Global

Highlights The liquidity-driven rally will soon be followed by an acceleration in global growth. The economic recovery will bump up expectations of long-term profit growth. The dollar has downside, but the euro will not benefit much. Overweight stocks relative to bonds and bet on traditional cyclical sectors and commodities. The potential for outperformance of value relative to growth favors European equities. The probability of a tech mania is escalating: how should investors factor an expanding bubble into their portfolios? Feature Chart I-1A Bull Market In Stocks And Volatility? Despite all odds, the nCoV-2019 outbreak is barely denting the S&P 500’s frenetic rally. Plentiful liquidity, thawing Sino-US trade relations and improving economic activity in Asia, all have created ideal conditions for risk assets to appreciate on a cyclical basis. Stocks may look increasingly expensive and are primed to correct, but the bubble will expand further. After lifting asset valuations, monetary policy easing will soon boost worldwide economic activity. Consequently, earnings in the US and Europe will improve. As long as central bankers remain unconcerned about inflation, investors will bid up stocks. Investors should remember we are in the final innings of a bull market. Stocks can deliver outsized returns during this period, but often at the cost of elevated volatility, and the options market is not pricing in this uncertainty (Chart I-1). Moreover, timing the ultimate end of the bubble is extremely difficult. Hence, we prefer to look for assets that can still benefit from easy monetary conditions and rebounding growth, but are not as expensive as equities. Industrial commodities fit that description, especially after their recent selloff. The dollar remains a crucial asset to gauge the path of least resistance for assets. If it refuses to swoon, then it will indicate that global growth is in a weaker state than we foresaw. The good news is that the broad trade-weighted dollar seems to have peaked. Accommodative Monetary Conditions Are Here To Stay Easy liquidity has been the lifeblood of the S&P 500’s rally. The surge in the index coincided with the lagged impact of the rise in our US Financial Liquidity Index (Chart I-2). Low rates have allowed stocks to climb higher, yet earnings expectations remain muted. For example, since November 26, 2018, the forward P/E ratio for the S&P 500 has increased from 15.2 to 18.7, while 10-year Treasury yields have collapsed from 3.1% to 1.6%. Meanwhile, expectations for long-term earnings annual growth extracted from equity multiples using a discounted cash flow model have dropped from 2.4% to 1.2%. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Yet, stocks and risk assets normally continue to climb when the economy recovers. Even without any additional monetary easing, as long as policy remains accommodative, risk assets will generate positive returns. Expectations for stronger cash flow growth become the force driving asset prices higher. Policy will likely remain accommodative around the world. Within this framework, peak monetary easing is probably behind us, even though liquidity conditions remain extremely accommodative. Nominal interest rates remain very low, and real bond yields are still falling. Unlike in 2018 and 2019, dropping TIPs yields reflect rising inflation expectations (Chart I-3). Those factors together indicate that policy is reflationary, which is confirmed by the gold rally. Chart I-2A Liquidity Driven Rally Chart I-3Today, Lower TIPS Yields Are Reflationary   Chart I-4Economic Activity To Respond To Liquidity Based on the historical lags between monetary easing and manufacturing activity, the global industrial sector is set to mend (Chart I-4). Moreover, the liquidity-driven surge in stock prices, combined with low yields and compressed credit spreads, has eased financial conditions, which creates the catalyst for an industrial recovery. Where will the growth come from? First, worldwide inventory levels have collapsed after making negative contributions to growth since mid-2018 (Chart I-5). Thus, there is room for an inventory restocking. Secondly, auto sales in Europe and China have rebounded to 18.5% from -23% and to -0.1% from -16.4%, respectively. Thirdly, China’s credit and fiscal impulse has improved. The uptick in Chinese iron ore imports indicates that the pass-through from domestic reflation to global economic activity will materialize soon (Chart I-6). Finally, following the Phase One Sino-US trade deal, global business confidence is bottoming, as exemplified by Belgium’s business confidence, Switzerland KOF LEI, Korea's manufacturing business survey, or US CFO and CEO confidence measures. The increase in EM earnings revisions shows that US capex intentions should soon re-accelerate, which bodes well for investment both in the US and globally (Chart I-7). Chart I-5Room For Inventory Restocking Chart I-6China Points To Stronger Global Growth   Construction activity, a gauge of the monetary stance, is looking up across the advanced economies. In the US, housing starts – a leading indicator of domestic demand – have hit a 13-year high. A pullback in this volatile data series is likely, but it should be limited. Vacancies remain at a paltry 1.4%, household formation is solid and affordability is not demanding (Chart I-8). In Europe, construction activity has been relatively stable through the economic slowdown. Even in Canada and Australia, housing transactions have gathered steam quickly following declines in mortgage rates (Chart I-9). Chart I-7Capex Is Set To Recover Chart I-8US Housing Is Robust Chart I-9Even The Canadian And Australian Housing Markets Are Stabilizing Consumers will remain a source of strength for the global economy. The dichotomy between weak manufacturing PMIs and the stable service sector reflects a healthy consumer spending. December retail sales in Europe and the US corroborate this assessment. The stabilization in US business confidence suggests that household incomes are not in as much jeopardy as three months ago. As household net worth and credit growth improve further, a stable outlook for household income will underwrite greater gains in consumption. Policy will likely remain accommodative around the world. For the time being, US inflationary pressures are muted. The New York Fed’s Underlying Inflation Gauge has rolled over, hourly earnings growth has moved back below 3%, our pipeline inflation indicator derived from the ISM is weak, and core producer prices are flagging (Chart I-10). This trend is not US-specific. In the OECD, core consumer price inflation is set to decelerate due to the lagged impact of the manufacturing slowdown. Central banks are also constrained to remain dovish by their own rhetoric. The Fed's statement this week was a testament to this reality. Central banks are increasingly looking to set symmetrical inflation targets. After a decade of missing their targets, a symmetric target would imply keeping policy easier for longer, even if realized inflation moves back above 2%. A rebound in global growth and weak inflation should create a poisonous environment for the US dollar. Finally, fiscal policy will make a small positive contribution to growth in most major advanced economies in 2020, particularly in Germany and the UK (Table I-1). Chart I-10Limited Inflation Will Allow The Fed To Remain Easy Table I-1Modest Fiscal Easing In 2020   The Dollar And The Sino-US Phase One Deal At first glance, a rebound in global growth and weak inflation should create a poisonous environment for the US dollar (Chart I-11). As we have often argued, the dollar’s defining characteristic is its pronounced counter-cyclicality. Chart I-11A Painful Backdrop For The Greenback Deteriorating dollar fundamentals make this risk particularly relevant. US interest rates are well above those in the rest of the G10, but the gap in short rates has significantly narrowed. Historically, the direction of rates differentials and not their levels has determined the trend in the USD (Chart I-12). Moreover, real differentials at the long end of the curve support the notion that the maximum tailwinds for the dollar are behind us (Chart I-12, bottom panel). Furthermore, now that the US Treasury has replenished its accounts at the Federal Reserve, the Fed’s addition of excess reserves in the system will likely become increasingly negative for the dollar, especially against EM currencies. Likewise, relative money supply trends between the US, Europe, Japan and China already predict a decline in the dollar (Chart I-13). Chart I-12Interest Rate Differentials Do Not Favor The Dollar... Chart I-13...Neither Do Money Supply Trends   Chart I-14The Phase One Deal Is Ambitious The recent Sino-US trade agreement obscures what appears to be a straightforward picture. According to the Phase One deal signed mid-January, China will increase its US imports by $200 billion in the next two years vis-à-vis the high-water mark of $186 billion reached in 2017. This is an extremely ambitious goal (Chart I-14). Politically, it is positive that China has committed to buy manufactured goods and services in addition to commodities. However, the scale of the increase in imports of US manufactured goods is large, at $77 billion. China cannot fulfill this obligation if domestic growth merely stabilizes or picks up just a little, especially now that the domestic economy is in the midst of a spreading illness. It will have to substitute some of its European and Japanese imports with US goods. A consequence of this trade deal is that the euro’s gains will probably lag those recorded in normal business cycle upswings. Historically, European growth outperforms the US when China’s monetary conditions are easing and its marginal propensity to consume is rising (Chart I-15). However, given the potential for China to substitute European goods in favor of US ones, China’s economic reacceleration probably will not benefit Europe as much as it normally does. China may not ultimately follow through with as big of US purchases as it has promised, but it is likely, at least initially, to show good faith in the agreement. The euro’s gains will probably lag those recorded in normal business cycle upswings. While the trade agreement is a headwind for the euro, it is a positive for the Chinese yuan. The US output gap stands at 0.1% of potential GDP and the US labor market is near full employment. The US industrial sector does not possess the required spare capacity to fulfill additional Chinese demand. To equilibrate the market for US goods, prices will have to adjust to become more favorable for Chinese purchasers. The simplest mechanism to achieve this outcome is for the RMB to appreciate. Meanwhile, the euro is trading 16% below its equilibrium, which will allow European producers to fulfill US domestic demand. A widening US trade deficit with Europe would undo improvements in the trade balance with China. The probability that US equities correct further in the short-term is elevated. The implication for the dollar is that the broad trade-weighted USD will likely outperform the Dollar Index (DXY). The euro represents 18.9% of the broad trade-weighted dollar versus 57.6% of the DXY. Asian currencies, EM currencies at large, the AUD and the NZD, all should benefit from their close correlation with the RMB (Chart I-16). Chart I-15Europe Normally Wins When China Recovers Chart I-16EM, Asian, And Antipodean Exchange Rates Love A Strong RMB   Obviously, before the RMB and the assets linked to it can appreciate further, the panic surrounding the coronavirus will have to dissipate. However, the economic damage created by SARS was short lived. This respiratory syndrome resulted in a 2.4% contraction Hong-Kong’s GDP in the second quarter of 2003. The economy of Hong Kong recovered that loss quickly afterward. Investment Forecasts BCA continues to forecast upside in safe-haven yields. Global interest rates remain well below equilibrium and a global economic recovery bodes poorly for bond prices (Chart I-17). However, inflation expectations and not real yields will drive nominal yield changes. The dovish slant of global central banks and the growing likelihood that symmetric inflation targets will become the norm is creating long-term upside risks for inflation. Moreover, if symmetric inflation targets imply lower real short rates in the future, then they also imply lower real long rates today. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Easy monetary conditions, decreased real rates and an improvement in economic activity are also consistent with an outperformance of assets with higher yields. High-yield bonds, which offer attractive breakeven spreads, will benefit from this backdrop (Chart I-18). Furthermore, carry trades will likely continue to perform well. In addition to low interest rates across most of the G10, the low currency volatility caused by an extended period of easy policy will continue to encourage carry-seeking strategies. Chart I-17Bonds Are Still Expensive Chart I-18Where Is The Value In Credit?   An environment in which growth is accelerating and monetary policy is accommodative argues in favor of stocks. Our profit growth model for the S&P 500 has finally moved back into positive territory. As earnings improve, investors will likely re-rate depressed long-term growth expectations for cash flows (Chart I-19). The flip side is that equity risk premia are elevated, especially outside the US (Chart I-19). Hence, as long as accelerating growth (but not tighter policy) drives up yields, equities should withstand rising borrowing costs. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. The 400 point surge in the S&P 500 since early October complicates the picture. The probability that US equities correct further in the short-term is elevated, based on their short-term momentum and sentiment measures, such as the put/call ratio (Chart I-20). Foreign equities will continue to correct along US ones, even if they are cheaper. Chart I-19Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Chart I-20Tactical Risks For Stocks   Chart I-21Buy Commodities/Sell Stocks? The coronavirus panic seems to be the catalyst for such a correction. When a market is overextended, any shock can cause a pullback in prices. Moreover, as of writing, medical professionals still have to ascertain the virus’s severity and potential mutations. Therefore, risk assets must embed a significant risk premium for such uncertainty, even if ultimately the infection turns out to be mild. However, that risk premium will likely prove to be short lived. During the SARS crisis in 2003, stocks bottomed when the number of reported new cases peaked. The tech sector has plentiful downside if the correction gathers strength. As indicated in BCA’s US Equity Sector Strategy, Apple, Microsoft, Google, Amazon and Facebook account for 18% of the US market capitalization, which is the highest market concentration since the late 1990s tech bubble. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Commodity prices are trading at a large discount to US equities. Moreover, the momentum of natural resource prices relative to stocks has begun to form a positive divergence with the price ratio of these two assets (Chart I-21). Technical divergences such as the one visible in the ratio of commodities to equities are often positive signals. Low real rates, an ample liquidity backdrop, a global economic recovery, a weak broad trade-weighted dollar and a strong RMB, all benefit commodities over equities. Tech stocks underperform commodities when the dollar weakens and growth strengthens. Moreover, our positive stance on the RMB justifies stronger prices for copper, oil and EM equities (Chart I-22). Chart I-22The Winners From A CNY Rebound Our US Equity Strategy Service has also reiterated its preference for industrials and energy stocks, and it recently upgraded materials stocks to neutral.1 All three sectors trade at significant valuation discounts to the broad market and to tech stocks in particular. They are also oversold in relative terms. Finally, their operating metrics are improving, a trend which will be magnified if global growth re-accelerates. Do not make these bets aggressively. A weakening broad trade-weighted dollar would allow for a rotation into foreign equities and an outperformance of value relative to growth stocks. The share of US equities in the MSCI All-Country World Index is a direct function of the broad trade-weighted dollar (Chart I-23). Moreover, since 1971, the dollar and the relative performance of growth stocks versus value stocks have exhibited a positive correlation (Chart I-24). Thus, the dollar’s recent strength has been a key component behind the run enjoyed by tech stocks. Chart I-23Global Stocks Love A Soft Dollar Chart I-24Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Despite the risks to the euro discussed in the previous section, European equities could still outperform US equities. Such a move would be consistent with value stocks beating growth equities (Chart I-24, bottom panel). This correlation exists because the euro area has a combined 17.7% weighting to tech and healthcare stocks compared with a 37.1% allocation in US benchmarks. Moreover, a cheap euro should allow European industrials and materials to outperform their US counterparts. Finally, the recent uptick in the European credit impulse indicates that an acceleration in European profit growth is imminent, a view that is in line with our preference for European financials (Chart I-25).2 Chart I-25Euro Area Profits Should Improve Bottom Line: The current environment remains favorable for risk assets on a 12-month investment horizon. As such, we expect stocks and bond yields to continue to rise in 2020. Moreover, a pick-up in global growth, along with a fall in the broad trade-weighted dollar, should weigh on tech and growth stocks, and boost the attractiveness of commodity plays, industrial, energy and materials stocks, as well as European and EM equities. Forecast Meets Strategy Liquidity-driven rallies, such as the current one, can carry on regardless of the fundamentals. As Keynes noted 90 years ago: “Markets can remain irrational longer than you can stay solvent.” The gap between forecast and strategy can be great. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. We assign a substantial 30% probability to the risk of another tech mania. Outflows from equity ETFs and mutual funds have been large. Investors will be tempted to move back into those vehicles if stocks continue to rally on the back of plentiful liquidity and improving global growth (Chart I-26). In the process, the new inflows will prop up the over-represented, over-valued, and over-extended tech behemoths. Chart I-26Depressed Equity Flows Should Pick Up The current tech bubble can easily run a lot further. Based on current valuations, the NASDAQ trades at a P/E ratio of 31 compared with 68 in March 2000 (Chart I-27). Moreover, momentum is becoming increasingly favorable for the NASDAQ and other high-flying tech stocks. The NASDAQ is outperforming high-dividend stocks and after a period of consolidation, its relative performance is breaking out. Momentum often performs very well in liquidity-driven rallies. Chart I-27Where Is The Bubble? Chart I-28Debt Loads Are Already High Everywhere A full-fledged tech mania would make our overweight equities / underweight bonds a profitable call, but it would invalidate our sector and regional recommendations. Moreover, with a few exceptions in China and Taiwan, the major tech bellwethers are listed in the US. A tech bubble would most likely push our bearish dollar stance to the offside. Bubbles are dangerous: participating on the upside is easy, but cashing out is not. Moreover, financial bubbles tend to exacerbate the economic pain that follows the bust. During manic phases, capital is poorly invested and the economy becomes geared to the sectors that benefit from the financial excesses. These assets lose their value when the bubble deflates. Moreover, bubbles often result in growing private-sector indebtedness. Writing off or paying back this debt saps the economy’s vitality. Making matters worse, today overall indebtedness is unprecedented and central banks have little room to reflate the global economy once the bubble bursts (Chart I-28). Finally, US/Iran tensions will create additional risk in the years ahead. Matt Gertken, BCA’s Geopolitical Strategist, warns that the ratcheting down of tensions following Iran’s retaliation to General Soleimani’s assassination is temporary.3 As a result, the oil market remains a source of left-handed tail-risk. Section II discusses other potential black swans lurking in the geopolitical sphere. We continue to recommend that investors overweight industrials and energy, upgrade materials to neutral, Europe to overweight, and curtail their USD exposure as long as US inflation remains well behaved and the US inflation breakeven rate stays below the 2.3% to 2.5% range. However, do not make these bets aggressively. Moreover, some downside protection is merited. Due to our very negative view on bonds, we prefer garnering these hedges via a 15% allocation to gold and the yen. The yen is especially attractive because it is one of the few cheap, safe-haven plays (Chart I-29). Chart I-29The Yen Offers Cheap Portfolio Protection Mathieu Savary Vice President The Bank Credit Analyst January 30, 2020 Next Report: February 27, 2020   II. Five Black Swans In 2020 Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels Chart II-10Distrust Of China Is Bipartisan   Chart II-11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.3 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… Chart II-13…Popular Support… Chart II-14…And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt Chart II-16Younger And Older Cohorts At Odds Demographically   Chart II-17Massive Turnout To The 2016 Referendum On Trump The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist   III. Indicators And Reference Charts The S&P 500 rally looks increasingly vulnerable from a tactical perspective. The US benchmark is overbought, and the percentage of NYSE stocks above their 30-week and 10-week moving averages is rolling over at elevated levels. Additionally, the number of NYSE new highs minus new lows has moved in a parabolic fashion and has hit levels that in previous years have warned of an imminent correction. The spread of nCoV-2019 is likely to be the catalyst to a pullback that could cause the S&P 500 to retest its October 2019 breakout. An improving outlook for global growth, limited inflationary pressures and global central banks who maintain an accommodative monetary stance bode well for stocks. Therefore, the anticipated equity correction will not morph into a bear market. For now, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator has strengthened. Additionally, our BCA Composite Valuation index suggests that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. Finally, our Speculation Indicator is elevated, but is not so high as to warn of an imminent market top. This somewhat muted level of speculation is congruent with the expectation of low long-term growth rates for profits embedded in equity prices. In contrast to our Revealed Preference Indicator, our Willingness-to-Pay (WTP) is moving in accordance with our constructive cyclical stance for stocks. Indeed, the WTP for the US, Japan and Europe continues to improve. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Meanwhile, net earnings revisions appear to be forming a trough. 10-year Treasury yields remain extremely expensive. Moreover, according to our Composite Technical Indicator, T-Note prices are losing momentum. The fear surrounding the spread of the new coronavirus has cause bonds to rally again, but this is likely to be the last hurrah for the Treasury markets before a major reversal takes hold. The rising risk premia linked to the coronavirus is also helping the dollar right now, but signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and Belgium’s Business Confidence surveys, or the improvement in Asia’s export growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24.5% relative to its purchasing-power parity equilibrium. Additionally, the negative divergence between the dollar and our Composite Momentum Indicator suggests that the dollar is technically vulnerable. In fact, the very modest pick-up in the dollar in response to the severe fears created by the spreading illness in China argues that dollar buying might have become exhausted. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of the coronavirus. However, they have not pulled back below the levels where they traded when they broke out in late 2019. Moreover, the advance/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar.   EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see US Equity Strategy Weekly Report "Three EPS Scenarios," dated January 13, 2020, available at uses.bcaresearch.com; US Equity Strategy Insight Report "Bombed Out Energy," dated January 8, 2020, available at uses.bcaresearch.com; US Equity Strategy Special Report "Industrials: Start Your Engines," dated January 21, 2020, available at uses.bcaresearch.com 2  Please see The Bank Credit Analyst Monthly Report "January 2020," dated December 20, 2019 available at bca.bcaresearch.com; The Bank Credit Analyst Monthly Report "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019 available at bca.bcaresearch.com 3 Please see Geopolitical Strategy "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 4 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Highlights Historically, the stocks with the lowest volatility have outperformed the stocks with the highest volatility, a trend that defies some of the most fundamental theories in finance. The low-volatility factor has outperformed the market in absolute return terms, with a substantial reduction in downside risk, in every major equity market. Compensation structure, benchmarking, analyst bias, and the preference for lottery-like stocks are all plausible explanations for why the low-volatility anomaly persists. Shifting some exposure from bonds to minimum-volatility equities might be an attractive way to keep returns high while remaining hedged against downside risk in a world of low interest rates. Feature Chart 1The Low-Volatility Anomaly Conventional wisdom suggests that achieving the right mix between risk and return requires a tradeoff: Take on too little risk, and returns will be subpar, but take on too much, and a large loss becomes likely. However, the empirical evidence shows that no such tradeoff exists in the equity market: Historically, the return of stocks with the lowest volatility has been better than the return of stocks with the highest volatility (Chart 1, top panel). Even when using a measure of systematic risk such as beta, there appears to be very little relationship between risk and return – a result that emphatically contradicts what is predicted by the CAPM (Chart 1, bottom panel). The success of low risk stocks – a well-documented phenomenon known as the low-volatility anomaly1  – challenges some of the most fundamental premises of finance and economics. After all, how could taking on less risk result in better returns? In this report, we dive into this anomaly, with the intent of answering the following questions: What kind of portfolios can exploit this anomaly? What are the risk/return characteristics to this factor and what sectors is it exposed to? Why does this factor work? How can investors use the low-volatility factor in their asset allocation process? To answer these questions we explore the historical performance of the MSCI minimum-volatility index. Additionally, we explore the academic research surrounding the low-volatility anomaly. Finally, we look into how low-volatility equities have performed as a hedge for a global equity portfolio when compared to government bonds. Low Volatility Vs. Minimum Volatility There are two types of portfolios that are generally used to exploit the low-volatility anomaly: Low-volatility portfolios are built first by sorting the stock universe according to the stocks' trailing standard deviation, and then by buying the stocks with the lowest standard deviation. Usually the index buys the bottom quintile of stocks ranked by volatility. Minimum-volatility portfolios are built through an optimization procedure, by which funds are allocated to the stock mix that would have minimized the historical volatility of a portfolio (subject to certain constraints). Chart 2No Dramatic Difference Between Low Vol And Min Vol The main advantage of minimum-volatility portfolios over low-volatility portfolios is that they do not consider only low-volatility stocks but also stocks with low covariance between each other. However, the construction of these portfolios also requires estimating large covariance matrices, which are prone to a significant degree of noise, and thus often have to be adjusted by statistical methods.2 That being said, there is little performance difference between these two methodologies in practice, though minimum-volatility portfolios do tend to be much more constrained than low-volatility portfolios (Chart 2). In this report we will focus on the more popular MSCI minimum-volatility portfolios, given that their historical data is more readily available.   Risk-Return Characteristics Of Minimum Volatility At the global level, minimum volatility has outperformed not only the market since 1990, but also the most popular equity factors, with the exception of momentum (Chart 3, top panel). The outperformance relative to the benchmark has proved to be robust, as minimum volatility has beaten the returns for the benchmark in the biggest developed markets as well as emerging markets for almost two decades (Chart 3, bottom panel). The most attractive feature of minimum volatility is the significant reduction in risk it provides. Since 1988, the annualized volatility of minimum volatility has been 10%, a considerable improvement vis-à-vis the market and relative to other popular equity factors (Chart 4, top panel). Meanwhile, even though return skew of minimum volatility has been more negative than the benchmark, minimum volatility achieved a substantial reduction in tail risk with a 10% conditional VaR of only 5% (Chart 4, middle and bottom panel). Chart 3Min Vol Outperformance Is Broad-Based Chart 4Min Vol Provides A Substantial Reduction In Risk In addition to its risk reduction, minimum volatility also has a countercyclical relative return profile, outperforming during bear markets, and underperforming slightly during bull markets (Chart 5, top panel). This return profile occurs partly due to the sector skew of this factor, which overweights defensive sectors such as Utilities and Consumer Staples relative to the global benchmark3 (Chart 5, middle panel). At the global level, this defensive tilt exposes minimum volatility to significant duration risk, given that the stocks in this index tend to have bond-like properties (Chart 5, bottom panel). The negative relationship between interest rates and the low-volatility factor has been well documented by the academic literature: Some studies estimate that up to 80% of the outperformance of low-volatility equities can be explained by exposure to duration risk.4 Chart 5Global Min Vol Is Sensitive To Interest Rates Chart 6Min Vol Is Expensive     On average, minimum volatility also tends to overweight stocks with a higher dividend yield than the market (Chart 6, panel 1). This yield difference accounts for roughly a quarter of the return difference between minimum volatility and the benchmark since 1990. However, high dividend yield and minimum volatility are not synonymous: Over the past decade, minimum volatility has selected stocks that are more expensive than the benchmark, a stark difference from high dividend yield portfolios, which exclusively select very cheap stocks (Chart 6, panel 2). The current high overvaluation of minimum volatility relative to the market could spell bad news for this factor in the near future: While valuation and returns do not have a straightforward relationship, extreme levels of valuation relative to the benchmark have historically resulted in subsequent underperformance of this factor relative to the market (Chart 6, panels 3 and 4). Why Does The Low-Volatility Factor Work? Analyst Forecasts It has been shown empirically that equity analysts tend to have an optimistic bias, due to the need of the analyst to maintain good relationships with the companies they cover. Moreover, investors do not adjust for this bias, meaning that the stocks of companies that receive an overly optimistic forecast tend to rise initially when the forecast is released, but then mean-revert once the forecast does not materialize. Chart 7Analyst Bias Is Larger In High-Vol Stocks It seems that this dynamic might be more pervasive in high-volatility stocks. In their paper “When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle,” Hsu et al. show that analysts’ positive bias is larger for more volatile stocks, even when adjusting for confounding variables like size, sector and country5 (Chart 7).  It is easy to see why this might be the case: An extremely optimistic bias on a low variance stock would look unrealistic to most investors. Thus, analysts are more prone to express a large positive bias on high variance stocks, where bias is harder to detect. Ultimately, this bias causes these stocks to become chronically overvalued. Salary Structure of Managers Chart 8Institutions Favor High Vol The payoff structure of fund managers has also been suggested as a possible cause of the low-volatility anomaly.6 The structure of compensation for fund managers often resembles an option: A bonus is granted if the portfolio returns are higher than a certain threshold. In such a structure, the compensation of portfolio managers resembles a call option: The probability of a payoff increases with volatility, creating an incentive to invest in high-volatility stocks.  However, this preference for high-volatility stocks will overbid them, causing them to underperform. There is some evidence that this is in fact the case. Once the effect of size is neutralized, stocks with high institutional ownership tend to be more volatile than stocks with low institutional ownership (Chart 8). Moreover, a study on the exposure of hedge funds to popular risk factors from 2000 to 2016, showed that hedge funds have a large short exposure to the anomaly, indicating that they favor high-volatility over low-volatility stocks.7   Lottery Stocks Chart 9The Low-Volatility Anomaly Is Most Prevalent In Lottery-Like Stocks Not all high-volatility stocks are chronic underperformers. In the paper “The Low Volatility Anomaly and the Preference for Gambling,” Hsu et al. identify that the low-volatility anomaly is largest in stocks with strong lottery-like characteristics (the authors define lottery-like as the stocks that had the highest maximum daily return the previous month)8 (Chart 9). Meanwhile, other high-volatility stocks are much more likely to have higher or equal returns than their low-volatility counterparts. Why is this the case? Investors tend to have a preference for “home-run” stocks, which have a large probability of a small loss, but a small probability of a large gain – a well-documented behavioral bias known as the long-shot bias.9 This bias might cause investors to overbid for lottery-like stocks, causing them to underperform as a cohort. This phenomenon might be related to the incentives in the money management industry. Flows to equity funds tend to be very skewed to the very best performing funds. This means that fund managers have a high incentive to invest in stocks that have the potential of an extremely high payoff. Benchmarking Chart 10Benchmarking Could Be To Blame For The Low-Vol Anomaly While the low-volatility anomaly has been found in other asset classes,10 it is interesting to note that the anomaly occurs only within asset classes and not across asset classes. Indeed, the traditional risk-return relationship is conserved when looking at a multi-asset universe (Chart 10, top panel). One possible solution to this puzzle might be the effect of benchmarking. Within an asset class, benchmarked managers are not only measured according to their return relative to their benchmark but also to their tracking risk (volatility of return difference). Under this structure, investors do not have a large incentive to exploit the alpha from low-volatility or low-beta stocks, since such a strategy would result in a relatively high tracking error.11 This high tracking error will make the excess return of low-volatility stocks relatively less attractive for benchmarked managers, even if these stocks are clearly superior in terms of raw risk-adjusted returns (Chart 10, bottom panel). How Can Minimum Volatility Be Used In Asset Allocation? Chart 11Sensitivity Of Min Vol To Interest Rates Has Increased In The Last Decade The interest rate sensitivity of low-volatility stocks has been a topic of significant interest for academic researchers. A study that attempted to measure this sensitivity found that equities in the lowest volatility decile have an interest-rate exposure equivalent to a 66% equity/34% bond portfolio.12 Moreover, this sensitivity has increased in recent years: Factor analysis shows that while the beta of the excess returns of minimum volatility to the equity market has remained constant, the beta to the bond market has increased significantly over the last decade13 (Chart 11, top panel). Interestingly this process seems to have accelerated as bond yields fell below dividend yields – a result which might arise because the market starts perceiving bonds, and low-volatility equities as close substitutes when they provide a similar cash flow (Chart 11, bottom panel). At first glance, this relatively high duration risk appears to be a red flag, particularly if you share our view that interest rates have reached a multi-year bottom. After all, an environment where interest rates rise would imply that minimum volatility would underperform global equities on a structural basis.  However, the sensitivity of minimum volatility to interest rates can be used to the advantage of an asset allocator. Specifically, in a world of low bond yields, it could be attractive for an investor to shift some of the exposure he or she has from bonds to minimum-volatility equities. Why would an investor do this? As we discussed in our October 2019 report, low bond yields will cause bonds to generate returns that are much lower than their historical averages. This means that using government bonds as a hedge for an equity portfolio is likely to result in a severe drag on performance.14 On the other hand, while minimum-volatility equities do not have the same hedging potency as bonds, their returns are much higher, which suggests that at the right allocation they could prove to be a better hedge. In a world of low bond yields, it could be attractive for an investor to shift some of the exposure he or she has from bonds to minimum-volatility equities. How has such a strategy worked historically? Chart 12 shows how allocating incremental amounts of global minimum-volatility equities to an equity portfolio compares to adding incremental amounts of global government bonds. Overall, allocating an additional 3% of minimum-volatility equities to a portfolio had the same effect as adding 1% of government bonds in terms of downside protection and volatility reduction, but with a much higher return. This effect was robust throughout the sample period. Consider a portfolio with 30% government bonds, 30% minimum volatility and 40% global equities. With the exception of the 1990-1994 period, this portfolio had roughly the same 10% conditional VaR in all sub periods as a portfolio with 40% government bonds and 60% equities, but a significantly higher return (Chart 13). Moreover, the volatility of the portfolio that includes minimum volatility has also been lower than the 60/40 portfolio since 2000. Chart 12Min Vol Provides Protection With A Relatively High Return Chart 13Min-Vol Protection Has Been Robust Bottom Line The low-volatility anomaly contradicts what is perhaps the most fundamental pillar in finance: The tradeoff between risk and return. As such, this anomaly might be the most puzzling inefficiency in markets. But will it persist? The evidence suggests that the anomaly is caused by strong institutional incentives, which are likely to continue. Thus, investors should strongly consider investing in low-volatility stocks in the future. However, the following points should be taken into account: Investors who are evaluated according to their information ratio should avoid low/minimum-volatility stocks, given that their large volatility difference with the benchmark will result in a relatively high tracking error. Relatively high valuations and an uptrend in interest rates may hurt the performance of low/minimum-volatility stocks relative to the broad equity market in the near future. However, the interest-rate exposure of low/minimum-volatility stocks might prove attractive to multi-asset investors. Specifically, investing in minimum-volatility equities and reducing bond exposure might be a way to boost returns while remaining hedged.   Juan Correa Ossa, CFA Senior Analyst juanc@bcaresearch.com   Footnotes 1  The discovery of the low-volatility anomaly predates the discovery of both the size and value anomalies. For more details, please see Michael C. Jensen, Fischer Black, and Myron S. Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” Studies in the Theory Of Capital Markets, Praeger Publishers Inc., 1972. 2 For more details on the construction of minimum-volatility portfolios, please see Tzee-man Chow, Jason C. Hsu,Li-Lan Kuo, and Feifei Li, “A Study of Low Volatility Portfolio Construction Methods,” The Journal of Portfolio Management, Vol. 40, No. 4, 2014. 3 However, research has shown that the low-volatility anomaly still holds within sectors, suggesting that its outperformance is not only a result of sector bias. For more details, please see Raul Leote de Carvalho, Majdouline Zakaria, Lu Xiao, and Pierre Moulin, “Low Risk Anomaly Everywhere - Evidence from Equity Sectors,” (November 19, 2014). 4 Please see Joost Driessen, Ivo Kuiper, Korhan Nazliben, and Robbert Beilo, “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Journal of Banking and Finance, Vol. 103, 2019. 5 Please see Jason C. Hsu, Hideaki Kudoh and Toru Yamada, “When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle,”  Journal Of Investment Management (JOIM), Second Quarter 2013. 6 Please see Nardin L. Baker and Robert A. Haugen, “Low Risk Stocks Outperform within All Observable Markets of the World,” (April 27, 2012). 7 Please see David Blitz, “Are Hedge Funds on the Other Side of the Low-Volatility Trade?”  The Journal of Alternatives Investments, Vol. 21, No. 1, Summer 2018. 8 Please see Jason C. Hsu and Vivek Viswanathan, “The Low Volatility Anomaly and the Preference for Gambling,” Risk-Based and Factor Investing, pages 291-303; (2015). 9 There is some debate as to whether the long-shot bias is truly irrational in financial markets, where payoffs and probabilities are not known with precision. 10 Researchers have found that the low-volatility anomaly exists in the government and corporate bond market. For more details please see, Raul Leote de Carvalho, Patrick Dugnolle, Lu Xiao, and Pierre Moulin, “Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets,” The Journal of Fixed Income, vol. 23, No. 4, Spring 2014. 11 Please see Malcolm Baker, and Brendan Bradley, and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” Financial Analysts Journal, Vol. 67, No. 1, 2011. 12 Please see Joost Driessen, Ivo Kuiper, and Korhan Nazliben, and Robbert Beilo, “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Journal of Banking and Finance, Vol. 103, 2019. 13 We calculate sensitivity for US stocks instead of global stocks due to the effects of currency returns. 14 Please see Global Asset Allocation Strategy Report “Safe Haven Review: A Guide To Portfolio Protection In The 2020s,” dated October 29 2019, available at gaa.bcaresearch.com.

Highlights Global growth is poised to accelerate this year, although the spread of the coronavirus could dampen spending in the very short term. History suggests that the likelihood of a recession rises when unemployment falls to very low levels. Three channels have been proposed to explain why that is: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation, forcing central banks to raise rates. The first channel is highly relevant for some smaller, developed economies where housing bubbles have formed and household debt has reached very high levels. However, it is not an immediate concern in the US, Japan, and most of the euro area. We would downplay the importance of the second channel, as faster wage growth is also likely to raise aggregate demand and incentivize firms to increase capital spending on labor-saving technologies. The third channel poses the greatest long-term risk, but is unlikely to be market-relevant this year. Investors should remain bullish on global equities over the next 12-to-18 months. A more prudent stance will be warranted starting in the second half of 2021. Global Equities: Sticking With Bullish Global equities are vulnerable to a short-term correction after having gained 16% since their August lows. Nevertheless, we continue to maintain a positive outlook on stocks for the next 12 months due to our expectation that global growth will gather steam over the course of the year. The latest data on global manufacturing activity has generally been supportive of our constructive thesis. The New York Fed Manufacturing PMI beat expectations, while the Philly Fed PMI jumped nearly 15 points to the highest level in eight months. The business outlook (six months ahead) component of the Philly Fed index rose to its best level since May 2018. European manufacturing should also improve this year. Growth expectations for Germany in the ZEW index surged in January, rising to the highest level since July 2015 (Chart 1). The Sentix and IFO indices have also moved higher. Encouragingly, euro area car registrations rose by 22% year-over-year in December. In the UK, business confidence in the CBI survey of manufacturers surged from -44 in Q3 of 2019 to +23 in Q4, the largest increase in the 62-year history of the survey. Fiscal stimulus and diminished risk of a disorderly Brexit should also bolster growth this year. Chart 1Some Green Shoots Emerging In The Euro Area Chart 2EM Asia Is Rebounding The manufacturing and trade data in Asia have been improving. Following last week’s better Chinese trade data, Korean exports recovered on a rate-of-change basis for a fourth month in a row. Japanese exports to China increased for the first time since last February. In Taiwan, industrial production increased by more than expected in December, as did export orders. Our EM Asia Economic Diffusion Index has risen to the highest level since October 2018 (Chart 2). Coronavirus: Nothing To Sneeze At? The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. Conceptually, outbreaks can affect the economy in two ways. One, they can reduce demand by curtailing spending on travel, entertainment, restaurants, or anything that requires close proximity to others. Two, they can reduce supply by causing people to avoid going to work. In practice, the first effect usually dominates the second. As a result, such outbreaks tend to have a deflationary impact. The Brookings Institution estimates that the 2003 SARS epidemic shaved about one percentage point from Chinese growth that year.1 The fact that this outbreak is happening during the Chinese New Year celebrations, when over 400 million people will be on the move, has the potential to exacerbate the transmission of the virus, and in the process, amplify the economic damage. That said, while it is from the same class of zoonotic viruses, early indications suggest that this particular strain is less lethal than SARS. In addition, the Chinese authorities have moved faster to address the risks than they did during the SARS outbreak. The government has effectively quarantined Wuhan, a city of 11 million people, where the virus appears to have originated. They have also sequenced the virus and shared the information with the global medical community. This has allowed the US Centers for Disease Control (CDC) to develop a test for the virus, which is likely to become available over the coming weeks. The Dark Side Of Low Unemployment Provided the coronavirus outbreak is contained, stronger global growth should continue to soak up lingering labor market slack. This raises the question of whether, at some point, declining unemployment could become counterproductive. The outbreak of the coronavirus represents a potential short-term threat to the budding global economic recovery. The unemployment rate in the OECD currently stands at 5.1%, below the low of 5.5% set in 2007 (Chart 3). In the US, the unemployment rate has dropped to a 50-year low. Chart 3Unemployment Rates Are Below Their Pre-Crisis Lows In Most Economies No one would deny that the decline in unemployment since the financial crisis has been a welcome development. However, it does carry one major risk: Historically, the likelihood of a recession has risen when unemployment has fallen to very low levels (Chart 4). Chart 4Recessions Become More Likely When The Labor Market Begins To Overheat Three channels have been proposed to explain this positive correlation: 1) Low unemployment can prompt households and businesses to overextend themselves, making the economy more fragile; 2) Faster wage growth stemming from a tight labor market can compress profit margins, leading to less capital spending and hiring; 3) Shrinking spare capacity can fuel inflation.  This can force central banks to raise rates, choking off growth. Let’s examine each in turn. Unemployment And Irrational Exuberance Chart 5Growing Housing Imbalances In Some Economies A strong economy promotes risk-taking. While some risk-taking is essential for capitalism, an excessive amount can lead to the buildup of imbalances, thereby setting the stage for an eventual downturn. In Australia, New Zealand, Canada, and the Scandinavian economies, the combination of low interest rates and strong economic growth has stoked debt-fueled housing bubbles (Chart 5, panel 3). As we discussed last week, higher interest rates in those economies could sow the seeds for economic distress.2 In most other countries, financial imbalances are not severe enough to trigger recessions. Chart 6 shows that the private-sector financial balance – the difference between what the private sector earns and spends – still stands at a healthy surplus of 3.4% of GDP in advanced economies. In 2007, the private-sector financial balance fell to 0.4% in advanced economies, reaching a deficit of 2% in the US. The private-sector balance also deteriorated sharply in the lead-up to the 2001 recession (Chart 7). Chart 6The Private Sector Spends Less Than It Earns In Most Economies Chart 7The Private-Sector Surplus Is Larger Than It Was Before The End Of Previous Expansions   In the US, the personal savings rate has risen to nearly 8%, much higher than one would expect based on the level of household net worth (Chart 8). Despite growing at around 2.5% in 2018/19, real personal consumption has increased at a slower pace than predicted by the level of consumer confidence. This suggests that households have maintained a fairly prudent disposition. Consistent with this, the ratio of household debt-to-disposable income has declined by 32 percentage points since 2008. Chart 8Households Are Saving More Than One Would Expect Granted, some credit categories have seen large increases (Chart 9). Student debt has risen to 9% of disposable income. Auto loans have moved back to their pre-recession highs. We would not worry too much about the former, as the vast majority of student debt is guaranteed by the government. Auto loans are more of a concern. However, it is important to keep in mind that the auto loan market is less than one-sixth as large as the mortgage market. Moreover, after loosening lending standards for vehicle loans between 2011 and 2016, banks have since tightened them. This adjustment appears to be largely complete. Lending standards did not tighten any further in the latest Senior Loan Officer Survey, while demand for auto loans rose at the fastest pace in two years. The share of auto loans falling into delinquency has been trending lower, which suggests that delinquency rates are peaking (Chart 10). Chart 9US Household Debt Levels Have Fallen, Despite Increases in Student And Auto Loans Chart 10Auto Loans: Monitoring Trends In Credit Standards And Delinquency Rates Lastly, we would point out that despite all the hoopla over the state of the auto market, auto loan asset-backed securities have performed well (Chart 11). While default rates have risen, lenders have generally set interest rates high enough to absorb incoming losses. Chart 11Securitized Auto Loans Have Performed Well Will Falling Profit Margins Derail The Expansion? Profit margins usually peak a few years before the onset of a recessions (Chart 12, top panel). This has led some to speculate that falling margins could usher in a recession by curbing companies’ willingness to hire workers and invest in new capacity. Chart 12A Peak In Profit Margins: An Ominous Sign? While it is an interesting theory, it does not stand up to closer scrutiny. Surveys of business sentiment clearly show that capital spending intentions are positively correlated with plans to raise wages (Chart 13, left panel). Far from cutting capital expenditures in response to rising wages, firms are more likely to boost capex if they are also planning to increase labor compensation.  Chart 13AFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (I) Chart 13BFaster Wage Growth, Increased Hiring, And More Capex Go Hand In Hand (II) One reason for this is that rising wages make automation more attractive. By definition, automation requires more capital spending. However, that is not the entire story because firms also tend to hire more workers during periods when wage growth is rising (Chart 13, right panel). This implies that a third factor – strong economic growth – is responsible for both accelerating wages and rising hiring intentions. The fact that real business sales are strongly correlated with both employment growth and nonresidential investment is evidence for this claim (Chart 12, bottom panel). Falling Margins: A Symptom Of A Problem The discussion above suggests that faster wage growth is unlikely to dissuade firms from either hiring more workers or boosting capital spending. Indeed, the opposite is probably true: Since workers normally spend more of every dollar of income than firms do, an increase in the share of national income flowing to workers will lift aggregate demand. So why do profit margins usually peak before recessions? The answer is that declining labor market slack tends to push up unit labor costs, forcing central banks to hike interest rates in an effort to stave off rising inflation. Thus, falling margins are just a symptom of an underlying problem: economic overheating. Don’t blame lower margins for recessions. Blame central banks. Inflation Is Not A Threat... Yet For now, unit labor cost inflation remains reasonably well contained in the major economies (Chart 14). However, there is little evidence to suggest that the historic relationship between labor market slack and wage growth has broken down (Chart 15). Barring a major surge in productivity growth, inflation is likely to accelerate eventually as companies try to pass on higher labor costs to their customers. Chart 14AUnit Labor Costs Are Well Behaved For Now (I) Chart 14BUnit Labor Costs Are Well Behaved For Now (II)       Chart 15Correlation Between Labor Market Slack And Wage Growth Remains Intact We do not know exactly when such a price-wage spiral will emerge. Inflation is a notoriously lagging indicator (Chart 16). Our best guess is that inflation could become a serious risk for investors in late 2021 or 2022. Thus, investors should remain overweight global equities for the next 12-to-18 months, but be prepared to turn more cautious in the second half of 2021.  Chart 16Inflation Is A Lagging Indicator   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1   Jong-Wha Lee and Warwick J. McKibbin, “Globalization and Disease: The Case of SARS,” Brookings Institution, dated February 2004. 2  Please see Global Investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020.   Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights The Wuhan coronavirus outbreak in China is now being priced into commodity markets, with comparisons to the 2003 SARS outbreak serving as an early benchmark.1 If it follows the SARS trajectory its impact likely will be limited, although oil demand could fall at the margin as global travel falls. The IMF expects growth in EM economies, the engine for commodity demand, to come in at 4.4% and 4.6% this year and next, respectively, down two-tenths of a percent from its previous forecast, but still up from 2019’s 3.7% rate. The Fund’s risk assessment tilts slightly to the upside, nonetheless, in the wake of global monetary and fiscal stimulus. We introduce our 2021 oil balances and price forecasts this week. We expect Brent crude oil to average $70/bbl next year, and for WTI to average $4/bbl below that. We are maintaining our $67/bbl Brent and $63/bbl WTI 2020 forecasts (Chart of the Week). Chart of the WeekCrude Oil Price Forecasts For 2020, 2021 Feature In its latest World Economic Outlook – Tentative Stabilization, Sluggish Recovery? – the IMF flags key risks to EM growth, which will continue to feed the economic policy uncertainty that dogs commodity demand.2 The Fund’s “downward revision primarily reflects negative surprises to economic activity in a few emerging market economies, notably India, which led to a reassessment of growth prospects over the next two years. In a few cases, this reassessment also reflects the impact of increased social unrest.” That said, the Fund sees the balance of risk slightly tilted to the upside versus its earlier assessment in October, in the wake of global monetary and fiscal stimulus. This is in line with our view that the effects of monetary stimulus – deployed over the better part of last year and still expected to remain accommodative this year – will boost growth this year. Our view remains tempered by risks we’ve been highlighting that keep political and economic policy uncertainty elevated – e.g., trade tensions, civil unrest, and the still-underappreciated risks to oil markets arising from US-Iran tensions and social unrest in Iraq, which remains high (Chart 2). The loss of 800k b/d from Libya is significant, but the world does not lack spare light-sweet crude oil production capacity – the US shales, in particular, abound in this type of crude oil. Chart 2Policy Uncertainty Will Trend Lower, But Continues To Dog Commodities Oil Fundamentals Improving As is typically the case, we expect global oil-demand growth this year will be led by EM economies. Crude oil fundamentals continue to favor higher prices: Production management and capital discipline will constrain the rate of growth of oil supplies, and, as discussed above, demand will benefit from policy stimulus globally (Chart 3). Oil demand growth will recover this year, following a lower-than-normal rate of just 830k b/d last year, based on the US EIA’s most recent estimates of historical consumption. We continue to expect demand to grow 1.4mm b/d this year.  For 2021, we expect growth of just under 1.5mm b/d, reaching 103.65mm b/d globally. For its part, the EIA’s estimating growth of 1.34mm and 1.37mm b/d for 2020 and 2021, respectively. As is typically the case, we expect global oil-demand growth this year will be led by EM economies, proxied by non-OECD oil consumption, of 1.26mm b/d. For next year, we expect EM demand growth to come in at 1.34mm b/d, or just over 90% of global oil consumption growth in 2021. On the supply side, we continue to expect OPEC 2.0 output to increase slightly in 2Q20 and return to levels consistent with its previous agreement to cut 1.2mm b/d of production. Our modeling also assumes this level of production remains flat for the rest of 2020. Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices Next year, we assume the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to increase production by 350k b/d in 1H21. In addition, we gradually remove 300k b/d of KSA’s overcompliance of 400k b/d next year, which moves its crude oil output in 2021 to 9.94mm b/d vs 9.76mm b/d this year. For Russia, we anticipate an increase in its condensate production, which it lobbied for last year. This will put our estimate of Russia’s crude and condensate production at 11.4mm b/d in 2020 and 11.64mm b/d in 2021.3 Most of the production cuts realized by OPEC 2.0 – ~ 2mm b/d – come at the expense of Venezuela and Iran, both of which are under sanctions limiting their production imposed by the US. We are holding Venezuela’s production at ~ 700k b/d in 2021, and will be monitoring this closely for any indication it is significantly changing. For Iran, we are keeping its production at 2.10mm b/d this year and next, assuming US sanctions remain in place. Oil production in both countries could be impacted by the outcome of US elections in November, and right now this is a near-impossible call to make. US Shales: No Longer A Growth Story? We continue to see slower production growth in the US than the EIA, particularly in the shales, as we expect capital markets to continue to discipline shale producers by only funding those firms that are able to return capital to shareholders or to deliver steady and increasing dividends. In our modeling, total US onshore production this year and next is expected to rise 800k b/d, and 310k b/d for 2021. We also continue to expect drilled-but-uncompleted (DUC) wells to continue to make significant contributions to overall shale-oil production in the US. Indeed, we expect DUCs to continue to offset part of the decline implied by lower rig counts, as they require less capex than drilling and completing new wells. We add ~ 500k b/d of production from DUCs completion over 2020 and 2021. Future production will depend heavily on the Majors and on productivity and lateral length. Our US crude and condensate production estimates for 2020 and 2021 reflect these constraints, and the slowing rate of growth being imposed by capital markets. For 2020, we expect total US crude and condensate production of 13.16mm b/d, of which 9.20mm b/d will come from the main shale basins led by the Permian.4 Tighter Fundamentals, Steeper Backwardations Our fundamental supply-demand balances are tighter than those assumed by the US EIA and the Paris-based IEA (Table 1). We expect US crude and liquids production to grow 1.6mm b/d this year, and only 500k b/d next year. We see global production growing 1.15mm b/d and 1.39mm b/d in 2020 and 2021, respectively. With demand growing 1.4mm b/d and close to 1.5mm b/d in 2020 and 2021, respectively, against this supply backdrop, our balances point to a deficit this year vs. the surplus expected by the IEA  (Table 2 and Chart 4). Table 1Fundamentals Comparison Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4BCA Research's Balances Estimates Point To Falling Inventories Chart 5Tighter Storage, Steeper Backwardation For this reason, we continue to anticipate a steepening in the Brent and WTI forward curves – i.e., more backwardation – which will support our long 2H20 Brent vs. short 2H21 Brent curve trade (Chart 5). As a result of the steeper backwardation, we expect higher volatility, and will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls (Chart 6). Bottom Line: We continue to expect crude oil markets to tighten, given persistent production restraint by OPEC 2.0, capital-market-imposed restraint on US shale-oil producers, and revived global demand growth in 2020 and 2021. The IMF’s assessment re the balance of risk being tilted to the upside, in the wake of global monetary stimulus, is broadly consistent with our maintained view. While we expect global policy uncertainty to fall following the so-called phase-one US-China trade deal and a definitive Brexit vote in the UK, geopolitical tension remains high, particularly in the Persian Gulf. Chart 6Steeper Backwardation To Higher Implied Volatility We will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories. As a result, we are keeping our 2020 Brent forecast at $67/bbl, and are expecting 2021 Brent to trade at $70/bbl; WTI is expected to trade $4/bbl below Brent this year and next, on average. At tonight’s close, we will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent prices traded sideways ~ $64/bbl since last Tuesday, dismissing the US and China phase-one agreement and disruptions to Libyan production and exports which could total as much as 800k b/d.  Over the weekend, concerns re the Wuhan coronavirus outbreak in China started being priced into commodities, particularly oil.  Separately, the US Treasury Department renewed Chevron’s waiver to operate in Venezuela for another three months.  The company is scheduled to export 1mm barrels of oil produced by PDVSA via a joint-venture, partially dodging US sanctions on Venezuelan oil.5  We expect the country’s output to stabilize close to its current level of 710 kb/d this year. Base Metals: Neutral On Tuesday Beijing reported more than 400 people had been infected with the Wuhan coronavirus, confirming person-to-person transmission of the virus. Concerns that a wider spread over the lunar New Year holidays starting this weekend will impact economic growth in the world’s top metal consumer brought copper prices down 1.8% on Tuesday.  Zinc reached two-month highs this week amidst concerns of low LME warehouses stocks, now close to their 20-year lows at 50,900 MT (Chart 7).  Supply concerns stemming from low iron ore stocked in China’s ports, along with good Chinese macro data, lifted iron-ore prices. Precious Metals: Neutral The US dollar is a key missing piece needed to propel gold prices higher from current levels. The 2.4% decline in the trade-weighted dollar index supported gold’s 5% increase since October 1, 2019 (Chart 8).  We expect the dollar to continue depreciating in 2020, as global growth rebounds and the Fed remains accommodative, keeping gold prices well bid.  Most precious metals have followed gold’s lead this year; palladium and platinum are up 17.63% and 3.15%, respectively. Chart 7 Chart 8 Ags/Softs:  Underweight CBOT Corn and soybeans futures traded lower on Tuesday as markets awaited evidence of China purchasing additional U.S. agricultural goods, fulfilling its commitment to buy $32 billion of agricultural goods over two years per the phase-one deal negotiated between China and the US earlier this month.  Corn traded lower, as US grain elevators have yet to confirm any Chinese buying.  Soybeans, further weakened by expectations of a massive harvest in rival exporter Brazil.  Wheat was the only ag posting gains early in the week on the back of strong Black Sea export demand.     Footnotes 1     Please see CDC SARS Response Timeline, published by the US Centers for Disease Control and Prevention.  The SARS outbreak was identified in February 2003 and lasted six months.  The CDC noted: “Globally, WHO received reports of SARS from 29 countries and regions; 8,096 persons with probable SARS resulting in 774 deaths. In the United States, eight SARS infections were documented by laboratory testing and an additional 19 probable SARS infections were reported.”  According to Chinese officials, there were 440 confirmed cases of the new coronavirus as of Wednesday; nine people were reported to have died thus far.  The World Health Organization met Wednesday to assess the Wuhan coronavirus outbreak.  The 2003 coronavirus outbreak was minor compared to the typical influenza outbreak: by way of comparison, every year there are an estimated one billion cases of influenza, resulting in 290,000 to 650,000 deaths, according to the International Federation of Pharmaceutical Manufacturers & Associations in Switzerland. 2               Economic policy uncertainty is a recurrent theme in our research.  It has been driving safe-haven demand for the USD and gold for months, as we recently discussed in Iran Responds To US Strike; Oil Markets Remain Taut.  It is available at ces.bcaresearch.com. 3     We use World Bank growth estimates to drive our EM demand forecasts.  Earlier this month, the Bank forecast EM GDP growth of 4.1% for 2020 and 4.3% for next year.  This will outpace last year’s growth rate of 3.5%. 4     US production growth, particularly in the Permian and Bakken basins, could be constrained by environmental restrictions, if state regulators crack down on the massive flaring occurring in both states.  Please see Lingering Oil-Demand Weakness Will Fade, published November 21, 2019, where we discuss this risk in more depth. 5     Please see Exclusive: PDVSA's partners act as traders of Venezuelan oil amid sanctions - documents, published by reuters.com January 13, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights Global Corporates: The cyclical backdrop – accommodative monetary policies, improving global growth momentum, moderate inflation and subdued volatility – is supportive for the continued outperformance of global corporate bonds over sovereign debt in 2020. Corporate Bond Valuation: Extending a valuation framework we’ve introduced for US corporates to non-US credit – looking at volatility-adjusted spreads relative to both their own history and the “phase” of the monetary policy cycle - we calculate spread targets for non-US corporates in the euro area, UK and Canada. 2020 Opportunities: Current corporate spread levels are furthest above our targets (i.e. cheap) for US high-yield (most notably for Ba- and Caa-rated credit), UK high-yield and UK investment grade. Spreads are furthest below our targets (i.e. expensive) for euro area high-yield (mostly Ba-rated), US investment grade (all credit tiers) and Canadian investment grade. Feature Chart 1Deviations From Corporate Spread Targets One of our main investment themes for 2020 is that accommodative monetary policies and faster economic growth will delay the peak in the aging global credit cycle, giving investors another year of corporate bond outperformance versus sovereign debt in the developed economies. Returns this year will be nowhere near as robust as in 2019, however, given rich valuation starting points for much of the global corporate universe. Against this backdrop, fixed income investors will have to be more selective in allocations by country, sector and credit quality in order to outperform. To that end, in this Special Report we extend a valuation framework for corporate bond spreads first introduced for US corporates by our sister service, US Bond Strategy, to non-US credit. This methodology looks at spreads on a volatility-adjusted basis, allowing comparison of valuations versus their own history and relative to similar stages of past monetary policy cycles. Chart 1 shows the deviations of current benchmark index option-adjusted spreads (OAS) from spread targets derived from our methodology for different countries (the US, euro area, the UK and Canada) and credit quality tiers (investment grade vs. high-yield). Positive deviations imply current spreads are above the targets derived from our framework – in other words, relatively undervalued - and vice-versa. Returns this year will be nowhere near as robust as in 2019, however, given rich valuation starting points for much of the global corporate universe. Against this backdrop, fixed income investors will have to be more selective in allocations by country, sector and credit quality in order to outperform. The conclusions are that there are still opportunities for additional spread tightening from current levels for lower-rated US high-yield and both UK investment grade and high-yield corporates. At the same time, valuations are looking most stretched for euro area high-yield, US investment grade (all credit tiers) and Canadian investment grade. A Brief Word On The Outlook For Global Corporate Credit In 2020 Chart 2Positive Backdrop For Corporate Bonds The backdrop for global corporate bond markets will remain positive in 2020 for three main reasons: Global monetary policies will remain accommodative. Central bankers are now focusing more on boosting soft growth and low inflation expectations. Real policy interest rates in the US, euro area, UK and Canada are already below estimates of neutral like r-star (Chart 2, top panel), and will likely remain so throughout 2020. In the past, periods of credit market underperformance have occurred when monetary policy was restrictive, with real rates above neutral or government bond yield curves that were very flat or inverted (more on that later). Global growth momentum will improve. Recent data releases (global manufacturing PMIs, sentiment surveys like the global ZEW and German IFO) have shown that the 2019 global industrial downturn was in the process of bottoming out during the 4th quarter of the year. Additional improvement is likely in the coming months, based on the steady gains of the BCA Global Leading Economic Indicator (LEI). The elevated level of our global LEI diffusion index – measuring the share of individual country LEIs that are rising and which is itself a leading indicator of both the global LEI and corporate bond returns - suggests that additional outperformance of global corporates versus sovereign bonds is likely within the next 12 months (Chart 2, middle panel). Financial conditions are stimulative. Global equities and credit are off to a strong start in 2020, while market volatility is subdued across a variety of asset classes. For example, the US VIX index is now just above its 2019 low, which is consistent with narrow global corporate bond spreads (Chart 2, bottom panel). That low volatility backdrop – supported by market-friendly central bank policies - is helping keep financial conditions easy enough to lift economic growth, while also boosting investor risk appetite for corporate credit. The overall outlook for global corporate credit is still positive and investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Nonetheless, returns will be lower in 2020 than in 2019 due to expensive valuation starting points. As can be seen from Chart 3, global corporate bond spreads are already fairly tight relative to their long-term historical range. Also, outright index yields in many asset classes, like US high-yield, are now at new all-time lows. We interpret this as a sign that the “easy money” has already been made in being generally long corporate credit versus government bonds. Having the right tools to assess the relative values among differing credit markets will be critical to finding the best investment opportunities in this environment. Chart 3Rich Valuation Starting Points In Corporate Credit We can use the breakeven spread as a valuation tool by looking at the percentile rank relative to its own history, effectively showing the percentage of time that the breakeven spread has been lower in the past. Bottom Line: The cyclical backdrop – accommodative monetary policies, improving global growth momentum, moderate inflation and subdued volatility – is supportive for the continued outperformance of global corporate bonds over sovereign debt in 2020. Valuations are likely to be more of a headwind for corporate bond returns, though. Using Breakeven Spreads As A Credit Valuation Tool As a reminder to existing readers (and to new clients), one of our main valuation tools for credit instruments is the 12-month breakeven spread. That is, the amount of spread widening required for corporate bond returns to break even with a duration-matched position in government bond securities over a 12-month horizon. It can be approximated by dividing the OAS of a bond (or a benchmark bond index) by its duration. More specifically, we can use the breakeven spread as a valuation tool by looking at the percentile rank relative to its own history, effectively showing the percentage of time that the breakeven spread has been lower in the past. We find this valuation tool to be superior to others for two main reasons: (i) using the breakeven spread rather than the average index OAS allows us to control for the changing average duration of the benchmark bond indices; and (ii) the percentile rank is often a better representation of credit spreads than the spread itself.1 BCA Research US Bond Strategy and Global Fixed Income Strategy have both regularly shown the percentile rankings of US investment grade and high-yield breakeven spreads as part of our discussion of US corporate bond markets. We have never produced such rankings for non-US credit, until now. InCharts 4- 7, we show those percentile ranks relative to history for credit in the US and, for the first time, the euro area, UK, Canada, Japan, Australia and Emerging Markets US dollar denominated corporates. We also provide the breakeven spread historical percentile ranks for each individual credit tier in the Appendix charts on pages 13-16. Chart 4US: Corporate Bond Breakeven Spreads Chart 5Euro Area: Corporate Bond Breakeven Spreads Chart 6UK: Corporate Bond Breakeven Spreads Using these charts, we can gauge which markets offer the best (or worst) level of spread, adjusted by its own volatility and compared to its own history. The most attractive corporate credit spreads on a volatility-adjusted basis are: US high-yield (mostly Caa-rated and B-rated) Japan investment grade (mostly Baa-rated and A-rated) Canada Aaa-rated UK high-yield (excluding financials) Chart 7Other Countries: Corporate Bond Breakeven Spreads The least attractive corporate credit spreads on a volatility-adjusted basis are: US investment grade (all credit tiers) UK Aaa-rated Canada Baa-rated Euro Area high-yield Using this metric, US Caa-rated junk bonds look most “undervalued”, with a volatility-adjusted spread in the upper 20% of all observations. Chart 8 displays the current breakeven spread historical percentile ranks across countries and credit quality, with high-yield markets shown in red. Using this metric, US Caa-rated junk bonds look most “undervalued”, with a volatility-adjusted spread in the upper 20% of all observations. While this chart provides a quick overview of which corporate bond markets are cheap/expensive with respect to their own history, it does not allow for comparisons of the relative cheapness between markets. To do this, we need to find a way to convert the percentile rankings into some measure of a “fair value” credit spread. Chart 8Global Corporate Bond 12-Month Breakeven Spreads By Percentile Rank (%) Using Monetary Policy Cycles To Determine Corporate Spread Targets Our colleagues at BCA Research US Bond Strategy have come up with a novel approach for determining spread targets for US corporate credit, based on the breakeven spread percentile rankings.2 Essentially, the stance of US monetary policy, as measured by the slope of the US Treasury curve, is used to predict changes in the US credit cycle, helping to determine “cyclical” spread targets relative to the stance of monetary policy. The first step of this process is to group corporate bond excess returns (vs government debt) into buckets defined by the following “phases” of the US monetary policy cycle, measured by the yield differential between 10-year and 3-year Treasuries: Phase 1: from the end of the previous recession until the slope goes below 50 bps. Phase 2: from the time that the slope crosses below 50 bps until it inverts. Phase 3: from the time that the yield curve first inverts to the start of the next recession. Recessionary periods are not included in these phases, as all corporate credit exhibits the worst returns during those episodes. That is because economic growth and downgrade/default risks, and not the state of monetary policy, are the driving factor behind credit spread moves during recessions. Chart 9 shows the history of the US corporate bond markets broken down into “curve-defined” cycles.3 Dating back to 1974, the earliest date for investment grade bond index data, there have been five such cycles. Chart 9US Corporate Bond Performance And The Yield Curve In Charts 10-12, we show the same phases for the euro area, the UK and Canada, using their own government bond yield curves to determine the phase of the monetary policy cycle in the same fashion as was done for the US.4 Once the phases of the monetary policy cycle are defined, we can then calculate corporate bond excess returns during each phase. Chart 10Euro Area: Corporate Bond Performance And The Yield Curve Chart 11UK: Corporate Bond Performance And The Yield Curve Chart 12Canada: Corporate Bond Performance And The Yield Curve Table 1 shows the average corporate bond annualized excess returns under each phase across every cycle that can be defined with available data. Excess returns tend to be highest in Phase 1, quite low but still positive in Phase 2, and usually turn negative during Phase 3, once the yield curve has inverted. Table 1Corporate Bond Annualized Excess Returns* (%) Under Each Phase Of The Cycle Currently, we are in Phase 2 in the US, euro area and UK, with yield curves that are relatively flat but still positively sloped. Historically, such periods have generated positive excess returns for corporate debt versus duration-matched government bonds, although of far smaller magnitudes compared to Phase 1 periods. Given our expectation that the Fed, ECB and Bank of England will maintain a dovish bias throughout 2020, we expect the no shift from Phase 2 for the US, euro area and the UK that would hurt corporate bond excess returns in those countries. With the Canadian yield curve now slightly inverted, however, Canada is now in Phase 3. This raises the risk that the recent strong outperformance of Canadian investment grade corporate bonds could end if the Bank of Canada does not deliver the monetary easing currently discounted in the Canadian yield curve. How We Determine Corporate Spread Targets Having defined the three phases of the monetary policy cycle, we then re-calculate our corporate bond breakeven spread percentile ranks within each phase. We then back-out a spread target for each credit tier by taking the median 12-month breakeven spread seen in similar monetary policy environments, as determined by the slope of the yield curve.5 Finally, we convert those “median” breakeven spreads into OAS targets using the current benchmark index duration and credit rating distribution. We are assuming that a reasonable spread target for any corporate bond market is determined by adjusting for both spread volatility AND the monetary policy cycle. So, essentially, we are assuming that a reasonable spread target for any corporate bond market is determined by adjusting for both spread volatility AND the monetary policy cycle. Charts 13-16 show the index OAS and their respective targets for the US (both investment grade and high-yield), euro area (both investment grade and high-yield), the UK (both investment grade and high-yield excluding financials), and Canada (only investment grade). Further, the spread targets for each individual credit tier are provided in the Appendix on pages 17-19. Chart 13US: Corporate Bond Spread Targets Chart 14Euro Area: Corporate Bond Spread Targets Chart 15UK: Corporate Bond Spread Targets Chart 16Canada: Corporate Bond Spread Targets For example, our spread target for US B-rated high-yield is 227bps, which is 80bps below the current index OAS. From the charts, we can make the following conclusions about the relative attractiveness of current spread levels: The largest deviations from our spread target (i.e. potentially most undervalued) are: US high-yield (mostly Caa-rated and B-rated) UK high-yield (excluding financials) The lowest deviations from our spread target (i.e. potentially most overvalued) are: Euro Area high-yield (mostly Ba-rated) Canada investment grade US investment grade (all credit tiers) This framework is an interesting way to derive corporate bond value, by adjusting for both the volatility and monetary policy backdrop. Of course, there are other factors that are more difficult to quantify that can keep spreads too tight or too wide versus these fair value levels, like investor risk tolerance or risk premia for political uncertainty. In terms of factors that are quantifiable, however, this spread target methodology is a useful way to get a sense of the richness or cheapness of global corporate debt. In terms of factors that are quantifiable, however, this spread target methodology is a useful way to get a sense of the richness or cheapness of global corporate debt. We will regularly update these targets in future BCA Research Global Fixed Income Strategy reports. Bottom Line: Current corporate spread levels are furthest above our targets (i.e. cheap) for US high-yield (most notably for Ba- and Caa-rated credit), UK high-yield and UK investment grade. Spreads are furthest below our targets (i.e. expensive) for euro area high-yield (mostly Ba-rated), US investment grade (all credit tiers) and Canadian investment grade.   Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 This is because credit spreads often tighten to very low levels and then remain tight for an extended period. Thus, by showing the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. 2 Please see US Bond Strategy Special Report, “2019 Key Views: Implications For US Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com. 3 Note that the Treasury curve used for this analysis is the spread between the 10-year Treasury and the 3-year Treasury yield. The more widely-followed 2-year Treasury was not used as there was more historical data available for the 3-year maturity. 4 Note that there are fewer cycles to analyze for these countries due to the shorter available history of corporate bond market data outside the US. 5 For more details on the spread targets please see US Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com. Appendix Chart 1AUS: Investment Grade Breakeven Spreads Chart 1BUS: High-Yield Breakeven Spreads Chart 1CEuro Area: Investment Grade Breakeven Spreads By Credit Tiers Chart 1DEuro Area: High-Yield Breakeven Spreads By Credit Tiers Chart 1EUK: Investment Grade Breakeven Spreads Chart 1FCanada: Investment Grade Breakeven Spreads Chart 1GJapan: Investment Grade Breakeven Spreads Chart 2AUS: Investment Grade Spread Targets Chart 2BUS: High-Yield Spread Targets Chart 2CEuro Area: Investment Grade Spread Targets By Credit Tiers Chart 2DEuro Area: High-Yield Spread Targets By Credit Tiers Chart 2EUK: Investment Grade Spread Targets By Credit Tiers Chart 2FCanada: Investment Grade Spread Targets By Credit Tiers