Fixed Income

Highlights Global Growth: Early leading indicators (credit impulses, our global LEI diffusion index) are signaling that the worst of the global economic downturn should soon end. Okun’s Law: In the developed economies, the observed relationships between economic growth and changes in unemployment suggest that the current pullback in global growth will not be severe enough to create slack in labor markets and reduce inflation pressures. Global Bond Allocation: Within dedicated global government bond portfolios, stay underweight the U.S. and Canada, neutral core Europe, and overweight the U.K., Japan and Australia. Remain tactically overweight global credit versus government bonds, at least until mid-year, with policymakers likely to stay cautiously dovish until global uncertainties recede. Feature Is This Risk Rally Too Good To Last? The mood of financial markets has improved significantly over the past few weeks, led by the dovish shift from central bankers that has revived investor risk appetite. Some positive headlines on U.S.-China trade negotiations have also generated hope over prospects for a deal, further fueling the bullish sentiment. The global economic picture remains muddled, though. Non-U.S. growth continues to languish, while the actual near-term state of the U.S. economy is proving difficult to determine given the data issues surrounding the 35-day U.S. government shutdown. Given lingering uncertainties, both political and economic, policymakers do not want to rock the boat by saying anything that might be interpreted as hawkish. With monetary policy no longer a near-term headwind, there is a window for continued outperformance of global risk assets in the next few months. That means higher global equity prices and stable-to-tighter global corporate credit spreads. Yet the seeds for the next wave of market turbulence may already be sewn. There are signs that the global growth downturn may soon end. Credit impulses are starting to pick up in several major economies, while our diffusion index of global leading economic indicators – itself a longer leading indicator – has clearly bottomed (Chart of the Week). The epicenter of global economic weakness, China, continues to deploy monetary and fiscal stimulus measures aimed at stabilizing growth. Meanwhile, the U.S. economy still appears to be in good shape, underpinned by solid consumer fundamentals. Chart of the WeekSunnier Days Ahead? A combination of easier financial conditions and faster economic growth will eventually prove to be incompatible with stable monetary policy, especially with surprisingly firm inflation in the major developed economies. Central bankers will respond by moving away from their current dovish bias, led by the U.S. Federal Reserve. With government bond markets now discounting both stable monetary policy and too-low inflation expectations, the path for global bond yields is eventually higher. While headline inflation rates are cooling in response to the lagged impact of weaker oil prices, the pullback has been far more muted so far compared to similar sharp oil-driven moves in the past (Chart 2). This is because domestically-driven inflation rates for services and wages are much sturdier today in many countries. If BCA’s bullish oil view for 2019 comes to fruition, then the current decline in headline/goods inflation rates may prove to be very short-lived and with little pass-through into core/services inflation. Chart 2Sticky Global Inflation, Despite Lower Oil Prices This dynamic is not the same in every country, however. When looking at the individual trends of goods inflation and services/wage inflation in the major developed economies, the largest gaps between the two exist in the U.S. and Canada (Chart 3). There, wage growth is accelerating and services inflation rates remain sturdy, despite sharp drops in goods inflation. Chart 3Domestic Inflation Pressures Most Acute In The U.S. & Canada Our recommended government bond allocation at the country level reflects these underlying inflation trends. We are more bearish on bond markets with the most intense domestic inflation pressures – and where future interest rate hikes are most likely – and vice versa. We remain underweight the U.S. and Canada, where wage growth and services inflation are both above the inflation targets of the Fed and Bank of Canada, and where market-based measures of inflation expectations like CPI swap rates have already bottomed (Chart 4). We remain neutral on core Europe (Germany, France) where wage growth has perked up, core/services inflation remains closer to 1% than the 2% target of the ECB, and inflation expectations continue to drift lower. Finally, we remain overweight the U.K., Japan and Australia, all of which have an underlying inflation picture that is muted enough to keep policymakers on hold for at least the next 6-9 months. Chart 4Favor Bond Markets Where Domestic Inflation Pressures Are Weakest Bottom Line: Early leading indicators (credit impulses, our global LEI diffusion index) are signaling that the worst of the global economic downturn should soon end. Central bankers will remain cautious and dovish in the near-term, however, implying that the current outperformance of global equity and credit markets has more room to run – but also setting up the next upleg for bond yields later this year. Okun’s Law Revisited Central bankers remain wedded to the idea that there is an “exploitable” relationship between unemployment and inflation, a.k.a. the Phillips Curve. A logical extension is that unless policymakers can credibly forecast a reduction in labor demand that pushes unemployment rates beyond levels associated with full employment, inflation will not be expected to decline. Policymakers will have a difficult time staying dovish without believing that inflation pressures are diminishing. One way to measure the relationship between economic growth and changes in economic slack is by using a concept that you may remember from an old macroeconomics class – Okun’s Law. More an empirically observable rule of thumb than any rule based in actual economic theory, Okun’s Law simply measures how much unemployment rates change relative to swings in real GDP growth. Past estimations for the U.S. economy have shown that the long-run coefficient in the Okun’s Law regression is around 2, which means that a 2% fall in real GDP growth should be associated with a 1% increase in the unemployment rate (and vice versa). That coefficient is not the same over shorter time horizons, though, as the unemployment/GDP growth relationship can be impacted by other cyclical factors like changes in hours worked or labor productivity. Charts 5 and 6 show annual real GDP growth (the percentage change over four quarters) versus the change in the unemployment rate over twelve months for the major developed economies (the U.S., U.K., euro area, Japan, Canada, Australia, New Zealand and Sweden) dating back to 1980. There is a reasonably strong relationship between the two series in the charts, although the “fit” does vary from country to country. Chart 5The Okun’s Law Relationship … Chart 6… Still Holds For Most Countries That can be seen in the individual country scatterplots shown in Charts 7 to 14, which plot each quarterly data point of the change in unemployment and real GDP growth. The darker dots represent the period from 1980-2010, while the lighter dots are the post-2010 era. The actual estimated regression, and its R-squared, are also shown in the charts (the equation can be defined as “the estimated change in the unemployment rate for a given pace of real GDP growth”). For most countries shown, the R-squareds are reasonably good (between 0.55 and 0.70) for a single-factor model like this. The coefficients on the change in real GDP are all between -0.35 and -0.45, which means that a fall in real GDP growth of 3.5 to 4.5 percentage points is consistent with a rise in the unemployment rate of 1 percentage point. The lone country where the Okun’s Law relationship has a relatively poor historical fit is in Japan, which is due to the lack of GDP variability relative to swings in the unemployment rate, especially over the past decade. We can use these estimates of the Okun’s Law coefficient to conduct a “back of the envelope” thought experiment that answers the following question that relates to the current economic and financial market backdrop: how much of a decline in GDP growth is necessary to raise unemployment rates back to full-employment (NAIRU) levels? As we have consistently noted in recent Weekly Reports, global central bankers can only turn so dovish, even after the severe market turbulence seen at the end of last year and with elevated political uncertainty in many locations. Why? Because unemployment rates remain below levels that are consistent with stable inflation. Without a meaningful weakening of labor markets that pushes unemployment rates back above “full employment” levels, policymakers will not be able to lower their inflation forecasts and signal a need for easier monetary policy. In Table 1, we present the estimated Okun’s Law regressions from 1980, along with the real GDP growth rate that falls out of those equations if we assume the employment gaps are closed.1 We also show the consensus 2019 real GDP growth forecasts taken from Bloomberg, as well as the expected change in central bank policy rates over the next year taken from our Central Bank Discounters. The conclusion from the Table is that it would take significant declines in real GDP growth to raise unemployment rates enough for policymakers to become less worried about inflation pressures. Table 12019 Consensus Growth Forecasts Are Well Above Levels That Would Eliminate The Unemployment Gap In the U.K., where the unemployment rate is furthest below the OECD’s estimate of the full-employment NAIRU rate, a whopping -3.3 percentage point cut to real GDP growth is needed to raise unemployment back to 5.6%. The required GDP fall is lower in the U.S., with only a -1.6 percentage point decline in real GDP growth need to push the unemployment rate back to the OECD NAIRU estimate of 4.3%. Falls in real GDP growth of between -1.5 and 2.0 percentage points are necessary in most of the other countries to close the “unemployment gap”, except for Japan. Given the weak estimated Okun’s Law relationship in Japan, we are reluctant to put much weight on the results of this thought experiment for Japan. Those “required” declines in real GDP growth are nowhere close to the 2019 consensus Bloomberg forecasts for each country. This is even true in the U.S., where the consensus expects real GDP growth to decline by -0.9 percentage points in 2019. Unsurprisingly, markets are discounting very little change in monetary policy over the next year according to our Central Bank Discounters, with modest odds of a rate cut now discounted in Australia (-19bps), New Zealand (-11bps) and the U.S. (-8bps) and a full 25bp hike now priced in Sweden. Summing it all up, our simple Okun’s Law thought experiment shows that it would take a significantly larger decline in global growth than the consensus, or BCA, expects for central banks to shift even more dovishly in the direction of interest rate cuts. This puts a cyclical floor underneath global bond yields, given that relatively stable policy rates are now discounted. Bottom Line: The observed relationships between economic growth and changes in unemployment suggest that the current pullback in global growth will not be severe enough to create slack in labor markets and an easing of inflation pressures in the developed economies.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Given the declining productivity trend seen in all countries over the past 20 years, we have made a downward adjustment to those Okun’s Law estimated coefficients. In other words, we do not think that it will take the same magnitude of GDP loss to generate the same increase in unemployment when labor productivity is low. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Spread Product Valuation: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Corporate Defaults: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Mexican Sovereign Bonds: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Feature Corporate bonds have been on fire since the start of the year. High-yield excess returns have already made back all of their lost ground from 2018, and investment grade credits are on their way (Chart 1). With the Fed’s rate hike cycle on hold and some signs of credit easing in China, the near-term backdrop is amenable to further spread compression. Especially from current elevated levels. Chart 1Corporate Bonds Having A Good Run In 2019 On the flipside, some indicators of corporate default risk are starting to deteriorate and we can easily envision a more difficult environment for corporate spreads in the second half of this year. Especially if the Fed re-starts rate hikes, as we expect.1 In this week’s report we illustrate the extent of undervaluation in corporate spreads, and also detail our concerns related to budding default risk. We conclude that investors should maintain an overweight allocation to corporate bonds (both investment grade and high-yield) for now, but be prepared to trim exposure once spreads reach more reasonable levels. Finally, we identify an opportunity in USD-denominated Mexican sovereign bonds. Too Cheap For Phase 2 In our Special Report from mid-December that laid out our key themes for 2019, we described how we split the economic cycle into different phases based on the slope of the yield curve (Chart 2).2 We define the three phases of the cycle as follows: Chart 2Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Phase 1: From the end of the prior recession until the 3-year / 10-year Treasury slope flattens to below 50 bps Phase 2: When the 3/10 slope is between 0 bps and 50 bps Phase 3: From when the 3/10 slope inverts until the start of the next recession Dividing the cycle this way reveals a reliable pattern in corporate bond excess returns versus Treasuries. Excess returns tend to be highest in Phase 1. They tend to be quite low but still positive in Phase 2, and they tend not to turn negative until Phase 3. We argued in December that we are currently in Phase 2 and that we will probably stay there for most, if not all, of 2019. The main reason that excess returns are lower in Phase 2 than in Phase 1 is that corporate bond spreads are much tighter in Phase 2. Most of the cyclical spread compression occurs in Phase 1, in the immediate aftermath of the recession. With that in mind, consider the data presented in Chart 3. The chart shows 12-month breakeven spreads for each corporate bond credit tier as a percentile rank relative to history.3 For example, a percentile rank of 50% means that the breakeven spread has been tighter than its current level half of the time throughout history. Chart 3 also divides the historical data into two samples, showing how breakeven spreads rank relative to the entire history of available data, and also how they rank relative to other Phase 2 periods only. When the full historical sample is considered, only the B-rated and Caa-rated credit tiers have breakeven spreads above their historical medians. However, when we focus exclusively on Phase 2 environments we see that spreads for every credit tier other than Aaa look extremely cheap. Essentially, Chart 3 shows that today’s spread levels are more consistent with periods when the economy is either just exiting or entering a recession. Absent that sort of macro environment, there would appear to be an obvious buying opportunity in corporate bonds. Interestingly, other spread products don’t look nearly as cheap as corporate bonds. Chart 4 shows the same data as Chart 3 but for all non-corporate U.S. spread products with available data prior to 2000. It shows that Agency MBS and Consumer ABS spreads are close to median Phase 2 levels. USD-denominated Sovereign debt looks somewhat cheap. Meanwhile, Domestic Agencies and Supranationals both look expensive. What’s clear is that right now corporate credit offers the most attractive opportunity in U.S. fixed income. Bottom Line: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Default Cycle At A Turning Point?  Another valuation tool in our arsenal is the High-Yield default-adjusted spread. This is the excess spread available in the high-yield index after accounting for expected 12-month default losses. It can also be thought of as the 12-month return earned by the High-Yield index in excess of a position in duration-matched Treasuries, assuming that default losses match expectations and that there are no capital gains (losses) from spread tightening (widening). Expected default losses are calculated using the Moody’s baseline default rate forecast and our own forecast of the recovery rate. Combining the Moody’s baseline default rate forecast of 2.4% and our recovery rate forecast of 45% gives expected 12-month default losses of 1.3%. Those expected default losses are then subtracted from the average High-Yield index option-adjusted spread to get a default-adjusted spread of 274 bps. This is slightly above the historical average of 250 bps (Chart 5). In other words, junk investors are currently being compensated at slightly above average levels to bear default risk. Chart 5A Look At The Default-Adjusted Spread Another way to conceptualize the default-adjusted spread is to ask what default rate would have to prevail over the next 12 months for junk investors to earn average historical excess compensation. This spread-implied default rate is denoted by the ‘X’ in the second panel of Chart 5. It is currently 2.8%, slightly above Moody’s baseline expectation. Is The Baseline Default Rate Forecast Reasonable? If we view the Moody’s 2.4% default rate forecast as reasonable, then we should conclude that junk bonds are attractively valued. However, some macro indicators suggest that 2.4% might be too optimistic. Chart 6 shows a model of the 12-month trailing speculative grade default rate based on gross leverage, which we define as total debt over pre-tax profits, and C&I lending standards. Chart 6A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate Gross leverage has improved during the past few quarters as profit growth has outpaced corporate debt growth (Chart 6, panel 2). This has acted to push down the fair value reading from our default rate model. On the other hand, commercial & industrial (C&I) lending standards tightened in the fourth quarter of last year (Chart 6, bottom panel). A net tightening in C&I lending standards is consistent with a higher default rate. Overall, the fair value reading from our default rate model is currently 3.5%, above the current 12-month trailing default rate of 2.6%. For the purposes of valuation, where the default rate will be 12 months from now is more important than where it is currently. To get a sense of where the fair value from our model is headed we need forecasts for corporate profit and debt growth. Profit growth will almost certainly moderate from its current lofty levels (Chart 7). Pressures on revenues and expenses both point in that direction. Total business sales and the ISM Manufacturing PMI have both fallen sharply from their recent highs (Chart 7, panel 2), suggesting lower corporate revenue growth going forward. Meanwhile, wages continue to accelerate (Chart 7, bottom panel). Chart 7Forecasting Profit Growth Using a model based on nominal GDP growth, wage growth, industrial production and the trade-weighted dollar, if we forecast that nominal GDP growth slows to the same rate as wage growth over the next 12 months, then the model predicts that profit growth will fall into the mid-single digits (Chart 7, top panel). This would be more or less consistent with the recent growth rate in corporate debt, meaning that gross leverage would flatten-off and the fair value reading from our default rate model would stabilize near 3.5%. In summary, if profit growth moderates in line with our expectations during the next 12 months, then it is likely that the corporate default rate will be somewhat higher than the current Moody’s forecast of 2.4%, possibly as high as 3.5%. But even a 3.5% default rate would still translate to a default-adjusted junk spread of 211 bps. Positive compensation for default risk, though less than average historical levels. In that case we would still expect solid positive excess returns from junk bonds. However, it will be important to monitor our default-adjusted spread during the next few months. If junk spreads tighten in the near-term, as we anticipate, then the excess compensation for default risk will evaporate quickly. Bottom Line: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Buy Mexican Bonds While most spread products have benefited from the Fed’s pause, delivering excellent year-to-date returns. We notice that the spreads on Mexico’s USD-denominated sovereign debt have not tightened alongside other comparable credits (Chart 8). This presents an attractive opportunity. Chart 8Mexican Bonds: An Attractive Opportunity When we compare 12-month breakeven spreads between the USD-denominated sovereign debt of different emerging market countries versus the spreads on equivalently-rated U.S. corporate bonds, we see that Mexico has now joined Argentina, Saudi Arabia, Qatar, UAE and Poland as the only countries that offer attractive compensation relative to the U.S. corporate sector (Chart 9). Why has this happened? Our Emerging Markets Strategy service postulates that many investors fear that the new political regime will bring fiscal profligacy, but in fact, the AMLO administration is proving to be less populist and more pragmatic than expected.4 The 2019 budget, for example, targets a primary surplus of 1% of GDP, and envisages a decline in nominal expenditures in 29 out of 56 categories. This commitment to sound fiscal policy should benefit Mexican sovereign bond spreads. More fundamentally, our Emerging Markets strategists note that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs. This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite interest rates being much higher in Mexico than in the U.S. The Mexican 10-year real yield is currently 4.1%, well above real GDP growth which was 2.6% during the past four quarters (Chart 10). Contrast that with the U.S., where the 10-year real yield is a meagre 0.8% versus real GDP growth of 3% during the past four quarters. In other words, interest rate differentials favor a stronger peso, which is positive for USD-denominated sovereign spreads. Chart 10Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Though the Mexican/U.S. interest rate differential remains wide, it is likely to compress going forward. Elevated Mexican interest rates relative to growth signal that monetary policy is restrictive. A fact that is already evident in decelerating Mexican money supply (Chart 10, bottom panel). Meanwhile, low U.S. real yields relative to GDP suggest that further Fed tightening is necessary before U.S. rates are similarly restrictive. Bottom Line: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 2      Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3      The 12-month breakeven spread is the spread widening required over the next 12 months for the corporate bond to break even with a duration-matched position in Treasury securities. We use the breakeven spread instead of the average index spread because it takes into account the changing duration of the bond indexes. 4      Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Investors like to hear non-consensus views, … : Part of our role is to help clients think about all of the potential outcomes, including ones that may not be as improbable as commonly believed. … but it seems that our Fed/rates call is starting to strike them as a little too non-consensus: Clients are having a hard time seeing the potential for inflation after ten years of errant predictions that it’s just around the corner. From our perspective, the probability of higher-rate outcomes is considerably higher than the probability of lower-rate outcomes, … : An investor with a low-duration bias has a whole lot more ways to win than an investor with a high-duration bias. … so we’re staying the course: We continue to recommend underweighting Treasuries and maintaining below-benchmark duration exposure, which aligns with our constructive take on markets and the economy. It’s too early to get defensive if a recession is at least a year away. Feature BCA clients like to hear contrarian calls, and there is little that’s more deflating from a strategist’s perspective than to be told in a meeting that his/her views are the same as everyone else’s. Except for the handful of strategists who make their living from provocative views that have almost no chance of coming to fruition, however, the calls have to be plausible. For many investors, our inflation concerns seem to be straining the bounds of plausibility. Even if BCA has only lately begun to beat the inflation drums, investors have had enough of warnings about inflation and interest-rate spikes that have repeatedly failed to come to pass. Regular readers are familiar with our contention that the sizable injection of fiscal stimulus into an economy already operating at capacity is a sure-fire recipe for inflation. They are also familiar with our view that an extremely tight labor market will necessarily give rise to robust wage gains. We have repeatedly argued that the Fed will respond to the combination of inflation pressures by hiking the fed funds rate above its equilibrium level, bringing the curtain down on the expansion and the equity bull market. With a Special Report examining the links between wage gains, consumer price inflation, and the Fed’s reaction function on the way, we’re instead devoting this week’s report to several other reasons why an investor would want to maintain below-benchmark duration in a fixed-income portfolio. Oil Prices Will Rise There is a good reason for devising core price indexes that smooth out the volatility inherent in food and energy prices. Core indexes provide a better read on the underlying inflation trend, and are a better predictor of moves in headline inflation than the headline indexes themselves. Inflation-linked Treasuries (TIPS) are tied to headline CPI, however, leaving the long-run inflation break-evens at the mercy of swings in oil prices (Chart 1). As we have previously written, our commodity strategists view the October-November swoon as a one-off event disconnected from market fundamentals that will quickly be unwound1 (Chart 2). Chart 1As Oil Goes, So Go Inflation Expectations, ... Chart 2... And Oil Prices Are Poised To Rise One need not fear that a rise in oil prices, while giving a fillip to headline inflation, would slow the economy and thereby offset inflation’s upward pressure on rates. Now that the U.S. is the world’s largest oil producer, its economy and financial markets are no longer negatively correlated with oil prices (Chart 3). It is still true that falling oil prices amount to a tax cut for American businesses and households, but they now also amount to fewer high-paying jobs in the oil patch, reduced earnings in an important domestic industry, and tighter monetary conditions as fracking bond spreads widen. Chart 3No Longer A Contrary Indicator Bottom Line: Higher oil prices will push headline inflation and inflation expectations higher, while also boosting the economy at the margin. The combination promotes higher bond yields, all else equal. The Economy’s Improved. Yields Haven’t Budged. Though we attributed the bulk of the fourth-quarter selloff to misplaced fears that the Fed was pulling the rug out from under the expansion, the economy was finding it harder and harder to produce positive surprises. By late January, however, the expectations bar had been reset low enough that new releases began surpassing it, day in and day out (until the end of last week). So far, though, the 10-year Treasury yield has stubbornly failed to reflect the improvement (Chart 4). Chart 4Surprises Turned Around, But Yields Didn't Financial conditions tightened sharply upon the sudden widening in corporate bond spreads and the sudden drop in equity prices. We viewed the seize-up as equivalent to at least a quarter-point increase in the fed funds rate and thereby found pausing to be a perfectly logical course of action for the Fed. The swiftness of the subsequent bounce in risk assets – the S&P 500 has retraced more than two-thirds of its losses and high-yield bonds have retraced close to 60% of their spread widening – has gone a long way toward undoing last quarter’s tightening. With the recovery in financial conditions, all three components of our Fed monitor now point to a need for tighter monetary conditions (Chart 5). Chart 5The Fed Can Pause, But It Can't Stop Adaptive Expectations’ Sluggish Response Investors’ inflation outlooks adhere closely to an adaptive expectations framework in which future predictions are largely a function of inflation’s recent path (Chart 6). This is not unreasonable; one could do a lot worse than pick the Patriots to reach the Super Bowl or only South American and European (ex-England) teams to win the World Cup. Adaptive expectations can fall prey to the recency bias, however, in which individuals overemphasize the most recent data points to the exclusion of older, potentially more representative data when forming their future views. From a recency-bias perspective, adaptive expectations can trap investors like the mythical frog contentedly lingering in a pot of water that’s only slowly brought to a boil. Chart 6Inflation Forecasts Take Their Cue From The Past ... We are skeptical of the notion that there will be no more inflation because there’s been no inflation since the crisis. The trend may be your friend, but not once the output gap has closed and the unemployment gap is persistently negative. Using the 10-year CPI forecast from the Philly Fed’s Survey of Professional Forecasters as an inflation-expectations proxy, one could argue that the lion’s share of the outsized gains in the pre-crisis phase of the bond bull market resulted from excessively generous inflation compensation (Chart 7, bottom panel). Chart 7... Which Is Great For Investors When Inflation Trends Lower The excessive compensation was a by-product of adaptive expectations. After the experience of the mid-seventies and early eighties (Chart 8), investors and issuers both assumed inflation would be higher than it turned out to be. Today’s bond-market participants, conditioned by ten years of soggy post-crisis readings, could well assume that inflation will be lower than it ultimately turns out to be. That may leave long-maturity bondholders with insufficient compensation, just like their early-fifties forebears. Chart 8Long Stretches Of Low Inflation May Be Bad For Future Treasury Returns Reversal Of Globalization The apex of globalization has been a key theme of our Geopolitical Strategy service since its launch. We cannot go as far as they sometimes do, arguing that globalization did more to bring inflation to heel than Paul Volcker, but it surely has been an important factor in limiting wage gains for low- and semi-skilled workers (Chart 9), and has helped to stymie retail price increases. The imposition of new tariffs have exacerbated globalization’s reversal, but it had already begun before the 2016 presidential election. The Reagan-Thatcher-Koizumi policies that were ascendant after the fall of the Berlin Wall, boosting global growth while tamping down inflation, have been in retreat in the developed world ever since the crisis. Chart 9China Syndrome Decomposing Core CPI When assessing inflation’s future direction, our U.S. Bond Strategy colleagues decompose the core CPI series into its primary components: Shelter (42% of the index); Goods (25%); Services, excluding shelter and medical care (25%); and Medical Care (8%). They then look at the drivers for each of the largest three components for an advance read on their future direction. Home price appreciation and the rental vacancy rate power their shelter costs model. With home price appreciation decelerating but still positive, and the rental vacancy rate hovering around its all-time lows, the model projects that shelter costs will remain well above 3% (Chart 10, top panel). Chart 10Core Inflation Isn't About To Melt Core goods inflation lags non-oil import prices by about a year and a half. The path of import prices suggests that core goods inflation will have a tailwind for much of the rest of the year before facing a headwind next year that will push it back to its current levels (Chart 10, second panel). Wage growth is the best predictor of core services inflation, ex-shelter and medical care (Chart 10, third panel). We expect continued upward pressure on services inflation, as labor-market slack continues to be absorbed, keeping wage growth accelerating. The Golden Rule Of Bond Investing Simplicity is a virtue in investment recommendations, models, and rationales, and our U.S. Bond Strategy colleagues’ golden rule of bond investing is elegantly simple.2 If Fed rate hikes exceed market expectations over a given time horizon, overweight duration positions will underperform over that horizon, and if Fed hikes fail to meet market expectations, overweight duration positions will outperform. Now that the money market has entirely priced out any rate-hike prospects over the next two years (Chart 11), overweight duration positions face a challenging backdrop. How will the fed funds rate surprise to the downside from here? Chart 11The Money Market Is Calling For A Rate Cut It can’t unless the Fed carries out more than one 25-basis-point cut in the next year or so. Given the underlying strength of the economy, gathering inflation pressures, and the swift unwinding of much of the tightening in financial conditions, rate cuts are a stretch. Against the current backdrop, the golden rule is a stern warning away from the longer-maturity reaches of the Treasury curve. Investment Implications We continue to stay the course with our fixed-income recommendations. If the Fed’s pause will extend the expansion for a few more months, it will extend the shelf life of our underweight Treasuries and overweight spread product recommendations, as well. As outlined above, we see many more potential catalysts for higher interest rates than we do for lower rates. We reiterate our recommendation that investors maintain below-benchmark duration across fixed-income segments. The expansion, and the bull markets in risk assets, will eventually end, but it’s too soon to position portfolios for it.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the U.S. Investment Strategy Weekly Report, “What Does Oil’s Slide Mean?,” published November 26, 2018. Available at usis.bcaresearch.com. 2 Please see the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” published July 24, 2018. Available at usbs.bcaresearch.com.

Special Report

Highlights In their current form and size, perpetual bonds issuance and the central bank bills swap program are unlikely game-changers for the banking system in China. However, this mechanism constitutes monetization of banks’ capital and bad assets, i.e., recapitalization of banks, by the PBoC via quantitative easing. Hence, this scheme can be presently viewed as a bazooka that has not yet been loaded by the government. If the authorities pursue this program on a large scale without forcing banks to acknowledge and write off bad assets, banks would regain power to expand their balance sheets, fostering a cyclical economic recovery. Nevertheless, the growth model based on continuous “out of thin air” money and credit expansion inevitably leads to falling productivity growth and rising inflation. Therefore, the economic outcome over the course of several years would be stagflation, which is profoundly bearish for the currency. Feature The Chinese authorities recently launched a Central Bank Bills Swap (CBS) program to boost liquidity and facilitate issuance of commercial banks’ perpetual bonds. Box I-1 on pages 12-13 elaborates on the scheme and provides more detail about the program. Under the CBS program, Chinese banks can buy each other’s perpetual bonds, then exchange these bonds for central bank bills and pledge those bills at the People Bank of China (PBoC) to receive funding. Insurance companies are also allowed to purchase perpetual bonds, but they cannot pledge them with the central bank for funding. What are the macro implications of this program? Can the government use this scheme to recapitalize the banking system? Does the CBS program amount to quantitative easing? Will it be sufficient to boost credit growth in China in 2019? We have conditional answers to these questions – i.e., they all depend on the extent to which the scheme is actually utilized by the authorities. On the one hand, the CBS program could potentially become a proverbial bazooka used by the government to recapitalize the banking system via the PBoC monetizing banks’ bad assets. By doing so, the PBoC would be expanding its balance sheet by injecting excess reserves into the banking system – i.e., quantitative easing. Consequently, it could help banks accelerate credit and money growth, in turn helping the economy. The long-run collateral damage in this scenario, however, would be an RMB depreciation. On the other hand, the authorities could limit the usage of the scheme via various regulatory approvals and norms. In such a case, the impact of the program on money/credit growth and the real economy as well as on the exchange rate would be limited. In other words, it might end up being no more than a tool to help the four large banks meet BIS's TLAC requirements. At the moment, there is not enough information to determine whether the program will be a game changer for the banking system in China, leading to a surge in credit and broader economic recovery. Both total assets and broad credit growth among banks remain very weak for now (Chart I-1). In other words, it is a bazooka that has not been loaded, and may never be loaded because of the potential for seriously negative ramifications over the long term. Chart I-1Chinese Banks: Total Assets And Broad Credit Growth Consequently, we maintain our view that China’s growth will continue to disappoint in the first half of 2019, and that China-related plays, including many emerging markets (EM), remain at risk of a renewed selloff. Bank Recapitalization? In theory, the issuance of perpetual bonds along with the CBS program can be used to recapitalize the banking system. Each bank can buy perpetual bonds issued by other banks up to 10% of their core Tier-1 capital. These banks can get cheap financing from the PBoC by swapping these perpetual bonds with central bank bills, and then pledging those bills at the central bank to get funding. Hence, under this scheme, the PBoC will be financing purchases of perpetual bonds, which means the monetary authorities will indirectly be funding banks’ recapitalization. It is an “open secret” that Chinese banks would be considerably undercapitalized if they were forced to recognize non-performing assets. The non-performing loan (NPL) ratio currently stands at 1.9%, and the special-mention loans ratio is at 3.2%; and the sum of both is at 5.1% of total loans (Chart I-2, top panel). NPL provisions presently amount to 3.4% of total loans. Chart I-2Chinese Banks Are Massively Under-Provisioned When expressed as a share of total risk-weighted assets, the aggregate NPLs and special-mention loans are equal to 4.2% (Chart I-2, bottom panel). At 2.8% of risk-weighted assets, NPL provisions are extremely inadequate. Assuming non-performing assets turn out to be 10% of total risk-weighted assets, some 40% of banks' capital would be wiped out, according to our simulation presented in Table I-1. This is after accounting for existing provisions and assuming a 20% recovery rate of non-performing assets. Provided that risk-weighting assigns a zero weight to banks’ claims on the government, a 50% risk weight to claims on households and a 100% weight to claims on companies, the assumption of 10% of non-performing assets in total risk-weighted assets is reasonable. This is especially the case when the enormous credit boom of the past 10 years is taken into consideration. As a result, in this scenario the capital adequacy ratio (CAR) will drop from its current level of 13.8% to 9.4%. This will bring the CAR below the regulatory minimum of 11%. To raise the CAR to the regulatory minimum of 11%, the banking system would require RMB 2 trillion of capital. This is greater than the maximum potential demand for perpetual bonds that we estimate to be up to RMB 1.4 trillion. To estimate this number, we assumed all banks purchase perpetual bonds in amounts equal to 5% of their core Tier-1 capital and all insurance companies buy perpetual bonds in an amount equal to 5% of assets. This is not an underestimation of potential demand for perpetual bonds since there are currently limitations on banks’ ability to issue and purchase these bonds as elaborated in Box I-1 on pages 12-13. In short, it is not clear if perpetual bond issuance and the CBS will be sufficient to undertake full recapitalization of the banking system and allow banks to accelerate their balance sheet expansion to finance an economic recovery. Bottom Line: In their current form and shape, perpetual bonds and the CBS program are unlikely to be a game-changer for the banking system in China. However, if the authorities eliminate limitations and change regulatory norms, the scheme could potentially be used to recapitalize China’s banking system. This is why this scheme can presently be viewed as a bazooka that has not yet been loaded by the government. Does CBS Represent QE? Its Impact On Liquidity And Money Supply The CBS program is a form of quantitative easing (QE). It will expand the PBoC’s balance sheet and banking system liquidity (excess reserves at the central bank), as elaborated in Box I-1 and Diagram I-1 on pages 12-14. If pursued on a large scale, this scheme would constitute monetization of banks’ capital and their bad assets by the central bank. The mechanism is already in place, but the extent to which authorities will use it to recapitalize banks remains unclear. Even though the CBS program will expand banking system liquidity – i.e., excess reserves at the central bank – it will not – however - affect broad money supply. The basis is simple: Banks’ excess reserves at the central bank are not part of the broad money supply in any country. Banks use excess reserves to settle payments between one another and with the central bank. Banks do not lend out excess reserves. Further, only a central bank can create excess reserves, and it does so “out of thin air.” In brief, excess reserves rather than corporate and individual deposits constitute genuine banking system liquidity. Barring lending to or buying assets from non-banks – which does not typically occur outside of QE programs – central banks do not create broad money or deposits.1 Money/deposits, the ultimate purchasing power for economic agents, is created by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings.2 Having adequate capital and liquidity as well as positive risk appetite, banks can expand their balance sheets, i.e., originate loans and buy various securities. When banks make loans or purchase assets from non-banks, they simultaneously create deposits and new purchasing power. Chart I-3 demonstrates that in recent years, excess reserves in China’s banking system have been flat, yet banks’ assets and the supply of money has expanded tremendously. The opposite can also occur: Banks’ excess reserves can mushroom, but banks may actually be reluctant to grow their balance sheets. This was the case after the Lehman crisis with U.S. banks and in the wake of the European debt crisis with euro area banks. Chart I-3China: Excess Reserves And Broad Money Finally, we have elaborated at great length in our past reports that China’s money and credit excesses do not stem from its high household savings rate. Rather, like any credit bubble in any country, China’s leverage is due to the creation of credit/money “out of thin air.”2 Bottom Line: Perpetual bond issuance and the CBS program will expand the banking system’s excess reserves, but not broad money supply. Besides, it is not certain that excess reserves will accelerate loan growth. Credit origination by banks depends on many other factors such as banks’ willingness to expand their risk assets, loan demand and the regulatory regime and norms. Deleveraging Has Not Yet Started One cannot discuss the potential for a monetary bazooka in China without an update on the status of deleveraging. The fact is that deleveraging in China has not even begun: Credit is still expanding faster than nominal GDP growth. The most common way to measure leverage/debt is to compare it with the cash flow that is used to service debt. Nominal GDP is a measure of cash flow in an economy from a macro perspective. The debt-to-asset ratio is a poor measure of leverage because asset valuations are often subjective: Assets are valued by debtors themselves. Besides, apart from distressed credit investors, one does not want to be a creditor to a country or company that has to sell assets to service its debt. Stock and bond prices of debtor countries or companies tailspin when the latter have to sell assets to service debt. The top panel of Chart I-4 illustrates that China’s enterprise and household domestic credit/debt is still expanding at an annual rate of close to 10% at a time when nominal GDP growth has slowed to 8%. Chart I-4China: Deleveraging Has Not Even Begun Consistently, the debt to GDP ratio has not declined at all (Chart I-4, bottom panel). In this context, a rhetorical question is in order: Should China ramp up money/credit growth and monetize banks’ NPLs, given that deleveraging has yet to take place? Economic Ramifications Of Deploying The Bazooka What would be the economic ramifications if the Chinese authorities once again promote and allow unrelenting money/credit expansion “out of thin air” to bail out zombie banks and companies? Cyclically: If the authorities compel banks to acknowledge NPLs and write them off as and when the PBoC finances their recapitalization, banks may not be in a position to accelerate loan growth. This scenario entails that credit growth and hence cyclical sectors in China would remain weak for a while. In contrast, if the authorities pursue recapitalization of banks without forcing them to acknowledge and write off bad assets, banks would regain their power to expand their balance sheets, fostering a cyclical economic recovery. Structurally (in the long term): The growth model based on continuous “out of thin air” money and credit expansion inevitably breeds economic inefficiencies, falling productivity growth and rising inflation. In short, the economic outcome over the course of several years would be stagflation. Chart I-5 illustrates that China’s ICOR (incremental capital-to-output ratio) is rising, or inversely that the output-to-capital ratio is falling. This entails worsening economic efficiency and slowing productivity growth. Chart I-5Symptoms Of Rising Inefficiencies Chart I-6 shows a potential stylized roadmap for the Chinese economy in the years ahead if the credit and money bubbles are inflated further without corporate restructuring, bankruptcies, the imposition of hard budget constraints and meaningfully improved capital/credit allocation. The red line represents potential GDP growth, and the dotted red line is our projection. In any economy, the potential growth rate is equal to the sum of growth rates of the labor force and productivity. China’s labor force is no longer expanding and will begin shrinking in the coming years (Chart I-7). Hence, going forward, the sole source of potential GDP growth in China will be productivity growth. Productivity growth has been slowing and will continue to do so if structural market-oriented reforms are not implemented (Chart I-8, top panel). Besides, the industrialization ratio has already risen a lot (Chart I-8, bottom panel). Chart I-7China: No Tailwind From Labor Force Chart I-8China: Productivity Is Slowing With the potential GDP growth rate in China declining, future fiscal and credit stimulus may lead to higher nominal – but not real – growth. The latter will be constrained by a slowing rate of potential real GDP growth. Higher nominal but weaker potential (real) growth entails rising inflation. The combination of higher inflation along with the need to maintain very low nominal interest rates to assist debtors is bearish for the currency. In such a scenario, there will be intensifying depreciation pressure on the yuan from the tremendous overhang of RMBs in the banking system (Chart I-9). The PBoC’s foreign exchange reserves of $3 trillion will not be sufficient to backstop the enormous amount of RMB (money) supply of RMB 210 trillion – which is equivalent to US$30 trillion (Chart I-10). Chart I-9Helicopter Money In China Chart I-10PBoC FX Reserves Are Equal To 10% Of Broad Money Supply If broad money supply continues to expand at an annual rate of close to 9-10% or above, downward pressure on the yuan will escalate immensely, and the Chinese authorities will have no choice but to close the capital account completely and also heavily regulate current account transactions. Bottom Line: If the authorities do not restrain the PBoC’s financing of perpetual bond issuance via the CBS and in the interim do not force banks to write off bad assets, the upshot will be the monetization of banks’ bad assets by the PBoC. This will constitute the ultimate socialist put for banks and zombie debtors, as well as for the entire economy. Business cycle swings, bankruptcies and deflation are inherent features of a market-driven/capitalist economy. A socialist put via promoting unlimited money and credit creation entails long-term stagflation – lower productivity growth and rising inflation. This is very bearish for the currency. Investment Conclusions To be sure, the above analysis suggests that the bazooka has not been loaded and the Chinese economy is not about to stage an imminent recovery. BCA’s Emerging Markets Strategy team maintains its bearish stance on China-related plays worldwide. We are closely monitoring China’s money and credit aggregates as well as indicators from the real economy to gauge when China’s business cycle will revive. So far, these indicators continue to point south. EM risk assets and currencies have recently been boosted by the Federal Reserve’s dovish turn. But as we argued in last week’s report, this will prove short-lived. Global trade, China’s growth and commodities prices are the key drivers of EM financial markets, not the Fed. Provided our negative outlook for these three factors due to the ongoing slowdown in China, we continue to recommend a negative stance on EM in absolute terms, and underweighting EM stocks and credit versus their U.S. peers. The dollar’s weakness stemming from the downshift in U.S. interest rate expectations is running out of steam. Chart I-11 shows that the broad trade-weighted dollar is trying to find support at its 200-day moving average. Conversely, the EM stocks index and copper prices are struggling to break above their 200-day moving averages (Chart I-11, middle and bottom panels). Chart I-11Dollar And EM / Commodities: Mirror Images We believe the dollar is poised for a breakout, and EM and copper are due for a breakdown. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Box 1 Issuance Of Perpetual Bonds And CBS Program The authorities are promoting the issuance of perpetual bonds and the CBS program as a scheme for the country’s big-four banks to raise capital to meet BIS ’s Total Loss-absorbing Capacity (TLAC) requirements for globally systemically important banks. Limitations and other details on the perpetual bonds issuance and CBS program: 24 out of 30 banks listed on the A-share market are presently qualified to issue perpetual bonds as their assets exceed RMB 200 billion, a threshold established by the PBoC. Perpetual bonds will boost the Tier-1 capital of issuing banks. Banks are allowed to purchase perpetual bonds issued by other banks in amounts up to 10% of their core Tier-1 capital. Only primary dealers (46 banks and 2 brokers) can exchange qualified perpetual bonds they hold for PBoC bills, with a maximum exchange period of three years. The incentive for banks to purchase perpetual bonds will for now be low because these bonds consume large amounts of capital. The risk weights for these perpetual bonds ranges between 150-250%. How Does It Work? As Diagram I-1 on page 14 illustrates, when Bank B purchases perpetual bonds from Bank A, the former transfers excess reserves to the latter. The amount of outstanding deposits, i.e., money supply, is not affected at all. Hence, there is no direct impact on the broad money supply. Banks do not require deposits to make loans and buy securities. Banks need excess reserves at the central bank to pay for or settle payments with other banks. When Bank B transfers excess reserves to Bank A, the aggregate amount of excess reserves in the banking system does not change. Bank B can swap these perpetual bonds with central bank bills, and then pledge these bills at the PBoC to get excess reserves. As it does so, Bank B will replenish its excess reserves. Consequently, the amount of excess reserves in the banking system will expand, as will the PBoC’s balance sheet. Overall, the issuance of perpetual bonds and CBS swaps lead to both bank recapitalization and banking system liquidity (excess reserves) expansion. Why has the PBoC decided to fund the issuance of perpetual bonds? Without PBoC funding, demand for perpetual bonds might be very low, and yields on them could spike. Higher yields could lure away capital from other corporate bonds, producing higher borrowing costs in credit markets. On the positive side, the monetary authorities will not only recapitalize a number of large banks but will also do so by capping borrowing costs in the credit markets and injecting more liquidity into the banking system. On the negative side, yields of these perpetual bonds will not be determined by the market. Rather they will be artificially suppressed by potential open-ended PBoC funding. This will preserve China’s inefficient credit allocation system and misallocation of capital in general. In a market economy, the authorities will typically force banks to raise capital in securities markets or privately. More issuance, especially when it comes from many banks simultaneously, typically pushes down the prices of bank stocks and bonds. The basis is securities issuance often dilutes existing shareholders and is also negative for bondholders. This threat of dilution and losing money incentivizes existing shareholders and bondholders of a bank to impose discipline on the bank’s management. Consequently, banks would be better run and capital allocation would be more efficient than it would otherwise be in a system where such oversight and incentives are absent. In brief, the market mechanism deters banks from risky and speculative behavior and contributes to the long-term health of the banking system, as well as the efficiency of capital allocation in the real economy. By allowing banks to purchase each other’s bonds, and with the PBoC financing it, China is not imposing the much-needed market discipline on bank shareholders, bondholders and by extension, bank management. This does not promote efficient capital allocation and higher productivity growth in the long run. Footnotes 1      Money supply is the sum of all deposits in the banking system. Hence, we use terms money and deposits interchangeably. 2      Please see the Emerging Markets Strategy Special Report “Misconceptions About China's Credit Excesses”, dated October 26, 2016, Special Report “China's Money Creation Redux And The RMB?”, dated November 23, 2016, Special Report “Do Credit Bubbles Originate From HIgh National Savings?”, dated January 18, 2017, Special Report “The True Meaning Of China's Great 'Savings Wall'”, dated December 20, 2017 Special Report “Is Investment Constrained By Savings? Tales Of China and Brazil”, dated March 22, 2018, available at www.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Stay tactically overweight to equities for the time being. Close the overweight to industrial commodities versus equities. The financials, basic resources, and industrials equity sectors can continue to outperform for a few months longer. EM can also continue to outperform DM for a few months longer. Overweight Germany’s DAX versus German bunds. The second half of the year is going to be much tougher than the first half. Feature Chart of the WeekPessimism Was Overdone: The Classical Cyclicals And EM Are Rebounding Locked In An Intimate Embrace Last week, we highlighted a frustrating truth: for the past 16 months the broad equity market has been on a journey to nowhere. Yet the journey has been far from boring. There have been exciting detours of 10-15 percent in both directions, albeit these moves have been short-lived, lasting no more than three months at a time. The same truth applies to the broad bond market: for the past sixteen months the global long bond yield – defined here as the average of the yields on the 30-year German bund yield and 30-year T-bond – has also ended up going nowhere. On this journey too, there have been exciting detours of up to 50 basis points in both directions, but these moves have also lasted no more than three months before retracing. It follows that for the past 16 months, the strategic allocation to equities, bonds and cash has had zero impact on investment performance, but the tactical allocation to the asset classes has had a huge impact. Yet here’s the thing: the sharp tactical moves in the bond market and in the stock market have been intimately embraced. When the global long bond yield has approached the top of its range, it has catalysed a sharp sell-off in equities; and when the bond yield has approached the bottom of its range, it has catalysed a sharp rally in equities (Chart I-2). In fact, over the past 16 months, asset allocation has boiled down to a very simple trading rule based on the global long bond yield: above 2.2 percent, sell equities; below 1.95 percent, buy equities. Today, the yield stands at 1.85 percent, suggesting a tactically overweight stance to equities. Chart I-2The Sharp Tactical Moves In The Bond Market And Stock Market Are Intimately Connected The Persistent Trends Are In Sectors Some investors cannot shift their portfolios quickly enough to exploit the tactical opportunities in the markets. They need trends that persist for at least six months to a year. The good news is that these more persistent trends do exist, but to find them you have to look at equity sectors, and specifically the classically cyclical sectors (Chart of the Week). The financials and basic resources sectors were in strong relative downtrends through most of 2018; but for the last four months these classically cyclical sectors have flipped into very clear uptrends (Chart I-3 and Chart I-4). The same is true for industrials, albeit the end of the downtrend has happened more recently (Chart I-5). Chart I-3Financials Are Rebounding Chart I-4Basic Resources Are Rebounding Chart I-5Industrials Are Rebounding For the avoidance of doubt, technology is not a classically cyclical sector because the sales of technology products – particularly to consumers – are relatively insensitive to short-term fluctuations in the economy. In fact, the relative performance of technology is an almost perfect mirror-image of financials (Chart I-6). Chart I-6The Technology Sector Is Not A Classical Cyclical Neither is the chemicals sector a classical cyclical. Given that raw material prices are an input cost for chemical manufacturers, the chemicals sector can underperform when raw material prices are rising in a cyclical up-oscillation (Chart I-7). It follows that the three true classically cyclical sectors are: financials, basic resources and industrials. Chart I-7The Chemicals Sector Is Not A Classical Cyclical What if your investment process does not allow you to invest in sectors and benefit from their well-defined and longer trends? The good news is that you can play these same trends through regional and country stock market indexes. We refer readers to previous reports for the details, but the crucial message is that regional and country relative performances stem from nothing more than the stock markets’ defining sector skews combined with sector relative performances.1 This revelation of what truly drives regional and country relative performance is bittersweet. It is sweet because it simplifies an investment process that can be very complicated. But it is also bitter because it highlights that the investment industry is still replete with unnecessary layers of complexity. Still, just to drive home the point, we would like the charts to do the talking. The relative performance of financials, the relative performance of Italy’s MIB, and the relative performance of Emerging Markets (EM) versus Developed Markets (DM) are all effectively one and the same story (Chart I-8 and Chart I-9). Chart I-8One And The Same Story: Financials And Italy... Chart I-9...And Financials And EM Versus DM What Are The Markets Telling Us, And Do We Agree? Another very common question we get is: what is our forecast for economic growth and profits growth? For example, two questions on everyone’s lips right now are: can Germany avoid a technical recession, and what is our forecast for Germany’s growth from here? These are indeed important questions, but for investors they are not the most important questions. Financial markets are a discounting mechanism. So for investors, the most important question should always be: what is discounted in the current market price, and is that too optimistic or too pessimistic? Over-optimism and over-pessimism on the economy are especially important for the classically cyclical sectors because their profits have a very high operational gearing to their sales: a small change in the sales outcome has a huge impact on the profit outcome and, therefore, the price.  If the price is discounting a booming economy and what actually transpires is that the economy grows modestly, then a seemingly benign outcome of respectable growth will paradoxically cause the price to slump. Conversely, if the price is discounting a very pessimistic outcome and what actually transpires is anything better than the ultra-pessimism, then even a bad outcome will paradoxically cause the price to soar. In this regard, the recent underperformance of Germany’s DAX versus German bunds is at an extreme not far from that during the euro sovereign debt crisis in 2011-12 (Chart I-10). So the important question for investors is: will the actual economic outcome transpire to be as extreme as that? Our answer is that the extreme underperformance of the DAX versus bunds is discounting an overly pessimistic outcome, and on that basis the correct stance is to be overweight the DAX versus bunds.   Chart I-10Overly Pessimistic: The DAX Versus Bunds Turning to the classical cyclicals, these sectors have rebounded because their embedded assumptions for growth reached peak pessimism in October. Since then, the pessimism has abated at the margin because of improving short-term impulses from Chinese stimulus, lower global bond yields, and sharply lower energy prices. Given that positive (and negative) impulse phases reliably tend to last for six to eight months, our expectation is that this tailwind for the classical cyclical sectors – financials, basic resources, and industrials – can continue for a few months longer. Which means that the outperformance of EM versus DM can also continue for a few months longer. In terms of asset allocation, long industrial commodities versus equities worked very powerfully at the end of last year, but the relative merits of the two asset classes are now more evenly balanced. Hence, we are now closing this position in profit. Finally, our major concern is for later in the year when the aforementioned improving short-term impulses will inevitably fade, and even potentially reverse. Bear in mind that the impulses arise from the short-term changes in credit flows, bond yields, and the oil price. It follows that to recreate these positive impulses for later in the year, bond yields and/or the oil price have to keep falling. This is not our base case, so enjoy the positive impulses while they last! As the year progresses the investment environment is going to get much tougher. Fractal Trading System* The sharp underperformance of the Nikkei 225 versus the Hang Seng is at the limit of tight liquidity that has signaled all of the recent trend reversals in this relative position. Accordingly, this week’s recommended trade is to go long the Nikkei 225 versus the Hang Seng. Set a profit target of 4.5 percent with a symmetrical stop-loss. We now have seven open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 Please see the European Investment Strategy Weekly Report “Oil, Banks, And Bonds: The Oddities Of 2018”, dated November 29, 2018 available at eis.bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations