Developed Countries

Highlights Duration: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. High-Yield: A supply shock in the oil market would most likely lead to steep backwardation in the oil futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. Emerging Market Sovereigns: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Feature Bond Breakout Chart 1The Long End Breaks Out Bond markets sold off sharply last week and long-dated Treasury yields took out some noteworthy technical levels in the process. The 10-year Treasury yield broke above its May 2018 peak of 3.11% and settled at 3.23% as of last Friday. The next big test for the 10-year's cyclical uptrend is the 2011 peak of 3.75% (Chart 1). The 30-year yield similarly broke above its May 2018 peak of 3.25%, settling at 3.39% as of last Friday. The next resistance for the 30-year occurs at the early-2014 peak of 3.96%. Removing our, admittedly uncomfortable, technical analysis hat, it is instructive to note which macro factors were responsible for last week's large bear-steepening of the Treasury curve and which weren't. Strong U.S. economic data - the non-manufacturing ISM survey hit its highest level since 1997 (Chart 2) - and Fed Chairman Powell commenting that the fed funds rate is "a long way from neutral at this point, probably" were the key drivers of the move.1 Taken together, these two developments suggest that the Fed is further behind the curve than was previously thought. This is consistent with an upward revision to the market's assessment of the neutral fed funds rate, which explains why the yield curve steepened and the price of gold edged higher.2 But it's equally important to note the factors that didn't drive the increase in yields. In this case, yields weren't driven by a rebound in growth outside of the U.S., which continues to flag (Chart 2, panel 2). The Global Manufacturing PMI fell for the fifth consecutive month in September. While our diffusion index based on the number of countries with PMIs above versus below the 50 boom/bust line ticked higher (Chart 2, panel 3), our diffusion index based on the number of countries with rising versus falling PMIs remained deeply negative (Chart 2, bottom panel). Chart 2Growth Divergences Deepen Chart 3Global PMIs Taken together, our diffusion indexes are consistent with an environment where most countries are experiencing decelerating growth from high levels. This message is confirmed by looking at the PMIs from the five largest economic blocs (Chart 3). The Eurozone PMI continues to fall rapidly, though it remains well above 50. The Emerging Markets (ex. China) PMI is also trending lower from a relatively high level, while the Chinese PMI is threatening to break below 50. Only the U.S. and Japan have healthy looking PMIs. The precariousness of non-U.S. growth leads us to reiterate the biggest risk to our below-benchmark duration view. The risk is that weak foreign growth eventually migrates to the U.S. via a stronger dollar and forces the Fed to pause its +25 bps per quarter rate hike cycle. If current trends continue, it is highly likely that U.S. growth will slow in the first half of next year, though it is unclear whether such a slowdown would be severe enough for the Fed to pause rate hikes.3 In any event, the bond market is only priced for the Fed to maintain its quarterly rate hike pace until June of next year (3 more hikes) before going on hold (Chart 4). Essentially, the market already discounts a rate hike pause, even after last week's large increase in yields. Chart 4Market's Rate Expectations Still Too Low For this reason, we prefer to maintain our below-benchmark portfolio duration stance, and to hedge the risk of weakening foreign growth by owning curve steepeners,4 and maintaining only a neutral allocation to spread product. Bottom Line: Last week's bond market rout was driven by strong U.S. data. Global growth (ex. U.S.) continues to weaken. Weak foreign growth that migrates stateside via a stronger dollar remains the biggest risk to our below-benchmark duration stance. For now, we prefer to hedge that risk by owning curve steepeners and maintaining only a neutral allocation to spread product. In Case You Needed Another Reason To Be Nervous About Junk As Treasury yields broke higher last week, the average high-yield index option-adjusted spread tightened to a fresh cyclical low of 303 bps. It has since rebounded to 316 bps (Chart 5). Our measure of the excess spread available in the high-yield index after adjusting for expected default losses is now at 196 bps, well below its historical average of 247 bps (Chart 5, panel 2). We have previously pointed out that even this below-average excess spread embeds a very low 12-month default loss expectation of 1.07%.5 Rarely have default losses been below that level. With job cut announcements forming a tentative bottom (Chart 5, bottom panel), we see high odds that default losses surprise to the upside during the next 12 months. In the absence of further spread tightening, that would translate to 12-month excess junk returns of 196 bps or less. But this week we want to highlight an additional risk to junk spreads. That risk being our Commodity & Energy Strategy service's view that crude oil prices could experience a positive supply shock in the first quarter of next year. At present, our strategists see high odds of $100 per barrel Brent crude oil in the first quarter of next year, and are forecasting an average price of $95 per barrel for 2019. At publication time, the Brent crude oil price was $85.6 At first blush it isn't obvious why high oil prices would pose a risk to junk spreads, and in fact there is no consistent correlation between the level of oil prices and junk spreads. However, there is a correlation between implied volatility in the crude oil market and junk spreads, with higher implied vol coinciding with wider spreads and vice-versa (Chart 6). Chart 5Default Loss Expectations Too Low Chart 6Higher Oil Vol = Wider Junk Spreads Would higher oil prices necessarily induce a spike in implied volatility? Not necessarily. It turns out that what matters for implied oil volatility is the slope of the futures curve.7 A contangoed futures curve where long-dated futures trade at a higher price than short-dated futures tends to be associated with high implied volatility. A steeply backwardated futures curve where long-dated futures trade well below short-dated futures is equally associated with elevated implied vol (Chart 7). Implied volatility tends to be lowest when the futures curve is in mild backwardation. A mild backwardation is typical when crude prices are in a gradual uptrend, as is the case at present. All in all, the following features provide a reasonable description of the current environment: Gradual uptrend in crude oil price Mild oil futures curve backwardation Low implied crude volatility Tight junk spreads However, as we head into next year, our commodity strategists anticipate that supply constraints will bite in the oil market. The U.S. is poised to implement an oil embargo against Iran in November, and Venezuela - another important oil exporter - remains on the brink of collapse. With global oil inventories already tight, and the loss of further production from Venezuela and Iran looming, our strategists anticipate that the number of days of demand covered by crude oil inventories will decline sharply. This decline will lead to a steep backwardation of the futures curve (Chart 8). Chart 7Brent Crude Oil Volatility Vs. Forward Slope Chart 8Supply Shock Will Lead To Steep Backwardation The bottom line for junk investors is that a supply shock in the oil market would most likely lead to a steep backwardation in the futures curve and an increase in implied oil volatility. An increase in implied oil volatility will translate into a higher risk premium embedded in junk spreads. We continue to recommend only a neutral allocation to high-yield in U.S. bond portfolios. We will await a signal that profit growth is set to deteriorate before advocating for a further reduction in exposure. Still No Buying Opportunity In EM Sovereigns Chart 9EM Index Spread Looks Cheap As growth divergences between the U.S. and the rest of the world increase, we are on high alert for an opportunity to shift some allocation out of U.S. corporate credit and into USD-denominated emerging market (EM) sovereign debt. However, so far EM spreads are simply not wide enough to merit attention from U.S. bond investors. This is not apparent from the average index spreads. In fact, a quick glance at the indexes shows that EM sovereign spreads have widened a lot relative to duration- and quality-matched U.S. corporates, and actually offer a healthy spread pick-up (Chart 9). However, a more detailed look at the spreads from individual countries shows that the spread advantage in EM is only available in a select few markets (Charts 10A & 10B). At the lower-end of the credit spectrum: Turkey, Argentina, Ukraine and Lebanon all offer higher breakeven spreads than comparable U.S. corporates. In the upper credit tiers: Saudi Arabia, Qatar and United Arab Emirates (UAE) look attractive. All other EM countries off lower breakeven spreads than comparable U.S. corporates. Chart 10ABreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates Chart 10BBreakeven Spreads: USD EM Sovereigns Vs. U.S. Corporates We would be very reluctant to shift any allocation out of U.S. corporates and into either Turkey or Argentina. Both of those countries are highly exposed to the tightening in global liquidity conditions that occurs alongside a strengthening U.S. dollar. Our Foreign Exchange and Global Investment Strategy teams created a Vulnerability Heat Map to identify which EM countries are likely to struggle as the U.S. dollar appreciates (Chart 11).8 These tend to be countries with large current account deficits and high external debt balances, though several other factors are also considered. The results show that Argentina and Turkey are the two most exposed nations. Chart 11Vulnerability Heat Map For Key EM Markets At the upper-end of the credit spectrum, the USD bonds from Saudi Arabia, Qatar and UAE are more interesting. Our geopolitical strategists anticipate an escalation of tensions between the U.S. and Iran following the U.S. midterm elections, and such tensions could increase the political risk premium embedded in all Middle Eastern debt. But for longer-term U.S. fixed income investors, it is worth noting that extra spread is available in the hard currency sovereign debt of Saudi Arabia, Qatar and UAE compared to A-rated U.S. corporates. Bottom Line: All of the recent widening in USD-denominated EM sovereign spreads has been concentrated in Turkey and Argentina, two nations that remain highly exposed to global growth divergences and a stronger U.S. dollar. Most other EM countries offer less attractive spreads than comparable U.S. corporate debt. Remain underweight USD-denominated EM sovereign bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Powell's full interview can be viewed here: https://www.youtube.com/watch?v=-CqaBSSl6ok 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com, where we note that every time the Global (ex. US) LEI has dipped below zero since 1993, the U.S. LEI has eventually followed. 4 Please see U.S. Bond Strategy Weekly Report, "More Than One Reason To Own Steepeners", dated September 25, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 6 Please see Commodity & Energy Strategy Weekly Report, "Odds Of Oil-Price Spike In 1H19 Rise; 2019 Brent Forecast Lifted $15 To $95/bbl", dated September 20, 2018, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, "Calm Before The Storm In Oil Markets", dated August 2, 2018, available at ces.bcaresearch.com 8 Please see Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights U.S. data keep surging, ... : The September ISM surveys, and the latest employment situation report, demonstrated that the economy has considerable momentum. ... and the Fed has taken note, ... : Chairman Powell and other FOMC speakers reiterated that they see no reason to de-escalate their tightening campaign. ... so we still see rates going higher, ... : Conditions do not justify checking any of the boxes on our checklist of items that might lead us to change our below-benchmark duration view. Only the international-duress box has moved closer to being checked, but nothing short of dire EM conditions will deter the Fed from following its intended path. ... and expect that concerns about the yield curve will abate for a while: The strong data and Powell's comment potentially implying a higher terminal rate promoted a bear steepening all along the yield curve. Feature It is a testament to how smoothly U.S. equities have been rising that Thursday's and Friday's 1% intraday S&P 500 declines inspired CNBC to frame the screen in fire-engine red, accompanied by a Market Sell-Off graphic. We all have to make a living, though, and it's easy to sympathize with a desperate producer. Episode after episode of Goldilocks is hardly must-see TV. Friday's employment situation report provided no relief. September payroll additions fell well short of the consensus estimate, but upward revisions for July and August more than offset the headline disappointment. The three-month moving average of 190,000 net additions is squarely within the tight range that has prevailed for several years. Forward guidance has been leached of any sort of drama as everyone on the Fed is singing from the same sheet - the economy's great; risks are balanced; and we're doing a fantastic job, if we do say so ourselves - and pointing to a continuation of the gradual pace. The market story will become more lively when inflation comes on much more strongly than either markets or the Fed seem to imagine it could, but that is next year's business (at the earliest), and we remain constructive in the meantime. More Strong Data (Yawn) The narrative that fiscal stimulus will keep the economy humming throughout this year and next is old news. Additionally, fiscal stimulus delivers the most bang for the buck when an economy is operating below potential; now that the output gap is closed, the odds are tilted against material positive surprises. Against that backdrop, last week's non-manufacturing ISM survey was startlingly robust. According to the Institute for Supply Management, the 61.6 reading, just off of the series' all-time high, corresponds to 4.6% real GDP growth. The components of the survey were strong across the board (Chart 1), with employment activity making a new all-time high (Chart 1, second panel). The prices-paid and supplier-delivery series, which provide insight into margin pressures, are contrary indicators once they get too strong, but each has yet to break out (Chart 1, bottom two panels). The September manufacturing ISM survey cooled a bit from August, but remains around 60, in the neighborhood of last cycle's high. Taken together, the two ISM surveys indicate that businesses are feeling flush, despite the deceleration in the rest of the developed world (Chart 2). Chart 1Firing On All Cylinders Chart 2American Exceptionalism The September employment report suggests that households should remain optimistic as well. Payroll growth has churned steadily ahead for seven years, and our payrolls model is calling for a pronounced uptick through the first quarter of 2019 (Chart 3). Expressed as a share of the labor force, initial claims continue to melt (Chart 4, top panel), and even after incorporating continuing claims, it looks like there's a job for everyone who wants one (Chart 4, bottom panel). A pessimist would say there's only one way that initial claims can go from here, but as the gaps between the circles and the shading show, there's typically a decent lag between the trough in claims and the onset of a recession. Chart 3The Employment Outlook Is Strong ... Chart 4... Given Initial Claims' Ongoing Collapse The bottom line is that U.S. demand is poised to remain strong. Data from the ISM and NFIB surveys, and the consumer confidence series, indicate that businesses and households are both feeling their oats. Payrolls should keep expanding, and the tight-as-a-drum labor market will keep wages nosing higher. With an elevated savings rate providing ample dry powder for additional consumption (Chart 5), the expansion should sail right through 2019. Chart 5Plenty Of Dry Powder For Consumption "A Long Way From Neutral" Fed officials have kept up an especially busy schedule of appearances since the latest FOMC meeting two weeks ago. Despite the potential for cacophony, the speakers have been singing the same tune. All agree that the economy is strong, and that the Fed has been meeting its dual mandate with unusual aplomb. The victory laps are off-putting socially, but their economic import could be far greater than their social import if they signal some institutional complacency about inflation. Potential future challenges aside, the FOMC is clearly united in its near-term course. Dovish Chicago President Evans, who has publicly agonized in recent years about the dangers of too-low inflation while pleading with his colleagues not to move too fast, has made his peace with the committee's gradual rate-hike pace. In a speech last Wednesday, he stated that, "I am more comfortable with the inflation outlook today than I have been for the past several years." In a subsequent interview with Bloomberg, he said, "Getting policy up to a slightly restrictive setting - 3, 3¼% - would be consistent with the strong economy and good inflation that we are looking at. ... I'm quite comfortable with the expected path." The week before, New York Fed President Williams was effusive in his praise of the economy's health and the Fed's role in sustaining it. "[T]he U.S. economy is doing very well overall. From the perspective of the Fed's dual mandate ..., quite honestly, this is about as good as it gets. ... The Fed has attained its dual-mandate objectives of maximum employment and price stability about as well as it ever has." Williams' speech may have been most interesting in its downplaying of the usefulness of the neutral-rate concept. The co-developer of the preeminent Laubach-Williams neutral-interest-rate model, Williams now says the idea is overblown, having "gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star [the estimate of the neutral rate] appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring r-star. More than that, r-star is just one factor affecting our decisions[.]" Williams' pivot would seem to suit Chairman Powell, who has shown little enthusiasm for neutral-rate models. His speech Tuesday on the Phillips curve relationship between inflation and unemployment was mostly anodyne, though he did repeatedly stress the importance of keeping inflation expectations anchored. His interview at a public forum on Wednesday was more revealing. While he continually expressed the view that he thinks the risks to the economy are balanced, he had much more to say about not hiking enough than he did about hiking too much. Now we've come to a situation where unemployment is close to a 20-year low and headed lower, by all accounts, and the really extraordinarily accommodative, low interest rates we needed when the economy was quite weak, we don't need those any more, they're not appropriate any more. We need interest rates to be gradually, very gradually, moving back toward normal, and that's what we've been doing now, for basically three years, and interest rates have just now, in real terms, moved above zero. Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral. Not that they'll be restraining the economy - we may go past neutral, but we're a long way from neutral at this point, probably.1 Our Rates Checklist Treasuries sold off sharply on Wednesday on the non-manufacturing ISM release and reports of Powell's "long way from neutral" remark. The sell-off was in line with the key pillar of our bearish duration view: the Fed will hike more than markets currently expect. Higher bond yields last week suggest the divergence between our view and the markets' view is converging in our favor. Despite the backup in yields, though, market expectations of the terminal rate are still below 3%, indicating that market participants don't expect the 25-bps-a-quarter pace to continue beyond next June. The market still has a ways to go to catch up to our 3.5-4% terminal rate forecast (Chart 6), so we are not yet close to checking the first box of the checklist (Table 1). Chart 6Fighting The Fed Table 1Rates View Checklist From the inflation section of the checklist, inflation break-evens have drifted higher. They are moving in line with our rates view, but not so swiftly that it no longer applies (Chart 7). All of the labor market indicators support the view that rates are going higher. The unemployment rate remains on course to decline, ancillary indicators of the labor market remain quite healthy, and average hourly earnings kept the beat in the September employment release (Chart 8). Chart 7Bonds Have Yet To Adjust ... Chart 8... To Building Inflation Pressures Duress in selected EM economies is the only item that has moved against our rates view since we rolled out the rates checklist last month. It is nowhere near acute enough to show up in the United States, however, so we are still a long way from checking the box. The bottom line is that strength in the U.S. economy should support higher real rates and push up inflation pressures, while the market has yet to revise its terminal-rate estimates upward. The combination supports higher rates three to twelve months down the road, even if lopsided below-benchmark positioning argues for near-term retracement. Investment Implications Expansions do not die of old age, they die because the Fed murders them. While we agree with many bond bulls that the Fed will eventually tighten monetary conditions enough to induce a recession, we do not think it will do so any time soon. BCA's modeled estimate of the equilibrium fed funds rate has been creeping higher, in line with a terminal rate somewhere between 3.5 and 4%. Given the median FOMC member terminal-rate projection of 3 3/8%, and Chicago President Evans' view that the terminal rate is somewhere around 3%, the Fed's not prepared to choke off the expansion just yet. Only rising inflation, and/or rising inflation expectations, will push the Fed to tighten policy enough to really squeeze the economy. We expect that inflation pressures will begin to show themselves over the next twelve to eighteen months as capacity bottlenecks emerge, and the Phillips curve relationship finally asserts itself. Treasuries will be an overweight once the Fed intervenes forcefully to counteract those inflation pressures, but they will be an underweight for a while first. In other words, we think long yields have to rise before they can fall. In line with the BCA house view, we remain equal weight equities, underweight fixed income, and overweight cash. We remain somewhat more constructive than our colleagues on risk assets, however, so we tweak the equity recommendation to say that investors should maintain at least an equal-weight position. Bull markets tend to sprint to the finish line, and underweighting equities too soon could prove hazardous to a manager's relative performance. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 October 3rd interview with Judy Woodruff at The Atlantic Festival. https://www.youtube.com/watch?v=lEPcPIYTMY0 Quoted passage runs from 7:26 to 8:06.

Underweight In our previous Insight, we highlighted the S&P REITs index’s tight inverse correlation with UST yields, but it is far from the only group with this trait. The S&P telecom services index (now a subsector within the S&P communication services index, please see our recent Special Report1), with its predictable earnings stream and dividend payout, trades on the same basis. The spike in yields is thus a negative omen for telco stock prices. It is worth noting that the S&P telecom services index has been bucking its inverse correlation with UST yields since hitting their nadir in mid-2017 (second panel). We expect the beaten-up sector to reestablish the correlation, particularly since telecom’s share of the consumer’s wallet is at a decade low with momentum to continue lower. Bottom Line: Stay underweight the telecom services index. The ticker symbols for the stocks in this index are: BLBG: S5TELSX - T, VZ, CTL.   1 Please see BCA U.S. Equity Strategy Special Report, “New Lines Of Communication” dated October 1, 2018, available at uses.bcaresearch.com.

Underweight The spike in UST yields have been weighing on fixed income-proxy sectors with REITs foremost among them. As noted in the top panel of the chart, excluding the inflating of the property bubble in advance of the GFC, REITs have had a very tight inverse correlation with UST yields; the resulting downward pressure on the S&P REITs index is thus very predictable. Such downward pressure could be overlooked if all was well on an operating basis but this is not the case. Non-residential construction continues to rise (albeit more slowly than last year) in the face of higher borrowing rates (second panel). Further, demand looks slack as occupancy rates clearly crested at the beginning of last year (bottom panel). As well, on the residential front, multi-family housing starts remain elevated which should prove deflationary to rents. Bottom Line: We reiterate our underweight recommendation on the S&P REITs index. The ticker symbols for the stocks in this index are BLBG: S5REITS - IRM, MAA, AMT, BXP, PLD, ESS, CCI, PSA, O, VTR, VNO, WY, EQIX, DLR, EXR, DRE, FRT, WELL, SBAC, HCP, GGP, KIM, EQR, UDR, REG, MAC, HST, SPG, AVB, AIV, SLG, ARE.

We have long argued that the U.S. economy can withstand a tightening of up to 100-125bps (using the 10-year UST yield) in a short time span. Empirical evidence supports our view, and with regard to stocks, what is most important is the correlation between the bond yield year-over-year change and momentum in the SPX (middle panel). In early March, we compared cyclical momentum in the S&P 500 with the annual change in the 10-year UST yield and documented the correlation shifts going back to the 1960s. We also filtered for a minimum of 100bps change in the 10-year UST yield and a concurrent negative correlation between the two variables. In other words, we searched for tightness in monetary conditions that caused equity market consternation, excluding recessions. Our analysis revealed that there have been five iterations when rising bond yields proved restrictive for equities: once in each of the 1960s, 1970s and 1990s and twice in the 1980s. On average, the SPX drawdown from peak-to-trough during these five iterations was 19% and lasted 6.5 months. While the correlation currently has clearly made a turn toward the zero line (bottom panel), it is not in negative territory yet. Using this simple rule of thumb suggests that it would take a selloff in the bond market that pushed yields above 3.70% to cause a significant hiccup in stocks (as a reminder this year’s trough in the 10-year UST yield is 2.72%). With regard to portfolio positioning and given BCA’s interest rate view of a continuation of a selloff in the bond market, we would shy away from interest rate-sensitive sectors (please see the next Insights).

Highlights U.S. domestic demand will remain robust for the foreseeable future thanks to fiscal stimulus, stronger credit growth, a falling savings rate, and plentiful sources of pent-up demand. Economic and financial imbalances in the U.S. are also muted, while the financial system is fairly resilient. All this implies that the Fed can raise rates quite a bit more - certainly above the 3% level that the market regards as the threshold at which the economy will go off the rails. Since both monetary and fiscal policy will remain accommodative for the foreseeable future, a recession is unlikely before 2020, with risks tilted to an even later onset date. The combination of a stronger dollar, slowing global trade, high EM debt levels, and the Chinese government's reluctance to pursue a massive fiscal/credit stimulus program due to concerns about financial stability and debt sustainability, all spell trouble for emerging markets. Investors should favor developed market equities over their EM counterparts. Within the developed market universe, remain overweight the U.S. over both Europe and Japan in common-currency terms. As we predicted two years ago, bonds have entered a secular bear market. However, a temporary countertrend rally is a growing risk in the near term, especially in light of extremely stretched short positioning and technically oversold conditions. Feature A New Record Will Be Set Next Year The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion (Chart 1). Will it last that long? We think so. In fact, the risk to our 2020 recession call is tilted towards a later downturn rather than an earlier one. Chart 1The Current Economic Expansion Will Likely Be The Longest On Record To understand why, it is useful to consider the forces that generate recessions. In one sense, business cycles are very simple things: Recessions occur when spending begins to decline in relation to the economy's productive capacity. This often sets in motion a vicious circle where rising unemployment reduces both income and confidence, leading to less spending and even higher unemployment. Conversely, recoveries occur when spending rises relative to the economy's productive capacity. This may happen because fiscal and/or monetary policy turn stimulative. It can also happen because the excesses that were built up in the lead-up to the recession are purged, allowing the economy to grow from a clean slate. Lessons From The Great Recession The Great Recession offers a vivid demonstration of these processes. The run-up in home prices starting in the early 2000s pushed up consumption. Rising housing demand also lifted residential investment. Once the housing bubble burst, everything went into reverse: Home prices and construction collapsed. Household debt, which had grown rapidly over the preceding 25 years, began to contract. The importance of shifts in aggregate demand in explaining business-cycle fluctuations may seem simple if not obvious, but it is remarkable how many people fail to understand them. One of the more strangely controversial reports I wrote while working in the global markets group at Goldman Sachs in September 2009 was a piece predicting that the Fed would need to keep rates low for "many years" to come.1 It is easy to forget now, but the U.S. 10-year yield rose as high as 3.92% in December 2009 on the expectation that the Fed would start "normalizing" monetary policy in the near future (Chart 2). Chart 2Rate Expectations Were Too Hawkish Shortly After The Great Recession, But Are Now Too Dovish Those who understood the mechanics of recessions and recoveries should have realized that the Fed would not be able to abandon its ultra-loose monetary stance so quickly. Yes, the financial crisis had ended in the sense that credit spreads were falling, equity prices were recovering, and fears of a massive bank run were receding. But the sources of demand that propped up spending prior to the Great Recession were not coming back anytime soon. The U.S. needs about 3.5% of GDP in residential investment to keep up with population growth. After the recession ended, it probably required something closer to 2% of GDP in residential investment in order to work off the excess inventory of homes that was created during the bubble years. Residential investment averaged nearly 6% of GDP between 2002 and 2006. Where exactly was that 4% of GDP in lost demand going to come from? Certainly not from the Obama stimulus package, which was too small and too transient. Likewise, while one could have reasonably debated in 2009 the extent to which debt levels would ultimately fall, it should have been pretty obvious that they would not start rising at least for the next few years. Conceptually, the level of demand is determined by the rate of growth of debt.2 Rising debt added to aggregate demand in the years leading to the Great Recession. If debt levels had simply stabilized in the aftermath of the recession, this would have still left the economy with less spending power than it had before the downturn. It took a long time, but by 2016 investors had finally internalized the lessons discussed above. The U.S. 10-year yield hit a record closing low of 1.37% on July 5, 2016. As luck would have it, this was also the day that we published a note declaring "The End Of The 35-Year Bond Bull Market." Our decision to turn more cautious on bonds was motivated by both valuation considerations and the fact that many of the forces that had dragged down bond yields were starting to drive them back up: The output gap had shrunk; fiscal policy had become more stimulative; and credit was growing anew. In addition, eight years of frugal living created plenty of pent-up demand for fixed capital and consumer durable goods. Chart 3 shows that the average age of the residential capital stock shot up from 25.8 years in 2007 to 30.1 years in 2016. The average age of the nonresidential capital stock also continued to drift up, rising to the highest level since 1963. The average age of consumer goods also increased (Chart 4). Chart 3The U.S. Capital Stock Has Aged (Part I) Chart 4The U.S. Capital Stock Has Aged (Part II) Where Things Stand Today This brings us to the present. Today, the output gap is fully closed, private-sector credit growth has returned to its long-term trend, and fiscal policy is even looser than it was two years ago (Chart 5). The replacement cycle for business investment still has further to run. Both capex intention surveys and the recent easing in lending standards for commercial and industrial loans suggest that capital expenditures will remain strong for the foreseeable future (Chart 6). Meanwhile, household spending will be supported by accelerating wage growth and a savings rate that has plenty of scope to fall from current levels (Chart 7). Chart 5The Need For Ultra-Low Rates Has Passed Chart 6Business Investment Still Going Strong Chart 7Stronger Wage Growth And A Falling Savings Rate Will Lift Spending Perhaps most importantly, the sort of financial imbalances that have triggered recessions in the past are largely absent today. Unlike a decade ago, the mortgage market is in good shape. The Urban Institute's Housing Credit Availability Index, which measures the percentage of housing loans that are likely to default over the next 90 days, remains near all-time lows (Chart 8). The corporate debt market is more problematic, and we continue to see it as the "weakest link" in the financial system. The ratio of corporate debt-to-GDP has climbed to a record high, while so-called "covenant-light loans" have proliferated. The situation is particularly bad among companies with publicly-traded bonds, who have generally been the worst offenders. Nevertheless, the situation is far from dire. The ratio of corporate net debt-to-EBITD is still reasonably low. The interest coverage ratio is fairly elevated, as is the "quick ratio," which takes the difference between current corporate assets and inventories and divides it by short-term liabilities. Corporate assets have also risen quite briskly over the past few years, which has kept the corporate debt-to-asset ratio broadly stable (Chart 9). Chart 8U.S. Mortgage Market Is In Good Shape Chart 9Corporate Debt: Problematic, But Far From Dire Looking out, rising interest rates will lift debt-servicing costs while faster wage growth will put downward pressure on profit margins. This is likely to strain corporate balance sheets, causing spreads to widen from today's ultra-low levels. However, a major wave of defaults is unlikely to occur unless earnings collapse, which rarely happens outside of recessions. The Financial System Is More Resilient Is it possible that rising defaults will force firms to lay off workers, leading to less spending throughout the economy, higher corporate defaults, and even more layoffs? Such a vicious circle cannot be dismissed, but its likelihood is mitigated by the fact that most corporate debt is held by unleveraged investors. Defaults are most economically pernicious when they lead to "leveraged losses," a term coined by my former Goldman Sachs colleague, Jan Hatzius. If a leveraged institution wishes to hold ten times as much assets as capital, a $1 loss on a bad loan will force it to reduce its assets by $10. This could result in a downward spiral in asset prices - one where fire sales lead to big haircuts to asset holders, generating even more forced sales. A credit crunch is almost inevitable in such a scenario. Unlike mortgages, which are often held by leveraged institutions, most corporate debt is held by unleveraged players 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 10). The share of leveraged loans held by banks has declined from about 25% a decade ago to less than 10% today. Moreover, banks today hold much more high-quality capital than in the past (Chart 11). Chart 10Banks Have Reduced Their Exposure To The Corporate Sector Chart 11U.S. Banks Are Well Capitalized 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 12). This suggests that corporate America could withstand quite a bit of monetary tightening without buckling under the pressure. Chart 12Corporate Debt Scare: 2015 Was A Preview No Recession On The Horizon The discussion above suggests that U.S. aggregate demand growth will remain robust for the foreseeable future thanks to fiscal stimulus, stronger credit growth, a falling savings rate, and still-abundant sources of pent-up demand. Economic and financial imbalances are also muted, while the financial system is fairly resilient. All this implies that the Fed can raise rates quite a bit more - certainly above the 3% level that the market regards as the threshold at which the economy will go off the rails (Chart 13). Comments this week from key Fed officials, including Chair Powell, suggest that the FOMC is finally starting to see things our way. Since it will take a while for the Fed to lift interest rates into restrictive territory, it follows that the next recession is nowhere on the horizon. This observation is supported by a variety of leading economic indicators, including the ISM index, initial unemployment claims, and core durable goods orders (Chart 14). Only the yield curve is sending a modestly worrying signal, although as we discussed in a prior report,3 the danger posed from a flatter yield curve is lower today than in the past. Chart 13Markets Expect No Fed Hikes Beyond Next Year Chart 14No Imminent Risk Of A U.S. Recession It will not be until 2020, and perhaps even later, that monetary policy turns restrictive. By that time, imbalances will have grown, which implies that debt levels and asset prices will probably be higher. The unemployment rate could be in the low 3% range and core PCE inflation will likely have moved squarely above the Fed's target. Risks To The View While our baseline scenario foresees a recession happening later rather than sooner, it would be unwise to ignore the risks to that sanguine view. Four things could hasten an economic downturn: A full-blown trade war with China: Trump's procyclical fiscal policy will drain domestic savings, causing the current account deficit to widen. Since Trump is unlikely to blame his own macro policies for a rising trade deficit, he will try to find a scapegoat. He cannot blame Canada or Mexico anymore since he just negotiated a "tremendous" new USMCA agreement with them, which allegedly redresses all the injustices of the prior trade deal. Japan and the EU will also get a break, if for no other reason than they are still needed as geopolitical allies. This just leaves China as the fall guy. The risk is that the Chinese government not only raises tariffs on U.S. exports, but also retaliates against U.S. firms with operations in China. Even more dangerously, a trade war with China could escalate into an outright military conflict. The underreported story of the near collision between a Chinese warship and a U.S. destroyer this week highlights the risk of such an outcome.4 An oil superspike: Our energy strategists have argued that extremely tight supply conditions, exacerbated by sanctions against Iranian oil exports, could cause the price of crude to shoot up to $100 dollars per barrel by early next year. Every U.S. recession over the past 40 years has been preceded by a rapid increase in oil prices (Chart 15). While there are reasons to think that an oil shock would be less damaging than in the past - the U.S. is now a net energy exporter; the volume of oil consumption as a share of real GDP has fallen by a third since 1995, and by half since 1980; inflation expectations are much better anchored - a big enough oil spike, if combined with other adverse shocks, could create the conditions for another recession. An Italian sovereign debt crisis: Italy is caught between a rock and a hard place. The Italian private sector saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 16). Unlike Germany, Italy cannot export its savings to the rest of the world through a large trade surplus because it does not have a hypercompetitive economy. Nor can the Italian government risk running afoul of the bond vigilantes by emulating Japan's strategy of absorbing private-sector savings with large budget deficits. It is unlikely that these tensions will come to a head before the next global recession. Nevertheless, Italy's fiscal woes certainly make global financial markets more vulnerable to a risk-off event. Emerging market meltdown: As our EM strategists have highlighted, the combination of a stronger dollar, slowing global trade, high EM debt levels, and the Chinese government's reluctance to pursue a massive fiscal/credit stimulus program due to concerns about financial stability, all spell trouble for emerging markets. It is doubtful that an EM crisis would bring down the U.S. economy - even the 1990s crises did not do that - but it could exacerbate a preexisting slowdown, especially if the spillovers from EM lead to a tightening in U.S. financial conditions via a sharp appreciation of the dollar, wider credit spreads, and a selloff in U.S. stocks. Chart 15Rapid Increases In Oil Prices Tend To Precede Recessions Chart 16Italy: Private Sector Saves Too Much And Spends Too Little Investment Conclusions In many respects, the economic and financial landscape today resembles that of late-1997 and early-1998. Back then, the U.S. stock market was rallying while emerging market assets were selling off. The decoupling between U.S. and global stocks came to a thunderous end in the summer of 1998. Popular lore attributes the 22% plunge in the S&P 500 from July 20 to October 8 to the implosion of Long-Term Capital Management (LTCM), but in fact almost all of the decline in the index occurred before the problems at LTCM surfaced. It was more the steady drip of bad news over the course of 1998 - the spread of the crisis from Thailand to Indonesia, Malaysia, and South Korea; the collapse of Hong Kong-based Peregrine Investments Holdings, Asia's largest private investment bank; growing fears that China would devalue its currency; and finally, the Russian sovereign debt default - which caused market sentiment among U.S. investors to turn from euphoric ambivalence to bearish hysteria (Chart 17). Chart 17Key Events During The Asian Crisis It is impossible to know if such a phase-transition will occur again, but prudent investors should consider scaling back risk if they are currently overweight risk assets. We moved to neutral from overweight on global equities in June, while maintaining our preference for developed over emerging markets. Within the developed market universe, we continue to favor the U.S. over both Europe and Japan in common-currency terms, given our expectation of further dollar strength. If global stocks do suffer a correction during the next few months, this will present a buying opportunity. U.S. equities, which account for over half of global stock market capitalization, tend not to peak until six months or so before the start of a recession (Table 1). Keep in mind that the S&P 500 rallied by 68% between its October 1998 lows and April 2000. Emerging market stocks bottomed in September 1998, before doubling over the subsequent 18 months. Following this script, we expect to flip our recommendation from being underweight to overweight EM equities at some point in 2019, probably in the first half of the year. The 1998 template is also helpful for thinking about the outlook for bond yields. The 10-year Treasury yield rose from 4.16% in October 1998 to 6.79% in January 2000, but not before falling from nearly 7% in April 1997. We do not expect a similar decline in yields this time around, but a modest dip from current levels would not be surprising, particularly because bond sentiment is highly bearish at the moment (Chart 18). As with stocks, any decline in bond yields would be temporary. Bonds are now in a secular bear market that could last a decade, if not longer. Our baseline views for global equities, bonds, currencies, and commodities are illustrated in Appendix A. Table 1Stocks And Recessions: Case-By-Case Chart 18Bond Sentiment Is Very Bearish Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 "Goldman Says Deleveraging May Keep Fed Rate Low for 'Years,' " Bloomberg, September 10, 2009. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). Thus, credit growth affects GDP and, by extension, the change in credit growth (the so-called credit impulse) affects GDP growth. 3 Please see Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," dated December 22, 2017. 4 Steven Lee Myers, "American and Chinese Warships Narrowly Avoid High-Seas Collision," The New York Times, October 2, 2018. Appendix A Appendix Chart IMarket Outlook: Equities Appendix Chart IIMarket Outlook: Bonds Appendix Chart IIIMarket Outlook: Currencies Appendix Chart IVMarket Outlook: Commodities Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights European and Japanese wages have firmed significantly, suggesting upside to inflation in these economies. However, the gain in European wages will soon reverse, as the slowdown in global trade percolates through the European economy. The ECB will not raise rates sooner or faster than currently discounted in markets, and German Bunds remain attractive in currency hedged terms. Japanese wage growth seems more sustainable but Japanese inflation expectations remain anchored to the downside, and Japan will suffer from a fiscal shock when the consumption tax is increased next October. Japan's YCC policy will remain in place for at least another 18 months, and fixed-income investors should continue to overweight JGBs in currency-hedged fixed income portfolios. Feature The pick-up in wage growth this summer in the euro area and Japan has been an interesting development. It raises the risk that inflation in these two economies is about to hit an inflection point. Since growth has returned to these two regions, if inflation were to join the party, the European Central Bank and the Bank of Japan would finally be able to follow in the Federal Reserve's footsteps and begin increasing rates sooner rather than later. This week we explore whether or not inflationary pressures are building in Europe and Japan, and whether or not the expected policy path of the ECB and the BoJ needs to be re-assessed. While cyclical pressures are growing, clouds above the global economy - the EM space in particular - suggest that the policy path currently anticipated by money markets is just right, and no glaring mis-pricings are evident. Euro Area: A Dawn Is Not A Sunrise The Necessary Condition For Inflation Is Here... There is no denying that we have seen massive improvements in the euro area economy. In fact, we would argue that the euro area has finally hit a stage where the necessary condition for a re-emergence of inflation has been met: Economic slack has vanished. There seems to be little spare capacity in the aggregate euro area economy. Today the OECD measure for the output gap stands at +0.5% of GDP. Additionally, a basic approach comparing the level of industrial production to a simple statistical filter further confirms this assessment, showing that production stands 2% above trend (Chart 1). The capacity utilization measure published by the European Commission goes one step further, showing that utilization is at its highest level since 2008. This represents a very significant change from the days of 2011-2015, when capacity utilization stood below the average that prevailed from the time of the euro's introduction (Chart 2). Chart 1No More Slack In Europe Chart 2Capacity Utilization Is At Previous Cycle Peaks The labor market has been a particular source of concern for euro area watchers. After all, how can an economy generate any domestic inflationary pressures if wages remain depressed? On that front too, there is plenty to rejoice about. The gap between the euro area's unemployment rate and the OECD's estimate of the non-accelerating rate of unemployment (NAIRU) has nearly fully disappeared. Historically, such an occurrence has been associated with a rise in European core inflation (Chart 3). In fact, the ECB's labor underutilization survey is now at its lowest level in 10 years. Moreover, in its various business conditions surveys, the European Commission asks firms whether labor is a factor limiting production. With the exception of Italy, the number of firms reporting that labor shortages are a problem in most of the major economies stands at or near record highs (Chart 4). This confirms the simple impression provided by the gap between the unemployment rate and NAIRU that the labor market is beginning to create generalized inflationary and wage pressures. Chart 3Diminishing Labor Market Slack Leads##br## To Growing Inflationary Pressures Chart 4Labor Shortages In ##br##The Euro Area ...But The Sufficient Conditions Remain Murkier While the tight labor market suggests that wages have cyclical upside, is it even true that higher wages do lead to higher inflation in the euro area? The answer is yes. Chart 5 shows that euro area wages tend to lead core CPI by approximately three quarters, with an explanatory power of nearly 87%. This makes sense. Higher wages increase the cost of production for businesses, which results in cost-push inflation. This is even more true if wages rise in real terms, which boosts household's income and supports consumption. Thus, it is likely that the recent spike in wages will lead to higher core inflation. Despite this positive backdrop, some key cyclical worries remain. First, our CPI diffusion index for the euro area, measuring the breadth of inflation increases within the subcomponents of the CPI, is in free-fall. Historically, this has been a worrying sign for core inflation, and for both nominal and real wages (Chart 6). Chart 5In Europe, Wages ##br##Lead Core CPI Chart 6But CPI Diffusion Index Suggests Real Wages ##br##And Core CPI Could Hit A Speed Bump The bigger risk originates from outside the euro area. We have shown in the past that EM shocks can have a disproportionate impact on European economic activity.1 This link seems to run deeper than we had originally realized. As Chart 7 shows, euro area nominal and real wages tend to follow the trend in European exports to EM and China. The logical conclusion is that export shocks end up affecting the whole economy by depressing profits, capex and the willingness of firms to provide wage increases to their employees. This also ends up reverberating into consumption as both nominal and, more importantly, real wages suffer. Today, weakening exports to EM and China suggest that European wages may soon roll over. This would take the wind out of price inflation as well, since wages lead core CPI by roughly three quarters. BCA's Foreign Exchange Strategy service as well as our Emerging Market Strategy sister publication have already highlighted that EM economies are likely to slow further in the coming quarters as China works to de-lever - a process which has already begun (Chart 8).2 Thus, the negative impact of EM on European growth and wages is likely only to grow over the coming quarters. The euro area leading economic indicator (LEI) has already picked up on these dynamics. The deterioration in the LEI suggests that real wages are likely to soon suffer, which will further dent euro area consumption and weigh on core inflation (Chart 9). Chart 7Exports To EM Are The Culprit##br## Behind This Speed Bump Chart 8Limited Upside Ahead##br## In Chinese Growth Chart 9Euro Area LEI Confirms##br## The Message From Exports Adding up those various message we conclude that while we could soon see some upside in inflation via a pass-through of the recent pick-up in wages, the upside is likely to prove transitory as the euro area economy will soon feel the deflationary impact of the slowdown in EM economic activity. What Will The ECB Do? The ECB will end its asset purchase program at the end of this year. Money markets are currently pricing in a full 25-basis-point hike in interest rates by March 2020. However, various formulations of the Taylor Rule suggest that euro area interest rates should already be higher than they currently are (Chart 10). What are interest rates likely to really do in relation to this date? Despite these hawkish Taylor Rule estimates, we think the ECB is likely to wait and see. As we highlighted above, the slack in the euro area economy is dissipating, and therefore inflationary pressures are bound to build up. However, the slowdown in EM that is reverberating through global trade will weigh on inflation over the coming six months. Additionally, we need to monitor developments in shadow policy rates.3 After the Fed began tapering its asset purchases in 2014, the U.S. shadow rate increased by roughly 300 basis points. While the actual fed funds rate was not raised until the end of 2015, the implied tightening from the rise in the shadow rate was enough to cause both U.S. and non-U.S. growth to slow sharply in 2015. Since bottoming in November 2016, the ECB's shadow rate has increased by 450 basis points. Even if European monetary conditions remain accommodative, this is a large and sudden shock to absorb - one that goes a long way in explaining the sudden contraction in the euro area credit impulse (Chart 11). Chart 10Does Europe Really Need Higher Rates? Chart 11Large Tightening In Euro Area Shadow Rate Ultimately, while the reduction in the euro area economic slack is real, the aforementioned dynamics are worrisome. Hence, we do not think that the ECB will want to prematurely kill off the recovery. Memories of the policy mistake of 2010, when the ECB raised rates in a too-weak economy, are still very much alive on the ECB's Governing Council. This means that a small first hike of less than 25 basis points in late 2019 or early 2020 seems appropriate, as there should be more convincing evidence by then that the economy can tolerate higher interest rates. Hence, there does not seem to currently be any mis-pricing in the European interest rate curve since investors are correctly pricing in a full 25-basis points of hikes from the ECB by March 2020. Investment Implications We continue to recommend U.S. investors hold European bonds while hedging the currency exposure back into U.S. dollar. A hedged 10-year Bund currently yields 3.66%, compared to 3.2% for a 10-year Treasury note. The picture above does not suggest that Bund yields will have enough upside to generate the capital losses needed to offset this yield pick-up, especially as Treasury prices suffer greater potential downside. This also means that once hedging costs are taken into account, European fixed-income investors are better off staying at home than playing in the U.S. government bond market. The impact for EUR/USD is more complex. The U.S. Overnight Index Swap (OIS) curve is currently pricing in roughly three rate hikes by the Fed over the next 12 months. BCA think that there could be even more U.S. rate hikes as the Fed continues to follow a 25 basis-points-per-quarter pace. Thus, we do not see the spread between U.S. and euro area interest rates narrowing in a more bullish direction for the euro Moreover, currencies trade on more than just interest rate differentials. The dollar has historically responded favorably to slowing EM growth. Moreover, as we highlighted three weeks ago, since the U.S. balance of payments is currently in surplus, this means that the U.S. is sucking in liquidity from the rest of the world.4 This is another way of saying that the world is buying more dollars than the U.S. is supplying. As a result, the dollar could continue to experience upside versus the euro over this period from factors beyond simple rate differentials. Bottom Line: The euro area economic slack has greatly dissipated and the medium term outlook for inflation is improving. Moreover, the recent pick-up in euro area wages suggest that core CPI could also pick up in the coming months. However, this increase in inflation is likely to prove temporary. Before inflation can increase durably, Europe will first have to digest the deflationary impact of slowing EM economies and global trade. This means that the ECB is likely to proceed with policy normalization very cautiously. The current pricing of 25 basis points of hikes by March 2020 is sensible. Hence, investors should continue to overweight Bunds hedged back into dollars in global fixed income portfolios. Moreover, EUR/USD could experience additional weaknesses on a 12-month basis. Japan: Fragile Progress, But Not Enough This past June, Japanese wage growth hit rates not seen in 21 years. This is enough to begin wondering if Japan is finally escaping its two-decades-long deflationary trap. After all, as Chart 12 shows, Japanese wages are a slow but nonetheless leading indicator of core inflation. Giving even more comfort to forecasts of higher Japanese inflation is the fact that, after falling continuously from the bubble peak in the early 1990s until Q1 2017, Japanese land prices have been slowly but surely increasing. Inflationary pressures in Japan are building up because the economy is at full employment. According to the BoJ, the output gap stands at +1.9% and has been positive for two years. The unemployment rate is at a stunningly low level of 2.4%, and the active job opening-to-applicant ratio stands at a four-decade high. The implications of this backdrop are evident. Chart 13 shows the demand/supply condition component of the Tankan survey of Japanese businesses, both in the manufacturing and non-manufacturing sectors. It has historically been a good explanatory variable for wage developments in Japan, and currently points to additional strength. Chart 12Rising Japanese Wages Should Boost Core Inflation Chart 13Capacity Pressures Are Lifting Japanese Wages Despite these positive developments, there remain some nagging worries. For one, the pick-up in wages seems strange in an economy where total hours worked are not rising (Chart 14). Moreover, Japanese households are currently increasing their savings ratio, which means that while they might be earning more, they are keeping this money in their bank accounts rather than spending it (Chart 14, bottom panel). As a result, there has been a limited pass-through of the recent wage acceleration into higher consumption. Additionally, like in Europe, the Japanese economy is at risk from foreign shocks. While the domestic economy seems robust, foreign machinery orders have been weakening. Industrial production has followed this path, decelerating sharply (Chart 15). Historically, Japanese inflation is very sensitive to the level of broader economic activity, so this weakening trend in industrial activity points to limited upside for overall inflation. Chart 14Weird Dynamics In Japan Chart 15Japan: The Domestic Front Is Healthy, The Foreign One Is Not The biggest problem faced by the BoJ, however, remains the weakness in inflation expectations. In the eyes of the Japanese central bank, the reason why Japanese realized inflation and wage growth have remained tepid is because decades of low inflation have created embedded expectations among the Japanese to not expect rising prices. Today, Japanese inflation expectations are once again weakening, a common occurrence when global growth slows (Chart 16). Additionally, Japan could hit a fiscal cliff of sorts next year. In October 2019, the consumption tax will increase from 8% to 10%. The last such increase - a three-percentage point hike in 2014 - caused a major slowdown in economic activity that had a deep deflationary impact. While the increase this time around is smaller and the Japanese economy is stronger than in 2014-2015, it remains to be seen how the country handles the shock of a fiscal tightening via a higher sales tax, especially if exports to EM remain on their downward path. The BoJ is likely to be very cognizant of this risk. Currently, the low level of inflation means that the real BoJ policy rate is in line with that of the U.S., a much stronger economy (Chart 17, top panel). Since Japan still faces a fiscal cliff next year and inflation expectations have not yet been unmoored to the upside, the current increase in wages is not enough to push the BoJ to abandon its Yield Curve Control (YCC) policy. What about QQE? The low shadow rate means that the BoJ does not need to buy assets anymore (Chart 17, bottom panel). Yet, the problem for Japan is that QQE possesses a strong signaling component. Ending this program is likely to cause markets to price in the end of YCC, which would drive nominal rates higher and thus result in both higher real rates and a significant tightening in monetary policy. As a result, we expect QQE to remain in place so that YCC will stay credible. However, the program is likely to have a slower pace of buying than before and will be too small to fully absorb the new issuances of JGBs by the MoF (Chart 18). Chart 16The BoJ's ##br##Number 1 Problem Chart 17The Signaling Effect Of QQE Is##br## Still Needed Because Of YCC... Chart 18...But QQE Doesn't Need To Be ##br##Quite As Large Anymore In terms of signposts that would signal to us to begin betting on an end to YCC, we continue to target three things that must ALL happen in unison, highlighted by BCA's Chief Global Fixed Income Strategist, Rob Robis, in February:5 USD/JPY rises at least to the 115-120 range; Japanese core CPI and nominal wage inflation both rise above 1.5%; 10-year JGB yields reaching an overvalued extreme, based on a model that includes potential GDP, BoJ purchases and the level of 10-year Treasury yields. So far, none of these conditions has been met. In fact, the slowdown in global trade and EM activity could even threaten the current improvement witnessed in wages. As a result, we expect all three of these developments to only happen in 2020, leaving Japanese yields with very limited upside. Investment Implications Japanese fixed-income investors continue to be subsidized to remain at home and avoid U.S. Treasuries. Because short rates in Japan are so low, the yield on 10-year U.S. Treasuries hedged into yen yield is 0.05%, less than the 0.16% yield on 10-year JGBs. At the same time, U.S. fixed income investors are incentivized to buy JGBs and hedge the currency exposure into dollars. Additionally, with the BoJ unlikely to abandon its YCC program for potentially two more years, JGBs with up to 10-year maturities are unlikely to suffer capital losses. Largely for this reason, BCA's Global Fixed Income Strategy's recommended model bond portfolio, maintains a large overweight position in JGBs, but only for maturities less than 10 years as the BoJ's YCC program is not focused on yields beyond the 10-year point. Regarding the yen, the outlooks is treacherous. On one hand, a strong USD implies a weaker yen. So do higher 10-year Treasury yields, especially if JGB yields possess little upside. On the other hand, weakness in the EM space tends to result in a stronger yen as carry trades get unwound. Due to these bifurcated risks, we do not recommend buying the yen against the dollar. However, we think that at current levels the yen remains an attractive play against the euro and against the Australian dollar, especially on a six- to nine-month basis. Bottom Line: Japanese wages have enjoyed significant upside, but Japanese inflation expectations remain moribund. Moreover, Japan is likely to experience a negative fiscal shock next year as the consumption tax will once again be increased. These two risks, in addition with slowing global growth, mean that the BoJ is unlikely to abandon YCC until well into 2020. As a result, investors should continue to overweight JGBs with maturities of less than 10-years hedged back into U.S. dollars in a global fixed income portfolio. USD/JPY should enjoy further upside on a 12-month basis. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "ECB: All About China", dated April 7, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com and Emerging Markets Strategy Special Report, titled "Deciphering Global Trade Linkages", dated September 27, 2018, available at ems.bcaresearch.com 3 The shadow rate is a measure of the impact of the various unorthodox policy initiatives implemented by central banks in the wake of the great financial crisis. It tries to express the effect of those measures in terms of the implied levels of policy rates that would have needed to prevail for the economy to generate the same performance if asset purchases had not been implemented. 4 Please see Foreign Exchange Strategy Weekly Report, titled "Policy Divergences Are Still The Name Of The Game", dated September 14, 2018, available at fes.bcaresearch.com 5 Please see Global Fixed Income Strategy Special Report, titled "What Would It Take For The Bank Of Japan To Raise Its Yield Target", dated February 13, 2018, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Underweight September was a tough month for the S&P hotels, resorts and cruise lines index. First, Carnival Corp, the largest cruise line operator warned that net revenue yield growth was slowing as prices for next year are flat; their share price (and those of their competitors) fell significantly. Next, the CEO of Marriott warned that the trade war was already having an impact on tourism, with Europe capturing a larger share of Chinese outbound travel. As with cruise lines, these comments weighed heavily on the hotel operators. Our negative thesis is unchanged with respect to cruise lines; we believe volume gains (the source of margin improvements) have peaked and, in the absence of better pricing, margins will suffer in the face of rising costs, particularly fuel (third panel). Further, despite recovering pricing in hotels, the splurging on new construction should mean a return to price competition (bottom panel), particularly if tourism from China is truly retrenching. Overall, we reiterate our underweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5HOTL - MAR, CCL, RCL, HLT, WYN, NCLH.