Developed Countries

Highlights So What? The Trump administration is focusing on re-election in 2020, which could push the recession call into 2021. Why? The midterms were investment-relevant, just not in the way most of our clients thought. We are downgrading our alarmism on Iran; Trump is aware of his constraints. But investor optimism regarding the trade war may be overdone. China has contained its capital outflows, which suggests Beijing will be comfortable with more CNY/USD downside. A new GPS mega-theme: Bifurcated Capitalism! Watch carefully for any upcoming trade action on semiconductors. Feature There is no better feeling than hearing from our clients that we got a call wrong because we misjudged the constraints of the Trump administration by focusing too much on its preferences. Why? Because it means that clients are keeping us honest by employing our most important method: constraints over preferences. This is one of the takeaways from a quarter filled with meetings with our clients in the Midwest, Toronto, Amsterdam, Rotterdam, The Hague, Frankfurt, Berlin, Auckland, Melbourne, Sydney, Dubai, Abu Dhabi, and sunny Marbella, Spain! In this report, we discuss several pieces of insight from our clients. Midterms Are Investment Relevant Generally speaking, few of our clients agreed with our assessment that the midterm elections were not investment-relevant. The further away from the U.S. we traveled, the greater the sense among investors that equity markets influence U.S. politics: both the upcoming takeover of the House of Representatives by the Democratic Party and the odds of trade war intensification. We strongly disagree with this assessment. Both periods of equity market turbulence this year were preceded by a rising U.S. 10-year yield, not any particularly damning trade war chatter (Chart 1). In fact, the intensification of the trade war this summer occurred amidst a fairly buoyant S&P 500! Meanwhile, the odds of a Democratic takeover of the House were priced in well before the October equity decline began. Chart 1Yields, Not Trade, Matter For Stocks Generally speaking, even midterms that produce gridlock have led to a relief rally (Chart 2). This time could be the same, especially because the likely next Speaker of the House, Nancy Pelosi, has signalled that the main policy goal for 2019 would be infrastructure spending. In her "victory" speech following the election, Pelosi mentioned infrastructure numerous times (impeachment, zero times). Chart 2Stocks Are Indifferent To Midterm Results Democratic Representative Peter DeFazio, likely head of the House of Representatives committee overseeing transportation, has already signalled that he will ask for "real money, real investment."1 DeFazio has previously proposed a $500bn infrastructure plan, backed by issuance of 30-year Treasuries and raising fuel taxes. He has rejected the February 2017 Trump proposal, which largely relied on raising private money for the job. Would President Trump go with such a plan? Maybe. In early 2018, he stunned lawmakers by saying that he supported hiking the federal gasoline tax by 25 cents a gallon (the federal 18.4 cent-a-gallon gasoline tax has not been hiked since 1993). He has since confirmed that "everything is on the table" to achieve an infrastructure deal. Several clients from around the world pointed out that both Democrats and President Trump have an incentive to make a deal. President Trump wants to avoid the deeply negative fiscal thrust awaiting him in 2020 (Chart 3). Given the House takeover by the Democrats, it is tough to imagine that new tax cuts are the means for Trump to avoid the "stimulus cliff." As such, another round of stimulative fiscal spending may be the only way for him to avoid a late-2020 recession (although the latter is currently the BCA House View). Chart 3Can Trump And Pelosi Reverse... Democrats, on the other hand, have an incentive to ditch "Resistance" and embrace policy-making. Yes, hastening the recession in 2020 would be the Machiavellian play, but President Trump would be able to blame Democrats for the downturn - since they will necessarily have had to participate in planning an infrastructure bill only to sink it. They also learned the lesson from the January 2018 government shutdown, which backfired at the polls and forced Senate Democrats to come to an agreement quickly on a two-year stimulative budget deal. What about the GOP fiscal conservatives? They don't necessarily need to come on board. The House is held by Democrats. And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given that infrastructure is popular, that the president will be pushing it, and that the GOP-controlled Senate agreed with the budget bill in January, we think that even more Republican Senators can go along with an infrastructure plan. Another big takeaway from the midterms is that the GOP suffered deep losses in the Midwest. President Trump's party lost ten out of twelve races in the region (Table 1). The two most representative contests were the loss of Republican Wisconsin Governor and one-time rising presidential star Scott Walker, and the victory of the left-wing and über-protectionist Democratic Senator Sherrod Brown of Ohio. Table 1Massive Republican Losses Across The Midwest Senator Brown won his contest comfortably by 6.4% in a state that Trump carried by 8.13%. The appeal of Brown to the very blue-collar voters that Trump himself won is obvious. On trade, there is no daylight between the left-wing Brown and President Trump. Meanwhile, Walker, an establishment Republican who built his reputation on busting public-sector unions, could not replicate Trump's success in Wisconsin. Several of our clients suggested that the GOP performance in the Midwest was poor because of the aggressive trade rhetoric. But that makes little sense. Republicans did not run Trump-style populists in the Midwest, to their obvious detriment. Democrats have always claimed to be for "fair trade" rather than "free trade." And we know, empirically, that Trump saw a key swing of turnout in 2016 in these states, largely thanks to his protectionist rhetoric (Chart 4). Chart 4Trump Owes The Midwest The Presidency President Trump cannot take Michigan, Pennsylvania, and Wisconsin lightly. His performance in 2016 was extraordinary, but also tight. The Democrats will win these states if Trump does not grow voter turnout and support, according to demographic projections - and they lost them by less than a percentage point of white voters (Map 1). As such, we think that Democrats will talk tough on trade and try to reclaim their union and blue-collar voters, while President Trump has to double down on an aggressive trade posture towards China. Map 1Can 'White Hype' Work In 2020? Trump's Margins Are Small The midterms are investment relevant after all, but not in the way some might think. The Democratic takeover of the House, and the resultant gridlock, will potentially avert the "stimulus cliff" in 2020. This ought to support short-term inflation expectations and thus allow the Fed to stay-the-course. For markets, this could be unsettling given the correlation between yields and downturns in 2018. For the dollar, this should be supportive. The odds of an infrastructure deal are good, above 50%, with the key risk being a Democratic House focused on impeaching Trump. Such a bill would augur even higher levels of fiscal spending through 2020, possibly prolonging the business cycle, and setting up an even wider budget deficit when the next recession hits (Chart 5). Chart 5Pro-Cyclical Policy Has To Continue Meanwhile, the shellacking in the Midwest ought to embolden the president to go even harder against China on trade. Rather than the upcoming Xi-Trump meeting in Buenos Aires, the key bellwether of this thesis is whether Trump signals afterwards that he will implement the tariff rate hike on January 1, 2019 (and whether he announces a third round of tariffs). Bottom Line: Go long building products and construction material stocks. Stay short China-exposed S&P 500 companies. The 10-year yield may end the year even closer to 3.5% when the market realizes that the odds of an infrastructure deal are higher than previously thought. The political path of least resistance in the U.S. continues to point towards greater profligacy. Trump Is Aware Of His Constraints In The Middle East Throughout 2018, we have flagged U.S.-Iran tensions as the risk for 2019. In early October, we went long Brent / short S&P 500 as a hedge against this risk, a trade that we closed for a 6% gain last week. During our meetings with clients this quarter, however, several astute observers pointed out that in our own analyses we have stressed the geopolitical and political constraints to President Trump. First, we have argued that the original 2015 nuclear deal signed by President Obama had a deep geopolitical logic, allowing the U.S. to pivot to Asia and stare down China by geopolitically deleveraging the U.S. from the Middle East. If President Trump undermined the détente with Iran, he would be opening up a two-front conflict with both China and Iran, diluting his administration's focus and capabilities. Second, we noted that a rise in oil prices could precipitate an early recession and push up gasoline prices in 2019, a probable death knell for any president's re-election prospects. Our clients were right to ask: Why would President Trump face down these constraints, given the high cost that he would incur? We did not have a very good answer to this question. It is difficult to understand President Trump's preferences for raising tensions against Iran beyond the fact that he promised to do so in his campaign, appears to want to undermine all of President Obama's policies, and turned to Iran hawks to head his foreign policy. Are these preferences worth the risk of a recession in 2019? Or worth the risk of triggering yet another military conflict in the Middle East over a country that only 7% of Americans consider is the 'greatest enemy' (Chart 6)? Chart 6Americans Don't Perceive Iran As 'The Greatest Enemy' Given that the administration has offered exemptions to the oil embargo to eight key importers, it now appears that President Trump is well aware of his geopolitical and domestic constraints. The combined imports of Iranian oil by these eight states is ~1.4mm b/d. While we do not have the detail of the volumes that will be allowed under the waivers, it is likely that these Iranian sales will recover some of the ~1mm b/d of exports lost already (Chart 7). Chart 7Waivers Will Restore Iranian Exports For 180 Days What does this mean for investors? On one hand, it means that the risk of oil prices spiking north of $100 per barrel have substantively decreased. On the other hand, however, it also means that the Trump administration agrees with BCA's Commodity & Energy Strategy view that oil markets remain tight and that OPEC 2.0's spare capacity may be a constraint to future production increases. Bottom Line: The risks of an oil-price-shock-induced 2019 recession have fallen. However, oil prices may yet surge in 2019 to the $85-95 level (Brent) on the back of supply risks in Venezuela and Iran, especially if Saudi Arabia and Russia prove unable to expand production much beyond their current levels. Most of our clients in the Middle East shared the skepticism of our commodity strategists that Saudi Arabia would be able to increase production much higher than current levels in 2019. However, the view was not unanimous. Risks Of Saudi Arabia Going Rogue Have Declined Clients in the Middle East were convinced that the murder of journalist Jamal Khashoggi would have no impact on Saudi oil production decisions. However, the insight from the region is that the incident has probably ended the "blank cheque" that the Trump administration initially gave Riyadh on foreign policy. For global investors, this may not have a major impact. But it may have been at least part of the administration's reasoning behind giving embargo exemptions to such a large number of economies. The incident has likely forced Saudi Arabia to adjust its calculus on three issues: Qatar: The Saudi-Qatari split never made much sense in the first place. It was initially endorsed by President Trump, who may not have understood the strategic value of Qatar to the United States. Defense Secretary James Mattis almost immediately responded by reaffirming the U.S. commitment to the Persian Gulf country which hosts one of the most strategic U.S. air bases in the world. Yemen: The U.S. has now openly called on Saudi Arabia to end its military operations in Yemen. We would expect Riyadh to acquiesce to the request. Iran: With the U.S. giving major importers of Iranian oil exemptions, the message is twofold. First, the U.S. cares about its domestic economic stability. Second, the U.S. does not care about Saudi domestic economic stability. Our commodity strategists believe that Saudi fiscal breakeven oil price is around $85. As such, the U.S. decision to slow-roll the sanctions against Iran will be received with chagrin in Riyadh, especially as the latter will now have to shoulder both lower oil prices and the American request for higher output. Could Saudi Arabia break with the U.S.? Not a chance. The U.S. is the Saudis' security guarantor. As such, it is up to Saudi Arabia to acquiesce to American foreign policy goals, not the other way around. While we think that President Trump ultimately succumbed to geopolitical and political constraints when he decided to take the "phoney war" approach to Iran, he may have been nudged in that direction by Khashoggi's tragic murder. Bottom Line: A major risk for investors in 2019 was that the Trump administration would treat Saudi preferences for a major confrontation with Iran as its own interests. Such a strategy would have destabilized the global oil markets and potentially have unwound the 2015 U.S.-Iran détente that has allowed the U.S. to focus on China. However, the death of Khashoggi has marginally hurt President Trump domestically - given that it makes him look soft on Saudi Arabia, an unpopular stance in the U.S. Moreover, the administration has come to grips with the risks of a dire oil shock should Iran retaliate. The shift in U.S. policy vis-à-vis Saudi Arabia will therefore refocus the Trump administration on its own priorities, not that of its ally in the Middle East. Trade War Is All About CNY/USD In The Short Term... Clients in Australia and New Zealand are the most sophisticated Western investors when it comes to China. The level of macro understanding of the Chinese economy and the markets in these two countries is unparalleled (outside of China itself, of course). We therefore always appreciate the insights we pick up from our clients Down Under. And they are convinced that the massive capital outflow from China has clearly ceased. The flow of Chinese capital into Auckland, Melbourne, and Sydney real estate has definitely slowed, and anecdotal evidence appears to be showing up in the price data (Chart 8). Separately, this intel has been confirmed by clients from British Columbia and California. Chart 8Pacific Rim Home Prices Rolling Over The reality is that China has successfully closed its capital account. How else can we explain that a 4.7% CNY/USD depreciation in 2015 precipitated a $483 billion outflow of forex reserves, whereas a 10.1% depreciation this year has not had a major impact (Chart 9)? Chart 9On Balance, China Is Experiencing Modest Outflows To be fair, forex reserves declined by $34bn in October, but that is still a far cry from the panic in 2015. Our other indicators suggest that the impact on capital seepage is muted this time around, largely due to the official crackdown on various forms of capital outflows: Quarterly data (Chart 10) reflecting the change in foreign exchange reserves minus the sum of the current account balance and FDI, indicate that while net inflows have remained negative, they are still a far cry from 2015 levels. Chart 10Far Cry From 2016 Crisis Import data (Chart 11) no longer show the massive deviation between Chinese national statistics and IMF figures. Imports from Hong Kong (Chart 12), specifically, are now down to normal levels, with the fake invoicing problem having quieted down for now. Chart 11No More Confusion Regarding Imports Chart 12Fake Invoicing Has Been Curbed Growth rate of foreign reserves (Chart 13) is not clearly contracting yet, and has been positive this year. Chart 13Severe FX Reserve Drawdown Has Ended Chinese foreign borrowing (Chart 14) is down from stratospheric levels, which limits the volume of potential outflows. Chart 14China's Foreign Lending Has Eased And the orgy of M&A and investment deals in the U.S. (Chart 15) has ended. Chart 15M&A Deals Have Eased Bottom Line: Anecdotal and official data suggest that capital outflows are in check despite their recent uptick. This could embolden Chinese leaders to continue using CNY/USD depreciation as their primary weapon against President Trump's tariffs, especially if the global backdrop is not collapsing. An increase of the 10% tariff rate to 25% on January 1 could, therefore, precipitate further weakness in the CNY/USD. The announcement of a third round of tariffs covering the remainder of Chinese imports could do the same. This would be negative for global risk assets, particularly EM equities and currencies. ... In the Long Term, Bifurcated Capitalism Our annual pilgrimage to Oceania included our traditional meeting with The Smartest Man In Oceania The Bloke From Down Under.2 He shares our belief that the long-term result of the broader Sino-American geopolitical conflict will be a form of Bifurcated Capitalism. His exact words were that "countries may soon have to choose between being in the Amazon or Alibaba camp," a great real-world implication of our mega-theme. Australian and New Zealand clients are particularly sensitive to the idea that the world may soon be split into spheres of influence because both countries are so high-beta to China, while obviously retaining their membership card in the West. Our suspicion is that both will be fine as they export mainly a high-grade and diversified range of commodities to China. Short of war, it is unlikely that the U.S. will one day demand that New Zealand stop its dairy exports to China, or that Australia stop iron ore and LNG exports. Countries exporting semiconductors to China, on the other hand, could face a choice between enforcing a future embargo or incurring the wrath of their closest military ally. The Bloke From Down Under has pointed out that, given China's dependency on semiconductor technology, a U.S. embargo of this critical tech could be comparable to the U.S. oil embargo against Japan that precipitated the latter's attack on Pearl Harbor. Chart 16China Accounts For 60% Of Global Semiconductor Demand The global semiconductor market reached $354 billion in 2016, with China accounting for 60% of total consumption (Chart 16). Despite the country's insatiable appetite for semiconductors, no Chinese firm is among the world's top 20 makers. This is why Beijing's "Made in China 2025" plan has focused so much on semiconductor capability (Chart 17). The goal is for China to become self-sufficient in semiconductors, gaining 35% share of the global design market. Chart 17China's High-Tech Protectionism A key feature of Bifurcated Capitalism will be impairment of investment in high-tech that has dual-use applications in military. Semiconductors obviously make that list. Another key feature would be investment restrictions in such high-tech sectors, particularly the kind of investments and M&A deals that China has been looking for in the U.S. this decade. Further, clients in California are very concerned about the U.S.'s proposed export controls, which would cut off access to China and wreak havoc on the industry. The Trump administration has already signalled that it will restrict Chinese inbound investment. Congress passed, with a large bipartisan majority, an expanded review system, the Foreign Investment Risk Review Modernization Act (FIRRMA). The law has expanded the purview of the Committee on Foreign Investment in the United States (CFIUS), a secretive interagency panel nominally under control of the Treasury Department that can block inbound investment on national security grounds. CFIUS, at its core, has always been an entity focused on China. While the Treasury Department initially signalled it would take as much as 18 months to adopt the new FIRRMA rules, Secretary Mnuchin has accelerated the process. The procedure now will expand review from only large-stake takeovers to joint ventures and smaller investments by foreigners, particularly in technology deemed critical for national security reasons. This oversight began on November 10 and will allow CFIUS to block foreigners from taking a stake in a business making sensitive technology even if it gives the foreign investors merely a board seat. Countries of "special concern" will inherently receive heightened scrutiny, and a country's history of compliance with U.S. law, as well as cybersecurity and American citizens' privacy, will be considerations. A new interagency process led by the Commerce Department will focus on refurbishing export controls so as to protect "emerging and foundational technologies." Such impediments to capital flows are likely to become endemic and expand beyond the U.S. We may be seeing the first steps in the Bifurcated Capitalism concept that one day comes to dominate the global economy. Entire countries and sectors may become off-limits to Western investors and vice-versa for Chinese market participants. At the very least, companies whose revenue growth is currently slated to come from expansion in overseas markets may see those expectations falter. At its most pessimistic, however, Bifurcated Capitalism may precipitate geopolitical conflict if it denies China or the U.S. critical technology or commodities. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see David Shepardson, "Democrats to push for big infrastructure bill with 'real money' in 2019," Reuters, dated November 7, 2018, available at reuters.com. 2 At the time of publication, the said investor was unable to secure the permission of his wife for the "The Smartest Man" moniker. Geopolitical Calendar

Highlights Duration: The waning impact from fiscal stimulus and the drag from weak foreign economic activity will cause U.S. growth to slow as we enter 2019. But with market-implied rate hike expectations still depressed, we are inclined to maintain below-benchmark portfolio duration. Yield Curve: Over the course of the year the sweet spot on the Treasury curve has shifted from the 5-year/7-year maturity point to the 2-year. The 2-year note offers the best combination of risk and reward of any point on the Treasury curve. This is true in both absolute and duration-neutral terms. Spread Product: Investors looking for attractive alternatives to Treasury debt at the short-end of the curve should consider Agency CMBS and Local Authority debt. Those sectors offer attractive spread pick-up and low risk of capital loss. Feature So far this year the Bloomberg Barclays Treasury index has returned -2.2% in absolute terms and -3.7% versus cash (Chart 1). If the year ended today, it would go into the books as the worst year for excess Treasury returns since 2009. Chart 1A Year To Forget Taking stock of this poor bond market performance makes us wonder what might prompt a reversal of fortunes. Our golden rule of bond investing tells us that if the economic outlook worsens enough for the market to discount a slower pace of Fed rate hikes, then bond market performance will improve.1 But with the market priced for only 63 bps of rate hikes during the next 12 months, we are reluctant to make that bet today. That being said, it also seems likely that U.S. GDP growth will slow as we head into the New Year. At the very least, the intensity of the bond market sell-off should diminish as well. Peak Growth There are two reasons why we think U.S. growth will soften during the next few quarters. The first is that global economic growth (excluding the U.S.) has already slowed. In past reports we demonstrated that weak foreign economic growth tends to pull down the U.S., rather than strong U.S. growth pulling up the rest of the world.2 While recent U.S. data show only tentative signs of contagion from the rest of the world, we also see no evidence of moderation in the global growth slowdown.3 The Global Manufacturing PMI fell to 52.1 in October, a far cry from its early-2018 peak above 54 (Chart 2). The percentage of countries with PMIs above the 50 boom/bust line also fell to 74% in October, down from its 2018 high of 95%. Chart 2The Global Growth Slowdown Continues... Considering the major economic blocs, the global growth slowdown continues to be driven by Europe and China (Chart 3). The Eurozone aggregate PMI remains above 50, but is falling rapidly. Meanwhile, the Chinese PMI is threatening to break below 50, and will probably do so during the next few months. The full slate of U.S. import tariffs have still not been implemented, and in the background, leading indicators of Chinese economic activity remain soft (Chart 4). Chart 3...Driven By Europe And China Chart 4Chinese Economy Keeps Slowing The second reason why U.S. growth is likely to slow during the next few quarters is the waning impact from fiscal stimulus. With the Democrats taking control of the House following last week's midterm elections, any hopes for another round of tax cuts should be quickly dashed. There is probably room for compromise between the two parties on infrastructure spending, but it will take some time (possibly the better part of two years) for them to reach an agreement. Meanwhile, the IMF estimates that fiscal policy will shift from adding 1% to GDP growth in 2018 to only 0.4% next year (Chart 5). Chart 5Less Boost From Fiscal In 2019 Bottom Line: The waning impact from fiscal stimulus and the drag from weak foreign economic activity will cause U.S. growth to slow as we enter 2019, but at this point it is not clear whether growth will slow sufficiently for the Fed to deviate from its +25 bps per quarter rate hike pace. With the market only priced for 63 bps of rate hikes during the next year, below-benchmark portfolio duration remains warranted. We prefer to position for slowing U.S. growth by taking less credit risk, maintaining only a neutral allocation to spread product with an up-in-quality bias. The Increasing Attractiveness Of Shorter Maturities Chart 1 shows a fairly consistent bearish trend in the bond market: at no point in 2018 were Treasury index returns in the black. But this doesn't mean that nothing has changed in the Treasury market this year, far from it. In fact, this year's bear-flattening of the yield curve has shifted the sweet spot for Treasury investors from the 5-year/7-year maturity point to the 2-year maturity point (Chart 6). This is true both in absolute and duration-neutral terms. Chart 6Par Coupon Treasury Curve Absolute Returns As can be seen in Chart 6, at the beginning of the year the steepest part of the Treasury curve ended at around the 5-year/7-year maturity point. Today, the curve flattens off considerably after the 2-year maturity point. This change in shape has important implications for the amount of return investors can earn from rolling down the yield curve. Table 1 shows expected 12-month returns for 2-year, 5-year and 10-year Treasury notes in three different scenarios. A scenario where the yield curve is unchanged during the next year, one where all yields rise by the average of historical 12-month yield increases, and one where all yields decrease by the average of historical 12-month yield declines. Table 1Bullish And Bearish Scenarios At Different Points Of The Curve In the unchanged yield curve scenario, expected returns are equal to "carry" which is simply the sum of the coupon income from the note (yield pick-up) and the capital gains earned from rolling down the curve (roll-down). It is in the roll-down component where the changing shape of the yield curve is most apparent. At the beginning of the year, an investor in the 5-year Treasury note could expect to earn 40 basis points of roll-down on a 12-month investment horizon, whereas an investor in the 2-year note would only earn 13 bps. But today, there is 21 bps of roll-down embedded in the 2-year note and only 6 bps in the 5-year. The end result is that we would actually expect the 2-year note to outperform the 5-year note in an unchanged yield curve environment, and only deliver 15 bps less return than the 10-year note. Charts 7A and 7B show that this sort of attractiveness in the 2-year note is quite rare. The 2-year does not usually offer more carry than the 5-year or 10-year, and periods when it does tend to coincide with an inverted yield curve. Since an inverted yield curve is a reliable predictor of recession, it usually makes sense to extend duration and favor long maturity Treasuries in those environments. This is because yields are likely to fall as the Fed cuts rates to fight the recession. But in the current environment, if recession is avoided during the next 12 months - as is our expectation - and Treasury yields continue to drift higher, a strategy of favoring the 2-year note will pay off handsomely. Chart 7AMore Carry In The 2-Year Note I Chart 7BMore Carry In The 2-Year Note II This is further elucidated by the bull and bear cases shown in Table 1. In the bearish scenario where each point on the yield curve rises by its historical 12-month average (the average is calculated only for periods when yields actually increased), the 2-year note still has a positive expected return. More importantly, the 2-year note offers an expected return that is 215 bps greater than the expected return from the 5-year note. At the beginning of the year, the 2-year note only offered 161 bps more expected return than the 5-year note in the bearish bond scenario. Similarly, in the bullish bond scenario, the 2-year note is only expected to lag the 5-year note by 228 bps. At the beginning of the year, the 2-year would have been expected to lag the 5-year by 297 bps in the bullish bond scenario. In other words, from an absolute return perspective the 2-year Treasury note is the most attractive part of the yield curve. The 2-year will outperform other maturities by more than usual in a rising yield scenario and underperform by less than usual in a falling yield scenario. This alluring combination of risk and reward looks even more enticing when coupled with our preference for keeping portfolio duration low. In Duration-Neutral Terms We do not typically look at expected total returns for specific maturity points. Rather, we prefer to separate the portfolio duration call from the yield curve positioning call. In other words, we communicate our view on the level of rates through our portfolio duration recommendation and then consider which parts of the yield curve look most attractive in duration-neutral terms. To do this, we look at butterfly spreads. Chart 8 shows that the 2/5/10 butterfly spread - the spread between the 5-year bullet and a duration-matched 2/10 barbell - has turned negative. This is unusual outside of environments where the 2/10 slope is inverted. In fact, our fair value model for the 2/5/10 butterfly spread is based on the slope of the 2/10 Treasury curve and it currently flags the 5-year bullet as expensive (Chart 8, bottom panel).4 Chart 8The 5-Year Bullet Is Expensive... In contrast, the 2-year bullet is the cheapest it has been since 2005 relative to the 1/5 barbell (Chart 9). This means that the 1/5 slope would have to flatten dramatically for returns in the 1/5 barbell to overcome the carry advantage in the 2-year note. For this reason we closed our prior yield curve position - long the 7-year bullet and short the 1/20 barbell - in last week's report, and entered a position long the 2-year bullet and short the 1/5 barbell. Chart 9...But The 2-Year Bullet Is Cheap Bottom Line: Over the course of the year the sweet spot on the Treasury curve has shifted from the 5-year/7-year maturity point to the 2-year. The 2-year note offers the best combination of risk and reward of any point on the Treasury curve. This is true in both absolute and duration-neutral terms. Short Maturity Spread Product Given that the sweet spot on the yield curve has shifted from the 5-year/7-year maturity point to the 2-year maturity point, we thought we should also examine which spread products offer attractive opportunities to earn extra compensation at the short-end of the curve, as an alternative to simply buying the 2-year Treasury note. Table 2 shows the spread per unit of duration offered by different high-quality (Aaa/Aa rated), low maturity (1-3 year) spread products. We exclude non-Agency CMBS and Agency MBS because the spread volatility in those sectors makes them riskier than their credit ratings imply. Table 21-3 Year Maturity Aaa/Aa-Rated Spread Products Auto loan ABS and Aa-rated corporate bonds offer the most spread pick-up per unit of duration, but we see some potential for spread widening in both sectors. Corporate spreads could widen as profit growth falls below the rate of debt growth during the next few quarters and consumer ABS spreads might also have upside. The consumer credit delinquency rate is rising, and banks are tightening standards lending standards (Chart 10). Chart 10Some Upside In Consumer ABS Spreads Agency CMBS and Foreign Agencies both offer 17 bps of spread per unit of duration. Of those two sectors we prefer Agency CMBS, which look very attractive on our Bond Map.5 Foreign Agencies also look attractive on our Map, but could struggle as the U.S. dollar appreciates making dollar debt more difficult for foreign borrowers to service. Of all the sectors listed in Table 2, the 15 bps spread per unit of duration offered by Local Authority debt looks most alluring. Largely composed of taxable municipal issues, Local Authority debt is insulated from weakness abroad and still offers a reasonably attractive spread pick-up. Bottom Line: Investors looking for attractive alternatives to Treasury debt at the short-end of the curve should consider Agency CMBS and Local Authority debt. Those sectors offer attractive spread pick-up and low risk of capital loss. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 While U.S. data remain very strong, the low contribution of nonresidential investment spending to overall GDP growth in Q3 could be a sign of contagion from the rest of the world. For further details please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For further details on our butterfly spread models, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Toxic Combination", dated November 6, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification