Developed Countries

Overweight (High-conviction) Despite recent tech stock ills, software stocks continue to defy gravity and remain in a multi-year uptrend, still above the dotcom bubble relative performance highs (top panel). We reiterate our high-conviction overweight status and within tech we continue to prefer the S&P software and S&P tech hardware, storage & peripherals indexes to the early-cyclical tech S&P semis and S&P semi equipment subgroups. While rising M&A premia have been a core driver of software stock performance, industry operating metrics are on fire which supports the elevated industry valuation multiples. Top line growth is accelerating and running at a higher clip than the broad market. The recovery in the software price deflator (middle panel), a proxy for industry pricing power, corroborates this bright demand backdrop. Impressively, labor additions have been muted, implying that margins can expand further and possibly challenge cyclical highs (bottom panel). Overall, feverish software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets, suggest that software stocks are a must have for equity portfolios; please see Monday's Weekly Report for more details. Bottom Line: The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, CA, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC.

Highlights Chart 12015 Repeat?   Credit spreads widened as Treasury yields rose in October, bringing to mind the experience of 2015 when tight monetary policy and flagging global growth combined to cause a large drawdown in spread product excess returns. Chart 1 shows the familiar pattern. The market's rate hike expectations held constant throughout most of 2015. Meanwhile, falling commodity prices signaled weakness in global demand. Eventually, the combination of tight money and slowing growth was too much for the market to bear. Junk sold off in late-2015 and didn't recover until after the Fed scaled back its rate hike plans. It's hard to ignore today's similar set-up. Commodity prices are once again falling and the Fed appears committed to lifting rates. Unless global demand rebounds, we could be in for a repeat of late-2015's ugly price performance. The best way to position U.S. bond portfolios for this risk is to maintain below-benchmark portfolio duration, and to scale back exposure to credit risk. We advocate nothing more than a neutral allocation to spread product, with an up-in-quality bias. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 82 basis points in October, dragging year-to-date excess returns down to -98 bps. The index option-adjusted spread widened 12 bps on the month, and currently sits at 117 bps. Recent spread widening has returned some value to the corporate bond space. The 12-month breakeven spread for Baa-rated corporate bonds is back up to its 36th percentile relative to history, while the same spread for A-rated securities is at its 18th percentile (Chart 2). Chart 2Investment Grade Market Overview Though spreads are somewhat more attractive, caution remains warranted in the corporate bond space. Corporate profit growth has only just managed to keep pace with debt growth during the past few quarters (bottom panel). In other words, even a mild deceleration in profits will be enough for leverage to resume its uptrend (panel 4). As we observed in last week's report, Q3's sharp decline in non-residential investment spending might signal that weak foreign growth is finally starting to weigh on profits.1 The possibility of rising leverage in the coming quarters leads us to recommend an up-in-quality bias within our neutral allocation to corporate bonds. To pick up extra spread we prefer a strategy of favoring long-maturity credits over short maturities. In last week's report we showed that the long-end of the credit curve outperforms (in excess return terms) when Treasury yields rise. High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 159 basis points in October, dragging year-to-date excess returns down to +161 bps. The average index option-adjusted spread widened 55 bps on the month, and currently sits at 363 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 259 bps, above the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months and junk spreads remain constant, we should expect high-yield returns of 259 bps in excess of duration-matched Treasuries. If we assume that spreads tighten enough to bring our default-adjusted spread back to its long-run average, we would expect an excess return of 306 bps. Chart 3High-Yield Market Overview The main reason for continued caution on junk bonds is that the default loss expectation embedded in our excess spread calculation is extremely low relative to history (panel 4). Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.04% during the next 12 months. Default losses have rarely come in below that level. Further, the recent trend in job cut announcements makes it even more likely that default losses surprise to the upside during the next 12 months. Job cut announcements are highly correlated with the default rate, and while they remain low relative to history, they have clearly formed a trough this year (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation*   Table 3BCorporate Sector Risk Vs. Reward* MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 37 basis points in October, dragging year-to-date excess returns down to -44 bps. The conventional 30-year zero-volatility MBS spread increased 2 bps on the month. A 4 bps widening of the option-adjusted spread (OAS) was partially offset by a 2 bps decline in the compensation for prepayment risk (option cost). The OAS has widened in recent months, though it remains tight compared to its average pre-crisis level (Chart 4). The overall nominal MBS spread remains very low, but for good reason (panel 4). Chart 4MBS Market Overview The two most important drivers of MBS excess returns are: (i) mortgage refinancing activity and (ii) bank lending standards. Refi activity is already depressed and will stay muted as interest rates rise. Bank lending standards eased in Q2 for the 17th consecutive quarter, but remain tight relative to history. In response to a special question from the Fed's July Senior Loan Officer Survey, respondents noted that mortgage lending standards are in the tighter end of the range since 2005. This suggests that further gradual easing is likely going forward. With lending standards easing and refi activity low, the macro environment is consistent with tight MBS spreads. We maintain only a neutral allocation to the sector for now, but will look to upgrade when it comes time to further pare exposure to corporate credit risk. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 55 basis points in October, dragging year-to-date excess returns down to -16 bps. Sovereign debt underperformed the Treasury benchmark by 184 bps, dragging year-to-date excess returns down to -118 bps. Foreign Agencies underperformed by 94 bps on the month, dragging year-to-date excess returns down to -60 bps. Local Authorities underperformed by 28 bps, dragging year-to-date excess returns down to +63 bps. Supranationals underperformed Treasuries by 3 bps, dragging year-to-date excess returns down to +13 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to +5 bps. Sovereign debt has underperformed this year, but spreads remain expensive compared to U.S. corporate credit. In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.2 Those countries being Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. Not only does the sector offer elevated spreads (Chart 5), but it is dominated by taxable municipal securities which are insulated from weak foreign growth and U.S. dollar strength. Chart 5Government-Related Market Overview Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +105 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 1% in October, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview But despite the low yield ratio, we see tax-exempt municipal yields as quite attractive, especially at the long-end of the curve. For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.55% versus a yield of 3.62% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 30% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. Further, unlike the corporate sector, state & local government balance sheets are relatively insulated from weakening foreign economic growth and a rising U.S. dollar. While our Municipal Health Monitor has bounced in recent quarters, it remains below zero, consistent with ratings upgrades outpacing downgrades (bottom panel). Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell The Treasury curve bear-steepened in October. The 2/10 slope steepened 4 bps and the 5/30 slope steepened 16 bps. As a result of the large curve steepening, our position long the 7-year bullet and short the 1/20 barbell returned +67 bps on the month, and is now up +107 bps since inception. However, the curve steepening also means that steepener trades focused on the belly (5-7 year) of the curve are no longer attractive according to our models (see Tables 4 & 5). The 7-year bullet is now fairly valued relative to the 1/20 barbell, meaning that the butterfly spread is priced for an unchanged 1/20 slope during the next six months (Chart 7). Our baseline macro assessment is that the yield curve slope will remain near current levels during that timeframe. As such, we close our position long the 7-year bullet and short the 1/20 barbell. Chart 7Treasury Yield Curve Overview Absent attractive value, the only reason to focus curve exposure on the 5-7 year maturity point is as a hedge against an unexpected pause in Fed rate hikes. In prior research we showed that the belly of the curve performs best when the 12-month discounter falls.3 But with our discounter priced for only 61 bps of rate hikes for the next 12 months, this risk may not be worth hedging. Instead, we prefer to go long the 2-year bullet and short a duration-matched 1/5 barbell. This trade is attractively priced on our model (bottom panel) and should outperform in a rising yield environment. The 1/5 slope tends to steepen when our 12-month discounter rises, and vice-versa. TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 61 basis points in October, dragging year-to-date excess returns down to +76 bps. The 10-year TIPS breakeven inflation rate fell 9 bps on the month and currently sits at 2.06%. The 5-year/5-year forward TIPS breakeven inflation rate also fell 9 bps on the month and currently sits at 2.21%. Both the 10-year and the 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. We think it is only a matter of time before inflation expectations adjust higher into that range, and we therefore maintain an overweight position in TIPS versus nominal Treasuries. The catalyst for wider TIPS breakevens will be persistent inflation readings near the Fed's 2% target. Trimmed mean inflation has only just returned to the Fed's 2% target (Chart 8), but will probably remain close to that level for the next six months. While base effects will pose a higher hurdle for year-over-year inflation during this time, pipeline inflation pressures are also building, as evidenced by the prices paid component of the ISM Manufacturing survey (panel 4).4 Chart 8Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 6 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month and now stands at 38 bps, 4 bps above its pre-crisis low. The excess return Bond Map on page 15 shows that consumer ABS offer attractive return potential compared to both Supranationals and Domestic Agencies, but carry a substantially higher risk of losses. Agency CMBS appear much more attractive than consumer ABS on a risk/reward basis, offering approximately the same expected return with less risk. From a credit quality perspective, the consumer credit delinquency rate remains low by historical standards but has clearly put in a bottom (Chart 9). The household interest coverage ratio has been rising for 10 consecutive quarters, suggesting that the delinquency rate will continue to increase. Chart 9ABS Market Overview We remain neutral on consumer ABS for now, but prefer Local Authorities, Municipal Bonds and Agency-backed CMBS when it comes to high-quality spread product. If consumer credit delinquencies continue to rise without a commensurate increase in ABS spreads, then our next move will likely be a reduction to underweight. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in October, dragging year-to-date excess returns down to +120 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 10 bps on the month and currently sits at 94 bps (Chart 10). Chart 10CMBS Market Overview A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed's Q2 Senior Loan Officer Survey showed that both lending standards and demand are close to unchanged. In other words, the macro picture for CMBS is decidedly mixed. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in October, dragging year-to-date excess returns down to +23 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 51 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of November 2, 2018)   Chart 12Total Return Bond Map (As Of November 2, 2018)   Table 4Butterfly Strategy Valuation (As Of September 28, 2018)   Table 5Discounted Slope Change During Next 6 Months (BPs) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Oil Supply Shock Is A Risk For Junk", dated October 9, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 4 For details on our base effects indicator for PCE inflation, please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Portfolio Strategy Frenzied software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets suggest that software stocks are a must have for equity portfolios. Rising interest rates along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion all suggest that it pays to remain bearish consumer discretionary stocks. Recent Changes We lifted the S&P Industrial Conglomerates index to overweight in a Sector Insight on Wednesday last week.1 Table 1 Feature Chart 1Stocks Are... The S&P 500 found its footing last week, but the volatility comeback assures more violent oscillations before equities resume their upward trajectory. Crash-prone October lived up to its reputation but it is now over, and once the midterm election uncertainty passes this week, investors will refocus their attention on the U.S./China trade war and U.S. economic growth. Trump's moderating approach on the former was welcome news last week, and any further de-escalation signs in the trade tussle will breathe a huge sigh of relief for equities. On the investment front, the 10% SPX drawdown triggered our "buy the dip" strategy on Friday October 26 (please see the "Time To Bargain Hunt" Sector Insight), when we put to work longer-term oriented capital. Our "buy the dip" view remains intact, as we still do not foresee a recession in the coming 9-12 months. On the volatility front, the CBOE SKEW index, a measure of tail risk,2 is sending a positive message as investors are no longer buying tail risk protection as they did in August. Interestingly, as the nominal level of the SPX has been increasing over the decades so has the price of tail risk protection (Chart 1). We view the recent collapse in the CBOE SKEW index as a positive indication that the worst may be behind the equity market. With regard to global flows to U.S. shores, the Treasury International Capital (TIC) System data revealed that global portfolio managers were not chasing U.S. equities this summer as they had been at the beginning of the year. The likely current trough in net foreign portfolio flows into U.S. equities should, at the margin, underpin U.S. stocks (Chart 2). Chart 2... Likely Out Of The Woods... On the U.S. economic front, the latest GDP release revealed that housing is indeed softening. This is the first time since the GFC that residential investment's contribution to real GDP growth turned negative for three consecutive quarters. Tack on decelerating house prices and collapsing lumber prices (Chart 3) and residential real estate confirms the yellow flag from our recently introduced Economic Impulse Indicator.3 Chart 3...But Housing Poses A Risk While house prices are decelerating, corporate pricing power remains upbeat. True, investors focused on anecdotes about input cost inflation this earnings season and all but ignored evidence that companies across different sectors have been able, and will continue, to raise selling prices by more than the rise in wage and commodity costs. Thus, corporate profit margin squeeze fears are overblown; they are likely a risk for the back half of 2019, especially if volume growth suffers a setback. This week we are updating our corporate pricing power gauge. While our overall proxy has ticked down, it is still clocking higher than wage inflation. In fact, our pricing power diffusion index shows excellent breadth (second panel, Chart 4). This firming corporate inflation backdrop suggests that businesses have been successful in passing on rising input costs down the supply chain or to the consumer, and thus suggests that investors are mistakenly fretting about a looming profit margin squeeze. Chart 4No Margin Pressures Yet While labor cost inflation is trending higher, wage growth remains contained near 3% despite a multi-decade low in the unemployment rate. According to our wage growth diffusion index, just over half of the 44 industries we track have to contend with rising wages, a visible fall from earlier in the year (middle panel, Chart 4). In addition, the Atlanta Fed Wage Growth Tracker remains tame and the switcher/stayer index recently nosedived to multi-year lows. The switcher/stayer index provides a reliable leading indication for the trend in overall labor expenses (fourth panel, Chart 4). Put differently, corporate pricing power is rising on a broadening basis while leading indicators of wage inflation suggest an easing in wage pressures in the coming months. As a result, there are rising odds that expanding forward operating margin expectations are likely, extending the two year margin expansion phase (bottom panel, Chart 4). Digging deeper into our corporate pricing power update is revealing. Table 2 summarizes the results. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Table 2Industry Group Pricing Power 73% of the industries we cover are lifting selling prices, while another ten industries are experiencing only mild price deflation (less than a 0.6% decline). If we include those ten industries then 90% of sectors are maintaining or raising selling prices. One third of the industries are lifting prices at a faster clip than overall inflation. This is lower than our early-July report. Outright deflating sectors increased by four to sixteen since our last update but only six are deflating at 1% or more. On a slightly negative note, fourteen industries are experiencing a downtrend in selling price inflation, twice as many since our most recent report (Table 2). Deep cyclicals/commodity-related industries continue to dominate the top ranks, occupying the top 7 slots (top panel, Chart 5). Despite the ongoing global export softness, intensifying trade tussle with China and 5% year-to-date appreciation in the trade-weighted U.S. dollar, the commodity complex's ability to increase prices is impressive especially given that the base effects from the late-2015/early-2016 manufacturing recession have filtered out. On the flip side, tech industries dominate the bottom ranks of Table 2. Chart 5Cyclicals Have The Upper Hand In sum, accelerating business sector selling prices will continue to underpin top line growth into 2019. As long as wage inflation rises gradually and does not gallop higher and the corporate sector sustains its pricing power, then profit margins and earnings will remain upbeat. This week we update a high-conviction overweight tech subgroup and reiterate our below benchmark allocation to an early cyclical sector. Software Is In High Demand Despite recent tech stock ills, software stocks continue to defy gravity and remain in a multi-year uptrend, still above the dotcom bubble relative performance highs (top panel, Chart 6). We reiterate our high-conviction overweight status and within tech we continue to prefer the S&P software and S&P tech hardware, storage & peripherals indexes to the early-cyclical tech S&P semis and S&P semi equipment subgroups. Chart 6Software Fever It did not take long for the large CA acquisition to get surpassed by RHT. Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels (fourth panel, Chart 6). The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. Chart 7Capex Gains... Beyond the positive M&A angle that we have been exploring for quite some time in our research, software stocks are particularly levered on capital spending. Chart 7 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits (Chart 8). Chart 8...Say Stick With Software Moreover, industry operating metrics are on fire. Top line growth is accelerating and running at a higher clip than the broad market. The recovery in the software price deflator (middle panel, Chart 9), a proxy for industry pricing power, corroborates this bright demand backdrop. Impressively, labor additions have been muted, implying that margins can expand further and possibly challenge cyclical highs (bottom panel, Chart 9). Chart 9Operating Metrics Are Firing On All Cylinders With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly (Chart 10). Chart 10Pristine Balance Sheets Nevertheless, all of these positives have pushed several valuation metrics to a premium to the broad market and leave little space for any mishaps. On a forward P/E, trailing P/S, and even EV/EBITDA basis, software equities are pricey, but we think for good reason (bottom panel, Chart 10). This rerating phase will likely continue until there is evidence of an end either to the M&A frenzy, or capex upcycle or business cycle. In sum, feverish software M&A activity, the ongoing capex upcycle, firming industry operating metrics and pristine balance sheets, suggest that software stocks are a must have for equity portfolios. Bottom Line: The S&P software index remains a high-conviction overweight. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, CA, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Consumer Discretionary Stocks Are Still A Sell While we remain constructive on financials that benefit from higher rates, we continue to recommend investors avoid the consumer discretionary sector - the other early cyclical - that suffers when interest rates rise. Chart 11 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Chart 11Rising Fed Funds Rates... Last week we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 12). Chart 12...The Volatility Comeback... Money aggregates also corroborate that the time to buy consumer discretionary equities is when the money supply is galloping higher and shed exposure when both M1 and M2 are decelerating as we have shown in previous research. Importantly, the velocity of M2 money stock is inversely correlated with relative share prices and the current message is negative for consumer discretionary stocks as GDP is finally growing faster than M2 money growth (velocity of M2 money stock shown inverted, Chart 13). Chart 13...And Money Velocity Point To More Losses In Consumer Discretionary Not only are higher interest rates anchoring consumer discretionary stocks but rising energy prices are also dealing a blow to this sector. Chart 14 shows our Consumer Drag Indicator (CDI, comprising mortgage rates and energy prices). Historically, our CDI has been an excellent leading indicator of relative share price momentum. Currently, the message is clear: the sinking CDI signals that a bear market in consumer discretionary stocks has likely commenced. Chart 14Heed The Message From The Consumer Drag Indicator Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged (Chart 15). Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth north of 30%/annum or twice as high as the overall market. Clearly this is not realistic as it assumes a near quadrupling of EPS in the coming 5 years. Chart 15Bad Breadth... In the near-term, analysts are more cautious (bottom panel, Chart 15). Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (top panel, Chart 16). As a result, the 12-month forward P/E ratio is trading at a 27% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 16). Chart 16...With Poor Technicals And No Valuation Cushion Adding it up, a rising interest rate backdrop along with the Fed's quantitative tightening, the return of volatility, higher gasoline prices, stretched technicals and a lack of a valuation cushion, all suggest that it pays to remain bearish consumer discretionary stocks. Bottom Line: The path of least resistance is lower for the S&P consumer discretionary index, stay underweight. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Sector Insight, "A Rout For Conglomerates Opens A Buying Opportunity," dated October 31, 2018, available at uses.bcaresearch.com. 2 "The crash of October 1987 sensitized investors to the potential for stock market crashes and forever changed their view of S&P 500® returns. Investors now realize that S&P 500 tail risk - the risk of outlier returns two or more standard deviations below the mean - is significantly greater than under a lognormal distribution. The Cboe SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk. Similar to VIX®, the price of S&P 500 tail risk is calculated from the prices of S&P 500 out-of-the-money options. SKEW typically ranges from 100 to 150. A SKEW value of 100 means that the perceived distribution of S&P 500 log-returns is normal, and the probability of outlier returns is therefore negligible. As SKEW rises above 100, the left tail of the S&P 500 distribution acquires more weight, and the probabilities of outlier returns become more significant. One can estimate these probabilities from the value of SKEW. Since an increase in perceived tail risk increases the relative demand for low strike puts, increases in SKEW also correspond to an overall steepening of the curve of implied volatilities, familiar to option traders as the "skew"." Source: CBOE, http://www.cboe.com/products/vix-index-volatility/volatility-indicators/skew 3 Please see BCA U.S. Equity Strategy Weekly Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Investors are worrying too much about the things that caused the global financial crisis, and not enough about those that could cause the next downturn. Despite the recent patch of soft data, the U.S. housing market is in good shape. Go long homebuilders relative to the S&P 500. Imbalances in the corporate debt market have increased, but are not severe enough to generate systemic economic distress. U.S. rates will need to rise quite a bit more than the market anticipates before the economy slows by enough to force the Fed to back off. The combination of a stronger dollar and inadequate Chinese stimulus will continue to pressure emerging markets. Even Brazil's pro-capitalist new president may not be able to reverse the country's bleak fiscal dynamics. Our MacroQuant model, which predicted the correction, points to further near-term downside risk for global equities. The cyclical (12-to-18 month) outlook looks much better, however. Feature The Market's Maginot Line One of the most reliable ways to make money as an investor is to figure out the market's collective biases and trade against them. Behavioral economists have long noted that people tend to assign too much weight to recent experience in taking decisions. As a result, in finance, as in military strategy, there is a constant temptation to fight the last war. The last war policymakers waged was against the scourge of deflation that followed the housing bust and financial crisis. For much of the past decade, investors have held a magnifying glass over anything that could possibly resemble the conditions that led up to the Global Financial Crisis. While such behavior is understandable, it is misplaced. History suggests that both lenders and borrowers tend to act prudently for years, if not decades, following major financial crises. Mistakes are still made, but they are different mistakes. People overcompensate. They obsess about the past rather than focusing on the future. U.S. Housing Is Okay There is no denying that the U.S. housing market has softened this year (Chart 1). Housing starts, building permits, and home sales have all fallen. Residential investment has subtracted from GDP growth over three consecutive quarters. Chart 1Housing Has Been A Drag On The U.S. Economy This Year There is little mystery as to why the housing market has been on the back foot. The Trump tax bill capped the deduction on state and local property taxes, while reducing the amount of mortgage debt on which homeowners can deduct interest payments from $1 million to $750,000. This had a negative effect on housing activity, especially in high-tax Democrat-leaning states with elevated real estate prices. More importantly, mortgage rates have risen by over 100 basis points since last August. Chart 2 shows that home sales and construction almost always decline after mortgage rates rise. In this respect, the weakness in housing activity is reminiscent of the period following the taper tantrum, when housing activity also slowed sharply. Chart 2No Mystery Why U.S. Housing Has Been Weak... We do not expect mortgage rates to fall from current levels. But they are not going to rise at the same pace as they have over the past year. Thus, while the headwinds from higher financing costs will not disappear, they will abate to some extent. Fundamentally, the housing market is on solid ground (Chart 3). Mortgage rates are still well below their historic average. Home prices have risen considerably, but do not appear excessively stretched compared to rents or incomes. Unlike in 2006, the home vacancy rate is near its historic lows. Residential investment stands at only 3.9% of GDP, compared with a peak of 6.7% of GDP in the second half of 2005. The average age of the residential capital stock has risen by nearly five years since 2006, the largest increase since the Great Depression. With household formation rebounding briskly from its post-recession lows, homebuilders are still arguably not churning out enough new homes. Chart 3A...But Fundamentals Are Still In Good Shape (I) Chart 3B...But Fundamentals Are Still In Good Shape (II) Mortgage lenders have learned from past mistakes (Chart 4). While lending standards have eased modestly over the past 4 years, underwriting standards have remained high. The average FICO score for new borrowers is more than 40 points above pre-recession levels. The Urban Institute Housing Credit Availability index, which measures the percentage of home purchase loans that are likely to default over the next 90 days, is at reassuringly low levels. This is particularly the case for private-label mortgages, whose default risk has hovered at just over 2% during the past few years, down from a peak of 22% in 2006. Moreover, banks today hold much more high-quality capital than in the past, which gives them additional space to absorb losses (Chart 5). Chart 4Lending Standards Have Been Tight, But Are Starting To Loosen Chart 5U.S. Banks Are Well Capitalized With all this in mind, we are initiating a new strategic trade to go long U.S. homebuilders relative to the S&P 500.1 Corporate Debt: How Big Are The Risks? Unlike household debt, U.S. corporate debt has risen over the past decade and now stands at a record high level as a share of GDP. The quality of the lending has also been less than pristine, as evidenced by the proliferation of "covenant lite" loans. The interest coverage ratio for the economy as a whole - defined as the volume of profits corporations generate for every dollar of interest paid - is still above its historic average (Chart 6). However, this number is skewed by a few mega-cap tech companies that hold a lot of cash and have little debt. Chart 6Interest Coverage Looks Relatively High My colleague Mark McClellan, who writes our monthly Bank Credit Analyst publication, has shown that the interest coverage ratio for companies comprising the Bloomberg Barclays index would drop close to the lows of the Great Recession if interest rates were to rise by a mere 100 basis points across the corporate curve. The damage would be far worse if profits also fell by 25% in this scenario.2 While the corporate debt market has become increasingly frothy, it does not pose an imminent danger to the economy. There are several reasons for this. First, while U.S. corporate debt is high in relation to the past, it is still quite low in comparison with many other economies (Chart 7). The ratio of corporate debt-to-GDP, for example, is 30 percentage points higher in the euro area. This suggests that U.S. businesses still have the "carrying capacity" to take on additional debt. Chart 7U.S. Corporate Debt Is Not That High By Global Standards Second, the average maturity of U.S. corporate debt has risen over the past decade, with an increasing share of companies opting for fixed over floating-rate borrowings. This implies that it will take a while for the effect of higher rates to make their way through the system. Third, and perhaps most importantly, corporate bonds are generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. Bank loans account for only 18% of nonfinancial corporate-sector debt, down from 40% in 1980 (Chart 8). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Chart 8Banks Have Reduced Their Exposure To The Corporate Sector Tellingly, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal (Chart 9). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 9The 2015 Debt Scare Did Not Topple The Economy Government Debt: No Worries... Yet If the risks posed by both the housing market and corporate debt market are contained, what about the risks posed by soaring government debt? The long-term fiscal outlook is certainly bleak, but the near-term risks are low.3 President Trump's tweets aside, the U.S. has an independent central bank which has been able to keep inflation expectations well anchored. The U.S. private sector is also running a financial surplus at the moment, meaning that it earns more than it spends (Chart 10). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its fiscal deficit. Chart 10The U.S. Private Sector Is A Net Saver The private sector's financial balance will deteriorate over the next two years as household savings decline and corporate investment rises. This will put upward pressure on Treasury yields. However, if rising yields are reflective of stronger aggregate demand, this is unlikely to derail the economy. When Things Break Recessions are usually caused when the Fed raises rates by enough to undermine spending on interest rate-sensitive purchases such as housing, or when higher rates prick an asset bubble just waiting to burst. Given the lack of clear imbalances either in the real economy or financial markets, the Fed may have to raise rates significantly more than the market is currently anticipating. In fact, far from having to press the pause button midway through next year, our baseline expectation is that the Fed will expedite the pace of rate hikes in late 2019 as inflation finally starts to accelerate. Aggressive Fed rate hikes combined with an incrementally less expansionary fiscal policy will sow the seeds of a recession in late 2020 or 2021. Before the next U.S. downturn arrives, the dollar will have strengthened further. A resurgent greenback will cast a long shadow over emerging markets and commodity producers. As we discussed last week, China is unlikely to save the day by launching a massive stimulus program of the sort that it orchestrated in both 2009 and 2015.4 True, not all emerging markets are equal. Emerging Asia is more resilient now than it was two decades ago. Thailand, for example, was patient zero for the Asian crisis in 1997. Today, it sports a current account surplus of over 10% of GDP and low levels of external debt. This resilience will not prevent Asian economies from experiencing slower growth on the back of weaker Chinese demand, but it will prevent a full-blown balance of payments crisis from spiraling out of control. In contrast to Emerging Asia, Latin America looks more vulnerable (Table 1). BCA's chief emerging market strategist, Arthur Budaghyan, wisely upgraded Brazilian assets on a tactical basis on October 9th ahead of the presidential elections. Nevertheless, Arthur still worries that Brazil's daunting fiscal challenges - the budget deficit currently stands at 7.8% of GDP and the IMF expects government debt to rise to nearly 100% of GDP over the next five years (Chart 11) - are so grave that even South America's answer to Donald Trump may not be able to save the Brazilian economy. Table 1Vulnerability Heat Map For Key EM Markets Chart 11Brazil Is Fiscally Challenged A Correction, Not A Bear Market The current market environment bears some similarities to the late 1990s. The Fed is tightening monetary policy in order to keep the domestic economy from overheating. The U.S. economy is responding to higher rates to some extent, but the main effects are being felt overseas. The Asian Crisis did not end the bull market in U.S. stocks, but it did generate a few nasty selloffs, the most notable being the 22% peak-to-trough decline in the S&P 500 between July 20 and October 8, 1998. We witnessed such a selloff this October. The bad news is that our MacroQuant model is pointing to additional equity weakness over the coming weeks (Chart 12). The model tends to downgrade stocks whenever growth is slipping, financial conditions are tightening, and sentiment is deteriorating from bullish levels. All three of these things are currently occurring. Chart 12MacroQuant* Model Suggests Caution Is Warranted The good news is that none of our recession indicators are flashing red. Since recessions and bear markets typically overlap (Chart 13), the odds are high that the current stock market correction will be just that, a correction. Chart 13Recessions And Bear Markets Usually Overlap Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 The corresponding ETFs are long ITB/short SPY. 2 Please see The Bank Credit Analyst Special Report, "The Long Shadow Of The Financial Crisis," dated October 25, 2018. 3 It is actually not even clear that a loss of confidence in America's fiscal management would cause a recession. The Fed largely determines borrowing costs at the short-to-medium end of the yield curve, which is where the government finances most of its debt. If people lose confidence in the dollar, they will either need to run down their cash balances by purchasing more goods and services or try to move their wealth abroad. The former will directly increase aggregate demand, while the latter will indirectly increase it through a weaker currency. To be clear, we are not suggesting that such an outcome would be beneficial to the economy; it would, among other things, greatly slow potential GDP growth by discouraging investment. But the near-term effect would likely be economic overheating and rising inflation rather than a recession. 4 Please see Global Investment Strategy Weekly Report, "Chinese Stimulus: Not So Stimulating," dated October 26, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Dear Client, Next week, I am on the road in the Middle East visiting clients and teaching the BCA Academy Principles of Global Macro course. There will be no regular Weekly Report on November 9th. Instead, we will be sending you a Special Report on November 6th written by my colleague Rob Robis, who runs BCA's Global Fixed Income Strategy service. In this piece, Rob will be discussing the outlook for Euro Area monetary policy and its implications for rate markets and the euro. This is an especially relevant topic as the end of the ECB's Asset Purchase Program is scheduled to soon materialize. I trust you will find this report both interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights Uncovered Interest Rate Parity still works for currencies. However, it needs to be based on a combination of short- and long-term real rates. Currencies are also affected by global risk appetite, as approximated by corporate spreads and commodity prices. Based on our timing models, the dollar is now fairly valued on short-term basis. However, slowing global growth and robust U.S. activity suggest that the dollar has room to rally further, with our models pointing to a move in the greenback's favor. These conflicting forces suggest the dollar's easy gains are behind us, and any further dollar rally will prove much more volatile. Feature In July 2016, in a Special Report titled, "In Search Of A Lost Timing Model," we introduced a set of intermediate-term models to complement our long-term fair value models for various currencies.1 These groups of models provide additional discipline - a sanity check if you will - to our regular analysis. Additionally, these models can help global equity investors manage their currency exposure, thanks to their ability to increase the Sharpe ratio of global equity portfolios vis-Ã -vis other hedging strategies, and also for a host of base-currencies.2 In this report, we review the logic underpinning these intermediate-term models and provide commentary on their most recent readings for the G10 currencies vis-Ã -vis the USD. UIP, Revisited The Uncovered Interest Rate Parity (UIP) relationship is at the core of this modeling exercise. This theory suggests that an equilibrium exchange rate is what will make an investor indifferent between holding the bonds of Country A or Country B. This means that as interest rates rise in Country A relative to Country B, the currency of Country B will fall today in order to appreciate in the future. These higher expected returns are what will drive investors to hold the lower-yielding bonds of Country B. There has long been debate as to whether investors should focus on short rates or long rates when looking at exchange rates through the prism of UIP. This debate has regained vigor in the past six months as the dollar has greatly lagged the levels implied by 2-year rate differentials (Chart 1). Research by the Federal Reserve and the IMF suggests that incorporating longer-term rates to UIP models increase their accuracy.3 This informational advantage works whether policy rates are or aren't close to their lower bound.4 Chart 1Interest Rate Parity: Generally Helpful, But... Incorporating long-term rates as an explanatory variable increases the performance of UIP models because exchange rate movements not only reflect current interest rate conditions, but currency market investors also try to anticipate the path of interest rates over many periods. By definition, long-term bonds do just that, as they are based on the expected path of short rates over their maturity - as well as a term premium, which compensates for the uncertain nature of future interest rates. There is another reason why long-term rate differential changes improve the power of UIP models. Since UIP models are based on the concept of indifference among investors between assets in two countries, changes in the spreads between 10-year bonds in these two countries will create more volatility in the currency pair than changes in the spreads between 3-month rates. This is because an equivalent delta in the 10-year spread will have a much greater impact on the relative prices of the bonds than on the short-term paper, courtesy of their much more elevated duration. To compensate for these greater changes in prices, the currency does have to overshoot its long-term PPP to a much greater extent to entice investors trading the long end of the curve. Bottom Line: The interest rate parity relationship still constitutes the bedrock of any shorter-term currency fair value model. However, to increase its accuracy, both long-term and short-term rates should be used. Real Rates Really Count Another perennial question regarding exchange rate determination is whether to use nominal or real rate differentials. At a theoretical level, real rates are what matter. Investors can look through the loss of purchasing power created by inflation. Therefore, exchange rates overshoot around real rate differentials, not nominal ones. On a practical level, there are additional reasons to believe that real rates should matter, especially when trying to explain currency moves beyond a few weeks. Indeed, various surveys and studies on models used by forecasters and traders show that FX professionals use purchasing power parity as well as productivity differential concepts when setting their forex forecasts.5 Indeed, as Chart 2 illustrates, real rate differentials have withstood the test of time as an explanatory variable for exchange rate dynamics, albeit with periods where rate differentials and the currency can deviate from one another. Chart 2Real Rates Work Better Over The Long Run It is true that very often, nominal rate differentials can be used as a shorthand for real rate differentials, as both interest rate gaps tend to move together. However, regularly enough, they do not. In countries with very depressed inflation expectations (Japan immediately comes to mind), nominal and real rate differentials can in fact look very different (Chart 3). With the informational cost of incorporating market-based inflation expectations being very low, we find the shorthand unnecessary when building UIP-based models. Chart 3Real And Nominal Rate Spreads Can Differ Finally, it is important to remark that in environments of high inflation, inflation differentials dominate any other factor when it comes to exchange rate determination. However, the currencies discussed in this report currently are not like Zimbabwe or Latin America in the early 1980s. Bottom Line: When considering an intermediate-term fair value model for exchange rates, investors should focus on real - not nominal - long-term rate differentials. Global Risk Aversion And Commodity Prices Global risk appetite is also a key factor in trying to model exchange rates. Risk-aversion shocks tend to lead to appreciation in the U.S. dollar, which benefits from its status as the global reserve currency.6 Much literature has focused on the use of the VIX as a gauge for global risk appetite. Our exercise shows stronger explanatory power with options-adjusted spreads on junk bonds (Chart 4). Chart 4The Dollar Benefits From Global Stresses Commodity prices, too, play a key role. Historically, commodity prices have displayed a very strong negative correlation with the dollar.7 This correlation is obviously at its strongest for commodity-producing nations, as rising natural resources prices constitute a terms-of-trade shock for them. However, this relationship holds up for the euro as well, something already documented by the European Central Bank.8 The Models The models for each cross rate are built to reflect the insight gleaned above. Each cross is modeled on three variables, with the model computed on a weekly timeframe. Real rates differentials: We use the average of 2-year and 10-year real rates. The rates are deflated using inflation expectations. Global risk appetite approximated by junk OAS. Commodity prices: We use the Bloomberg Continuous Commodity Index. For all countries, the variables are statistically highly significant and of the expected signs. These models help us understand in which direction the fundamentals are pushing the currency. We refer to these as Fundamental Intermediate-Term Models (FITM). We created a second set of models, based on the variables above, which also include a 52-week moving average for each cross. The real rates differentials, junk spreads and commodity prices remain statistically very significant and of the correct sign. They are therefore trend- and risk-appetite adjusted UIP-deviation models. These models are more useful as timing indicators on a three- to nine-month basis, as their error terms revert to zero much faster. We refer to these as Intermediate-Term Timing Models (ITTM). Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com The U.S. Dollar To model the dollar index (DXY), we used two approaches. In the first one, we took all the deviation from fair value for the pairs constituting the index, based on their weights in the DXY. In the second approach, we ran the model specifically for the DXY, using the three variables described above. U.S. real rates were compared to an average of euro area, Japanese, Canadian, British, Swiss and Swedish real rates, weighted by their contribution to the DXY. We then averaged both approaches, which gave us very similar results to begin with. Currently, there is no evident mispricing in the USD, as it trades near fair value when compared to both the FITM (Chart 5) and ITTM. While this means that the easy part of the dollar rally is behind us, it does not imply that the rally is over. As Chart 6 illustrates, periods of dollar strength tend to end when the dollar trades at a 5% premium to the ITTM. This would imply that a move to 102 on the DXY is likely over the coming months. Moreover, the widening interest rate differential between the U.S. and the rest of the world, as well the bout of rising volatility the world is experiencing, should continue to push the fair values of both the FITM and ITTM higher. Chart 5Fundamentals Continue To Help The Dollar Chart 6More Upside Is Possible The Euro As a mirror image to the DXY, there is no evident mispricing in EUR/USD. Currently, based on both the FITM and the ITTM, the euro trades at a small premium to fair value (Chart 7). However, the sell signal generated by the deviation from the ITTM in 2017 is still in place, as periods of overvaluation tend to be followed by periods of undervaluation (Chart 8). This indicator will only generate a buy signal for the euro once EUR/USD falls 5% below equilibrium, or to a level of 1.06. Moreover, this target is a moving one. European growth and inflation continue to disappoint, as the euro area feels the drag of a slowing China and decelerating global growth. This means that interest rate differentials are likely to continue to move in a euro-bearish fashion in the coming months. Hence, the flattening in the FITM that materialized in 2018 is at risk of becoming an outright deterioration. Chart 7Fundamentals For The Euro Are Deteriorating Chart 8EUR/USD Is Not Cheap The Yen In an environment of rising global bond yields, the FITM for the yen continues to trend south, as Japanese rates lag well behind U.S. interest rates (Chart 9). This means the yen is once again trading at a small premium to its FITM, implying that even if global risk assets sell off further, the upside for the yen against the dollar may prove limited. However, the picture for the yen against the ITTM is more benign. The yen is at equilibrium on this basis (Chart 10). However, due to the design of the ITTM, previous periods of overvaluations tend to be followed by periods of undervaluation. As a result, on the basis of this model, the yen could continue to experience downside against the dollar over the coming three to six months. This will be even truer if U.S. bond yields can continue to rise. Chart 9Rate Differentials Continue To Hurt The Yen Chart 10More Downside Ahead If U.S. Yields Keep Rising The British Pound The GBP/USD has deteriorated in recent weeks, a move that was mimicked by cable itself. As a result, the pound does not show any evident mispricing on this basis against the USD (Chart 11). The ITTM corroborates this message, as GBP/USD trades at a marginal 1% discount to this indicator (Chart 12). This upholds our analysis of September 7, which showed there was little risk premium embedded in the pound to compensate investors for the risks associated with the Brexit negotiations and the cloudy British political climate.9 Since British politics remain a minefield, this lack of valuation cushion suggests that the GBP is likely to continue to swing widely. As a result, a strategy to be long volatility in the pound, or to bet on the reversal of both large upside and downside weekly moves in the GBP, remains our preferred approach. Chart 11Cable Is At Equilibrium Chart 12Small Valuation Cushion Could Be Problem If Political Risk Increases The Canadian Dollar Despite the softening evident in the Loonie's FITM, the Canadian dollar continues to trade at a substantial discount to this fair value model (Chart 13). However, the FITM for the CAD is at risk of weakening further as oil prices have begun to be engulfed in the weakness that has gripped EM and risk assets globally. Mitigating this message, on the eve of the announcement of the USMCA trade deal, which essentially kept in place the trade relationships that existed between the U.S. and Canada under NAFTA, the Loonie was trading at a 1.5 sigma discount to the ITTM, a level normally constituting a buy signal (Chart 14). As a result, we expect the Canadian dollar to not be as sensitive to commodity price weakness as would have been the case had the CAD traded at a premium to its ITTM. This is one factor explaining why the Canadian dollar remains one of our favorite currencies outside the USD for the coming three to six months. The second favorable factor for the CAD is that the Bank of Canada is likely to hike interest rates at the same pace as the Fed. Hence, unlike with other currencies, interest rate differentials are unlikely to move against the CAD. Chart 13Loonie Trades At A Big Discount To Fundamentals... Chart 14...Which Will Help The CAD Mitigate A Fall In Oil Prices The Swiss Franc Like the euro, the Swiss franc trades in line with both its FITM and ITTM fair values (Chart 15). Moreover, the CHF has been hovering around its fair value for nearly a year now, which means there is less of a case for an undershoot of the ITTM fair value than for currencies that have experienced recent overshoot (Chart 16). Moreover, if volatility in financial markets remains elevated, and volatility within the bond market picks up, the fair value of the Swissie could experience some upside. However, this is where the positives for the Swiss franc end. The Swiss economy remains mired by underlying deflationary weaknesses, reflecting the lack of Swiss pricing power as well as the tepid growth of Swiss wages. As a result, the interest rate differential components of the models are likely to continue to represent a headwind for the CHF, especially as the Swiss National Bank remains firmly dovish and wants to keep real interest rates at low levels in order to weigh on the franc and also stimulate domestic demand. Based on these bifurcated influences, while we remain negative on the CHF against both the dollar and the euro on a cyclical basis, EUR/CHF may remain under downward pressure over the coming three to six months. Chart 15No Valuation Mismatch... Chart 16...Implies That The CHF Will Be At The Mercy Of Central Banks The Australian Dollar While the Australian dollar continues to trade at a significant premium against long-term models, it now trades at an important discount against both its FITM and ITTM equilibria (Chart 17). However, the problem for the AUD is that the FITM estimates continue to trend lower as Australian interest rates are lagging U.S. rates, especially in real terms. This is a direct consequence of the Reserve Bank of Australia maintaining the cash rate at multi-generational lows, while the Fed keeps hiking its own policy benchmark. With real estate prices sagging in both Melbourne and Sydney, as well as with a lack of wage growth and inflationary pressures, this down-under dichotomy is likely to remain in place and further weigh on the AUD. Meanwhile, while it is true that the AUD is also trading at a discount to its ITTM, historically, the Aussie has bottomed at slightly deeper levels of undervaluation (Chart 18). When all these factors are taken in aggregate, they suggest that for the AUD to fall meaningfully from current levels, we need to see more EM pain, more Chinese economic weaknesses, and commodity prices following these two variables lower. While this remains BCA's central scenario for the coming three to six months, if this scenario does not pan out the AUD could experience a sharp rebound over that timeframe. Chart 17Discount In AUD Emerging... Chart 18...But Not Yet Large Enough The New Zealand Dollar The NZD now trades at an even greater discount to both its FITM and ITTM equilibria than the AUD (Chart 19). In fact, so large is this discount that the ITTM is flashing a buy signal for the kiwi (Chart 20). This further confirms the view that we espoused 3 weeks ago that the NZD was set to rebound. As a result, we remain comfortable with our tactical recommendation of buying NZD/USD and selling GBP/NZD. The long NZD/USD position is definitely the riskier one of the two, as the NZD's upside may be limited if EM markets sell off further. In fact, NZD/USD traded at an even greater discount to its ITTM fair value when EM markets were extremely weak in late 2015 and early 2016. However, EM spreads are narrower and EM equities today trade well above the levels that prevail in those days, implying a margin of safety exists for the NZD. Meanwhile, short GBP/NZD is less likely to be challenged by weak EM asset prices, especially as in a post-Brexit environment the U.K. needs global risk aversion to stay low and global liquidity to remain ample in order to finance its large current account deficit of 3.3% of GDP. Chart 19NZD Is Now So Cheap... Chart 20...That It Is A Buy The Norwegian Krone The Norwegian krone continues to trade at a large discount to its FITM. However, this pair often experiences large and persistent deviations from this model (Chart 21). Nonetheless, it is important to note that as real interest rate differentials between the U.S. and Norway continue to widen, the fundamental drivers of the NOK are set to deteriorate further. By construction, the ITTM has proven to be a more reliable indicator for the Norwegian krone. While the NOK is currently at fair value on this metric, it is concerning that the upward trend in the ITTM has ended and that the equilibrium value for this currency has begun to deteriorate (Chart 22). As such, if oil prices are not able to find a floor at current levels, USD/NOK is likely to experience additional upside. This is because on a three- to six-month basis, there is not enough of a valuation cushion embedded in the NOK at current levels to prevent the Norwegian krone from experiencing deleterious effects in a weak energy price environment. Chart 21The NOK Fundmentals's Are Still Pointing South Chart 22...And The NOK Remains Vulnerable Versus The USD The Swedish Krona The very easy monetary policy conducted by the Riksbank is the key factor explaining why the Swedish krona remains so weak. Indeed, despite a robust economy, Swedish real interest rates are lagging well behind U.S. rates, which is putting strong downward pressure on the SEK's FITM (Chart 23). Meanwhile, despite the SEK's prodigious weakness, this currency only trades at a modest, statistically insignificant discount to its ITTM (Chart 24). This picture suggests that for the SEK to appreciate, the Riksbank needs to become much more aggressive. It is true that the Swedish central bank has flagged an imminent rise in interest rates, but the pace of increase will continue to lag far behind the Fed's own tightening. Moreover, the weakness in global trade is likely to hamper Swedish growth as Sweden is a small, open economy very influenced by gyrations in global industrial activity. As a result, the current slowdown in global trade may well give the Riksbank yet another excuse to only timidly remove monetary accommodation. This suggests that both the FITM and ITTM for the SEK have downward potential. Chart 23The Riskbank Still Hurts The SEK Chart 24...And The Krona Needs To Build A Greater Valuation Cushion 1 Please see Foreign Exchange Strategy / Global Investment Strategy Special Report titled, "Assessing Fair Value In FX Markets", dated February 26, 2016, available at fes.bcaresearch.com and gis.bcaresearch.com 2 Please see Foreign Exchange Strategy / Global Asset Allocation Special Reports titled, "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors", dated September 29, 2017, and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)", dated October 13, 2017, available at fes.bcaresearch.com and gaa.bcaresearch.com 3 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori, "U.S. Dollar Dynamics: How Important Are Policy Divergence And FX Risk Premiums?" IMF Working Paper No.16/125 (July 2016); and Michael T. Kiley, "Exchange Rates, Monetary Policy Statements, And Uncovered Interest Parity: Before And After The Zero Lower Bound," Finance and Economics Discussion Series 2013-17, Board of Governors of the Federal Reserve System (January 2013). 4 Michael T. Kiley (January 2013). 5 Please see Yin-Wong Cheung and Menzie David Chinn, "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series No. 251 (February 2000); and David Hauner, Jaewoo Lee, and Hajime Takizawa, "In which exchange rate models do forecasters trust?" IMF Working Paper No.11/116 (May 2010) for revealed preference approach based on published forecasts from Consensus Economics. 6 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 7 Ravi Balakrishnan, Stefan Laseen, and Andrea Pescatori (July 2016) 8 Francisco Maeso-Fernandez, Chiara Osbat, and Bernd Schnatz, "Determinants Of The Euro Real Effective Exchange Rate: A BEER/PEER Approach," Working Paper No.85, European Central Bank (November 2001). 9 Please see Foreign Exchange Strategy Special Report, titled "Assesing The Geopolitical Risk Premium In the Pound", dated September 7, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades