stocks are heavily oversold, is now a good time for investors to buy? Our view is no, on a cyclical 6-12 month horizon. Relative to the MSCI China investable index, tech stocks are not so badly beaten down as they first appear (Chart 14). The incredible earnings performance of this sector over the past five years has rolled over lately, as reflected in trailing earnings-per-share. This is true relative to U.S. tech stocks and the global equity market as well (Chart 15). Chart 14China's Tech Selloff In Line With Market Chart 15Tech Earnings Rolled Over Pre-Tariffs Since this is a decline in trailing earnings, it does not stem from the trade war, but rather from internal factors like consumer sentiment and retail sales (given the large weights of consumer-related firms like Alibaba and Tencent in this sector). Relative to global tech stocks, Chinese tech has definitely become less expensive after the recent selloff. But they are still not cheap (Chart 16). Given the headwinds outlined above – the fact that the tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war – we think it is too early to bottom-feed. Chart 16Tech Stocks Not All That Cheap In short, U.S.-China tensions are rising when looked at from the perspective of, first, China’s aggressive state-backed industrial programs and technological acquisition and, second, the U.S.’s emerging technological protectionism and alliance formation. Two long-term implications can be drawn: First, many of the United States’ complaints stem not only from China taking advantage of its economic openness, but also from the U.S.’s low-regulation environment and opposition to state-driven industrial policy. The U.S. will not have much luck demanding that China stop pouring billions of dollars of government funds into its nascent industries; it will deprive its own emerging sectors of funds if it prevents Chinese investment into Silicon Valley. In other words, the U.S. will have to become less open and more heavily regulated. The CFIUS reforms and the proposed export controls highlight this trend. In addition, any escalation of tensions will likely result in Chinese reprisals against U.S. companies. The U.S. tech sector is the marginal loser (Table 3). Table 3S&P Tech Companies With Large China Exposure Second, while it is often believed that China is playing “the long game,” the government’s technological acquisition policies suggest a very short-term modus operandi. The allegations of widespread and flagrant use of tech company employees by intelligence agencies, and gross cyber intrusions, if true, imply that China is making a mad dash for technology even at the risk of alienating its trading partners and driving them into a coalition against it. Since no government can overlook the national security implications of such practices, China will continue to suffer from foreign sanctions and embargoes, until it convinces foreign competitors it has changed its ways. As a result, China’s tech and industrial sectors are the marginal losers. The big picture is that the U.S. is setting up a “firewall” of rules and regulations to protect its knowledge and innovation, and China is frantically “downloading” as much data as possible before the firewall is fully operational. This dynamic will be difficult to reverse given that the overall context is one of rising suspicion and strategic distrust.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1      The Rise and Fall of the Great Powers: Economic Change and Military Conflict from 1500-2000 (Random House, 1988). 2      Please see “Assessing and Strengthening the Manufacturing and Defense Industrial Base and Supply Chain Resiliency of the United States,” Interagency Task Force in Fulfillment of Executive Order 13806, September 2018, available at media.defense.gov. 3      Please see U.S. Bureau of Industry and Security, “Review of Controls for Certain Emerging Technologies,” Department of Commerce, November 19, 2018, available at www.federalregister.gov. 4      Please see Dan Kim, "Semiconductor Supply Chains and International Trade,” SEMI ITPC, November 5, 2018. 5      Please see President’s Council of Advisors on Science and Technology, “Ensuring Long-Term U.S. Leadership In Semiconductors,” Report to the President, January 2017, available at obamawhitehouse.archives.gov. 6      Please see Department of Justice, “PRC State-Owned Company, Taiwan Company, and Three Individuals Charged With Economic Espionage,” Office of Public Affairs, November 1, 2018, available at www.justice.gov. 7      Please see Stu Woo and Kate O’Keeffe, “Washington Asks Allies To Drop Huawei,” Wall Street Journal, November 22, 2018, available at www.wsj.com. 8      Please see Lorand Laskai, “Civil-Military Fusion and the PLA’s Pursuit of Dominance in Emerging Technologies,” China Brief 18:6, April 9, 2018, available at Jamestown.org. 9      Please see Office of the United States Trade Representative, “Update Concerning China’s Acts, Policies, And Practices Related To Technology Transfer, Intellectual Property, And Innovation,” dated November 20, 2018, available at ustr.gov.

Special Report

Highlights Below-Benchmark Duration: Below-benchmark duration positions will continue to pay off in 2019 as the Fed delivers more than the 32 bps of rate hikes that are priced into the curve for the next 12 months. While tighter financial conditions will probably necessitate a pause in the Fed’s gradual rate hike cycle at some point next year, this is already more than discounted in current market prices. A further deterioration in housing starts and new home sales, or a significant uptick in initial jobless claims would call our below-benchmark duration view into question. Neutral Corporate Credit: In an environment where the yield curve is quite flat but still positively sloped, excess returns to corporate bonds also tend to be quite low, but still positive on average. Investors should be looking for low, but positive, excess returns from credit on a 12-month investment horizon. However, credit spreads will probably widen further in the near-term and then tighten once the Fed signals a pause and global growth improves. Overweight Munis and Local Authorities: Tax-exempt municipal bond yields are very attractive relative to corporate bonds and both municipal and Local Authority bonds are relatively insulated from the weakness in global growth that will threaten the corporate profit outlook in the coming quarters. Both of these sectors should perform well in 2019. Overweight TIPS: Long-maturity TIPS breakeven inflation rates have shifted down in recent weeks, but will move higher in 2019, eventually stabilizing in a range between 2.3% and 2.5%. The rebound in oil prices that our commodity strategists expect will help, but TIPS outperformance will largely be driven by investor expectations slowly adapting to the new reality that inflation will remain much closer to the Fed’s target than it has in recent years. Yield Curve Inversion In Late 2019: Below-target TIPS breakeven inflation rates and an inverted yield curve cannot coexist. As such, investors should not worry about a sustained inversion of the yield curve until later in 2019. To profit from this view, investors should position for steepeners at the front-end of the curve. We recommend going long the 2-year bullet and short a duration-matched 1/5 barbell. The belly (5-7 year) part of the curve has become very expensive and should be avoided at all costs. Feature BCA published its 2019 Outlook two weeks ago.1 That report lays out the macroeconomic themes that our strategists think will drive markets next year. In this Special Report, we specify how investors should implement those views in the context of a U.S. bond portfolio. Key Views The main conclusions from the 2019 Outlook are: Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. […] that means capacity pressures will intensify, causing inflation to move higher. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. […] Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. In the verbiage of monetary policymakers, the BCA view is that U.S. interest rates remain below the neutral level that is consistent with trend GDP growth and stable inflation. This means that the Fed’s rate hike cycle will continue in 2019, and that monetary policy will not turn restrictive until later in the year. It is this view of U.S. interest rates remaining below neutral until late 2019 that drives our portfolio recommendations. Key Risks Given our main premise, the biggest risk to our recommended portfolio allocation is that interest rates move above neutral sooner than we anticipate. We will be monitoring three main risks in the coming months to help us decide whether our main premise needs to be re-evaluated. Risk #1: Housing Since a large amount of leverage is employed in the acquisition of new homes, there is good reason to believe that housing is the main channel through which interest rates impact the real economy. This is validated by the empirical data which show that residential investment, housing starts and new home sales all provide a good indication of when monetary policy turns restrictive and of when Treasury yields peak for the cycle.2 With that in mind, the housing data have clearly deteriorated during the past 6-9 months. However, with the 12-month moving averages of housing starts and new home sales still trending higher, it is too soon to say that housing has peaked for the cycle (Chart 1). Our sense is that the recent deterioration is a result of the sharp move higher in mortgage rates that occurred earlier this year. Now that rates have moderated, the housing data should improve.3 Chart 1The Housing Market Predicts Recessions A decisive breakdown in the 12-month moving averages of housing starts and new home sales would cause us to question our premise that U.S. interest rates remain below neutral. Risk #2: Jobless Claims With the unemployment rate at 3.7%, the U.S. labor market is in rude health. That being said, a move higher in the unemployment rate would be a clear sign that monetary policy is restrictive and that a recession is right around the corner. In the post-war era, there has never been a case where the 3-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession taking place. Often, a turn higher in the unemployment rate is preceded by an increase in initial jobless claims, and the 4-week moving average in claims has increased for four consecutive weeks (Chart 2). So far, that increase is no cause for concern. Historically, the 6-month change in jobless claims needs to reach +75k before a recession occurs (Chart 2, bottom panel). Nevertheless, the recent upturn in claims will bear monitoring in the months ahead. Chart 2Initial Jobless Claims Are Worth Monitoring Risk #3: Weak Foreign Growth & A Strong Dollar It is a bit misleading for us to include weak foreign growth and a strong dollar in the “key risks” section. In fact, our base case outlook involves weak foreign economic growth migrating to the U.S. via a stronger dollar and leading to a mild slowdown in U.S. economic activity during the next few quarters (Chart 3).4 This will probably even cause the Fed to pause its gradual rate hike cycle, but will not bring it to an end. This report also contains our recommendations for how to tactically position for this pause. Chart 3Weak Global Growth Will Drag The U.S. Lower The Awkward Middle Phase When constructing U.S. bond portfolios on a cyclical (6-12 month) investment horizon, we find it useful to split the economic cycle into phases based on the slope of the yield curve. Our economic view informs what phase (or phases) of the cycle will reign during the next 6-12 months, and the phase of the cycle informs our investment posture. We define three phases of the cycle as follows (Chart 4): Chart 4The Three Phases Of The Cycle Phase 1: From the end of the prior recession until the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2: When the 3-year/10-year Treasury slope is between 0 bps and +50 bps. Phase 3: From when the 3-year/10-year Treasury curve inverts until the start of the next recession.5 Table 1 shows how each U.S. fixed income asset class has performed in each phase. We use excess returns from the Bloomberg Barclays Treasury index versus cash to track the returns earned from taking portfolio duration risk. For other fixed income sectors we display excess returns versus duration-matched Treasuries. We also include the performance of the S&P 500 versus the Bloomberg Barclays Treasury index. Table 1Risk Asset Performance In Different Yield Curve Regimes As should be clear from the macro view discussed above, we believe that we will remain in Phase 2 of the cycle for the bulk of 2019. With the 3/10 Treasury slope a mere 13 bps at present, temporary curve inversions might occur earlier in the year, but they will not be sustained (see Key View #5 below). The first implication of being in Phase 2 is that corporate bond excess returns (both investment grade and high-yield) are likely to be positive on average, but will be very low. The bulk of corporate bond excess returns are earned in Phase 1 of the cycle when the yield curve is very steep. Excess returns don’t turn decisively negative until after the curve inverts and we enter Phase 3. Like corporate credit, Treasury excess returns are also lower in Phase 2 than in Phase 1. This makes Phase 2 an awkward one for portfolio positioning. The expected return from taking an extra unit of credit risk is quite low, as is the expected return from taking an extra unit of duration risk. In fact, cash tends to be one of the best performing asset classes in Phase 2. The excess returns from most other spread products present a similar pattern to those from corporate bonds. Elevated excess returns in Phase 1, much lower – though typically still positive – excess returns in Phase 2, negative excess returns in Phase 3. One exception to this pattern is tax-exempt municipal debt which, outside of the mid-1990s cycle, has performed similarly or better in Phase 2 than it has in Phase 1. Domestic Agency bonds and Supranationals also stick out as being very defensive sectors. They both almost always provide a small positive excess return versus Treasuries, but never provide a large reward. In the remainder of this report we discuss the five key implications for U.S. bond portfolio positioning that follow from remaining in Phase 2 of the cycle for most of 2019. Key View #1: Below-Benchmark Duration We think below-benchmark portfolio duration positions will continue to pay off in 2019. We have already shown that Phase 2 of the cycle tends to coincide with relatively low excess Treasury returns, but the slope of the yield curve is not the best indicator for Treasury returns versus cash. For that, we turn to our Golden Rule of Bond Investing which says that Treasuries tend to underperform (outperform) cash on a 12-month investment horizon when the Fed delivers more (fewer) rate hikes than what was discounted at the beginning of the 12-month period (Chart 5).6 Chart 5The Golden Rule's Track Record At present, the market is priced for only 32 bps of rate hikes during the next 12 months. More specifically, the market is pricing-in a rate increase this month, followed by one more in 2019 and then rate cuts in 2020 (Chart 6). Chart 6Market's Rate Expectations Are Too Low This extremely depressed market pricing makes us reluctant to increase duration, even tactically. While we do expect U.S. growth to slow during the next few quarters, probably by enough to necessitate a pause in the Fed’s tightening cycle, this pause is already more than reflected in current market prices. Key View #2: Neutral Corporate Credit Cyclical Horizon (6-12 Months) Being in Phase 2 of the cycle warrants a relatively defensive posture toward credit risk. For now, we recommend a neutral allocation to corporate bonds with an up-in-quality bias. We will further reduce exposure to underweight when we transition to Phase 3 of the cycle, likely late in 2019. We also recommend looking at the long-end of the credit curve to increase the average spread of your portfolio.7 Table 2 makes the importance of correctly identifying the phase of the cycle even more apparent. It shows the excess returns to both investment grade and high-yield corporate bonds for different investment horizons directly after the 3/10 Treasury slope flattens into a given range. For example, the median excess return to investment grade corporate bonds in the 12 months after the 3/10 slope breaks below 25 bps is -1.02%. Table 2Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) As in Table 1, Table 2 shows that excess returns are much higher when the yield curve is steep and that they tend to turn negative after the curve inverts. But unlike the results in Table 1, the analysis in Table 2 includes recessionary periods and makes no attempt to split the cycle into different phases. It is a purely forward looking rule that calculates excess returns after different “trigger points” are reached. For example, the 12-month median excess return of -1.02% after the 3/10 slope breaks below 25 bps is biased downward because of periods when the slope broke below 25 bps and then continued to flatten until it inverted. An environment where the slope stayed range-bound between 0 bps and +25 bps for an extended period – closer to what we expect in 2019 – will deliver somewhat better excess returns. Tactical Horizon (< 6 Months) The phase of the cycle helps us specify our excess return expectations for the next 12 months, and based on our outlook, we expect excess returns will be positive, but close to zero. However, as we write this report, corporate spreads are widening at a fairly rapid clip. We expect the carnage will continue in the near-term, but are monitoring catalysts to initiate a tactical overweight recommendation on corporate credit.8 As they were in 2015, corporate spreads are widening at the moment due to the toxic combination of slowing global growth and relatively hawkish monetary policy. We expect that sometime in early 2019, Fed policy will ease at the margin and this will coincide with a near-term peak in credit spreads and a period of improved global growth. To determine when spreads peak we are monitoring several indicators of global growth and Fed policy that successfully called the last peak in early-2016. On the global growth side, the key indicators are (Chart 7A): The CRB Raw Industrials Index The BCA Market-Based China Growth Indicator9 The price of global industrial mining stocks On the monetary policy front, the key indicators are (Chart 7B): The 12-month Fed Funds Discounter The gold price The trade-weighted dollar Chart 7AKey Indicators: Global Growth Chart 7BKey Indicators: Monetary Policy All in all, our conviction that we will remain in Phase 2 of the cycle for most of 2019 suggests we should maintain a neutral allocation to corporate bonds on a 6-12 month investment horizon, looking for small positive excess returns. In the near-term, we expect spreads will continue to widen in the next few weeks, but will peak once the Fed signals a pause in its rate hike cycle and global growth indicators show some improvement. We are monitoring several catalysts that will help us decide when to initiate a tactical overweight position in corporate bonds. Key View #3: Overweight Munis And Local Authorities The analysis in Table 1 showed that tax-exempt municipal bonds often provide strong excess returns in Phase 2 of the cycle. This makes them an attractive place to position in the current environment, especially given the relative attractiveness of muni yields. Table 3 shows that the average yield on the Bloomberg Barclays Municipal Index is 2.75%. If we assume even a 30% effective tax rate, the taxable-equivalent yield becomes 3.93%, well above the average yield offered by the Aa-rated Corporate index. Table 3Municipals Are Attractive Another reason to like munis in the current cycle is that state & local government revenues are relatively insulated from weakness in the global economy. As foreign growth weakens and drives up the dollar, corporate profits will suffer much more than state & local government tax revenues. A similar case can be made for the Local Authority sub-index of the Bloomberg Barclays Aggregate. This index is comprised largely of taxable municipal debt (and some Canadian provincial debt), and while the average yield is lower than for tax-exempt munis, it is still competitive compared to corporate bonds. But most importantly, the sector is relatively insulated from weak foreign growth and a strong dollar. Municipal bonds and the Local Authority sub-index are important overweights in our recommended portfolio as we head into 2019. Key View #4: Overweight TIPS Versus Nominal Treasuries Though long-maturity TIPS breakeven inflation rates have fallen in recent weeks, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. We believe that both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates will reach our target range of 2.3% to 2.5% in 2019. At present, TIPS breakevens are caught between being pulled down by weakening global growth and pushed up by mounting U.S. inflationary pressures (Chart 8). Most recently, weaker global growth has been winning and breakevens have moved lower alongside the plunge in oil prices. Chart 8TIPS Breakevens Face Opposing Forces Taking a step back, it is very unlikely that global growth and commodity prices will continue to fall at their current rates throughout 2019. At some point, a dovish turn from the Fed will lead to some depreciation of the dollar and global growth will stage a rebound. Our commodity strategists also expect a rebound in the oil price. They target an average of $82/bbl for Brent crude oil in 2019.10 In the meantime, core U.S. inflation will continue to print close to the Fed’s 2% target, and maybe even a bit higher in late 2019. At some point, inflation expectations will need to adapt to the new reality of inflation being near the Fed’s target. Historically, this suggests a range of 2.3% to 2.5% for TIPS breakeven inflation rates. Inflation expectations can be slow to adapt to a changing environment, and after several years of the Fed missing its inflation target from below, many investors remain trapped in a deflationary mindset. To get an idea of how long it takes inflation expectations to adjust to changes in the economy, we use our Adaptive Expectations Model of TIPS breakevens (Chart 9).11 The model is based on three factors: Chart 9The Adaptive Expectations Model Of The 10-Year Breakeven Rate The 12-month rate of change in headline CPI The New York Fed’s Underlying Inflation Gauge The 120-month rate of change in core CPI Of the three factors, the 120-month rate of change in core CPI carries the largest weight in the model. In other words, the catalyst for moving TIPS breakeven rates higher will simply be core U.S. inflation continuing to print near the Fed’s target for a prolonged period of time. All in all, investors should maintain overweight allocations to TIPS versus nominal Treasuries in 2019, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. The current slowdown in global growth and commodity prices will not last for the entire year, and U.S. inflationary pressures will continue to mount as the U.S. economy grows at an above-trend pace with a very tight labor market. Key View #5: No Yield Curve Inversion Until Late 2019 The final key view that falls out of our main macro premise, which is that the fed funds rate will remain below neutral for the bulk of 2019, is that the yield curve will not sustainably invert until late 2019. This is also probably the most contentious of our key views, given recent market moves. The main reason why we think the slope of the yield curve will remain quite flat, but positive, for most of 2019 is that sustainable yield curve inversion cannot coexist with below-target TIPS breakeven inflation rates. An inverted yield curve is a signal that the market views monetary policy as overly restrictive. It means that investors expect U.S. growth and inflation to fall in the future, necessitating rate cuts. However, long-maturity TIPS breakeven inflation rates below the 2.3% - 2.5% range that has historically been consistent with well-anchored inflation expectations signal that the market believes that inflation will not sustainably return to the Fed’s target. In other words, for an inverted yield curve and below-target TIPS breakeven inflation rates to coexist, we would have to believe that the Fed would tighten monetary policy into restrictive territory without sufficient inflationary pressures to meet its target. It is difficult to envision the Fed committing such an egregious policy error. In the event that the yield curve does invert while TIPS breakevens are below target, it is much more likely that either the Fed will adopt a more  dovish policy stance, leading to a bull-steepening of the curve; or, inflation will rise leading to higher TIPS breakevens and causing the curve to bear-steepen. In either scenario, it is hard to see how yield curve inversion will last very long without significantly higher TIPS breakevens. We will call an end to Phase 2 of the cycle only when the yield curve is inverted and long-maturity TIPS breakeven inflation rates are above 2.3%. Curve Positioning As for how to position on the yield curve in 2019, the biggest change since the end of last year is that the belly (5-7 year) of the curve is now very expensive (Chart 10). In fact, the 2/5 slope is slightly inverted as we go to press, meaning there is actually negative rolldown in the 5-year note. Chart 10Par Coupon Treasury Curve By far, the best place to position on the curve is the 2-year maturity point.12 Our model of the 1/2/5 butterfly spread (2-year bullet over duration-matched 1/5 barbell) shows that the 2-year is cheap relative to the 1/5 slope. Conversely, our model of the 2/5/10 butterfly spread shows that the 5-year bullet has become expensive relative to the 2/10 slope (Chart 11). Chart 11Favor The 2-Year Bullet Butterfly trades where you favor the bullet maturity versus the barbell perform well when the curve steepens. For example, the 2-year tends to outperform the 1/5 barbell when the 1/5 slope steepens. At present, the cheapness of the 2-year suggests that the butterfly spread is priced for significant 1/5 flattening in the coming months. Even stability in the 1/5 slope will cause the 2-year to outperform, and our key yield curve recommendation at the moment is to go long the 2-year bullet and short a duration-matched 1/5 barbell.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at bca.bcaresearch.com 2  Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 5 We use the 3-year/10-year Treasury slope because it closely approximates the 2-year/10-year slope, but with more back-data. 6 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “What Kind Of Correction Is This?”, dated October 30, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 9 A combination of 17 different financial market variables that are highly levered to Chinese growth. Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 10 Please see Commodity & Energy Strategy Weekly Report, “The Third Man At OPEC 2.0’s Meeting”, dated November 29, 2018, available at ces.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, “The Sweet Spot On The Yield Curve”, dated November 13, 2018, available at usbs.bcaresearch.com

An infrastructure bill has been the focus of economists and strategists as the next leg in fiscal easing to sustain the economy. On the face of it, such a thesis appears eminently believable. Despite historically low unemployment, 2018 has seen tremendous fiscal easing, both via the tax cuts at the end of 2017 and through the bipartisan spending agreement in early 2018, implying the current administration fears neither inflation nor deficits in its pursuit of economic growth. The logical investment conclusion from infrastructure stimulus would be to position overweight in infrastructure stocks. We created a basket of such equities to test this hypothesis. When compared to the historic U.S. federal budget deficit (top panel), we found that, while a correlation exists, there are prolonged periods where fiscal largesse has not translated into infrastructure stock outperformance. Drilling down, we found that EM stock performance (second panel) in general and capital spending in China (bottom panel)in particular have taken over as the principal drivers of these stocks. Please see this week’s Special Report for our deep dive into infrastructure stock performance and drivers as well as our sister Geopolitical Strategy Service’s take on why they believe an infrastructure bill worth $200-$400 billion over ten years has a greater than 50% chance of passing.