Gov Sovereigns/Treasurys

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

Highlights Chart 1Checklist To Buy Credit The sell-off in spread product continued through the holiday season, but with spreads now looking more attractive, it is time to consider increasing exposure to corporate credit. Much like in 2015/16, spread widening is being driven by the combination of weaker global growth and the perception of restrictive monetary policy. With that in mind, we are monitoring a checklist of global growth and monetary policy indicators to help us decide when to step back in.1 With the market now pricing-in rate cuts for the next 12 months, monetary policy indicators already signal a buying opportunity (Chart 1). However, before increasing spread product exposure from neutral to overweight we are waiting for a signal from our high frequency global growth indicators. The CRB Raw Industrials index has so far only flattened off (Chart 1, top panel). It started to rise prior to the early-2016 peak in credit spreads. Investors should maintain below-benchmark portfolio duration on a 6-12 month investment horizon, and a neutral allocation to spread product for now. We expect to upgrade spread product in the near future as global growth indicators stabilize. Stay tuned. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 106 basis points in December. The index option-adjusted spread widened 16 bps on the month to reach 153 bps. Corporate bonds underperformed the duration-equivalent Treasury index by 320 bps in 2018, making it the worst year for corporate bond performance since 2011. Recent poor performance has restored some value to the corporate bond sector. The 12-month breakeven spread for Baa-rated debt has only been wider 37% of the time since 1988 (Chart 2). As a result, we are actively looking for an opportunity to increase exposure to corporate bonds. Chart 2Investment Grade Market Overview To assess when to raise exposure from neutral to overweight, we are monitoring a checklist of indicators related to global growth and monetary policy.2 While current spread levels present an attractive tactical entry point, spreads may not re-tighten all the way back to their post-crisis lows. Corporate profit growth far outpaced debt growth during the past year causing our measure of gross leverage to fall (panel 4), but a stronger dollar and rising wage bill will weigh on profit growth in 2019. We expect gross corporate leverage to rise in 2019.   High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 366 basis points in December. The average index option-adjusted spread widened 108 bps, and currently sits at 498 bps. High-Yield underperformed the duration-equivalent Treasury index by 363 bps in 2018, making it the worst year for high-yield excess returns since 2015. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 394 bps, well above average historical levels (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 394 bps in excess of duration-matched Treasuries, assuming no change in spreads. If we factor in enough spread compression to bring the default-adjusted spread back to its historical average, then we get a 12-month expected excess return of 814 bps. Chart 3High-Yield Market Overview For a different perspective on valuation, we can also calculate the default rate necessary for High-Yield to deliver 12-month excess returns in line with the historical average. As of today, this spread-implied default rate is 4.58%, well above the 2.64% default rate anticipated by Moody’s (panel 4). Junk bond value is definitely attractive, and as stated on the front page of this report, we are looking for an opportunity to tactically upgrade the sector. That being said, the uptrend in job cut announcements makes it likely that default rate forecasts will be revised higher in 2019 (bottom panel). At present, spreads appear to offer enough of a buffer to absorb these upward revisions. MBS: Neutral Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 15 basis points in December. The conventional 30-year zero-volatility spread widened 8 bps on the month, driven by a 7 bps increase in the compensation for prepayment risk (option cost) and a 1 bp widening in the option-adjusted spread (OAS). MBS underperformed the duration-equivalent Treasury index by 59 bps in 2018. The zero-volatility spread widened 12 bps on the year, split between a 10 bps widening in the OAS and a 2 bps increase in the option cost. Lower mortgage rates during the past two months spurred a small jump in refinancings, but this increase will prove fleeting. Interest rates are poised to move higher in 2019, and higher rates will limit mortgage refi activity and keep a lid on MBS spreads (Chart 4). Chart 4MBS Market Overview All in all, with higher interest rates likely to limit refinancings, and with mortgage lending standards still easing from restrictive levels (bottom panel), the macro back-drop for MBS remains supportive. Elevated corporate bond spreads currently offer a better opportunity than those in the MBS space, but the supportive macro back-drop means that there is very low risk of significant MBS spread widening during the next 12 months. We maintain a neutral allocation to MBS for now, and will only look to upgrade the sector as the credit cycle matures and it becomes time to adopt an underweight allocation to corporate credit. For the time being, corporate bonds are the more attractive play. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 31 basis points in December, and by 80 bps in 2018. Sovereign debt underperformed the Treasury benchmark by 77 bps in December and by 263 bps in 2018. Sovereign spreads still appear unattractive compared to similarly-rated U.S. corporate spreads (Chart 5). Chart 5Government-Related Market Overview Foreign Agencies underperformed by 24 bps in December and by 152 bps in 2018. Local Authorities underperformed by 86 bps in December and by 75 bps in 2018. Domestic Agencies underperformed by 7 bps in December and by 6 bps in 2018. Supranationals outperformed by 3 bps in December and by 22 bps in 2018. In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.3 Those countries are Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds underperformed the duration-equivalent Treasury index by 114 basis points in December, and by 17 bps in 2018 (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 2% in December, and currently sits at 87% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of -49 bps. In contrast, municipal bonds have delivered annualized excess returns of +45 bps before adjusting for the tax advantage.4 We attribute the pattern of mid-cycle outperformance to the fact that state & local government balance sheet health tends to lag the health of the corporate sector. At present, our Municipal Health Monitor remains in “improving health” territory, consistent with an environment where ratings upgrades will outpace downgrades (bottom panel). Meanwhile, corporations are already deep into the releveraging process. Treasury Curve: Favor The 2-Year Bullet Over The 1/5 Barbell Treasury yields fell sharply in December, but with only minor changes to the slope beyond the 2-year maturity point. The 2/10 slope was unchanged on the month and currently sits at 17 bps. The 5/30 slope steepened 5 bps on the month and currently sits at 49 bps. The biggest changes in slope occurred for maturities less than 2 years, as a result of Fed rate hikes being completely priced out of the curve (Chart 7). Our 12-month Fed Funds Discounter fell from +44 bps at the beginning of the month to -11 bps currently. Meanwhile, our 24-month discounter fell from +41 bps to -23 bps. Chart 7Treasury Yield Curve Overview As a result of the sharp 1/2 flattening, the 2-year note no longer appears cheap relative to the 1/5 barbell (panel 4). Alternatively, we could say that the 1/2/5 butterfly spread is now priced for 15 bps of 1/5 steepening during the next six months (bottom panel). In fact, our yield curve models now point to bullets being expensive relative to barbells for almost every butterfly spread combination (see Tables 4 and 5). This means it is currently less attractive to initiate curve steeper trades than flattener trades. Despite the relatively low yield pick-up in steepener trades, we think they still make sense at the moment given that the Treasury market is discounting an economic outlook that is far too grim. As we discussed in our Key Views report for 2019, sustainable yield curve inversion is unlikely until later in the year, after inflation expectations are re-anchored around pre-crisis levels.5 As such, we maintain our recommendation to favor the 2-year bullet over the duration-matched 1/5 barbell.  TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 196 basis points in December, and by 175 bps in 2018. The 10-year TIPS breakeven inflation rate fell 26 bps on the month and currently sits at 1.71%. The 5-year/5-year forward TIPS breakeven inflation rate also fell 26 bps on the month and currently sits at 1.91%. Long-maturity TIPS breakeven inflation rates have fallen sharply alongside the prices of oil and other commodities during the past two months, as they continue to grapple with two competing forces: Falling commodity prices on the one hand, and U.S. core inflation that continues to print close to the Fed’s target on the other. Eventually, the decisive factor in the TIPS market will be core U.S. inflation continuing to print close to the Fed’s 2% target. This will drive both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates back into a range between 2.3% and 2.5%, once the headwind from weakening commodity prices has passed. This is reinforced by the fact that the 10-year TIPS breakeven inflation rate is now well below the fair value from our Adaptive Expectations Model (Chart 8).6 This model is based on a combination of long-run and short-run inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. In other words, the market will need to see core inflation print close to the Fed’s target for some time before deciding that it will remain there on a sustained basis. Chart 8Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 8 basis points in December, but outperformed by 13 bps in 2018. The index option-adjusted spread for Aaa-rated ABS widened by 6 bps on the month and now stands at 48 bps, 14 bps above its pre-crisis low. The excess return Bond Map on page 15 shows that consumer ABS offer greater expected returns than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The New York Fed’s most recent SCE Credit Access Survey showed a decline in consumer credit applications during the past year, as well as an increase in rejection rates. This is consistent with the observed uptrends in household interest expense and the consumer credit delinquency rate (Chart 9). Chart 9ABS Market Overview Going forward, consumer credit delinquencies will continue to rise from very low levels, but are unlikely to spike without a significant deterioration in labor market conditions. As such, we maintain a neutral allocation to consumer ABS for now, but our next move will likely be a reduction to underweight as consumer credit delinquencies rise further. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 62 basis points in December, but outperformed by 20 bps in 2018. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 14 bps on the month and currently sits at 92 bps (Chart 10). A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed’s Q3 Senior Loan Officer Survey showed that lending standards were close to unchanged and that demand deteriorated. All in all, a slightly negative macro picture for CMBS that will bear close monitoring in the coming quarters. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 15 bps in December, and by 2 bps in 2018. The index option-adjusted spread widened 4 bps on the month and currently sits at 60 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this sector continues to make sense. Chart 10CMBS Market Overview The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%.     Table 4Butterfly Strategy Valuation (As Of January 4, 2019)   Table 5Discounted Slope Change During Next 6 Months (BPs)   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com Footnotes 1 Please see Charts 2A and 2B in U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 2 For the full checklist please see Charts 2A and 2B from the U.S. Bond Strategy Weekly Report, “The Fed In 2019”, dated December 18, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 4 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 5 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 6 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 Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Investors ran for cover in December as they succumbed to a litany of worries regarding the outlook. The key question is whether the pessimism is overdone or an extended equity bear market is underway. Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. There are some tentative signs that the two U.S. weak spots, housing and capital spending, are bottoming out. However, our global leading economic indicators continue to herald a soft first half of 2019 outside of the U.S. The dollar thus has more upside in the near term. The political risks facing investors have not diminished either. In particular, we expect turbulence related to the U.S./China trade war to extend well beyond the 3-month “truce” period. The returns to stocks, corporate bonds and commodities historically have not been particularly attractive on average when the U.S. yield curve is this flat. Nonetheless, the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies back to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. The upgrade to stocks in the developed markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now, but be prepared to upgrade sometime in 2019. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil prices have overshot to the downside. Supply is adjusting and, given robust energy demand in 2019, we still expect prices to rise to $82. Feature Investors ran for cover in December as they succumbed to concerns regarding the U.S./China trade war, corporate leverage, global growth, rising U.S. interest rates and the shift toward quantitative tightening. Some equity indexes, such as the Russell 2000, reached bear market territory, having lost more than 20%. Losses have been even worse outside the U.S. Earnings revisions have plunged into the “net downgrade” zone. Implied volatility has spiked and corporate bond spreads are surging (Chart I-1). The key question is whether the pessimism is overdone or an extended equity bear market is underway. Chart I-1A Flight To Quality We laid out our economic view in detail in the BCA Outlook 2019 report, published in late November. Not enough has changed on the global economic front in the three weeks since then that would justify such a violent shift in investor sentiment. That said, our favorite global leading economic indicators continue to erode (Chart I-2). The only ray of hope is that the diffusion index constructed from our Global Leading Economic Indicator appears to have bottomed. Nonetheless, the actual LEI will keep falling until the diffusion index shifts into positive territory.   Chart I-2Global Leading Indicators Still Weak For China, a key source of investor angst, the latest retail sales and industrial production reports reinforced that economic momentum continues to recede. We will not be convinced that growth is bottoming until we see an upturn in our credit impulse indicator (Chart I-3). Its continued decline in November suggests that the outlook for emerging market assets and commodity prices is poor for at least the next quarter. Global industrial output appears headed for a mild contraction. The manufacturing troubles are centered in the emerging Asian economies, but Europe and Japan are also feeling the negative effects. Chart I-3China: No Bottom Yet In the U.S., November’s bounce in housing starts and permits is a hopeful sign that the soft patch in this sector is ending. However, it is not clear how the devastating wildfires on the west coast have affected the housing data (Chart I-4). The downdraft in capital goods orders may also be drawing to a close, based on the latest reading from the Fed’s survey of capital spending intentions. The U.S. leading economic indicator dipped slightly in November, but remains consistent with above-trend real GDP growth in the months ahead. Chart I-4U.S.: Some Hopeful Signs The bottom line is that our outlook for growth has not been significantly altered. We see little risk of a U.S. recession in 2019. The global economy continues to weaken, but we expect enough policy stimulus out of China to stabilize growth in that economy in the second half of the year. We highlighted in the BCA Outlook 2019 that, while the risks appeared elevated, we would consider shifting back to overweight in stocks if they cheapened sufficiently. Valuation has indeed improved in recent weeks and sentiment has turned more cautious. Global growth will likely continue to decelerate in the first half of 2019, but markets have largely discounted this outcome. In other words, the shift toward pessimism in financial markets appears overdone. The fact that the Fed has signaled a move away from regular quarter-point rate hikes adds to our confidence in playing what will likely be the last upleg in risk assets in this cycle. Fed: Rate Hikes No Longer On Autopilot The Fed lifted rates by a quarter point in December and signaled that any additional tightening will be data-dependent. The FOMC also trimmed the expected peak in the funds rate and its estimate of the long-run, or neutral, level. Policymakers were likely swayed by some disappointing U.S. economic data, the pullback in core PCE inflation, and the sharp tightening in financial conditions (Chart I-5). Chart I-5Financial Conditions Have Tightened Monetary conditions are not tight by historical yardsticks, such as the level of real interest rates. The problem is that investors fear that the neutral level of the fed funds rate, the so-called R-star, remains very depressed. If true, it could mean that the Fed is already outright restrictive, which would signal that the monetary backdrop has turned hostile for risk assets. The OIS curve signals that the consensus believes that the Fed is pretty much done the tightening cycle (Chart I-6) Chart I-6Investors Believe The Fed Is Done! We believe that R-star is higher than the current policy setting and is rising, as the growth headwinds related to the Great Financial Crisis fade with the passage of time. The problem is that nobody knows the level of the neutral rate. Thus, we need to watch for signs that the fed funds rate has surpassed that level, such as an inverted yield curve. The 10-year/3-month T-bill spread is still in positive territory, but barely so. Meanwhile, our R-star indicator is also flashing yellow as it sits on the zero line (Chart I-7). It is a composite of monetary indicators that in the past have been useful in signaling that monetary policy had become outright restrictive, leading to slower growth and trouble for risk assets. The lead time of this indicator relative to economic activity and risk asset prices has been quite variable historically, but a breakdown below zero would send a powerful bearish signal for risk assets if confirmed by an inverted yield curve. Chart I-7Worrying Signs Of Tight Money The Implications Of Four Fed Scenarios It is not surprising that investors are struggling with a number of different possible scenarios on how the R-star/Fed policy nexus will play out. We can perhaps boil down discussion of the Fed and the implications for financial markets to a matrix of four main outcomes, based on combinations related to the level of R-Star (high or low) and the pace of Fed rate hikes in 2019 (pause or continue increasing rates by 25 basis points per quarter). Policy Mistake #1: R-star is still very low, but policymakers do not realize this and the FOMC continues to tighten into restrictive territory in 2019. By definition, the economy begins to suffer in this scenario, inflation and inflation expectations decline and long-bond yields are flat-to-lower. The yield curve inverts. However, current real rates are still so low that the fed funds rate cannot be very far above R-Star, which means it would represent only a small policy mistake. As long as the Fed recognizes the economic slowdown early enough and truncates the rate hike cycle, then there is a good chance that a recession would be avoided. Investors would initially fear a recession, however, which means that risk assets would be hit hard in absolute terms and relative to bonds and cash until recession fears fade. The direction of the dollar is perhaps trickiest part because there are so many potential cross currents. To keep things simple we will assume that global growth follows our base-case view and remains lackluster in the first half of 2019, followed by a modest re-acceleration. We believe the dollar would likely rally a little as the Fed continues tightening, but then would fall back as the FOMC is forced to turn dovish in the face of a U.S. growth scare. Policy Mistake #2: R-Star is high and rising but the Fed fails to hike rates fast enough to keep up. The economy accelerates in this scenario because monetary policy remains stimulative through 2019, at a time when the 2018 fiscal stimulus will still be providing a demand tailwind. Core PCE inflation moves above 2% and long-term inflation expectations shift up, signaling to investors that the Fed has fallen behind the inflation curve. Risk assets rip for a while and the yield curve bear-steepens as the 10-year Treasury yield moves gradually higher at first. Belatedly, the FOMC realizes it has underestimated the neutral rate and signals a hawkish policy shift. A 50-basis point rate hike at one FOMC meeting causes risk assets to buckle on the back of surging Treasury yields. The yield curve begins to bear-flatten. Eventually the curve inverts and the economy enters recession. The dollar weakens at first because higher inflation lowers U.S. real interest rates relative to the rest of the world. Global growth prospects would initially get a boost from the acceleration in U.S. growth, which is also dollar-bearish. However, in the end the dollar would likely rise as global financial markets turn risk-off. Fed Gets It Right (1): R-star is high and rising. The Fed continues to tighten in line with the increase in the neutral rate. Treasurys sell off hard and the yield curve shifts higher, but remains fairly flat (parallel shift). The curve could mildly invert temporarily, but market worries about a recession eventually recede as economic momentum remains robust, allowing the curve to subsequently trade in the 0-50 basis point range. As discussed below, risk assets tend to outperform Treasurys and cash when the yield curve is in this range, but not by much. The Treasury market would suffer significant losses. This is the most dollar-bullish of the four scenarios, given our global growth view (tepid) and the fact that the market is not even priced for a full quarter-point rate hike in 2019. Fed Gets It Right (2): R-Star is actually still quite low, but the Fed correctly sees recent economic data disappointments and the tightening in financial conditions as signs that policy is close to neutral. The Fed pauses the rate hike cycle, followed by a slower and more data-dependent pace of tightening. The yield curve stays fairly flat and flirts with inversion as investors try to figure out if the Fed has overdone it. Risk assets are volatile and deliver little return over cash. Treasurys rally a bit as the chance of any further rate hikes is priced out of the market, but the rally is limited unless the economy falls into recession (which is not part of this scenario because we are assuming the Fed “gets it right”). The dollar fluctuates, but delivers no real trend since U.S. yield differentials versus the rest of the world do not change much. As we go to press, financial markets are moving in a way that is consistent the Policy Mistake #1; the consensus appears to believe that the Fed has already lifted the fed funds rate too far, causing financial conditions to tighten. But if U.S. real GDP growth remains above-trend as we expect, then the market view could eventually transition to a belief in Mistake #2; the Fed falls behind the inflation curve. The curve would re-steepen and risk assets could have one last hurrah before the Fed gets hawkish again and the 2020 recession arrives. The transition from Mistake #1 to Mistake #2 is essentially our base-case outlook. Nonetheless, obviously the risks around this central scenario are high, especially given how late it is in the U.S. economic and policy cycle. Asset Returns And The Yield Curve Our 2018 late-cycle investing theme focussed on historical asset return and policy dynamics after the U.S. unemployment rate fell below the full-employment level in past cycles. We found that risk assets tend to run into trouble once the U.S. S&P 500 operating margin peaks. As we highlighted in the BCA Outlook 2019, our margin proxies are still not heralding that a peak is at hand. Given the recent investor obsession with the U.S. yield curve, this month we look at historical asset returns at different levels of the 10-year/3-month T-bill yield curve slope: Phase I, when the slope is above 50 basis points; Phase II, when the curve is between 0 and 50 basis points; and Phase III, when the curve is inverted (Table I-1). The data are presented as (not annualized) monthly average returns. It may be surprising that risk asset returns are for the most part positive even in when the curve is inverted. However, keep in mind that we are focussing on the curve, not on recession periods. The curve can be inverted for a long time before the subsequent recession occurs. Risk asset returns often remain positive during this period. The broad conclusions are as follows: Unsurprisingly, risk assets perform their best, in absolute terms and relative to government bonds and cash, in Phase I when the yield curve is steep. Returns tend to deteriorate as the curve flattens. This includes equities, corporate bonds and commodities. Small caps underperform large caps when the curve is between 0 and 50 basis points, but the reverse is true when the curve is flatter or steeper than that range. The ratio of cyclical stocks to defensives has not revealed a consistent pattern with respect to the yield curve, although this may reflect the short historical period available. Value stocks shine versus growth when the curve is inverted. Hedge fund and private equity returns have not varied greatly across the three yield curve environments. Structured product, such as CMBS and ABS, have enjoyed their best performance when the curve is inverted. Timberland and Farmland have also rewarded investors during Phase III. We suspected that asset returns when the curve is in the 0-50 basis point range would vary importantly with the direction of the curve. In Table I-I we split Phase II into two parts: when the curve is steepening after being inverted, and when the curve is flattening after being steep. In other words, when the consensus is either transitioning from quite bullish to very bearish, or vice-versa. Risk assets such as equities (U.S. and Global) and U.S. investment-grade corporate bonds indeed perform much better in absolute terms when the curve is flat but is steepening rather than flattening. The same is true for U.S. structured product. In terms of excess returns relative to government issues, both U.S. IG and HY corporates have tended to underperform when the curve is in the 0-50 basis point range. Surprisingly, the underperformance is worse when the curve is steepening than when it is flattening. This appears to reflect an anomalous period in early 2006 when the curve was flattening but corporate bonds enjoyed strong excess returns. Emerging market equities show very strong returns in all three curve phases. This reflects the inclusion of the pre-2000 period in the mean calculations, a time when EM equities were much less correlated with U.S. financial conditions. EM equity returns have been significantly lower on average since 2000 when the curve is in the 0-50 basis point range (and especially when the curve is flattening) The bottom line is that risk assets can still reward investors with positive returns during periods when the yield curve is flat. However, it is a dangerous time, especially when the global economy is up to its eyeballs in debt. This month’s Special Report beginning on page 17 argues that, although regulation has made the global financial system more resilient to shocks compared to the pre-Lehman years, the number of potentially destabilizing shocks has increased. Moreover, the trade war and Brexit risks make the investment backdrop all the more precarious. No Quick End To The Trade War The honeymoon following the trade ceasefire between the U.S. and China, agreed at the G20 summit in early December, did not last long. The arrest of the chief financial officer of Chinese telecom maker Huawei and continuing hawkish tweets from the U.S. president dampened hopes that a trade agreement can be negotiated by March. Even news that China intended to cut tariffs on U.S. auto imports did not help much. We highlighted in the BCA Outlook 2019 that negotiations will prove to be protracted and testy. It will take a lot more than some token market-opening action on the part of China to placate the U.S. Our geopolitical team emphasizes that “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance.1 For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart I-8). While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Chart I-8R&D Expenditure By Country U.S. demands will also be hard for China to swallow. Most importantly, the U.S. is requesting that China rein in its hacking and spying, shift its direct investment to less tech-sensitive sectors, adjust its “Made in China” targets to allow for more foreign competition, and lower foreign investment equity restrictions. These stumbling blocks will make it difficult to strike a deal on trade. We continue to believe that a final trade deal between the U.S. and China will not arrive in the 90-day timeframe of the ceasefire. Thus, global risk assets will be subject to swings in sentiment regarding the likelihood of a trade deal well beyond March. Meanwhile, as previously discussed, Chinese policy stimulus has not yet become aggressive enough to spark animal spirits in the private sector. The Chinese authorities are proceeding cautiously so as to avoid adding significantly to private- and public-sector’s debt mountain. This month’s Special Report also discusses the risks that the surge in debt over the past decade poses for the global financial system, including escalating risk in China’s shadow banking system. Brexit Pain Continues Politics surrounding the torturous Brexit process will also remain a source of volatility for global markets in 2019. Prime Minister May survived a leadership challenge, but this is hardly confidence-inspiring. The question is whether any deal can get through Westminster. The votes appear to be in place for the softest of soft Brexits, the so-called Norway+ option, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to essentially pay for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election (which may usher the even less pro-Brexit Labour Party into power), or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the failure of the Tories to endorse May’s proposed agreement means that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear; the median voter is turning forcefully towards Bremain (Chart I-9). It will soon become untenable to delay the second referendum. The bottom line is that, while a soft Brexit is the most likely outcome, the path from here to the end result will be punishing. We do not recommend Brexit-related bets on the pound, despite the fact that it is cheap. Chart I-9A Shift Toward Bremain 2019: A Tale Of Two Halves For EM, Commodities And The Dollar One of our key themes in the BCA Outlook 2019 is that the growth divergence between China and the U.S. will persist at least for the first half of 2019. The result will be weak EM asset prices and currencies, little upside for base metals and a strong U.S. dollar. We expect the Chinese authorities will do enough to stabilize growth by mid-year, providing the impetus for a playable bounce in EM and commodity prices in the second half of 2019, coinciding with a peak in the U.S. dollar. Nonetheless, the dollar still has some upside potential in broad trade-weighted terms in the first half of 2019. Our Central Bank Monitors continue to show a greater need for policy tightening in the U.S. than in the rest of the major countries. The dollar has usually strengthened when this has been the case historically. In particular, the ECB’s Central Bank Monitor has slipped back into “easy money required” territory, reflecting moderating economic momentum and still-depressed consumer price inflation (Chart I-10). Chart I-10Our CB Monitors Support A Stronger Dollar The ECB announced the well-anticipated end of its asset purchase program in December. The central bank will now focus on forward guidance as its main policy tool outside of setting short-term interest rates. Lending via targeted LTROs will also be considered under certain circumstances. Policymakers retained the latest forward guidance after the December MPC meeting, that rates are on hold “through the summer of 2019”. The latest reading from our ECB Monitor suggests that the central bank could be on hold for longer than that. We expect Eurozone growth to improve somewhat through the year, but we still believe that interest rate differentials will move further in favor of the dollar relative to the euro and the other major currencies. Periods of slow global growth also tend to favor the greenback. The bottom line is that, while a correction is possible in the very near term, investors with at least a six-month horizon should remain long the dollar. Investment Conclusions: Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. The risks facing investors have not diminished either, especially given the precarious nature of late-cycle investing and the uncertainty regarding the neutral level of the fed funds rate. Historically, the returns to stocks, corporate bonds and commodities have not been particularly attractive on average when the yield curve is this flat. Nonetheless, we believe that the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. Despite our more positive view on equities, we remain cautious on credit. Spreads have widened recently to more attractive levels, but we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009. Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019.  Credit is an asset class that is likely to perform particularly poorly in the next recession. Our upgrade to stocks in the advanced markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil markets are still in the process of re-adjusting to an extraordinary policy reversal by the Trump Administration on its Iranian oil-export sanctions in November, as last-minute waivers were granted to Iran’s largest oil importers. We believe that oil prices have overshot to the downside. Following OPEC 2.0’s decision to cut 1.2mm b/d of production to re-balance markets in the first half of the year, we continue to expect prices to recover on the back of solid global energy demand. Canada also mandated energy firms to trim production. Our energy experts expect oil prices to reach $82/bbl in 2019. We also like gold as long as the fed funds rate remains below its neutral level. Mark McClellan Senior Vice President The Bank Credit Analyst December 21, 2018 Next Report: January 31, 2019 II. (Part II) The Long Shadow Of The Financial Crisis This is the second of a two-part Special Report on the structural changes that have occurred as a result of the Great Recession and financial crisis. We look at three issues: asset correlation, the safety of the financial system, and the level of global debt. First, correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. Some believe that the underlying level of correlation among risk assets has shifted permanently higher for two main reasons: (1) trading factors such as the increased use of exchange-traded funds and algorithms; and (2) the risk-on/risk-off environment in which trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. We have sympathy for the second explanation. The equity risk premium (ERP) was forced higher on a sustained basis by the financial crisis, driven by fears that the advanced economies had entered a ‘secular stagnation’. Elevated correlation among risk assets was a result of a higher-than-normal ERP. The ERP should decline as fears of secular stagnation fade, leading to a lower average level of risk asset correlation than has been the case over the last decade. Second, regulators have been working hard to ensure that the financial crisis never happens again. But is the financial system really any safer today? Undoubtedly, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. The propensity for contagion among banks has diminished and there has been a dramatic decline in the volume of complex structured credit securities. The bad news is that the level of global debt has increased at an alarming pace. The third part of this report highlights that elevated levels of debt could cause instability in the global financial system. Choking debt levels boost the vulnerability to negative shocks. The number and probability of potential shocks appear to have increased since 2007, including extreme weather events, sovereign debt crises, large-scale migration, populism, water crises and cyber & data attacks. The lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide any fiscal relief in the event of a negative shock. Moreover, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend more in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. The Great Recession and Financial Crisis cast a long shadow that will affect economies, policy and financial markets for years to come. Rather than reviewing the roots of the crisis, the first of our two-part series examined the areas where we believe structural change has occurred related to the economy or financial markets. We covered the changing structure of the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. We highlighted that the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. We made the case that the prolonged inflation undershoot is sowing the seeds of an overshoot in the coming years, in part related to central bank policymakers that are doomed to fight the last war. Finally, we argued that the forces behind the structural and cyclical bull market in bonds reached an inflection point in 2016/2017. In Part II, we examine the theory that the financial crisis has permanently lifted market correlations among risk assets. Next, we look at whether regulatory changes implemented as a result of the financial crisis have made the global financial system safer. Finally, we highlight the implications of the continued rise in global leverage over the past decade in the context of BCA’s Debt Supercycle theme. The bottom line is that the global financial system still faces substantial risks, despite a more highly regulated banking system. (1) Are Risk Asset Correlations Permanently Higher? Correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. For example, risk assets became more highly correlated, suggesting little differentiation within or across asset classes. Chart II-1 presents a proxy for U.S. equity market correlations, using a sample of current S&P 100 companies. The average correlation was depressed in the 1990s and 2000s relative to the 1980s. It spiked in 2007 and fluctuated at extremely high levels for several years, before moving erratically lower. It has jumped recently and is roughly in the middle of the post-1980s range. Chart II-1Two Factors Driving Correlation Correlations will undoubtedly ebb and flow in the coming years and will spike again in the next recession. But a key question is whether correlations will oscillate around a higher average level than in the 1990s and 2000s. The consensus seems to believe that the underlying level of correlation among risk assets has indeed shifted higher on a structural basis for two main reasons: Market Structure Changes: Many investors point to trading factors such as the increased use of index products (exchange-traded funds for example), and high-frequency/algorithmic trading as likely culprits. Macro “theme” investing has reportedly become more popular and is often implemented through algorithms. The result is an increase in stock market volatility and a tendency for risk-asset prices to move up and down based on momentum because they are all being traded as a group. These factors would likely be evident today even if the financial crisis never happened, but the popularity of algorithm trading may have been encouraged by the fact that the macro backdrop was so uncertain for years after Lehman collapsed. Risk On/Off Trading Environment: Trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. Even after the recession ended, the headwinds to growth were formidable and many felt that the sustainability of the recovery hinged largely on the success or failure of unorthodox monetary policies. The general feeling was that either the policies would “work”, the output gap would gradually close and risk assets would perform well, or it would fail and risk assets would be dragged down by a return to recession. Thus, markets traded on an extreme “risk-on/risk-off” basis, as sentiment swung wildly with each new piece of economic and earnings data. While the market structure thesis has merit on the surface, the impact should only be short term in nature. It is difficult to see how a change in the intra-day microstructure of the market could have such a fundamental, wide-ranging and permanent impact on market prices. Previous research suggests that any impact on market correlation beyond the very short term is likely to be small. For the sake of brevity, we won’t present the evidence here, but instead refer readers to two BCA Special Reports.2 The risk on/off trading environment thesis is a more plausible explanation. However, we find it more useful to think about it in terms of the equity risk premium (ERP). A higher ERP causes investors to revalue cash flows from all firms, which, in turn, causes structural shifts in the correlation among stocks. A lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious are an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Shifts in the ERP are sometimes structural in nature, but there is also a strong cyclical element in that persistent equity declines historically have had the effect of temporarily raising the ERP and correlations. A simple model based on the ERP and volatility explains a lot of the historical variation in equity correlation, including the elevated levels observed in the years after 2007 (Chart II-2).3 The shift lower in correlations after 2012 reflects both a lower equity risk premium and a dramatic decline in downside volatility. Chart II-2Simple Model Explains Correlation It is tempting to believe that the lingering shell-shock related to the financial crisis means that the underlying equity risk premium has shifted permanently higher. The ERP is still elevated by historical standards, but this is more reflective of extraordinarily low bond yields than an elevated forward earnings yield. Investors evidently believe that the U.S. and other developed economies are stuck in a “secular stagnation”, which will require low interest rates for many years just to keep economic growth near its trend pace. In other words, the equilibrium interest rate, or R-star, is still very low. The ERP and correlations among risk assets will undoubtedly spike again in the next recession. Nonetheless, in the absence of recession, we expect fears regarding secular stagnation to fade further. If the advanced economies hold up as short-term interest rates and bond yields rise, then concerns that R-star is extremely low will dissipate and expectations regarding equilibrium bond yields will shift higher. The ERP will move lower as bond yields, rather than the earnings yield, do most of the adjustment. The underlying correlations among risk asset prices should correspondingly recede. This includes correlations among a wide variety of risk assets, such as corporate bonds and commodities. While this describes our base case outlook, there is a non-trivial risk that the next recession arrives soon and is deep. This would underscore the view that R-star is indeed very low and the economy needs constant monetary stimulus just to keep it out of recession (i.e. the secular stagnation thesis). The ERP and correlations would stay elevated on average in that scenario. What About The Stock/Bond Correlation? Chart II-3 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and the early-2000s. Bond yields tended to rise whenever the S&P 500 was falling. Over the past two decades, however, bond yields have generally declined when the stock market has swooned. Chart II-3Structural Shifts In The Stock/Bond Correlation Inflation expectations can help explain the shift in stock/bond correlation. Expectations became unmoored after 1970, which meant that inflationary shocks became the primary driver of bond yields. Strong growth became associated with rising inflation and inflation expectations, and the view that central banks had fallen behind the curve. Bond yields surged as markets discounted aggressive tightening designed to choke off inflation. And, given that inflation lags the cycle and had a lot of persistence, central banks were not in a position to ease policy at the first hint of a growth slowdown. This was obviously a poor backdrop for stocks. When inflation expectations became well anchored again around the late 1990s, investors no longer feared that central banks would have to aggressively stomp on growth whenever actual inflation edged higher. Central banks also had more latitude to react quickly by cutting rates at the first sign of slower economic growth. Fluctuations in growth became the primary driver of bond yields, allowing stock prices to rise and fall along with yields. The correlation has therefore been positive most of the time since 2003. Bottom Line: A negative correlation between stocks and bond yields reared its ugly head in the last quarter of 2018. The equity correction reflected several factors, but the previous surge in bond yields and hawkish Fed comments appeared to spook markets. Investors became nervous that the fed funds rate had already entered restrictive territory, at a time when the global economy was cooling off. We expect more of these episodes as the Fed normalizes short-term interest rates over the next couple of years. Nonetheless, we see no evidence that inflation expectations have become unmoored. This implies that the stock-bond correlation will generally be positive most of the time over the medium term. In addition, the average level of correlation among risk assets has probably not been permanently raised, although spikes during recessions or growth scares will inevitably occur. (2) Is The Global Financial System Really Safer Today? The roots of the great financial crisis and recession involved a global banking and shadow banking system that encouraged leverage and risk-taking in ways that were hard for investors and regulators to assess. Complex and opaque financial instruments helped to hide risk, at a time when regulators were “asleep at the switch”. In many countries, credit grew at a much faster pace than GDP and capital buffers were dangerously low. Banking sector compensation skewed the system toward short-term gains over long-term sustainable returns. Lax lending standards and a heavy reliance on short-term wholesale markets to fund trading and lending activity contributed to cascading defaults and a complete seizure in parts of the money and fixed income markets. A vital question is whether the financial system is any less vulnerable today to contagion and seizure. The short answer is that the financial system is better prepared for a shock, but the problem is that the number of potential sources of instability have increased since 2007. Since the financial crisis, regulators have been working hard to ensure that the financial crisis never happens again. Reforms have come under four key headings: Capital: Regulators raised the minimum capital requirement for banks, added a buffer requirement, and implemented a surcharge on systemically important banks. Liquidity: Regulators implemented a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR) in order to ensure that banks have sufficient short-term funds to avoid liquidity shortages and bank runs.4 Risk Management: Banks are being forced to develop systems to better monitor risk, and are subject to periodic stress tests. Resolution Planning: Banks have also been asked to detail options for resolution that, hopefully, should reduce systemic risk should a major financial institution become insolvent. Global systemically-important banks, in particular, will require sufficient loss-absorbing capacity. A major study by the Bank for International Settlements,5 along with other recent studies, found that systemic risk in the global financial system has diminished markedly as a result of the new regulations. On the whole, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. Lending standards have tightened almost across the board relative to pre-crisis levels, particularly for residential mortgages. Additional capital and liquid assets provide a much wider buffer today against adverse shocks, allowing most banks to pass recent stress tests (Chart II-4). Financial institutions have generally re-positioned toward retail and commercial banking and wealth management, and away from more complex and capital-intensive activities (Chart II-5). The median share of trading assets in total assets for individual G-SIBs has declined from around 20% to 12% over 2009-16. Moreover, the propensity for contagion among banks has diminished. The BIS notes that assessing all the complex interactions in the global financial system is extremely difficult. Nonetheless, a positive sign is that banks are focusing more on their home markets since the crisis, and that direct connections between banks through lending and derivatives exposures have declined. The BIS highlights that aggregate foreign bank claims have declined by 16% since the crisis, driven particularly by banks from the advanced economies most affected by the crisis, especially from some European countries (Chart II-6). It is also positive that European banks have made some headway in diminishing over-capacity, although problems still exist in Italy. Finally, and importantly, there has been a distinct shift toward more stable sources of funding, such as deposits, away from fickle wholesale markets (Charts II-7 and II-8). Chart II-6Less Cross Border Lending (Until Recently)   Outside of banking, many other regulatory changes have been implemented to make the system safer. One important example is that rules were adjusted to reduce the risk of runs on money market funds. What About Shadow Banking? Of course, more could be done to further indemnify the financial system. Concentration in the global banking system has not diminished, and it appears that the problem of “too big to fail” has not been solved. And then there is the shadow banking sector, which played a major role in the financial crisis by providing banks a way of moving risk to off-balance sheet entities and securities, and thereby hiding the inherent risks. Shadow banking is defined as credit provision that occurs outside of the banking system, but involves the key features of bank lending including leverage, and liquidity and maturity transformation. Complex structured credit securities, such as Collateralized Debt Obligations, allowed this type of transformation to mushroom in ways that were difficult for regulators and investors to understand. A recent study by the Group of Thirty6 concluded that securitization has dropped to a small fraction of its pre-crisis level, and that growing non-bank credit intermediation since the Great Recession has primarily been in forms that do not appear to raise financial stability concerns. Much of the credit creation has been in non-financial corporate bonds, which is a more stable and less risky form of credit extension than bank lending. Other types of lending have increased, such as corporate credit to pension funds and insurance companies, but this does not involve maturity transformation, according to the Group of Thirty. There has been a dramatic decline in the volume of complex structured credit securities such as collateralized debt obligations, asset-backed commercial paper, and structured investment vehicles since 2007 (Chart II-9). While the situation must be monitored, the Group of Thirty study concludes that the financial system in the advanced economies appears to be less vulnerable to bouts of self-reinforcing forced selling, such as occurred during the 2008 crisis. Chart II-9Less Private-Sector Securitization One exception is the U.S. leveraged loan market, which has swelled to $1.13 trillion and about half has been pooled into Collateralized Loan Obligations. As with U.S. high-yield bonds, the situation is fine as long as profitability remains favorable. But in the next recession, lax lending standards today will contribute to painful losses in leveraged loans. The Bad News That’s the good news. The bad news is that, while the financial system might have become less complex and opaque, the level of debt has increased at an alarming rate in both the private and public sectors in many countries. Elevated levels of debt could cause instability in the global financial system, especially as global bond yields return to more normal levels by historical standards. We discuss other pressure points such as Emerging Markets and China in the next section, although the latter deserves a few comments before we leave the subject of shadow banking. The Group of Thirty notes that 30% of Chinese credit is provided by a broad array of poorly regulated shadow banking entities and activities, including trust funds, wealth management products, and “entrusted loans.” Links between these entities and banks are unclear, and sometimes involve informal commitments to provide credit or liquidity support. The study takes some comfort that most of Chinese debt takes place between Chinese domestic state-owned banks and state-owned companies or local government financing vehicles. Foreign investors have limited involvement, thus reducing potential direct contagion outside of China in the event of a financial event. Still, the potential for contagion internationally via global sentiment and/or the economic fallout is high. The other bad news is that, while regulators in the advanced economies have managed to improve the ability of financial institutions to weather shocks, potential risks to the financial system have increased in number and in probability of occurrence. The Global Risk Institute (GRI) recently published a detailed comparison of potential shocks today relative to 2007.7 The report sees twice the number of risks versus 2007 that are identified as “current” (i.e. could occur at any time) and of “high impact”. The most pressing risks today include extreme weather events, asset bubbles, sovereign debt crises, large-scale involuntary migration, water crises and cyber & data attacks. Any of these could trigger a broad financial crisis if the shock is sufficiently intense, despite improved regulation. The GRI study also eventuates how the risks will evolve over the next 11 years. Readers should see the study for details, but it is interesting that the experts foresee cyber dependency rising to the top of the risk pile by 2030. The increase is driven by the importance of data ownership, the increasing role of algorithms and control systems, and the $1.2 trillion projected cost of cyber, data and infrastructure attacks. Our computer systems are not prepared for the advances of technology, such as quantum computing. Climate change moves to the number two risk spot in its base-case outlook. Space limitations precluded a discussion of the rise of populism in this report, but the GRI sees the political tensions related to income inequality as the number three threat to the global financial system by 2030. Bottom Line: Regulators have managed to substantially reduce the amount of hidden risk and the potential for contagion between financial institutions and across countries since 2007. Banks have a larger buffer against stocks. Unfortunately, the number and probability of potential shocks to the financial system appear to have increased since 2007. (3) Implications Of The Global Debt Overhang The End of the Debt Supercycle is a key BCA theme influencing our macro view of the economic and market outlook for the coming years. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness of monetary policy. During times of economic and/or financial stress, it was relatively easy for the Federal Reserve and other central banks to improve the situation by engineering a new credit up-cycle. However, since the 2007-09 meltdown, even zero (or negative) policy rates have been unable to trigger a strong revival in private credit growth in the major developed economies, except in a few cases. The end of the Debt Supercycle has severely impaired the key transmission channel between changes in monetary policy and economic activity. The combination of high debt burdens and economic uncertainty has curbed borrowers’ appetite for credit while increased regulatory pressures and those same uncertainties have made lenders less willing to extend loans. This has severely eroded the effectiveness of lower interest in boosting credit demand and supply, forcing central banks to rely increasingly on manipulating asset prices and exchange rates. On a positive note, the plunge in interest rates has lowered debt servicing costs to historically low levels. Yet, it is the level, rather than the cost, of debt that seems to have been an impediment to the credit cycle, contributing to a lethargic economic expansion. The Bank for International Settlements (BIS) publishes an excellent dataset of credit trends across a broad swath of developing and emerging economies. Some broad conclusions come from an examination of the data (Charts II-10 and II-11):8 Chart II-10Advanced Economies: Some Deleveraging Chart II-11EM: Deleveraging Has Not Even Started Private debt growth has only recently accelerated for the advanced economies as a whole. There are only a handful of developed economies where private debt-to-GDP ratios have moved up meaningfully in the past few years. These are countries that avoided a real estate/banking bust and where property prices have continued to rise (e.g. Canada and Australia). The high level of real estate prices and household debt currently is a major source of concern to the authorities in those few countries. Even where some significant consumer deleveraging has occurred (e.g. the U.S., Spain and Ireland), debt-to-income ratios remain very high by historical standards. In many cases, a stabilization or decline in private debt burdens has been offset by a continued rise in public debt, keeping overall leverage close to peak levels. This is a key legacy of the financial crisis; many governments were forced to offset the loss of demand from private sector deleveraging by running larger and persistent budget deficits. Weak private demand accounts for close to 50% of the rise in public debt on average according to the IMF. Global debt of all types (public and private) has soared from 207% of GDP in 2007 to 246% today. The Debt Supercycle did not end everywhere at the same time. It peaked in Japan more than 20 years ago and has not yet reached a decisive bottom. The 2007-09 meltdown marked the turning point for the U.S. and Europe, but it has not even started in the emerging world. The financial crisis accelerated the accumulation of debt in the latter as investors shifted capital away from the struggling advanced economies to (seemingly less risky) emerging markets. Both EM private- and public-sector debt ratios have continued to move up at an alarming pace. The lesson from Japan is that deleveraging cycles following the bursting of a major credit bubble can last a very long time indeed. One key area where there has been significant deleveraging is the U.S. household sector (Chart II-12). The ratio of household debt to income has fallen below its long-term trend, suggesting that the deleveraging process is well advanced. However, one could argue that the ratio will undershoot the trend for an extended period in a mirror image of the previous overshoot. Or, it may be that the trend has changed; it could now be flat or even down. Chart II-12U.S. Household Deleveraging... What is clear is that U.S. attitudes toward saving and spending have changed dramatically since the Great Financial Crisis (GFC) (Chart II-13). Like the Great Depression of the 1930s that turned more than one generation off of debt, the 2008/09 crisis appears to have been a watershed event that marked a structural shift in U.S. consumer attitudes toward credit-financed spending. The Debt Supercycle is over for this sector. Chart II-13...As Attitudes To Debt Change Developing Countries: Debt And Economic Fundamentals BCA’s long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Trade wars and a tightening Fed are negative for EM assets, but the main headwinds facing this asset class are structural. Excessive debt is a ticking time bomb for many of these countries. EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart II-14). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart II-14, bottom panel). Chart II-14EM: High Debt And Slow Growth... The 2019 Key Views9 report from our Emerging Markets Strategy team highlights that excessive capital inflows over the past decade have contributed to over-investment and mal-investment. Much of the borrowing was used to fund unprofitable projects, as highlighted by the plunge in productivity growth, profit margins and return on assets in the EM space relative to pre-Lehman levels (Chart II-15) Decelerating global growth in 2018 has exposed these poor fundamentals. Chart II-15...Along With Deteriorating Profitability As we highlighted in the BCA Outlook 2019, emerging financial markets may enjoy a rally in the second half of 2019 on the back of Chinese policy stimulus. However, this will only represent a ‘sugar high’. The debt overhang in emerging market economies is unlikely to end benignly because a painful period of corporate restructuring, bank recapitalization and structural reforms are required in order to boost productivity and thereby improve these countries’ ability to service their debt mountains. China’s Debt Problem Space limitations preclude a full discussion of the complex debt situation in China and the risks it poses for the global financial system. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart II-16). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart II-17). Chinese banks are currently being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. Chart II-16China's Overinvestment... Chart II-17Has Undermined The Return On Assets The previous section highlighted that much of the debt has been created in the opaque shadow banking system, where vast amounts of hidden risk have likely accumulated. Whether or not the central government is willing and/or able to cover a wave of defaults and recapitalize the banking system in the event of a negative shock is hotly debated, both within and outside of BCA. But even if a financial crisis can be avoided, bringing an end to the unsustainable credit boom will undoubtedly have significant consequences for the Chinese economy and the emerging economies that trade with it. Interest Costs To Rise Globally, many are concerned about rising interest costs as interest rates normalize over the coming years. In Appendix Charts II-19 to II-21, we provide interest-cost simulations for selected government, corporate and household sectors under three interest-rate scenarios. The good news is that the starting point for interest rates is still low, and that it takes years for the stock of outstanding debt to adjust to higher market rates. Even if rates rise by another 100 basis points, interest burdens will increase but will generally remain low by historical standards. It would take a surge of 300 basis points across the yield curve to really ‘move the needle’ in terms of interest expense. This does not imply that the global debt situation is sustainable or that a financial crisis can be easily avoided. The next economic downturn will probably not be the direct result of rising interest costs. Nonetheless, elevated government, household and/or corporate leverage has several important long-term negative implications: Limits To Counter-Cyclical Fiscal Policy: Government indebtedness will limit the use of counter-cyclical fiscal policy during the next economic downturn. Chart II-18 highlights that structural budget deficits and government debt levels are higher today compared to previous years that preceded recessions. The risk is especially high for emerging economies and some advanced economies (such as Italy) where investors will be unwilling to lend at a reasonable rate due to default fears. Even in countries where the market still appears willing to lend to the government at a low interest rate, political constraints may limit the room to maneuver as voters and fiscally-conservative politicians revolt against a surge in budget deficits. This will almost certainly be the case in the U.S., where the 2018 tax cuts mean that the federal budget deficit is likely to be around 6% of GDP in the coming years even in the absence of recession. A recession would push it close to a whopping 10%. Even in countries where fiscal stimulus is possible, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend and take on more debt. Growth Headwinds: The debt situation condemns the global economy to a slower pace of trend growth in part because of weaker capital spending. From one perspective this is a good thing, because spending financed by the excessive use of credit is unsustainable. Still, deleveraging has much further to go at the global level, which means that spending will have to be constrained relative to income growth. The IMF estimates that deleveraging in the private sector for the advanced economies is only a third of historical precedents at this point in the cycle. The IMF also found that debt overhangs have historically been associated with lower GDP growth even in the absence of a financial crisis. Sooner or later, overleveraged sectors have to retrench. Vulnerability To Negative Shocks: If adjustment is postponed, debt reaches levels that make the economy highly vulnerable to negative shocks as defaults rise and lenders demand a higher return or withdraw funding altogether. IMF work shows that economic downturns are more costly in terms of lost GDP when it is driven or accompanied by a financial crisis. This is particularly the case for emerging markets. Bottom Line: Although credit growth has been subdued in most major advanced economies, there has been little deleveraging overall and debt-to-GDP is still rising at the global level. Elevated debt levels are far from benign, even if it appears to be easily financed at the moment. It acts as dead weight on economic activity and makes the world economy vulnerable to negative shocks. It steals growth from the future and, in the event of such a shock, the lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide fiscal relief. The end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. Mark McClellan Senior Vice President The Bank Credit Analyst APPENDIX Chart II-19Corporate Interest Cost Scenarios   Chart II-20Government Interest Cost Scenarios   Chart II-21U.S. Household Sector Interest Cost Scenarios   III. Indicators And Reference Charts Our tactical upgrade of equities to overweight this month goes against most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicators for the U.S., Japan and Europe are all heading lower. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors are clearly moving funds away from the equity market at the moment. Our Revealed Preference Indicator (RPI) for stocks continues to issue a ‘sell’ signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, supporting the view that caution is still warranted. The U.S. net earnings revisions ratio has dropped into negative territory. The earnings surprises index has also declined, although it remains above 60%. Finally, our Composite Technical Equity Indicator has broken below the zero line and its 9-month exponential moving average, sending a negative technical signal. On the positive side, our Monetary Indicator has hooked up, although it is still in negative territory for equities. From a contrary perspective, the fact that equity sentiment has turned bearish is positive for stocks. In fact, this is the main reason why we upgraded stocks this month. While it is late in the U.S. economic expansion and the Fed is tightening, sentiment regarding U.S. and global growth has become overly pessimistic. Thus, we are playing a late-cycle bounce in stocks. For bonds, the term premium moved further into negative territory in December, which is unsustainable from a long-term perspective. Long-term inflation expectations are also too low to be consistent with the Fed meeting its 2% target over the medium term. These facts suggest that bond yields have not peaked for the cycle, although at the moment they have not yet worked off oversold conditions according to our technical indicator. The U.S. dollar is overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. EQUITIES: Chart III-1U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator   Chart III-18U.S. 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-28U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst   1      For more details, please see BCA Geopolitical Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at gps.bcaresearch.com 2      Please see BCA U.S. Investment Strategy Special Report "The Bane Of Investors’ Existence: Why Is Correlation High And When Will It Fall?" dated January 4, 2012, available at usis.bcaresearch.com. Also see BCA Global ETF Strategy Special Report "The Passive Menace," dated September 13, 2017, available at etf.bcaresearch.com 3       We use only below average returns in the calculation of volatility (downside volatility) because we are more concerned with the risk of equity market declines for the purposes of this model. 4       The LCR requires a large bank to hold enough high-quality liquid assets to cover the net cash outflows the bank would expect to occur over a 30-day stress scenario. The NSFR complements the LCR by requiring an amount of stable funding that is tailored to the liquidity risk of a bank’s assets and liabilities, based on a one-year time horizon. 5       Structural Changes in Banking After the Crisis. CGFS Papers No.60. Bank for International Settlements, January 2018. 6       Shadow Banking and Capital Markets Risks and Opportunities. Group of Thirty. Washington, D.C., November 2016. 7       Back to the Future: 2007 to 2030. Are New Financial Risks Foreshadowing a Systemic Risk Event? Global Risk Institute. 8       For more details on public and private debt trends, please see BCA Special Report "The End Of The Debt Supercycle: An Update," dated May 11, 2016, available at bca.bcaresearch.com 9       Please see BCA Emerging Markets Strategy Weekly Report "2019 Key Views: Will The EM Lost Decade End With A Bang Or A Whimper?" dated December 6, 2018, available at ems.bcaresearch.com EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Asset allocation: Start 2019 with an overweight to industrial commodities versus equities. Await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Equities: Start 2019 with a cyclical equity sector tilt, but become more defensive as the global economy inevitably flips into a down-oscillation later in 2019. Start tactically overweight Italy’s MIB versus the Eurostoxx. Bonds: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. Currencies: Start 2019 short EUR/JPY combined with long EUR/USD. There will be a great opportunity to buy the GBP, but not yet. Alternatives: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. Feature 2019 will present investors a mirror-image pattern to 2018. Through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse. Growth To Rebound, Then Fade Global growth has entered an up-oscillation, for which the evidence is irrefutable: Industrial (non-oil) commodities are strongly outperforming equities, and rising even in absolute terms (Chart of the Week and Chart 2). Emerging markets are strongly outperforming developed markets (Chart 3). Financials are outperforming the broad equity market (Chart 4). Sweden’s manufacturing PMI – a bellwether of global activity – is rebounding strongly (Chart 5). Perhaps most importantly, China’s 6-month credit impulse has gone vertical (Chart 6). Chart of the WeekNon-Oil Commodities Are Strongly Outperforming Equities   Chart I-2Non-Oil Commodities Are Recovering In Absolute Terms Too   Chart I-3Emerging Markets Are Strongly Outperforming Developed Markets Chart I-4Financials Are Outperforming Chart I-5Sweden’s Manufacturing PMI Is Up Sharply Chart I-6China’s 6-Month Credit Impulse Has Gone Vertical Taken together, this is compelling evidence of a growth rebound, even if it is modest. Crucially, such up-oscillations tend to last at least six to eight months. Hence, equity sector performances, which always take their cue from global growth, will follow a mirror-image pattern in 2019 to that in 2018. Bottom Line: Start the year with an overweight to industrial commodities versus equities and a cyclical equity sector tilt, but prepare to fade to a more defensive tilt as the global economy inevitably flips into a down-oscillation later in 2019. Inflation Is The Dog That Will Not Bark There are not many things that are certain in the economy, but a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price – 40 percent so far and getting worse by the day – is about to feed through into headline consumer price indexes (Chart 7 and Chart 8). Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs. Chart I-7Headline Inflation Will Collapse In Europe Chart I-8Headline Inflation Will Collapse In The U.S. Coming at a time that central banks have professed a much greater reliance on “incoming data”, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Fed. This makes the dollar vulnerable, leaving us a choice between the euro and yen as our preferred major currency. And on this head-to-head the yen still beats the euro given its lower political risk: Bottom Line: Start 2019 short EUR/JPY combined with long EUR/USD. Use ‘The Rule Of 4’ And Fractals To Predict Tipping-Points For Equities Investment strategists are obsessed with timing the next recession. The thinking is that by predicting the next recession they can predict the next equity bear market. The logic sounds fine, except that the causality rarely runs from economic downturns to financial market instabilities. The causality almost always runs the other way. Paul Volcker, arguably the greatest central banker of the modern era, correctly points out that the danger to the economy almost always comes from systemic financial disturbances. The last three downturns, in 2000, 2007 and 2011, all resulted from financial disturbances: the bursting of the dot com bubble, the gross mispricing of U.S. sub-prime mortgages, and the distortion of euro area sovereign debt markets respectively. Instead of timing the next recession to predict financial market instability, the correct approach is to flip the logic around and ask: is there a glaring source of financial instability that could cause the next recession? To which the answer is yes. The current glaring instability is the hyper-vulnerability of elevated risk-asset valuations to the global bond yield. Near the lower bound of bond yields, bond prices develop the same unattractive negative asymmetry as equities, removing the need for an equity risk premium, and justifying sharply higher equity valuations. But when the 10-year global bond yield rises back to around 2 percent – or equivalently when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent ‘the rule of 4’ – the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower equity valuations (Chart 9 and Chart 10). Chart I-9Equities Plunged In February After A Spike In Bond Yields Chart I-10Equities Plunged In October After A Spike In Bond Yields In 2019, just as in 2018, investors should use this dynamic to allocate tactically to equities versus cash as follows: 1. When the rule of 4 approaches 4 and the market’s 65-day fractal dimension signals an overbought rally, go underweight equities. 2. When the rule of 4 approaches 3 and the market’s 65-day fractal dimension signals an oversold sell-off, go overweight equities. 3. At all other times stay neutral. Bottom Line: With the rule of 4 now approaching 3, await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Britain Escalates EU Tensions, Italy De-Escalates The two points of political tension in Europe, the U.K. and Italy, have a common theme: brinkmanship with the EU. The Brexit tension remains high and may even intensify in early 2019 before a resolution. Hence, while 2019 will offer a great opportunity to buy the pound, it might require a little patience. In contrast, Italy is de-escalating its brinkmanship with Brussels over its budget deficit. Meanwhile the crux of Italy’s long-standing woes – its banking system – is also showing signs of healing. The proportion of bank loans that are non-performing is plummeting, while the solvency of the banking system continues to improve (Chart 11 and Chart 12). Chart I-11Italian Banks’ NPLs Are Plummeting… Chart I-12…And Italian Banks’ Solvency Is Improving Bottom Line: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. And tactically overweight Italy’s MIB versus the Eurostoxx. Cryptocurrencies Will Rebound 60 Percent Cryptocurrencies are here to stay, because the underlying technology, the blockchain, is here to stay. Just as the internet’s major innovation was to decentralise and democratise information, the blockchain’s major innovation is to decentralise and democratise trust. Until now, counterparties without an established trust relationship could only transact through an intermediary who could provide the necessary trust overlay. But once each participant in a transaction trusts the blockchain itself, they no longer need to use a conventional intermediary, like a bank or a law firm. One major argument against the blockchain is that it is energy intensive and therefore prohibitively costly. But conventional intermediation also exacts a significant cost. Let’s say that the stock of excess savings that the banks intermediate to borrowers conservatively equals global GDP. If the risk-adjusted interest rate spread that banks charge for their intermediation role conservatively equals 1 percent, it means that this conventional intermediation is costing 1 percent of global GDP. Against this, global energy consumption equals roughly 5 percent of global GDP. So even if the blockchain consumed a fifth of the world’s energy, its cost might still be comparable to conventional intermediation. The plunge in cryptocurrencies during 2018 was exacerbated by the recent ‘hard fork’ in bitcoin protocol. But such hard forks are a necessary part of the evolutionary process – being analogous to a Darwinian mutation which eliminates the weakest protocols while allowing the strongest and fittest to thrive. In the latest fork, the battle was between those who want cryptocurrencies to remain a speculative asset with low long-term survival prospects, and those who want them to become a stable means of payment with high long-term survival prospects. A year ago almost to the day, we recommended selling bitcoin at a price of $18,000. Our rationale was that excessive herding required a price gap down to normalise liquidity. The subsequent decline in the price to $3500 today has rewarded that recommendation handsomely. But today, Litecoin and Ethereum are approaching an opposite tipping-point where the price may have to gap up to normalise liquidity (Chart 13 and Chart 14). Chart I-13Litecoin Is Oversold On A 65-Day Horizon   Chart I-14Litecoin Is Oversold On A 130-Day Horizon Bottom Line: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. For a 50:50 basket, target a return of 60 percent. And on that positive note, I am signing off for the year. I do hope that you have enjoyed reading this year’s reports, but more importantly that you have found value in them. This publication’s philosophy is to think out of the box, independently and unconstrained, never to shirk from challenging the received wisdom, and ultimately to provide successful investment ideas. We promise to continue this way in 2019! It just remains for me to wish you a very happy holiday season and a prosperous new year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com   Fractal Trading Model* As discussed in the main body of this report, this week’s recommended trade is to buy a 50:50 combination of Litecoin and Ethereum. Set a profit target of 60 percent with a symmetrical stop-loss. As also discussed in the main body of this report, remain tactically overweight Italy’s MIB versus the Eurostoxx. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1 Chart II-2 Chart II-3 Chart II-4 Interest Rate Chart II-5 Chart II-6 Chart II-7 Chart II-8

HighlightsDuration: The Fed will probably signal a slowing of its +25 bps per quarter rate hike pace during the next few months. However, rate hikes will ramp up again after a brief pause, and the Fed will ultimately deliver more tightening than is currently priced. Maintain below-benchmark portfolio duration.Credit Spreads: Our checklist of global growth and monetary policy indicators does not yet signal a tactical buying opportunity in credit. A dovish message from the Fed tomorrow would bring us closer to meeting the criteria on our checklist.Fed Balance Sheet: It is likely that the Fed will continue running down its balance sheet throughout all of 2019. However, if it turns out that the amount of bank reserves demanded exceeds $1.1 trillion, it will force the Fed to halt the run-off next year. The timing will only become clear when the effective fed funds rate threatens to break above the upper-end of the Fed’s target band.FeatureThis will be the last U.S. Bond Strategy report of 2018. Publication will resume on January 8 with our Portfolio Allocation Summary for January 2019. Until then, we extend our best wishes for a wonderful holiday and a Happy New Year. With the stock market well off its highs and credit spreads in the midst of an uptrend, there is an uncommon amount of pressure on tomorrow’s FOMC meeting. For their part, interest rate curves have already moved to discount a substantial dovish shift in Fed policy. In fact, our 12-month fed funds discounter has fallen all the way down to 36 bps (Chart 1). Chart 1All Eyes On The Fed With the market even more focused on the Fed than usual, there is a chance that a dovish signal tomorrow could spark a rally in risk assets. Conversely, a more hawkish Fed could prolong the market’s pain. Against that back-drop, in this week’s report we discuss what we are likely to hear from the Fed tomorrow and over the course of 2019.The Fed’s RoadmapIn our view, a recent speech from Fed Governor Lael Brainard gives a good indication of the Fed’s current thinking:1Our goal now is to sustain the expansion by maintaining the economy around full employment and inflation around target. The gradual path of increases in the federal funds rate has served us well by giving us time to assess the effects of policy as we have proceeded. That approach remains appropriate in the near term, although the policy path increasingly will depend on how the outlook evolves.This passage strongly suggests that the Fed is committed to delivering one more 25 basis point rate hike this week. But starting next year, the Fed is likely to abandon the predictable +25 bps per quarter rate hike pace that has been in place since December 2016, and shift to a regime in which rate hikes at any given meeting are much more dependent on the incoming economic and financial market data.What To Look For TomorrowFirst off, the Fed is very likely to deliver a rate hike tomorrow, a move that is widely anticipated. Failure to do so would constitute a major dovish surprise that would lead to a bounce in risk assets. We agree with the market that a rate hike tomorrow is highly probable.The DotsBeyond the actual policy move, the most important thing to watch will be the changes to FOMC participants’ forecasts for where the fed funds rate will be at the end of 2019, aka the 2019 dots. This is the easiest place to look to get a sense for how the recent market turmoil and global growth weakness is impacting the Fed’s thinking. At present, the median 2019 dot is between 3% and 3.25%. This suggests that, after lifting rates once more this week, the median Fed member anticipates three more rate hikes in 2019. We expect that the median 2019 dot will shift lower tomorrow, and that the magnitude of the shift will determine the reaction in financial markets. If the downward revision is considered sufficiently dovish, then expect risk assets to rally. If not, then risk assets could sell off.As always, it will be interesting to see whether Fed members revise their longer run rate expectations, i.e. their estimates of the neutral fed funds rate. However, we expect very little movement in neutral rate estimates tomorrow. In any case, the market will be much more focused on the expected policy path for 2019.The StatementIn tomorrow’s post-meeting statement, the following passage will likely be edited:The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.The minutes from November’s FOMC meeting suggest that the committee is increasingly uncomfortable with the phrase “further gradual increases”. The Fed will probably remove this phrase from tomorrow’s statement and replace it with guidance that is more consistent with the above excerpt from Governor Brainard’s speech. In general, the Fed wants to signal that it is transitioning away from a predictable +25 bps per quarter rate hike pace and toward a reaction function that is much more data dependent.The Press ConferenceSince the beginning of his tenure, Fed Chairman Jerome Powell has preached a message of uncertainty and data dependence.2 These themes will be stressed again tomorrow and we expect his forward guidance will be consistent with what we already heard from Governor Brainard. As such, we view any revisions to the 2019 dots as having more potential to move markets than what Powell says in the press conference.Other BusinessAs was the case in June, tomorrow’s rate hike will result in a 25 bps shift higher in the target range for the fed funds rate, from 2%-2.25% to 2.25%-2.5%, but only a 20 bps increase in the interest rate paid on excess reserves (IOER). This means that the IOER will rise to 2.4%, 10 bps below the upper-end of the Fed’s target range.The smaller IOER increase will occur because the Fed is trying to pressure the effective fed funds rate back toward the middle of its target range. The funds rate has been creeping higher in recent months and the Fed is taking steps to limit its rise. This will continue to be an operational issue for the Fed next year, which we discuss in more detail below.Investment ImplicationsWe think tomorrow’s Fed meeting could be more important for credit spreads than for Treasury yields. In recent reports we discussed why the combination of weakening global growth and relatively hawkish Fed policy is causing credit spreads to widen, and suggested that a significant dovish turn from the Fed could prompt a recovery in global growth and a near-term rally in credit.Our checklist of global growth and monetary policy indicators (Charts 2A & Chart 2B) does not yet decisively signal a tactical buying opportunity in corporate credit, but we have seen the 12-month discounter fall and the gold price rally in recent weeks. A dovish message from the Fed tomorrow would bring us closer to meeting the criteria on our checklist, and thus closer to a near-term peak in spreads. Chart 2AChecklist For Peak Spreads: Global Growth  Chart 2BChecklist For Peak Spreads: Fed Capitulation   On the duration front, with the market already priced for essentially no further rate hikes in 2019 (after a rate hike tomorrow), we view any potential dovish move as already in the price. Since we expect the economic environment will support further rate hikes in 2019, we are inclined to maintain below-benchmark portfolio duration while we look for an opportunity to tactically buy credit.What To Expect In 2019More important for portfolios than what to expect from tomorrow’s Fed meeting is what to expect from the Fed over the course of next year. As we have already mentioned, the path for rate hikes will be much less predictable in 2019. An increased focus on the incoming data will replace the Fed’s current predilection for consistent quarterly rate hikes.The Fed will also hold a press conference after all eight FOMC meetings in 2019. Until now, press conferences have only occurred four times per year – in March, June, September and December – and the Fed has shown a reluctance to change interest rates at meetings without a scheduled press conference. Next year, with press conferences after every meeting, the Fed will have more flexibility to vary the pattern of hikes.But what will determine the number of rate hikes in 2019? We focus on three main areas.1) Financial ConditionsBy tightening policy, the Fed is trying to both prevent a future overshoot of its inflation target and tighten financial conditions at the margin. The Fed also increasingly recognizes the importance of financial conditions relative to inflation. As Governor Brainard noted in her recent speech:The last several times resource utilization approached levels similar to today, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation.But overheating is not the only concern. Excessive tightening in financial conditions could also force the Fed to adopt a more dovish policy stance. In fact, this is exactly what we see happening in the next few months. Financial conditions are already tightening (Chart 3), and will continue to do so until the Fed moderates its pace of rate hikes. At that point, financial conditions will probably ease, and that will allow the Fed to speed up the pace of hikes in the back half of 2019. Chart 3Financial Conditions Are Tightening 2) InflationCore inflation remains relatively close to the Fed’s target. While year-over-year core PCE fell back to 1.78% in October, year-over-year core and trimmed mean CPI came in at 2.24% and 2.22%, respectively, in November (Chart 4). We expect that inflation will move higher in 2019, but will remain relatively close to the Fed’s target. Base effects will pose a high hurdle for year-over-year inflation during the next few months, but inflationary pressures in the economy continue to rise. Survey data on firms’ input prices (Chart 4, panel 3) and planned selling prices (Chart 4, bottom panel) remain very strong. Chart 4Expect Higher Inflation In 2019 Long-maturity TIPS breakeven inflation rates are at odds with the economy’s inflationary backdrop. They remain below levels that have historically been consistent with the Fed’s inflation target (Chart 4, panel 2). Relatively low TIPS breakeven rates give the Fed cover to slow the pace of rate hikes during the next few months. However, long-maturity breakevens can also rise quickly, and we anticipate that they will return to our target 2.3%-2.5% range in 2019.3) Recession SignalsIn last week’s Key Views for 2019 report, we discussed in detail why we think the Fed’s rate hike cycle will continue throughout 2019, and also why it will probably slow down during the next few months.3 In summary, we see tighter financial conditions causing the Fed to slow the pace of hikes in the near term, but we also doubt that interest rates will get high enough next year to send the U.S. economy into recession.That said, in our Key Views report we flagged several economic indicators to watch that could force us to change our view. Specifically, if the 12-month moving averages in housing starts and new home sales turn down, or if the unemployment rate rises, then it would suggest that a recession is closer than we currently anticipate.Concerning the unemployment rate, it will also be important to watch the trend in initial jobless claims (Chart 5). Rising claims tend to precede increases in the unemployment rate and claims have bounced during the past few weeks. We expect the bounce will prove temporary, but are monitoring it closely. Chart 5Rising Claims A Risk Bottom Line: The Fed is likely to signal a slowing of its +25 bps per quarter rate hike pace during the next few months. This move will be in response to financial conditions that are tightening more quickly than is desirable. But after a pause, we see rate hikes resuming in the second half of 2019 and the Fed will ultimately deliver more rate hikes than are currently priced into the Treasury market.The Balance Sheet In 2019It is also possible that the Fed will have to take steps to deal with its balance sheet in 2019. Right now, the runoff of the balance sheet is proceeding quite smoothly, but as mentioned above, there is some concern that the effective fed funds rate has been creeping toward the upper-end of its target range.Table 1 shows the Fed’s balance sheet compared to just before it started to run down its assets. The table illustrates how the size of the Fed’s securities portfolio determines the amount of reserves supplied to the banking system. The concern is that for the Fed to maintain control of the funds rate using its current “floor system”, it needs to supply more reserves to the banking system than are demanded.4 If it fails to do so, then the fed funds rate will rise above the upper-end of its target range. Table 1A Simplified Federal Reserve Balance Sheet A further complication is that the strict post-crisis regulatory regime makes it difficult to know what level of reserves are currently in demand. In essence, the Fed does not know when it will be time to stop shrinking its balance sheet. The plan appears to be that it will wait for signs that the effective fed funds rate is breaking above the upper-end of its target range, and will then decide that balance sheet run-off needs to stop.Last September, we projected that the Fed would continue to run down its balance sheet until bank reserves reached a steady state of $650 billion. Using that same assumption today, the Fed would shrink its portfolio until March 2021 and would still have combined Treasury and MBS holdings of $3 trillion at that time (Chart 6A). Chart 6AFed Balance Sheet: $650 Billion Steady-State Reserves  Chart 6BFed Balance Sheet: $1.1 Trillion Steady-State Reserves However, the fact that the effective fed funds rate has mostly been near the upper-end of its target range this year has caused many market participants to revise their estimates for the steady state of bank reserves higher. In fact, we infer from responses to the New York Fed’s most recent Survey of Primary Dealers that most dealers think that the steady state for bank reserves is above $1 trillion.5If we use an assumption of $1.1 trillion for steady state bank reserves, then we project that the Fed will stop running down its portfolio in March 2020 and will have combined Treasury and MBS holdings of $3.3 trillion at that time (Chart 6B).Bottom Line: It is likely that the Fed will continue running down its balance sheet throughout all of 2019. However, if it turns out that the amount of bank reserves demanded exceeds $1.1 trillion, it will force the Fed to halt the run-off next year. The timing will only become clear when the effective fed funds rate threatens to break above the upper-end of the Fed’s target band. Ryan Swift, Vice PresidentU.S. Bond Strategyrswift@bcaresearch.comFootnotes1 https://www.federalreserve.gov/newsevents/speech/brainard20181207a.htm2 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com3 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.com4 For a detailed description of the floor system for controlling interest rates please see U.S. Bond Strategy Special Report, “Cleaning Up After The 100-Year Flood”, dated June 10, 2014, available at usbs.bcaresearch.com5 The survey shows that the median dealer thought that a reserve balance of $1 trillion would cause IOER to trade 5.5 bps below the effective fed funds rate. In other words, reserve balances would be sufficiently scarce for the effective fed funds rate to rise relative to the rates controlled directly by the Fed. https://www.newyorkfed.org/medialibrary/media/markets/survey/2018/nov-2018-spd-results.pdfFixed Income Sector PerformanceRecommended Portfolio Specification

Dear Client, This will be the last Global Investment Strategy report of 2018. Publication will resume on January 4th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Feature 1.  Will the Fed raise rates more or less than what is priced into the futures curve? Answer: More. The fed funds futures curve is pricing in less than one rate hike in 2019 and rate cuts beyond then. In contrast, we think the Fed will raise rates three or four times next year and continue hiking into 2020. For all the worries about a slowdown, U.S. real GDP growth is still tracking at 3% in Q4 according to the Atlanta Fed, while consumption is set to rise by 4.1%. Ongoing fiscal stimulus, decent credit growth, rising wages, and a decline in the savings rate should continue to support the economy in 2019. Housing construction should also stabilize thanks to a low vacancy rate and a pickup in household formation. The fact that mortgage applications for purchase have rebounded swiftly in recent weeks is evidence that the housing market is not as weak as many people believe (Chart 1). Chart 1U.S. Housing: No Oversupply Problem, While Demand Is Firming 2.  Will U.S. 10-year Treasury yields rise more or less than expected? Answer: More. Treasurys almost always underperform cash when the Fed delivers more rate hikes than the market is discounting (Chart 2). We expect a modest bear flattening of the yield curve in 2019, with rising bond yields nearly offsetting the increase in short-term rates. Most of the flattening is likely to come in the next six months, as slower global growth and the disinflationary effects of lower oil prices keep bond yields contained. As we enter the second half of next year, global growth should reaccelerate as the effects of Chinese stimulus measures fully kick in and the drag on global growth from the recent tightening in financial conditions dissipates. By that time, the U.S. unemployment rate will be in the low 3% range, a level that could trigger material inflationary pressures. Chart 2Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected 3. Will the yield spreads between U.S. Treasurys and other developed economy bond markets widen? Answer: Yes, particularly at the short end of the curve. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will support wider differentials between Treasurys and non-U.S. bond yields. The greatest potential for spread widening will be for Treasurys versus JGBs. With Japanese inflation still stubbornly low and fiscal policy set to tighten from a hike in the sales tax, the BoJ will be in no position to abandon its yield curve control regime. The 10-year Treasury-gilt spread could also widen if the Bank of England is forced to stay on the sidelines until Brexit uncertainty is resolved. Likewise, the U.S.-New Zealand spread will widen as the RBNZ stays on hold due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be range-bound, with the Bank of Canada coming close to matching, but not surpassing, Fed tightening in 2019. While the ECB will refrain from raising rates next year, the U.S. Treasury-German bund spread should narrow marginally if the end of ECB QE lifts bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads, as both the RBA and Riksbank begin a tightening cycle. 4. What will happen to U.S. corporate credit spreads? Answer: They are likely to finish 2019 close to current levels. As a rule of thumb, corporate bond returns are highest when the yield curve is very steep, and lowest when it is inverted (Table 1). The former generally corresponds to the early stages of business-cycle expansions, while the latter encompasses the period directly preceding recessions. We are still in the intermediate phase, when excess corporate bond returns (relative to cash) are positive but low. This conclusion is consistent with the observation that corporate balance-sheet leverage has increased over the past four years, but not by enough to instigate a major wave of defaults. Table 1Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 5. Will the U.S. dollar continue to strengthen? Answer: The dollar will strengthen until the middle of 2019 and then begin to weaken. Three main factors determine the short-to-medium term direction of the dollar: 1) momentum; 2) interest rate spreads between the U.S. and its trading partners; and 3) global growth. In general, the dollar does well when it is trending higher, spreads relative to the rest of the world are wide and getting wider, and global growth is slowing (Chart 3). For the time being, momentum continues to work in the greenback’s favor. Spreads have narrowed a bit recently, but the dollar still looks cheap relative to what one would expect based on the current level of spreads (Chart 4). As in 2017, the direction of global growth will likely be the key driver of the dollar next year. If growth bottoms in mid-2019, as we expect, the dollar will probably put in a top. Chart 3Dollar Returns Driven By Momentum, Rate Differentials, And Global Growth   Chart 4Wider Spreads Bode Well For The Dollar   6. Will global equities rise or fall? Answer: Rise. Our tactical MacroQuant stock market timing model finally moved back into neutral territory on Monday after having successfully flagged the correction that began in October (Chart 5). Having downgraded global equities this past summer, we will return to overweight if the ACWI ETF drops to $64, which is only 2.4% below yesterday’s close. The cyclical backdrop for stocks is reasonably constructive. We expect the MSCI All-Country World Index to rise by about 10%-to-15% in dollar terms from current levels by the end of 2019. The higher end of this range would leave it slightly below its January 2018 peak (Chart 6). The index is currently trading at 13.3-times forward earnings, similar to where it was in early-2016. The U.S. accounts for over 50% of global stock market capitalization (Chart 7). As such, the U.S. equity market tends to influence non-U.S. stocks more than the other way around. Sustained U.S. equity bear markets are rare outside of recessions (Chart 8). With another U.S. recession unlikely to occur at least until late-2020, that gives global stocks enough room to rally. Indeed, history suggests that the late stages of business-cycle expansions are often the juiciest for equity investors (Table 2).  Chart 5The MacroQuant Equity Score* Improves To Neutral   Chart 6Global Stocks Have Cheapened Chart 7The U.S. Is The Dominant Equity Market   Chart 8Recessions And Bear Markets Usually Overlap     Table 2Too Soon To Get Out 7. Will cyclical stocks outperform defensives? Answer: Yes, although this is likely to be more of a phenomenon for the second half of 2019. Cyclicals typically outperform defensives when bond yields are climbing (Chart 9). Rising bond yields are usually a sign of stronger growth — manna from heaven for capital goods and commodity producers. As long as global growth is under pressure, cyclicals will struggle. But once growth bottoms in the middle of next year, cyclical stocks will have their day in the sun. Chart 9Cyclicals Tend To Outperform When Yields Rise 8. Will U.S. equities continue to outperform other global stock markets? Answer: Yes, but probably only until mid-2019. The U.S. stock market has less exposure to cyclical sectors such as industrials, materials, energy, and financials than the rest of the world (Table 3). Therefore, it stands to reason that an inflection point for cyclicals versus defensives will correspond to an inflection point for U.S. versus non-U.S. stocks. If this were to happen, it would resemble the period between October 1998 and April 2000, a time when bond yields rose, the dollar rally stalled, cyclicals outperformed defensives, and non-U.S. equities outperformed (Chart 10). Table 3Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials And Materials Are Overrepresented In Markets Outside The U.S.   Chart 10Will The Late-1990s Pattern Be Repeated?   9. Will oil prices rise more than expected? Answer: Yes. The December-2019 Brent futures contract is currently trading at $61/bbl (Chart 11). Our energy strategists expect Saudi Arabia and Russia to cut production by enough to push prices to an average of $82/bbl in 2019. Looking further out, the outlook for oil prices is less favorable. As every first-year economics student learns, prices in a competitive market eventually converge to average costs. Shale companies are now the swing producers in the global petroleum market. Their breakeven costs are in the low-$50 range, a number that has been trending lower due to productivity gains. If that is the long-term anchor for oil prices, it means that any major rally in oil is unlikely to extend deep into the next decade. Chart 11Oil Prices Will Recover 10. Will gold prices finally rally? Answer: Yes, but only in the second half of 2019. Gold prices typically fall when the dollar is strengthening (Chart 12). Given our view that the dollar will rally into mid-2019, now is not the time to be loading up on bullion. However, once the dollar peaks and U.S. inflation moves decidedly higher late next year, gold should become a star performer. Chart 12Gold Will Shine Bright After The Dollar Peaks     Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Dear Client, This is the final Global Fixed Income Strategy report for 2018. We will return with our first report of the new year on January 8th, 2019. Our entire team wishes you a very happy holiday season and a prosperous new year. Best regards, Rob Robis, Chief Strategist 2019 Model Bond Portfolio Positioning: Translating our 2019 key global fixed income views into recommended overall positioning within our model bond portfolio yields the following: target a modest level of active portfolio risk, with below-benchmark duration and only neutral exposure to corporate credit. Country Allocation: Government bond allocation should continue to reflect relative expectations for monetary policy changes. That means an overweight in countries where central banks will have little scope to increase rates (core Europe, Japan, the U.K., Australia, New Zealand) and an underweight where central banks are likely to tighten more than markets currently discount (U.S., Canada, Sweden). Corporate Credit: We currently prefer U.S. corporate bonds to European and EM equivalents based on better U.S. profit prospects, which enhances debt serviceability. However, we will look to pare U.S. exposure as the Fed shifts to a more restrictive stance later in 2019. Feature Last week, we published our 2019 “Key Views” report, outlining the thematic implications of the 2019 BCA Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations for next year. We also recommend changes to the allocations in the Global Fixed Income Strategy model bond portfolio to reflect our 2019 themes. The main takeaway is that 2019 will be another year of poor returns, with increased volatility, for most global fixed income markets. The greater pressures should come in the latter half of the year, after the U.S. Federal Reserve delivers additional rate hikes and decisive signs of a slowing U.S. economy unfold. Investors should maintain a defensive strategic posture on fixed income markets throughout the year, both for interest rate duration and credit exposure. Selling into market rallies, rather than chasing them, will prove to be the prudent strategy. Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from last week’s Key Views report were the following: Late-cycle pressures will keep bond yields elevated. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for both government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay modest in 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. We now present the specific fixed income investment recommendations that flow from those themes in the following categories: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Risk: DEFENSIVE Government bond yields enter 2019 at very low (i.e. expensive) levels across the major developed markets, even after the cumulative rise in U.S. Treasury yields seen over the past twelve months. Real yields remain below trend real GDP growth rates, a consequence of central banks keeping policy rates below neutral levels as measured by concepts like the Taylor Rule (Chart of the Week). In addition, credit spreads remain near the low end of long-run historical ranges in all markets. Without the initial starting point of cheap valuations, fixed income return expectations in 2019 should be severely tempered (Charts 2& 3).   Chart 2Low Yields = Low Expected Returns For U.S. Corporates …   Chart 3… And European Corporates Volatility measures like the VIX index will remain elevated until markets begin to sniff out a bottoming of global growth. Much will depend on developments in China, but our expectation is that policymakers there will only act to stabilize the economy rather than provide large, 2016-scale stimulus. That may be enough to create a tactical “risk-on” trading opportunity by mid-year but we recommend using any such rally to reduce credit exposure given the risk of a more lasting global economic downturn in 2020. Importantly, cross-asset correlations should continue to drift lower without broad support from coordinated global economic growth or expanding monetary liquidity via central bank asset purchases (Chart 4). Without those rising tides lifting all boats, more active security selection by country, sector and credit rating should help portfolio managers outperform their benchmarks in what is likely to be another down year for absolute returns. Chart 4High Volatilities With Low Correlations That combination of diminished return prospects and elevated volatility means investors should maintain a defensive bias in fixed income portfolios heading into 2019. Within our own GFIS recommended model bond portfolio, this means keeping our tracking error (the relative expected volatility versus our custom benchmark performance index) well below our maximum target level of 100bps (Chart 5). Chart 5Maintain Moderate Overall Portfolio Risk Overall Duration Stance: BELOW BENCHMARK We do not think that global bond yields have peaked for this business cycle. The current period of softening global economic momentum will not turn into a prolonged period of sub-trend growth that would push up unemployment rates in the major developed economies. With the global output gap nearly closed, and monetary policymakers firmly believing in the Phillips Curve framework (lower unemployment leads to higher inflation) to forecast inflation, a more dovish stance from the major central banks seems unlikely. As we discussed in last week’s report, global bond yields are in a process of normalization away from the depressed levels seen after the 2008-09 global financial crisis and recession (Chart 6). Term premia, inflation expectations and real yields all have upside potential as central banks slowly back away from quantitative easing and low interest rate policies. Thus, we continue to recommend a defensive, below-benchmark strategic stance on overall portfolio duration exposure (Chart 7). Chart 6Bond Yields Will Continue To Normalize In 2019   Chart 7Stay Below-Benchmark On Duration Risk Government Bond Country Allocation: Underweight U.S., Canada, Sweden, Italy. Overweight Germany, France, U.K., Japan, Australia, New Zealand At the country level, we recommend underweighting government bond markets where central banks will be more likely to raise interest rates (because of firm domestic economic growth and building inflation pressures), but where too few rate hikes are currently discounted in money market yield curves. The U.S., Canada and Sweden fit that description (Chart 8). The U.K. would also be part of this group, but the Brexit uncertainty leads us to maintain an overweight stance on U.K. Gilts entering 2019. Chart 8Monetary Policy Expectations Drive Country Allocations By the same token, we are recommending overweights in countries where rate hikes are unlikely to occur in 2019 because of underwhelming inflation, like core Europe, Japan and New Zealand. We are currently overweight Australian government bonds, but we expect to cut that exposure in 2019 as pressure builds for a rate hike in the latter half of the year as inflation picks up. Italian government bonds represent a special case of a developed market trading off sovereign credit risk rather than interest rate or inflation risk. We continue to treat Italian government bonds the same way we view corporate debt, as a growth-sensitive asset. On that basis, we will remain underweight Italian government bonds until Italy’s leading economic indicator bottoms out, mollifying concerns about debt sustainability. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will sustain wide differentials between Treasuries and non-U.S. bond yields (Chart 9). Chart 9ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets The greatest potential for spread widening will be for Treasuries versus JGBs, with no changes in the Bank of Japan’s monetary policy expected due to stubbornly low inflation. The 10-year Treasury-Gilt spread could also widen if the Bank of England stays on the sidelines for longer until Brexit uncertainty is resolved. The 10-year U.S.-New Zealand spread should also widen with the Reserve Bank of New Zealand staying on hold for a while due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be rangebound, with the Bank of Canada likely to match, but not exceed, Fed tightening in 2019. There are some markets, though, where yields could rise a bit more than Treasury yields due to shifting monetary policies. While the ECB will refrain from raising rates next year, there is a potential for the U.S. Treasury-German Bund spread to narrow marginally if the end of ECB new asset purchases lifts Bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads. After keeping monetary policy very loose for a long time, the beginning of rate hikes next year by the Reserve Bank of Australia and Riksbank could put meaningful upward pressure on deeply depressed longer-maturity Australian and Swedish yields. Yield Curve Positioning: Favor Bearish Steepeners Everywhere In The First Half Of 2019, Then Switch To Bearish Flatteners In The U.S., Canada, Australia And Sweden We expect some bearish steepening pressures to appear in most countries in the first quarter of 2019 with inflation breakevens likely to rebound if the bullish oil forecast of BCA’s Commodity & Energy Strategy team comes to fruition (Charts 10 & 11). The end of the net new buying phase of the ECB’s Asset Purchase Program in January will also put upward pressure on longer-dated European yields through a worsening supply/demand balance for European government bonds and a wider term premium, helping keep European yield curves steep. Chart 10Inflation Expectations & Bond Yields Will Rebound In 2019 …   Chart 11… As BCA’s Bullish Oil View Comes To Fruition Importantly, it is too soon to worry about an inversion of the U.S. Treasury curve, as we discussed in last week’s report, with the fed funds rate not yet at a restrictive level (i.e. real rates above measures of neutral like R-star). That outcome should occur by the end of 2019, when we expect the Treasury curve to move towards a true monetary policy-induced inversion. Similar patterns – steepening first from rising inflation expectations, flattening later from more hawkish central banks delivering rate hikes – should unfold in Canada, Australia and Sweden. Applying Our Global Golden Rule To Government Bond Allocations Back in September, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.”2 This is an extension of a framework introduced by our sister service, U.S. Bond Strategy, that links U.S. Treasury returns to changes in the fed funds rate that are not discounted in money markets (using our 12-month Discounters derived from Overnight Index Swap curves). In Table 1, we show the expected returns generated by the Global Golden Rule (shown hedged into U.S. dollars) for the countries in our model bond portfolio custom benchmark, based on monetary policy scenarios that we deem to be most plausible for 2019. In Table 2, we show the returns on a duration-adjusted basis (expected total return divided by duration). We then rank the return scenarios for overall country indices, aggregating the returns of the individual yield curve maturity buckets shown in those two tables, in Table 3. Table 1Global Golden Rule Return Forecasts For 2019   Table 2Global Golden Rule Duration-Adjusted Return Forecasts For 2019 The shaded cells in Table 3 represent our base case forecasts for policy rate changes in each country. On this basis, the better return prospects for 2019 will be in markets where central banks will stand pat throughout the year (Germany, Japan). Conversely, the weaker returns will occur where we expect more rate hikes than currently discounted by markets (U.S., Canada). These returns fit with our recommended country allocation outlined above. Table 3Ranking The 2019 Return Scenarios Corporate Credit Allocation: Neutral Overall, But Overweight In U.S. Investment Grade And High-Yield Relative To European And Emerging Market Equivalents. Look To Cut The U.S. To Underweight In The Latter Half Of 2019. We enter 2019 maintaining our recommended overall neutral exposure to corporate debt. As discussed earlier, we expect to see some stabilization of global growth in the first half of 2019. This will create a playable “risk-on” rally for growth sensitive assets like corporates, but we anticipate selling into that rally by downgrading our recommended U.S. credit allocations to underweight. Within U.S. credit markets, we are recommending a less aggressive medium-term stance, staying up in quality within investment grade debt (single-B and single-A rated names versus BBBs) and high-yield (BB-rated vs CCC-rated). With 50% of the investment grade benchmark index now rated just above junk, there is a growing risk of “fallen angel” downgrades to junk status in the event of a material slowing of U.S. economic growth. At the same time, default-adjusted spreads on U.S. high-yield debt only appear attractive if the current exceptionally low default rate backdrop persists (Chart 12). In other words, both U.S. investment grade and high-yield corporate debt are vulnerable to any major slowing of U.S. economic growth and slump in corporate profits. Chart 12U.S. Corporates Vulnerable To Slower Growth The confluence of above-trend U.S. growth and still pro-cyclical Fed policy will support U.S. credit in the near-term, but that will all change later in 2019. We expect the Fed to deliver at least 75bps of rate hikes in 2019 – perhaps only pausing from the current 25bps per quarter pace at the March meeting – which will push the funds rate into restrictive territory and invert the Treasury curve sometime in the 4th quarter of the year. This will cause investors to start to discount a deep growth slowdown in 2020, which will trigger systemic credit spread widening (Chart 13). We expect our next move on U.S. corporate debt to be a downgrade to underweight, likely sometime around mid-year. Chart 13Growth Differentials Continue To Favor U.S. We still prefer U.S. corporates to European or Emerging Market (EM) equivalents, however, thanks to the likelihood of better near-term growth prospects in the U.S. We are concerned about how the European corporate bond market will perform without the support of ECB asset purchases, which leads us to underweight both investment grade and high-yield European corporates (Chart 14).3 Chart 14Stay Overweight U.S. Corporates Vs European Corporates EM corporates will continue to suffer from the toxic combination of rising U.S. interest rates, a stronger dollar and global growth concerns. Our political strategists remain skeptical on the prospects for a permanent deal on thorny U.S.-China trade issues, leaving EM assets exposed to slowing momentum in China’s economy. We continue to prefer owning U.S. credit, given how the relative performance of EM and U.S. credit has not yet converged to levels implied by U.S./EM growth differentials (Chart 15). Chart 15Stay Overweight U.S. Corporates Vs EM Corporates Model Portfolio Adjustments To Begin 2019 In terms of our model bond portfolio, we recommend a few changes to our current allocations to reflect our 2019 outlook and key views (see the table below). We make a few adjustments to our individual country duration allocations, given our expectations of some re-steepening of global yield curves. We also bump up our allocation to core European debt given our expectation that the ECB will keep policy rates on hold throughout 2019. We fund that increase in European exposure from U.S. Treasuries, where too few Fed rate hikes are now discounted. Finally, we make a modest adjustment to our U.S. high-yield allocations, cutting CCC-rated exposure and upgrading B-rated credit.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “2019 Key Views: Normalization Is The “New Normal””, dated December 12th 2018, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “The Global Golden Rule Of Bond Investing”, dated September 25th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Stubbornly Resilient Bond Yields”, dated November 13th 2018, available at gfis.bcaresearch.com. 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 Late-cycle pressures will keep pushing bond yields higher. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay benign through 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. Feature BCA’s annual Outlook report, outlining the main investment themes that will drive global asset markets in 2019, was sent to all clients in late November.1 In this Weekly Report, we discuss the four broad implications of those themes for global fixed income. In a follow-up report to be published next week, we will translate those themes into strategic investment recommendations and allocations within our model bond portfolio framework. Key View #1: Late-Cycle Inflation Pressures Will Keep Pushing Bond Yield Higher The main theme from last year’s BCA Outlook was that markets and policy would collide in 2018. This year’s Outlook concluded that those same frictions would persist in 2019, and for similar reasons. The global economy is likely to see another year of above trend growth, after the current deceleration phase bottoms out in the first half of the year. Tight labor markets will continue to force developed market central banks, who still strongly believe in the Phillips Curve relationship as the best way to forecast inflation, to move toward less dovish monetary policies, putting steady upward pressure on global bond yields. Our own Central Bank Monitors signal a need for tighter monetary policy (Chart of the Week), most notably in the U.S. That may sound strange given the recent softening of global growth momentum and plunge in oil prices. Yet economic survey data (like the global ZEW index) show a huge divergence between actual and expected growth, with real bond yields responding more to the former than the latter (Chart 2). Chart of the WeekStill A Bearish Bond Backdrop   Chart 2Global Yields Will Remain Resilient In 2019 The fear of a global economic downturn appears greater than the current reality - a trend likely magnified by the ongoing U.S.-China trade tensions and the sharp fall in oil prices which some are interpreting to be a sign of weaker demand. BCA’s commodity strategists view the oil decline as purely supply driven, and expect that a tighter demand/supply balance will result in oil prices recovering recent losses and rising smartly in 2019. This should lead to a rebound in the inflation expectations component of global bond yields later next year (bottom panel). As was argued in the 2019 BCA Outlook, the conditions for a deep pullback in global growth are not yet in place, especially in the U.S. where consumer fundamentals remain solid (strong income growth, booming net worth and a low debt service ratio). China, where growth is currently slowing, remains the biggest wild card for the world economy, especially given the degree to which emerging market economies are levered to Chinese growth. Yet the most likely outcome is that Chinese authorities will make enough policy adjustments to stabilize the economy in the first half of 2019, which will help put a floor under global growth. With over 80% of OECD economies now with an unemployment rate below estimates of “full employment”, the backdrop today is more conducive to sustained higher inflation than at any point since the 2008 Global Financial Crisis (Chart 3). This means that actual inflation readings are likely to be stickier to the upside, especially for domestically focused measures like wages and services which are accelerating in many countries. Chart 3Tight Labor Markets Will Prevent A Sharp Drop In Inflation From the point of view of global central bankers, this means that as long as global growth does not slow sustainably below trend, then unemployment rates are unlikely to begin to rise. For policymakers who slavishly follow the Phillips Curve when forecasting inflation, that will make it difficult to shift to a more dovish policy bias, even if inflation remains below target for a time thanks to the recent pullback in oil prices (Chart 4). Chart 4Central Banks Who Believe In The Phillips Curve Can’t Turn Dovish The degree of policy bias in 2019 will not be uniform, though, which was also the case in 2018. Central banks in countries with core inflation rates closer to policymaker targets (the U.S., Canada, the U.K. if the Brexit uncertainty fades, Sweden) will be more likely to raise rates than those where inflation is still well below target (Japan, the euro area, Australia). Relative government bond market performance over the course of 2019 should reflect those trends. U.S. Treasury yields will still most likely to see the largest increase from current levels as the Fed will lift rates over the full 2019 calendar by more than markets are currently discounting (only 33bps are currently priced in the U.S. Overnight Index Swap curve – a low hurdle to beat). Key View #2: The Unwind Of Crisis-Era Global Monetary Policies Will Continue Quantitative easing (QE) – central banks buying huge amounts of bonds to help keep yields low enough to sustain economic growth amid weak inflation expectations – has been a dominant feature of global bond markets since the 2009 recession. Policymakers have been forced to engage in such unusual activities to try and boost weak inflation expectations even after policy interest rates have been cut to 0% (and even lower in some cases). Now, a decade later, inflation expectations are more stable and much closer to central bank targets in most countries (except, as always, Japan). That means government bond returns are no longer negatively correlated to equity returns (Chart 5), reducing the value of bonds as a hedge to stocks. Chart 5Bonds Are A Less-Effective Hedge For Equities With More Stable Inflation In the 2019 BCA Outlook, several other reasons were given as to why that correlation has been weakening, including a shift towards more consumption and less savings from aging populations entering their retirement years. The biggest change, however, has been the move from QE to “QT” (quantitative tightening) as central banks buy fewer bonds or, in the case of the U.S. Fed, actually letting bonds run of its massive balance sheet. The new year will bring an end to the net new buying phase of the European Central Bank (ECB) Asset Purchase Program. That represents a loss of €180 billion of liquidity into European bond markets compared to 2018 (twelve months at €15bn per month), both for government debt and investment grade corporates which are also part of the ECB’s program. This will come on top of reduced purchases from the Bank of Japan (BoJ), who will likely buy at a reduced ¥30 trillion pace in 2019 (down from around ¥40 trillion in 2018), and from the Fed who will let $600bn of maturing bonds run off its balance sheet ($360bn of which will be Treasuries). That slowing pace of central bank asset accumulation means that private investors must absorb an even greater supply of government bonds next year. The BCA Outlook estimated that the change in the supply of government bonds available to private investors would equal $1.2 trillion in 2019, a huge increase from the $400bn seen in 2018 (Chart 6). This will come at a time when new government bond issuance is set to increase once again thanks to wider U.S. budget deficits, further worsening the global supply/demand balance for government debt from the major developed economies. Chart 6Private Sector To Absorb More Bonds The reduction in the pace of central bank bond buying will continue to put gentle upward pressure on government bond yields, as has been the case since the pace of ECB purchases peaked in 2016 (Chart 7). More importantly, the diminished central bank liquidity expansion means there will be less money going into risky assets via the portfolio balance channel (i.e. private investors taking the funds earned from selling bonds to central banks and placing that in equity and credit markets). Chart 7Upward Pressure On Yields & Vol From 'QT' This creates a backdrop where volatility spikes will be more frequent, as has been the case in 2018 (bottom panel). Risky asset valuations will also be impacted from reduced inflows from yield-seeking investors who have sold government bonds to central banks. This suggests wider credit spreads and lower equity price/earnings multiples, all else equal (Chart 8). Chart 8Risk Asset Valuations Will Continue To Suffer From QT In 2019 Of course, all is not equal. A rebound in global growth could trigger a new wave of inflows into global equity and credit markets with valuations having cheapened in recent months. The important point is that, without central bank liquidity propping up asset prices, global risk assets will trade more off fundamentals in 2019 than has been the case during the past couple of years. Key View #3: Too Soon To Worry About Inverted Yield Curves “Yield curve inversions lead to recessions” is a well-known (if not well understood) relationship that has gained almost mythical status among investors. As the widely-watched spread between 2-year and 10-year U.S. Treasury yields (the 2/10 curve) has melted away during the course of 2018 – now sitting at a mere 13bps – the prognosticating power of the curve has many worried that a U.S. recession could be just around the corner. Especially after the Fed has raised the fed funds rate by 200 basis points over the past three years. Those fears are misguided, for several reasons: 1. The Treasury curve segment with the most successful track record in heralding U.S. recessions is the spread between the 10-year U.S. Treasury bond yield and the 3-month U.S. Treasury bill rate (Chart 9). That spread is still a firmly positive 42bps. We showed in a Special Report published last July that, on average, the length of time between the inversion of the 3-month/10-year Treasury curve and the beginning of a recession is seventeen months.2 Chart 9UST Curve Not Close To A True Recessionary Inversion Signal 2. The slope of the Treasury curve is unusually flat given the level of the fed funds rate measured in real (inflation-adjusted) terms. The previous three episodes where the 2-year/10-year Treasury curve has inverted over the past thirty years have occurred when the real fed funds rate was between 300-400bps (Chart 10). The current level of the real funds rate (deflated by headline CPI inflation) is near zero which, in the past, has occurred alongside a 2-year/10-year Treasury curve that had a positive slope between 150-200bps. Chart 10Global Yield Curves Look Too Flat Vs Real Policy Rates... 3. The depressed level of bond term premia is weighing on longer-dated Treasury yields and dampening the slope of the curve. This is happening not only in the U.S., but also in other major bond markets in Germany, the U.K. and Japan (Chart 11). The impact of global QE programs is the most likely common factor. Chart 11...With Global Term Premia Depressed 4. The 2-year/10-year U.S. Treasury curve has never been inverted without the real fed funds rate being above the neutral real rate, also known as R-star (Chart 12). Chart 12No 2/10 UST Inversion Before Real Rates Exceed R* The implication for fixed income investing for 2019 is that it is too soon in the Fed’s monetary tightening cycle to expect an inverted yield curve driven by an overly tight monetary policy. That outcome is more likely by late 2019 after inflation expectations pick up and the Fed delivers at least another 75bps over the course of the year, pushing the funds rate into restrictive territory. Key View #4: Poor Corporate Returns From The Aging Credit Cycle The other major fixed income implication of the 2019 BCA Outlook is that global corporate bond markets are likely to see another year of poor returns (both in absolute terms and relative to government bonds). Spreads remain near historically tight levels across most spread product sectors, suggesting that credit risk premia will need to be repriced higher as the endgame of the multi-year credit cycle draws nearer (Chart 13). Both investors and policymakers have grown increasingly worried about the risks to the U.S. corporate bond market from high corporate leverage. However, as was discussed in the Outlook, U.S. corporate interest coverage remains well above levels that have preceded the end of previous credit cycles and BCA’s models suggest U.S. corporate profit growth will remain solid (albeit much slower than the rapid +20% growth seen in 2018). Chart 13Fading Support For Corporate Bonds From Growth & Policy That does not mean that corporate bonds are without risk. With 50% of global investment grade bond indices now rated BBB (one notch above junk), the greater threat to corporates may come from downgrades. While those are less likely in a growing economy, investors in lower-rated investment grade bonds may require higher yields and spreads to compensate for the future risk of losses as those bonds could become “fallen angel” high-yield debt in the next economic downturn. This impact would be magnified as how many large fixed income managers have mandates that forbid investment in bonds rated below investment grade, thus creating forced selling in the event of downgrades. More fundamentally, the outlook for global corporate bonds, with spreads still much closer to historical tights than long-run averages, remains reliant on strong economic growth momentum and supportive monetary policy. On the former, we do not anticipate a move to sub-trend global growth, as discussed earlier, and corporate bond returns could stabilize once the current downtrend in the world economy subsides (Chart 14). This would likely represent a final period of calm, however. Tightening global monetary policies – both Fed hikes and diminished asset purchases – will create a more bearish backdrop for credit in the latter half of 2019 as markets begin to discount slower economic growth in 2020. Chart 14Fading Support For Corporate Bonds From Growth & Policy   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see the December 2018 edition of The Bank Credit Analyst, “Outlook 2019 – Late Cycle Turbulence”, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31st 2018, available at gfis.bcaresearch.com.   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 Below-Benchmark Duration: Below-benchmark duration positions will continue to pay off in 2019 as the Fed delivers more than the 32 bps of rate hikes that are priced into the curve for the next 12 months. While tighter financial conditions will probably necessitate a pause in the Fed’s gradual rate hike cycle at some point next year, this is already more than discounted in current market prices. A further deterioration in housing starts and new home sales, or a significant uptick in initial jobless claims would call our below-benchmark duration view into question. Neutral Corporate Credit: In an environment where the yield curve is quite flat but still positively sloped, excess returns to corporate bonds also tend to be quite low, but still positive on average. Investors should be looking for low, but positive, excess returns from credit on a 12-month investment horizon. However, credit spreads will probably widen further in the near-term and then tighten once the Fed signals a pause and global growth improves. Overweight Munis and Local Authorities: Tax-exempt municipal bond yields are very attractive relative to corporate bonds and both municipal and Local Authority bonds are relatively insulated from the weakness in global growth that will threaten the corporate profit outlook in the coming quarters. Both of these sectors should perform well in 2019. Overweight TIPS: Long-maturity TIPS breakeven inflation rates have shifted down in recent weeks, but will move higher in 2019, eventually stabilizing in a range between 2.3% and 2.5%. The rebound in oil prices that our commodity strategists expect will help, but TIPS outperformance will largely be driven by investor expectations slowly adapting to the new reality that inflation will remain much closer to the Fed’s target than it has in recent years. Yield Curve Inversion In Late 2019: Below-target TIPS breakeven inflation rates and an inverted yield curve cannot coexist. As such, investors should not worry about a sustained inversion of the yield curve until later in 2019. To profit from this view, investors should position for steepeners at the front-end of the curve. We recommend going long the 2-year bullet and short a duration-matched 1/5 barbell. The belly (5-7 year) part of the curve has become very expensive and should be avoided at all costs. Feature BCA published its 2019 Outlook two weeks ago.1 That report lays out the macroeconomic themes that our strategists think will drive markets next year. In this Special Report, we specify how investors should implement those views in the context of a U.S. bond portfolio. Key Views The main conclusions from the 2019 Outlook are: Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. […] that means capacity pressures will intensify, causing inflation to move higher. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. […] Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. In the verbiage of monetary policymakers, the BCA view is that U.S. interest rates remain below the neutral level that is consistent with trend GDP growth and stable inflation. This means that the Fed’s rate hike cycle will continue in 2019, and that monetary policy will not turn restrictive until later in the year. It is this view of U.S. interest rates remaining below neutral until late 2019 that drives our portfolio recommendations. Key Risks Given our main premise, the biggest risk to our recommended portfolio allocation is that interest rates move above neutral sooner than we anticipate. We will be monitoring three main risks in the coming months to help us decide whether our main premise needs to be re-evaluated. Risk #1: Housing Since a large amount of leverage is employed in the acquisition of new homes, there is good reason to believe that housing is the main channel through which interest rates impact the real economy. This is validated by the empirical data which show that residential investment, housing starts and new home sales all provide a good indication of when monetary policy turns restrictive and of when Treasury yields peak for the cycle.2 With that in mind, the housing data have clearly deteriorated during the past 6-9 months. However, with the 12-month moving averages of housing starts and new home sales still trending higher, it is too soon to say that housing has peaked for the cycle (Chart 1). Our sense is that the recent deterioration is a result of the sharp move higher in mortgage rates that occurred earlier this year. Now that rates have moderated, the housing data should improve.3 Chart 1The Housing Market Predicts Recessions A decisive breakdown in the 12-month moving averages of housing starts and new home sales would cause us to question our premise that U.S. interest rates remain below neutral. Risk #2: Jobless Claims With the unemployment rate at 3.7%, the U.S. labor market is in rude health. That being said, a move higher in the unemployment rate would be a clear sign that monetary policy is restrictive and that a recession is right around the corner. In the post-war era, there has never been a case where the 3-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession taking place. Often, a turn higher in the unemployment rate is preceded by an increase in initial jobless claims, and the 4-week moving average in claims has increased for four consecutive weeks (Chart 2). So far, that increase is no cause for concern. Historically, the 6-month change in jobless claims needs to reach +75k before a recession occurs (Chart 2, bottom panel). Nevertheless, the recent upturn in claims will bear monitoring in the months ahead. Chart 2Initial Jobless Claims Are Worth Monitoring Risk #3: Weak Foreign Growth & A Strong Dollar It is a bit misleading for us to include weak foreign growth and a strong dollar in the “key risks” section. In fact, our base case outlook involves weak foreign economic growth migrating to the U.S. via a stronger dollar and leading to a mild slowdown in U.S. economic activity during the next few quarters (Chart 3).4 This will probably even cause the Fed to pause its gradual rate hike cycle, but will not bring it to an end. This report also contains our recommendations for how to tactically position for this pause. Chart 3Weak Global Growth Will Drag The U.S. Lower The Awkward Middle Phase When constructing U.S. bond portfolios on a cyclical (6-12 month) investment horizon, we find it useful to split the economic cycle into phases based on the slope of the yield curve. Our economic view informs what phase (or phases) of the cycle will reign during the next 6-12 months, and the phase of the cycle informs our investment posture. We define three phases of the cycle as follows (Chart 4): Chart 4The Three Phases Of The Cycle Phase 1: From the end of the prior recession until the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2: When the 3-year/10-year Treasury slope is between 0 bps and +50 bps. Phase 3: From when the 3-year/10-year Treasury curve inverts until the start of the next recession.5 Table 1 shows how each U.S. fixed income asset class has performed in each phase. We use excess returns from the Bloomberg Barclays Treasury index versus cash to track the returns earned from taking portfolio duration risk. For other fixed income sectors we display excess returns versus duration-matched Treasuries. We also include the performance of the S&P 500 versus the Bloomberg Barclays Treasury index. Table 1Risk Asset Performance In Different Yield Curve Regimes As should be clear from the macro view discussed above, we believe that we will remain in Phase 2 of the cycle for the bulk of 2019. With the 3/10 Treasury slope a mere 13 bps at present, temporary curve inversions might occur earlier in the year, but they will not be sustained (see Key View #5 below). The first implication of being in Phase 2 is that corporate bond excess returns (both investment grade and high-yield) are likely to be positive on average, but will be very low. The bulk of corporate bond excess returns are earned in Phase 1 of the cycle when the yield curve is very steep. Excess returns don’t turn decisively negative until after the curve inverts and we enter Phase 3. Like corporate credit, Treasury excess returns are also lower in Phase 2 than in Phase 1. This makes Phase 2 an awkward one for portfolio positioning. The expected return from taking an extra unit of credit risk is quite low, as is the expected return from taking an extra unit of duration risk. In fact, cash tends to be one of the best performing asset classes in Phase 2. The excess returns from most other spread products present a similar pattern to those from corporate bonds. Elevated excess returns in Phase 1, much lower – though typically still positive – excess returns in Phase 2, negative excess returns in Phase 3. One exception to this pattern is tax-exempt municipal debt which, outside of the mid-1990s cycle, has performed similarly or better in Phase 2 than it has in Phase 1. Domestic Agency bonds and Supranationals also stick out as being very defensive sectors. They both almost always provide a small positive excess return versus Treasuries, but never provide a large reward. In the remainder of this report we discuss the five key implications for U.S. bond portfolio positioning that follow from remaining in Phase 2 of the cycle for most of 2019. Key View #1: Below-Benchmark Duration We think below-benchmark portfolio duration positions will continue to pay off in 2019. We have already shown that Phase 2 of the cycle tends to coincide with relatively low excess Treasury returns, but the slope of the yield curve is not the best indicator for Treasury returns versus cash. For that, we turn to our Golden Rule of Bond Investing which says that Treasuries tend to underperform (outperform) cash on a 12-month investment horizon when the Fed delivers more (fewer) rate hikes than what was discounted at the beginning of the 12-month period (Chart 5).6 Chart 5The Golden Rule's Track Record At present, the market is priced for only 32 bps of rate hikes during the next 12 months. More specifically, the market is pricing-in a rate increase this month, followed by one more in 2019 and then rate cuts in 2020 (Chart 6). Chart 6Market's Rate Expectations Are Too Low This extremely depressed market pricing makes us reluctant to increase duration, even tactically. While we do expect U.S. growth to slow during the next few quarters, probably by enough to necessitate a pause in the Fed’s tightening cycle, this pause is already more than reflected in current market prices. Key View #2: Neutral Corporate Credit Cyclical Horizon (6-12 Months) Being in Phase 2 of the cycle warrants a relatively defensive posture toward credit risk. For now, we recommend a neutral allocation to corporate bonds with an up-in-quality bias. We will further reduce exposure to underweight when we transition to Phase 3 of the cycle, likely late in 2019. We also recommend looking at the long-end of the credit curve to increase the average spread of your portfolio.7 Table 2 makes the importance of correctly identifying the phase of the cycle even more apparent. It shows the excess returns to both investment grade and high-yield corporate bonds for different investment horizons directly after the 3/10 Treasury slope flattens into a given range. For example, the median excess return to investment grade corporate bonds in the 12 months after the 3/10 slope breaks below 25 bps is -1.02%. Table 2Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) As in Table 1, Table 2 shows that excess returns are much higher when the yield curve is steep and that they tend to turn negative after the curve inverts. But unlike the results in Table 1, the analysis in Table 2 includes recessionary periods and makes no attempt to split the cycle into different phases. It is a purely forward looking rule that calculates excess returns after different “trigger points” are reached. For example, the 12-month median excess return of -1.02% after the 3/10 slope breaks below 25 bps is biased downward because of periods when the slope broke below 25 bps and then continued to flatten until it inverted. An environment where the slope stayed range-bound between 0 bps and +25 bps for an extended period – closer to what we expect in 2019 – will deliver somewhat better excess returns. Tactical Horizon (< 6 Months) The phase of the cycle helps us specify our excess return expectations for the next 12 months, and based on our outlook, we expect excess returns will be positive, but close to zero. However, as we write this report, corporate spreads are widening at a fairly rapid clip. We expect the carnage will continue in the near-term, but are monitoring catalysts to initiate a tactical overweight recommendation on corporate credit.8 As they were in 2015, corporate spreads are widening at the moment due to the toxic combination of slowing global growth and relatively hawkish monetary policy. We expect that sometime in early 2019, Fed policy will ease at the margin and this will coincide with a near-term peak in credit spreads and a period of improved global growth. To determine when spreads peak we are monitoring several indicators of global growth and Fed policy that successfully called the last peak in early-2016. On the global growth side, the key indicators are (Chart 7A): The CRB Raw Industrials Index The BCA Market-Based China Growth Indicator9 The price of global industrial mining stocks On the monetary policy front, the key indicators are (Chart 7B): The 12-month Fed Funds Discounter The gold price The trade-weighted dollar Chart 7AKey Indicators: Global Growth Chart 7BKey Indicators: Monetary Policy All in all, our conviction that we will remain in Phase 2 of the cycle for most of 2019 suggests we should maintain a neutral allocation to corporate bonds on a 6-12 month investment horizon, looking for small positive excess returns. In the near-term, we expect spreads will continue to widen in the next few weeks, but will peak once the Fed signals a pause in its rate hike cycle and global growth indicators show some improvement. We are monitoring several catalysts that will help us decide when to initiate a tactical overweight position in corporate bonds. Key View #3: Overweight Munis And Local Authorities The analysis in Table 1 showed that tax-exempt municipal bonds often provide strong excess returns in Phase 2 of the cycle. This makes them an attractive place to position in the current environment, especially given the relative attractiveness of muni yields. Table 3 shows that the average yield on the Bloomberg Barclays Municipal Index is 2.75%. If we assume even a 30% effective tax rate, the taxable-equivalent yield becomes 3.93%, well above the average yield offered by the Aa-rated Corporate index. Table 3Municipals Are Attractive Another reason to like munis in the current cycle is that state & local government revenues are relatively insulated from weakness in the global economy. As foreign growth weakens and drives up the dollar, corporate profits will suffer much more than state & local government tax revenues. A similar case can be made for the Local Authority sub-index of the Bloomberg Barclays Aggregate. This index is comprised largely of taxable municipal debt (and some Canadian provincial debt), and while the average yield is lower than for tax-exempt munis, it is still competitive compared to corporate bonds. But most importantly, the sector is relatively insulated from weak foreign growth and a strong dollar. Municipal bonds and the Local Authority sub-index are important overweights in our recommended portfolio as we head into 2019. Key View #4: Overweight TIPS Versus Nominal Treasuries Though long-maturity TIPS breakeven inflation rates have fallen in recent weeks, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. We believe that both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates will reach our target range of 2.3% to 2.5% in 2019. At present, TIPS breakevens are caught between being pulled down by weakening global growth and pushed up by mounting U.S. inflationary pressures (Chart 8). Most recently, weaker global growth has been winning and breakevens have moved lower alongside the plunge in oil prices. Chart 8TIPS Breakevens Face Opposing Forces Taking a step back, it is very unlikely that global growth and commodity prices will continue to fall at their current rates throughout 2019. At some point, a dovish turn from the Fed will lead to some depreciation of the dollar and global growth will stage a rebound. Our commodity strategists also expect a rebound in the oil price. They target an average of $82/bbl for Brent crude oil in 2019.10 In the meantime, core U.S. inflation will continue to print close to the Fed’s 2% target, and maybe even a bit higher in late 2019. At some point, inflation expectations will need to adapt to the new reality of inflation being near the Fed’s target. Historically, this suggests a range of 2.3% to 2.5% for TIPS breakeven inflation rates. Inflation expectations can be slow to adapt to a changing environment, and after several years of the Fed missing its inflation target from below, many investors remain trapped in a deflationary mindset. To get an idea of how long it takes inflation expectations to adjust to changes in the economy, we use our Adaptive Expectations Model of TIPS breakevens (Chart 9).11 The model is based on three factors: Chart 9The Adaptive Expectations Model Of The 10-Year Breakeven Rate The 12-month rate of change in headline CPI The New York Fed’s Underlying Inflation Gauge The 120-month rate of change in core CPI Of the three factors, the 120-month rate of change in core CPI carries the largest weight in the model. In other words, the catalyst for moving TIPS breakeven rates higher will simply be core U.S. inflation continuing to print near the Fed’s target for a prolonged period of time. All in all, investors should maintain overweight allocations to TIPS versus nominal Treasuries in 2019, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. The current slowdown in global growth and commodity prices will not last for the entire year, and U.S. inflationary pressures will continue to mount as the U.S. economy grows at an above-trend pace with a very tight labor market. Key View #5: No Yield Curve Inversion Until Late 2019 The final key view that falls out of our main macro premise, which is that the fed funds rate will remain below neutral for the bulk of 2019, is that the yield curve will not sustainably invert until late 2019. This is also probably the most contentious of our key views, given recent market moves. The main reason why we think the slope of the yield curve will remain quite flat, but positive, for most of 2019 is that sustainable yield curve inversion cannot coexist with below-target TIPS breakeven inflation rates. An inverted yield curve is a signal that the market views monetary policy as overly restrictive. It means that investors expect U.S. growth and inflation to fall in the future, necessitating rate cuts. However, long-maturity TIPS breakeven inflation rates below the 2.3% - 2.5% range that has historically been consistent with well-anchored inflation expectations signal that the market believes that inflation will not sustainably return to the Fed’s target. In other words, for an inverted yield curve and below-target TIPS breakeven inflation rates to coexist, we would have to believe that the Fed would tighten monetary policy into restrictive territory without sufficient inflationary pressures to meet its target. It is difficult to envision the Fed committing such an egregious policy error. In the event that the yield curve does invert while TIPS breakevens are below target, it is much more likely that either the Fed will adopt a more  dovish policy stance, leading to a bull-steepening of the curve; or, inflation will rise leading to higher TIPS breakevens and causing the curve to bear-steepen. In either scenario, it is hard to see how yield curve inversion will last very long without significantly higher TIPS breakevens. We will call an end to Phase 2 of the cycle only when the yield curve is inverted and long-maturity TIPS breakeven inflation rates are above 2.3%. Curve Positioning As for how to position on the yield curve in 2019, the biggest change since the end of last year is that the belly (5-7 year) of the curve is now very expensive (Chart 10). In fact, the 2/5 slope is slightly inverted as we go to press, meaning there is actually negative rolldown in the 5-year note. Chart 10Par Coupon Treasury Curve By far, the best place to position on the curve is the 2-year maturity point.12 Our model of the 1/2/5 butterfly spread (2-year bullet over duration-matched 1/5 barbell) shows that the 2-year is cheap relative to the 1/5 slope. Conversely, our model of the 2/5/10 butterfly spread shows that the 5-year bullet has become expensive relative to the 2/10 slope (Chart 11). Chart 11Favor The 2-Year Bullet Butterfly trades where you favor the bullet maturity versus the barbell perform well when the curve steepens. For example, the 2-year tends to outperform the 1/5 barbell when the 1/5 slope steepens. At present, the cheapness of the 2-year suggests that the butterfly spread is priced for significant 1/5 flattening in the coming months. Even stability in the 1/5 slope will cause the 2-year to outperform, and our key yield curve recommendation at the moment is to go long the 2-year bullet and short a duration-matched 1/5 barbell.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at bca.bcaresearch.com 2  Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 5 We use the 3-year/10-year Treasury slope because it closely approximates the 2-year/10-year slope, but with more back-data. 6 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “What Kind Of Correction Is This?”, dated October 30, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 9 A combination of 17 different financial market variables that are highly levered to Chinese growth. Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 10 Please see Commodity & Energy Strategy Weekly Report, “The Third Man At OPEC 2.0’s Meeting”, dated November 29, 2018, available at ces.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, “The Sweet Spot On The Yield Curve”, dated November 13, 2018, available at usbs.bcaresearch.com

Highlights Our take on the key macro drivers of financial markets hasn’t evolved much since we laid it out this summer, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... but the inflection points are getting nearer: The good times won’t last forever, though. The Fed is resolutely tightening policy, BBB-heavy investment-grade issuance has the corporate bond market flirting with a plague of fallen angels, and the global economy is slowing. Our strategy remains more cautious than our outlook for now, … : Although we think the equity bull market has another year to run, and the expansion will stretch into 2020, we are only equal-weight equities, while underweighting bonds and overweighting cash. … but we’re alert to opportunities to get more aggressive: Investment-grade and high-yield bonds are unlikely to offer an attractive risk-reward profile, but the S&P 500 shouldn’t decline much more if the economy holds up. Feature Mr. and Ms. X’s annual visit is an occasion for every BCA service to look toward the coming year, mindful of how it could improve on the one just past. The theme we settled on in last year’s discussion, Policy and Markets on a Collision Course, began asserting itself in earnest in October, and appears as it will be with us throughout 2019. The Fed is nearing its fourth rate hike this year, on the heels of three in 2017, and markets are warily contemplating the tipping point at which higher interest rates begin to interfere with activity. The yield curve has become a constant worry (Chart 1), with short rates moving in step with the fed funds rate while yields at the long end have been just one-half as sensitive (Chart 2). Chart 1Yield Curve Anxiety Has Exploded ...   Chart 2... As The Curve Has Steadily Flattened Trade tensions are an even thornier policy challenge. After flitting on and off investors’ radar earlier in the year, trade barriers have been a major source of angst in recent months as central banks, investor polls and company managements increasingly cite them among their foremost concerns. Unfortunately, our geopolitical strategists do not expect relief any time soon. They see trade as just one aspect of an extended contest for supremacy between China and the U.S. Late-Cycle Turbulence, our 2019 house theme, pairs nicely with Policy-Market Collision. The gap between our terminal fed funds rate expectation and the money market’s is huge, and leaves ample room for a repricing of the entire yield curve. Trade has been a roller coaster, capable of inducing whiplash in 140 characters or less, and it may already have brought global manufacturing to the brink of a recession. Oil lost 30% in two months at the stroke of a pen; its immediate fate is in the hands of OPEC, but the caprice with which Iranian sanctions may or may not be re-imposed is likely to feed uncertainty. As we advised Mr. and Ms. X a few weeks ago, investors should stay nimble; there is no point to committing to a twelve-month strategy right now.1 The Fed Funds Rate Cycle Our equilibrium fed funds rate model estimates that the equilibrium fed funds rate, the rate that neither encourages nor discourages economic activity, is currently around 3%. It projects that the equilibrium rate will approach 3¼% by the middle of 2019, and 3⅜% by year end. The implication is that policy is comfortably accommodative now, and will not cross into restrictive territory for another 12 months – assuming that the Fed hikes four times next year, in line with our ambitious expectation. If the Fed steps back from its gradual pace, and only hikes three times in 2019 (as per the dots), or just once (as per the money market), the day when the economy and markets will have to confront tight monetary conditions will be pushed even further into the future. Stretching monetary accommodation until late next year would seem to forestall the arrival of the next recession until at least the first half of 2020. Tight policy is a necessary, if not sufficient, condition for a recession, as recessions have only occurred when the policy rate has exceeded our estimate of equilibrium over the six decades covered by our model. A longer stretch of accommodation would also continue to nourish the equity bull market and discourage allocations to Treasuries. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 1), while Treasuries have wilted, especially in the current phase of the fed funds rate cycle (Table 2). Table 1Equities Flourish When Policy’s Easy ...   Table 2... While Treasuries Stumble The Business Cycle The state of policy is one of the three components in our simple recession indicator. Neither of the other two is sounding the alarm, either. Our preferred 3-month-to-10-year segment of the Treasury yield curve is still comfortably upward sloping, even if it has been steadily flattening and we expect it to invert late next year (Chart 3). Year-over-year growth in leading economic indicators decelerated slightly last month, but remains well above the zero line that has reliably preceded past recessions. Chart 3Flattening, But Not Yet Flat The Credit Cycle Anyone following the credit cycle would do well to start with the axiom that bad loans are made in good times. Its converse is just as true: good loans are made in bad times. Loan officers are every bit as susceptible to the recency bias as other human beings, and they tend to extrapolate from the freshest observations when assessing a borrower’s prospects. When things are good, lenders assume they will continue to be good, and let their guard down by lending to marginal borrowers and/or relaxing the terms on which they will lend. When things are bad, on the other hand, loans have to be underwritten so tightly that they squeak. The upshot is that lending standards and loan performance are tightly bound up with one another. In the near term, standards and performance are joined at the hip; over a five-year period, standards lead performance as a contrary indicator. Defaults almost certainly bottomed for the cycle in 2014, to judge by speculative-grade bonds (Chart 4, top panel), and loans (Chart 4, bottom panel). Standards reliably followed, and the proportion of lenders easing standards for corporate borrowers, as per the Fed’s senior loan officer survey, spiked (Chart 5). Chart 4Weakening, But Not Yet Weak   Chart 5Standards Follow Performance In Real Time ... The 2012 and 2014 peaks in willingness suggest that performance is due to erode (Chart 6). We do not foresee a step-function move higher in defaults, or a sudden collapse in loan availability, but we do expect some fraying at the edges. Given how tight spreads remain, any weakness at the margin could go a long way to wiping out much, if not all, of spread product’s excess return. The bottom line is that the credit cycle is well advanced, and investors should expect borrower performance and lender willingness to weaken from their current levels. Chart 6... And Lead Them Over The Intermediate Term Bonds We have written at length on our bearish view on rates and Treasuries.2 The key pillar supporting our rationale is the gap between our terminal fed funds rate estimate, 3.5-4%, and the market’s view that the Fed will not go beyond 2.75%, if indeed it gets to that level at all (Chart 7). The gap is big enough to drive a truck through, and leaves a lot of room for yields to shift higher all along the curve, even if the Fed were to slow its 25-bps-a-quarter tempo, as the Wall Street Journal suggested it might in a report last Thursday. We continue to believe that inflation is the inevitable outcome once surging aggregate demand collides with limited spare capacity, and that the Fed will be forced to push the fed funds rate to 3.5% and beyond. Chart 7Something's Gotta Give Our view that the credit cycle has already passed its peak drives our view on spread product. Though we remain constructive on the economy and the outlook for corporate earnings, we are not enamored of the risk-reward offered by corporate bonds. Although high-yield spreads blew out by nearly 125 bps from early October to late November, high yield still does not look cheap (Chart 8, bottom panel). The same holds for investment-grade spreads, which remain near the bottom of their long-term range despite widening by over 50 bps (Chart 8, top panel). Chart 8Spreads Are Still Tight Bottom Line: We recommend that investors underweight fixed income within balanced portfolios, while underweighting Treasuries and maintaining below-benchmark duration. We recommend benchmark holdings in spread product, but we expect to downgrade it to underweight before the end of the first half. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive for another twelve months or so, the bull market should have about another year to go. We downgraded equities to equal weight as a firm in mid-June nonetheless, on signs of global deceleration and the potentially malign effects of tariffs and other impediments to global trade. U.S. Investment Strategy fully supported that decision, but we are alert to opportunities to upgrade equities to overweight within U.S. portfolios if prices decline enough to make the prospect of a new cycle high attractive on a risk-reward basis. The risk-reward requirement implies that the fall in price would have to occur without a material weakening of the fundamental backdrop. For now, we think the fundamental supports remain stable, as per the equity downgrade checklist we constructed to keep tabs on them. The checklist monitors recession indicators, none of which betray any concern now; factors that may weigh on corporate earnings; inflation measures, because higher inflation could motivate the Fed to hike more quickly than planned, with adverse consequences for the bull market; and signs of overexuberance (Table 3). Table 3Equity Downgrade Checklist The earnings-pressure section focuses on the key factors that might signal margin contraction – wage growth, dollar strength and rising bond yields – but none of them look especially problematic now. While we think compensation gains will eventually push the Fed to go beyond its own terminal rate estimates, they have not yet picked up enough to cause concern. The dollar has paused in its advance, mostly marking time since the end of October. Only BBB corporate yields have gotten closer to checking the box (Chart 9). BCA’s preferred margin proxies remain in good shape, on balance (Chart 10), and our EPS profit model is calling for robust profit growth across all of next year (Chart 11). Chart 9Higher Rates Will Exert Some Margin Pressure   Chart 10In The Absence Of Margin Pressures, ...   Chart 11... 2019 Earnings Could Hold Up Nicely Oil’s plunge has pulled both headline CPI and longer-run inflation expectations lower. Although we think that the inflation respite is merely a head fake, and that oil will soon regain its footing (please see below), the run of harmless inflation data has the potential to soothe some market concerns about the Fed. If the Fed itself takes the data at face value, it may signal that the current 25-bps-a-quarter gradual pace could be slowed. As for exuberance, the de-rating the S&P 500 has endured since its forward multiple peaked at 18.5 in January suggests that it’s not a problem. We are not living through anything remotely resembling an equity mania. Bottom Line: BCA’s mid-June downgrade of global equities from overweight to equal-weight was timely. We remain equal-weight in balanced U.S. portfolios, but are more likely to upgrade U.S. equities than downgrade them, given the supportive cyclical backdrop. Oil We devoted our report two weeks ago to the oil outlook and its implications for the economy. Our Commodity & Energy Strategy service’s bullish 2019 view has not changed: it still sees a market in a tight supply/demand balance with high potential for supply disruptions and a smaller-than-usual inventory reserve to make up the slack. The unexpected release of over a million barrels a day of Iranian output has played havoc with oil prices, but does not provoke the growth concerns that declining demand would. Provided OPEC is able to agree on production cuts, and abide by them going forward, our strategists see Brent and WTI averaging $82 and $76/barrel across 2019. The Dollar We remain bullish on the dollar, though it will find the going rougher than it did in 2018. Traders have built up sizable net long positions, so it will take more for the greenback to extend its advance than it did to begin it. Ultimately, we think desynchronization between the U.S. and the rest of the major DM economies will keep the dollar moving higher. If the U.S. does not continue to outgrow the currency-major economies by a healthy margin, and/or the Fed does not respond to that growth by hiking rates to prevent overheating, the dollar’s advance may be nearly played out. Putting It All Together Three major assumptions underpin our views: The U.S. economy is at risk of overheating in its second year of markedly above-trend growth fueled by fiscal stimulus, and the Fed will respond to that risk by decisively raising rates. There will be a noticeable global slowdown, but it will not go far enough to turn into a recession. The U.S. will remain mostly immune to the global slump. We will be positioned well if all of these assumptions are validated by events, though timing is always uncertain. Financial-market volatility often increases late in the cycle, and we expect the backdrop to remain fluid. We are trying to maintain a fluid mindset in kind, monitoring the incoming data to make sure our cyclical assessments still apply, while remaining alert to opportunities created by significant price swings. Although we are neither traders nor tacticians, we want to retain some flexibility, and are trying to resist mentally locking in our positioning for the entire year. We are particularly focused on the monetary policy backdrop and the transition from accommodative to restrictive policy, which has historically been critically important for asset allocation. Our main goal is to anticipate the approach of inflection points in the key cycles – business, credit and monetary – as adeptly as we can. We are also resolved to look through the noise of one-off price swings and the blather that has already been clogging the airwaves. We seek to help our clients formulate a strategy for navigating the turbulence without being swept up in it. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the December 2018 Bank Credit Analyst, “Outlook 2019: Late-Cycle Turbulence,” available at www.bcaresearch.com. 2 Please see the July 30, 2018 U.S. Investment Strategy, “The Rates Outlook,” the September 17, 2018; U.S. Investment Strategy, “What Would It Take To Change Our Bearish Rates View?” and the November 5, 2018; U.S. Investment Strategy, “Checking In On Our Rates View,” available at usis.bcaresearch.com.