Global

Special Report

Highlights As investors increasingly look at allocating assets based on environmental, social, and governance (ESG) considerations, these strategies are becoming less niche. We look at different ESG investing strategies, in both equities and bonds, and analyze their historical risk-adjusted returns and performance in bear markets and recessions. We find that ESG indices have at least performed in line with, and often outperformed, aggregate indices, with lower volatility. However, performance varies from region to region and between asset classes. Markets with the worst ESG standards tend to see the biggest improvement in performance when ESG factors are considered Feature Increasing investor interest in environmental, social, and governance (ESG) investing poses a big question for money managers: how does an allocation to ESG investments affect the return and volatility profile of a traditional portfolio? This Special Report addresses the following issues: What are the risk-return characteristics of ESG investments from a top-down perspective? Do ESG investments provide recession/bear market protection? What are the unique challenges that money managers using an ESG strategy need to account for? A Brief Overview Of ESG To begin, we need to define what exactly ESG investing means. We see it as any investment activity that recognizes a certain set of principles to screen for environmental, social, and governance standards. ESG investing, as a term, is relatively new. However, the core concept can be traced back several decades. During the 20th century, ethical investing (EI) emerged, as investors applied faith-based criteria to their investments. From the 1980s, socially responsible investing (SRI) allowed investors to focus on social and environmental goals, in addition to their ethical beliefs. This was mainly due to an increased global awareness of environmentalism that emerged in this period, following events such as the Exxon Valdez oil spill in 1989 and claims of labor-rights abuses in various industries. In the early 2000s, ESG investing arose from investors' increasing awareness of the need to include corporate governance as an additional screening to SRI investing. The inclusion of the governance factor was also due to numerous corporate scandals, such as Enron's bankruptcy in 2001. Simply put, ESG is a broader concept than the previous incarnations of ethical investing. Throughout the early 2000s, various global initiatives started supporting the cause of ESG investing. The United Nations launched the Principles for Responsible Investing (PRI) in 2006 to promote ESG investing among institutional investors.1 Based upon six pillars, the PRI aims to encourage the use of ESG factors by investors in their investment process. Currently, most of the demand for ESG investing comes from larger financial institutions, particularly pension funds, whereas smaller investment institutions and retail investors lag in their interest. The Global Sustainable Investment Alliance (GSIA) has released a global standard classification to distinguish between the different ESG strategies as summarized in Table 1. Negative screening, positive screening, and corporate engagement are the most used strategies, while themed investing and targeted-situation investing have relatively less allocation. Figure 1 illustrates various examples of which types of investments might fall under ESG.2 Table 1Global Standard ESG Classification* Figure 1Types Of Investments That Fall Under ESG* The total market size of "sustainable investing" is difficult to quantify, due to the wide range of securities that could fall under this ambiguous label. According to the 2016 Global Sustainable Investment Review, published bi-annually by the GSIA, global ESG assets under management (using a very broad definition of ESG) totaled $22.9 trillion dollars as of 2016, a 25% increase from 2014.3 The development of cleaner energy sources, changing social norms, interest by millennials in environmental and social issues, and regulation are among the drivers of this growth. The increasing number of ETFs and mutual funds that define themselves as "socially conscious", standing at 279 as of Q3 2018, also demonstrates the growing interest in ESG investing.4 Additionally, the number of active managers integrating ESG factors in their investment strategy has grown (Chart 1). Chart 1Growing Interest... Increasing investor demand has translated into further transparency from companies. According to the Governance & Accountability Institute, the number of S&P 500 firms that disclose their sustainability, corporate governance and social responsibility performance more than quadrupled between 2011 and 2017 (Chart 2).5 Chart 2...More Transparency However, transparency is not the only barrier to the growth of ESG investing. The term ESG is still utilized and defined in different ways, confusing investors. A joint survey by the UN and the CFA Institute showed that 43% of U.S. equity and fixed income investors cited a lack of historical data, and 41% limited understanding and knowledge of ESG issues as the top barriers to incorporating ESG.6 Additionally, due to the lack of a standardized reporting system, investors cannot properly assess and compare ESG metrics across firms.7 ESG factors tend to be hard to quantify. Inconsistent ESG ratings due to differences in data analysis and reporting contribute to the lack of comparability. Investors should do their own thorough due diligence before investing. Various funds that screen for "socially responsible" criteria do sometimes include controversial stocks. For example, Vanguard's SRI European Stock Fund includes Royal Dutch Shell and British American Tobacco plc amongst its top 10 holdings.8 Risk-Return Characteristics9 To compare returns across regions, we use the MSCI ESG Leaders Index, which MSCI describes as using a best-in-class strategy and excluding companies involved in the alcohol, gambling, tobacco, nuclear power, and weapons businesses. It also minimizes sector-based tracking error by targeting 50% of the market capitalization within each GICS sector.10 MSCI assigns companies an ESG rating ranging from AAA to CCC; companies must maintain a rating above BB to be eligible for inclusion. We use the Bloomberg Barclays MSCI Socially Responsible Indices for our fixed-income comparisons. These indices use a negative screening process to exclude issuers involved in businesses that are in conflict with social and environmental values. Historical data for ESG indices tend to be limited; the earliest data-point for the MSCI ESG Leaders Index is September 2007. We analyze historical metrics for two periods: one starting September 2007, and the other starting July 2009 to show returns after the negative impact of the Global Financial Crisis (GFC). Tables 2 and 3 show that equity investors have enjoyed higher risk-adjusted returns on equity ESG indices thanon standard equity indices. However, this is not the case across all regions. The global ESG equity index outperformed in both periods, with lower volatility (Chart 3). In the U.S. and U.K., ESG indices underperformed their conventional counterparts, but in the euro area, China and Canada they significantly outperformed, while achieving lower volatility (charts for all countries shown in the Appendix). Emerging markets are perhaps the biggest surprise, since here the ESG index outperformed by over 3.5% annually in both periods. However, EM outperformance was mainly driven by China (Chart 4). Table 2Equities: Risk-Return Profile (September 2007 - October 2018) Table 3Equities: Risk-Return Profile (July 2009 - October 2018) Chart 3ESG Equities: Global Outperformance Chart 4China Drove EM Outperformance A study conducted by MSCI ESG Research showed that stock selection had the biggest contribution to the excess return of the emerging markets ESG equity indices, followed by sector-selection tilts. In fact, stock-selection added value in most regions, except the U.S. The MSCI ESG Leaders Index excludes firms such as Amazon (for its labor practices), Apple (supply-chain issues), and Facebook (privacy and data security) from both the U.S. and the global ESG indices, which resulted in its relative poor performance during the strong technology market of the past few years. Some argue that the regions with the worst ESG standards tend to see the biggest improvement in performance when ESG factors are considered. However, a debate then arises as to whether ESG ratings can be taken at face value, or should simply be an input into a broader analysis.11 One of the most surprising results from Tables 2 and 3 is the finding that the global ESG index has lower volatility, given the more idiosyncratic risk of ESG indices, which have on average only about half the number of constituents of aggregate market indices. The concentration - based on a Herfindahl-Hirschman Index (HHI) - of the top 10 ESG constituents is about four times that of the broad indices. ESG equity indices trade at lower PE multiples than traditional indices. Chart 5 shows that, on average, ESG equities' outperformance has been mainly driven by stronger relative earnings growth rather than relative multiple expansion. Earnings contributed 48% to total return growth for the ACWI ESG index, compared to 41% for its counterpart. PE expansion contributed 21% of the ESG index's total return, compared to over 30% for the ACWI index. Chart 5Drivers Of Return The conclusions are not very different for fixed income (Table 4). There is little difference between returns for corporate SRI bonds and investment grade bonds. Despite the slight sector tilts towards financials and banks in SRI Bond Indices, the indices have largely tracked each other (Chart 6). Table 4Bonds: Risk-Return Profile (July 2009 - October 2018) Chart 6ESG Bonds: No Difference In Performance Only a limited amount of research has been conducted into the importance of ESG factors for credit portfolios, but several papers concluded that ESG scores do not significantly impact performance, though there was some evidence that bonds of companies with higher ESG scores actually trade at wider spreads.12 Recession/Bear Market Protection Despite the efforts of ESG providers to limit sector-based tracking error, ESG equity indices still tend to have sector tilts due to over- and under-weighting firms based on their ESG scores. Sectors such as Information Technology, Financials, Communication Services, and Healthcare usually are favored relative to Materials, Industrials, and Energy. However, the magnitude of these tilts differs from region to region, and understanding the scope of these tilts is important when considering an ESG allocation. For example, the Chinese MSCI ESG Leaders Index is heavily skewed towards Communication Services (one stock, Tencent, in particular). Simply put, the sector composition/index construction of ESG indices alters their cyclicality and, therefore, performance. To understand this, it is important to observe this behavior over as many cycles as possible. To analyze this, we looked at the U.S. MSCI KLD 400 Index, one of the oldest ESG indices, with data starting in 1990. In 2001-2002 (the aftermath of the tech bubble), the KLD 400 underperformed the S&P 500 due to the former's larger exposure to tech. On the other hand, during the 2007-2008 GFC, the KLD 400 had a smaller drawdown than the S&P 500 (Chart 7). Chart 7Sector Tilts Matter Additionally, Table 5 shows that an ESG allocation has tended to at least perform in line with equities overall, if not slightly outperform them, during bear markets. The MSCI KLD 400 outperformed the S&P 500 by an annualized average of 1% in the past five bear markets.13 Table 5Bear Market Protection? We performed a risk-return analysis of a portfolio consisting of 60% conventional equities and 40% investment-grade bonds, compared to similarly weighted ESG-focused equity and fixed income indices. The results for the three regions for the period July 2009 and October 2018 are shown in Chart 8. Chart 8Portfolio Performance (Jul 2009 - Oct 2018) The global and the euro area multi-asset ESG portfolios outperformed the conventional portfolios by 2 and 10 bps a year respectively while achieving slightly lower volatility. The U.S. ESG portfolio, on the other hand, slightly underperformed due to the underperformance of the ESG equity index in a strong tech market of the past nine years. Conclusion From the above analysis, we would draw the following conclusions: There is little evidence that ESG investing detracts from performance. In fact, there is some evidence that it can provide some outperformance and bear-market protection depending on the ESG index composition. Consideration of ESG factors in taking investment decisions needs to go beyond simply looking at ESG scores. Incorporating ESG analysis will increasingly become a core step in assessing risk for both equity and fixed-income investors. Index methodology and construction, as well as sector composition, play a big role in evaluating expected performance. ESG indices are growing. As of end of 2017, there were 42 ESG-focused equity indices by the major three providers as shown in Appendix Table 1. We expect to see more as ESG becomes increasingly acknowledged. Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1 Please see https://www.unpri.org/pri/about-the-pri 2 Please see https://www.ussif.org/files/Publications/Retail_Investor_Guide.pdf 3 Please see http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf 4 Please see Charles Schwab, Socially Conscious Funds List https://www.schwab.com/public/file/P-9561751/. Based on data from Morningstar, Inc. 5 Please see https://www.ga-institute.com/press-releases/article/flash-report-85-of-sp-500-indexR-companies-publish-sustainability-reports-in-2017.html 6 Please see ESG Integration In The Americas: Markets, Practices, And Data https://www.unpri.org/download?ac=5397 7 Please see CFA Financial Analysts Journal, Third Quarter 2018, Volume 74, Issue 3 https://www.cfapubs.org/doi/pdf/10.2469/faj.v74.n3.full 8 Please see https://global.vanguard.com/portal/site/loadPDF?country=ch&docId=14053 9 It is important to note that, in this report, we make no assumptions regarding the methodology or ESG ranking scores of the indices discussed, but rather take them as given by their providers (MSCI and Bloomberg Barclays). 10 Please see https://www.msci.com/eqb/methodology/meth_docs/MSCI_ESG_Leaders_Indexes_Methodology_June_2017.pdf 11 Please see http://www.whebgroup.com/what-do-esg-ratings-actually-tell-us/#_edn4 12 Please see https://static.macquarie.com/dafiles/Internet/mgl/global/shared/sf/images/corporate/asset-management/investment-management/understanding-esg-in-credit-portfolios.pdf?v=3 13 Bear markets defined as a drawdown of 15% lasting more than three months. Appendix Appendix Table 1ESG Equity Indices Appendix Chart 1ESG Equities: U.S. Appendix Chart 2ESG Equities: Euro Area Appendix Chart 3ESG Equities: Emerging Markets Appendix Chart 4ESG Equities: Canada Appendix Chart 5ESG Equities: U.K. Appendix Chart 6ESG Bonds: U.S. Appendix Chart 7ESG Bonds: Euro Area

Highlights Global Yields: Global bond yields appear to be settling into a new trading range, with the downside limited by tight labor markets but the upside capped by slowing global growth momentum. 2014/15 Redux?: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Feature Dear Client, There will be no Global Fixed Income Strategy report published next Tuesday, November 27th. Instead, you will be receiving a Special Report this Thursday, November 22nd. The report - authored by BCA's Chief Emerging Markets strategist, Arthur Budaghyan - will discuss the outlook for Emerging Market hard currency debt. Best regards, Rob Robis Chief Strategist On the surface, it appears that uncertainty is increasing in global fixed income markets. Government bond yields have dipped over the past couple of weeks, most notably in the U.S. where the benchmark 10-year Treasury yield is back down to 3.05% as we go to press. Corporate credit spreads have also been drifting wider, especially in the U.S. where there is growing concern that economic momentum has peaked, at least temporarily. The problem for bond markets is that while global growth momentum has clearly slowed, it has not been by enough to alleviate inflation pressures coming from tight labor markets. This story is clearly most visible in the U.S., but also in the majority of major developed market economies. Central bankers are sticking to their guns and focusing on their belief in the Phillips Curve model to forecast inflation. Until there are signs that more turbulent financial markets are feeding into actual weaker economic growth, bond yields will not be able to fall by enough to help bail out flailing equities and corporate credit. There are now 83% of OECD countries with an unemployment rate below the estimated full employment NAIRU. As expected with such a backdrop, our Central Bank Monitors are calling for tighter monetary policy across the developed economies. This is also showing up in an unusual divergence between rising global real bond yields and falling global leading economic indicators (Chart of the Week). Chart of the WeekYields Are Less Responsive To Slowing Growth By most conventional measures, monetary policy settings are not restrictive across the major economies. Actual policy interest rates remain below conventional measures of equilibrium like a Taylor Rule, while government bond yields - adjusted for inflation expectations - are less than trend real GDP growth (Chart 2). Those gaps are smallest in the U.S., where the Fed has been raising interest rates for the past three years, but remain wide in other countries. Chart 2Global Interest Rates Are Still Below Equilibrium Levels If global growth is merely shifting from above-trend (falling unemployment) to trend (stable unemployment), then central bankers will not be able to move back to a more dovish posture that could trigger a major fall in bond yields. Trading ranges are more likely to result in such an environment, where yields struggle to break higher because of shaky risk assets but cannot break lower because of low unemployment. We are likely in one of those ranges now, measured by a 3-3.25% range on the 10-year U.S. Treasury. Without a friendly boost from falling bond yields, we continue to recommend a cautious stance on global spread product, while maintaining an overall below-benchmark stance on global duration exposure. Will It Be 2014/15 All Over Again? Watch The USD & China Two months ago, we published a comparison of the current macro backdrop to that of the 2014/15 period.1 Back then, the Fed was forced to alter its plans to deliver a series of rate hikes after the end of its quantitative easing program, thanks to a sharply rising U.S. dollar that triggered major financial market selloffs and, eventually, slower U.S. growth. We concluded that such an outcome could occur again in the next few months, but it would take a much larger tightening of financial conditions to get the Fed to stand down this time given tighter U.S. labor markets and stronger U.S. inflation pressures. The way we presented that comparison between today and four years ago was though "cycle-on-cycle" charts, showing financial and economic data today overlapped with data from that 2014/15 period. The two episodes were indexed to the trough in the U.S. dollar in May 2014 and February 2018. This week, we update a few of those charts, but also add a few new indicators to assess if there has been enough financial and economic damage to trigger a shift to a more dovish Fed. U.S. Economy: The domestic U.S. economy appears healthier today versus the 2014/15 period, judging by the more robust readings from the NFIB Small Business Optimism index and the high level of job openings from the JOLTS data (Chart 3). Yet there are similarities seen in the latest decline in the Conference Board survey of U.S. CEO confidence, and the sharp fall in the ISM Manufacturing New Orders index. We suspect that this divergence in business optimism reflects U.S.-China trade tensions, which should have a greater impact on larger corporations that sell globally compared to smaller companies with a more domestic customer base. Chart 3U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Inflation: U.S. core CPI inflation is much faster now than at the similar point in the 2014/15 cycle, as is the growth in Average Hourly Earnings (Chart 4). This is due to the much lower unemployment rate today in the U.S., which is putting more upward pressure on domestically-generated prices and wages. Yet while the ISM Prices Paid index is also at a higher level today than 2014/15, the upward momentum has peaked and the latest decline in commodity prices is following an ominously similar path to four years ago (bottom panel). Chart 4U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation Emerging Markets (EM): EM economic growth has been decelerating at a similar pace to 2014/15, with the aggregate EM (ex-China) PMI produced by our EM strategists now sitting right at the boom/bust 50 line (Chart 5). China's economic growth appears to be holding up better today when looking at the more elevated Li Keqiang index. A possible reason for that is the much larger and faster easing of Chinese monetary conditions today compared to 2014/15, thanks to the sharp weakening of the yuan. Chart 5EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) Global Financial Markets: Here, the current cycle is sticking very close to the 2014/15 script when looking at the rising U.S. trade-weighted dollar, widening spreads for U.S. investment grade (IG) corporate bonds and EM USD-denominated sovereign debt, and the tightening of U.S. financial conditions (Chart 6). Although it should be noted that the trade-weighted dollar would have to rise another 10% from current levels, and U.S. IG spreads would have to widen another 60bps, to generate similar moves compared to 2014/15. Chart 6Financial Markets Today Vs. 2014/15: Following A Similar Script U.S. Treasury Yields: Nominal U.S. Treasury yields are at much higher levels today than four years ago, an obvious consequence of the Fed's tightening cycle and more elevated U.S. inflation expectations (Chart 7). Yet the amount of tightening discounted over the next 12-months in the U.S. Overnight Index Swap (OIS) is similar to 2014/15, as is our estimate of the market-implied level of the terminal real fed funds rate (around 0.5%).2 One major difference: there is a large net short position in the Treasury market today, while positioning was fairly neutral during 2014/15 (bottom panel). Chart 7U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing Summing it all up, the broader range of evidence we present here confirms our conclusion from two months ago. There needs to be a much larger tightening of U.S. financial conditions before the Fed can signal a pause on its planned rate hikes, because of a much healthier domestic U.S. economy and a more entrenched acceleration of inflation (especially wage growth). If China's economy can continue to outperform the 2014/15 path - still a big "if" given U.S.-China trade uncertainties and with Chinese policymakers less willing to reflate the domestic credit bubble to boost growth - then the odds of U.S. growth converging down to non-U.S. growth will be reduced. We will continue to monitor these charts and relationships in future Weekly Reports but, for now, we see nothing yet to change our bearish views on U.S. Treasuries and our cautious view on U.S. corporate credit. Bottom Line: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand Update: Fade The Recent Bump In Yields We have been structurally positive on New Zealand (NZ) government bonds for some time, dating back to mid-2017. Our view was based on an assessment that the Reserve Bank of New Zealand (RBNZ) would be unable to make any upward change in policy rates due to sub-par economic growth and inflation that would struggle to meet the RBNZ's target of 2% (the midpoint of the 1-3% target band). So far, that scenario has fully played out, and NZ government bonds have significantly outperformed their global peers as a result (Chart 8). Chart 8Sticking With Our Successful Long NZ Trades Our preferred trades, which are part of our Tactical Overlay shown on page 14, have been yield spread trades for NZ government bonds versus U.S. and German equivalents.3 Specifically, we have been recommending long positions in 5-year NZ bonds vs. 5-year U.S. Treasuries and 5-year German government debt. The trades have performed well, but have given back some of the gains in recent weeks. This has mostly come via a surge in NZ yields (+29bps higher since the recent low on September 7th) that has driven yield spreads wider versus the U.S. and Germany (+23bps and +34bps, respectively, since September 7th). These increases are likely to prove unsustainable, given the sluggish momentum in NZ growth and inflation. The latest read on year-over-year real GDP growth came in at below-potential pace of 2.8% in the 2nd quarter of 2018. The manufacturing and services purchasing managers' indices (PMIs) have both fallen sharply throughout 2018, although the latest data points suggest some stabilization above the 50 level on the PMIs (Chart 9). Similar trends can be seen in the RBNZ surveys of business confidence and capacity utilization, which both remain near the post-2008 lows but may also be stabilizing. Chart 9Sub-Par Growth In New Zealand In the November Monetary Policy Statement (MPS) that was released after the RBNZ meeting earlier this month, a cautious view on growth was outlined.4 The pickup in Q2 GDP growth was dismissed as driven by temporary factors, and policymakers expressed concern that deteriorating business confidence could be signaling a more prolonged period of slowing domestic demand. The central bank did also highlight growth risks coming from slowing exports if U.S.-China trade tensions intensify. It is difficult to find an obvious trigger for faster NZ growth at the moment. Both consumer spending and residential investment were fueled by rising immigration and population growth from 2013 to 2017, but those trends have since begun to reverse. The RBNZ projects net monthly immigration to NZ to slow to levels last seen in 2014 and in line with the current growth rate of consumer spending around 3% (Chart 10). Business investment growth has already stalled (middle panel), while the RBNZ'S Business Outlook surveys indicate a negative outlook for export growth (bottom panel). Chart 10Where Will NZ Growth Come From? Against this sluggish growth backdrop, the RBNZ must continue to run an accommodative monetary policy to support growth. This can be done given the persistent undershooting of NZ inflation versus the RBNZ target. Headline CPI inflation did accelerate to 1.9% in Q3, but core inflation at 1.2% continued to languish near the bottom end of the RBNZ target range. The gap between the two inflation measures can be attributed to previous increases in global energy prices, which caused a blip up in the tradeables portion of the NZ CPI (Chart 11). Yet the recent decline in oil prices, combined with a bounce in the NZ dollar, suggests that the bump in tradeables inflation is likely to reverse in Q4 (middle panel). Non-tradeables inflation, which is driven by domestic factors such as wage growth, has remained stable at just over 2%, even with the NZ unemployment rate at a 10-year low of 4.5% that is below the OECD's NAIRU estimate. Chart 11Stubbornly Low NZ Inflation With an obvious trigger from higher inflation, the RBNZ will be forced to maintain a highly accommodative policy stance. This is especially true given the RBNZ's mandate, which now includes maximizing sustainable employment alongside keeping inflation between 1-3%. We think that means the RBNZ is more likely to tolerate a move to the upper end of that inflation band if the growth outlook was less certain, as is currently the case. Our RBNZ Monitor sits close to the zero line, indicating no pressure to either hike or cut interest rates. In the November MPS, the RBNZ stuck to its forecast that the Official Cash Rate (OCR) would remain unchanged at 1.75% until mid-2020, consistent with the signal from our RBNZ Monitor. The market is differing on this, with the NZ OIS curve currently discounting almost one full 25bp rate hike by the end of 2019, and a faster pace of hikes after that (Chart 12). Chart 12Market-Priced RBNZ Hikes Will Not Happen We continue to recommending fading any pricing of RBNZ rate hikes over the next 6-12 months. Given our still bearish views on U.S. Treasuries, we are maintaining our recommended long NZ 5-year/short U.S. 5-year position (on a currency-hedged basis into U.S. dollars). We have been running our long NZ/short Germany position on an UN-hedged basis - atypical for the Global Fixed Income Strategy service, where our views are almost always currency-hedged into U.S. dollars - since the trade's inception last year, based on a currency view that was more bearish on the euro than the New Zealand dollar. The NZD/EUR cross instead fell substantially, which more than fully eroded the gains on the bond side of the trade until the recent 7.5% pop in that exchange rate. After that move, the return on our unhedged trade is nearly back to flat. We are using that as an opportunity to switch our NZ/Germany trade to a more typical currency-hedged basis, moving the exposure into euros from New Zealand dollars. Bottom Line: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "EM Contagion? Or Just QT On The Q.T.?", dated September 11th 2018, available at gfis.bcarsearch.com. 2 This is calculated by subtracting the 5-year U.S. CPI swap rate, 5-years forward, from the 5-year U.S. OIS rate, 5-years forward. 3 We freely admit that a position held for over one full year should not be described as "tactical", as the name of our overlay portfolio suggests. Yet we have seen no reason to close these trades early given our market views on NZ. 4 The full Monetary Policy Statement can be found here: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2018/mpsnov2018.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns