Market Returns

Highlights Chart 1Wage Growth Playing Catch-Up To Curve Last Friday's employment report confirmed that the U.S. economy remained on a solid footing through August, even as leading indicators outside of the U.S. have weakened. Our back-of-the-envelope GDP tracking estimate - the year-over-year growth in aggregate weekly hours worked (2.14%) plus average quarterly productivity growth since 2012 (0.86%, annualized) - points to U.S. growth of approximately 3%. But strong GDP growth is old news for markets. Rather, it was the 0.4% month-over-month increase in average hourly earnings that caused bond yields to jump last Friday. Rising wage growth is usually a bear-flattener, consistent with both higher yields and a flatter curve (Chart 1). But in recent years the yield curve has flattened considerably while wage growth has lagged. The curve's front-running suggests that continued gains in wage growth will keep the Fed on its current tightening path, but may not translate into much curve flattening. Investors should maintain below-benchmark duration, but look for attractively valued curve steepeners. We also recommend only a neutral allocation to spread product to hedge the risk from weakening global growth. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 43 basis points in August, dragging year-to-date excess returns down to -93 bps. The index option-adjusted spread widened 5 bps on the month, and currently sits at 113 bps. Despite recent spread widening, corporate bonds remain expensive with 12-month breakeven spreads for both the A and Baa-rated credit tiers near their 25th percentiles since 1989 (Chart 2). Further, with inflation now close to the Fed's target, monetary policy will provide much less support for corporate bond returns going forward. These are the two main reasons we downgraded our cyclical corporate bond exposure to neutral in June.1 On a positive note, gross leverage for the non-financial corporate sector likely declined for the third consecutive quarter in Q2 (panel 4), but we remain pessimistic that such declines will continue in the back-half of the year. As we noted in a recent report, weaker foreign economic growth and the resultant dollar strength will eventually weigh on corporate revenues.2 Accelerating wage growth will also hurt profits if it is not completely passed through to higher prices. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in August, bringing year-to-date excess returns up to +220 bps. The average index option-adjusted spread widened 2 bps on the month, and currently sits at 336 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 226 bps, slightly below the long-run mean of 247 bps (Chart 3). This tells us that if default losses are in line with our expectations during the next 12 months, we should expect excess high-yield returns of 226 bps over duration-matched Treasuries, assuming also that there are no capital gains/losses from spread tightening/widening. However, we showed in a recent report that the default loss expectations embedded in our calculation are extremely low relative to history (panel 4).3 Our assumption, derived from the Moody's baseline default rate forecast and our own forecast of the recovery rate, calls for default losses of 1.15% during the next 12 months. The only historical period to show significantly lower default losses was 2007, a time when corporate balance were in much better shape than today. While most indicators suggest that default losses will in fact remain low for the next 12 months, historical context clearly demonstrates that the risks are to the upside. It will be critical to track real-time indicators of the default rate such as job cut announcements, which have increased since mid-2017 (bottom panel), for signals about whether current default forecasts are overly optimistic. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in August, dragging year-to-date excess returns down to -18 bps. The conventional 30-year zero-volatility MBS spread widened 5 bps on the month, driven by a 3 bps increase in the compensation for prepayment risk (option cost) and a 2 bps widening of the option-adjusted spread. The excess return Bond Map shows that MBS offer a relatively poor risk/reward trade-off, particularly compared to Aaa-rated non-Agency CMBS, High-Yield and Sovereigns. However, our Bond Map does not account for the macro environment, which remains very favorable for the sector. In a recent report we showed that the two main factors that influence MBS spreads are mortgage refinancing activity and residential mortgage lending standards.4 Refi activity is tepid, and continued Fed rate hikes will ensure that it stays that way (Chart 4). Meanwhile, lending standards have been slowly easing since 2014 (bottom panel), but the Fed's most recent Senior Loan Officer Survey reports that standards remain at the tighter end of the range since 2005. The still-tight level of lending standards suggests that further easing is likely going forward. The amount of MBS running off the Fed's balance sheet has failed to exceed its cap in recent months, meaning that the Fed has not needed to enter the market to purchase MBS. This will probably continue to be the case going forward, due to both limited run-off and increases in the monthly cap. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to -10 bps. Sovereign debt underperformed the Treasury benchmark by 48 bps on the month, dragging year-to-date excess returns down to -83 bps. Foreign Agencies underperformed by 14 bps on the month, dragging year-to-date excess returns down to -36 bps. Local Authorities underperformed by 20 bps on the month, dragging year-to-date excess returns down to +41 bps. Supranationals performed in line with Treasuries in August, keeping year-to-date excess returns at +12 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +4 bps. Despite poor returns relative to Treasuries, Sovereign debt managed to outperform similarly-rated U.S. corporate debt in recent months. The outperformance is particularly puzzling given the unattractive relative valuation and the strengthening U.S. dollar (Chart 5). We reiterate our underweight allocation to Sovereign debt. The excess return Bond Map shows that both Local Authorities and Foreign Agencies offer exceptional risk/reward trade-offs compared to other U.S. bond sectors. We remain overweight both sectors. The excess return Bond Map also shows that while Supranational and Domestic Agency sectors are very low risk, expected returns are feeble. Both sectors should be avoided. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 70 basis points in August, dragging year-to-date excess returns down to +116 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 3% in August, and currently sits at 85% (Chart 6). This is more than one standard deviation below its post-crisis mean and only slightly higher than the average of 81% that was observed in the late stages of the previous cycle, between mid-2006 and mid-2007. In a recent report we demonstrated that while M/T yield ratios are low, municipal bonds offer attractive yields compared to corporate bonds.5 For example, we observe that a 5-year Aa-rated municipal bond carries a yield of 2.29% versus a yield of 3.35% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 32% should be indifferent between the two bonds. Moving further out the curve, the breakeven tax rate falls to 23% at the 10-year maturity point and is even lower at the 20-year maturity point. What's more, municipal bonds are also more insulated from the risk of weak foreign growth than the U.S. corporate sector, and recent enacted revenue increases at the state level should lead to lower net borrowing in the coming quarters (bottom panel). All in all, attractive relative yields and lower risk make municipal bonds preferable to corporates in the current environment. Remain overweight. Treasury Curve: Favor The 7-Year Bullet Over The 1/20 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve has flattened since the end of July, with yields at the short-end of the curve slightly higher and yields at the long-end slightly lower. The 2/10 Treasury slope currently sits at 23 bps and the 5/30 slope is currently 29 bps. The yield curve is already quite flat, consistent with a late-cycle economy. However, the economic data do not yet synch up with the curve's assessment. Chart 1 shows that wage growth is lagging the yield curve, while another yield curve indicator - nominal GDP growth less the fed funds rate - is moving in the opposite direction (Chart 7). We are likely to see both accelerating wage growth and decelerating nominal GDP growth during the next few quarters, but such outcomes are to a large extent in the price. In other words, the pace of curve flattening is likely to moderate in the coming months. With that in mind, we maintain our position long the 7-year bullet versus a duration-matched 1/20 barbell. That position is priced for 20 bps of 1/20 flattening during the next six months (Table 5). Table 4Butterfly Strategy Valuation (As Of August 3, 2018) Table 5Discounted Slope Change During Next 6 Months (BPs) Curve flatteners look more attractive at the long-end of curve. For example, the 5/30 barbell over 10-year bullet is priced for no change in 5/30 slope during the next six months. We also continue to hold this position to take advantage of the attractive value, and as a partial hedge to our position in the 1/7/20. TIPS: Overweight Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 17 basis points in August, dragging year-to-date excess returns down to +122 bps. The 10-year TIPS breakeven inflation rate declined 4 bps on the month and currently sits at 2.10%. The 5-year/5-year forward TIPS breakeven inflation rate declined 6 bps on the month and currently sits at 2.22%. Both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remain below the 2.3% to 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed's 2% target. TIPS breakevens have remained relatively firm in recent weeks even as commodity prices have declined sharply (Chart 8). This suggests that breakevens are increasingly taking cues from the U.S. inflation data, and might now be less sensitive to the global growth outlook. Core inflation should remain close to the Fed's 2% target going forward. This will gradually wring deflationary expectations out of the market, allowing long-dated TIPS breakevens to reach our 2.3% to 2.5% target range. While the macro back-drop remains highly inflationary - pipeline inflation measures are elevated (panel 4) and the labor market is tight - we noted in a recent report that the rate of increase in year-over-year core inflation will probably moderate in the months ahead, due to base effects that have become less supportive.6 ABS: Neutral CHart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in August, bringing year-to-date excess returns up to 18 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 1 basis point on the month and now stands at 37 bps, 10 bps above its pre-crisis low. The excess return Bond Map shows that consumer ABS offer attractive return potential compared to other high-rated spread products - such as Agency CMBS and Domestic Agencies - but also carry a greater risk of losses. Further, credit quality trends have been slowly moving against the sector and we think caution is warranted. The consumer credit delinquency rate bottomed in 2015, albeit from a very low level, and it should continue to head higher based on the trend in household interest coverage (Chart 9). Average consumer credit bank lending standards have also been tightening for nine consecutive quarters (bottom panel). The New York Fed's Household Debt and Credit report showed that consumer credit growth increased at an annualized rate of 4.6% in the second quarter, compared to 3.3% in Q1. However, the prospects for further acceleration in consumer credit are probably limited. A rising delinquency rate and tightening lending standards will both weigh on future credit growth (panel 3). Non-Agency CMBS: Underweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 28 basis points in August, bringing year-to-date excess returns up to +126 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 2 bps on the month and currently sits at 68 bps (Chart 10). In a recent report we showed that the macro picture for CMBS is decidedly mixed.7 A typical negative environment for CMBS is characterized by tightening bank lending standards for commercial real estate loans and falling demand. At present, both lending standards and demand for nonresidential real estate loans are close to unchanged (bottom two panels). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in August, bringing year-to-date excess returns up to +41 bps. The index option-adjusted spread was flat on the month and currently sits at 45 bps. The Bond Maps show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this defensive sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of September 7, 2018) Chart 12Total Return Bond Map (As Of September 7, 2018) Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Go To Neutral On Spread Product", dated June 26, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Out Of Sync", dated July 3, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "The Powell Doctrine Emerges", dated September 4, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, "The Fed's Balance Sheet Problem", dated July 17, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Last week's View Meeting underlined the point that BCA's take on the macro backdrop hasn't changed. Decelerating global growth and the potential for a nasty EM debt episode still argue for slightly cautious asset allocation. Global desynchronization is in full swing, with the U.S. leading the other major DM economies by a wide margin. The growth disparity will be dollar-positive while it lasts, but the deteriorating U.S. budget position will weigh on the dollar in the long run. S&P 500 performance across the earnings cycle reveals that decelerating earnings growth is not a problem for stocks as long as earnings are still growing year-on-year. Acceleration beats deceleration, but peaking earnings growth is not a signal to trim equity exposures. The U.S. is not impervious to a meaningful EM credit event, but its direct exposures are very limited. Post-crisis banking regulations have meaningfully reduced the banking system's vulnerabilities and make it very unlikely that another LTCM-like event might occur. Feature BCA researchers convened last week for our monthly View Meeting with the explicit goal of taking stock of our strategy teams' macro views. The nine-year-plus U.S. expansion is well advanced, and we are carefully monitoring the business cycle, the credit cycle, and the policy cycle for early warning of inflections in the rates, credit, and equity markets. In addition to the regular cyclical movements, we also have to gauge the impact of the ongoing reversal of extraordinary monetary accommodation and a raft of geopolitical issues. The investment outcome of the many crosscurrents continues to be subject to spirited debate, but the warily constructive house view, in place since mid-June, was not challenged. Decelerating global growth was a key driver of our June downgrade to neutral on equities. The U.S. economy may be surging as two years of fiscal stimulus makes its presence felt, but the other major developed-world economies are softening, and the emerging-market bloc faces considerable pressure. Although the S&P 500 has since made new highs (Chart 1, top panel), the MSCI All-Country World Index ("ACWI") has gone nowhere (Chart 1, second panel). Within the ACWI, DM equities (Chart 1, third panel), have handily outperformed struggling EM equities (Chart 1, bottom panel). We continue to expect more of the same. Tax cuts will keep corporate profits growing at better than 20% for the rest of the year, and federal spending will boost the U.S. economy through the end of 2019. The pickup in aggregate demand will strain dwindling spare capacity, feeding inflation pressures, and keeping the Fed from easing up on its rate-hiking campaign. A resolute Fed will ratchet up the pressure on EM borrowers, while increasing trade barriers pose a headwind for the many DM and EM economies that are more open than the U.S. Chinese policymakers could provide some respite to the global economy, but our China and EM strategists aren't counting on it. Easing monetary and/or fiscal policy would run counter to the Party's ongoing deleveraging and anti-corruption campaigns (Chart 2). Though China's rulers have demonstrated a tendency to overreact when acting to offset adverse economic events, our in-house experts think conditions will have to get a good bit worse to provoke meaningful stimulus of any sort. The strike price on a Chinese policy put may be considerably out of the money. Chart 1So Far, So Good Chart 2Will They Swim Against The Tide? Bottom Line: Overindebtedness, rising trade barriers, and a U.S. economy with the potential to overheat will keep the pressure on the EM bloc and cast a shadow over global growth. The Chinese policy cavalry may not feel any particular urgency to ride to the rescue. Leading The Pack There was no dispute about the U.S. growth outlook, absolute or relative. The U.S. economy is flying high, and will continue to outdistance its DM peers for the rest of this year and next. S&P 500 EPS growth will maintain its better than 20% pace in the third and fourth quarters. Next year's 10% consensus may be ambitious, given that this year's dollar appreciation probably hasn't shown up in earnings data, but corporate management teams have not yet expressed much in the way of dollar concerns. Decoupling cannot go on forever in the 21st-century global economy, but the comparatively closed U.S. economy has room to run in the near term. Last week's August ISM Manufacturing survey reached a 14-year high while the global PMI continued to hook lower (Chart 3). The gap between the U.S. LEI index and the global ex-U.S. LEI index has been widening for over a year (Chart 4), and would seem to herald additional dollar strength (Chart 4, bottom panel). Our corporate earnings models see U.S. EPS growth widening its lead on Europe and Japan over the rest of the year (Chart 5). Chart 3You Go Your Way And I'll Go Mine Chart 4Dollar Strength... Chart 5...Hasn't Gotten In Earnings' Way Yet Bottom Line: The U.S. is outgrowing its developed market peers, and there is nothing on the immediate horizon that suggests a reversal is in store. Superior corporate earnings growth and dollar strength should allow U.S. equities to outperform their major DM peers on a common-currency basis well into 2019. The Change, Or The Change Of The Change? Deceleration has been at the heart of BCA's managing editors' concerns, and there is an intuitive appeal to the idea that equity markets prize the change of the change (the second derivative) over the first-order move itself. It has the potential to clash, however, with the empirical fact that stocks typically rise unless earnings are contracting. To determine the degree to which decelerating earnings growth has historically presented a challenge to the S&P 500, we posit a four-phase earnings cycle based on the interaction between earnings-estimate growth and acceleration (Diagram 1), as follows: Diagram 1The Earnings Cycle Phase I begins when the worst part of the cycle has ended. Earnings estimates are contracting on a year-over-year basis, but at a slowing rate. Because earnings typically grow, and the bounce off the bottom is typically swift, this phase has occurred just 8% of the time. In Phase II, year-over-year earnings are growing at an accelerating rate. In Phase III, year-over-year earnings are still growing, but at a slowing rate. Phase II and Phase III are the de facto default phases, each accounting for 39% of all observations. In Phase IV, year-over-year earnings are contracting at an accelerating rate. Phase IV is more common than Phase I because the decline to the bottom tends to unfold more slowly than the bounce off of it, but it still occurs just 14% of the time. Table 1 shows annualized S&P 500 price returns for each phase of the cycle and then groups the phases by acceleration/deceleration and expansion/contraction. Stocks perform better when the rate of earnings growth is accelerating than they do when it's decelerating, but they also perform better when earnings are growing on a year-over-year basis than they do when they're declining. Stocks perform terribly when earnings are falling year-on-year at an increasing rate (Phase IV), and do great when the pace at which they're falling slows (Phase I), but those occurrences are few and far between. Earnings grow four-fifths of the time, and when they do, the differences between accelerating and decelerating growth aren't all that big a deal (Chart 6). Table 1Acceleration Is Better, But Deceleration Isn't All Bad... Chart 6...As It's Not A Problem As Long As Earnings Still Grow Bottom Line: Deceleration in the rate of earnings growth is not a signal to abandon stocks as long as earnings are still growing year-on-year. Investors have fared well for 40 years when earnings estimates expand, regardless of whether the rate of expansion is accelerating. 2018 Is Not 1997-98 In the wake of August's wobbles, several clients have been eager to explore various EM economies' vulnerabilities1 in more detail. We have fielded several questions relating to U.S. banks' EM exposures and how they compare to their exposures to the Asian Tigers on the cusp of the Asian Crisis. Per data from the Bank for International Settlements and the FDIC, U.S. claims on Thailand, Indonesia, the Philippines, Singapore, Malaysia, South Korea and Taiwan amounted to about 14% of all U.S. bank credit at the end of 1996. That exposure is very similar to the U.S. banking system's current exposure to Argentina, Turkey, Brazil, Colombia, Mexico, Chile, South Africa, and Indonesia. Direct exposure to fragile EM economies did not drive the S&P 500's 19% decline across July and August of 1998, however, nor did it inspire a consortium of fourteen major global financial institutions to come together to attempt to ring-fence the U.S. banking system. Those outcomes can be laid to the brokers' and investment banks' indirect exposure to the massively leveraged investment portfolio of the Long-Term Capital Management hedge fund (LTCM). To gauge the system's fragility back then, we perform a simple comparison of LTCM's debt to the publicly traded U.S. investment banks' total equity. In our back-of-the-envelope analysis (Table 2), we assume that the four investment banks, which contributed a quarter of the funds to rescue LTCM, had provided at least a quarter of LTCM's financing.2 Per our assumptions, LTCM claims accounted for 82% of the four banks' total equity. Losses given default would not have been anywhere near 100%, but a disorderly exit from LTCM's positions would surely have forced several of LTCM's creditors to conduct urgent capital raisings of their own. Fortunately for investors, today's banking system is nowhere near as vulnerable. Investment bank leverage ratios of 30 or more, commonplace in the late '90s, are a practical impossibility today. While lenders are no less likely to chase business late in the cycle today, post-crisis regulation makes it far more difficult to indulge their folly. Today's investment banks operate with a third of the leverage of 20 years ago (Table 3). The odds that another overextended investor, or group of investors, could imperil the U.S. banking system are much longer today than they were then. It's considerably harder to come by leverage via the regulated banking system, and leverage is the essential contagion ingredient. Table 2Enormous Leverage Made The Banking System Unstable In The Summer Of 1998 ... Table 3... But It's Not A Problem Anymore Bottom Line: Basel III, Dodd-Frank and the Volcker Rule save lenders from their own worst impulses. The odds of another LTCM crisis are far slimmer than they were in the late '90s. Investment Implications We continue to have a constructive view of the business, market and policy cycles in the U.S., but there's more to the global investing backdrop than just the U.S. Global investors should overweight U.S. equities versus equities in the rest of the world and U.S. investors should be sure to be at least equal weight equities, but the environment is sufficiently risky to inspire caution. We join our colleagues in continuing to recommend a benchmark equity allocation, while underweighting bonds and overweighting cash. August's employment report supports our economic and investment takes. The labor market remains tight, with the broader U-6 definition of unemployment (including involuntary part-time and discouraged workers) making a second straight 17-year low (Chart 7, top panel), and average hourly earnings extending their slow march higher (Chart 7, bottom panel). With the three-month moving average of payrolls (185,000) expanding at a rate well above the 110,000-per-month pace required to absorb new entrants to the labor market, qualified candidates are going to become even more difficult to find. The upshot is that the Fed remains firmly on a path to hike rates more than the market consensus currently expects. Despite the potential for a near-term flight-to-safety bid for Treasury bonds, we are sticking with our below-benchmark duration call. Chart 7As Slack Is Absorbed, Wages Will Rise Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Please see the August 20, 2018 U.S. Investment Strategy Weekly Report, "Rude Health," available at usis.bcaresearch.com. 2 Lehman did not contribute to the bailout, but it is highly improbable that it had not lent to LTCM.

Highlights The U.S. has outperformed most major stock markets over the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. U.S. companies will continue to deliver superior earnings growth during the remainder of this year. However, profit growth is likely to slow in 2019 owing to a larger wage bill, a stronger dollar, and a sluggish global economy. The efficacy of buybacks in boosting earnings-per-share is waning due to soaring valuations and rising interest rates. For the time being, asset allocators should maintain a neutral weighting to global equities, while favoring developed market stocks over emerging markets and overweighting defensive sectors relative to cyclical ones. Within the developed market equity space, the U.S. will outperform over the coming months in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, odds are high that earnings growth in the rest of the world will catch up with that of the U.S. Feature There Is No Mystery As To Why U.S. Stocks Have Outperformed The stock market is influenced by many variables, but in the end, the one that matters most is earnings. The U.S. has outperformed most major stock markets during the past few years largely because U.S. earnings have increased more rapidly than earnings abroad. Stronger earnings growth, in turn, has caused investors to assign a higher earnings multiple to the U.S. in comparison to other regions. This has given U.S. stocks a further lift (Chart 1). Differences in sector weights have helped flatter overall U.S. earnings to some extent. Globally, earnings in the tech and health care sectors have grown much more quickly than earnings in the financials and materials sectors (Chart 2). The former sectors have large weights in U.S. indices, while the latter are overrepresented in overseas indices (Table 1). Still, our analysis suggests that most of the outperformance of U.S. firms can be explained by their superior earnings growth within sectors (Chart 3). Chart 1U.S. Stocks Have Outperformed ##br##Thanks To Faster Earnings Growth Chart 2Global Earnings Sector Breakdown Table 1Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials ##br##And Materials Are Overrepresented In Markets Outside The U.S. Chart 3AU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (I) Chart 3BU.S. Earnings Have Risen Faster ##br##Within Each Equity Sector (II) We do not expect U.S. corporate earnings growth to slow sharply this year. In fact, our margin proxy points to a slight increase in profit margins in the second half of the year (Chart 4). Nevertheless, there are four reasons why U.S. earnings growth will decelerate in 2019 and beyond: Wage growth is likely to pick up. Chart 5 shows that there is an almost perfect correlation between profit margins and the ratio of selling prices-to-unit labor costs. A variety of surveys suggest that U.S. firms are struggling to find qualified workers (Chart 6). This is confirmed both by the most recent Fed Beige Book and by firms' Q2 earnings conference calls. A stronger dollar will eat into earnings. A reasonable rule of thumb is that every 5% appreciation in the broad trade-weighted dollar reduces S&P 500 earnings by 1% over the course of the ensuing 12-to-18 months. The broad trade-weighted dollar has risen 6.2% so far this year and we expect further strength in the months ahead. Global growth will weaken further. The U.S. is increasingly running out of spare capacity, which is limiting domestic growth prospects. Emerging markets are struggling, with the crises in Turkey and Argentina likely to spread to bigger players such as Brazil and South Africa. A major Chinese stimulus package would help reboot global growth, but concerns about high debt levels, overcapacity, and an overheated housing market will limit the response. The policy environment will become more challenging. Corporate tax cuts helped boost earnings earlier this year. However, the regulatory landscape is likely to turn less benign over the next few years. The tech sector is facing increased scrutiny.1 New EU privacy rules came into effect in May, which will limit the ability of internet companies to harvest personal data. The Trump Administration is also increasingly targeting social media companies for allegedly suppressing conservative voices. In addition, our geopolitical strategists expect U.S.-China trade tensions to remain elevated, with the U.S. likely to impose tariffs on an additional $200 billion worth of Chinese imports. Meanwhile, a trade deal with Canada is no slam dunk. President Trump has even reiterated that he would be willing to exit the World Trade Organization. Chart 4Margins Could Rise A Bit More ##br##In The Near Term Chart 5Higher Wage Growth Will Undermine Profit Margins Chart 6U.S. Firms Are Having Difficulty ##br##Finding Qualified Workers Diminishing Returns From Buybacks U.S. companies are on track to spend a record amount of money buying back shares in 2018, with tech companies accounting for about 40% of all shares repurchased. While this may seem very bullish for stocks, one should keep in mind that the prior peak in share buybacks occurred in 2007. Companies are not particularly adept at timing the stock market, even when it is their own shares they are purchasing. Moreover, U.S. stock market capitalization has doubled since 2007. As a share of market cap, today's pace of buybacks is high, but not exceptionally so (Chart 7). To state the obvious, the more expensive stocks get, the more money it takes to purchase the same number of shares. U.S. equity valuations are quite stretched by historic standards (Chart 8). On a price-to-sales basis, U.S. stocks are now as expensive as they were in 2000. Our estimate of the U.S. equity risk premium - calculated as the difference between the cyclically-adjusted earnings yield and the average expected short-term real interest rate over the next decade - is well below its historic average (Chart 9). Chart 7Buybacks As A Share Of Market Cap: Fairly Muted Chart 8U.S. Equities Are Trading At Lofty Valuations Chart 9The U.S. Equity Risk Premium Is Well Below Its Historic Average It is also important to remember that share repurchases will only boost EPS if the interest rate that companies receive on their cash balances is below their earnings yield. To see this, consider a simple example where the earnings yield and the interest rate are the same. Specifically, suppose that a company has a market cap of $1 billion, $20 million in earnings, and earns 2% on its cash holdings. If the company buys back $100 million in shares, its share count will decline by 10%, but the interest payments that it receives will fall by $2 million, pushing profits down by 10% from $20 million to $18 million. The net result is no change in EPS. As U.S. interest rates continue to increase, companies will see ever-smaller benefits to their bottom lines from share buybacks. Where's The Earnings Growth Going To Come From? The foregoing discussion raises another point, which is that buybacks, by their very nature, leave companies with less cash to invest in future growth. This issue is quite relevant for the current environment. Analysts today expect the average S&P 500 company to grow earnings at an annual rate of 16.6% over the next 3-to-5 years (Chart 10). This is wildly optimistic. It is six points higher than the long-term earnings growth rate they expected just three years ago. Indeed, it is only topped by the euphoric projection of 18.7% reached in 2000 - just before the stock market came crashing down. Apparently, on Wall Street, companies can have their cake and eat it too. Chart 10Analyst Expectations Are Too Optimistic Creative Accounting? Earnings are earnings, correct? Actually, no. What constitutes earnings has changed over the years. Up until the 1990s, companies generally reported GAAP earnings - earnings based on Generally Accepted Accounting Principles. Over the past two decades, however, companies have moved towards reporting so-called "pro forma" or "operating" earnings. Unlike GAAP earnings, there is no codified set of rules governing the definition of operating earnings. Conceptually, companies are supposed to exclude both one-off losses and gains when calculating operating earnings in order to give shareholders a better sense of the underlying trend in profits. In practice, they tend to exclude the former much more often than the latter. This problem has gotten worse over time, so much so that an apples-to-apples comparison now requires that we reduce earnings today by about 15% in order to compare them with earnings in the early 1980s (Chart 11). More ominously, it is possible that even GAAP earnings are currently overstated. Chart 12 shows that EBITDA profit margins, which are generally more difficult to fudge, have fallen over the past decade, while operating margins have risen. Economy-wide profit margins, as measured in the national accounts, have also increased much more slowly than S&P 500 operating margins (Chart 13). Chart 11A Bull Market In Creative Accounting? Chart 12S&P 500 Operating Margins Have Risen Much More Than EBITDA Margins Chart 13Profit Margins, As Measured In The National Accounts, Have Fallen Relative To S&P 500 Margins This raises the risk that we will see more earning restatements - or at the very least, earnings disappointments - in the years ahead as companies run out of magic asterisks to pull out of their bag of accounting tricks. Investment Conclusions Corporate earnings are highly correlated with the state of the business cycle (Chart 14). We do not expect the U.S. to enter a recession at least until 2020. Thus, it is doubtful that U.S. earnings will suffer a sharp decline before then. Nevertheless, as this report argues, earnings growth is likely to decelerate early next year. Investors have a lot riding on the assumption that earnings growth will hold up. U.S. households owned nearly $30 trillion of equities in Q1 of 2018, or 25% of total household assets, the highest level since 2000 (Chart 15). The monthly asset allocation survey published by the Association of Individual Investors (AAII) shows that stocks comprised 68.5% of investors' portfolios in August (Chart 16). While this is below the peak of 77% reached in March 2000, it is still more than seven points above the post-1987 average of 61%, putting it in the 84th percentile of the historic distribution. Chart 14Earnings Are Highly Correlated ##br##With The Business Cycle Chart 15Households Are Loaded Up On Stocks Which... Chart 16...Comprise A Big Chunk Of Their Portfolios If earnings growth slows significantly, investors could end up deciding to cut their exposure to the stock market. Since for every buyer there must be a seller, the only way for investors to collectively reduce the value of their equity holdings is if share prices decline. U.S. equities account for 55% of global stock market capitalization (Chart 17). Thus, if U.S. earnings begin to stagnate, this will limit the upside for global equity indices. Chart 17U.S. Equities Account For More Than Half Of Global Stock Market Capitalization Chart 18Earnings In Other Regions Will Eventually Catch Up With The U.S. Does this mean that investors should look for greener pastures abroad? Not yet. We expect the dollar to strengthen and global growth to slow further over the coming months. This will put downward pressure on cyclical stocks, which are overrepresented in foreign indices. For the time being, asset allocators should maintain a neutral weighting to global equities, favoring developed market stocks over emerging markets. Within the DM space, the U.S. will outperform in dollar terms, but will trade broadly in line with Europe and Japan in local-currency terms. Longer term, we are more sanguine about the prospects for non-U.S. stocks. The outperformance of U.S. equities over the past decade follows a decade of underperformance. In fact, EPS in Europe and emerging markets actually grew more rapidly between 1990 and 2007 than in the United States (Chart 18). Historically, the relative growth of earnings across different regions follows multi-year cycles, and there is no reason to think that this will change. As such, it is likely that earnings growth in the rest of the world will begin to outstrip the U.S. once the problems plaguing emerging markets have been flushed out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see U.S. Equity Strategy, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Portfolio Strategy Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. A looming positive global growth impulse, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuations all suggest that now is not the time to throw in the towel on the S&P construction machinery & heavy truck (CMHT) index. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Chart 1All-time Highs Everywhere The SPX catapulted to fresh all-time highs last week following an eight month hiatus, as a de-escalation in the global trade war gained further traction. Chart 1 shows that this is a broad based equity market advance as a slew of major equity market indexes have simultaneously vaulted to new highs. Even the high-yield corporate bond market confirms this breakout with the total return index also vaulting to new all-time highs (not shown). Any further moderation in trade rhetoric from the U.S. administration could serve as a catalyst for additional gains in the SPX, and trade-affected sectors would likely lead the charge, especially post the mid-term elections.1 While the U.S./China trade spat will prove the ultimate equity market litmus test, the longevity and magnitude of the profit upcycle remain the key equity market advance pillars. On that front, a deeper dive into profit margins is in order. The S&P 500's profit margins are benefiting from the one-time fillip of lower corporate taxes in calendar 2018. Nevertheless, it is important to remember that this year's strong profits are not the result of any massaging from CEOs/CFOs of the share count. In other words, profit margins (earnings per share / sales per share) are not impacted by changes in the number of shares outstanding, unlike simple EPS growth. Chart 2 shows that SPX margins recently slingshot to all-time highs. However, excluding tech they remain below the previous cycle's mid-2007 peak. While we are not fans of excluding sectors from our analysis, the sheer size and persistence of the tech sector's profit margin expansion is surprising. Tech sector profit margins are twice the SPX's margins, and tech stocks have been pulling SPX margins higher consistently for the past 8 years as tech giants are flexing their oligopolistic/monopolistic muscle. The implication is that SPX EPS growth of 10% is likely in 2019, but the tech sector has to continue doing most of the heavy lifting given the high profit and market cap weight in the SPX. Keep in mind that the commodity complex in general and energy in particular are also adding to the recent margin euphoria. The late-2015/early-2016 global manufacturing recession-induced collapse in margins is now re-normalizing across basic resources, with margins in the S&P energy sector increasing by 11 percentage points since the Q2 2016 trough (Chart 2). Beyond the sector-related margin implications, from a macro point of view, U.S. stock market-reported employment has also been a significant contributor to the phenomenal profit margin expansion phase. Typically, stock market constituents reported job count growth peaks right before the NBER designated recession commences, on average at over an 8% year-over-year growth rate. The current labor market, while vibrant, has been trailing previous cycles by a wide margin. The most recent year-over-year growth rate clocked in at 3.5% (second panel, Chart 3). Chart 2Tech Margins Leading##br## The Pack Chart 3Smaller Than Usual Labor Footprint##br## Is A Boon For Margins National accounts data also corroborate this enticing profit margin backdrop. Average hourly earnings (AHE) have crested north of 4% in the past three cyclical peaks. Currently AHE are 130bps below that level (top panel, Chart 3). The implication is that as long as top line growth remains solid and corporate pricing power stays upbeat, profit margins will continue to underpin profits. Unlike the tech sector's excessive contribution to the SPX profit margin, the opposite rings true with regard to analysts' forward profit projections. Both on a 12-month and 5-year forward basis the S&P tech sector is trailing the SPX (Chart 4). Importantly, the latter has been at the center of a healthy debate within BCA, and decomposing this seemingly high number is instructive. A 16% long-term EPS growth rate is a tall order. However, sell-side analysts never get the shorter-term, let alone longer-term, forecasts correct. In hindsight, analysts' 5-year forward EPS growth forecasts back in 2016 sunk to an all-time low, even lower than the depths of the Great Recession (top panel, Chart 4). Currently, all we are experiencing is a move from one extreme to the other, and while we are clearly in overshoot territory, it is impossible to predict where this number will peak. Decomposing the broad market's projected long-term EPS growth rate is revealing. First, we note that the tech sector is projected to grow at half the rate predicted during the tech bubble. Second, four sectors comprise the outliers (i.e. forecast to surpass the 16% SPX growth rate) and such a breakneck pace will surely fail to materialize. Another common characteristic these four sectors share is that they all surpassed their tech bubble peak rates, something that the broad market has yet to achieve. Thus, consumer discretionary, financials, industrials and especially energy are in uncharted territory (Chart 5). On the opposite end of the spectrum, Chart 6 highlights the sectors that have yet to overtake their respective peaks and are sporting long-term EPS growth rates below the broad market. Chart 4Putting Tech Long-term Profit##br## Growth Rate In Context Chart 5Decomposing... Chart 6...Long-Term EPS Growth Netting it all out, we continue to have a sanguine cyclical (9-12 month horizon) SPX view, and our price target for 2019 remains 10% higher, assuming the multiple moves sideways leaving the onus on EPS to do all the heavy lifting.2 The week we are highlighting a deep cyclical sector that can benefit from a further de-escalation of the trade war and update one of its key subcomponents that remains a high-conviction overweight. Are Industrials Running On Empty? Last week, in a Special Report on President Trump's trade rhetoric impact on equity markets, we showed that trade policy uncertainty has risen to the highest level with the exception of the 1994 Clinton-era trade spat with the Japanese.3 While U.S. stocks have come out on top versus their global peers, within the U.S. equity market industrials have borne the brunt of the President's trade wrath (Chart 7). Chart 7Trade Uncertainty Weighing On Industrials In more detail, since peaking on January 26th, 2018, two stocks explain over 62% of the S&P industrials sector's fall: GE and MMM, two industrial conglomerates highly exposed to global trade. However, transports in general and rails in particular have been rising smartly almost entirely offsetting the industrial conglomerates' weakness. As a reminder, we are overweight the rails and air freight & logistics, underweight the airlines, neutral on industrial conglomerates and remain comfortable with that intra-sector positioning. Importantly, green shoots are emerging, warning that it does not pay to become bearish on this deep cyclical sector. Our Cyclical Macro Indicator remains upbeat, diverging from relative profitability (Chart 8). Domestic ex-tech output is firing on all cylinders (Chart 8), a message reviving core capital goods orders corroborate (Chart 9). All of this has resulted in firming pricing power. Tack on the reacceleration in our U.S. capital expenditure indicator (second panel, Chart 8) - capex upcycle remains a key BCA theme for the remainder of 2018 - and industrials sector stars are aligned. The upshot is that depressed relative profit growth will easily surprise to the upside (bottom panel, Chart 8). Chart 8Green Shoots... Chart 9...Appearing Not only are there U.S. macro tailwinds, but also a global growth recovery is in the offing that will herald a snapback in relative share prices. The global manufacturing PMI remains squarely above the 50 boom/bust line (fourth panel, Chart 9), and there are early signs of a budding recovery in China. The Li-Keqiang index is ticking higher, Chinese monetary conditions have eased significantly via a depreciating currency and a drop in interest rates, excavator sales continue to expand at a healthy clip, industrial profits are reaccelerating and even Chinese share prices have likely troughed. Expanding Chinese wholesale selling prices also suggest that a reflationary impulse is looming (bottom panel, Chart 9). Were trade tensions to further de-escalate, especially post the midterm elections that could serve as a powerful tonic for relative share prices. Our Industrials EPS growth model does an excellent job in capturing all these forces and is currently signaling that profits will continue to grow into 2019 (Chart 10). Valuations have returned to the neutral zone, but technicals have plunged to one standard deviation below the mean, a level that has historically been associated with playable rallies (bottom panel, Chart 10). One key risk to our optimistic take on the S&P industrials sector is the U.S. dollar. Chart 11 highlights that capital goods revenues, exports and multiples are in jeopardy if the greenback continues to appreciate. Add to that a full blown trade war between the U.S. and China - which is dollar positive - and industrials stocks would suffer another blow. Chart 10Great Entry Point Chart 11Further U.S. Dollar Appreciation Is A Risk Bottom Line: Firming domestic and encouraging global macro conditions along with neutral valuations and washed out technicals suggest that the path of least resistance is higher for the S&P industrials sector. What To Do With Construction Machinery? Early in the year, following our risk management implementation of a 10% stop on our high conviction call list, we got stopped out with a 10% gain from the high-conviction overweight call in the S&P CMHT index. We were subsequently compelled to reinstitute this high-conviction call as all of the fundamental drivers remained in place. However, our timing was not perfect, and given that bellwether Caterpillar has a near 60% foreign sourced revenue exposure, this industrial subsector also bore the brunt of the President's hawkish trade rhetoric. The key question currently is: does it still make sense to be overweight this highly cyclical industrials sub group? The short answer is yes. First, while global growth has decelerated, global trade is still expanding and the signal from the Baltic Dry Index is that the risk of an abrupt halt in global trade similar to the late-2015/early-2016 episode is small (second panel, Chart 12). In addition, the global capex upcycle remains in place and is one of BCA's two themes we continue to explore for the rest of the year. The upshot is that it still pays to remain invested in the S&P CMHT index. Demand for machinery remains upbeat across the globe. Both our global exports and orders proxies for machinery continue to grow, underscoring that a profit-led recovery in construction machinery stocks is looming (third & fourth panels, Chart 12). Second, while China is the administration's primary trade target, easy monetary conditions there will provide much needed breathing room for the Chinese economy. Already, Chinese housing construction data and the rebounding Li-Keqiang Index are pointing to a brighter backdrop for relative share prices (top two panels, Chart 13). Moreover, Chinese excavator sales are advancing at a brisk year-over-year rate, highlighting that construction machinery end-demand remains solid. Chart 12Global Growth & CAPEX Are Tailwinds... Chart 13...And So Is The Troughing Chinese Economy Third, the key energy end-market shows no signs of deceleration. The steeply recovering global oil rig count on the back of a $78 Brent crude oil price suggests that demand for oil & gas field machinery remains on the recovery path and is a harbinger of a rising relative share price ratio (Chart 14). Fourth, industry operating metrics are overheating and signal that profits will continue to surprise to the upside. Rising capex budgets have reduced industry slack (second & third panels, Chart 15). As a result, machinery selling prices have soared to the highest level since the Great Recession (bottom panel, Chart 15) and will underpin industry profits. Chart 14Energy End-market To The Rescue? Chart 15Vibrant Operating Metrics Finally, relative valuations have plunged to near one standard deviation below the average and so have relative technicals. While both can sink further, we would be taking a punt here (Chart 16). Despite our optimistic view on the S&P CMHT index's profit prospects, the appreciating U.S. dollar and recent cresting in the CRB raw industrials index represent key downside risks to our overweight call. This commodity price index is a crucial input to our machinery EPS growth model that has petered out, but at a high level. Any further steep appreciation in the greenback will likely deal a blow to the commodity complex and jeopardize the virtuous machinery profit upcycle (Chart 17). Chart 16Compelling Valuations And Washed Out Technicals Chart 17Risk To Monitor: Commodity Price Relapse Adding it up, a looming global growth pick up, easy Chinese monetary conditions, a still buoyant energy end-market, enticing industry operating metrics and compelling valuation and technical conditions all suggest that now is not the time to throw in the towel in the S&P CMHT index. Bottom Line: Were we not overweight already we would not hesitate to initiate a new above benchmark position in the S&P CMHT index. We reiterate our high-conviction overweight status. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, "Lifting SPX Target" dated April 30, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Special Report, "Trump, Trade, Tweets & Tumult - Does The Stock Market Care?" dated August 22, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades

Highlights 2018 YTD Summary: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Sector Portfolios: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Looking Ahead: We are maintaining a neutral level of target spread risk (i.e. duration-times-spread equal that of the benchmark index) in our sector model portfolios for the U.S., euro area and U.K. We will look to reduce that spread risk on signs of a deeper global growth slowdown, which we expect will unfold in 2019. Feature Chart of the WeekReversal Of Fortune The performance of investment grade (IG) corporate bonds in the developed markets, as an asset class, has been underwhelming so far in 2018. Using the total return indices from Bloomberg Barclays, IG corporates in the U.S., euro area and U.K. - the regions with the three largest corporate bond markets among the developed economies - have lost -2.0%, -0.3% and -1.1%, respectively. The numbers do not look much better when shown on an excess return basis versus duration-matched government bonds: U.S. IG -0.8%, euro area -1.2% and the U.K. -1.3%. The sluggish performance for IG corporates is a mirror image of the strong showing in 2017 when looking at credit spreads, which reached very tight levels at the end of last year (Chart of the Week). The 2017 rally left global corporates exposed to any negative shocks, of which there have been many so far in 2018 (the February VIX spike, the Q1 global growth slowdown, intensifying U.S.-China trade tensions, ongoing Fed tightening, a strengthening U.S. dollar, less dovish non-U.S. central banks, Italian politics, emerging market turmoil). Given the more challenging environment for overall corporate bond performance, the role of sector selection as a way to generate alpha, by mitigating losses from beta, is critical. In this Weekly Report, we take a brief look at IG sector performance so far this year and update our sector allocations based on our relative value models for IG corporates in the U.S., euro area and U.K. 2018 YTD Global Corporates Performance: A Down Year The major IG sector groupings for the U.S., euro area and U.K. are presented in Table 1, ranked by the 2018 year-to-date excess returns (all are shown in local currency terms). The overall index return for each region is also shown (highlighted in gray) in the table, to highlight how individual sectors have performed relative to the overall IG index. Table 12018 Year-To-Date Investment Grade Sector Returns For The U.S., Euro Area & U.K. As is always the case with IG corporates, the performance of the broad Financials grouping (which includes banks, insurance companies, REITs, etc.) heavily influences the returns of the overall IG index given the large weighting of Financials within the Corporates index across all three regions. In both the euro area and U.K., the sharp underperformance of Financials seen year-to-date (-1.3% and -1.4%, respectively) has created a somewhat odd situation where the majority of sectors have outperformed the overall index. That could only happen given the large weight of Financials in the euro area index (40%) and U.K. index (43%). Financials are also a big part of the U.S. index (32%), but there is more balance in the U.S. IG index which has helped boost the "beta" return from U.S. corporates. Specifically, the weightings of the top three largest U.S. broad sector groupings - Energy (9%), Technology (8%) and Communications (9%) - are a combined 26% of the overall U.S. IG index. Those three sectors are also among upper tier of the 2018 performance table in the euro area and U.K., but only represent a combined 15% and 8%, respectively, of each region's IG index. The conclusion is that index composition has flattered the performance of U.S. IG corporates versus European equivalents, given the latter's heavier weighting in Financials. The poor performance of Financials can be attributed to flattening global government bond yield curves (which is a negative for banks) and poor returns from global credit, especially in emerging markets (which is a negative for insurers that invest in spread product). We do not anticipate either of those trends reversing anytime soon - particularly the ongoing selloff in emerging market assets - thus Financials are likely to remain a drag on corporate bond performance for at least the next 3-6 months. One other factor that has weighed on overall IG corporate performance has been the steepening of credit spread curves. The gaps between credit spreads for Baa- and A-rated corporates have widened since the end of January, most notably in the euro area and the U.K. where growth has been slower than in the fiscal-policy fueled U.S. economy (Chart 2). With Baa-rated debt now representing one-half of the IG index for the U.S., euro area and U.K. (Chart 3) - a function of rising corporate leverage - continued underperformance of lower quality sectors will negatively impact the future overall returns from IG corporates. Chart 2Spread Curves Are##BR##Steepening In Europe Chart 31/2 Of Investment Grade Corporate Indices##BR##Are Now Baa-Rated Looking ahead, credit investors should be wary of the potential for downgrade risk in their portfolios given the high proportion of Baa-rated debt in the IG benchmark indices. This risk will become more acute when the global business cycle runs out of steam (a 2019 story, at the earliest, in our view). Bottom Line: Investment grade corporate debt in the developed economies has performed poorly so far in 2018, led by lagging returns in Financials and some steepening of credit curves. U.S. credit has outperformed European equivalents. These trends are likely to continue over at least the next six months. Our Corporate Sector Valuation Models: Winners & Losers Our recommended IG sector allocations come from our relative value model, which measures the valuation of each individual sector compared to the overall Bloomberg Barclays corporate bond index for each region. The methodology takes each sector's individual option-adjusted spread (OAS) and regresses it in a panel regression with all other sectors in each region. The dependent variables in the model are each sector's duration, convexity (duration squared) and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that panel regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. The latest output from the models can be found in the tables and charts in the Appendix starting on Page 13. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot charts in the Appendix show the tradeoff between the valuation residual from our model and each sector's DTS. We then apply individual sector weights based on the model output and our desired level of overall spread risk in our recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. That target portfolio DTS is the first decision in our discretionary allocation process, which is informed by our strategic views on corporate credit in each region. For example, if we were recommending an overweight allocation to U.S. IG corporates, then we would target a portfolio DTS that was greater than the index DTS. If we then became a bit more cautious on U.S. corporates, we could reduce the target DTS (spread risk) of our model sector portfolio while maintaining an overall overweight allocation to U.S. corporates versus U.S. Treasuries. That is exactly what we did one year ago, when we began to target a weighted DTS of all our individual sector tilts that was roughly equal to the overall IG corporate index DTS for each region (U.S. euro area, U.K.) while maintaining an overall overweight stance on global corporate credit versus government debt. More recently, we have downgraded our stance on global spread product to neutral, while continuing to favor the U.S. over Europe, in response to growing tensions from emerging markets and the brewing U.S.-China trade war.1 Chart 4Performance Of Our IG Sector Allocations We last presented a performance update for our global IG corporate sector allocations back on April 12th of this year. Since then, our recommended tilts have modestly underperformed the benchmark index in excess return terms by a combined -3bps (Chart 4). This came entirely from the euro area, with both the U.S. and U.K. sector allocations simply matching the benchmark index. Year-to-date, our IG sector allocations have underperformed the benchmark by a combined -9bps in excess return terms, split equally among the U.S., euro area and U.K. This is a result entirely consistent with our long-standing stance to overweight Financials in all three regions, which continue to appear cheap in our valuation framework. Also, an increasing number of sectors had become expensive within that framework, in all three regions, so some portion of that overweight to global Financials was "by default" given that our model portfolios must be fully invested (finding value has been a persistent problem for credit investors over the past year). The return numbers for our U.S. sector allocations can be found in Table 2. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have all been underweights: Pharmaceuticals (+1.2bps), Electric Utilities (+1.1bps), Retailers (+0.6bps), Health Care (+0.6bps), Diversified Manufacturing (+0.5bps) and Chemicals (+0.4bps). These were fully offset, however, by underperformance from our large overweights to Energy (-4.1bps) and Financials (-2.7bps). Table 2U.S. Investment Grade Performance The return numbers for our euro area sector allocations - shown here hedged into U.S. dollars as is the case when we present all our model portfolio returns - can be found in Table 3. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been underweights to Transportation (+2.0bps) and Electric Utilities (+0.6bps), with underperformance coming from our underweight to Food/Beverage (-2.4bps) and overweight to Life Insurers (-3.1bps). Table 3Euro Area Investment Grade Performance The return numbers for our U.K. sector allocations (again, hedged into U.S. dollars) can be found in Table 4. Since our last update in April, the best performing sectors (in excess return terms) within our recommended tilts have been our underweight to Utilities (+2.0bps) and Consumer Non-Cyclicals (+0.9bps), but this was nearly fully offset by our large overweight to Financials (-2.6bps). Table 4U.K. Investment Grade Performance Despite the underperformance of our sector portfolios year-to-date, the cumulative alpha from the portfolios since we began tracking the performance of the recommendations remains positive (+2bps in the U.S., +9bps in the euro area, +42bps in the U.K.). Bottom Line: Our investment grade sector model portfolios have underperformed modestly so far in 2018 (-3bps each in the U.S., euro area & U.K.) - primarily due to our overweight stance on Financials which have performed poorly. Changes To Our Sector Model Portfolios As mentioned earlier, the first choice we make when determining the recommended sector allocations within our model portfolios is how much spread risk (DTS) to take. For the U.S., euro area and U.K., we have already been maintaining a portfolio DTS that is close to the index DTS since August 2017. After our recent decision to downgrade global spread product allocations to neutral versus government bonds, we do not feel a need to further reduce our spread risk by targeting a below-index DTS. That would likely be our next decision when we wish to get more defensive on credit, which would await evidence that global leading economic indicators are sharply slowing and/or global monetary policy is becoming restrictive. Within that neutral level of spread risk, we are making the following portfolio changes based on the updated output from our valuation models presented in the Appendix Tables on pages 13-18. The goal is to favor sectors that have a DTS close the index DTS but have positive valuation residuals from our model: U.S.: We downgrade Tobacco and Wireless to Neutral; we downgrade Paper to Underweight. Euro Area: We upgrade Transportation, Other Industrials, Natural Gas, Brokerages/Asset Managers and Finance Companies to Overweight; we upgrade Automotive, Retailers and Tobacco to Neutral; we downgrade Wireless to Neutral; we downgrade Diversified Manufacturing & Media Entertainment to Underweight. U.K.: We upgrade Health Care, Transportation and Other Industrials to Overweight; we upgrade Integrated Energy to Neutral; we downgrade Technology & Wireless to Neutral; we downgrade Metals & Mining and Supermarkets to underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Time To Take Some Chips Off The Table: Downgrade Global Corporate Bond Exposure To Neutral", dated June 26th 2018, available at gfis.bcaresearch.com. Appendix Appendix Table 1U.S. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 1U.S. Corporate Sector Risk Vs. Reward* Appendix Table 2Euro Area Corporate Sector Valuation And Recommended Allocation* Appendix Chart 2Euro Area Corporate Sector Risk Vs. Reward* Appendix Table 3U.K. Corporate Sector Valuation And Recommended Allocation* Appendix Chart 3U.K. Corporate Sector Risk Vs. Reward* Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Desynchronization To Continue This year has been characterized by strong growth and asset performance in the U.S., and weakness everywhere else. While U.S. stocks are up by 10% year-to-date, those in the rest of the world have fallen by 3% in dollar terms (Chart 1). GDP growth in Q2 was 4.2% QoQ annualized in the U.S., compared to 1.6% in the euro area and 1.9% in Japan. Leading economic indicators point to this continuing and, therefore, to the U.S. dollar strengthening further (Chart 2). This has already put significant pressure on emerging markets, where equities have fallen by 7% this year in USD terms. Recommended Allocation Chart 1U.S. Has Outperformed Chart 2...And Leading Indicators Suggest This Will Continue There are many reasons why the desynchronization is likely to continue: U.S. growth continues to be boosted by tax cuts and increased fiscal spending which, according to IMF estimates, will add 0.7% to GDP growth this year and 0.8% next. The peak impact from the stimulus will not come until around Q1 next year. Further protectionist tariff increases. Despite August's tentative agreement between the U.S. and Mexico, the Trump administration still plans to implement 10-25% tariffs on $200 billion of Chinese imports, and also possibly 25% tariffs on auto imports, in September. This will - initially at least - be more negative for global exporters, such as China, the euro area and Japan, than for the U.S. China is unlikely to implement the sort of massive stimulus that it carried out in 2009 and 2015.1 It has recently cut interest rates and brought forward fiscal spending to cushion downside risk. But, given the Xi administration's focus on deleveraging and structural reform, we do not expect to see a substantial increase in credit creation (Chart 3). This indicates that emerging markets, and capital goods and commodities exporters, will continue to struggle. European banks will stay under pressure because of the problems in Italy (which will fight this fall with the European Commission over its fiscal stimulus plans) and Turkey. Euro zone equity relative performance is heavily influenced by the performance of financials, even though the sector is only 18% of market cap (Chart 4). The euro zone and Japan are also far more sensitive to a slowdown in EM growth: exports to EM are 8.4% and 6.4% of GDP in the euro zone and Japan respectively, but only 3.6% in the U.S. Chart 3China Unlikely To Repeat 2009 and 2015 Chart 4Banks Drive European Equity Performance Eventually, however, strong growth in the U.S. will become a headwind for U.S. assets too. Already, there are some signs of wage growth ticking up (Chart 5), suggesting that the labor market is finally becoming tight. Fed chair Jerome Powell, in his speech at Jackson Hole last month, reiterated that a "gradual process of normalization [of monetary policy] remains appropriate", suggesting that the Fed will continue to hike by 25 basis points a quarter. But the futures market is pricing in only 75 basis points in hikes over the next two years (Chart 6). And, if core PCE inflation were to rise above the Fed's forecast of 2.1% (it is currently 2.0%), the Fed would need to accelerate the pace of tightening. This all points to further dollar strength which will hurt emerging markets, given the consistent inverse correlation between U.S. financial conditions and EM asset performance (Chart 7). Chart 5Is Wage Growth Finally Accelerating? Chart 6Markets Pricing In Only Three More Fed Hikes Chart 7Tightening Financial Conditions Are Bad For EM We continue for now, therefore, to remain overweight U.S. equities in USD terms within a global multi-asset portfolio, despite their strong performance this year. We are neutral on equities overall and expect to move to negative perhaps early next year, when we will see some of the classic warning signs of recession (inverted yield curve, rise in credit spreads, peak in profit margins) starting to flash. Profit expectations are one key to the timing of this. Analysts forecast 22% YoY EPS growth for S&P 500 companies in Q3 and 21% in Q4, slowing to 10% in 2019. Those are strong numbers. But if companies are unable to beat these forecasts, what would be the catalyst for stocks to continue to rise? Moreover, analysts' expectations for long-term earnings growth are more optimistic currently than any time since 2000 (Chart 8). It would not take much of a downside earnings surprise - perhaps caused by the strength of the dollar, or regulatory change for internet companies - to disappoint the market. Equities: Our strongest conviction call remains an underweight on emerging markets. Emerging markets are entering what is likely to be a prolonged period of deleveraging, given their elevated levels of debt relative to GDP and exports (Chart 9). That makes them very vulnerable to the stronger U.S. dollar and higher interest rates that we expect. While EM equities have already fallen significantly, they are not yet cheap and investors have mostly not capitulated: outflows from EM funds have been small relative to inflows in previous years (Chart 10). Among developed markets, we keep our overweight on the U.S.: not only does its lower beta mean it should outperform in the event of a sell-off, but if markets were to see a last-year-of-the-bull-market "melt-up" (similar to 1999), this would likely be led by tech and internet stocks, where the U.S. is overweight. Chart 8Analysts Too Optimistic About Long-Term Earnings Growth Chart 9Long Period Of Deleveraging Ahead For EM Chart 10No Signs Of Capitulation In EM Yet Fixed Income: Higher inflation, and more Fed tightening than the market is pricing in, suggest that long-term rates have further to rise. Fed rate surprises have historically been a good indicator of the return from U.S. Treasury bonds (Chart 11). We expect to see the 10-year yield reach 3.3-3.5% by early next year. We therefore remain underweight duration, and prefer TIPS over nominal bonds. We recently lowered our weighting in corporate credit to neutral (within the underweight fixed-income category). Junk bonds have continued to perform well, thanks to their 250 basis point default-adjusted spread over Treasuries. But spreads typically start to widen one to two quarters before equities peak, so we think caution is already warranted, particularly in the light of the higher leverage, longer duration, and falling average credit rating which currently characterize the U.S. corporate credit market. Currencies: As described above, mainly because of divergent growth and monetary policy, we expect the U.S. dollar to strengthen further, but more against emerging market currencies than against the yen or euro. Short-term, however, the dollar may have overshot and speculative positions are significantly dollar-long (Chart 12), so a temporary pullback would not be surprising. Chart 11More Fed Hikes Means Higher Long-Term Rates Chart 12Are Investors Too Dollar Bullish? Chart 13Dollar And China Hurting Commodities Commodities: Industrial metals prices have declined sharply over the past few months, on the back of the stronger dollar and slowdown in China (Chart 13). We expect this to continue. Gold, we have long argued, has a place in a portfolio as an inflation hedge. But it is also negatively impacted by rises in the dollar and real interest rates, and these are likely to continue to be a drag on performance. The oil price is currently being driven by supply dynamics: How much more oil will Saudi Arabia produce? Will the E.U. and Japan follow the U.S. in imposing sanctions on Iran? Will Venezuelan production fall further? These will make the crude oil price more volatile, but our energy strategists see Brent softening a little to average $70 in H2 this year, but with potential upside surprises taking it up to an average of $80 in 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For details on why we think massive stimulus is unlikely, please see BCA Geopolitical Strategy Special Reports, "China: How Stimulating Is The Stimulus?" Parts One and Two, dated 8 August 2018 and 15 August 2018, available at gps.bcaresearch.com GAA Asset Allocation

Special Report

Highlights The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. Feature Dear Client, This week, we are sending you a Special Report written by Ryan Swift, Chief Strategist of our sister publication, U.S. Bond Strategy. The report introduces an intriguing framework that directly links market expectations of changes in short-term interest rates to bond market returns for both U.S. Treasuries and U.S. spread product. We will extend the analysis to non-U.S. bond markets in a future Special Report to be published in late September. I trust you will find this report to be interesting and insightful. Best Regards, Rob Robis It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return &##BR##Fed Funds Rate Surprises (1990 - Present) Chart 3Treasury Index Price Return &##BR##Fed Funds Rate Surprises (1990 - Present) Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. Chart 5The 2017 Example The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. Chart 6Market Has Underestimated##BR##The Fed In Recent Years First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.59% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.36%. Table 2Treasury Index Total Return Forecasts Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.79%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 8Change In 2-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 9Change In 3-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 10Change In 5-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 11Change In 7-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 12Change In 10-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Chart 13Change In 30-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise Appendix B Chart 14Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios

Special Report

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com.

Dear Client, There will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on September 4th. Best regards, Ryan Swift Highlights Global Growth Divergences: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. But history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporates: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wages will exacerbate the problem, much like in the late 1990s. Municipal Bonds: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Feature "It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress." - Alan Greenspan, September 19981 Fed Chairman Alan Greenspan uttered the above sentence in early September 1998. Russia had just defaulted on its government debt and a few weeks later the heavily-exposed hedge fund Long-Term Capital Management would require a bail-out, kicking off a period of turmoil in U.S. financial markets. The Federal Reserve responded by cutting interest rates by 75 basis points between September 30th and November 4th, despite a domestic labor market that Chairman Greenspan described as "unusually tight." We recall this tumultuous period because a divergence between strong U.S. and weak non-U.S. growth is once again putting upward pressure on the U.S. dollar, leading to pain in emerging markets. So far it is the Turkish lira bearing the brunt of the sell-off, but the lesson from the late 1990s is that other EMs, and eventually the U.S., are also vulnerable. A joint Special Report, published last week, from our Foreign Exchange Strategy and Geopolitical Strategy services provides a blow-by-blow account of the late 1990s period, with implications for today's currency markets.2 In this week's report, we focus on what divergences between strong U.S. growth and weak non-U.S. growth mean for U.S. bond portfolios. A History Of False Starts The divergence between strong U.S. and weak non-U.S. growth is illustrated in Chart 1. The shaded regions in the chart correspond to periods when the Global (ex. U.S) leading economic indicator (LEI) is contracting while the U.S. LEI continues to rise. There have been 10 such episodes since 1966. In the four instances that occurred prior to 1993, the U.S. economy remained insulated from flagging growth in the rest of the world. That is, the U.S. LEI continued to expand and the Global (ex. U.S.) LEI eventually recovered into positive territory. However, since 1993, every time the Global (ex. U.S) LEI has dipped below zero the U.S. LEI has eventually followed. In other words, prior to 1993 the U.S. economy acted very much like an oasis of prosperity. But global events have become much more important since then. Chairman Greenspan's claim was correct in 1998 and remains relevant today. Case Study: 1997 Two of the post-1993 growth divergence episodes are particularly relevant for bond investors today. The first occurred in 1997 (Chart 2). The Fed tried to kick off a rate hike cycle in March 1997, but the combination of a Fed rate hike and weak foreign growth led to a surge in the dollar. Eventually, the strong dollar dragged our Fed Monitor below zero and the Fed was forced to abandon rate hikes until June 1999. In the interim, the Fed's dovish turn caused the dollar to halt its uptrend (Chart 2, panel 3). Treasury yields collapsed and then recovered (Chart 2, panel 4). Credit spreads moved in line with the exchange rate (Chart 2, bottom panel), widening alongside a stronger dollar in 1997/98, and then leveling off as the Fed eased policy and the dollar moved sideways. The end result of the 1997 episode is that Treasury yields took a round trip, falling as the Fed backed away from its rate hike path, then rising again once rate hikes resumed. Credit spreads, however, never fully recovered their 1997 tights. Case Study: 2015 More recently, growth divergences flared again in 2015 (Chart 3). This time, our Fed Monitor was already recommending rate cuts in late-2015, but the Fed pressed on and delivered the first rate hike of the cycle that December. Once again, the combination of a hawkish Fed and weak foreign growth put upward pressure on the dollar (Chart 3, panel 3), and the Fed was forced to pause its rate hike cycle. Chart 1The Weight Of The World Chart 2False Start 1997 Chart 3False Start 2015 Much like in 1997, Treasury yields declined as the Fed went on hold and then started to rise again as rate hikes resumed (Chart 3, panel 4). Also like 1997, credit spreads widened alongside the strengthening dollar, though this time they actually managed to tighten back to new lows when the Fed went on hold and the upward pressure on the dollar abated in 2016/17 (Chart 3, bottom panel). Implications For The Present Day Chart 4Inflation Is Much Closer To Target What lessons can we take away from these two episodes? The first is that if growth divergences continue to worsen and the dollar continues to appreciate, it will eventually cause our Fed Monitor to dip below zero and the Fed will likely pause its rate hike cycle. Such a dovish pause will lead to a decline in Treasury yields and a flattening-off, or even depreciation, of the dollar. However, we also know from history that any decline in Treasury yields is likely to prove fleeting. Once dovish Fed action takes the shine off the dollar, foreign economic growth will improve and the Fed will soon be able to resume rate hikes. This was the case in both 1997 and 2015. There is even reason to believe that any pause in Fed rate hikes could be particularly short-lived this time around. Inflation is already closing-in on the Fed's target and there is some evidence that long-dated inflation expectations have become stickier. Long-maturity TIPS breakeven inflation rates have not fallen much in recent weeks, even as weakening foreign growth has dragged down commodity prices (Chart 4). As for credit spreads, history shows that they are likely to widen as global growth divergences deepen and the dollar appreciates. Then, any pause in Fed rate hikes will improve credit's outlook for a time. Once again, because relatively strong inflation will limit the length of time that the Fed can pause lifting rates, we think any period of spread tightening that coincides with more dovish Fed policy will be short-lived. We also see similarities with the 1997 episode in terms of the outlook for corporate defaults. Such similarities bode ill for credit spreads, as is discussed in the next section. Bottom Line: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. However, history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporate Defaults: Look To The Late 1990s Considering the two case studies presented above, the reason corporate bonds performed worse in 1997 compared to 2015 is that in 1997 corporate leverage and defaults started to creep higher and did not peak until the 2001 recession. In contrast, corporate leverage flattened-off and defaults fell once the Fed paused its rate hike cycle in 2016 (Chart 5). Chart 5Corporate Defaults: The Late 1990s Roadmap Looking closer, the bottom panel of Chart 5 shows that once profit growth fell below the rate of debt growth in 1997 it continued to trend down. In 2015/16, profit growth was again dragged lower by the strong dollar, but it quickly rebounded once the Fed turned dovish. In our view, if global growth divergences continue to worsen and the dollar continues to strengthen, the next increase in corporate leverage will probably look more like 1997. To see why, we consider the two reasons why profit growth decelerated in 1997. The first is the obvious reason that the strong dollar started to weigh on corporate revenues. The growth in business sales moderated and the PMI dipped below 50 (Chart 6). Today, we have not yet seen enough dollar strength to weigh on business sales or the manufacturing PMI, which is still hovering around 60 (Chart 6, bottom panel). But this will change as the emerging market turmoil spreads and eventually impacts the U.S. business sector. The second reason why the 1997 corporate default episode is the most comparable to the present day is that much like in 1997, but unlike in 2015, the labor market is extremely tight and wages are starting to accelerate (Chart 7). The growth in unit labor costs started to outpace the growth in corporate selling prices in 1997, and this caused our Profit Margin Proxy to fall (Chart 7, panel 2). At present, our Profit Margin Proxy is very close to the zero line, but with a sub-4% unemployment rate further downside is likely. Finally, much like in 1997, small businesses are increasingly citing labor quality as a more important problem than lack of sales (Chart 7, bottom panel). The difference between the rankings of these two problems has done a good job tracking profit growth historically. This indicator is currently at levels that are much more reminiscent of the late 1990s. Chart 6Dollar Strength Drags Down Revenue Chart 7Wages Will Weigh On Profits Bottom Line: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wage growth will exacerbate the problem, much like in the late 1990s. Take Shelter In Municipal Bonds Chart 8Munis As A Safe Haven Another implication of the divergence in growth between the U.S. and the rest of the world is that fixed income sectors that are more exposed to the domestic U.S. economy and less exposed to foreign growth and the exchange rate should fare better. In this regard, municipal bonds are an obvious candidate. While state & local government net borrowing has flattened off at a relatively high level during the past few quarters, state governments have recently re-committed to austerity (Chart 8). Data from the National Association of State Budget Officers show that states enacted a net $9.9 billion increase in revenues in fiscal year 2018, with another $2.8 billion planned for fiscal year 2019. Historically, revenue raises of this magnitude have led to declines in net borrowing, which should ensure that municipal ratings upgrades continue to outpace downgrades for the time being (Chart 8, bottom panel). But there's an even better reason for investors to favor municipal bonds. Quite simply, yields remain attractive compared to the riskier corporate alternatives, particularly at longer maturities. The top section of Table 1 shows relevant statistics for the 5-year, 10-year and 20-year tax-exempt Bloomberg Barclays Municipal bond indexes, along with the closest comparable indexes from the investment grade corporate sector. We observe that a 5-year Aa-rated municipal bond carries a yield of 2.18% versus a yield of 3.26% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 33% should be indifferent between the two bonds. Any investor exposed to an effective tax rate above 33% should favor the municipal bond, even before considering the differences in risk between the two sectors. Moving further out the curve, the breakeven tax rate falls to 24% at the 10-year maturity point and to either 13% or 21% at the 20-year maturity point, depending on whether you use Aa-rated or A-rated corporate debt as the relevant comparable. We also find that High-Yield municipal debt looks attractive compared to the corporate alternative. The Bloomberg Barclays High-Yield Muni Index (excluding Puerto Rico) trades at a breakeven tax rate of 18% relative to a Ba-rated corporate bond, and 33% relative to a B-rated corporate bond. Even the taxable municipal space is attractive. The bottom section of Table 1 shows that the average yield on the 1-5 year taxable municipal bond index is slightly higher than that of the closest comparable corporate bond index. The same goes for the 5-10 year taxable muni index. Table 1A Comparison Of Municipal And Corporate Bond Yields Finally, drawing on work we presented in a recent Special Report, we provide total return forecasts for different municipal bond indexes along with the comparable corporate sector indexes (Table 2).3 We show results for three different effective tax rates, depending on how many rate hikes you expect from the Fed during the next 12 months and whether you expect Municipal / Treasury yield ratios to remain flat, widen to their post-2016 highs, or tighten to their post-2016 lows. Table 2Municipal Bonds Total Return Forecasts Vs. Corporate Sector Comparables For example, in an environment where the Fed delivers four rate hikes during the next 12 months and Municipal / Treasury yield ratios remain flat, an investor with a 24% effective tax rate can expect a total return of 2.81% from the 10-year Municipal bond index. If we adjust returns using the top marginal tax rate of 37% the expected total return rises to 3.52%. In the same scenario, where corporate spreads also remain flat, investors can expect a total return of 2.86% from a corporate bond with similar duration and credit rating. Bottom Line: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/speeches/1998/19980904.htm 2 Please see Foreign Exchange Strategy / Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Dear client, Our publishing schedule will be shifting over the next two weeks. Next Friday, we will publish a Special Report aggregating various pieces from our colleague Matt Gertken of BCA's Geopolitical Strategy detailing the reforms taking place in China and their past and future evolution, and the economic and investment implications for China and the rest of the world. Matt argues that Chinese reforms are in place and here to stay, which should deepen the malaise in EM and support the dollar. We will not publish any report on August 31st. We will resume our regular publishing schedule on September 7. I hope you enjoy the rest of your summer. Best regards, Mathieu Savary Highlights The 1997 Asian Crisis was a deflationary event, causing commodity prices, commodity currencies and the yen to fall against the dollar, but it had a limited impact on the euro. When Russia collapsed in 1998, the LTCM crisis hit the U.S. banking system, with fears of solvency dragging Treasury yields lower, hurting the dollar against the yen and the euro. Today is not 1997, but the tightness of the U.S. economy suggests the Federal Reserve will need a large shock before abandoning its current pace of a hike per quarter; additionally, global liquidity conditions are tightening and China is slowing. The EM crisis is therefore not over, and vulnerable Brazil, Chile, Mexico, Colombia and South Africa could still experience significant pain. Unlike in 1998, the hot potato is not hiding in the U.S. but in Europe. A contagion event is therefore more likely to hurt the euro than 20 years ago; meanwhile, the yen stands to benefit. DXY could hit 100, and commodity currencies still have ample downside, the AUD in particular. Continue to monitor our China Play Index to gauge if Chinese stimulus could delay the day of reckoning for EM; this index can also be employed as a hedge for investors long the dollar or short EM plays. Feature "Misfortune tests the sincerity of friends." - Aesop This summer is oddly reminiscent of that of 1997. The Federal Reserve is tightening policy because the U.S. economy is not only at full employment but is also growing strongly and generating increasing domestic inflationary pressures. But the most familiar echoes come from outside the U.S. Specifically, emerging market trepidations are once again front page news as the Turkish lira, which had already fallen by 24% between January 2018 and July 31st, dropped by an additional 28% at its worst in a mere two weeks. Consequently, investors are now fretting about the risks of contagion across EM markets, one that could reverberate among G10 economies as well. We too worry that the echoes of 1997 are becoming increasingly louder. EM economies have built up large stocks of debt, and have financed themselves heavily by tapping foreign investors. However, these investors can be rather fickle friends, and we are set to test their sincerity. In this piece, we review how the events of 1997-'98 unfolded, what it meant for G10 currencies, and whether the same lessons can be applied today. We find that in 2018, an EM crisis could ultimately be more supportive for the dollar versus the euro, as unlike in 1998, where the hot potatoes were held by U.S. hedge funds, this time the mess sits squarely in Europe. Tom Yum Goong Goes Viral Initiated in the second half of the 1980s, the peg of the Thai baht seemed like a very successful experiment. The stability created by this institutional setup not only contributed to keeping Thai inflation at manageable levels, but by incentivizing capital inflows in the country it also helped Thailand build up its capital stock. At the time, this yielded a large growth dividend, with real GDP growth averaging 9% from 1985 to 1996. However, the economic boost generated by this cheap financing had a dark side. The Thai current account balance ballooned to a deficit of 8% of GDP in 1995-'96. As Herb Stein famously expressed, if something cannot go on forever, it will stop. Like in Aesop's fable where one of two travelers climbed up a tree to avoid a bear, leaving his friend to fend off the bear on his own, foreign investors abandoned Thailand, which was left on its own to finance its large current account deficit. While the Bank of Thailand was able to fend off the attacks for a few weeks, on July 2nd, 1997, it abandoned its efforts. The THB was left to float freely and dropped 56% against the USD over the subsequent six months. Other EM countries including Malaysia, Brazil and Korea, to name a few, had implemented similar U.S. dollar pegs. They too enjoyed stable inflation, growing money inflows and improved growth, but also experienced growing current account deficits and foreign currency debt loads. It did not take long for investors to extrapolate Thailand's woes to other countries. The Malaysian ringgit and the Indonesian rupiah began falling soon after the THB, while the Korean won began its own steep descent four months later (Chart 1). The economic pain was felt globally. The collapse in EM Asian exchange rates and the deep recessions experienced in these countries caused their export prices to collapse, which created a global deflationary shock (Chart 2). This shock was compounded by a fall in commodity prices that materialized as market participants realized that demand for commodities from the crisis-stricken countries was set to evaporate (Chart 2, bottom panel). Chart 1How The Thai Crisis Morphed Into An Asian Crisis Chart 2The Asian Crisis Was A Deflationary Shock Not only did this deflationary shock lift the USD against EM currencies and commodity currencies, it also caused inflation breakevens in the U.S. to fall significantly (Chart 3). However, because the U.S. economy remained robust through the second half of 1997 and in the early days of 1998, real rates did not respond much (Chart 3, bottom panel). Markets where not very concerned that this shock would force the Fed to cut rates, as it did not seem to affect the outlook for U.S. growth and employment. However, this combination of stable real rates in the face of weaker growth in EM, as well as the collapse in commodity prices ended up having large second-round effects. Russia defaulted in August 1998, prompting a collapse in the ruble. To patch up its finances, Russia began pumping ever more oil out of the ground, causing oil prices to fall below US$10/bbl in December 1998, deepening the malaise in commodity prices. This caused the Brazilian real to collapse in 1999, and the Argentinian peso to follow in 2002 (Chart 4). Chart 31997: Falling Breakevens, Stable Real Yields Chart 4Asian Crisis Goes Global Among these contagions, the Russian default was the event with the greatest systemic impact. This was because it was a direct hit to the U.S. banking system. Long Term Capital Management, a large Connecticut-based hedge fund, had accumulated massive bets on Russia. The country's default plunged the fund into the abyss. However, LTCM had liabilities to banks to the tune of US$125 billion. The exposure was perceived as an existential threat to the banking sector, and the market began to anticipate a repeat of the 1907 panic.1 Junk bond spreads jumped, the S&P 500 fell by 18%, and U.S. government bond yields collapsed by 120 basis points (Chart 5). The Fed was forced to respond, coming out of hibernation and cutting rates by 75 basis points between September and November of 1998. As the Fed forcefully responded to this shock and 10-year Treasury yields fell, the dollar, which had managed to stay somewhat stable against the synthetic euro from July 1997 to August 1998, fell 11%. Within the same one-year window starting in July 1997, the yen dropped 23%, dragged lower by the competitive pressures created by weaker Asian currencies. However, as soon as U.S. bond yields collapsed, the yen began to surge, rising by 36% from August 1998 to January 1999 (Chart 6). Only once the Fed started increasing rates anew did the euro and the yen level off. Chart 5The Russian Default Was The Real Shock For The U.S. Chart 6The Dollar Buckled After LTCM In aggregate, the dollar's performance through the 1997-1998 period was very mixed. The trade-weighted dollar managed to rise from July 1997 to August 1998. Nevertheless, this was a complex picture. During this timeframe the dollar rose against EM currencies - against the CAD, the AUD, the NZD and the JPY - but was flat against the euro. The USD then fell against everything from August 1998 to the first half of 1999. Only once the Fed started hiking again in the summer 1999, was the greenback able to resuming its broad ascent, one that lasted all the way until late 2001. Bottom Line: In 1997, the first domino to fall was Thailand. Since many East Asian economies suffered the same ills - current account deficits, foreign currency debt loads and falling foreign exchange reserves - Asian currencies followed, dragging the yen lower in the process. This generated a deflationary shock that hurt commodity prices and commodity currencies, leading to the infamous Russian default of 1998. The associated LTCM bankruptcy threatened the survival of the U.S. banking system, forcing bond yields much lower as the Fed cut rates three times. The dollar suffered because of this policy move, especially against the yen. However, once the Fed resumed its hiking campaign, the dollar recovered across the board, making new highs all the way to late 2001 and early 2002. Is 2018: 1997, 1998, Or 2018? In one key regard, today is not the late 1990s: Dollar pegs are few and far between. However, in many respects, similarities abound. First and most obviously, EM foreign currency debt loads, as measured against exports, GDP or reserves, are at similar levels to those prevailing in the late 1990s (Chart 7). This means that EM economies suffer when the dollar rises, as it represents an increase in their cost of capital, and thus a tightening in financial conditions. Second, the Fed has been increasing interest rates. Most importantly, the Fed is growingly concerned that domestic inflationary pressures in the U.S. are intensifying, courtesy of strong growth - at least relative to potential; a high degree of capacity utilization, especially in the labor market (Chart 8); and, unique to today, the U.S. has received a large degree of unneeded fiscal stimulus. Chart 7EM Dollar Debt Is High EM Have More ##br##Foreign-Currency Debt Than In The 1990s Chart 8The Foreign Pain Threshold For The Fed Is Much Higher ##br##Now Than In 2015 or 2016 This means it will take a lot of pain to derail the Fed from its desire to hike rates once a quarter. This also makes the current environment very different from 2015, the most recent episode of EM tumult. In 2015-2016, the Fed easily abandoned its hiking campaign. When it hiked rates in December 2015, the Fed anticipated increasing rates four times over the following 12 months. It delivered only one hike in December 2016. The reason was straightforward: Unlike today, the U.S. economy was still replete with slack (Chart 8) and was not on the receiving end of a large fiscal stimulus program, suggesting the Fed could not tolerate the deflationary impact of tightening financial conditions. Third, global liquidity is tightening, which is hurting the global growth outlook. Today, global excess money, as defined by the growth of broad money supply above that of loan growth in the U.S., the euro area and Japan, is contracting. Today, as in 1997, this indicator forebodes important weaknesses in global industrial production (Chart 9). U.S. liquidity is particularly important. Not only is dollar-based liquidity crucial to financing the large stock of dollar-denominated foreign debt, but the U.S. is also driving the fall in global excess money. The pick-up in U.S. economic activity is sucking liquidity from both the rest world and from the financial system to finance U.S. loan growth (Chart 10). This phenomenon was also at play in 1997. Chart 9Excess Money Is Contracting Global Excess ##br##Money Contracting, Just Like In Early 1997 Chart 10The U.S. Economy Is ##br##Sucking In Liquidity Why does this matter? Simply put, U.S. financial liquidity; built as a composite of 3-month T-bills, total bank deposits minus bank loans, bank investments, and M2 money supply; is a wonderful leading indicator. The current collapse in financial liquidity suggests that the global economy is about to hit a rough patch. As Chart 11 illustrates, the weakness of this indicator points to declines in our Global Leading Economic Indicators and in global commodity prices. This suggests the indicator is foretelling that a deflationary scare could materialize, an event normally also associated with a stronger dollar and downside in EM export prices (Chart 12). In a logically consistent fashion, the liquidity indicator is also warning that the AUD, CAD and NZD have substantial downside, while EM equity prices could also suffer more (Chart 13). Finally, it also highlights that even the U.S. stock market may not be immune to upcoming troubles (Chart 14). Chart 11U.S. Financial Liquidity Points To Weaker Growth... Chart 12...And A Stronger Dollar But Weaker EM Export Prices... Chart 13...Falling EM Stocks And Commodity Currencies... Chart 14...And Maybe Even A Correction In U.S. Stock Prices Fourth, gold is sending a similar signal as in the late 1990. As we have argued in the past, gold is a very good gauge of global liquidity conditions. During the Asian Crisis and the Russia/LTCM fiasco, industrial commodity prices only experienced a serious decline after the Thai baht had dragged down Asia into a tailspin. However, gold had been falling since 1996, a move predating the fall in Asian currencies (Chart 15). The precious metal was confirming that global liquidity was tightening and being sucked back into the booming U.S. economy. Today, gold prices are sending an ominous signal. After forming a large tapering wedge from 2011 to 2018, gold prices have broken down below the major upward-sloping trend line that had defined the bull market that began in 2001 (Chart 16). This indicates that gold may be starting another leg of a major bear market. Moreover, as the bottom panel of Chart 16 illustrates, it is true that net speculative positions in the yellow metal have plunged, but they remain far above the large net short positions that prevailed in the late 1990s. If gold is indeed entering another major down leg, this would confirm that tightening liquidity will further hurt EM asset prices, commodity prices and non-U.S. economic activity. Chart 15As Early As 1996, Gold Warned Of Upcoming Problems In Asia Chart 16Is A Secular Bear Market In Gold Beginning? Finally, adding insult to injury is China. The current communist party leadership is hell-bent on reforming the Chinese economy, moving it away from its dependence on capex and leverage. Consequently, China is in the midst of a major deleveraging campaign concentrated in the shadow banking sector, which has already caused money growth and total social financing to plumb to new lows (Chart 17). This is deflationary for the global economy as weaker Chinese credit weighs on capex, which in turns weighs on Chinese imports, as 69% of China's intake from the rest of the world are commodities and intermediate as well as industrial goods. Chart 17Chinese Monetary And Credit Conditions Remain ##br##Tight China Deleveraging Is Biting Chart 18No Capitulation ##br##Yet Moreover, the recent wave of renminbi weakness is exacerbating these deflationary pressures. The 9% fall in the yuan versus the dollar since April 11th represents a competitive devaluation that will hurt many EM countries. It also implies downside in China's import volumes, as it increases the prices paid by Chinese economic agents for foreign-sourced industrial goods and commodities.2 All these forces suggest that the pain that started in Argentina and Turkey could continue to spread across other vulnerable EM economies. It is doubtful that economies with large debt loads, large upcoming debt rollovers and other underlying economic problems will find it easy to receive financing in an environment of declining global liquidity, a strong dollar, budding deflationary pressures and a slowing China. Making this worry even more real, EM investors have not capitulated, as bottom-fishing has prompted massive inflows into Turkey in recent days (Chart 18). 2018 may not be 1997 or 1998, but it is likely to be a year to remember. Bottom Line: EM currency pegs to the dollar may not be as prevalent as they were back in the 1990s, but enough risks are present that contagion from Argentina and Turkey to other EM economies is a very real risk. Specifically, the domestic economic situation in the U.S. warrants higher interest rates, which suggests the Fed is unlikely to be fazed by EM market routs unless they become deep enough to present a threat to U.S. growth itself. Moreover, global liquidity conditions are tightening as the U.S.'s economic strength is sucking in capital from around the world. This combination means that EM countries with large dollar debt loads are likely to find debt refinancing a very onerous exercise. Finally, China is slowing and letting the RMB fall, which is exerting a deflationary impact on the world. Investment implications An environment of slower global economic activity, tightening global liquidity conditions and a potential deflationary scare is positive for the dollar. But 1998 shows that if the hot potato hides in the U.S. and the Fed is forced to ease aggressively, the dollar could nonetheless suffer. In order to get a sense as to whether the dollar can continue to strengthen or not, it is important to get a sense of where the exposure to an EM accident may lie. To begin this exercise, we need to first assess which EM countries are most vulnerable to catching the "Turkish Flu." To do so, we collaborated with our colleague Peter Berezin and his team at BCA's Global Investment Strategy to build a heat map of vulnerable EM economies. This heat map is based on the following factors: current account balance, net international investment position, external debt, external debt service obligation, external funding requirements, private sector savings/investment balance, private sector debt, government budget balance, government debt, foreign ownership of local currency bonds, and inflation. This method shows that after Turkey and Argentina, the next six most vulnerable countries are Colombia, Brazil, Mexico, Chile, South Africa, and Indonesia in this order (Chart 19). Chart 19Vulnerability Heat Map For Key EM Markets While our long-term valuation models show that the Colombian peso is already trading at a significant discount to its fair value, the BRL, the CLP, the ZAR, and the MXN are not (Chart 20). This highlights that these markets could provide serious fireworks in the coming months. Moreover, they all have their own idiosyncrasies that accentuate these risks. Brazil will soon undergo elections that will likely not result in a market-friendly outcome.3 Chile has an extremely large dollar-debt load, copper prices are tanking and the CLP is very pricey. Finally, South Africa is contemplating the kind of land expropriations reminiscent of those that plunged Zimbabwe into chaos - not a good optic for a still-expensive currency. So, who is most exposed to this potential mess? The answer is the euro area, most specifically, Spain. As Chart 21 shows, the exposure of Spanish banks to the most vulnerable EM markets totals nearly 170% of the banking system's capital and reserves. This means that 30% of the capital and reserves of the banking systems in the euro area's five largest economies is exposed to these markets. Making the risk even more acute, French banks have large exposure to Spain, and German banks to France. This combined exposure dwarfs the exposure of the U.K., Japan or the U.S. to the most vulnerable EM economies. To be fair to Spain, Spanish banks often have set up their foreign affiliates as separate legal entities. This means that the impact on the balance sheets of the Spanish banking system of defaults in vulnerable EM countries may be more limited than seems at face value. Yet, this is far from certain. Chart 20BRL, CLP, ZAR, And MXN Are Too Expensive##br## In Light Of Their Vulnerabilities Chart 21Who Has More Exposure To EM? As a result, we would not be surprised if the European Central Bank is forced by an EM accident to back away from its desire to abandon its extraordinary accommodative stance. The ECB would first use forward guidance to message that a hike will be delayed ever further in the future. The ECB may even be forced to resume government and corporate bonds purchases past 2018. This is a potential nightmare scenario for the euro. In fact, as Chart 22 illustrates, a euro at parity may not be a far stretch. Historically, the euro bottoms when it trades 10% below our fair value model, based on real short rate differentials, relative yield curve slopes and the ratio of copper to lumber prices. Such a discount would correspond to EUR/USD at parity. Because under such circumstances the Fed could be forced to pause its own hiking cycle for a quarter or two, a move to EUR/USD between 1.10 and 1.05 seems more likely than a collapse to parity right now. This also means that in conjunction with BCA's Geopolitical Strategy team, we recommend our clients close overweight positions in Spanish assets. Chart 22The Euro Still Has Downside If EM Go Bust What about the yen? In the late 1990s, the yen fell against the U.S. dollar as Asian currencies were collapsing, but surged once the Fed backtracked and bond yields tanked in 1998. This time could follow a different road map. Japan does not compete against Brazil, Colombia, Mexico, Chile and South Africa in the same way as it was competing against industrial companies in countries like Taiwan, Singapore or South Korea. This means that Japan is unlikely to need to competitively devalue to remain afloat if the BRL, COP, MXN, CLP and ZAR collapse further. However, since an EM shock is likely to prove to be a deflationary event, this means that bond yields could experience downside, especially as positioning in the U.S. bond market is massively crowded to the short side (Chart 23). A countertrend bull market in bonds would greatly flatter the yen. As a result, we are maintaining our short EUR/JPY bias over the coming months. The G10 commodity currency complex is also at risk. Not only does tightening dollar liquidity imply further weakness in this group of currencies, so does slowing EM activity and a deflationary scare. Additionally, the CAD and the NZD are not trading at much of a discount to their fair value, and the AUD trades at a premium (Chart 24). This means we would anticipate these currencies to suffer more in the coming quarters, led by the AUD, which is not only the most expensive of the group, but also the most geared to EM economic activity. Being short AUD/CAD still makes sense. Chart 23A Bond Rally Would ##br##Support The Yen Chart 24TDollar-Bloc Currencies Offer Limited Cushion##br## In The Event of An EM Selloff Finally, the pound is its own animal. GBP/USD is now quite cheap, but the U.K.'s large current account deficit of 3.9% of GDP, which is not funded through FDIs anymore, means that Great Britain remains vulnerable to tightening global liquidity conditions. Moreover, Brexit negotiations will heat up in the fall, as the March 2019 deadline for reaching a deal with the EU looms large. This means that political tumult in the U.K. will remain a large source of risk for the pound. We will explore the outlook for the pound in an upcoming report this September. Currently, our long DXY trade is posting an 8.5% profit, with a target at 98. The above picture suggests that the dollar could move well past 98, especially as the momentum factor that is so important to the greenback still plays in favor of the USD.4 As a result, we are upgrading our target on the dollar to 100. However, we are also tightening our stop loss to 94.88. We will update our stop loss to 97 if the DXY hits 98 in the coming weeks, in order to protect gains while still being exposed to the dollar's potential upside. Bottom Line: Beyond Turkey and Argentina, the EMs most vulnerable to tightening global liquidity conditions are Brazil, Colombia, Mexico, Chile and South Africa. Spanish banks have outsized exposure to these markets, which means the euro area is at risk if the "Turkish Flu" becomes contagious. As such, the ECB could be forced to remain easier than it wants to. The euro is still at risk. The yen could strengthen if global bond yields suffer. Hence, it still makes sense to be short EUR/JPY. While the CAD, AUD and NZD are also all vulnerable to a deflationary scare, the Aussie is the worst positioned of the three. Shorting AUD/CAD still makes sense. The DXY is likely to experience significant upside from here, with a move to 100 becoming an increasingly probable scenario. Risks To Our View Chart 25A Gauge And A Hedge Against Chinese Stimulus The biggest risk to our view is China. In 2016, a vicious EM selloff was staunched by a large wave of stimulus that put a floor under Chinese economic activity, and caused China to re-lever. The impact was felt around the world, lifting commodity prices and EM assets while plunging the dollar into a vicious selloff in 2017. It is conceivable that such an outcome materializes anew, especially as China is, in fact, injecting stimulus into its economy. However, as we wrote two weeks ago, the current stimulus still pales in comparison to what took place in 2015. Moreover, reforms and deleveraging have much greater primacy now than they did back then.5 BCA believes that the current wave of stimulus is not designed to cause growth to surge again, as was the case in 2015, but is instead aimed at limiting the negative impact of the ongoing trade war with the U.S. Yet, we cannot be dogmatic. Not only is it hard to gauge the actual degree of stimulus currently applied to the Chinese economy, there is a heightened risk that the flow of policy announcements causes a shift in the dominant narrative among market participants. Such a shift in attitudes could easily cause a mass buying of EM assets and commodities, delaying the day of reckoning for vulnerable EM. As a result, we continue to promulgate that investors track the behavior of our China Play Index, introduced two weeks ago (Chart 25).6 Not only does this index provide a live read on how traders are pricing in Chinese developments, but it also provides a great hedge for investors long the dollar, short EM, or short the commodity complex. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 In the panic of 1907, the Knickerbocker Trust Company went bankrupt, threatening the health of the U.S. banking system. The stock market crashed, money markets went into paralysis, and a consortium of bankers led by J.P. Morgan himself ended up acting as a lender of last resort, staunching the crisis. As a consequence of this panic, the Federal Reserve System was born in 1913. 2 For a more detailed discussion of the deflationary risk created by the RMB, please see Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World", dated June 29, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Special Report, "Brazil: Faceoff Time", dated July 27, 2018, available at ems.bcaresearch.com 4 Please see Foreign Exchange Strategy Special Report, "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 5 Please see Foreign Exchange Strategy Weekly Report, "The Dollar And Risk Assets Are Beholden To China's Stimulus", dated August 3, 2018, available at fes.bcaresearch.com 6 Ibid. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades