Economy

Executive Summary A Structural Downshift In China’s Real Estate Investment Growth The Politburo has set a date for the much-anticipated 20th Communist Party Congress at which President Xi will most likely secure his third term as general secretary. Although we expect China’s leaders to focus on supporting the economy following the Party Congress, there are high odds that the authorities will underdeliver on policy easing. Beijing may recalibrate its stringent zero-Covid policy next year, but the conditions are presently not yet met for a turnaround in the current strategy. China’s structural issues remain, and policymakers will likely continue to tackle them while downplaying the importance of GDP growth. The housing market remains the epicenter of risk to both China’s financial system and social stability. China’s leaders have incrementally introduced accommodative initiatives, but they still continue to seek reduced leverage among property developers. Investors should be prepared for a scenario that China will avoid “irrigation-type” stimulus in the next six months. Therefore, the economy will continue to expand at below potential growth. Bottom Line: There is a nontrivial risk that China’s stimulus will fall short of market expectations following the upcoming Party Congress. This poses risks to Chinese share prices.   Market participants believe that the 20th Communist Party Congress beginning October 16 will be a jumping off point for Chinese leaders to stimulate the economy more aggressively. This would signal a shift in the leadership’s focus, from securing political stability ahead of the Party Congress to ensuring an economic recovery next year. However, to achieve a meaningful and sustainable rebound in economic activity and equity market performance, policymakers will need to overcome two major hurdles: the zero-Covid policy and the "three red lines" regulation for property developers. At the risk of being wrong, we identify some of the factors that will preclude using irrigation type of stimulus after the conclusion of the Party Congress. Given the prevailing headwinds to China’s economy and the lack of “all-in” type of stimulus, we recommend that global equity portfolios stay neutral for now on Chinese onshore stocks and underweight offshore stocks. The Date Is Set! The Politburo’s announcement that the 20th Party Congress would take place earlier than November, in our view, is a sign of political stability and marginally positive for the economy. On the opening day, President Xi will deliver the Party’s work report, which will chart China’s policy trajectory for the next five years and beyond. It is generally believed that President’s Xi’s vision to turn China into an advanced global power will be endorsed by the Party. The earlier date for the Congress is significant for the following reasons: It shows that preparations for the Party Congress are progressing on schedule. President Xi will most likely cement his third term as general secretary, leaving little room for surprises from a political standpoint. The Party Congress will provide some indication whether the leadership will revise policies, including the zero-Covid strategy and industry regulations. Lower-level officials have been waiting to see which way the political winds are blowing. The Party Congress will clarify the situation and allow officials to focus on their economic work. Bottom Line: The Party Congress, along with the Central Economic Work Conference in December, will set the tone for China’s key economic, social, and industry policies for 2023 and beyond. Endgame To The Zero-Covid Strategy? Chart 1The Primary Risk To China's Economic Recovery Is Its Zero-Covid Policy The primary risk to China’s economic recovery is its stringent zero-Covid policy, which has significantly impacted the service sector, household income and consumption (Chart 1). In recent months policymakers have incrementally adjusted their Covid-containment measures, such as shortening the quarantine period for international travelers and streamlining mass testing procedures. However, the fundamental goal of eradicating domestic Covid cases remains intact. The best scenario in the coming year, in our view, is that China will adopt hybrid measures to combat Covid. Countries like Japan, South Korea, New Zealand, and Australia have all adopted a mixed series of Covid-control policies. These include a gradual reduction in testing and quarantine protocols, an increase in targeted vaccination among the elderly, an introduction of antiviral drugs and strengthening the quality of primary care. However, China may not tolerate the level of Covid experienced in these countries, especially since their number of new cases and related deaths have risen of late (Chart 2A and 2B). Chart 2ACovid Case Counts In Other Countries Have Risen Or Remain Elevated... Chart 2B...Along With Number Of Deaths   China sees its extremely low case count as proof that the dynamic zero-Covid policy has succeeded (Chart 3). It argues that if it shifts course and re-opens before proper protective measures have been introduced, then the losses might exceed a million deaths. China’s authorities believe that Hong Kong SAR’s high death rate in the spring is stark proof of that possible scenario (Chart 4). Chart 3China Has Managed To Keep Its Covid Case And Death Counts Extremely Low Chart 4Situation In HK SAR Earlier This Year Has Probably Sent A Warning Sign To The Mainland Thus, a sudden pivot from zero-Covid to living with the virus next year seems farfetched. China’s National Health Commission experts recently stated that victory over the virus would require effective vaccines, treatments and mild variants. We examine these three premises as follows: Covid vaccination rate: China’s overall Covid vaccination rate is high at 90% as of August this year. However, more than 35% of Chinese over age 60 have not received a booster dose and only 61% above age 80 have had a primary vaccination. Given that the majority of China’s population has not been exposed to the virus and is immunologically naïve, unlike their Western counterparts, the population relies completely on immunity acquired through Covid vaccines.  Chart 5China's Vaccination Progress Has Stalled China’s daily vaccination rate has fallen to below 200,000 per day, sharply down from the peak of 3-5 million per day in March and April (Chart 5). Even if we assume that three doses of China’s domestically produced vaccines are as effective as the West’s mRNA vaccines, at the current pace it would take several years to provide three doses of Covid vaccines to China’s 1.4 billion people. Hence, to significantly loosen zero-Covid policy, we would need to see a huge acceleration in the country’s vaccination rate. Treatment drugs: China okayed the imports and use of Pfizer’s antiviral drug Paxlovid in February and approved its first homegrown Covid antiviral medication “Azvudine” in July. Azvudine’s efficacy in reducing Covid-related hospitalization and deaths remains to be seen. The manufacturer, Genuine Biotech, says that the facility's annual production capacity is 1 billion tablets (each tablet is 1 mg), but is expected to reach 3 billion tablets in the future. Assuming each patient will need 50 mgs of Azvudine to complete a full course of treatment (as instructed by the drug manufacturer), the company can provide enough tablets for approximately 20 million Chinese within one year. To put the number into respective, China has more than 26 million people over age 80, of which more than 10 million have not had their first Covid vaccine. Chart 6The Level Of Beijing's Covid Policy Stringency Remains Elevated ​​​​​​​ Milder variants: Another possibility is if new mild variants emerge next year and they cause no harm or panic among the population. However, there is no guarantee that Beijing will be willing to relent on its Covid policy based on evidence and statistics from other countries where the populations may have received mRNA vaccines. Even statistics provided within China may not warrant a decisive reopening of the economy. A recent study conducted by leading Chinese public health experts found that only 22 of the nearly 34,000 Covid patients hospitalized in Shanghai from March 22 to May 3 developed severe illness. Nonetheless, the study has not prompted policymakers to step back from the tight Covid control protocols (Chart 6). Bottom Line: The conditions do not seem to be met for a drastic change in Beijing’s dynamic zero-Covid strategy. China’s transition from zero tolerance to an orderly, managed approach to life with an evolving Covid virus will likely be long and difficult. The Housing Market Policy Dilemma The other key to achieving a meaningful recovery in China’s economy is through stimulating the country’s housing market. We expect that more accommodative real estate policy initiatives will be introduced later this year and early next year. However, structural headwinds in the property market will limit the government's willingness to stimulate the sector as aggressively as in previous cycles. China’s shrinking working population since 2015 likely led to a peak in the demand for housing in 2017/18. Moreover, it is estimated that China's total population growth will turn negative this year, further suppressing demand (Chart 7). The combination of demographic headwinds and a slowdown in urbanization, means that if policymakers overstimulate the sector as in the past, then they will have a bigger bubble to pop in the future.  There is no indication that the authorities will stop focusing on deleveraging and reducing financial risks in the real estate sector. The magnitude of mortgage rate cuts so far this year is much smaller than in the 2008/09 and 2015/16 cycles. Moreover, mortgage rates remain higher than growth in household income and home prices (Chart 8). The positive gaps between mortgage rates and both household income growth and house price appreciation discourage house purchases. Chart 7Demand For Housing In China Is On A Structural Downtrend Chart 8Current Rate Cuts Are Not Enough To Meaningfully Spur Demand For Housing Importantly, while policymakers have intervened and provided liquidity to cash-strapped real estate developers, the “three red lines” policies restraining developers’ leverage remain intact. The message is clear: Beijing will use all necessary tools to prevent systemic risks and social unrest by ensuring the completion of existing housing projects. However, the authorities will continue to force developers to structurally shift their business models and reduce their leverage. Chinese authorities would be more incentivized to bail out the sector if there were risks of widespread mortgage loan defaults among households. In our view, this risk remains low in the next 6 to 12 months. The mortgage down payment ratio is relatively high in China and mortgages are full recourse loans as borrowers are personally liable beyond the collateral (i.e., the property asset). This combination reduces the incentive for homebuyers to stop paying mortgages even in a situation of negative equity (i.e., when the value of the property asset falls below the outstanding mortgage). Indeed, ongoing mortgage boycotts have been isolated to unfinished apartments in stalled projects. The boycotts are driven by homebuyers to pressure developers to finish these projects and are not due to household financial difficulties. There will likely be more defaults by overleveraged developers next year. The sector will consolidate further, with opportunistic, well-funded developers taking advantage of the situation to acquire distressed assets at a discount. Many of these may be state-owned or state-backed companies and investment funds. Chart 9Real Estate Investment Growth In China Will Structurally Shift Lower Bottom Line: Policymakers will continue to feed the housing sector with stimulus measures, but the leadership might be reluctant to overstimulate the sector. China’s real estate market dynamics, particularly the completion of existing projects, will likely improve on the margin in the next 6 to 12 months. Structurally, however, China’s home sales and real estate investment growth will continue shifting to a lower gear (Chart 9).    Investment Conclusions At the start of the year, China was expected to aggressively stimulate its economy. This was based on the premise that policymakers would not tolerate slower economic growth ahead of the Party Congress. Nonetheless, Chinese leaders downplayed the annual GDP growth target this year, a major deviation from the past. Post October’s Party Congress, we think that the authorities will continue to roll out measures to support the economy, but we recommend that investors remain realistic about the magnitude of policy easing. There are nontrivial risks that policymakers will continue to tackle structural issues, while allowing the economy to muddle through. With piecemeal stimulus, China may still be able to manage a soft landing in its property market and prevent the risks from spilling over to other sectors of the economy. In this case, we will monitor macro and financial market dynamics and change our stance on Chinese equities if warranted (Chart 10A and 10B). Chart 10AWithout More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Chart 10BWithout More Aggressive Stimulus, Upsides In Chinese Equity Prices Are Capped Lastly, investors should be prepared for greater emphasis of common prosperity policies at the Party Congress. Reducing income inequality and improving social welfare will remain core principles of President Xi’s political agenda. Common property policies mean that there will be a continued shift towards a larger share of labor compensation versus capital in the country’s national income (Chart 11). The pandemic in the past 2.5 years has likely exacerbated the country’s income inequality and discontent among middle-class households. Chart 11Implications Of China’s Common Prosperity Policy Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com ​​​​​​​Jing Sima Consulting China Strategist Strategic Themes Cyclical Recommendations

Highlights Chart 1A Hot Labor Market The balance of data that’s come out during the past month points to a labor market that is not cooling very quickly. In fact, it is cooling much more slowly than we anticipated. First, nonfarm payroll growth of +315k in August is well above the +79k that is needed to maintain the unemployment and participation rates at current levels (Chart 1). Second, what had initially looked like a significant drop in job openings was revised away with the July JOLTS report. While the ratio of job openings to unemployed has leveled-off just below 2.0, it is no longer showing any signs of falling (bottom panel). Finally, the employment component of August’s ISM Manufacturing PMI jumped back above 50 and even initial unemployment claims have reversed their nascent uptrend. The conclusion we draw from this spate of strong employment data is that the Fed’s tightening cycle is not close to over. This means that the average fed funds rate that is priced into markets for 2023 is almost certainly too low. Feature Table 1 Recommended Portfolio Specification Table 2Fixed Income Sector Performance Table 3A Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* Investment Grade: Underweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to -267 bps. The average index option-adjusted spread tightened 4 bps on the month, and it currently sits at 145 bps. Our quality-adjusted 12-month breakeven spread ticked up to its 56th percentile since 1995 (Chart 2). A report from a few months ago made the case for why investors should underweight investment grade corporate bonds on a 6-12 month investment horizon.1 The main rationale for this recommendation is that the slope of the Treasury curve suggests that the credit cycle is in its late stages. Corporate bond performance tends to be weak during periods when the yield curve is very flat or inverted. Despite our underweight 6-12 month investment stance, we wouldn’t be surprised to see some modest spread narrowing during the next couple of months as inflation heads lower. That said, spread compression will be limited by the inverted yield curve and the persistent removal of monetary accommodation. A recent report dug deeper into the corporate bond space and concluded that investment grade-rated Energy bonds offer exceptional value on a 6-12 month horizon.2 That report also concluded that long maturity investment grade corporates are attractively priced relative to short maturity bonds. High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 28 basis points in August, dragging year-to-date excess returns down to -519 bps. The average index option-adjusted spread tightened 15 bps on the month and it currently sits at 494 bps, 125 bps above the 2017-19 average and 43 bps below the 2018 peak. The 12-month spread-implied default rate – the default rate that is priced into the junk index assuming a 40% recovery rate on defaulted debt and an excess spread of 100 bps – increased modestly in August. It currently sits at 6.6% (Chart 3). As is the case with investment grade, high-yield spreads could stage a relief rally during the next few months as inflation falls and recession fears abate. However, the inverted yield curve will likely prevent spreads from moving much below the average level seen during the last tightening cycle (2017-19). All that said, even a move back to average 2017-19 levels would equate to a roughly 7% excess return for the junk index if it is realized over a six month period. This return potential is the main reason to prefer high-yield over investment grade in a US bond portfolio. While we maintain a neutral (3 out of 5) allocation to high-yield for now, we will downgrade the sector if spreads tighten to the 2017-19 average or if core inflation falls back to our 4% estimate of its underlying trend.3 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 100 basis points in August, dragging year-to-date excess returns down to -144 bps. We discussed the outlook for Agency MBS in a recent report.4 We noted that MBS’ poor performance in 2021 and early-2022 was driven by duration extension. Fewer homeowners refinanced their loans as mortgage rates rose, and the MBS index’s average duration increased (Chart 4). But now, the index’s duration extension is over. The average convexity of the MBS index is close to zero (panel 3), meaning that duration is now insensitive to changes in rates. This is because hardly any homeowners have an incentive to refinance at current mortgage rates. With the duration extension trade over, the only thing preventing us from increasing exposure to the Agency MBS space is that spreads still aren’t sufficiently attractive. The average index spread versus duration-matched Treasuries is roughly midway between its post-2014 minimum and post-2014 mean (panel 4). Meanwhile, the option-adjusted spread has moved above its post-2014 mean (bottom panel), but at just 42 bps, it still offers less compensation than a Aa-rated corporate bond or a Aaa-rated consumer ABS. At the coupon level, we moved to a neutral allocation across the coupon stack last month, but this month we initiate a recommendation to favor high-coupon (3%-4.5%) securities over low coupon (1.5%-2.5%) ones. Given the lower duration of high coupon MBS, this position will profit from rising bond yields on a 6-12 month investment horizon. Emerging Market Bonds (USD): Underweight Chart 5Emerging Markets Overview Emerging Market bonds outperformed the duration-equivalent Treasury index by 156 basis points in August, bringing year-to-date excess returns up to -563 bps. EM Sovereigns outperformed the Treasury benchmark by 117 bps on the month, bringing year-to-date excess returns up to -677 bps. The EM Corporate & Quasi-Sovereign Index outperformed by 180 bps, bringing year-to-date excess returns up to -491 bps. The EM Sovereign index outperformed the duration-equivalent US corporate bond index by 111 bps in August. Meanwhile, the yield differential between EM sovereigns and US corporates moved deeper into negative territory (Chart 5). As such, we continue to recommend a maximum underweight (1 out of 5) allocation to EM sovereigns. The EM Corporate & Quasi-Sovereign Index outperformed duration-matched US corporates by 168 bps in August. The index continues to offer a significant yield advantage versus duration-matched US corporates (panel 4). As such, we continue to recommend a neutral (3 out of 5) allocation to the sector. China is the most important trading partner for most EM countries and thus represents a major source of economic growth. Consequently, Chinese import volumes are a useful gauge for the outlook of EM economies. The persistent contraction of Chinese import volumes (bottom panel) therefore sends a negative signal for EM bond performance. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 126 basis points in August, bringing year-to-date excess returns up to -44 bps (before adjusting for the tax advantage). We view the municipal bond sector as better placed than most to cope with the recent bout of spread volatility. As we noted in a recent report, state & local government revenue growth has been strong, but governments have been slow to hire (Chart 6).5 The result is that net state & local government savings are incredibly high (bottom panel) and it will take some time to deplete those coffers. On the valuation front, munis have cheapened up relative to both Treasuries and corporates since last year. The 10-year Aaa Muni / Treasury yield ratio is currently 82%, up from its 2021 trough of 55%. The yield ratio between 12-17 year munis and duration-matched corporate bonds is also up significantly off its lows (panel 2). We reiterate our overweight allocation to municipal bonds within US fixed income portfolios, and we continue to have a strong preference for long-maturity munis. The yield ratio between 17-year+ General Obligation municipal bonds and duration-matched US corporates is 80%. The same measure for Revenue bonds is 94%, just below parity even without considering municipal debt’s tax advantage. Treasury Curve: Buy 5/30 Barbell Versus 10-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in August as investors significantly marked up their 12-month rate expectations. Our 12-month Fed Funds Discounter – the market’s expected 12-month change in the funds rate – rose from 78 bps to 175 bps during the month and this caused the 2-year/10-year Treasury slope to flatten by 8 bps and the 5-year/30-year Treasury slope to flatten by 33 bps (Chart 7). We initiated a position in 5/30 flatteners (short 10-year bullet versus duration-matched 5/30 barbell) in our August 9th report.6 The main reason for this recommendation is our view that the Fed tightening cycle is not close to over. Therefore, it is too soon to position for a steepening of the 5-year/30-year Treasury slope. An analysis of past Fed tightening cycles shows that the 5-year/30-year Treasury slope tends to trough earlier than other segments of the yield curve. However, that trough has always occurred within a window spanning five months before the last Fed rate hike and three months after.7 On average, the 5-year/30-year slope troughs 1-2 months before the last Fed rate hike. Given our view that the Fed tightening cycle still has a lot of room to run, we think it makes sense to bet on a further flattening of the 5-year/30-year slope. This trade looks particularly attractive when you consider that a position short the 10-year bullet and long a duration-matched 5/30 barbell provides a yield pick-up of 12 bps (bottom panel). TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 8 basis points in August, bringing year-to-date excess returns up to +264 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month, moving back into the Fed’s 2.3% - 2.5% comfort zone (Chart 8). Meanwhile, our TIPS Breakeven Valuation Indicator shows that 10-year TIPS are close to fairly valued versus nominals. In a recent report we unveiled our Golden Rule of TIPS Investing.8 In that report we showed that TIPS of all maturities tend to outperform equivalent-maturity nominal bonds whenever headline CPI inflation exceeds the 1-year CPI swap rate during a 12-month period. The 1-year CPI swap rate is currently 2.77%, and we think this will turn out to be too low based on our modeling of headline CPI. While we see value in TIPS relative to nominals, especially at the front-end of the curve, we also suspect that more value will be created during the next few months as CPI prints come in soft. Therefore, we are reluctant to immediately upgrade TIPS to overweight. Instead, we recommend that investors initiate a 2-year/10-year TIPS breakeven inflation curve flattener. The 2/10 TIPS breakeven inflation curve has recently jumped into positive territory (bottom panel), but an inverted inflation curve is much more consistent with the current macro environment where the Fed is battling above-target inflation. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to -25 bps. Aaa-rated ABS outperformed by 19 bps on the month, bringing year-to-date excess returns up to -24 bps. Non-Aaa ABS outperformed by 76 bps on the month, bringing year-to-date excess returns up to -28 bps. Substantial federal government support caused US households to build up an extremely large buffer of excess savings during the past two years. This year, consumers are starting to draw down that savings and are even starting to take on more debt. The amount of outstanding credit card debt is still low relative to household income, but it is rising quickly in absolute terms (Chart 9). Elsewhere, consumers are still paying down their credit card balances at high rates (panel 4), but banks are no longer easing lending standards on auto loans or credit cards (panel 3). To us, the prevailing evidence suggests that it will be a long time before delinquencies are a serious problem for consumer ABS. This justifies our overweight recommendation. That said, given that the trend toward consumer re-leveraging is in full swing, it makes sense to turn more cautious at the margin. We therefore close our prior recommendation to favor non-Aaa over Aaa-rated consumer ABS and move to a neutral allocation across the consumer ABS credit curve. Non-Agency CMBS: Overweight Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 26 basis points in August, bringing year-to-date excess returns up to -150 bps. Aaa Non-Agency CMBS outperformed Treasuries by 20 bps on the month, bringing year-to-date excess returns up to -103 bps. Non-Aaa Non-Agency CMBS outperformed by 41 bps on the month, bringing year-to-date excess returns up to -280 bps. CMBS spreads remain wide compared to other similarly risky spread products and are currently close to their historic averages. However, the most recent Senior Loan Officer Survey showed tightening lending standards and weaker demand for commercial real estate (CRE) loans (Chart 10). This suggests a more negative back-drop for CRE prices and CMBS spreads and causes us to reduce our recommended allocation from overweight (4 out of 5) to neutral (3 out of 5). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 29 basis points in August, dragging year-to-date excess returns down to -44 bps. The average index option-adjusted spread held flat on the month, close to its long-term average (bottom panel). At 55 bps, the average Agency CMBS spread continues to look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. At present, the market is priced for 175 basis points of rate hikes during the next 12 months. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with excess returns for a front-loaded and a back-loaded rate hike scenario. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 1, 2022) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 1, 2022) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -7 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 slope flattens by less than 7 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of September 1, 2022)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Robert Timper Research Analyst robert.timper@bcaresearch.com Footnotes 1     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Turning Defensive On US Corporate Bonds”, dated April 12, 2022. 2     Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Looking For Opportunities In US & European Corporates After The Recent Selloff”, dated May 31, 2022. 3    For more details on this call please see US Bond Strategy Weekly Report, “When The Dual Mandates Clash”, dated June 28, 2022. 4    Please see US Bond Strategy Weekly Report, “The Bond Market Implications Of A 5% Mortgage Rate”, dated April 26, 2022. 5    Please see US Bond Strategy Weekly Report, “Echoes Of 2018”, dated May 24, 2022. 6    Please see US Bond Strategy Weekly Report, “The Great Soft Landing Debate”, dated August 9, 2022. 7     In our analysis we examined seven Fed tightening cycles. The five most recent cycles and the two cycles that occurred during the inflation spike of the early 1980s. 8    Please see US Bond Strategy Special Report, “The Golden Rule Of TIPS Investing”, dated August 23, 2022.   Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns