Developed Countries

Highlights Global Yields: Global bond yields appear to be settling into a new trading range, with the downside limited by tight labor markets but the upside capped by slowing global growth momentum. 2014/15 Redux?: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Feature Dear Client, There will be no Global Fixed Income Strategy report published next Tuesday, November 27th. Instead, you will be receiving a Special Report this Thursday, November 22nd. The report - authored by BCA's Chief Emerging Markets strategist, Arthur Budaghyan - will discuss the outlook for Emerging Market hard currency debt. Best regards, Rob Robis Chief Strategist On the surface, it appears that uncertainty is increasing in global fixed income markets. Government bond yields have dipped over the past couple of weeks, most notably in the U.S. where the benchmark 10-year Treasury yield is back down to 3.05% as we go to press. Corporate credit spreads have also been drifting wider, especially in the U.S. where there is growing concern that economic momentum has peaked, at least temporarily. The problem for bond markets is that while global growth momentum has clearly slowed, it has not been by enough to alleviate inflation pressures coming from tight labor markets. This story is clearly most visible in the U.S., but also in the majority of major developed market economies. Central bankers are sticking to their guns and focusing on their belief in the Phillips Curve model to forecast inflation. Until there are signs that more turbulent financial markets are feeding into actual weaker economic growth, bond yields will not be able to fall by enough to help bail out flailing equities and corporate credit. There are now 83% of OECD countries with an unemployment rate below the estimated full employment NAIRU. As expected with such a backdrop, our Central Bank Monitors are calling for tighter monetary policy across the developed economies. This is also showing up in an unusual divergence between rising global real bond yields and falling global leading economic indicators (Chart of the Week). Chart of the WeekYields Are Less Responsive To Slowing Growth By most conventional measures, monetary policy settings are not restrictive across the major economies. Actual policy interest rates remain below conventional measures of equilibrium like a Taylor Rule, while government bond yields - adjusted for inflation expectations - are less than trend real GDP growth (Chart 2). Those gaps are smallest in the U.S., where the Fed has been raising interest rates for the past three years, but remain wide in other countries. Chart 2Global Interest Rates Are Still Below Equilibrium Levels If global growth is merely shifting from above-trend (falling unemployment) to trend (stable unemployment), then central bankers will not be able to move back to a more dovish posture that could trigger a major fall in bond yields. Trading ranges are more likely to result in such an environment, where yields struggle to break higher because of shaky risk assets but cannot break lower because of low unemployment. We are likely in one of those ranges now, measured by a 3-3.25% range on the 10-year U.S. Treasury. Without a friendly boost from falling bond yields, we continue to recommend a cautious stance on global spread product, while maintaining an overall below-benchmark stance on global duration exposure. Will It Be 2014/15 All Over Again? Watch The USD & China Two months ago, we published a comparison of the current macro backdrop to that of the 2014/15 period.1 Back then, the Fed was forced to alter its plans to deliver a series of rate hikes after the end of its quantitative easing program, thanks to a sharply rising U.S. dollar that triggered major financial market selloffs and, eventually, slower U.S. growth. We concluded that such an outcome could occur again in the next few months, but it would take a much larger tightening of financial conditions to get the Fed to stand down this time given tighter U.S. labor markets and stronger U.S. inflation pressures. The way we presented that comparison between today and four years ago was though "cycle-on-cycle" charts, showing financial and economic data today overlapped with data from that 2014/15 period. The two episodes were indexed to the trough in the U.S. dollar in May 2014 and February 2018. This week, we update a few of those charts, but also add a few new indicators to assess if there has been enough financial and economic damage to trigger a shift to a more dovish Fed. U.S. Economy: The domestic U.S. economy appears healthier today versus the 2014/15 period, judging by the more robust readings from the NFIB Small Business Optimism index and the high level of job openings from the JOLTS data (Chart 3). Yet there are similarities seen in the latest decline in the Conference Board survey of U.S. CEO confidence, and the sharp fall in the ISM Manufacturing New Orders index. We suspect that this divergence in business optimism reflects U.S.-China trade tensions, which should have a greater impact on larger corporations that sell globally compared to smaller companies with a more domestic customer base. Chart 3U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Inflation: U.S. core CPI inflation is much faster now than at the similar point in the 2014/15 cycle, as is the growth in Average Hourly Earnings (Chart 4). This is due to the much lower unemployment rate today in the U.S., which is putting more upward pressure on domestically-generated prices and wages. Yet while the ISM Prices Paid index is also at a higher level today than 2014/15, the upward momentum has peaked and the latest decline in commodity prices is following an ominously similar path to four years ago (bottom panel). Chart 4U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation Emerging Markets (EM): EM economic growth has been decelerating at a similar pace to 2014/15, with the aggregate EM (ex-China) PMI produced by our EM strategists now sitting right at the boom/bust 50 line (Chart 5). China's economic growth appears to be holding up better today when looking at the more elevated Li Keqiang index. A possible reason for that is the much larger and faster easing of Chinese monetary conditions today compared to 2014/15, thanks to the sharp weakening of the yuan. Chart 5EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) Global Financial Markets: Here, the current cycle is sticking very close to the 2014/15 script when looking at the rising U.S. trade-weighted dollar, widening spreads for U.S. investment grade (IG) corporate bonds and EM USD-denominated sovereign debt, and the tightening of U.S. financial conditions (Chart 6). Although it should be noted that the trade-weighted dollar would have to rise another 10% from current levels, and U.S. IG spreads would have to widen another 60bps, to generate similar moves compared to 2014/15. Chart 6Financial Markets Today Vs. 2014/15: Following A Similar Script U.S. Treasury Yields: Nominal U.S. Treasury yields are at much higher levels today than four years ago, an obvious consequence of the Fed's tightening cycle and more elevated U.S. inflation expectations (Chart 7). Yet the amount of tightening discounted over the next 12-months in the U.S. Overnight Index Swap (OIS) is similar to 2014/15, as is our estimate of the market-implied level of the terminal real fed funds rate (around 0.5%).2 One major difference: there is a large net short position in the Treasury market today, while positioning was fairly neutral during 2014/15 (bottom panel). Chart 7U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing Summing it all up, the broader range of evidence we present here confirms our conclusion from two months ago. There needs to be a much larger tightening of U.S. financial conditions before the Fed can signal a pause on its planned rate hikes, because of a much healthier domestic U.S. economy and a more entrenched acceleration of inflation (especially wage growth). If China's economy can continue to outperform the 2014/15 path - still a big "if" given U.S.-China trade uncertainties and with Chinese policymakers less willing to reflate the domestic credit bubble to boost growth - then the odds of U.S. growth converging down to non-U.S. growth will be reduced. We will continue to monitor these charts and relationships in future Weekly Reports but, for now, we see nothing yet to change our bearish views on U.S. Treasuries and our cautious view on U.S. corporate credit. Bottom Line: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand Update: Fade The Recent Bump In Yields We have been structurally positive on New Zealand (NZ) government bonds for some time, dating back to mid-2017. Our view was based on an assessment that the Reserve Bank of New Zealand (RBNZ) would be unable to make any upward change in policy rates due to sub-par economic growth and inflation that would struggle to meet the RBNZ's target of 2% (the midpoint of the 1-3% target band). So far, that scenario has fully played out, and NZ government bonds have significantly outperformed their global peers as a result (Chart 8). Chart 8Sticking With Our Successful Long NZ Trades Our preferred trades, which are part of our Tactical Overlay shown on page 14, have been yield spread trades for NZ government bonds versus U.S. and German equivalents.3 Specifically, we have been recommending long positions in 5-year NZ bonds vs. 5-year U.S. Treasuries and 5-year German government debt. The trades have performed well, but have given back some of the gains in recent weeks. This has mostly come via a surge in NZ yields (+29bps higher since the recent low on September 7th) that has driven yield spreads wider versus the U.S. and Germany (+23bps and +34bps, respectively, since September 7th). These increases are likely to prove unsustainable, given the sluggish momentum in NZ growth and inflation. The latest read on year-over-year real GDP growth came in at below-potential pace of 2.8% in the 2nd quarter of 2018. The manufacturing and services purchasing managers' indices (PMIs) have both fallen sharply throughout 2018, although the latest data points suggest some stabilization above the 50 level on the PMIs (Chart 9). Similar trends can be seen in the RBNZ surveys of business confidence and capacity utilization, which both remain near the post-2008 lows but may also be stabilizing. Chart 9Sub-Par Growth In New Zealand In the November Monetary Policy Statement (MPS) that was released after the RBNZ meeting earlier this month, a cautious view on growth was outlined.4 The pickup in Q2 GDP growth was dismissed as driven by temporary factors, and policymakers expressed concern that deteriorating business confidence could be signaling a more prolonged period of slowing domestic demand. The central bank did also highlight growth risks coming from slowing exports if U.S.-China trade tensions intensify. It is difficult to find an obvious trigger for faster NZ growth at the moment. Both consumer spending and residential investment were fueled by rising immigration and population growth from 2013 to 2017, but those trends have since begun to reverse. The RBNZ projects net monthly immigration to NZ to slow to levels last seen in 2014 and in line with the current growth rate of consumer spending around 3% (Chart 10). Business investment growth has already stalled (middle panel), while the RBNZ'S Business Outlook surveys indicate a negative outlook for export growth (bottom panel). Chart 10Where Will NZ Growth Come From? Against this sluggish growth backdrop, the RBNZ must continue to run an accommodative monetary policy to support growth. This can be done given the persistent undershooting of NZ inflation versus the RBNZ target. Headline CPI inflation did accelerate to 1.9% in Q3, but core inflation at 1.2% continued to languish near the bottom end of the RBNZ target range. The gap between the two inflation measures can be attributed to previous increases in global energy prices, which caused a blip up in the tradeables portion of the NZ CPI (Chart 11). Yet the recent decline in oil prices, combined with a bounce in the NZ dollar, suggests that the bump in tradeables inflation is likely to reverse in Q4 (middle panel). Non-tradeables inflation, which is driven by domestic factors such as wage growth, has remained stable at just over 2%, even with the NZ unemployment rate at a 10-year low of 4.5% that is below the OECD's NAIRU estimate. Chart 11Stubbornly Low NZ Inflation With an obvious trigger from higher inflation, the RBNZ will be forced to maintain a highly accommodative policy stance. This is especially true given the RBNZ's mandate, which now includes maximizing sustainable employment alongside keeping inflation between 1-3%. We think that means the RBNZ is more likely to tolerate a move to the upper end of that inflation band if the growth outlook was less certain, as is currently the case. Our RBNZ Monitor sits close to the zero line, indicating no pressure to either hike or cut interest rates. In the November MPS, the RBNZ stuck to its forecast that the Official Cash Rate (OCR) would remain unchanged at 1.75% until mid-2020, consistent with the signal from our RBNZ Monitor. The market is differing on this, with the NZ OIS curve currently discounting almost one full 25bp rate hike by the end of 2019, and a faster pace of hikes after that (Chart 12). Chart 12Market-Priced RBNZ Hikes Will Not Happen We continue to recommending fading any pricing of RBNZ rate hikes over the next 6-12 months. Given our still bearish views on U.S. Treasuries, we are maintaining our recommended long NZ 5-year/short U.S. 5-year position (on a currency-hedged basis into U.S. dollars). We have been running our long NZ/short Germany position on an UN-hedged basis - atypical for the Global Fixed Income Strategy service, where our views are almost always currency-hedged into U.S. dollars - since the trade's inception last year, based on a currency view that was more bearish on the euro than the New Zealand dollar. The NZD/EUR cross instead fell substantially, which more than fully eroded the gains on the bond side of the trade until the recent 7.5% pop in that exchange rate. After that move, the return on our unhedged trade is nearly back to flat. We are using that as an opportunity to switch our NZ/Germany trade to a more typical currency-hedged basis, moving the exposure into euros from New Zealand dollars. Bottom Line: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "EM Contagion? Or Just QT On The Q.T.?", dated September 11th 2018, available at gfis.bcarsearch.com. 2 This is calculated by subtracting the 5-year U.S. CPI swap rate, 5-years forward, from the 5-year U.S. OIS rate, 5-years forward. 3 We freely admit that a position held for over one full year should not be described as "tactical", as the name of our overlay portfolio suggests. Yet we have seen no reason to close these trades early given our market views on NZ. 4 The full Monetary Policy Statement can be found here: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2018/mpsnov2018.pdf 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 The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. As we noted in our early-summer report when we added an upgrade alert to this sector, a letup in jet fuel prices would be the catalyst for a change in view1; we executed this upgrade in Monday's Weekly Report. The second panel of our chart shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. However, not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (third and bottom panels). Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: We crystallized gains of 18% since inception and lifted exposure to an above benchmark allocation on Monday, please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. ​​​​ 1 Please see BCA U.S. Equity Strategy Insight Report, "Could Jet Fuel Be The Tailwind Airlines Need?" dated June 6, 2018, available at uses.bcaresearch.com.

Highlights Duration: The Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. With only 54 bps of rate hikes priced into the curve for the next 12 months, investors should maintain below-benchmark portfolio duration. Credit Spreads: A likely deceleration in U.S. economic growth during the next few quarters is a near-term risk for credit spreads, while waning demand for C&I loans could signal that the market's default outlook is too benign. We see a high risk of spread widening during the next few months, and would advocate only a neutral allocation to spread product on a 6-12 month horizon. TIPS: Breakeven inflation rates remain low because investors are much less fearful of high inflation than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly shift to price more two-way risk into the inflation market. Remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. Feature More Pain Required Fed Chairman Jerome Powell spoke at the Dallas Fed last week, amidst some expectation that he might try to assuage financial market concerns about the pace of monetary tightening. Instead, the Chairman struck a balanced tone that the market took as slightly dovish. A rate hike next month remains fully discounted, but investors are now split on whether the Fed will move again in March (Chart 1). The April 2019 fed funds futures contract implies a funds rate of 2.525% by next April, just barely above the lower-end of the 2.5% - 2.75% target band consistent with two more rate hikes. Chart 1Markets Doubt The Gradual Pace Of Hikes Chairman Powell's remarks did not alter our view of the Fed's reaction function, which we expect will result in continued quarterly rate hikes until a preponderance of evidence is consistent with a significant slow-down in U.S. economic activity. As we discussed in last week's report, it is highly likely that the combination of a waning fiscal impulse and a stronger U.S. dollar will cause U.S. growth to slow during the next few quarters.1 What remains uncertain is whether the slow-down will be severe enough for the Fed to pause its +25 bps per quarter tightening cycle. With only 54 bps of rate hikes priced into the yield curve for the next 12 months, we are inclined to maintain below-benchmark portfolio duration on a 6-12 month investment horizon. However, we do not anticipate a significant move higher in yields during the next few months. We also think credit spreads can widen further in the near-term as growth slows, and we recommend only a neutral allocation to spread product versus Treasuries on a 6-12 month horizon, given the less attractive risk/reward trade-off in corporate credit. Another reason to get defensive on credit spreads before increasing portfolio duration is that further spread widening and tighter financial conditions are likely a necessary pre-condition for the Fed to slow its pace of rate hikes. Chairman Powell noted last week that financial conditions are an important input to the Fed's assessment of future economic growth, and also stressed that the Fed takes a broad view of financial conditions - encompassing not just the stock market but also the level of rates, credit spreads and other factors. With that in mind, we observe that there has been very little tightening in broad indexes of financial conditions during the past few months. In fact, the Chicago Fed's National Financial Conditions Index shows that financial conditions remain far more accommodative than when the Fed started hiking rates in December 2015 (Chart 2). Chart 2More Pain Needed For The Fed To Pause We conclude that much more financial market pain will be required before the Fed takes a dovish turn. As such, we are inclined to get more defensive with respect to credit, but to remain bearish on rates for now. Last week's release of the Fed's Senior Loan Officer Survey provided one more negative datapoint for corporate credit. While banks continue to ease standards on commercial & industrial loans, respondents reported that demand for such loans waned during the past three months (Chart 3). If the demand slow-down continues, then lending standards will eventually start to tighten and we will see more corporate defaults. For now, the slow-down in loan demand is a tentative signal that could be reversed next quarter, but it bears close monitoring as a potential warning that we are moving into the late stages of the credit cycle. Stay tuned. Chart 3Tighter Lending Standards Ahead? Bottom Line: U.S. economic growth will decelerate from a high level during the next few quarters, but the Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. Investors should get more defensive on credit spreads, but maintain below-benchmark duration. Stick With TIPS We have been recommending overweight positions in TIPS versus nominal Treasuries for some time, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. This range is consistent with prior periods when core inflation was well-anchored around the Fed's target.2 This recommendation suffered a set-back last week when long-maturity breakevens finally capitulated to the trend in other financial market indicators that have been pointing to weakness in global demand for several months (Chart 4). In fact, for most of this year falling commodity prices and a strengthening dollar have been signaling that global demand is on the decline. But until last week, TIPS breakevens had mostly bucked the trend. Chart 4Held Down By Global Demand The reason is that long-maturity TIPS breakeven inflation rates remain under the influence of two competing forces. Signals of waning global demand on the one hand, and rapidly rising U.S. inflation on the other. Last December, the 12-month rate of change in core PCE inflation stood at 1.64%. As of September it stands at 1.97%, within a hair of the Fed's 2% target. Likewise, year-over-year core CPI inflation has increased from 1.76% as of last December to 2.15% as of October. Survey measures of realized and expected price changes have similarly strengthened (Chart 5). Chart 5Pulled Up By U.S. Inflation The combination of strong U.S. inflation and waning global growth has left long-dated breakevens relatively trendless for most of the year. And although we think year-over-year U.S. core inflation will flatten-off during the next few months (see Box), we would remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. BOX Core Inflation: Grappling With Base Effects Year-over-year core CPI inflation was 2.15% in October, down slightly from 2.17% in September. Meanwhile, our Base Effects Indicator ticked up from 3 to 4 but it remains below the critical 5.5 level (Chart 6). Chart 6Expect Year-Over-Year Core CPI To Flatten-Off In our Weekly Report from September 4, 2018, we showed that when our Base Effects Indicator - an indicator derived from near-term rates of change in core CPI - is below 5.5, 12-month core inflation is much more likely to fall than rise during the next six months. While pipeline inflation measures and the tightness of the labor market both suggest that the uptrend in core inflation will remain intact, we expect that year-over-year core inflation will flatten-off during the next six months, at levels close to the Fed's target. Our view is that as long as inflation remains sufficiently close to the Fed's target, over time, investors will start to price two-way risk back into the inflation market. It simply takes time for expectations to fully adapt to the new economic reality. Expectations Are Slow To Adapt To illustrate why we remain optimistic that TIPS breakevens have further upside, we created what we call our Adaptive Expectations Model of the 10-year breakeven rate (Chart 7). The model combines both forward-looking and backward-looking measures of inflation, and is premised on the idea that investors are slow to fully adapt their expectations to a changing environment. Chart 7Adaptive Expectations Model For example, even though core inflation is now close to the Fed's target on a 12-month rate of change basis, investors remain scarred by the past decade when it was stubbornly low. The long period of low inflation makes it much more difficult for investors to believe that the regime is finally shifting. Our Adaptive Expectations Model includes three variables: The 120-month rate of change in core CPI inflation (annualized) The 12-month rate of change in headline CPI inflation The New York Fed's Underlying Inflation Gauge (full data set measure) The 120-month rate of change is included to capture the impact from investors' long memories when it comes to inflation. The 12-month rate of change is included to capture the more recent trend in prices and the New York Fed's Underlying Inflation Gauge is included to provide a forward-looking measure of inflationary pressures in the economy. Notice in Table 1 that the 120-month rate of change in core CPI carries much greater importance in our model than the other two variables. Table 1Adaptive Expectations Model Regression Output (2003 To Present) Turning back to Chart 7, we see that the current 10-year TIPS breakeven inflation rate is more or less in line with our model's fair value. We also see that two of the model's three variables (12-month headline CPI and the Underlying Inflation Gauge) have returned to pre-crisis levels. It is only the 120-month rate of change in core CPI that is preventing breakevens from reaching our target range. In other words, even though inflation is more or less back to target levels, investors still doubt whether we have transitioned out of the prior low-inflation regime. The Fear Of High Inflation Is Missing Digging further into the data, we see that the real difference between today and the pre-crisis period is that investors are now much less worried about significantly higher inflation. A break-down of individual responses from the Survey of Professional Forecasters shows that, as in 2004, most forecasters think inflation will average between 2.01% and 2.5% during the next 10 years. But today, only 7% of forecasters think inflation will average above 2.51%. In 2004, 32% of forecasters thought inflation would average above 2.51% over the next 10 years (Chart 8). Chart 8High Inflation Is Less Of A Worry This assessment of likely inflation outcomes is backed-up by the economic data. The St. Louis Fed's Price Pressures Measure is a macro model designed to output the probability that inflation falls into different ranges over the next year.3 Here again, we see that the probability of inflation being between 1.5% and 2.5% is similar to its pre-crisis level, but the probability of inflation exceeding 2.5% is much lower (Chart 9). Chart 9Price Pressures Even looking at only the post-crisis period shows that it is the upper-tail of the inflation expectations distribution that is lagging. The Fed's Survey of Primary Dealers has been asking respondents to place probabilities on different long-run inflation outcomes since 2011. Chart 10 shows how the most recent responses - from September - compare to the post-2011 range. It shows that respondents are more certain than at any time since 2011 that inflation will be between 2.01% and 2.5% on average during the next 10 years, but are also more doubtful that inflation will be 2.51% or higher. Chart 10Primary Dealer Inflation Expectations Bottom Line: Even though 12-month inflation has more or less returned to the Fed's target, long-maturity TIPS breakeven inflation rates remain below levels that have been historically consistent with that target. Breakevens remain low because investors are much less fearful of elevated inflation (> 2.5%) than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly adapt to the new regime. Remain overweight TIPS versus nominal Treasuries on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, "The Sweet Spot On The Yield Curve", dated November 13, 2018, available at usbs.bcaresearch.com 2 For details on how we arrive at that range please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/   Fixed Income Sector Performance Recommended Portfolio Specification

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Highlights U.S. housing's immediate past will not repeat, ... : It is understandable that investors who lived through the financial crisis are acutely sensitive to any sign of trouble in housing, but none of the factors that helped precipitate the crisis are in place now. ... and its older history will only rhyme: Home construction slowdowns have a good record of signaling recessions, but residential investment's steadily waning share of GDP has chipped away at its influence. The current housing soft patch is not over, but it's unlikely to get much worse, ... : The rapid rise in mortgage rates sharply reduced affordability, but it still remains at a very comfortable level relative to history. Inventories of new and existing homes are very low, and the pace of new construction continues to run slightly behind household formation. Most importantly for the expansion, there were no construction excesses in this cycle that need to be worked off. ... so we don't think it's sending any broader signal about the economy: A tiny contraction in residential investment is not a harbinger of recession, nor is it an indication that monetary policy is already tight. Feature Desynchronization has been the name of the game in 2018. The U.S. economy, already ahead of its peers in putting the crisis in its rear-view mirror, has gotten an additional fillip from the fiscal stimulus package. Global growth, on the other hand, has been slipping. As Fed chair Jay Powell put it last week, the rest of the world is "gradual[ly] chipping away" at the U.S., but there "is not a terrible slowdown" in the global ex-U.S. economy. Global conditions have not slowed enough to get the Fed to interrupt its tightening campaign, but signs of softness outside of the U.S.'s borders have been popping up like mushrooms after the rain. With disappointments having been few and far between in the U.S., any pockets of weakness that do appear attract immediate attention. Against this backdrop, the slowing in housing - residential investment has now contracted for three consecutive quarters - is making some investors a little uneasy. We have spent a good deal of time within BCA debating housing's recent softness, its outlook, and its implications for financial assets and the economy, and clients are increasingly inquiring about our views. Housing's Recent Past Housing is top of mind for many investors because it was at the center of the financial crisis. Residential mortgages were ground zero of the credit bubble that systemically threatened the banking system. Wobbles in housing bring back unpleasant memories of the searing trauma that unfolded just ten years ago. With the dot-com mania and the financial crisis having occurred just a decade apart, the financial media, and many strategists, analysts and investors are on high alert for the next crash. The concerns are understandable, but conditions today are nearly the polar opposite of conditions in 2005 and 2006. There is nothing even remotely bubble-like about the current housing market. The critical weakness back then was the shunning of time-tested underwriting standards, as revealed by the homeownership rate. An average of just over 64% of households owned their own homes for the first three decades of the ownership series in a remarkably steady pattern,1 but a steady debauching of standards pushed the rate to above 69% at its peak (Chart 1, top panel). Chart 1Too-Easy Lending Standards ... The homeownership rate was built on a foundation of increasingly unserviceable mortgages (Chart 1, bottom panel). Prices surged (Chart 2, top panel), flippers flooded the market, and homebuilders ramped up production to meet the ensuing demand (Chart 2, second panel). When the music stopped, the housing market was left with unprecedentedly large inventories of unsold homes (Chart 2, third panel); the banking system's primary source of collateral was poised to suffer a body blow; and a hiring surge that played out over a decade and a half was unwound in just two years (Chart 2, bottom panel). Chart 2... Made Housing Unstable Housing In The Current Cycle Current conditions are much more stable. The homeownership rate is back to its time-tested levels. New housing supply has generally undershot the smoothed trend in household formations ever since the crisis ended (Chart 3, top panel). Inventories are strikingly low when adjusted for the overall size of the housing stock (Chart 3, middle panel). The vacancy rate is low (Chart 3, bottom panel), and there is no construction employment cliff. Most importantly from a stability perspective, the Basel III/Dodd-Frank regulatory framework makes it very difficult to replicate the reckless credit conditions that enabled the housing bubble. This cycle has been devoid of housing excesses. Chart 3Plenty Of Room For More Homes A broader historical context reveals that housing has been exerting steadily less influence on the economy across the entire postwar era. We have a good deal of sympathy for the argument that the postwar business cycle has been a consumption cycle, largely led by housing,2 but it's possible that the crisis marked housing's last hurrah as a driver of recessions. Residential investment's share of GDP exploded when pent-up demand was released upon the return of servicemen and women needing homes for their burgeoning families (Chart 4). The construction of the interstate system, and the network of subsidiary roads that sprang up to connect to it, facilitated the creation of the suburbs, and Levittown-style tract housing communities had to be built from scratch to meet the demand. Chart 4The Incredible Shrinking Impact Of Housing Activity The baby boom kept demand for more, and larger, houses going strong. Once grown themselves, the baby boomers helped keep household formation growth flush. The baby boomers are now net sellers, however, and will be at an increasing rate across the next couple of decades. The time trend of residential investment's share of GDP is stark, and demographics are poised to keep it going as long as the baby boomers are divesting their holdings. The bottom line is that we do not think housing is the business cycle this time around. It is a highly cyclical part of the economy, and its fluctuations will still be felt, but its influence on the overall economy has been steadily waning for 70 years, and it is not currently in a position to exert a powerful drag. It would be overstating matters to say that housing booms cause recessions, but they've been observed at the scene of the crime in every recession of the last 60 years except for the dot-com bust. In this cycle, the barely visible white area above the trend line in Chart 4 is nowhere near large enough to give rise to a big swing below the trend line, and inspire a patch of gray shading on its own. The ratio of housing starts to the existing stock of homes (Chart 5) reinforces the message of residential investment's declining contribution to overall output. The United States has been augmenting and/or replacing the existing stock of homes at a steadily diminishing rate for 60 years. Assuming that the rate of obsolescence has remained roughly constant, it seems that there has simply been less to build once the suburban frontier was settled. Even against the declining time trend, however, residential construction activity in this cycle has not revived enough to require a correction. Chart 5Tinkering Around The Edges We attribute the current softness to the backup in mortgage rates over the last twelve months. 100 basis points may not seem like the end of the world, but the rise in interest rates has been sudden, and it is entirely plausible to think that it has sent some marginal first-time buyers to the sidelines. The Housing Affordability Index is way below its 2013 peak, but remains quite high relative to its pre-ZIRP history (Chart 6, top panel). The sudden drop in the index has been a function of mortgage payments (Chart 6, second panel) as sudden moves almost always are - the median home price (Chart 6, third panel) and the median income series (Chart 6, bottom panel) are much less variable. Chart 6Mortgage Rates Drive Affordability We expect that rates will go still higher, but our bond strategists don't think it will happen any time soon. They see rates consolidating for a while as the economy digests the sharp move higher, and favorable year-over-year comparisons cool off inflation's upward momentum over the coming months. Our above-consensus view on the terminal fed funds rate is not housing friendly. Housing will have to contend with ongoing bond-market headwinds, but we don't expect another move of this magnitude will recur in such a concentrated time frame. Bottom Line: Housing may face a headwind from higher rates for at least another year, but a big drop-off in activity is not in the cards. There are no current cycle excesses that need to be unwound, and housing has become too small a part of the economy to induce a recession on its own. Housing Demand And The Fed Funds Rate Cycle The notion that mortgage rates are to blame for the housing soft patch raises some questions about our assessment of the monetary policy backdrop. Is it possible that a funds rate that's proximally related to a slowdown in housing demand is not impacting consumer demand for other goods or services, or corporate demand? Could there be multiple equilibrium fed funds rates? If not, is the housing soft patch a sign that the economy is actually in Phase II of the cycle, and not Phase I? We are unperturbed by the three-quarter contraction in residential investment, which one has to squint to see (Chart 7). We do not believe that housing demand has reached an inflection point; we simply think that prospective monthly mortgage payments have moved so fast that some buyers have temporarily stepped aside. Given that buying a home still looks quite inviting by the historical standards of the affordability index, conditions are not yet restrictive. Ex-the ZIRP era, the index had not exceeded 140 for more than three decades (Chart 6, top panel). If homes are still affordable relative to history, then housing would seem to support our equilibrium fed funds rate model's assessment that monetary policy remains accommodative. Chart 7Not Much Of A Downturn Yet We view the state of policy as binary for the economy as a whole, even if some activity is necessarily more rate-sensitive. While some marginal investment projects cease to generate positive prospective net present value any time interest rates rise, encouraging or discouraging activity is a universal condition. The broader investment-relevant question is whether or not our assessment that the fed funds rate cycle has not yet transited from Phase I to Phase II is correct (Chart 8). If the economy is still in Phase I, and will remain there for a year, our constructive take on the economy and financial markets still applies. If it's shifted to Phase II, however, the empirical record says investors should be paring back risk. Chart 8The Fed Funds Rate Cycle The preponderance of evidence supports the idea that we remain in Phase I. Real-time measures of activity remain robust. Credit performance remains very good, so banks are still eager lenders. Employment is surging, and a follow-up dose of fiscal stimulus in 2019 should keep all the plates spinning for another year. As macro investors, and students of cycles, we are as eager as anyone to recognize the inflection point as swiftly as possible, but the data series we follow do not indicate that it is approaching. We continue to abide by our equilibrium fed funds rate model's benign conclusion. Investment Implications Although housing's direct impact on GDP has steadily waned, it remains an important part of the economy, given how it feeds into several other elements of consumer demand. Three consecutive quarters of contraction in residential investment are worthy of notice, but such a run has occurred before without provoking a recession, and the contraction to date has been awfully modest in any event. We do not view the slowdown as the beginning of the end for the expansion. We also do not view it as a sign that monetary policy is tighter than we originally judged. We expect that the ongoing surprise over the rest of this cycle will be that the neutral fed funds rate is considerably higher than the market consensus expects. We therefore think that investors should continue to maintain benchmark exposure to risk assets while remaining underweight Treasuries and holding all bond exposure below benchmark duration. Since we think the expansion remains in place, supported by accommodative monetary policy, we view the recurring mini-scares provoked by data points like housing's soft patch as potential opportunities to put our cash overweight to work. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Over the 120 quarters through the end of 1994, a mean 64.3% of households owned a home, with a standard deviation of 0.6%. Only 22% of the quarterly observations were more than a standard deviation away from the mean, as opposed to the 32% predicted by the normal distribution. 2 Leamer, Edward E., "Housing IS the Business Cycle," NBER Working Paper No. 13428, September 2007. http://www.nber.org/papers/w13428

Dear Client, Next week on November 26th instead of our regular weekly publication you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 3rd with our high-conviction trades for 2019. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy We maintain our sanguine U.S. equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our Economic Impulse Indicator represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals, especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Take profits and boost to an overweight stance today. Burgeoning domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals, suggest that the path of least resistance is higher for the S&P air freight & logistics group. Recent Changes Book gains in the S&P Airlines index of 18% since inception and lift from below benchmark to overweight today. Table 1 FEATURE The SPX was rudderless last week, as the tug-of-war between bears and bulls has yet to be decided. Equities have been experiencing mini-aftershocks following October's seismic move because the Fed has injected some volatility back into the markets via raising interest rates and allowing bonds to roll off its balance sheet at an accelerating pace. While the Fed stayed pat in November, it will most definitely tighten monetary policy next month for the ninth time this cycle. Fed policy is at the epicenter of recent S&P 500 oscillations, which raises the question: is the Fed tightening monetary policy too far too fast to cause equity market consternation? To put the latest monetary tightening cycle in perspective, we examined trough-to-peak moves in the fed funds rate since the 1950s. Chart 1 shows the results of our analysis. During the past ten Fed tightening cycles, the median trough-to-peak delta in the fed funds rate heading into recession has been 495bps. The latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect (Chart 2). Were the Fed to hike three more times by the first half of 2019, as our fixed income strategists expect, this will push the current cycle 100bps above the historical median. Chart 1Too Far Too Fast? Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median While almost everyone raves about the stellar U.S. economic performance squarely focused on levels of different economic indicators (Chart 3), drilling beneath the surface reveals that small cracks are forming, as we first highlighted in the October 22nd Weekly Report when we introduced our Economic Impulse Indicator (EII).1 The EII is a second derivate equally-weighted composite of six indicators of the U.S. economy, highlighting that peak economy was likely hit this year in Q2, when nominal GDP grew 7.6% on a quarter-over-quarter annualized growth rate basis. Chart 3Do Not Focus On Levels Alone... Chart 4 shows that 5 out of the 6 indicators included in the EII are losing steam, 4 out of 6 are in outright contraction, and only capex is showing modest signs of life. While this backdrop in isolation does not portend recession, were the Fed to go ahead with three additional hikes by mid-year 2019 that would push the fed funds rate to a range of 2.75%-3% and a possible negative Q2/2019 GDP print could then easily invert the yield curve, ticking the box in one of our three recession indicators we track.2 Chart 4...Impulses Tell A Different Story The latest Fed Senior Loan Officer survey released last week also struck a nerve. While bankers are willing extenders of credit throughout most loan categories, demand for loans is declining across the board (Chart 5A); only other consumer (likely student) loans are in high demand, and subprime residential loans are also threatening to break above the zero line.3 Nevertheless, before getting too bearish, a bond valuation examination is in order. BCA's 10-year bond valuation index has been an excellent predictor of cycle ends dating back to the 1960s. It has accurately forecast 6 out of the last 7 recessions missing only the 1974 iteration. When this valuation metric swings to extremely undervalued territory - defined as at least one standard deviation above the historical mean - it signals that a recession is approaching. Why? Typically a selloff in the bond market is associated with a fed tightening cycle and such steep monetary tightening slams the breaks on the economy via the slowing housing market and the dent in consumer spending power. True, we are closing in on this level, but we are not there yet (Chart 5B). Chart 5ALoan Demand In Freefall Chart 5BWatch Bond Valuations Finally, we bought the proverbial dip on October 26th as we did not (and still do not) foresee recession in the coming 9-12 months, underscoring that likely the trough is in place.4 On that front the Minneapolis Fed's implied probability of a 20%+ correction remains tame near the 10% probability mark, corroborating our sense that the worst is behind the equity market, at least for now (Chart 6). Chart 6Risk Of A Bear Market Is Low Netting it all out, we maintain our sanguine equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our EII represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. This week we crystalize gains in the smallest transportation sub-index we cover and boost exposure to overweight, and reiterate our high-conviction overweight stance on a large transportation sub-index. Airlines: Up In The Air Within transports we have been advocating a barbell portfolio preferring air freight & logistics (see below for an update) to airlines (as a reminder we recently downgraded rails to neutral5). The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. Chart 7 shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. Thus, we are compelled to trigger our upgrade alert and cement gains of 18% in our underweight and lift exposure to overweight in the niche S&P airlines index. Chart 7Energy Price Plunge Is Bullish For Airline EPS Not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (Chart 8). Chart 8Air Travel Demand... In fact, a larger proportion of the consumer's wallet is used for air travel, a trend that has been recently gaining steam according to national accounts. Airline load factors are pushing cyclical highs and passenger revenue per available seat mile is also gaining momentum, corroborating the U.S. government consumption expenditure data (Chart 9). Chart 9...Is Upbeat... As a result, airlines have been successful at raising selling prices and will soon exit the deflationary zone. International airfares are also in positive territory. Taken together, robust demand and higher selling prices along with declining fuel costs are a harbinger of rising margins and profits (Chart 10). Chart 10Firming Ticket Prices Is A Boon To Margins This is not yet reflected in depressed relative forward sales and profit growth estimates. Net earnings revisions have also recovered to the zero line and there is scope for additional positive EPS revisions, especially if jet fuel prices stay tamed and travel demand remains healthy. The implication is that relative share price momentum can lift off further (Chart 11). Chart 11Low Hurdle Finally, valuations are perched deeply in the undervalued zone while technicals have only recently returned to a neutral setting (Chart 12). Chart 12Unloved and Under-owned Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: Take profits in the S&P airlines index of 18% since inception and lift exposure to an above benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. Air Freight & Logistics: We Have Liftoff Air freight & logistics stocks have been bouncing along the bottom for the better part of the past year and have formed a base that should serve as a launch board higher in the coming months. Firming industry operating metrics tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures, at a time when industry executives have been showing labor restraint, with employment growth decelerating steadily over the past two years (Chart 13). This is a conducive backdrop for air freight profit margins and sell-side analysts have taken notice, penciling in higher margins in the coming 12 months. Chart 13Enticing Margin Prospects Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 14). Chart 14Holiday Selling Season Beneficiary On that front, there are high odds that this holiday sales season will be another record setting one, especially given that corporations have paid out bonuses and shared part of the lowering in corporate taxes and also wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (middle & bottom panels, Chart 14). With regard to the global macro and trade backdrop, while global revenue ton miles and G3 capital goods orders remain near cyclical highs (Chart 15), were Trump's trade rhetoric to re-escalate then global exports would give way. Already international and U.S. export expectations are on the verge of contracting - according to the IFO World Economic Survey and ISM manufacturing survey, respectively. Tack on the appreciating U.S. currency and the clouds darken further (bottom panel, Chart 15). The U.S./China trade tussle and the greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex. Chart 15Greenback And Decelerating Global Growth Are Key Risks... Nevertheless, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals. In sum, firming domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals suggest that the path of least resistance is higher for the S&P air freight & logistics group (Chart 16). Chart 16...But Already Reflected In Depressed Valuations And Washed Out Technicals Bottom Line: We reiterate our high-conviction overweight status in the S&P air freight & logistics index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 https://www.federalreserve.gov/data/documents/sloos-201810-charts.pdf 4 Please see BCA U.S. Equity Strategy Insight Report, “Time To Bargain Hunt” dated October 26, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Report, "Critical Reset" dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps