High-Yield

Highlights Chart 1Manufacturing PMIs Track Bond Yields Manufacturing PMIs Track Bond Yields Manufacturing PMIs Track Bond Yields November’s manufacturing PMI data were released yesterday, giving us an update for two of our preferred global growth indicators: the Global Manufacturing PMI and the US ISM Manufacturing PMI (Chart 1). Unfortunately, the two indicators sent conflicting signals, providing us with very little clarity on the global growth outlook. On the positive side, the Global Manufacturing PMI jumped back above 50 for the first time since April. China is the largest weighting in the global index, and its PMI rose for the fifth consecutive month. Conversely, the US ISM Manufacturing PMI dipped further into contractionary territory in November – from 48.3 to 48.1. Optimistically, the index’s inventory component contracted by more than the new orders component, meaning that the difference between new orders and inventories rose to its highest level since May. The difference between new orders and inventories often leads the overall ISM index by several months. All in all, we continue to see tentative signs of stabilization in our preferred global growth indicators. But a more significant rebound will be necessary to push bond yields higher in the first half of next year, as we expect. Stay tuned. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in November, bringing year-to-date excess returns up to +494 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is high and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The third quarter’s tightening of C&I lending standards is a concern, because it suggests that monetary conditions may not be sufficiently stimulative for banks to keep the credit taps running (bottom panel). But the yield curve, another indicator of monetary conditions, has steepened significantly since Q3, suggesting that lending standards will soon move back into “net easing” territory. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher (see page 7). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Mixed Messages Mixed Messages Table 3BCorporate Sector Risk Vs. Reward* Mixed Messages Mixed Messages High-Yield Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 47 basis points in November, bringing year-to-date excess returns up to +671 bps. The index option-adjusted spread tightened 22 bps on the month and currently sits at 370 bps, 131 bps above our target (Chart 3). Ba and B rated junk bonds outperformed the Treasury benchmark by 79 bps and 76 bps, respectively, in November. But Caa-rated credit underperformed Treasuries by 89 bps. This continues the trend of Caa underperformance that has been in place since late last year (panel 3). We analyzed the divergence between Caa and the rest of the junk bond universe in last week’s report and came to two conclusions.3 First, the historical data show that 12-month periods of overall junk bond outperformance are more likely to be followed by underperformance if Caa is the worst performing credit tier. Second, we can identify several reasons for this year’s Caa underperformance that make us inclined to downplay any potential negative signal. Specifically, we note that the Caa credit tier’s exposure to the shale oil sector is responsible for the bulk of this year’s underperformance (bottom panel). With elevated spreads, accommodative monetary conditions and a looming recovery in global economic growth, we expect junk spreads to tighten during the next 6-12 months.    MBS: Overweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 19 basis points in November, bringing year-to-date excess returns up to +22 bps. The conventional 30-year zero-volatility spread tightened 3 bps on the month, as a 5 bps tightening of the option-adjusted spread (OAS) was offset by a 2 bps increase in expected prepayment losses (aka option cost). We recommend an overweight allocation to Agency MBS, particularly relative to corporate bonds rated A or higher, for three reasons.4 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 50 bps (Chart 4). This is very close to its pre-crisis average and only 3 bps below the spread offered by Aa-rated corporate bonds (panel 4). Also, spreads for all investment grade corporate bond credit tiers trade below our targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most homeowners have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 14 basis points in November, bringing year-to-date excess returns up to +197 bps. Sovereign debt outperformed duration-equivalent Treasuries by 36 bps on the month, bringing year-to-date excess returns up to +513 bps. Local Authorities outperformed the Treasury benchmark by 24 bps, bringing year-to-date excess returns up to +245 bps. Meanwhile, Foreign Agencies outperformed by 4 bps, bringing year-to-date excess returns up to +266 bps. Domestic Agencies outperformed by 11 bps in November, bringing year-to-date excess returns up to +51 bps. Supranationals outperformed by 5 bps on the month, bringing year-to-date excess returns up to +36 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to US corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.5 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).6 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 70 basis points in November, bringing year-to-date excess returns up to +6bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 4% in November, and currently sits at 83% (Chart 6). We upgraded municipal bonds in early October, as yield ratios had become significantly more attractive, especially at the long-end of the Aaa curve (panel 2).7 Specifically, 2-year and 5-year M/T yield ratios are somewhat below average pre-crisis levels at 68% and 72%, respectively. However, M/T yield ratios for longer maturities (10 years and higher) are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 84%, 93% and 97%, respectively. Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher in November, steepening out to the 7-year maturity and flattening beyond that. The 2/10 Treasury slope was unchanged on the month. It currently sits at 17 bps. The 5/30 slope flattened 7 bps to end the month at 59 bps (Chart 7). In a recent report we discussed the 6-12 month outlook for the 2/10 Treasury slope.8 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight   Chart 8TIPS Market Overview Inflation Compensation Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in November, bringing year-to-date excess returns up to -70 bps.The 10-year TIPS breakeven inflation rate rose 8 bps on the month and currently sits at 1.62%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps on the month and currently sits at 1.73%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations remains stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.9 That being said, the 10-year TIPS breakeven inflation rate is currently 29 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +74 bps. Chart 9ABS Market Overview ABS Market Overview ABS Market Overview The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 34 bps; its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive US spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The is true for the household interest expense ratio (panel 3). Senior Loan Officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 12 basis points in November, dragging year-to-date excess returns down to +221 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 1 bp on the month. It currently sits at 72 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer Survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 7 basis points in November, bringing year-to-date excess returns up to +107 bps. The index option-adjusted spread tightened 2 bps on the month, and currently sits at 54 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 26 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index.   To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Mixed Messages Mixed Messages Mixed Messages Mixed Messages Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of November 29 2019) Mixed Messages Mixed Messages Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 29, 2019) Mixed Messages Mixed Messages Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 45 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 45 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Mixed Messages Mixed Messages Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 29, 2019) Mixed Messages Mixed Messages Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2   For details on how we arrive at our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3  Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 4  Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 5  Please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 6  Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 7  Please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8  Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 9  Please see US 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

Feature Recommended Allocation Monthly Portfolio Update: How To Position For The End Game Monthly Portfolio Update: How To Position For The End Game In late November, BCA Research published its 2020 Outlook titled Heading Into The End Game, an annual discussion between BCA’s managing editors and the firm’s longstanding clients Mr. and Ms X.1 We recommend GAA clients read that document for a full analysis of the macro and investment environment we expect in 2020. In this Monthly Portfolio Outlook, we focus on portfolio construction: how we would recommend positioning a global multi-asset portfolio for the 12-month investment horizon in light of that analysis. First, a brief summary of the BCA macro outlook. We believe the global manufacturing cycle is starting to bottom out, partly because of its usual periodicity of 18 months from peak to trough, and also because of easier financial conditions, and some moderate fiscal and credit stimulus from China (Chart 1).  Central banks will remain dovish next year despite accelerating growth. The Fed, in particular, worries that inflation expectations have become unanchored (Chart 2) and, moreover, will be reluctant to raise rates ahead of the US presidential election. This environment implies a moderate rise in long-term interest rates, with the US 10-year Treasury yield rising to 2.2-2.5%. Chart 1Reasons To Expect A Rebound Reasons To Expect A Rebound Reasons To Expect A Rebound Chart 2Unanchored Inflation Expectations Worry The Fed Unanchored Inflation Expectations Worry The Fed Unanchored Inflation Expectations Worry The Fed For an asset allocator, this combination of an improving manufacturing cycle and easy monetary policy looks like a very positive environment for risk assets (Chart 3). We, therefore, remain overweight equities and underweight fixed income. We have discussed over the past few months the timing to turn more risk-on and pro-cyclical in our recommendations.2 Since we are increasingly confident about the probability of the manufacturing cycle turning up, this is the time to make that change. Consequently, the shifts we are recommending in our global portfolio, shown in the Recommended Allocation table and discussed in detail below, add to its beta (Chart 4).   Chart 3A Positive Environment For Risk Assets A Positive Environment For Risk Assets A Positive Environment For Risk Assets Chart 4Raising The Beta Of Our Portfolio Raising The Beta Of Our Portfolio Raising The Beta Of Our Portfolio Chart 5Some Signs Of Risk-On Still Missing Some Signs Of Risk-On Still Missing Some Signs Of Risk-On Still Missing Nonetheless, we still have some concerns. China’s stimulus (particularly credit growth) remains half-hearted compared to previous cyclical rebounds in 2012 and 2016. We expect a “phase one” ceasefire in the trade war. But even that is not certain, and it would not anyway solve the long-term structural disputes. To turn fully risk-on, we would want to see signs of a clear rebound in commodity prices and a depreciation of the US dollar, which have not yet happened (Chart 5). The 2020 Outlook proposed some milestones to monitor whether our scenario is playing out and whether we should turn more or less risk-on. We summarize these milestones in Table 1. Given these uncertainties, to hedge our pro-cyclical positioning we continue to recommend an overweight in cash, and we are instituting an overweight position in gold. Table 1Milestones For 2020 Monthly Portfolio Update: How To Position For The End Game Monthly Portfolio Update: How To Position For The End Game Chart 6Recessions Are Caused By Inflation Or Debt Recessions Are Caused By Inflation Or Debt Recessions Are Caused By Inflation Or Debt How will this cycle end? All recessions in modern history have been caused either by a sharp rise in inflation, or by a debt-fueled asset bubble (Chart 6). The Fed will likely fall behind the curve at some point as, after further tightening in the labor market, inflation starts to pick up. How the Fed reacts to that will determine what triggers the recession. If – as is most likely – it lets inflation run, that could blow up an asset bubble (and it was the bursting of such bubbles which caused the 2000 and 2007 recessions); if it decides to tighten monetary policy to kill inflation, the recession would look more like those of the 1970s and 1980s. But it is hard to see either happening over the next 12-18 months. Equities: As part of our shift to a more pro-risk, pro-cyclical stance, we are cutting US equities to underweight, and raising the euro zone to overweight, and Emerging Markets and the UK to neutral. US equities have outperformed fairly consistently since the Global Financial Crisis (Chart 7) – except during the two periods of accelerating global growth, in 2012-13 (when Europe did better) and 2016-17 (when EM particularly outperformed). The US today is expensive, particularly in terms of price/sales, which looks more expensive than the P/E ratio because the profit margin is at a record high level (Chart 8). The upside for US stocks in 2020 is likely to be limited. In 2019 so far, US equities have risen by 29% despite earnings growth close to zero. Multiples expanded because the Fed turned dovish, but investors should not assume further multiple expansion in 2020. Our rough model for US EPS growth points to around 8% next year (sales in line with nominal GDP growth of 4%, margins expanding by a couple of points, plus 2% in share buybacks). Add a dividend yield of 2%, and US stocks might give a total return of 10% or so. Chart 7US Doesn't Always Outperform US Doesn't Always Outperform US Doesn't Always Outperform Chart 8US Equities Are Expensive US Equities Are Expensive US Equities Are Expensive To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Euro zone stocks have a higher weighting in sectors we like such as Financials and Industrials (Table 2). European banks, in particular, look attractively valued (Chart 9) and offer a dividend yield of 6%, something investors should find appealing in this low-yield world. EM is more closely linked to China and commodities prices, which are not yet sending strong positive signals. We worry about the excess of debt in EM (Chart 10), which remains a structural headwind: the IMF and World Bank put total external EM debt at $6.8 trillion (Chart 11). Table 2Equity Sector Composition Monthly Portfolio Update: How To Position For The End Game Monthly Portfolio Update: How To Position For The End Game Chart 9Euro Zone Banks Are Especially Cheap Euro Zone Banks Are Especially Cheap Euro Zone Banks Are Especially Cheap Chart 10EM Debt Remains A Headwind EM Debt Remains A Headwind EM Debt Remains A Headwind Japan is another likely beneficiary of a cyclical recovery. But, before we turn positive, we want to see (1) signs of a stabilization of consumption after the recent tax rise (retail sales fell by 7% year-on-year in October), and (2) clarification of a worrying new investment law (which will require any investor which intends to “influence management” to get prior government approval before buying as little as a 1% stake in many sectors). For an asset allocator this combination of an improving manufacturing cycle and easy monetary policy looks very positive for risk assets. We raise the UK to neutral. The market has been a serial underperformer over the past few years, but this has been due to the weak pound and derating, rather than poor earnings growth (Chart 12). It now looks very cheap and, with the risk of a no-deal Brexit off the table, sterling should rebound further. The UK is notably overweight the sectors we like (Table 2). However, political risk makes us limit our recommendation to neutral. Although the Conservatives look likely to win a majority in this month’s general election, which will allow them to push through the negotiated Brexit deal, subsequent arguments over the future trade relationship with the EU will be divisive. Chart 116.8 Trillion In EM External Debt $6.8 Trillion In EM External Debt $6.8 Trillion In EM External Debt Chart 12The UK Has Been Derated Since 2016 The UK Has Been Derated Since 2016 The UK Has Been Derated Since 2016   Fixed Income: We remain underweight government bonds. Stronger economic growth is likely to push up long-term rates (Chart 13). Nonetheless, the rise in yields should be limited. The Fed looks to be on hold for the next 12 months, but the futures market is not far away from that view: it has priced in only a 60% probability of one rate cut over that time. The gap between market expectations and what the Fed actually does is what our bond strategists call the “golden rule of bond investing”. US inflation is also likely to soften over the next few months due to the lagged effect of this year’s weaker growth and appreciating dollar. We do not expect the 10-year US Treasury to rise above 2.5% – the current FOMC estimate of the long-run equilibrium level of short-term rates (Chart 14). Chart 13Growth Will Push Up Rates... Growth Will Push Up Rates... Growth Will Push Up Rates...   Chart 14...But Only As Far As 2.5% ...But Only As Far As 2.5% ...But Only As Far As 2.5%   Within the fixed-income universe, we remain positive on corporate credit. But US investment-grade bond spreads are no longer attractive and so we downgrade them to neutral (Chart 15). Investors looking for high-quality bond exposure should prefer Agency MBS, which trade on an attractive spread relative to Aa- and A-rated corporate bonds. European IG should do better since spreads are not so close to historical lows, risk-free rates should rise less than in the US, and because the ECB is increasing its purchases of corporate bonds. Chart 15US IG Spreads Are Close To Historical Lows Monthly Portfolio Update: How To Position For The End Game Monthly Portfolio Update: How To Position For The End Game Chart 16US Caa Bonds Have Some Catching Up To Do The Puzzling Case Of Caa-Rated Junk Bonds US Caa Bonds Have Some Catching Up To Do The Puzzling Case Of Caa-Rated Junk Bonds US Caa Bonds Have Some Catching Up To Do We continue to like high-yield bonds, both in the US and Europe. But we would suggest moving down the credit curve and increasing the weight in Caa-rated bonds. These have underperformed this year (Chart 16), mainly because of technical factors such as their overweight in the energy sector and relatively smaller decline in duration.3 With a stronger economy and rising oil prices, they should catch up to their higher-rated HY peers in 2020. To play the cyclical rebound, we prefer euro zone stocks over those in EM or Japan. Currencies: Since the US dollar is a counter-cyclical currency (Chart 17), we would expect it to weaken against more cyclical currencies such as the euro, and commodity currencies such as the Australian dollar and Canadian dollar. But it should appreciate relative to the yen and Swiss franc, which are the most defensive major currencies. We expect EM currencies to continue to depreciate. Most emerging markets are experiencing disinflation (Chart 18), which will push central banks to cut rates and inject liquidity into the banking system. This will tend to weaken their currencies. Overall, we are neutral on the US dollar. Chart 17The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency Chart 18Disinflation Will Push EM Currencies Down Further Disinflation Will Push EM Currencies Down Further Disinflation Will Push EM Currencies Down Further     Commodities: Industrials metals prices are closely linked to Chinese stimulus (Chart 19). A moderate recovery in Chinese growth should be a positive, and so we raise our recommendation to neutral. But with question-marks still lingering over the strength of the rebound in the Chinese economy, we would not be more positive than that. Oil prices should see moderate upside over the next 12 months, with supply tight and demand growth recovering in line with the global economy. Our energy strategists forecast Brent crude to average $67 a barrel in 2020 (compared to a little over $60 today). Chart 19Metals Prices Depend On China Metals Prices Depend On China Metals Prices Depend On China Chart 20Gold: Short-Term Negatives, But Remains A Good Hedge Gold: Short-Term Negatives, But Remains A Good Hedge Gold: Short-Term Negatives, But Remains A Good Hedge   Gold looks a little overbought in the short term, and less monetary stimulus and a rise in rates next year would be negative factors (Chart 20). Nonetheless, we see it as a good hedge against our positive economic view going awry, and against geopolitical risks. If central banks do decide to let economies run hot next year and ignore rising inflation, gold could do particularly well. We, therefore, raise our recommendation to overweight on a 12-month horizon.     Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1    Please see "Outlook 2020," dated November 22 2019, available at bcaresearch.com 2   Please see, for example, last month’s GAA Monthly Portfolio Update, “Looking For The Turning-Point,” dated November 1, 2019, available at gaa.bcaresearch.com 3   For a more detailed explanation, please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Signs Or Buying Opportunity,” dated 26 November 2019, available at usbs.bcaresearch.com GAA Asset Allocation

An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities bca.ems_wr_2019_11_28_s1_c1 bca.ems_wr_2019_11_28_s1_c1 I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies bca.ems_wr_2019_11_28_s1_c3 bca.ems_wr_2019_11_28_s1_c3   Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle bca.ems_wr_2019_11_28_s1_c4 bca.ems_wr_2019_11_28_s1_c4 Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect China: A Weak Multiplier Effect China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession China Construction Is In Recession China Construction Is In Recession   It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak EM/China Capex Is Very Weak EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers No Recovery For Chinese Consumers No Recovery For Chinese Consumers     In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over?   European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence European Manufacturing And Business Confidence European Manufacturing And Business Confidence   In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices EM Profits And Share Prices EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US   In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies bca.ems_wr_2019_11_28_s1_c15 bca.ems_wr_2019_11_28_s1_c15 In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks High-Beta Stocks High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture European Equities: At A Critical Juncture European Equities: At A Critical Juncture   That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market bca.ems_wr_2019_11_28_s1_c17 bca.ems_wr_2019_11_28_s1_c17 Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen   Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable   The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Brazil: The Economy Is Weak Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining   The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices BRL And Commodities Prices BRL And Commodities Prices Chart II-6Widening Current Account Deficit Widening Current Account Deficit Widening Current Account Deficit   Chart II-7The BRL Is Not Cheap The BRL Is Not Cheap The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    Processing trade includes imports of goods that undergo further processing before being re-exported.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Global High-Yield: The widening of US Caa-rated high-yield spreads is narrowly focused in Energy-related companies. The conditions for a spillover into the broader junk bond market (tight monetary policy, tightening lending standards & deteriorating corporate health) are not currently in place. Stay overweight high-yield in both the US and euro area, where Caa-rated spreads have also widened. Australia: A sluggish economy and soggy inflation, with little evidence of an imminent turnaround, imply that the Reserve Bank of Australia may not be done with its rate cutting cycle. Maintain an overweight stance on Australian sovereign debt relative to global benchmarks. Feature There’s Nothing To “Caa” Here The clouds of pessimism on global growth, and financial markets, continue to slowly dissipate. The global manufacturing PMI has clearly bottomed, our rising global leading economic indicator is signaling more upside for the first half of 2020, equity markets worldwide are grinding higher, volatility is subdued, while corporate credit spreads in the US and Europe remain generally tight. Yet within the corporate bond market, a peculiar dynamic has emerged. We do not see a reason to extrapolate the weakness in lower-rated US junk bonds into a broader macro issue for the corporate bond market, and the US economy. The option-adjusted spread (OAS) for the overall Bloomberg Barclays US high-yield (HY) index now sits at 376bps. While this spread is relatively narrow from a longer-term perspective, investors may have become more discerning about credit risk. Lower-rated HY has dramatically underperformed higher-rated HY debt of late, with the US Caa-rated OAS now sitting at 985bps compared to Ba-rated spreads of 196bps (Chart of the Week). The divergence across credit tiers is unprecedented, in that Caa spreads are widening while Ba spreads are narrowing – typically, spreads move in tandem directionally, both in bull and bear markets for US junk bonds. The widening of US Caa-rated junk bond spreads has started to raise concerns that this is a “canary in the coal mine” signaling future financial stress among US corporate borrowers. Yet the same dynamic is occurring in euro area HY, with Caa-rated and Ba-rated spreads tracking the US on an almost tick-for-tick basis. In a report published yesterday, our colleagues at BCA Research US Bond Strategy investigated the history of Caa spread widenings dating back to 1996.1 They noted that Caa spread widening has typically been a good predictor of one-year-ahead negative excess returns for the overall US junk bond index. However, there has never been a period like today where Caa spreads have widened while overall HY spreads have remained stable. Chart of the WeekSome Odd Divergences In Global Credit Some Odd Divergences In Global Credit Some Odd Divergences In Global Credit We do not see a reason to extrapolate the weakness in lower-rated US junk bonds into a broader macro issue for the corporate bond market, and the US economy, for two main reasons: Chart 2Lower Energy Prices Hurt Lower Rated US HY Lower Energy Prices Hurt Lower Rated US HY Lower Energy Prices Hurt Lower Rated US HY 1) The widening is focused on Energy related debt The widening of US Caa-rated spreads in 2019 has occurred alongside a parallel increase in the spreads of Energy-related companies in the US junk bond universe (Chart 2). A similar trend played out during the 2014/15 HY bear phase, which was triggered by the collapse of world oil prices that ravaged the US shale oil industry which dominated the lower-rated tiers of the junk bond market. In 2019, oil prices have declined, although not as dramatically, and HY Energy spreads have widened but to nowhere near the levels seen five years ago. More importantly, non-Energy junk spreads remain very subdued and stable, unlike the case in 2014/15 (bottom panel). When looking at the 2019 year-to-date excess returns for the Bloomberg Barclays US HY index, it is clear that the overall negative returns for the Caa-rated bucket have been driven by the lagging performance of Energy names (Chart 3). The rest of the market has generally been delivering solid excess returns. Chart 3Contribution To 2019 YTD US HY Excess Returns* The Lowdown On Low-Rated High-Yield The Lowdown On Low-Rated High-Yield 2) The widening has not been confirmed by signals from other reliable credit cycle indicators We believe that, from a top-down macro perspective, corporate credit performance in the US is influenced by three main factors: the state of US corporate health, the stance of the Fed’s monetary policy and the trend in lending standards for US banks. We have dubbed this our “Credit Checklist”, and we present a version of that checklist for US high-yield in Chart 4. Chart 4Conditions Not In Place For A Broad US HY Selloff Conditions Not In Place For A Broad US HY Selloff Conditions Not In Place For A Broad US HY Selloff Our “bottom-up” US HY Corporate Health Monitor (CHM) aggregates, for a sample set of US HY issuers, published financial ratios that are typically used to determine the creditworthiness of borrowers – measures like interest coverage, operating margins and leverage. The US HY CHM is currently at a “neutral” reading (2nd panel), unlike past periods where Caa-rated spreads widened sharply: during the early 2000s telecom bust, the 2008 Financial Crisis and the 2014/15 collapse in oil prices. The readings for the three components of our US HY Credit Checklist are all at neutral levels, suggesting that there is no fundamental underpinning at the moment for a sustained increase in US HY spreads. Yet another reason why the latest widening of Caa-rated spreads looks unusual. Turning to measures of the stance of US monetary policy, we look at both the slope of the US Treasury curve (2-year vs 10-year) and the gap between the real fed funds rate and the New York Fed’s estimate of the neutral “r-star” rate. Prior to the early 2000s and 2008 blowout in Caa spreads, the Fed had pushed the real funds rate into restrictive territory above r-star, and the Treasury curve subsequently inverted. That was not the case during the 2014/15 Caa widening, as the Fed was only beginning to transition away from its QE/zero-rate era at that time. Currently, the real funds rate is right at r-star, and the Treasury curve is very flat but not inverted, indicating a broadly neutral monetary policy stance. Finally, we look at data from the Fed’s Senior Loan Officer Survey to evaluate lending standards for US banks. On that front, the latest reading on standards for commercial and industrial loans showed a very modest tightening in the third quarter of 2019, but the overall level remains broadly neutral – unlike the sharp tightening of conditions seen in the early 2000s and 2008 (and the modest tightening in 2014/15). The readings for the three components of our US HY Credit Checklist are all at neutral levels, suggesting that there is no fundamental underpinning at the moment for a sustained increase in US HY spreads. Yet another reason why the latest widening of Caa-rated spreads looks unusual, rather than a sign of future stress in US credit markets. We even see a similar dynamic at work in the euro area. In Chart 5, we present a Credit Checklist for euro area HY, using the same indicators that go into our US HY Credit Checklist. The readings here are even more positive for corporate credit performance than in the US. Our euro area bottom-up HY CHM is showing no deterioration of euro area corporate health, the real ECB policy rate is well below the estimate of r-star, the German yield curve is not inverted and the ECB’s survey of euro area bank lending standards showed a modest easing in the third quarter. Just like in the US, the fundamental backdrop does not argue for a sustained period of euro area HY spread widening, making the latest move higher in euro area Caa spreads as unusual as the move in US Caa. We cannot even blame lower oil prices for the spread widening, as Energy represents only a tiny fraction of the euro area HY market, compared to the large weighting of Energy borrowers in the US junk bond universe. Chart 5Conditions Not In Place For A Broad European HY Selloff Conditions Not In Place For A Broad European HY Selloff Conditions Not In Place For A Broad European HY Selloff We suspect that the correlation between US and euro area HY spreads, by credit tier, has more to do with the increased correlation of trading within global credit markets. Or perhaps it is a sign of investors staying cautious and staying up in quality, even within the riskier HY market. Whatever the reason, we see little fundamental reason to expect the widening of Caa-rated spreads to leak into the broader high-yield market. In fact, if oil prices begin to move higher again, as our commodity strategists are expecting for 2020, that might create a tactical buying opportunity in Caa-rated junk bonds in both the US and euro area. In the meantime, we see no reason to change our recommended overweight stance on US and euro area HY corporate bonds, even with the widening of lower-rated spreads. Bottom Line: The recent widening of US Caa-rated high-yield spreads is narrowly focused in Energy-related companies. The conditions for a spillover into the broader junk bond market (tight monetary policy, tightening lending standards & deteriorating corporate health) are not currently in place. Stay overweight high-yield in both the US and euro area, where Caa-rated spreads have also widened. Australia: The RBA May Not Be Done Yet The rally in Australian government bonds has been driven by the dovish policy response from the Reserve Bank of Australia (RBA) to weak economic growth and tepid inflation – a backdrop that is showing little sign of reversing quickly. We have maintained a recommended overweight investment stance on Australian government bonds since December 19, 2017. Since then, the yield on Bloomberg Barclays Australian Treasury index has declined by -140bps, sharply outperforming bonds in the other developed markets and ending Australia’s long-time status as a “high-yielding” developed economy bond market (Chart 6). The rally in Australian government bonds has been driven by the dovish policy response from the Reserve Bank of Australia (RBA) to weak economic growth and tepid inflation – a backdrop that is showing little sign of reversing quickly. The central bank has already cut interest rates by 75bps this year, taking the Cash Rate down to a record low of 0.75%. At the November 5th monetary policy meeting, the RBA held off on additional easing but still delivered what was perceived by the market to be a dovish surprise, emphasizing persistently below-target inflation and potential downside risks stemming from the housing market. The door was kept wide open for further rate cuts, if necessary. RBA Governor Philip Lowe has even discussed the possibility that the RBA may have to cut rates to the zero bound and start buying assets via quantitative easing to try and restore inflation back to the midpoint of the RBA’s 2-3% target band. Chart 6Australian Bonds Have Outperformed Sharply Australian Bonds Have Outperformed Sharply Australian Bonds Have Outperformed Sharply   The RBA’s dovishness is justified, given sluggish economic growth and tepid inflation. Real GDP growth slowed sharply in the first half of 2019 to a meager 1.4% on a year-over-year basis (Chart 7). Consumer sentiment and business confidence remain depressed, having both declined since the start of the year. The former is being hit by weak house prices and sub-par income growth, while the latter is suffering under the weight of weaker demand from Australia’s most important trade partner, China. In addition, persistent drought conditions in much of the country have pushed up food prices and brought down incomes related to the farming sector. Chart 7Sluggish Australian Domestic Demand Sluggish Australian Domestic Demand Sluggish Australian Domestic Demand Chart 8From Boom To Bust In Australian Housing From Boom To Bust In Australian Housing From Boom To Bust In Australian Housing A bellwether for the Australian economy, the housing market, has not fared much better (Chart 8). Building approvals for new dwelling units have fallen almost 20% since September of last year, while house prices in the major cities have been contracting since the fourth quarter of 2017. Responding to easy financial conditions in Australia and the rest of the world, the standard variable mortgage rate has now fallen to a 60-year low. It remains to be seen how quickly the housing market will turn around and when that, in turn, will lift dwelling investment, but the RBA cuts in 2019 should give a bit of a lift to Australian housing in 2020. As in other developed markets, trade uncertainty and fears of a recession have made Australian firms more hesitant to invest. Real private business investment is now falling in year-over-year terms, even with the boost to the terms of trade (and corporate profits) from the increase in prices for Australia’s most important commodities seen in 2019 (Chart 9). That impact may be starting to fade, however. The price for iron ore – a major Australian commodity export – has already fallen 28% from the 2019 peak. In addition, Chinese iron ore imports from Australia are contracting in year-over-terms, even with Chinese growth starting to show signs of stabilization in response to stimulus measures implemented earlier this year. Those is an ominous signal for Australian growth, given the massive swing in net exports seen this year. Chart 9Terms Of Trade Turning Negative For Australian Capex Terms Of Trade Turning Negative For Australian Capex Terms Of Trade Turning Negative For Australian Capex Chart 10An Unsustainable Lift From Net Exports An Unsustainable Lift From Net Exports An Unsustainable Lift From Net Exports Driven by the persistent depreciation of the Australian dollar, and supportive terms of trade, the Australian trade balance has reached its highest value as a percent of nominal GDP (3.7%) since 1959, when quarterly data began (Chart 10). The surge has come almost entirely from the export side, occurring alongside the boost to commodity prices that was concentrated in iron ore, and looks both unsustainable and unrepeatable on a rate-of-change basis. Slowing Australian economic momentum has also impacted the labor market. Employment growth is slowing and the unemployment rate has ticked up to 5.3% from a cyclical low of 5% in February 2019 (Chart 11). The so-called “underemployment rate”, is a much higher 8.5%, indicating that there is still ample slack in the Australian labor market as workers are working fewer hours than they wish (and are hence, “underemployed”). The underemployment rate is negatively correlated to wage growth, suggesting that the modest upturn in the latter seen since the end of 2016 is likely to cool off (bottom panel). Chart 11Some Softening In The Australian Labor Market Some Softening In The Australian Labor Market Some Softening In The Australian Labor Market Chart 12Australian Inflation Remains Subdued Australian Inflation Remains Subdued Australian Inflation Remains Subdued The RBA has already warned that wage growth expectations may have become anchored at a lower level given the anemic growth over the past several years. That mirrors the trend seen in overall price inflation. Headline CPI inflation was only 1.6% in the third quarter of 2019, as was the “trimmed mean” CPI inflation rate that is favored by the RBA. Both are below the bottom end of the RBA’s target range of 2-3%, as are survey-based expectations of short-term inflation (Chart 12). The previously mentioned drought conditions have put some upward pressure on overall inflation via grocery food prices, but that is expected to be transitory. With depressed house prices and ongoing issues with spare capacity in the labor market, longer-term market-based inflation expectations, captured by the 5-year/5-year forward CPI swap rate, have dipped below the 2% level. The combination of weakening growth and soggy inflation poses a problem for the RBA, as it tries to use monetary policy tools to reverse those trends at a time when Australian banks have seen an unprecedented level of scrutiny of their lending practices. Australian banks have been under the harsh political spotlight after the government’s Royal Commission on misconduct in the financial industry released its findings back in February of this year. Many banks were exposed for serious violations, including money laundering and “improperly” selling financial products to households. Several top bank executives lost their jobs as a result, with the overall industry duly chastised and humbled.  Australian banks remain well capitalized, following the path of most developed market banks in response to the Basel III reforms, while non-performing loans remain modest. Yet the risk moving forward is that Australian banks become more prudent in their lending practices after the public “flogging” they received this year, which may impair the transmission mechanism from low RBA policy rates to increased loan growth - and, eventually, faster economic activity. Already, private credit growth has slowed sharply, with the sharpest declines coming for housing and business lending (Chart 13). Investment implications for Australian bonds In the case of Australia, however, the underlying economy and inflation trends still point to a possibility that the RBA will have to ease again sometime in the next few months – a move that is unlikely to be matched in the other major developed markets. This likely means that Australian government bonds can continue to outperform in 2020. Despite signs that the global economy is starting to bottom out after the 2019 downturn, the momentum in Australian economic growth and inflation remains tepid. This suggests that Australian sovereign debt is likely to continue outperforming global peers on a relative basis over the next 6-12 months. Our RBA Monitor continues to signal that more interest rate cuts from the RBA are needed. Yet the Australian Overnight Index Swap (OIS) curve now discounts only 19bps of rate cuts over the next year (Chart 14). This mirrors the trend seen in other developed interest rate markets, as investors have shifted to pricing out the dovish policy expectations as global growth starts to improve. Chart 13Weakening Loan Demand, But No Credit Crunch Weakening Loan Demand, But No Credit Crunch Weakening Loan Demand, But No Credit Crunch Chart 14Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds In the case of Australia, however, the underlying economy and inflation trends still point to a possibility that the RBA will have to ease again sometime in the next few months – a move that is unlikely to be matched in the other major developed markets. This likely means that Australian government bonds can continue to outperform in 2020. We advise staying strategically overweight Australian government bonds in global fixed income portfolios. Bottom Line: A sluggish economy and soggy inflation, with little evidence of an imminent turnaround, imply that the Reserve Bank of Australia may not be done with its rate cutting cycle. Maintain an overweight stance on Australian sovereign debt relative to global benchmarks.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com     Footnotes 1    Please see BCA Research US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Lowdown On Low-Rated High-Yield The Lowdown On Low-Rated High-Yield Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Incoming data are consistent with our view that global growth is at an inflection point, and will improve during the next few months. As this plays out and recessionary fears fade into the background, we expect the 5-year/5-year forward Treasury yield to settle near 2.5%, 57 bps above its current level. High-Yield: Caa-rated debt has underperformed the duration-matched Treasury index so far this year, despite strong performance for junk bonds overall. We document that weak Caa returns often precede negative returns for the overall junk index. High-Yield: We show several ways in which this year’s Caa underperformance is unique compared to prior episodes. All in all, we conclude that we should not take too strong a signal from the recent Caa spread widening. Remain overweight high-yield in US bond portfolios. The Way Back To 2.5% Chart 1Target 2.5% Target 2.5% Target 2.5% Worries about a looming US recession peaked in late August when the 2/10 Treasury curve inverted and the 10-year yield hit 1.47%. Since then, some better economic data and the prospect of a “phase 1” US/China trade deal have lifted yields and un-inverted the curve. But the bond market is not yet sending the all-clear. Once recession fears completely fade into the background, we would expect the 5-year/5-year forward Treasury yield to settle near 2.5%. This is the FOMC’s median estimate of the longer-run fed funds rate, and also where the 5-year/5-year forward yield peaked during the last two global growth upturns (Chart 1). We expect that the 5-year/5-year forward Treasury yield will reach 2.5% in the first half of 2020, but global growth needs to rebound for that to happen. At present, we detect some positive signals from our preferred global growth indicators. The Global Manufacturing PMI troughed at 49.3 in July and came in at 49.8 in October (Chart 1, bottom panel). Then last week, Flash PMI data showed further gains in November for the US, Eurozone and Japan (Chart 2). Only the UK saw its manufacturing PMI drop in November, and it accounts for a mere 2% of the global index. There is no Flash PMI estimate for China. We detect some positive signals from our preferred global growth indicators.  More signs of economic optimism are found in regional manufacturing PMIs, which continue to diverge positively from the national number (Chart 3). November data have already been released for New York, Philadelphia, Kansas City and Dallas. All four surveys point to a stronger national print. Chart 2A Bottom In Global PMIs A Bottom In Global PMIs A Bottom In Global PMIs Chart 3Regional PMIs Hooking Up Regional PMIs Hooking Up Regional PMIs Hooking Up Other data released last week include the Conference Board’s Leading Economic Indicator, which held flat at just above zero in year-over-year terms (Chart 4). The Leading Index is at a key inflection point. A rebound from here would be consistent with the 2015/16 episode (our base case expectation), while a dip into negative territory would sound some alarm bells. Chart 4Keep A Close Eye On Jobless Claims Keep A Close Eye On Jobless Claims Keep A Close Eye On Jobless Claims October existing home sales and housing starts came out last week (Chart 4, panels 2 & 3). Both series continue to rebound sharply from the depressed levels seen earlier in the year. This should not be too surprising, given this year’s large drop in mortgage rates. It will be more interesting to see what happens to the housing data as bond yields move higher and the stimulus from low rates fades. We have previously argued that the housing market will provide important clues about where bond yields will peak for the cycle. It will be critical to monitor the housing data as bond yields move higher in 2020.1 One note of caution comes from initial jobless claims, which printed at 227k in each of the past two weeks, slightly above recent levels (Chart 4, bottom panel). Claims remain roughly flat on a 6-month basis, consistent with continued economic recovery. However, a sustained increase would send an important warning sign about the labor market. We will be watching claims closely during the next few weeks. Bottom Line: Incoming data are consistent with our view that global growth is at an inflection point, and will improve during the next few months. As this plays out and recessionary fears fade into the background, we expect the 5-year/5-year forward Treasury yield to settle near 2.5%, 57 bps above its current level. The Puzzling Underperformance Of Caa-Rated Junk Bonds Chart 5The Puzzling Case Of Caa-Rated Junk Bonds The Puzzling Case Of Caa-Rated Junk Bonds The Puzzling Case Of Caa-Rated Junk Bonds Overall high-yield returns have been solid in 2019, but oddly, the lowest-rated junk bonds have not participated in the rally. So far this year, Ba and B-rated junk bonds have bested duration-matched Treasuries by 786 bps and 717 bps, respectively. But Caa-rated bonds have underperformed the duration-matched Treasury index by 87 bps (Chart 5). We usually think of the Caa-rated credit tier as being “higher beta” than the Ba and B tiers. That is, it should perform best in “risk on” environments, and worst in “risk off” environments. With that in mind, this year’s Caa underperformance is puzzling, and raises two important questions that we attempt to answer in this report. Is Caa underperformance a warning sign for the overall junk sector? Can we identify the reasons for this year’s Caa underperformance? And if so, do they suggest a buying opportunity? A Caa-nary In The Coal Mine? To assess whether this year’s Caa underperformance might be a warning sign for overall junk bond excess returns, we ran a few tests using historical data. First, we looked at calendar year excess returns going back to 1996 (Table 1). We then tested the performance of a couple trading rules to see whether Caa performance is a bellwether for the overall index. For the first test, we identified calendar years when junk index excess returns were positive but Caa was the worst performing credit tier. Four years fit this criteria: 1999, 2005, 2014 and 2019. Of the three years other than 2019, two (1999 and 2014) were followed by negative junk index excess returns the next year. Table 1Junk Excess Returns By Calendar Year Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Caa-Rated Bonds: Warning Sign Or Buying Opportunity? We also posited that one difference between the Caa and Ba/B credit tiers might be that Caa-rated firms tend to be smaller. We therefore identified calendar years when junk index excess returns were positive but when small cap equities underperformed large cap equities. We identified eight such years. Of the seven years other than 2019, five were followed by negative junk index excess returns the next year. Both rules appear to give a good warning sign for the overall junk index. What if we combine them? We identify three years when junk index excess returns were positive, but Caa was the worst performing credit tier and small cap equities lagged large caps: 1999, 2014 and 2019. Both 1999 and 2014 were followed by negative junk index excess returns the next year. So far the evidence of Caa underperformance being a warning sign for the overall index is quite compelling. But let’s look more closely at the periods flagged by our trading rules. It is only this year that we have seen a large divergence in terms of direction between Caa spreads and overall junk index spreads. Recall that we identified 2019, 2014, 2005 and 1999 as the four years when overall junk index excess returns were positive, but when the Caa credit tier was the worst performer. If we look at the direction of junk spreads in those periods, we see that the direction of Caa spreads tracked the overall index very closely throughout 2014, 2005 and 1999. It is only this year that we have seen a large divergence in terms of direction between Caa spreads and overall junk index spreads (Chart 6). This divergence is odd, and it suggests that this year is unique compared to the other periods identified in our analysis (more on this below). Chart 62019 Is Unique 2019 Is Unique 2019 Is Unique Another reason to doubt the potential relevance of our calendar year analysis is that the decision to use calendar years is arbitrary, and it severely limits our sample size. We therefore run the same analysis using rolling 12-month periods. The results are presented in Table 2. Table 2Predictive Power Of Caa Returns: Rolling 12-Month Periods From December 1996 To October 2019 Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Caa-Rated Bonds: Warning Sign Or Buying Opportunity? First, note the baseline result that there are 178 12-month periods of positive junk index excess returns in our sample. Of those 178 periods, 31% were followed by negative excess returns during the subsequent 12 months. If we apply our “Caa Return” filter and look only at 12-month periods when junk index excess returns were positive but Caa was the worst performing credit tier, our 178 examples fall to just 22. Of those 22 episodes, half were followed by negative junk index excess returns during the subsequent 12 months. Our “Small Cap/Large Cap Equity” filter provides a similar 51% hit rate with a larger sample size of 78. In this analysis we also test a “Caa Spread” filter where we scan for 12-month periods when junk index excess returns were positive, but when Caa spreads widened despite tightening in the overall index spread. We identify only 16 such periods, 56% of which were followed by negative index excess returns. We also looked at what happens when we combine two or more of our filters. Using our “Caa Return” and “Small Cap / Large Cap Equity” filters together, we identify only 18 episodes, 61% of which were followed by negative junk index excess returns during the next 12 months. If we take all three of our filters together, we find only 5 episodes, 4 of which preceded a period of negative junk excess returns. Please recall that the most recent 12-month period meets the criteria of all three of our filters. As was the case with our Table 1 results, an important caveat to this analysis is that of the 5 episodes identified by all three of our filters, the direction of Caa spreads never diverged from the direction of the overall index spread. In fact, we could find no historical period other than this year when Caa spreads diverged in direction from the overall index spread for so long. We conclude that Caa underperformance can provide advance notice of negative junk index excess returns, but also that the current period is so unique that it requires further analysis. Can We Explain The Divergence Between Caa Spreads And The Overall Index? As mentioned above, the current period of sharply widening Caa spreads alongside a rangebound overall index spread is unique historically. This not only raises questions about the relevance of the historical analysis we just presented, but also cries out for an explanation. Fortunately, several things appear to explain the odd behavior of Caa spreads. First, changes in index duration. Junk index duration fell dramatically in 2019, but the decline was much larger for Ba and B rated credits than for the Caa tier. If we control for changes in index duration by looking at 12-month breakeven spreads instead of the average index option-adjusted spread, we see that the spread divergence looks much less dramatic (Chart 7). Controlling  for changes in index duration by looking at 12-month breakeven spreads instead of the average index OAS, we see that the spread divergence looks much less dramatic. Second, it’s possible that credit quality has deteriorated more for the lowest-rated credits than for the rest of the junk index. That would explain the spread divergence. However, this appears to not be the case. Our bottom-up sample of high-yield firms shows that debt-to-assets and interest coverage look similar compared to history for both the median high-yield firm and the worst 10% of firms (Chart 8). Chart 7A Duration Story A Duration Story A Duration Story Chart 8Credit Quality Is Not The Culprit Credit Quality Is Not The Culprit Credit Quality Is Not The Culprit   Finally, we consider the sector composition of the different credit tiers. We look at year-to-date sector contributions to each credit tier’s excess returns and find that the difference between Caa and the rest of the index is concentrated in the Energy and Communications sectors (Chart 9). Caa-rated Communications firms underperformed the Ba and B credit tiers because of two Caa-rated firms – Frontier Communications Corp and Intelsat – that ran into problems. As for Energy, we note that the Caa tier has much more exposure to the Oil Field Services sub-sector than the other credit tiers. This sub-sector captures many of the shale players, who have struggled with falling oil prices. Notice that this year’s decline in the WTI oil price tracks Caa spread widening very closely (Chart 10). Chart 9Contribution To Year-To-Date Excess Returns* (%) Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Caa-Rated Bonds: Warning Sign Or Buying Opportunity?   Chart 10Blame Energy Blame Energy Blame Energy The Appendix at the end of this report provides a sector decomposition of the different junk credit tiers. Specifically, it presents three tables. One showing the sector weights in each credit tier. A second showing year-to-date excess returns for each sector by credit tier. A third showing the contribution from each sector to each credit tier’s year-to-date excess returns. Investment Conclusions Overall, we are hesitant to make too much of the recent Caa underperformance. Yes, we find compelling evidence that Caa underperformance can be a bellwether for negative high-yield excess returns. However, the behavior of Caa spreads in 2019 doesn’t resemble the prior periods in our analysis very closely. Specifically, the Caa spread doesn’t tend to diverge from the overall index spread in terms of direction, as it has this year. We are also able to identify two compelling reasons for this year’s divergence between Caa spreads and the overall index. The first is the change in relative index duration, and the second is stress in the shale oil sector due to a falling oil price. Spreads should adjust to changes in duration over time, and the stress in the shale sector should ease if oil prices rise as our commodity strategists expect.2 Given the uniqueness of the current period, and our base case outlook for a rebound in global growth, we are inclined to view Caa bonds (and junk bonds more generally) as an attractive buying opportunity in the current environment. But we will keep an eye on the performance of Caa bonds during the next few months. If global growth recovers and the oil price rises, but Caa continues to lag the overall index, then it may compel us to change our view. Appendix Table 3Sector Weights Within High-Yield Corporate Bond Credit Tiers* (%) Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Table 4Sector Year-To-Date Excess Return* By High-Yield Credit Tier (%) Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Table 5Sector Contribution To Year-To-Date Excess Return* For Each High-Yield Credit Tier (%) Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Caa-Rated Bonds: Warning Sign Or Buying Opportunity? Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1  Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 2 Our commodity strategists forecast an average price of $63/bbl for WTI crude oil in 2020. Please see Commodity & Energy Strategy Weekly Report, “Lingering Oil-Demand Weakness Will Fade”, dated November 21, 2019, available at ces.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Investors’ perception of “fallen angels” – bonds downgraded from investment grade to high yield – is mostly negative, especially since many believe we are near the end of the economic and credit cycle. In this report, we show that fallen angels can provide investors with an opportunity to invest in relatively high-quality bonds at attractive valuations – bonds which on average outperform other corporate bonds. We find that a good entry-point into fallen angels is usually a week after the bonds are downgraded, after which selling pressures begin to fade. However, investors need to be aware that fallen angels are accompanied by some, less obvious, risks, particularly longer duration and sector skewness. Introduction Chart 1Baa-Rated Bonds Are Now 50% Of The IG Universe Baa-Rated Bonds Are Now 50% Of The IG Universe Baa-Rated Bonds Are Now 50% Of The IG Universe Elevated levels of US corporate debt, as well as declining credit quality in the investment-grade space, have raised investor worries that a large portion of bonds will be downgraded in the next recession and default cycle. The lowest tranche of investment-grade debt, Baa-rated, now constitutes over 50% of the investment-grade index (Chart 1). However, investors tend to dismiss the opportunities that this tranche of debt can provide when downgraded from investment grade to high yield – known as “fallen angels”. The change in the ownership structure of corporate bonds has contributed to the performance of fallen angels. Increasing demand for corporate-bond funds – both mutual funds and ETFs – has displaced direct ownership of corporate bonds by households and financial institutions over the past few years (Chart 2, panels 1 & 2). Chart 2Corporate Bond Ownership Corporate Bond Ownership Corporate Bond Ownership Active fund managers, constrained by their rules to hold only bonds with a certain (usually non-speculative grade) rating, are often forced to sell their holdings ahead of a potential downgrade. In addition, passive funds exacerbate the selling pressure, since they are forced to sell a bond in the event of a downgrade. Insurance companies and pensions funds, the biggest holders of corporate bonds, have increased their allocation to corporate bonds in the search for income in an environment of low yields. Estimates suggest that life insurance companies’ holdings of Baa-rated bonds comprise 34% of their total portfolios.1 However, high-yield bonds represented less than 5% as of the end of 2016.2 There is no regulation prohibiting them from owning sub-investment-grade bonds, but they face higher capital costs when they do. This could also fuel fire sales during the next downgrade cycle. Fallen angels therefore often enter the high-yield index at a much cheaper valuation than bonds that were originally issued as high yield. In fact, during the past two downgrade cycles, in 2007-2008 and 2015-2016, the average spread of fallen angels over an adjusted high-yield index (weighted so that it has the same credit rating as fallen angels) widened by 560 and 130 basis points, respectively (Chart 3). While this seems negative at a first glance, it also leaves more room for spread compression, once market conditions improve, for investors who correctly time their entry into this market. As the bottom panel of Chart 3 shows, investors almost always receive a higher yield for holding fallen angels compared to a similarly rated high-yield basket. Chart 3Fallen Angels Have Mostly Traded At A Discount... Fallen Angels Have Mostly Traded At A Discount... Fallen Angels Have Mostly Traded At A Discount... Chart 4...Despite Their Better Performance ...Despite Their Better Performance ...Despite Their Better Performance In this Special Report, we explain what fallen angels are, analyze their historical risk-return characteristics, and compare them to other major asset classes, particularly high-yield corporate bonds in general. We show that, once downgraded, fallen angels – due to oversold pressures – tend to outperform other asset classes as well as similarly-credit-rated high-yield bonds (Chart 4). We also assess their performance during periods of financial-market stress. Finally, we discuss the risks associated with owning fallen angels, and highlight the vehicles investors can use to access this asset class. What Are Fallen Angels? Fallen angels refer to bonds that have been downgraded from investment grade to junk (or speculative grade). Whereas different commercial indices can have slightly different classifications for the term (discussed below in the Historical Risk And Return section), the generic definition includes bonds previously classified as investment grade but later downgraded to high yield. These transitions can occur from and to any credit rating within both universes. However, the majority of downgrades occur between the lowest tranche of investment-grade bonds, rated Baa, and the highest tranche of high-yield bonds rated Ba (Chart 5). Generally, fallen angels have provided inves­tors with an opportunity to buy higher qual­ity, cheaper, and better performing corpo­rate bonds than those originally issued as high yield. Generally, fallen angels have provided investors with an opportunity to buy higher quality, cheaper, and better performing corporate bonds than those originally issued as high yield. So how do fallen angels differ? Higher quality: Over 73% of bonds within the fallen angels ETF fall into the Ba bucket – the highest tranche in the speculative space — versus 45% within the broader high-yield ETF (Chart 6). Chart 5The Downgrade Transition Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 6Fallen Angels Have Better Credit Quality Than High Yield Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Cheaper: In anticipation of a downgrade, selling pressure from fund managers intensifies, causing prices of “potential” fallen angels to drop prior to their downgrade date. However, our US Bond Strategists report academic findings that show forced fire sales of fallen angels are usually short-lived.3 They conclude that, once Baa-rated securities are downgraded, there is no mechanism to force downward pressure on the price to continue. Chart 7Selling Pressures Intensify Even After The Bonds Are Downgraded Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Academic research corroborates this view: fallen angels exhibit ‘V-shaped’ price action,4 where their prices start falling ahead of a potential downgrade. This is the result of the reaction of active fund managers as discussed earlier. This trend persists for a short while even after the bonds are downgraded, as passive funds – index mutual funds and ETFs – offload the bonds. Selling pressures come to a halt shortly after the downgrade date (on average around seven trading days). This represents an entry-point for investors to add fallen angels to their portfolios. These conclusions are also supported by the price trajectory of a sample5 of fallen angels we tested (Chart 7). Note, however, that the trajectory shown in our results suggests that the attractiveness of fallen angels disappears quite quickly, since prices plateau about three to four months after the downgrade. Chart 8Fallen Angels Peform Better Than Similar High- Yield Bonds Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Better performance: The fallen angels index has outperformed a similarly credit-rated duration-matched high-yield basket in eight out of the 15 years since the index’s inception. In particular, fallen angels have tended to outperform in years when the Federal Reserve was on hold or cutting interest rates, due to their longer average duration of 5.5 years versus 2.9 years for high-yield bonds – as discussed below in the Risks section (Chart 8). Generally, fallen angels are concentrated in sectors that were subject to a recent shock. This was the case in the Telecommunications sector in 2001, the Financials sector in 2007-2008, and the Energy sector in 2014-2015. How Many Fallen Angels Will There Be In The Next Downturn? Over the past three decades, US Baa-rated debt – the lowest tranche in investment grade – has doubled from only 20% of total corporate debt to 40%. This coincided with an increase in nonfinancial corporate debt from 55% of GDP in the mid-1990s to nearly 75% by the end of 2018. Low interest rates over the past 10 years incentivized firms to take advantage of cheaper financing for capital expenditure, equity buybacks, M&A, and more (Chart 9). To a degree, this corporate behavior was rational since businesses understood that their optimal capital structure in a world of low interest rates required them to take on more debt. Simply put, firms found that targeting a Baa rating was more desirable. While rising leverage and weaker corporate health are concerns, we do not see these as imminent risks until the next recession and downgrade cycle hit – which we do not see happening in the next 12 months. For now, there is no worrying trend in downgrades. In fact, there are more “rising stars” – corporate bonds previously classified as high yield that have been upgraded to investment grade – than fallen angels (Chart 10). Nevertheless, it is important for investors to gauge the extent of potential downgrades during the next recession. Chart 9Debt Issuance: A Smart Corporate Decision Debt Issuance: A Smart Corporate Decision Debt Issuance: A Smart Corporate Decision Chart 10Rising Stars Versus Fallen Angels Rising Stars Versus Fallen Angels Rising Stars Versus Fallen Angels Several research papers use historical probabilities and downgrade rates to estimate a range for potential fallen angels. Given that investment-grade bonds currently amount to $5.3 trillion, and that the average peak in the one-year rate of investment-grade bond downgrades over the past four decades was 7.1%, that would imply the amount of new fallen angels in the next recession to be $376 billion. That is three times bigger than the current value of fallen angels, and represents nearly 30% of the entire junk-bond universe.6  Historical Risk And Return Chart 11Fallen Angels Provide Alpha Fallen Angels Provide Alpha Fallen Angels Provide Alpha To assess the performance of fallen angels versus other high-yield bonds, we adjust the indices to which we compare the fallen angels index in two ways. First, we remove the fallen angels from the overall high-yield index. However, that on its own would fail to consider the different credit qualities of the two indices – shown in Chart 6. It would also make it difficult to account for differences in duration. We therefore create a high-yield duration-matched basket with similar credit ratings to the fallen angels index in order to account for this. Fallen angels significantly outperformed both indices (Chart 11). In doing so, we were also able to distinguish between the extra performance due to duration– the gap between the jade and indigo lines – and the alpha created by fallen angels – the gap between the dark green and the jade lines. For the purpose of this report, we use the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Bond Index, which is designed to track USD-denominated fallen angels. The index, based on the market value of the underlying bonds, includes securities that have a current high-yield rating, while having been assigned an investment-grade index rating at some point since issuance. The index relies on the average of three credit-rating agencies, Fitch, Moody’s, and S&P, to qualify bonds for inclusion. It is worth noting that there are other indices that track fallen angels, with different methodologies. For example, the FTSE Time-Weighted US Fallen Angel Index implements a time-weighted metric, assigning a larger weight to recently downgraded securities. It also adds a maximum inclusion period of 60 months. Since the index’s inception, fallen angels have outperformed other fixed-income assets on both an absolute and risk-adjusted return basis (Table 1). In absolute terms, fallen angels had the highest return of all the assets we compared them with. However, that came with an annualized volatility of 1.5 percentage points higher than the similarly rated high-yield basket – albeit not when compared to its duration-matched counterpart. Another explanation is that the extra volatility is a function of the swift fall and recovery in prices, as well as on going turbulence in the impacted sectors. Table 1Historical Risk-Return Characteristics Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Financial Market Stress Having established that fallen angels on average outperform other types of bonds, we now address the question: how do they perform during recessions and other periods of financial market stress? Given the index’s relatively short history, the only recession we are able to cover is the Global Financial Crisis (GFC) of 2007-2009. Nevertheless, we also look at other market crises dating back to 2005. During the GFC, fallen angels fell, similarly to their high-yield peers. However, coming out of the recession, fallen angels’ performance diverged from similarly rated high-yield bonds as well as from Treasurys and investment-grade bonds. Fallen angels have outperformed other similarly rated high-yield bonds after every market stress period over the past 14 years, except the Q4 2018 equity selloff caused by trade tensions (Chart 12). Fallen angels – even when credit and dura­tion are accounted for – have outperformed following periods of broad credit distress. They also seem to outperform during peri­ods of sector-specific distress. Fallen angels – even when credit and duration are accounted for – have outperformed following periods of broad credit distress. They also seem to outperform following periods of sector-specific distress. Chart 12Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Chart 13The Energy Sector: A Perfect Example The Energy Sector: A Perfect Example The Energy Sector: A Perfect Example This was evident in 2015-2017, when Brent crude oil fell from $120 to nearly $40, causing spreads of energy-rated junk bonds to widen dramatically. There was also a rise in corporate downgrades, particularly within the Energy sector. However, as the oil market stabilized and the Energy sector recovered, Energy corporate spreads quickly tightened and fallen angels outperformed a similarly credit-rated high-yield index. In the second half of 2016, the Energy sector comprised 28% of the fallen angels ETF, compared to 13% and 10% of the high-yield and investment grade ETFs respectively (Chart 13).7 Risks The arguments above should make fallen angels of interest to any investor. However, there are also risks, in particular the following: Sector skew: We have shown that fallen angels can be concentrated in sectors going through distress – the oil market in 2014-2015 being a perfect example. It is important to be aware of the sector skew of fallen angels compared to the high-yield and investment-grade bond universes. As of October 2019, the fallen angels universe was skewed towards the Energy, Technology, and the Industrials sectors compared to both high-yield and investment-grade bonds. It was notably underweight Consumer Non-cyclicals (Chart 14). Fallen angels also have a skew towards Banks – 12% as opposed to 2% in the high-yield universe. This might represent an opportunity rather than a risk. It could allow investors to exploit sectoral differences in the credit market. Longer Duration: Fallen angels also present greater duration risk. Given that they were once investment grade, they have a longer maturity of 9.8 years on average, versus 7.1 years for the credit-weighted high-yield basket. That would partially explain why fallen angels’ duration did not decline as much this year when long-term bond yields fell over 100 bps. We expect higher long-term interest rates over the next 12 months, which might hurt the performance of fallen angels (Chart 15). Chart 14Sector Skew: Risk And Opportunity Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 15Fallen Angels: Characteristics Fallen Angels: Characteristics Fallen Angels: Characteristics Idiosyncratic Risks: The most obvious risk would be that the firm is incapable of fixing its balance sheet, and ultimately becomes subject to further downgrades. Catching Fallen Angels Investors now have access to vehicles that track fallen angels, though these ETFs are still new and rather small. ANGL and FALN were launched in 2012 and 2016 and track the BofA Merrill Lynch and Bloomberg Barclays fallen angles indices respectively (Table 2). Table 2ETFs Tracking Fallen Angels Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 16Catching Fallen Angels Catching Fallen Angels Catching Fallen Angels Chart 16 shows the tracking error and tracking difference between the fallen angels index and the FALN ETF. The tracking error for FALN has been higher than the ETF tracking the overall high-yield index (HYG), but the tracking difference has been less volatile. Conclusion        Fallen angels allow investors to buy certain high-yield bonds at an attractive valuation for a period of time. Fallen angels have historically provided a pick-up in risk-adjusted performance over overall high-yield bonds, even when adjusting for quality differences. They have also outperformed investment-grade bonds on a risk-adjusted basis, as well as other asset classes. Investors need to time their entry-point into fallen angels. The ideal timing is usually about a week after the bond is downgraded. The sector weighting of the fallen-angels index tends to be related to a recent market or sector shock. Sector skew and long duration remain the principal risks that investors should be wary of.   Amr Hanafy Research Associate AmrH@bcaresearch.com   Footnotes 1    Please see Financial Times "Search for yield draws US life insurers to risky places", available at https://www.ft.com/ 2   Please see National Association Of Insurance Commissioners, Capital Markets Special Report Index, “U.S. Insurers’ High-Yield Bond Exposure On The Rise”, December 21st 2017. 3   Please see US Bond Strategy Special Report titled “The Risk From US Corporate Debt Part 2: Fund Flows, BBBs, And Leveraged Loans", available at usbs.bcaresearch.com 4   Please see Prof. Andrew Clare, Prof. Stephen Thomas, Dr Nick Motson “Fallen Angels: The investment opportunity”, dated September 2016, Cass Business School. 5   We looked at the 12-month price trajectory (six months before and after the downgrade date) of 60 corporate bonds in the FALN ETF. 6   Please see Moody’s Investors Service, Fallen angels: High-yield market buffers potential transitions amid wider risks, May 13, 2019. 7   We used the iShares Fallen Angels USD Bond ETF (FALN) as a proxy for fallen angels, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) as a proxy for high-yield bonds, and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) as a proxy for investment-grade bonds.

Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered.  Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices bca.ems_wr_2019_11_14_s1_c1 bca.ems_wr_2019_11_14_s1_c1 Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks EM Share Prices Move In Tandem With Global Materials Stocks EM Share Prices Move In Tandem With Global Materials Stocks   The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling EM: Inflation Is Low And Falling EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating EM: Nominal GDP Is Subdued And Decelerating EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Property Prices In Local Currency Terms Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Chinese Imports For Domestic Consumption And EM Exports Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth.  Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Barring Slowdown, US Core Inflation Will Rise Further Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze Beware Of A US Profit Margin Squeeze Beware Of A US Profit Margin Squeeze   With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth.  In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate EM External Debt Is A Risk If EM Currencies Depreciate EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship bca.ems_wr_2019_11_14_s1_c12 bca.ems_wr_2019_11_14_s1_c12   Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable.   Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Asian Export Prices And Container Freight Herald Weaker Regional Currencies Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated Trade-Weighted Dollar And EM Share Prices Are Still Correlated Trade-Weighted Dollar And EM Share Prices Are Still Correlated   Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Undershooting CB's 4% Inflation Target Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”.  The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Russia: Sluggish Wage Growth Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy Russia: Tight Monetary Policy Russia: Tight Monetary Policy   Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Russia: High Real Lending Rate Across Sectors Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment Weakening Credit Impulses = Lower Demand And Investment Weakening Credit Impulses = Lower Demand And Investment   Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending A Lot Of Room To Boost Government Spending A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low Foreigners' Holding Of Russian Financial Assets Are Low Foreigners' Holding Of Russian Financial Assets Are Low   Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Local Bonds Are Decoupling From Oil Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2   BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations