Global

Special Report

Highlights MLPs’ one-of-a-kind legal structure offers investors gaudy distribution yields and tax-saving advantages. They boomed alongside fracking, enjoying spectacular growth between 2009 and 2014. MLPs used to exhibit a high correlation with utilities, but since the 2014 oil bust, they have performed in step with the rest of the energy sector. Improved valuations have recently put MLPs back on investors’ radar. However, structural impediments and heterogeneous balance-sheet quality argue against broad index exposure. Investors would be better served by concentrating their efforts on picking individual stocks. Opportunities reside within smaller-cap MLPs and MLPs exposed to the Permian basin. Feature Dear Client, In place of a Weekly Report written from South Africa, where I have been meeting with clients, we are sending you this Special Report on Master Limited Partnerships (MLPs), written by my colleague Jennifer Lacombe.* Like mortgage REITs, which U.S. Investment Strategy followed from 2011 to 2013, MLPs are a yield play that investors might find to be an appealing bond alternative. We trust that you will find this report interesting and informative. Best regards, Doug Peta, Senior Vice President U.S. Investment Strategy * This report was initially published by our Global ETF Strategy service on November 15, 2018. It has been lightly revised to update charts and reflect subsequent market developments.   Q: What are MLPs and their tax benefits? Master Limited Partnerships (MLPs) are publicly listed partnerships involving two classes of partners. A General Partner (GP) controls the assets and manages the daily operations of the business. Limited Partners (LPs) - and public investors - provide the capital and collect cash flow distributions. Unlike corporations, which pay corporate taxes on their income, MLPs have the ability to pass through all of their income to their owners, along with deductible items like amortization and depreciation expenses. MLP investors, in turn pay income tax at their own individual marginal tax rates. MLP owners are thereby shielded from the double taxation that would otherwise apply when the corporation paid taxes on its income, and the shareholder paid taxes on the dividend distributed from the corporation’s income. Q: Why are they predominantly found in the energy sector? Concerns about the potential loss of federal income led Congress to limit MLP eligibility to companies in the energy and real estate sectors when it overhauled the tax code in 1986. Since the 1986 Act took effect, MLPs have had to generate at least 90% of “qualifying income” from their energy or real estate operations. Section 7704 of the Internal Revenue Code defines “qualifying income” as income derived from exploration, development, mining or production, processing, refining, transportation or marketing of any mineral or natural resource, as well as certain passive-type income including interest, dividends and real property rents. Over the years, the shale revolution and the rise of new technologies, such as horizontal drilling and fracturing, created elevated demand for energy infrastructure. Today, MLPs almost exclusively operate in the natural resources space (Chart 1). Q: Why did MLPs outperform assets of all stripes following the Great Financial Crisis? A combination of several factors led MLPs to record stunning returns between 2009 and 2014. The Alerian MLP Total Return Index grew by a whopping annualized rate of 38% during that time. Decreasing interest-rate environments are typically supportive of yield plays’ outperformance. Powered by high single-digit to double-digit distribution yields, MLPs led Treasuries, utilities stocks, high-yield bonds and even the S&P 500 over that six-year stretch (Chart 2). With the shale revolution in full swing, sustaining strong demand for pipelines and other energy infrastructure, investors’ funds flowed abundantly into the energy MLP space (Chart 3). Prices - a mathematical function of multiples and earnings - soared as money kept pouring in and P/E tripled in the first 7 years following the Great Financial Crisis (Chart 4). Chart 2Decreasing Interest Rates Are A Boon To Yield Plays   Chart 3Horizontal Drilling Attracted A Lot Of Money...   Chart 4...Sending Multiples Soaring Q: Why has such outperformance not attracted more institutional and foreign investors? Because of U.S. tax rules, MLPs are relatively unattractive to tax-exempt investors and non-U.S. investors. The tax rule for U.S. tax-exempt investors – institutional investors such as pension funds, university endowments, charities and IRAs – treats MLP earnings as unrelated business taxable income (UBTI), making them subject to income tax. Moreover, to retain their own pass-through status and tax shield, open-ended funds – like many mutual funds and ETFs – can allocate no more than 25% of their total holdings to MLPs, and no more than 10% to a single MLP. U.S. tax rules consider foreign owners of MLPs to be engaged in a business in the U.S., and require them to file and pay U.S. federal income tax. Therefore, only U.S. individuals can truly reap the full benefits of the MLP structure. Though they easily access these securities on public exchanges, the tax shield comes at the price of convoluted accounting treatments. Unitholders receive Schedule K-1 tax forms that can be complicated enough to result in significant accounting costs. They are most suited for high net worth investors’ portfolios, although smaller investors who are not daunted by accounting burdens have also embraced the vehicle. Q: Why are MLP yields so high? The typical MLP partnership agreement incentivizes a GP to distribute all available cash to unitholders, after retaining reserves for business operations and liabilities. Not only does the corporate tax exemption increase the amount of available cash, but the General Partner also has wide discretion over the amount of retained reserves. Because distributions are the main determinant of any yield play’s performance, GPs have historically emphasized distribution yields – sometimes at the expense of retained earnings. The more assurance investors have that they will receive reliable cash flows, the better the MLP will perform in the market. Q: Do MLPs trade like other bond proxies? The distribution model worked beautifully during the shale-oil boom. Low retained reserves never became an issue because MLPs collected steady revenues – a function of prices and volumes of oil or gas processed - and could fund distributions in excess of operating cash flow by issuing new debt or equity. Investors were so eager to invest that GPs found themselves at the controls of a positive feedback loop in which the more cash they distributed to investors, the more capital flowed in to fund even higher distributions. The infrastructure-heavy business model and high payout ratios echoed companies in the utilities sector and, indeed, MLP returns correlated strongly with utilities stocks. However, the discretion embedded in the MLP model reached a breaking point soon after the oil bust arrived in mid-2014. The price-led decline in revenues necessitated distribution cuts and severed the correlation with utilities (Chart 5). Chart 5A Utilities Proxy No More... Q: Were MLPs immune to energy price swings before the 2014 bust? Conventional investor wisdom maintains that MLPs are immune to commodity price swings in the aggregate because of their utility-like characteristics and because long-term contracts lock in selling prices. Actually, however, MLP revenue structures differ greatly from one line of activity to the other. Natural gas pipeline transportation accounts for a quarter of aggregate MLP activity. Prices per unit of volume transited are contractually locked in 5-to-20-year contracts, providing immunity to spot price moves during the entire duration of the contract. Storage (natural gas not immediately needed, or crude oil waiting to be refined) accounts for another quarter of aggregate activity and is subject to a similar pricing model as natural gas pipelines. Only the contract lengths are much shorter, ranging from 1 to 5 years. Petroleum pipeline transportation accounts for 44% of MLP activity. Contracts locking prices over the long run are not typical in this line of business. The Federal Energy Regulatory Commission (FERC) also imposes a yearly price increase amounting to the Producer Price Index for Finished Goods, plus a 1.23% adjustment. MLP revenue structures are therefore varied, and only natural gas pipeline transportation’s revenue streams - a quarter of the sector – are truly immune to fluctuations in spot prices, thanks to their long-term contracts. It follows that MLPs in aggregate are indeed correlated with energy price swings and trade closely in line with energy stocks (Chart 6). Chart 6...An Energy Proxy Instead Up until recently, their correlation to spot oil prices in particular was even more striking. However, they failed to match the 2017-18 recovery in oil markets (Chart 8). Because cash flow reliability is a key driver of the investment decision for any yield play, distribution cuts are bound to make any MLP investors skittish, and oil prices may have to enter an extended bull market before they overcome their fears (Chart 7).   Chart 8...Kept MLPs Depressed In Spite Of Oil Price Recovery Q: So, how cheap are they now? Since its peak in the summer of 2014, the Alerian MLP Total Return index has declined by 38% and is now flirting with the two-standard-deviation-cheap zone (Chart 9). Their profit margins have also strongly recovered (Chart 10). Chart 9Cheap Valuations...   Chart 10...Amid Recovering Profit Margins Because of the infrastructure-heavy nature of MLPs, traditional valuation metrics such as price-to-earnings can be misleading. High depreciation charges have significant impacts on earnings. Cash flows are an appropriate measure as they best inform a firm’s ability to maintain its distributions. Q: Great! So which ETF should I buy? The Alerian MLP index’s low multiples and recovering profit margins are not sufficient endorsements in themselves. An index is not an investible vehicle and even the best of index-tracking instruments can only imperfectly replicate an exposure. In the MLP space in particular, structural impediments reduce the attractiveness of exchange-traded products. Because ETFs are subject to the previously mentioned 25% cap on MLP holdings, many supplement their portfolios with regular pipeline or infrastructure stocks. Although the overall fund provides a decent exposure to the energy infrastructure sector, the diluted MLP exposure does not offer distribution yields anywhere comparable to the yields direct MLP owners receive. An alternative is to opt for a C-corporation structure. The flagship Alerian MLP ETF (ticker: AMLP) falls into this category. This structure allows for an undiluted exposure to MLPs, all the while relieving an ETF shareholder from having to deal with the complicated and costly accounting treatment that direct MLP ownership involves. However, C-corporations are subject to corporate income taxes, which cancels out the tax benefits of investing in MLPs in the first place. The resulting cumulative tax drag on returns can become substantial over time (Chart 11). Investors seek MLP exposure for the high distribution yields made possible by tax advantages. A fund will indeed provide diversification and accounting relief, but at the cost of surrendering either some yield or some of the tax advantages. This is not to mention that the bulk of the exchange-traded vehicles are Exchange Traded Notes (ETNs). Unlike ETFs, they do not own any underlying shares or units of securities. Instead, they are instruments issued and backed by financial institutions. Even in the case of well-established lending institutions, we shy away from these types of products, as we are not keen on taking unnecessary counterparty risk. Many MLP exchange-traded products are also illiquid, or have not gathered a significant mass of assets under management. The expense ratios are also high in the MLP exchange-traded product space, a result of the complicated accounting treatment of K-1 forms that are borne by the ETF or ETN sponsor (Table 1). Table 1ETNs Constitute Two Thirds Of A Relatively Illiquid Universe Q: What about the flagship Alerian MLP ETF? It’s clearly well-established. The flagship Alerian MLP ETF (ticker: AMLP) tracks the Alerian MLP Infrastructure Index and has gathered close to USD 10bn of AUM under its belt since its inception in 2010. Amid all the above limitations, it is the only viable option. However, it comes with its own set of yellow flags. Because it tracks a market-capitalization weighted index, half of the fund’s assets under management are concentrated in its five largest holdings. As we go to press, these are Magellan Midstream Partners LP, Enterprise Products Partners LP, Energy Transfer LP, Plains All American Pipeline LP and MPLX LP. These companies’ distribution yields have recovered since the 2014 oil crash, but the question of the sustainability of these cash flows is of utmost importance. Although retained earnings are at all-time highs, so is the level of debt (Chart 12). The fact that 50% of the fund is concentrated in these top 5 constituents dilutes the diversification benefits of index investing. Chart 12Distributions Are Financed By Cash Flows...And A Lot Of Debt Q: So, what are my options? The MLP universe is heterogeneous. Wide disparity in valuation (Chart 13), debt levels (Chart 14) and performance (Chart 15) indicate that opportunities reside further down the capitalization scale.     Because an index is a weighted average, a heterogeneous market does not warrant broad-index exposure, especially when the smallest constituents offer the best opportunities. Amalgamation is always a process of blending wheat and chaff together, but in this case it disproportionately favors the chaff. Stock picking thrives against this backdrop. Our expertise does not extend to evaluating individual energy MLPs. We leave the honor of recommending the best-in-class opportunities to the professional bottom-up analysts, backed by thorough and diligent review of company fundamentals and management capabilities. Where we can add value is in the analysis of economic cycles and secular macroeconomic forces. Despite the sharp fall in prices over the past two months, brought about by the surprise eleventh-hour waivers granted to Iranian oil importers, BCA’s Commodity & Energy Strategy service believes the global oil market remains tight. Our strategists expect that oil prices will recover in 2019 as OPEC producers, Russia, and Canada reduce output by an aggregate 1.4 million barrels a day, and the Iran-driven supply glut is worked off. While a 2019 oil spike would be a tailwind to petroleum pipeline MLPs, surging production in U.S. shales – led by the Permian Basin in West Texas – means the new pipeline capacity being built to accommodate higher output will find a ready market. Regardless of what happens with prices, our energy strategists foresee a localized surge in demand for transportation and other midstream services in the U.S. shales. In line with IEA projections, they expect U.S. crude oil production to grow by approximately 1.3 million barrels a day in 2019 once the constraints imposed by a lack of pipeline capacity in the fecund Permian basin ease. MLPs positioned to resolve the transportation bottleneck should be able to count on a bright near-term future. “Location, location, location” applies to pipelines as well as real estate, and reinforces a bottom-up focus when selecting MLPs.   Jennifer Lacombe, Senior Analyst jenniferl@bcaresearch.com

Highlights The U.S. economy is slowing in a completely predictable manner. With inflationary pressures largely dormant, the Fed can afford to stay on hold for the next few FOMC meetings. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. A bearish stance towards U.S. Treasurys is warranted over a 12-month horizon. As long as the Fed is hiking rates in response to above-trend GDP growth rather than accelerating inflation, risk assets will fare well. Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Brexit fears are overdone. Stay long the pound versus the euro. We were stopped out of our short AUD/JPY trade for a gain of 10%. Feature A Predictable Slowdown Investors are misunderstanding the nature of the current slowdown in the United States and much of the world. Completely predictable slowdowns, such as this one, rarely morph into recessions. Real U.S. GDP rose at a blistering 3.8% average annualized pace in Q2 and Q3 of 2018. There is no way that sort of growth rate could have been sustained. Financial conditions also tightened sharply in Q4, which has inevitably weighed on growth. Given the stock market rout, it is actually surprising that the economy has not weakened more than it has. The New York Fed GDP Nowcast points to growth of 2.5% in Q4 of 2018 and 2.1% in Q1 of 2019. This is still above the Fed’s long-term estimate of potential GDP growth of 1.9%. Most of the slowdown has been concentrated in the manufacturing sector, but even there, the bloodletting may be ending. The latest Philadelphia Fed survey — arguably the most important of the regional Fed manufacturing reports — showed an uptick in activity, with the new orders component hitting the highest level since last July. Despite the tightening in financial conditions, bank lending to the business sector has accelerated over the past three months (Chart 1). The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 2). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 3). Chart 1Credit Is Still Flowing To U.S. Businesses Chart 2Little Sign Of A Looming Credit Crunch Chart 3Capex Plans Still Solid The labor market remains healthy, as evidenced by ongoing strong payroll growth and low initial unemployment claims. Faster wage growth is boosting consumer spending. Holiday sales rose by 5.1% from a year earlier according to the Mastercard SpendingPulse report, the fastest growth in six years. The Redbook same-store index tells a similar story (Chart 4). Chart 4Same-Store Sales Are Robust The housing market struggled for much of 2018, but the recent stabilization in mortgage rates should help matters (Chart 5). Notably, mortgage applications for purchase have surged to their highest levels since 2010 (Chart 6). Homebuilder confidence improved in January, mirroring the rally in homebuilder shares (Chart 7). We are long homebuilders versus the S&P 500, a trade that is up 5.3% since we recommended it on November 1, 2018. Chart 5aThe U.S. Housing Sector Will Stabilize (I) Chart 5BThe U.S. Housing Sector Will Stabilize (II) Chart 6A Positive Signal For U.S. Housing Chart 7U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Government Shutdown: A Near-Term Hit To Growth The government shutdown poses a near-term risk to the U.S. economy. If it lasts until the end of March, it will shave about 1.7% off Q1 GDP based on White House estimates. While this represents a potentially significant hit to the economy, the effect is likely to be completely reversed once the shutdown ends. Moreover, the drag to growth from the shutdown pales in comparison to the overall stance of fiscal policy. According to the IMF, the cyclically-adjusted budget deficit is set to reach 5.7% of GDP this year, up from 3.2% of GDP in 2015. There is also a reasonable chance that any deal to end the shutdown will involve a commitment to increase spending beyond currently budgeted levels. This would increase the overall amount of fiscal stimulus the economy is receiving. Taking The Pulse Of Global Growth The slowdown in growth has been deeper and more protracted outside the United States. Nevertheless, rays of sunshine are emerging. Our global Leading Economic Indicator diffusion index, which measures the proportion of countries with rising LEIs compared to those with falling LEIs, has bottomed. The diffusion index leads the global LEI by a few months (Chart 8). Chart 8The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize As is increasingly the case, the fate of the Chinese economy will be critical in determining when global growth begins to reaccelerate. The latest Chinese activity data has been disappointing, with this week’s downright awful export figures being the latest example. That said, credit growth may be starting to stabilize, as evidenced by stronger-than-expected loan growth for December. With credit growth now running only slightly above nominal GDP growth, the need for the authorities to maintain their deleveraging campaign has diminished. In an encouraging sign, the Market-Based China Growth Indicator developed by our China Investment Strategy service has been moving higher (Chart 9). Chart 9Encouraging Sign For The Chinese Economy A revival in Chinese growth would aid trade-sensitive economies such as Japan and Germany. The former saw a decline in economic momentum in the second half of 2018, exacerbated by typhoons and an earthquake in Hokkaido. With the consumption tax set to increase from 8% to 10% in October, the Bank of Japan will need to maintain its yield curve control regime at least until 2020. This could weigh on the yen. With that in mind, we tightened the stop on our short AUD/JPY trade two weeks ago and subsequently exited the position with a gain of 10%. The German economy has taken it on the chin recently. Real GDP contracted in the third quarter and barely grew in the fourth quarter. The economy should rebound in 2019 as external demand improves. The drag on growth from the decline in automobile assemblies following the introduction of new emission standards should also turn into a modest tailwind as production resumes. In addition, fiscal policy is set to turn more stimulative, while robust wage growth, lower oil prices, and rising home prices should support consumption. Elsewhere in Europe, the Italian economy should recover as bond yields come down from their highs and confidence improves following the resolution of the impasse with the EU over budget targets. The modest easing in Italy’s fiscal policy of about 0.5% of GDP in 2019 should also benefit growth. It is too early to quantify the effect on the French economy from the “yellow vest” protests. France is no stranger to protests of this sort, so our guess is that the impact on the economy will be minimal. President Macron’s pledge to loosen fiscal policy in hopes of placating the protestors should also support demand. Brexit: A “No Deal” Outcome Looks Less Likely The Brexit saga could end in one of three ways: 1) A “no deal” where the U.K. leaves the EU with no alternative in place; 2) A “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; 3) A decision to reverse the results of the original referendum and stay in the EU. In thinking about which of these three outcomes is most likely, one should keep the following in mind: Any course of action that the U.K. takes must have the support of the British parliament. A no deal outcome does not have parliament’s support. Not even close. Thus, it will not happen. This leaves options 2 and 3. This publication has argued since the day after the Brexit vote that the European establishment, following the example of the Irish and Danish referendums over various EU treaties, will keep insisting on do-overs until it gets the result it wants. If one referendum is good, two is even better – it’s twice as much democracy! The betting markets seem to be coming around to our view. As we go to press, PredictIt shows a one-in-three chance that a new referendum will be called by March 31 (Chart 10). Polling trends suggest that if another referendum were held, the remain side would probably prevail (Chart 11). Chart 11U.K.: A Change Of Heart? In some sense though, it does not matter for investors whether the original referendum is reversed or a soft-Brexit deal is reached. Either outcome would be welcomed by markets. We continue to advocate buying GBP/EUR. My colleague Dhaval Joshi, BCA’s Chief European strategist, also recommends that equity investors purchase the FTSE 250 index, which comprises from the 101st to the 350th largest companies listed on the London Stock Exchange. Unlike its large-cap counterpart, the FTSE 100, the FTSE 250 index is more geared to what happens in the U.K. than in the rest of the world. Investment Conclusions Global inflation remains subdued, which gives central banks the luxury of taking a wait-and-see approach to tightening monetary policy. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. Given that the market is no longer pricing in any Fed hikes, a bearish stance towards U.S. Treasurys is warranted over a 12-month horizon (Chart 12). Outside of Japan, bond yields will also rise in the major developed economies. Chart 12Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected We downgraded global equities in June as our leading indicators began to point to slower growth ahead, but upgraded them back to overweight after stocks plunged following the December FOMC meeting. The rally over the past three weeks has reversed deeply oversold conditions and our tactical MacroQuant model is once again flagging some near-term risk to stocks. Nevertheless, if the global economy avoids a recession this year, as we expect, equities should fare well over a 12-month horizon. The MSCI All-Country World index is trading at a modest 13.6-times forward earnings (Chart 13). Profit estimates have been revised down meaningfully, suggesting that the bar for upward earnings surprises is now quite low. Chart 13A Lot Of Bad News Already Discounted? Risk assets can tolerate higher rates as long as tighter monetary policy is the result of stronger growth. What risk assets cannot withstand is a stagflationary environment where growth is slowing but the Fed is hiking rates in order to bring down inflation. That is not the situation today, but could be the situation next year. Bottom line: Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights Global Corporates: The Fed is now clearly signaling a near-term capitulation to tightening financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. Country Allocation: Move to overweight (4 of 5) on both U.S. investment grade and high-yield corporates, while downgrading U.S. Treasuries to underweight (2 of 5). Upgrade euro area investment grade and high-yield corporates to neutral (3 of 5), while downgrading euro area governments to underweight (2 of 5). Upgrade emerging market U.S. dollar denominated debt (both sovereign and corporate) from maximum underweight to underweight (2 of 5). Feature We downgraded our overall recommended investment stance on global corporate debt to neutral on June 26 of last year.1 That decision reflected our concern at the time that less accommodative central banks, a rising U.S. dollar, weakening global growth momentum and intensifying U.S.-China trade tensions had all significantly worsened the near-term risk/reward tradeoff for owning corporate bonds. This accompanied a firm-wide call at BCA to pare back our recommended exposure to global equities for the same reasons. We now see an opportunity, driven by better value and diminished market volatility after the Fed has clearly signaled a pause on U.S. rate hikes (Chart of the Week), to go back to an overweight stance on corporate credit on a tactical basis (3-6 months). Chart of the WeekTime For A Pause In Corporate Spread Widening To be clear, we still see medium-term risks for corporate credit once global growth stabilizes and a resilient U.S. economy forces the Fed to restart the rate hikes in the latter half of 2019. A move to a restrictive stance by the Fed toward year-end, signaled by an inversion of the U.S. Treasury yield curve, will raise recession risks and be the eventual death knell for this credit cycle. In the meantime, corporate debt is likely to outperform government bonds, justifying a tactical overweight position. This mirrors the recent change in the BCA House View, returning to a tactical overweight stance on global equities. On a regional basis, we prefer taking more of our upgraded credit risk in U.S. corporates over European and emerging market (EM) equivalents. The outlook for growth remains more favorable on a relative basis to Europe or China, the latter being most critical for the outperformance of EM assets. Why The Spread Widening Will Pause: A Patient Fed Is Taking A Break Global corporate bond spreads have widened since we did our downgrade in June, across all countries and credit tiers (Chart 2). Typically, some underperformance of corporate credit should occur when global growth momentum slows, as was the case throughout 2018. Yet the most violent period of spread widening only began once the Fed began signaling that it would continue with its interest hikes and balance sheet runoff, despite softening global growth. This set off yet another clash between policy and the markets – one of BCA’s key investment themes for 2018 that still applies in 2019 – resulting in a sharp selloff in global risk assets, including corporate debt. The result was a tightening of U.S. financial conditions, first through a stronger U.S. dollar (supported by rate hike expectations) and later through lower equity prices and wider corporate spreads. This echoed the 2014/15 period when the Fed was trying to lift rates off the zero bound after ending its quantitative easing program. The Fed was only able to deliver a single rate hike in December 2015 before pausing because of severely slumping global growth (most notably in China) and a sharp tightening in financial conditions, both of which knocked the wind out of the U.S. economy. Turning to 2019, the downturn in cyclical growth indicators like manufacturing purchasing managers indices (PMI) and the global leading economic indicator (LEI) has reached levels last seen after that 2014/15 episode (Chart 3). Importantly, our global LEI diffusion index, which measures the number of countries with rising LEIs compared to falling LEIs and is itself a reliable leading indicator of the global LEI, is bottoming out at the same level that preceded the 2016 LEI revival (middle panel). This suggests that a stabilization of the global LEI could unfold in the next few months, which would also signal a potential rebound in corporate credit returns (bottom panel). Chart 3Credit Returns Already Reflect Slowing Growth Given the many similarities between today and the 2014/15 backdrop, it is sensible to look for other indicators that accurately heralded the end of that period of spread widening to help time a potential increase in recommended exposure to corporates. Over the past several weeks, our colleagues at our sister BCA service, U.S. Bond Strategy, have been following a checklist of market-based signals to determine the timing of a potential peak in U.S. credit spreads.2 These are grouped into two categories: signals of rebounding global growth and signals of Fed capitulation on rate hikes. For global growth, the indicators monitored are shown in Chart 4: Chart 4Checklist For Peak U.S. Spreads: Global Growth the CRB raw industrials index of commodity prices (a broader measure that excludes highly volatile oil prices) the BCA Market-Based China Growth Indicator (created by our China Investment Strategy team as a proxy of investor expectations of Chinese growth3) the Global Industrial Mining equity price index For Fed capitulation, the indicators monitored are shown in Chart 5: Chart 5Checklist For Peak U.S. Spreads: Fed Capitulation our 12-month fed funds discounter, which measures the amount of expected Fed rate hikes over the next year discounted in the U.S. Overnight Index Swap (OIS) curve the price of gold in dollars (a higher price correlating with perceptions of easier U.S. monetary policy and vice versa) the nominal trade-weighted U.S. dollar index Among the growth-focused elements of the checklist, only the China Growth Indicator is in a clear uptrend. Non-oil commodity prices had been stabilizing at the end of 2018 but appear to be rolling over, while it is not yet clear if the downturn in Mining stocks has ended. With momentum in global PMIs and LEIs still having not yet bottomed out, it may be too early to expect a cyclical rebound in non-oil commodities and related equities. At a minimum, that will require even greater signs that China’s economy is regaining some vigor. However, as we discussed last week, Chinese policymakers’ options to stimulate growth are far more limited now than they were in 2015 and 2016 when a rebounding China boosted commodity demand and EM asset performance.4 Within the Fed-focused components of the “Peak Spreads Checklist”, the near-term bullish signal for credit is much stronger. Our fed funds discounter has rapidly priced out all rate hikes for 2019. Since November, gold is up nearly 8% and the nominal trade-weighted U.S. dollar is down 2%. The shift in recent Fed messaging from signaling a “gradual pace” of tightening to exhibiting “patience” on any future policy moves was a highly dovish signal for investors. This alone has been enough to stabilize equity and credit markets, which had been discounting that Fed tightening in 2019 would drive the U.S. into a possible recession. In the constant battle between financial conditions and the Fed, the former has won this latest round. How long will this Fed pause last? Continuing with the comparison to the 2014/15 episode, a critical difference is that underlying trends in U.S. economic growth and inflation are firmer today. This is evident in the BCA Fed Monitor, which is comprised of economic and financial data that indicate pressure on the Fed to tighten or ease monetary policy. Chart 6 shows a “cycle-on-cycle” comparison of the Fed Monitor (and its subcomponents) today versus 2014/15. The Fed Monitor is still signaling a need for the Fed to continue tightening because the Economic Growth and Inflation Components remain elevated. Yet the Monitor has declined from its recent peak thanks entirely to the plunge in the Financial Conditions Component, which has fallen even faster than it did in 2014/15. Chart 6BCA Fed Monitor: Today Vs 2014/15 The implication from our Fed Monitor is that there needs to be more evidence of slowing U.S. economic growth and reduced inflation pressures for the Fed to stay on hold for longer. If the data stay firm, but financial conditions ease because investors expect a prolonged pause from the Fed, then the Fed could quickly return to a hawkish bias later this year. This is now our base case scenario for how 2019 will play out. This is also why we are only upgrading corporate debt on a tactical basis. We do not expect U.S. growth or inflation to slow enough to prevent more Fed tightening later this year – an outcome that will weigh on credit returns as the Fed moves to a restrictive policy stance. Yet even if we are wrong and the U.S. economy decelerates more sharply, that is also a bad outcome for credit because it means weaker corporate profits and rising downgrades and defaults. For bond investors with longer-time horizons than 3-6 months, the credit rally that we are anticipating can actually provide an opportunity to reduce credit exposure for the final leg of the Fed’s monetary policy cycle and the multi-year corporate credit cycle. In other words, selling into the rally rather than chasing it. For now, we are choosing to play for the shorter-term move by upgrading our recommended global credit allocations. Yet we do not envision this turning into a long-term position. The medium-term outlook for corporates is far more challenging given the advanced age of the monetary, business and credit cycles. Bottom Line: The Fed is now clearly signaling a near-term capitulation to tightening global financial conditions alongside slowing global growth and inflation. A pause in the U.S. rate hiking cycle, after credit spread valuations have cheapened up, opens up a window of opportunity for global corporate bond market outperformance versus government debt over the next 3-6 months. The Specific Changes To Our Recommended Asset Allocation As part of our tactical upgrade of global corporate debt, we are making the following changes to our recommended portfolio allocation tables (see Page 13): Upgrade overall global credit exposure to overweight (4 out of 5) Upgrade both U.S. investment grade and high-yield corporate exposure to overweight (4 out of 5), while downgrading U.S. Treasury exposure to underweight (2 out of 5) Upgrade euro area investment grade and high-yield corporate exposure to neutral (3 out of 5) and downgrade euro area government bond exposure to underweight (2 out of 5) Upgrade EM U.S. dollar denominated debt from maximum underweight to underweight (2 out of 5), both for sovereign and corporate debt. The changes all represent a one-notch upgrade from our previous allocations, based on our more positive tactical view on overall global credit risk, while still maintaining our relative preference for U.S. corporates over non-U.S. equivalents. We prefer U.S. credit not only because we expect better relative economic growth momentum in the U.S., but also because our preferred valuation metrics indicate that U.S. corporate bond spreads now look relatively attractive. Our estimate of the default-adjusted spread on U.S. high-yield corporates, which is simply the current spread minus losses from defaults, has risen to 302bps, well above the long-run average of 268bps (Chart 7). That is a function of the high-yield spread now discounting a 2019 default rate of nearly 6%, well above our forecasted default rate of 2.5%.5 Chart 7Too Much Default Risk Priced Into U.S. Junk Corporate credit spreads in the U.S. also look attractive on a volatility-adjusted basis. Our estimates of Breakeven Spreads – the amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon – shows that credit spreads have cheapened to levels that are in the upper end of the historical range for both investment grade and high-yield debt (Charts 8 & 9). Chart 8Vol-Adjusted IG Spreads Have Cheapened   Chart 9Vol-Adjusted HY Spreads Are Cheap Credit spreads have also cheapened up in Europe and EM, and a “risk-on” rally from a Fed pause will likely benefit spread product in those regions. However, the performance of U.S. credit versus non-U.S. credit remains largely determined by relative growth trends (Charts 10 & 11). Given our more positive view on U.S. growth on a relative basis, we are maintaining a higher recommended allocation to U.S. corporates versus euro area and EM equivalents, even as we upgrade overall global corporate exposure. This is also a way to provide a partial hedge to the specific risks in the latter regions coming from: Chart 10Global Corporates: Continue Favoring U.S. Over Europe   Chart 11Global Corporates: Continue Favoring U.S. Over EM a) an end of the ECB’s corporate bond buying as part of its Asset Purchase Program, which takes a major buyer out of the euro area corporate market b) a more persistent slowing of Chinese growth momentum and softer non-oil commodity prices, both of which would be negatives for EM assets On a final note, we are also changing the specific weighting in our Model Bond Portfolio on Page 12 to reflect all of the above changes. The allocations to all U.S., euro area and EM corporates are increased – with bigger allocation changes in the U.S. – funded out of reduced weightings in U.S., German and French government bonds. Note that we are not making any changes to our relative U.K. exposures this week, given the unique risk for U.K. financial markets from the Brexit uncertainty. Thus, we are maintaining an overweight stance on U.K. Gilts in the government bond portion of the model portfolio, while remaining underweight U.K. corporates on the credit side.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral”, dated June 26th 2018, available at gfis.bcaresearch.com. 2 Please see BCA U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27th 2018, available at usbs.bcaresearch.com. 3 Please see BCA China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21st 2018, available at cis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “Three Big Questions To Start Off 2019”, dated January 8th 2019, available at gfis.bcaresearch.com. 5 That forecasted default rate is taken from Moody’s, who have a similarly positive outlook on 2019 U.S. growth as BCA. Therefore, we see no reason to use a different default rate assumption in our high-yield valuation estimate. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1  However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4  Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening.  Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7  Chart 10Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification