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Highlights Chart 1Contagion? Until last week, global growth weakness had been wholly confined to the manufacturing sector. But the drop to 52.6 in September’s Non-Manufacturing PMI (from 56.4 in August) raises the specter of contagion from manufacturing into the broader U.S. economy. A further drop would be consistent with an economy headed toward recession, and run contrary to the 2015/16 roadmap that has been our base case (Chart 1). We think it is still premature to abandon the 2015/16 episode as an appropriate comparable for the current period. For one thing, the hard economic data paint a rosier picture than the PMI surveys. Industrial production and core durable goods new orders are up 2.5% and 2.3% (annualized), respectively, during the past 3 months. These data have helped drive the economic surprise index above zero, an event that usually coincides with rising yields (bottom panel). The divergence between soft and hard data makes it clear that trade uncertainties are so far having a greater impact on business sentiment than on actual production, but history tells us that these divergences don’t last long. Some positive news on the trade front will be required during the next few months to raise business sentiment and push bond yields higher. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 42 basis points in September, before giving back 37 bps in the first week of October. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions, and (iii) valuation. At present, the chief conundrum for investors is that while corporate balance sheet health is weak, the monetary environment is extraordinarily accommodative.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still very low, the Fed can maintain its “easy money” policy for some time yet. This will ensure that interest coverage stays solid and that bank lending standards continue to ease (bottom panel). This is an environment where corporate bond spreads should tighten. How low can spreads go? Our assessment of reasonable spread targets for the current environment suggests that Aaa, Aa and A-rated spreads are already fully valued, while Baa-rated spreads are 13 bps cheap (panels 2 & 3).2 We recommend focusing investment grade corporate bond exposure on the Baa credit tier, and subbing some Agency MBS into your portfolio in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in September, before giving back 117 bps in the first week of October. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 171 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, before giving back 25 bps in the first week of October. MBS have underperformed Treasuries by 31 bps, year-to-date. The conventional 30-year zero volatility spread held flat at 82 bps in September, as a 3 bps increase in expected prepayment losses (option cost) was offset by a 3 bps tightening in the option-adjusted spread (OAS). In last week’s report, we recommended favoring Agency MBS over Aaa, Aa and A-rated corporate bonds.6 We have three main reasons for this recommendation. First, expected compensation is competitive. The conventional 30-year MBS OAS is now 57 bps. This is above the pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. Aaa, Aa and A-rated corporate bond spreads also all look expensive relative to our targets. Second, risk-adjusted compensation heavily favors MBS. The 12-month breakeven spread for a conventional 30-year MBS is 21 bps. This compares to 6 bps, 8 bps and 12 bps for Aaa, Aa and A-rated corporates, respectively. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgage. This burnout will keep refi activity low, and MBS spreads tight (panel 2), going forward. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +163 bps. September returns were concentrated in the Foreign Agency sub-sector. These securities outperformed the Treasury benchmark by 55 bps on the month, bringing year-to-date excess returns up to +197 bps. Sovereign bonds underperformed duration-equivalent Treasuries by 6 bps in September, dragging year-to-date excess returns down to +436 bps. Local Authority and Domestic Agency debt underperformed by 1 bp and 2 bps on the month, respectively. Meanwhile, Supranationals bested the Treasury benchmark by a single basis point. Sovereign debt remains very expensive relative to equivalently-rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would also perform well in such an environment. Given the much more attractive starting point for U.S. corporate bond spreads, we find it difficult to recommend sovereign debt as an alternative. While sovereign debt in general looks expensive. USD-denominated Mexican sovereign bonds continue to look attractive relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 10 basis points in September, dragging year-to-date excess returns down to -57 bps (before adjusting for the tax advantage). We recommended upgrading municipal bonds from neutral to overweight in last week’s report.7  We based the decision on the increasing attractiveness of yield ratios, despite an underlying credit environment that remains supportive for munis. Municipal bond yields failed to keep pace with falling Treasury yields in recent months, and now look quite attractive as a result (Chart 6). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 4% in September and is now back above 90%. This is well above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. In fact, Aaa M/T yield ratios for every maturity are now above average pre-crisis levels. Though yield ratios still look best at the long-end of the Aaa curve (panel 2), we now recommend owning munis in place of Treasuries across the entire maturity spectrum. Fundamentally, state & local government balance sheets remain solid. We showed in last week’s report that our Municipal Health Monitor is in “improving health” territory, and noted that state & local government interest coverage is positive (bottom panel). Both of those trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in September, and then bull-steepened sharply last week. All in all, the 2/10 Treasury slope is +12 bps, 12 bps steeper than it was at the end of August. The 5/30 slope is +67 bps, 10 bps steeper than at the end of August. Our fair value models (see Appendix B) continue to show that bullets are expensive relative to barbells across the entire Treasury curve. In particular, 5-year and 7-year maturities look very expensive compared to the short and long ends of the curve. Notice that the 2/5/10 butterfly spread, the spread between the 5-year bullet and a duration-matched 2/10 barbell, remains negative despite the recent 2/10 steepening (Chart 7). We have shown in prior research that the 5-year and 7-year maturities are the most highly correlated with our 12-month Fed Funds Discounter. Our discounter is currently at -74 bps, meaning that the market is priced for nearly three more Fed rate cuts during the next 12 months (top panel). We expect fewer cuts than that, and as such, think the Discounter is more likely to rise. 5-year and 7-year maturities would underperform the rest of the curve in that scenario. We also continue to hold our short position in the February 2020 fed funds futures contract. That contract is currently priced for 2 more rate cuts during the next 3 FOMC meetings. That outcome is possible, but our base case economic outlook is more consistent with 1 further cut, likely occurring this month. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 38 basis points in September, dragging year-to-date excess returns down to -142 bps. The 10-year TIPS breakeven inflation rate fell 3 bps in September, and then another 2 bps last week. It currently sits at 1.51%, well below levels consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low, nowhere near the 2.3% - 2.5% range that is consistent with the Fed’s target. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.8 That being said, the 10-year TIPS breakeven inflation rate is currently 43 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and we maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in September, dragging year-to-date excess returns down to +72 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 36 bps, very close to its minimum pre-crisis level (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries on a 12-month horizon. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in September, bringing year-to-date excess returns up to +227 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS held flat on the month, before widening 4 bps last week. It currently sits at 75 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 2 basis points in September, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread held flat on the month, before widening by 5 bps last week. It currently sits at 61 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 74 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of October 4, 2019) Table 5Butterfly Strategy Valuation: Standardized Residuals (As of October 4, 2019) Table 6 Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the 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 of excess return. Chart 12Excess Return Bond Map (As Of October 4, 2019) Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

ハイライト 世界の製造業サイクルはまもなくボトムに達する公算が大きく、消費とサービスは依然として堅調です。今後12か月の景気後退リスクは低く、これは株式が債券より引き続きアウトパフォームすることを示唆しています。 しかし、この楽観的なシナリオに対するリスクは高まっています。消費者信頼感の低下や地政学的緊張の悪化はリスク資産に打撃を与える可能性があります。我々はこれをヘッジするためにキャッシュをオーバーウェイトしています。 中国は現時点では積極的な金融緩和の使用に及び腰です。中国が動くまでは、景気循環性が低い米国株式市場がアウトパフォームするはずです。 中国が景気刺激を本格化させ、製造業サイクルが明確にボトムを打ったときに、新興市場（EM）および欧州株へシフトする可能性があります。この上振れリスクをヘッジするために、我々はファイナンシャルズを戦術的にオーバーウェイトとし、またインダストリアルズのオーバーウェイトとオーストラリアのニュートラルを再確認します。 債券利回りはリバウンドを継続するはずです。デュレーションをアンダーウェイトとし、TIPSを優先します。クレジットは景気循環の視点ではアウトパフォームするはずですが、企業の高負債はリスクですのでニュートラルを推奨します。 推奨 四半期ポートフォリオ見通し：全面的なヘッジ 四半期ポートフォリオ見通し：全面的なヘッジ   特集 概要 万全のヘッジ 世界経済にとって特に不確実な時期であり、資産配分担当者にとっては悩ましい局面です。製造業の活動はまもなく底打ちするのか、それともサービス部門や消費を巻き込んで下押しするのか。債券利回りは強いリバウンドを続けるのか。米連邦準備制度理事会（Fed）は利下げを終了したのか。中国は今や積極的に金融刺激を拡大するのか。イランはサウジアラビアとの対立を激化させるのか。トランプ大統領は次に何をツイートするのか。 こうした環境ではポートフォリオ構築の手腕が試されます。我々はこれらすべての問いについて見解を持っていますが、確信度は通常よりやや低めです。投資家が取るべき対応は、最も起こりそうなシナリオすべてにおいてポートフォリオが強靭であるように資産配分を計画することです。 我々は世界の製造業サイクルがまもなくボトムに達すると予想しています。グローバル先行経済指標はすでに回復しており、グローバルPMIも底打ちの兆候を示しています（チャート 1）。最短期の先行指標であるシティグループ経済サプライズ指数は、欧州を除くすべての地域で最近急上昇しました（チャート 2）。（サイクル底のより風変わりな指標については、7ページのクライアントが尋ねていることも参照してください。）底打ちの要因は、この9か月間の金融環境の緩和、 中国成長の安定化、そして単純に時間の経過です。製造業サイクルの下落局面は典型的に18か月続き、このサイクルは2018年上半期にピークをつけました。 チャート 1底打ちの最初の兆候 底打ちの最初の兆し 底打ちの最初の兆し チャート 2予想外に強いサプライズ 驚くほど強いサプライズ 驚くほど強いサプライズ     同時に、国債利回りはさらに上昇余地があるはずです。Fedはあと一度利下げする可能性がありますが、米国経済の堅調さを踏まえるとそれ以上にはならないでしょう。これはフェドファンド先物が織り込んでいる今後12か月の59ベーシスポイントの利下げよりも小さい幅です。最近の経済サプライズの持ち直しは、米10年国債利回りが少なくとも6か月前の水準である2.3～2.4％に戻ることを示唆しています（チャート 3）。ただし、例えば米中貿易協議の破綻のような政治的緊張の高まりがあると、この動きは遅れる可能性があります（チャート 4）。 チャート 3長期金利はさらにリバウンドへ... 長期金利、さらに反発へ... 長期金利、さらに反発へ... チャート 4...しかし地政学的緊張は依然リスク ...しかし地政学的緊張は依然としてリスクである ...しかし地政学的緊張は依然としてリスクである これは、今後数四半期にわたり株式が債券をアウトパフォームし続ける可能性が高いことを意味し、我々は12か月の投資期間でグローバル株式をオーバーウェイト、グローバル債券をアンダーウェイトの立場を維持しています。ただし、この明るいシナリオに対するリスクは増しています。我々は第二次世界大戦以降、ほぼ18か月前にほぼすべての景気後退を的中させてきたイールドカーブの逆イールド化を依然として懸念しています（チャート 5）。3か月/10年のカーブは今年中頃に逆イールド化しました。また、製造業部門の弱さが消費者信頼感を損なうことを懸念しています。これは欧州と日本にいくつかの兆候がありますが、米国ではまだ顕著ではありません（チャート 6）。したがって先月、景気後退に対するヘッジとして我々はキャッシュをオーバーウェイトしました。リスク／リワードの観点から、債券よりもキャッシュをより魅力的なヘッジとみなしています。 チャート 5イールドカーブのメッセージを無視できますか？ イールド・カーブからのメッセージを無視できますか？ イールド・カーブからのメッセージを無視できますか？ チャート 6消費者信頼感の弱さのいくつかの兆候 消費者信頼感の弱まりを示すいくつかの兆候 消費者信頼感の弱まりを示すいくつかの兆候     我々はまた、ベータが低く他地域の株式ほど構造的逆風が少ない米国株式を引き続きオーバーウェイトします。ただし、中国のより大胆な刺激策の恩恵を受けるであろう、より景気循環性の高い株式市場への参入ポイントを引き続き探しています。中国の金融緩和はこれまでの景気刺激局面に比べてなお慎重です。国内活動を安定化させるにはおそらく十分でした（チャート 7）が、2016年のように工業用コモディティ価格や新興市場資産、ユーロ圏株式のラリーを引き起こすほどではありません。グローバルPMIの上昇と中国の信用成長の強まりの兆候は、明らかに新興市場と欧州を助けるでしょう（チャート 8）が、我々が実際にそれらが起きているとより高い確信を持つまではその動きを取ることはしません。その間、欧州株がアウトパフォームし始めた場合に有利になるはずのため、我々は上振れリスクをヘッジする目的でグローバルの金融セクターを戦術的にオーバーウェイトに引き上げています。今年初めには、より積極的な中国刺激による上振れリスクをヘッジするためにインダストリアルズをオーバーウェイト、オーストラリア株式をニュートラルに引き上げました。 チャート 7中国の刺激は成長を単に安定化させただけ 中国の景気刺激策は成長を単に安定させただけに過ぎない 中国の景気刺激策は成長を単に安定させただけに過ぎない チャート 8欧州と新興市場は最も景気循環的な市場 欧州と新興市場は最も景気循環性の高い市場だ 欧州と新興市場は最も景気循環性の高い市場だ     チャート 9原油価格の急騰はしばしば景気後退に先行する 原油価格の急騰は景気後退に先行することが多い。 原油価格の急騰は景気後退に先行することが多い。 我々の楽観的なシナリオに対する最大の地政学的リスクは、サウジの石油精製施設への攻撃後の中東情勢です。過去50年のすべての景気後退は、原油価格の前年同月比100％の急騰に先行されてきました（ただし、この事態が現実となるにはブレントが年末までに現在の61ドルから100ドル超へ上昇する必要があります（チャート 9   チャート 10原油のリスクプレミアムは低すぎるのか？ 四半期ポートフォリオ見通し：全方位のヘッジ 四半期ポートフォリオ見通し：全方位のヘッジ   ギャリー・エヴァンス、シニア・バイス・プレジデント チーフ・グローバル・アセット・アロケーション・ストラテジスト garry@bcaresearch.com     クライアントが尋ねていること 世界成長の反発のタイミングを図るために投資家はどの先行指標を注視すべきか？ チャート 11世界成長に関するポジティブなシグナル ユーロ圏の製造業は底打ちに近いか？ 世界経済の成長に対するポジティブなシグナル ユーロ圏の製造業は底打ちに近いか？ 世界経済の成長に対するポジティブなシグナル 2019年の世界的な成長鈍化は、債券ラリーとディフェンシブ資産のアウトパフォーマンスの主要因でした。したがって、この下落がいつ反転するかのタイミングを見極めることは極めて重要です。反転はディフェンシブから景気循環性の資産へのリーダーシップの交代ももたらすからです。では、どのようにしてこれを行うか。以下に、過去に世界経済に関する信頼できる先行シグナルを提供してきた我々のお気に入りの指標を三つ挙げます。 キャリートレードのパフォーマンス：非常に高いキャリーを持つ新興国通貨の対円でのパフォーマンスは、世界成長の先行指標となる傾向があります（チャート 11, パネル1）。一般に、キャリートレードは資金が豊富だが利回りが低い国（日本のような）から、貯蓄不足でリスクは高いが見込み収益が高い国へ流動性を分配します。これらの通貨のポジティブなパフォーマンスは、世界的な流動性の改善を示す傾向があり、通常は世界成長を後押しします。 スウェーデンの在庫サイクル：スウェーデンの受注在庫比率は世界の製造業サイクルの先行指標です（パネル2）。なぜか。スウェーデンは小さな開放経済であり、世界成長のダイナミクスに非常に敏感です。さらに、スウェーデンの輸出は中間財に重心が置かれており、これはグローバルなサプライチェーンの早い段階に位置します。これによりスウェーデンの在庫サイクルは世界の製造業サイクルの良い早期のバロメーターとなります。 G3のマネタリートレンド：G3の実質的なマネーサプライ超過（マネーサプライ成長率と貸出成長率の差として測定）は、世界の工業生産の先行指標です（パネル3）。ベースマネーと預金が既存の貸出プールに対して銀行システム内でより豊富になると、商業銀行の流動性ポジションは改善します。これにより銀行はより多くの貸出成長を生み出す燃料を得られ、最終的に経済活動に追い風を提供します。 重要なのは、これらすべての先行指標が世界経済に対してポジティブなシグナルを送っていることです。これは、世界成長が強まるにつれて金利は上昇すべきだという我々の見解を裏付けます。したがって、投資家はポートフォリオで株式をオーバーウェイト、債券をアンダーウェイトのままにしておくべきです。   ユーロ圏の銀行を買う時期か？ 2018年12月のユーロ圏の銀行に関するスペシャルレポートでは、「歴史的に、相対P/Bディスカウントが下限バンドに達し、相対配当利回りが上限バンドに達したとき、相対リターンの反発が期待できる」と指摘しました。1 当時の我々の推奨は「長期投資家はこの地域の銀行を避けるべきだが、より戦術的な権限を持ち、機動的なスタイルの投資家は評価指標を利用して銀行への出入りを短期トレードとして『タイミング』できる」というものでした。 それ以降、銀行は市場全体を10％以上アウトパフォームできずに引き続きアンダーパフォームし、相対的な評価指標をさらに押し下げました。現在、相対P/Bと相対配当利回りはともに、歴史的に少なくとも短期的な反発を予告してきた極端な水準にあります。 ユーロ圏のPMIはまだ50を下回っていますが、ユーロ圏経済が今年後半に持ち直す兆候があり、これは銀行の相対的な収益にとってポジティブになるはずです。すでに、フォワードの1株当たり利益（EPS）成長は幅広い市場に対して安定化しています（チャート 12、パネル4）。 さらに、2018年12月当時の主要な懸念材料の二つはイタリア政府債務と量的緩和（QE）の巻き戻しでした。現在、イタリア債務はもはや危機的な状況にはなく、ECBはQEを再開しています。 したがって、戦術的な権限を持ち機動的に運用できる投資家はユーロ圏の銀行を買う（オーバーウェイト）べきです。長期投資家は構造的な問題が残っているため、依然としてこのような短期トレードは避けるべきです。 チャート 12戦術的にユーロ圏の銀行をアップグレード 戦術的にユーロ圏の銀行を格上げ 戦術的にユーロ圏の銀行を格上げ  金相場の上昇は終わったのか？ スポット金価格は年初来で17%上昇しており、その背景には世界的な成長鈍化、ハト派に傾いた中央銀行、そして高まる政治的緊張がある。投資家は今、金のエクスポージャーを削減すべきだろうか。常識的にはそうすべきだろう。しかし、今回は通常の時期ではない。 短期的には、テクニカル面での買われ過ぎと行き過ぎたポジティブなセンチメントのために一部利益確定が入り、金価格は下押しを受ける可能性がある（チャート13、パネル1）。さらに、今年の金価格の動きは中央銀行の緩和期待の高まりによるところが大きい（パネル2）。今後、市場は利下げが限定的にとどまることに失望する可能性があり、それが金の下落圧力となり得ると予想する。 他方で、現在世界の債務の約27%、すなわち14.9兆ドルがマイナス利回りであるため、投資家は次善の資産である利回りゼロの金へ引き続きシフトしていくだろう（パネル3）。中央銀行と投資家の双方によるここ数年の金保有増加（パネル4・5）からもこれが明らかである。投資家がマイナス利回りを回避し資本保全に重点を置く動きが続く限り、この傾向は持続すると見ている。 年初以来、地政学的緊張は強まっている：米中間の継続するが決定的でない貿易交渉、さらなる関税の実施、ブレグジットの不確実性、そして中東での最近の軍事攻撃（パネル6）。このような環境は金価格を押し上げ続けるはずだ。 我々は引き続き、今後12か月で加速すると見ているインフレに対するヘッジとして、また世界成長や地政学的状況のさらなる悪化に対するヘッジとして金を推奨する。 Chart 13Gold: Sell Or Hold? ゴールド：売却か保有か？ ゴールド：売却か保有か？ 楽観的シナリオへのリスクは高まっている。我々は依然として逆イールド曲線を懸念している。逆イールド曲線は第二次世界大戦以降のすべての景気後退を正確に予測してきた。 金利はどこまで下がり得るか？ ゼロ下限は過去のものだ。先月、デンマーク中央銀行は金利を-0.75%に引き下げ、スイスの10年国債は主要国として歴史的最低水準の-1.12%に達した。次の景気後退において、理論上金利はさらにどこまで下落し得るだろうか？ 個人にとって、紙幣の保管コストが現金金利の下限を制約する可能性がある。紙幣自体は利回りゼロだからだ（政府が現金を禁止する方法や年会費を課す方法を見出さない限り）。銀行の貸金庫は年間約300ドル、また100万ドルを保管するのに十分なプロ用金庫（100ドル札の山で31 x 55 cm、重さ約10kg）は設置費を含め約2,000ドルである。後者を10年で償却すれば、100万ドルの保管コストは年率約0.2%〜0.3%になる。スイスフラン紙幣（最高額面CHF1,000）は保管コストがより低くなるだろう。しかし、現物金の保管コストは年率約2%である。 金利がこれを下回っている場合、他の制約が存在するはずだ。個人が現金を保管することは危険であり、確実に非常に不便である（税金の支払いのために現金を銀行に運ばなければならないことを想像してみてほしい）。また、例えば10億ドル（重さ10トン）を保管する個人や企業のコストははるかに高くなるだろう。低金利国の歴史を踏まえると（チャート14、パネル1）、現金保有者が政府短期債の銀行預金の代替を模索し始める水準は概ね-1%前後だと我々は考えている。 Chart 14How Low Can They Go? どこまで下がるのか？ どこまで下がるのか？ Chart 15Yield Curves When Rates Are At Zero Or Below 金利がゼロ以下のときのイールドカーブ 金利がゼロ以下のときのイールドカーブ   長期側では、短期金利がゼロまたはマイナスのときにイールドカーブが大きく逆転することは通常ない（チャート15）。今年初めにスイスで観測された3か月/10年の最大逆イールドは-0.05%だった。 したがって、どこであれ10年債の絶対的な最低水準は、たとえ厳しい景気後退の只中であっても概ね-1.1%付近であろうという示唆になる。 これは資産配分担当者にとっての懸念材料だ。現在の水準（スイス-0.8%）からスイス国債が取り得る数学的最大上昇幅は3%であり、ドイツ国債（現-0.5%）では5%である。これはあまり有効なヘッジとは言えない。米国だけが相対的に有利に見える：10年物米国債利回りが0%に低下した場合、トータルリターンは18%になる。   世界経済 Chart 16U.S. Growth Remains Solid 米国の成長は堅調を維持 米国の成長は堅調を維持 概観：世界的に産業部門の成長は弱く、多くの国で製造業PMIが50を下回っている。しかし、消費とサービスはほぼすべての地域で持ち堪えており、製造業比重の高いユーロ圏でも例外ではない。製造業の底打ちの兆しが断続的に見られるが、本格的な回復は中国におけるさらなる金融緩和の規模に依存するだろう。中国当局は2016年に行ったほどの大規模な緩和を展開することには慎重な姿勢を崩していないようだ。 米国：米国の製造業は既に世界の他地域に続いて収縮局面に入っており、ISM製造業景況指数は8月に50を下回った（チャート16、パネル2）。しかし、消費とサービスは概ね好調を維持している。雇用は拡大を続けている（ただし昨年よりやや鈍いペースで、求職者不足が一因かもしれない）、解雇の増加は見られず、消費者信頼感は依然として歴史的高水準に近い（9月にわずかに低下した）。住宅は昨年の減速後に回復しており、最近の議会での予算合意により今後12か月は財政政策がやや拡張的になる見込みだ。設備投資（パネル5）のみが、貿易戦争を巡る不確実性のために企業が投資判断を先送りしている影響で鈍化している。コンセンサスは今年の米国実質GDP成長率を2.2%と見込んでおり、多くの潜在成長率の推定を上回っている。 ユーロ圏：製造業の比重が高いため、欧州の成長は米国より弱い。製造業PMIは2月以来50を下回り、8月にはさらに45.6に低下した。鉱工業生産は前年比で2%縮小している。イタリアは2四半期のマイナス成長を経験しており、ドイツも第3四半期にテクニカルリセッションに入る可能性がある（第2四半期はGDPが0.1%縮小した）。しかし、製造業の底打ちの兆候は断続的に見られる：例えば9月のZEW調査は上振れのサプライズとなった。また、米国同様に消費は強い。製造業比重の高いドイツでも雇用は増加を続け、7月の小売売上高は前年同月比で4.4%増だった。一方、英国ではブレグジットを巡る不確実性が企業の投資を損なっているが、雇用は堅調である。2 Chart 17First Signs Of A Rebound In The Rest Of The World? 世界のその他地域で反発の兆候が見え始めたか？ 世界のその他地域で反発の兆候が見え始めたか？ 日本：消費は既に低下しており、10月に予定された消費税率の引き上げ前でさえ落ち込んでいる。7月の小売売上高は前年比で2%減少し、賃金のマイナス成長と消費者センチメントの5年ぶりの低水準への低下が原因である。製造業は中国の減速と強い円（過去12か月で6%上昇）の影響を受け続けており、輸出は6%減、鉱工業生産は過去3か月で前年比2%減少している。消費税率引上げの影響は自動車税の軽減や高校教育の無償化といった政府の措置により緩和される可能性があるし、中国成長の回復が輸出を押し上げるだろう。しかし、活動の底打ちの兆候はまだ乏しい。 新興市場：中国の成長は安定化しているように見え、製造業・非製造業の両PMIが50を上回っている（チャート17、パネル3）。しかし、景況感は脆弱で、小売売上高の伸びは20年ぶりの低水準に鈍化し、自動車販売は8月に7%減少した。これは新排出基準適合車の導入にもかかわらずである。当局は追加の緩和策（9月の預金準備率の追加引き下げを含む）で対応したが、2016年のような本格的な金融刺激を再度実施することには消極的なようだ。他の新興国では、構造的な問題を抱える国で成長が鈍化している（アルゼンチンの最新の前年比実質GDP成長率は-5.7%、トルコは-1.5%、メキシコは-0.8%）が、他方で比較的堅調なのはインド5%、インドネシア5%、ポーランド4.2%、コロンビア3.4%である。 金利：ほぼすべての中央銀行がハト派に転じており、FRBは2回目の利下げを行い、ECBは資産買入れを再開し、日銀は10月に緩和を示唆した。しかし、さらなる金融緩和は市場の期待よりも小幅にとどまる可能性が高い。FRBは今回の利下げを中間的な修正に過ぎないと示し、追加緩和は考えにくいと示唆した。ECBと日銀には利用可能な手段がほとんど残っていない。成長の底打ちの兆しと、中央銀行のハト派転換が終盤に差し掛かっているという市場の理解を踏まえ、既に米国で1.45%から9月に1.72%へと上昇している長期金利はさらに上昇する可能性が高い。投資家はまた、米国のインフレに注意深く注視すべきである。基調の強さを示す兆候があり、コアCPIは8月に前年比2.4%上昇している（過去3か月の年率換算では最大3.4%に達する）。   世界株式 Chart 18Has Earnings Growth Bottomed? 利益の伸びは底を打ったか？ 利益の伸びは底を打ったか？ 依然として慎重だが、上方リスクに対するヘッジを追加：地政学的リスクや弱まる経済指標といったヘッドラインリスクにもかかわらず、グローバル株式は第3四半期に8ベーシスポイントの小幅な損失にとどまった（チャート18）。総じて、我々のディフェンシブな国別配分は第3四半期によく機能した。先進国（DM）株式は新興国（EM）を4.5%上回り、米国はユーロ圏を2.8%上回った。 ただしセクター配分は期待通りにはいかなかった。ユーティリティーと生活必需品のアンダーウェイト、および資本財、エネルギー、ヘルスケアのオーバーウェイトがすべて逆方向に動いたためである。とはいえマテリアルのアンダーウェイトが損失の一部を相殺するのに寄与した。 四半期の間、債券利回りの大きな変動に合わせて、グローバル株式の世界ではセクターおよび国別のローテーションが明確に見られた。9月には先進国／新興国、米国／ユーロ圏、景気循環株／ディフェンシブ株で一部の反転が確認された。 今後について、BCAのハウスビューは世界経済成長がここ数か月のうちに回復し始めるという見方を維持しているが、以前に予想したよりやや遅れると予想している。したがって、我々のディフェンシブな国別配分は依然として適切だ。4月にユーロ圏と新興国株をアップグレード監視リストに入れたが、世界的な回復の遅れはまだその判断を発動する時ではないことを示している。3 我々は債券利回りが底を打ったとの見方を持っているため4、グローバルのセクター配分で1つ調整を行い、金融セクターをニュートラルからオーバーウェイトへ格上げする。資金はヘルスケアのダブルオーバーウェイトを半分にしてオーバーウェイトに削減することで賄う（詳細は次ページ参照）。この調整は、1) ユーロ圏が米国をアウトパフォームする場合、2) 今後の米国大統領選でエリザベス・ウォーレンが勝利する場合、という二つの可能性に対するヘッジにもなる。5  グローバル金融株をニュートラルからオーバーウェイトへ格上げ Chart 19Upgrade Global Financials グローバル・ファイナンシャルズをアップグレード グローバル・ファイナンシャルズをアップグレード グローバルの金融株の総株式市場に対する相対パフォーマンスは、グローバル債券利回りの動きに大きく影響を受けてきた（Chart 19、パネル1）。9月に債券利回りが急反転したのに伴い、金融株の相対パフォーマンスも反転した。ただし、近年にわたり金融株が幅広い市場に対して大きくアンダーパフォームしてきたことから、チャート上ではほとんど見えない。 債券利回りの急反転がどの程度持続するかは明確ではないが、BCAのハウスビューでは今後9～12か月で債券利回りは上昇すると見ている。したがって、以下の追加的な理由により金融株をニュートラルからオーバーウェイトへ格上げする。 バリュエーションはパネル2に示されているように非常に魅力的である。さらに重要なのは、相対バリュエーションが現在、歴史的に金融株の相対パフォーマンスの反発を予告してきた極端な水準にあることである。 ローンの質が改善している。米国の不良債権（NPL）比率は世界金融危機（GFC）前に達した底に近づいている。スペインやイタリアにおいてもNPL比率は大幅に低下しているが、GFC前の水準よりは依然高いままである（パネル3）。 米国の消費は堅調で、住宅は回復し、ローン需要は強まっている（パネル4）。シティ・エコノミック・サプライズ・インデックスなどのデータと一致しており、経済指標が底入れした可能性を示唆している。 この格上げを資金繰りするため、ヘルスケアのダブル・オーバーウェイトをオーバーウェイトに引き下げた。これは、来年の米大統領選でエリザベス・ウォーレンが勝利し医薬品価格規制を厳格化するリスクへのヘッジである。 国債 デュレーションはややアンダーウェイトを維持。 第3四半期の最初の2か月間、我々のベンチマーク比デュレーション縮小の判断はグローバル債券市場によって大きく試された。米国の10年物国債利回りは9月3日に1.43%を付けたが、これは米国のISM製造業指数が予想を下回ったことを受けたもので、前四半期末の水準より57ベーシスポイント低く、2016年7月6日に記録した歴史的低水準1.32%をわずかに上回る水準だった。ただし、9月5日以降の債券利回りの反発は、米中貿易政策の起伏だけでなく、Chart 20に示される通り経済指標のサプライズがポジティブだったことにも牽引されている。 BCAのグローバル・デュレーション・インジケーターは、当社のグローバル・フィクスト・インカム・ストラテジーチームが複数の先行経済指標を用いて構築したもので、今後世界的に利回り上昇を示唆している。投資家は今後9～12か月間、デュレーションをややアンダーウェイトで維持すべきである。 名目債よりインフレ連動債を優先。 グローバルのインフレ期待も、四半期の最初の2か月間に続いた下降トレンドの後に反発している。これは主に8月にコアCPI、コアPCE、平均時給といった実現インフレ指標が加速したことを反映している。加えて、歴史的に原油価格の変化はインフレ期待と良好な相関を持つ傾向がある。サウジアラビアの石油生産施設への攻撃を受けて原油価格は一時20%急騰した。中東の地政学的緊張がどのように進展するかは不透明だが、サウジ側が主張するように失われた生産の70%を復旧できると仮定すると、OPECの余剰生産能力（日量約180万バレル）が市場の均衡を保ち、残る失われた生産をカバーできるはずである。年末まで原油価格が横ばいで推移するという保守的な前提でも、インフレ期待ははるかに高まる方向にあり、これが名目債よりインフレ連動債を支持する根拠となる。日本およびオーストラリアにおいても、それぞれの名目債よりインフレ連動債を好む（Chart 21）。 Chart 20Bond Yields Have Hit Bottom 債券利回りは底を打った 債券利回りは底を打った Chart 21Favor Inflation Linkers リンク債を選好 リンク債を選好 より大胆な中国の景気刺激が実現した場合に恩恵を受ける、景気循環性の高い市場への参入機会を引き続き探している。 社債 我々がフィクスト・インカム・ポートフォリオ内で景気循環的にクレジットをオーバーウェイトに転じて以来、投資適格社債とハイイールド債は、それぞれデュレーションを合わせた国債に対して220および73ベーシスポイントの超過リターンを生み出している。 我々は今後12か月のクレジット見通しに対して引き続き強気である。年末までにグローバル成長が加速すると予想しているからである。歴史的に見ると、グローバル成長の改善はクレジットが国債に対して持続的にアウトパフォームすることをもたらしてきた。さらに、貸出基準が緩和を続けていることを踏まえれば、デフォルト率は今後1年にわたり抑制されると見られる（Chart 22、パネル1）。 どのくらいの期間クレジットをオーバーウェイトにするのか。米国企業債市場における高いレバレッジ水準、利息支払能力（interest coverage ratio）の低下、およびBaa格付け債の比率の高さは、構造的にクレジットをリスクの高い選択肢にしている。しかし、インフレ期待が依然として非常に低いため、FRBは金融政策を緩和的に保つインセンティブが強い。このハト派的な金融政策は金利コストを抑え、クレジットが今後1年でアウトパフォームするのを助けるだろう。 とはいえ、魅力的なクレジットのカテゴリーには差があると我々は考えている。具体的には、Baa格付けとハイイールド証券を優先することを推奨する。これらのクレジット・バケットにはさらなるスプレッド圧縮の余地が残されているためである（パネル2およびパネル3）。一方で、最上位の信用カテゴリーはもはやバリューを提供していないため避けるべきである（パネル4）。 Chart 22Baa-rated And High-Yield Credit Offer The Most Value Baa格付けおよびハイイールド・クレジットは最も高い価値を提供する Baa格付けおよびハイイールド・クレジットは最も高い価値を提供する   コモディティ Chart 23No Supply Shock In The Oil Market 四半期ポートフォリオ見通し：全方位でのヘッジ 四半期ポートフォリオ見通し：全方位でのヘッジ エネルギー（オーバーウェイト）：9月のドローン攻撃はサウジの原油施設に対する供給懸念を引き起こし、攻撃直後の数日間で原油価格は最大で約20%上昇したが、その後攻撃前の水準まで下落した。初期の推計では供給障害は日量約570万バレル、つまり世界供給量の約5.5%に相当し、史上最大の原油供給停止となった。ただし、サウジが主張するように失われた生産の70%を復旧できると仮定すれば、OPECの予備能力である日量約180万バレルが市場を均衡させ、残る失われた生産をカバーできるはずである。より長期的には、経済成長の回復に伴う世界的な原油需要の伸びと供給の緊張が原油価格を押し上げる見込みで、ブレントは今年70ドルに達し、2020年は平均74ドルになると予想される（Chart 23、パネル1およびパネル2）。 工業用金属（ニュートラル）：年初来の中国当局による消極的な刺激策と2019年第2四半期・第3四半期の米ドル高が工業用金属のスポット価格を押し下げてきた。しかし、中国政府は9月に追加の刺激策を発表し、インフラ事業の資金調達のためのさらなる債券発行や金融緩和を行うと表明した（パネル3）。これにより、今後6～12か月で工業用金属価格に上振れ余地が出るはずである。 貴金属（ニュートラル）：年初来の力強いパフォーマンスを踏まえつつも、我々は金に対して依然としてポジティブである。金は景気後退、インフレ、地政学リスクに対する優れたヘッジと見なせるからである。金については第9ページのクライアントからの質問セクションで詳述している。銀も短期的には魅力的に見える。過去20年で銀の利用用途の性質は変化し、主に工業用素材としての側面から、安全資産としての貴金属的側面が強まっている。金と銀の価格の相関は世界金融危機前の平均0.5から危機後は0.8へと上昇している（パネル4およびパネル5）。グローバル成長と政治的不確実性が今後数か月で銀価格を支えるだろう。 通貨 米ドル：4月にニュートラルに転じて以来、貿易加重ドルは2.5%上昇している。利回りの急落は金融条件を緩和し、年末の第4四半期に世界成長を下支えする公算が大きい。米ドルは逆景気循環的な通貨であるため、世界的な成長の回復局面は歴史的にドルにとってネガティブであった。 ユーロ：4月に強気に転じて以来、EUR/USDは2.7%の下落となっている。全体として、我々は景気循環的な時間軸においてEUR/USDに対して引き続きポジティブである。ECBが金利を10ベーシスポイント引き下げ、追加の量的緩和を発表した後、ユーロ圏が米国に対してさらに緩和を続ける余地はあまり残っていない（Chart 24、パネル1）。加えて、ユーロ圏の利益成長見通しが米国に比べて改善することが期待されれば、資金フローは欧州へ向かい、それがEUR/USDを押し上げるだろう（パネル2）。 新興国通貨：当面の間、新興国通貨に対しては弱気の見方を維持する。ただし、年末に向けては格上げ監視中である。世界成長が反転しつつある兆候が複数みられ、これは歴史的に記録的に低い債券利回りがもたらす緩和的な金融環境の結果である。さらに、新興国成長の主要エンジンである中国における限界的な消費傾向（M1成長率とM2成長率の差で代理される）は、新興国通貨のさらなる上昇を示唆し続けている（パネル3）。 Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro ユーロはまもなく急騰するかもしれない。金利と利益期待の差がユーロに有利だ。 ユーロはまもなく急騰するかもしれない。金利と利益期待の差がユーロに有利だ。     オルタナティブ Chart 25Favor Hedge Funds Untill Global Growth Bottoms グローバル成長が底打ちするまでヘッジファンドを推奨 グローバル成長が底打ちするまでヘッジファンドを推奨 リターン増強策：過去12か月にわたり、我々は投資家に対してプライベート・エクイティの配分を減らし、ヘッジファンド、特にマクロ・ヘッジファンドへの配分を増やすことを推奨してきた。これは、我々の判断として景気サイクルが後期にあるためである。成長が今後数か月で回復すると期待しているが、現時点のデータではまだ明確ではない（Chart 25、パネル1）。この不確実なマクロ環境は、特にマルチプルの上昇と買収競争の激化という環境下でプライベート・エクイティにとって厳しいものとなるだろう。グローバル・マクロ・ヘッジファンドは次の景気後退に先立つ最良のヘッジであると引き続き見ており、非流動性資産への配分を変更するには時間がかかるため、投資家には今のうちに資金を配分することを勧める。 インフレ・ヘッジ：現状では、TIPSは非流動性のオルタナティブ資産よりも優れたインフレ・ヘッジである可能性が高い。2019年5月のスペシャルレポート8は、インフレが上昇しているが依然として比較的低い（2.3%未満）局面では、TIPSが特に魅力的なリスク調整後リターンを生み出すことを示している。したがって、FRBがハト派を維持し、金利をもう一度引き下げるかもしれない一方でインフレの中程度の加速を容認するという我々の見通しの下では、TIPSは今後数か月の環境で良好に推移するはずである（パネル2）。 ボラティリティ抑制策：ストラクチャード・プロダクツ、主にモーゲージ担保証券（MBS）は、ポートフォリオのボラティリティを低減する点で優れた実績を持っている（パネル3）。それにもかかわらず、現在の評価は必ずしも魅力的ではないため、MBSへの配分はニュートラルを超えて推奨しない。今シーズンは長期金利が100ベーシスポイント以上低下し、借り換え活動が活発化しているにもかかわらず、名目ベースのMBSスプレッドは史上最低水準付近にとどまっている。ただし、国債利回りが底打ちするにつれて借り換えは減速し、スプレッドに下押し圧力がかかると予想している。当社見解に対するリスク 最も起こり得る上方リスクは、FRB（米連邦準備制度理事会）が過度にハト派になり、対応が遅れることである。米国の基調的なインフレ圧力は依然として強い（コア消費者物価指数は過去3か月で年率換算3.4％上昇）。2回の利下げ後、フェデラルファンド金利は現在中立金利を大きく下回っている：実質で0.1％、Laubach‑Williamsのr*は0.8％に対してである（チャート26）。マネー・マーケットのタイトさからFRBは再びバランスシートの拡大を開始している。来年に製造業の成長が加速し、賃金と利益が上昇し始めれば、1999年のような株式市場のメルトアップが起こり得る。しかし最終的には、インフレを抑えるためにFRBは利上げ（場合によっては急激な利上げ）を行う必要があり、それが次の景気後退を招く可能性がある。 下方リスクの範囲はより広い。 本四半期報告全体で論じた通り、景気後退の引き金になり得る要因は様々ある：特に中国が景気刺激に失敗することや、消費者の信頼の喪失などである。一部の景気後退モデルは今後12か月のリスクを最大30％と見積もっている（チャート27）。構造的に見て、最大のリスクはおそらく米国における企業債務の高水準である（チャート28）。昨年12月に短期間観測されたようなジャンク債市場の崩壊は、今後18か月で満期を迎える大量の債務を企業が借り換えできなくなる事態を招く可能性がある。 地政学的リスクも依然として高止まりしており、その性質上予測が困難である。ブレグジットの帰結は依然として非常に不確実であるが、合意なき離脱のリスクは低いと見ている。米中の貿易協議は包括的な合意なく長期化すると予想しており、明確な決裂はネガティブである。トランプ大統領の弾劾はおそらく市場にとって重大な出来事ではないが、市場心理を一時的に悪化させる可能性がある（特にそれがエリザベス・ウォーレンの当選可能性を高める場合）。イランとサウジ間の紛争がエスカレートする可能性もある。これらの脅威を織り込むためにリスクプレミアムは上昇する必要があるかもしれない。 チャート26FRBは過度にハト派になっているのか？ 米FRBはハト派に傾きすぎているのか？ 米FRBはハト派に傾きすぎているのか？ チャート27景気後退のリスクはどの程度か？ 景気後退のリスクは？ 景気後退のリスクは？ チャート28企業債務が最大のリスクか？ 企業債務は最大のリスクか？ 企業債務は最大のリスクか？   脚注 1詳細はグローバル・アセット・アロケーション・スペシャル・レポート、「ユーロ圏の銀行：バリュー・プレイかバリュー・トラップか？」2018年12月14日付、gaa.bcaresearch.comで入手可能。 2詳細はフォーリン・エクスチェンジ・ストラテジー・スペシャル・レポート、「英国：循環的減速か構造的停滞か？」2019年9月20日付、fes.bcaresearch.comで入手可能。 3詳細はグローバル・アセット・アロケーション・クォータリー、「クォータリー - 2019年4月」2019年4月1日付、gaa.bcaresearch.comで入手可能。 4詳細はグローバル・インベストメント・ストラテジー・ウィークリー・レポート、「債券利回りは底を打った,」2019年9月6日付、gis.bcaresearch.comで入手可能。 5詳細はグローバル・インベストメント・ストラテジー・ウィークリー・レポート、「エリザベス・ウォーレンと市場,」2019年9月13日付、gis.bcaresearch.comで入手可能。 6Dmitry Zhdannikov and Alex Lawler “独占：サウジの石油生産、当初予想より速く回復へ－関係筋,” ロイター、2019年9月17日付。 7詳細はジオポリティカル・ストラテジー・スペシャル・アラート、「サウジの重要インフラへの攻撃は米国の対応に疑問を投げかける」2019年9月16日付、gps.bcaresearch.comで入手可能。 8詳細はグローバル・アセット・アロケーション・スペシャル・レポート、「インフレ・ヘッジのための投資家ガイド：インフレ上昇時の投資方法」2019年5月22日付、gaa.bcaresearch.comで入手可能。 GAA アセット・アロケーション

ハイライト コーポレート債：高い企業債務残高は次の景気後退期にコーポレート債投資家にとって問題となるが、インフレ圧力が高まり金融政策が引き締めに転じるまではスプレッドはそれに反応しない。米国債に対してコーポレート債をオーバーウェイトで保ちつつ、Baaおよびハイイールドのクレジット層を優先する。 MBS: エージェンシーMBSスプレッドは高格付け（Aaa、Aa、A）のコーポレート債と競合し、リスク調整後ではさらに魅力的に見える。ポートフォリオのAaa、Aa、A格付けのコーポレート債をエージェンシーMBSにスワップすることを推奨する。 ミュニシパル債: ミュニシパル／米国債イールド比の最近の戻りを踏まえ、ミュニシパル債の評価をニュートラルからオーバーウェイトに引き上げるべきである。ミュニシパルの中では、利回りが最も魅力的な長期のAaa格付け債を引き続き優先すべきである。 特集 先週、BCAの年次投資カンファレンスに参加した。イベントは常に専門家パネリストの話を聞き、クライアントが最も関心を寄せている課題を知る良い機会を提供する。何よりも、複数のプレゼンテーションや参加者との会話で2つのテーマが繰り返し浮かび上がった： 大きな企業債務残高 過小評価されたインフレリスク 私たちはこの2つの間に強い関連性を見ている。 企業債務について パネリストや参加者のコンセンサスは我々の見解と非常に一致していた：高レバレッジのバランスシートは次のデフォルトサイクルでコーポレート債投資家にとって問題になるが、それがいつ起きるかを決定する助けにはならない。 チャート1は、負債対利益比率が持続的に上昇しているにもかかわらず企業倒産は抑制されていることを示している。私たちは最近のレポートでこの乖離の理由を検討し、金融緩和的な金融政策が金利コストを低く抑え、銀行に満期を迎える債務をロールオーバーする自信を与えることでデフォルト率を抑えていると結論付けた。1 本質的には、FRBがより引き締め的な政策姿勢に転じるまでは銀行は企業のバランスシート悪化の兆候を見過ごすだろう。 チャート 1 企業のバランスシートは悪化しているが、デフォルトは低い Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low インフレについて ここでインフレが重要になる。FRBは長年の低インフレにより投資家がインフレが再来しないと確信しているため、現在も緩和的な金融政策を運営している。その結果、10年物TIPSのブレークイーブン・インフレーション率はわずか1.53%であり、FRBのターゲットと整合する2.3% - 2.5%の範囲を大きく下回っている。 FRBはインフレ期待の再固定化という目標を達成するまで緩和的な政策姿勢を維持しなければならない。そうなって初めて金融政策は引き締めに転じ、企業のデフォルトサイクルのリスクが高まる。我々は以前より、10年物TIPSのブレークイーブン・インフレーション率が2.3%以上になればコーポレートクレジットに対してより慎重になるだろうと考えている。 コアインフレがFRBのターゲット付近で何ヶ月も連続して示されるまで、投資家がそれが永続すると思い始めるには時間がかかるかもしれない。 多くのカンファレンスパネリストはインフレリスクが現在過小評価されていると考えており、我々もフィリップス曲線の死を宣言するには時期尚早だという点では同意するが、インフレ期待が我々の目標レンジ2.3% - 2.5%に到達するまでにはまだ時間を要すると予想している。過去の研究で示したように、インフレ期待は実際のインフレデータの変化に対してゆっくりとしか順応しない。2  現時点で、我々の適応的期待モデルが示す10年物TIPSの公正価値水準はわずか1.94%（チャート 2）である。インフレが現在の水準付近で推移し続ければこの公正価値は上昇するだろうが、そのプロセスには時間がかかる。言い換えれば、コアインフレがFRBのターゲット付近で何ヶ月も出続けるまで、投資家がそれが永続すると信じ始めるには時間がかかるだろう。 チャート 2 適応的期待モデル Adaptive Expectations Model Adaptive Expectations Model チャート 3 インフレは目標からそれほど遠くない Inflation Not Far From Target Inflation Not Far From Target 適応プロセスには時間がかかるかもしれないが、インフレはすでにFRBの目標にかなり近いことに注意することが重要である。トレイリング12か月のトリム平均PCEインフレ率は8月時点で1.96%、年率ベースのコアPCEは1.77%であった（チャート 3）。トリム平均インフレは金融危機以降、他のインフレ指標よりも安定しており、コアPCEは時間をかけてトリム平均に近づく傾向がある。      企業債務とインフレについて 我々の見解では、高い企業債務と過小評価されたインフレリスクという2つのテーマは密接に結び付いている。景気回復に非常に長い時間を要したため、インフレは長期にわたり低位にあり、FRBは緩和的な政策姿勢を維持せざるを得なかった。その緩和的姿勢は銀行の貸し出しを促し、企業の債券発行を促進した。最終的にインフレ圧力が高まり、FRBの政策が引き締めに転じると、脆弱な企業バランスシートが露呈する。そうなって初めてコーポレートスプレッドは大幅に拡大するだろう。 それまでは、企業スプレッドがインフレ圧力が予想より早く出現するリスクに対して十分な補償を提供しているかが重要な問題となる。現時点では、リスク／リワードのトレードオフは下位クレジット層でより魅力的であるという但し書き付きで、十分な補償を提供していると考えている。 12か月のハイイールドのブレークイーブン・スプレッドは非常に魅力的で、歴史的中央値を大きく上回っている（チャート 4）。しかし投資適格内では、Baa格付け層のみが十分な補償を提供していると見ている（チャート 4、下段）。Aaa、Aa、A格付けのコーポレート債を保有するよりも良い代替案がある。次節で議論するように。 チャート 4 コーポレート債のバリュエーション Corporate Bond Valuation Corporate Bond Valuation 高格付けコーポレートクレジットよりエージェンシーMBSを推奨 チャート 5 MBSは高格付けのコーポレート債より魅力的 MBS More Attractive Than High-Rated Corporate Bonds MBS More Attractive Than High-Rated Corporate Bonds 前述の通り、A格以上の投資適格コーポレート債は現行のスプレッド水準ではあまり期待される補償を提供していない。実際、我々の以前の調査はそれらのスプレッドがすでに循環的なターゲットを下回っていることを指摘している。3 しかし好材料として、通常の30年エージェンシーMBSの平均オプション調整スプレッド（OAS）はここ数か月で拡大し、高格付けのコーポレートクレジットに対する魅力的な代替となっている。投資家は3つの理由からポートフォリオのAaa、Aa、A格付けコーポレートクレジットをエージェンシーMBSにシフトすることを推奨する。 1) 期待補償は競争力がある 通常の30年エージェンシーMBSの平均OASは現在52ベーシスポイントに達している。これはAa格付けコーポレート債の平均OASよりわずか6ベーシスポイント低く、A格付けよりは37ベーシスポイント低い（チャート 5 2) リスク調整後の補償は優れている MBSスプレッドはリスクプロファイルを考慮するとさらに魅力的に見える。具体的には、今年MBS指数の平均デュレーションが急低下した一方で、投資適格コーポレート債指数の平均デュレーションは上昇したことを考慮した場合である（チャート 5、パネル2）。実際、MBS指数の平均デュレーションはわずか2.9であるのに対し、A格コーポレート債は7.8である。これは、投資家が損失を被るにはMBSスプレッドが今後12か月で18ベーシスポイント拡大する必要があるのに対し、A格スプレッドはわずか11ベーシスポイント拡大すればよいことを意味する（チャート 5、下段）。 投資家はポートフォリオのAaa、Aa、A格付けコーポレートクレジットをエージェンシーMBSにシフトすることを推奨する。 MBSは負のコンベクシティを示すため、利回りが低下するとデュレーションが下がる。対照的に、ノンコーラブルの投資適格コーポレート債は正のコンベクシティを持ち、デュレーションが上昇している。これは、他の条件が同じであれば、利回りが大幅に低下した後に負のコンベクシティを持つ証券の方がリスク調整後の面で魅力的に見え始めることを意味する。これはまた、負のコンベクシティを持つハイイールドのコーポレート債が現在、投資適格コーポレート債よりもはるかに魅力的に見える主な理由でもある。4 興味深いことに、MBSの指数デュレーションが急低下した直近の2015/16年には、MBSはコーポレート債と比較してそれほど魅力的に見えなかった。それは当時コーポレート債スプレッドも拡大していたからである。今回は、MBS指数デュレーションが急落する間にコーポレート債スプレッドは安定している。米国債利回りにさらなる下値余地があると考えない限り、エージェンシーMBSは良い買いに見える。5 3) マクロリスクは低い 前述のとおり、我々はまだコーポレート債に対するマクロリスクを警鐘を鳴らす段階にはないが、エージェンシーMBSを取り巻くマクロリスクについてはさらに懸念が少ない。モーゲージの借り換え活動はMBSスプレッドの最も重要なマクロドライバーであり、長期にわたり比較的低位にとどまるはずである。現在のような低いモーゲージ金利では、ほとんどの住宅所有者がすでに借り換えの機会を得ているため、借り換えの消耗（refi burnout）は非常に高い。今年はモーゲージ金利が大きく低下したにもかかわらず借り換え活動は小幅のスパイクにとどまったことからも明らかである（チャート 6）。 チャート 6 抑制された借り換え活動は名目スプレッドを低位に保つ Muted Refi Activity Will Keep Nominal Spreads Low Muted Refi Activity Will Keep Nominal Spreads Low チャート 6はまた、名目MBSスプレッドが借り換え活動と高い相関を持ち、現在歴史的なタイト付近にあることを示している。このスプレッドはOAS（MBS投資家の期待リターンの代理）と前払（プレペイメント）活動によって失われると予想されるスプレッド部分の両方を含む。OASが歴史と比べてやや高めである一方で名目スプレッド全体が低位にあるということは、MBSが前払損失に対するバッファをほとんど織り込んでいないことを意味する。マクロの背景を考えると、これは妥当であるように思われる。 借り換えリスクに加えて、未償還モーゲージの信用クオリティが依然として非常に高いことにも注意する。新規モーゲージの中央値FICOスコアは金融危機以降ほとんど低下していない（チャート 7）。さらに、危機後期間の大部分でモーゲージ貸出基準は緩和されてきたが、FRBの7月のシニアローンオフィサー調査では、貸出基準が2005年以降平均より厳しいとする銀行が、基準が緩いとする銀行より多いと報告している。 住宅活動データの改善は一般にモーゲージ金利を押し上げ、それが借り換え活動を制約する。 最後に、住宅活動が大きく弱化する懸念はほとんどない。私たちが追跡する6つの主要な住宅活動データ系列はすべて、今年のモーゲージ金利低下以降で大きく回復している（チャート 8）。住宅活動データの改善は一般にモーゲージ金利を上昇させ、それが借り換え活動を制限する。 チャート 7 モーゲージ貸出基準はタイト Mortgage Lending Standards Are Tight Mortgage Lending Standards Are Tight チャート 8 住宅活動が回復 Housing Activity Hooking Up Housing Activity Hooking Up   結論: エージェンシーMBSスプレッドは高格付け（Aaa、Aa、A）のコーポレート債と競合し、リスク調整後ではさらに魅力的に見える。ポートフォリオのAaa、Aa、A格付けコーポレート債をエージェンシーMBSにスワップすることを推奨する。 ミュニシパル債の格上げ 7月23日、我々はミュニシパル債のエクスポージャーをオーバーウェイトからニュートラルに引き下げるよう投資家に助言した。6 理由は純粋にバリュエーションによるものである。即時のミュニシパル信用の悪化の兆候は見えなかったが、利回りが代替案に対して単純に低すぎると指摘した。 現在、同様に即時の信用悪化の兆候は見られない。実際、ミュニシパル債の格付けのアップグレードはダウングレードを上回り続け、当社のミュニシパルヘルスモニターは「健康改善」領域にあり、州および地方政府の利払い余力は強い（チャート 9）。7 チャート 9 ミュニシパルの信用クオリティは懸念事項ではない Muni Credit Quality Is Not A Concern Muni Credit Quality Is Not A Concern しかし違いは、イールド比が8月初旬以来劇的に回復し、ミュニシパル債が再び魅力的になったことである（チャート 10）。 チャート 10 ミュニシパル債が再び魅力的に Munis Attractive Once Again Munis Attractive Once Again 結論: ミュニシパル／米国債イールド比の最近の戻りを踏まえ、投資家はミュニシパル債をニュートラルからオーバーウェイトに格上げすべきである。ミュニシパルの中では、利回りが最も魅力的な長期のAaa格付け債を引き続き優先するべきである。   Ryan Swift, 米国債ストラテジスト rswift@bcaresearch.com 脚注 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 ハイイールド債指数は大半のハイイールドクレジットが組み込まれたコールオプションを有しているため負のコンベクシティを持つ。投資適格コーポレート債はノンコーラブルである傾向がある。 5 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Municipal Health Monitor please see U.S. Bond Strategy Special Report, “Trading The Municipal Credit Cycle”, dated October 18, 2016, available at usbs.bcaresearch.com フィクスト・インカム部門のパフォーマンス 推奨ポートフォリオ仕様

Highlights Chart 1Waiting For A Manufacturing Rebound The 2015/16 roadmap is holding. As in that period, the ISM Manufacturing PMI has fallen into recessionary territory, but the Services PMI remains strong (Chart 1). As is typically the case, bond yields have taken their cue from the manufacturing index. The resilient service sector and global shift toward easier monetary policy will support an eventual rebound in manufacturing, and the Fed will continue to play its part this month with another 25 basis point rate cut. As for the Treasury market, much stronger wage growth than in 2016 will prevent the Fed from cutting rates back to zero. This means that the 10-year yield will not re-visit its 2016 trough of 1.37% (Chart 1, bottom panel). Strategically, investors should maintain a benchmark duration stance for now, but stand ready to reduce duration once the global manufacturing data stabilize. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 105 basis points in August, dragging year-to-date excess returns down to +323 bps. In remarks last week, Fed Chairman Powell noted that the Fed has lowered the market’s expected path of interest rates, and that he views this easing of financial conditions as providing important support for the economy.1  The July FOMC minutes echoed this sentiment, sending a strong signal that the Fed will do everything it can to prevent a significant tightening of financial conditions. The accommodative monetary environment is extremely positive for corporate spreads. In terms of valuation, Baa-rated securities offer the most value in the investment grade corporate bond space (Chart 2). Baa spreads remain 13 bps above our cyclical target (panel 2).2 Conversely, Aa and A-rated spreads are 2 bps and 1 bp below target, respectively (panel 3). Aaa spreads are 15 bps below target (not shown). The main risk to spreads comes from the relatively poor state of corporate balance sheets. Our measure of gross leverage – total debt over pre-tax profits – was already high, and was revised even higher after the Bureau of Economic Analysis’ annual GDP revision (panel 4). But for now, likely in large part due to accommodative Fed policy, loan officers aren’t inclined to cut off the flow of credit. C&I lending standards remain in “net easing” territory (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 114 basis points in August, dragging year-to-date excess returns down to +551 bps. The average index option-adjusted spread widened 22 bps on the month. At 385 bps, it is well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 49 bps above our target (Chart 3), B-rated spreads are 151 bps above our target (panel 3) and Caa-rated spreads are 398 bps cheap (not shown).3   Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 3.2% over the next 12 months. This translates into 207 bps of excess spread in the High-Yield index after adjusting for expected default losses (panel 4). That 207 bps of excess spread is comfortably above zero, though it is below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in August, dragging year-to-date excess returns down to -31 bps. The conventional 30-year zero-volatility spread widened 9 bps on the month, driven entirely by the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat at 29 bps. At 51 bps, the OAS for conventional 30-year MBS has widened back close to its average pre-crisis level (Chart 4). However, value is less attractive when we look at the nominal MBS spread, which remains near its all-time lows.4 The nominal spread has also widened less than would have been expected in recent months, considering the jump in refi activity (panel 2). The mixed valuation picture means we are not yet inclined to augment MBS exposure. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. An increase in Treasury yields would cause refi activity to slow, putting downward pressure on MBS spreads. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. 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 +152 bps. Sovereign debt underperformed duration-equivalent Treasuries by 45 bps on the month, dragging year-to-date excess returns down to +442 bps. Local Authorities underperformed the Treasury benchmark by 31 bps, dragging year-to-date excess returns down to +212 bps. Meanwhile, Foreign Agencies underperformed by 11 bps, dragging year-to-date excess returns down to +141 bps. Domestic Agencies outperformed by 13 bps in August, bringing year-to-date excess returns up to +44 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +39 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 104 basis points in August, dragging year-to-date excess returns down to -46 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 9% in August, and currently sits at 85% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but slightly above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We shifted our recommended stance on municipal bonds from overweight to neutral near the end of July.5 The reason for the downgrade was that the sector had become extremely expensive. Yield ratios have risen somewhat since then, but not yet by enough for us to re-initiate an overweight recommendation. We also continue to observe that the best value in the municipal bond space is found at the long-end of the Aaa curve. 2-year and 5-year M/T yield ratios remain below average pre-crisis levels, while yield ratios beyond the 10-year maturity point are above. 20-year and 30-year Aaa M/T yield ratios, in particular, are the most attractive (panel 2). Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our recent shift to a more cautious stance was driven purely by valuation and not a concern for municipal bond credit quality. A further cheapening in the coming months would cause us to re-initiate an overweight stance.    Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in August, as the global manufacturing recession continued to pull yields down. At present, the 2/10 Treasury slope is just above the zero line at 2 bps, 11 bps flatter than at the end of July. The 5/30 slope is currently 60 bps, 9 bps flatter than at the end of July. Our 12-month Fed Funds Discounter is currently -98 bps (Chart 7). This means that the market is priced for almost four more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of uncertainty surrounding the timing of the next move higher in yields, four rate cuts on a 12-month horizon seems excessive given the underlying strength of the U.S. economy. For this reason, we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts over the next four FOMC meetings. One of those rate cuts will occur this month, but if the global manufacturing data recover, further cuts may not be needed. A short position in this contract continues to make sense. On the Treasury curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 174 basis points in August, dragging year-to-date excess returns down to -104 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.55% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate also fell 21 bps in August. It currently sits at 1.74%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.6 Eventually, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors also need to see evidence that inflation will be sustained near 2%. On that note, recent trends are encouraging. Through July, trimmed mean PCE is running at 2.22% on a trailing 6-month basis (annualized) and at 1.99% on a trailing 12-month basis (bottom panel). As a result, the 10-year TIPS breakeven inflation rate looks very low relative to the reading from our Adaptive Expectations model, a model based on several different measures of inflation (panel 4).7 Supportive Fed policy and rising inflation should support wider TIPS breakevens in the coming months, remain overweight.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in August, bringing year-to-date excess returns up to +74 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month. It currently sits at 28 bps, below its minimum pre-crisis level of 34 bps (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (see Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 16 basis points in August, dragging year-to-date excess returns down to +218 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 6 bps on the month. It currently sits at 69 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in August, dragging year-to-date excess returns down to +88 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 56 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 98 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of September 6, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of September 6, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +49 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 49 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the 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 of excess return. Chart 12Excess Return Bond Map (As Of September 6, 2019)     Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 https://www.cnbc.com/2019/09/06/watch-fed-chairman-jerome-powells-qa-in-zurich-live.html 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 The nominal spread is simply the difference between MBS index yield and the duration-matched Treasury yield. No adjustment is made for prepayment risk. 5 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Keep Tracking The CRB / Gold Ratio The Fed cut rates by 25 basis points last week, a move that Chairman Powell described as an “insurance” cut meant to counter the risks from trade tensions and global growth weakness. Powell also described the move as a “mid-cycle adjustment to policy” and not “the beginning of a lengthy cutting cycle”. We agree with the Fed’s “mid-cycle” view of the U.S. economy and think an extended cutting cycle is unwarranted, but the market clearly disagrees. Long-end yields fell on Powell’s remarks and fell further as U.S. / China trade tensions re-escalated during the past few days. The 2015/16 period continues to be a good roadmap for the current environment, and we expect the next big move in Treasury yields will be higher. The timing of that move, however, is highly uncertain. Our political strategists expect an increase in saber-rattling between the U.S. and China in the coming months, and bond yields will not rise until either trade tensions ease and/or the global growth data recover. We recommend a tactical neutral allocation to portfolio duration, but expect to switch back to below-benchmark when those conditions are met. The CRB / Gold ratio will continue to be a good guide for the 10-year yield (Chart 1). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in July, bringing year-to-date excess returns up to +432 bps. Corporate spreads widened somewhat following Jerome Powell’s perceived hawkishness at last week’s FOMC meeting, but that spread widening will prove fleeting. The Fed remains committed to keeping monetary policy accommodative and that means doing everything it can to prevent a significant tightening of financial conditions.1 The soaring price of gold is the strongest indicator of the Fed’s dovishness, and it is also a buy signal for corporate credit (Chart 2). In terms of valuation, Baa-rated securities offer the most value in investment grade corporate bond space. Baa spreads remain 7 bps above our cyclical target.2 Conversely, Aa and A-rated spreads are 3 bps and 4 bps below target, respectively (panel 4). Aaa spreads are 16 bps below target (not shown). The Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed that commercial & industrial (C&I) lending standards eased for the second consecutive quarter. C&I loan demand continued to contract, but less aggressively than its recent pace (bottom panel). Easing lending standards usually coincide with spread tightening, and vice-versa.  High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +673 bps. The average index option-adjusted spread tightened 6 bps in July, then widened 26 bps in the first two days of August. At 397 bps, it is currently well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 71 bps above our target (Chart 3), B-rated spreads are 142 bps above our target (panel 3) and Caa-rated spreads are 298 bps above our target (not shown).3 Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.9% over the next 12 months, not far from our own projection.4 This would translate into 238 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +32 bps. The conventional 30-year zero-volatility spread tightened 10 bps on the month, consisting of a 9 bps tightening in the option-adjusted spread (OAS) and a 1 bp decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS moved all the way back to its pre-crisis mean, before tightening last month (panel 3). However, as we noted in a recent report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment MBS exposure, especially given the recent downleg in Treasury yields that could spur another small jump in refis. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in July, bringing year-to-date excess returns up to +164 bps. Sovereign debt outperformed duration-equivalent Treasuries by 68 bps on the month, bringing year-to-date excess returns up to +490 bps. Local Authorities outperformed the Treasury benchmark by 31 bps, bringing year-to-date excess returns up to +244 bps. Meanwhile, Foreign Agencies outperformed by 49 bps, bringing year-to-date excess returns up to +153 bps. Domestic Agencies outperformed by 6 bps in July, bringing year-to-date excess returns up to +31 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +36 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 102 basis points in July, bringing year-to-date excess returns up to +58 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 8% in July, and currently sits at 78% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, and even below the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We noted the strong outperformance of municipal bonds in our report two weeks ago, and recommended cutting exposure from overweight to neutral, based on how expensive the bonds have become.6 In that report we noted that Aaa-rated Municipal / Treasury yield ratios for 2-year, 5-year and 10-year maturities were all more than one standard deviation below average pre-crisis levels. Only 20-year and 30-year Aaa-rated municipal bonds continue to look cheap, and we recommend that investors focus muni exposure on that segment of the market. Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our shift to a more cautious stance is driven purely by valuation, and not any immediate concern for municipal bond credit quality. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in July, before undergoing a roughly parallel shift down of about 30 bps in the first two days of August, following the FOMC meeting and news about the escalation of the U.S./China trade war. As we go to press, the 2/10 Treasury slope stands at 16 bps, 9 bps flatter than at the end of June. The 5/30 slope is currently 76 bps, exactly equal to its end-of-June level. Our 12-month Fed Funds Discounter is currently -78 bps (Chart 7). This means that the market is priced for roughly three more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of the uncertainty surrounding the timing of the next move higher in yields, three rate cuts on a 12-month horizon still seems excessive given the underlying strength of the U.S. economy. For this reason we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts spread over the next four FOMC meetings. A short position continues to make sense. On the yield curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +71 bps. The 10-year TIPS breakeven inflation rate rose 8 bps in July to reach 1.77%, before falling back to 1.67% in the first few days of August (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate followed a similar path and currently sits at 1.88%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.7 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at an annualized rate of 2.48% during the past three months. However, the 12-month rate of change remains at 1.5%. The 12-month trimmed mean PCE inflation rate is currently running at 2%, exactly equal to the Fed’s target. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.8 We see continued upside in core inflation over the remainder of the year, and therefore recommend an overweight allocation to TIPS versus nominal Treasuries.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in July, bringing year-to-date excess returns up to +59 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. It currently sits at 31 bps, well below the pre-crisis mean of 64 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed a continued tightening in lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). On the bright side, stronger demand for both credit cards and auto loans was reported for the first time since the fourth quarter of 2016. All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.       Non-Agency CMBS: Neutral     Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to +234 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 64 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation compared to other similarly-rated fixed income sectors.9 Agency CMBS: Overweight   Agency CMBS outperformed the duration-equivalent Treasury index by 26 bps in July, bringing year-to-date excess returns up to +119 bps. The index option-adjusted spread tightened 3 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 78 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of August 2, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of August 2, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +55 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the 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 of excess return.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Monetary Policy: The Fed’s message to markets is “lower for longer” until inflation expectations are re-anchored. But that guiding principle will manifest itself in only a 25 bps rate cut this month. Beyond that, we see a good chance that July’s 25 bps rate cut could be one and done. Stay short the February 2020 fed funds futures contract. TIPS: Stay overweight TIPS versus nominal Treasury securities. Our model shows that the 10-year TIPS breakeven inflation rate is 12 bps too low, and core inflation should gradually move higher in the second half of the year. Municipal Bonds: We downgrade our recommended allocation to municipal bonds from overweight to neutral, based on valuations that have become historically expensive. We continue to recommend an overweight allocation to 20-year and 30-year Aaa munis, where yields are more reasonable. Feature Chart 1Is “Lower For Longer” Working? If nothing else, the Fed is definitely staying on message. That message being that monetary policy will remain accommodative until the “re-anchoring” of inflation expectations is complete. Case in point, from the June FOMC minutes:1 Many participants further noted that longer-term inflation expectations could be somewhat below levels consistent with the Committee’s 2 percent inflation objective, or that continued weakness in inflation could prompt expectations to slip further. These developments might make it more difficult to achieve their inflation objective on a sustained basis. And last week, from a speech delivered by New York Fed President John Williams:2 Investors are increasingly viewing these low inflation readings not as an aberration, but rather a new normal. This is evidenced by a broad-based decline in market-based measures of longer-run inflation expectations … According to Williams, the solution to the low inflation expectations problem is: First, take swift action when faced with adverse economic conditions. Second, keep interest rates lower for longer. And third, adapt monetary policy strategies to succeed in the context of low r-star and the ZLB (zero-lower bound). “Lower for longer” until inflation expectations are re-anchored. That’s the Fed’s message to markets and policymakers are going out of their way to deliver it aggressively – sometimes too aggressively (see Box on page 3). The upshot is that there is some indication it might be working. BOX July Rate Cut Will Be 25 bps, And Could Be One And Done Chart B1Short The February 2020 Fed Funds Futures Contract An interesting series of events unfolded last Thursday when New York Fed President John Williams delivered a speech titled “Living Life Near the ZLB”. The speech focused on how, when interest rates are close to the zero bound, the Fed should “act quickly to lower rates at the first sign of economic distress”. Investors interpreted this dovish speech as a signal that the Fed might be gearing up for a 50 bps rate cut this month, and prices of interest rate futures rose sharply. But within a couple hours, the New York Fed released a statement saying that Williams’ comments were made in the context of an academic speech, and had nothing to do with upcoming policy actions. The New York Fed’s clarification almost certainly means that the Fed intends to cut rates by only 25 bps in July. In fact, based on the June Summary of Economic Projections where 9 out of 17 participants saw no need for rate cuts this year and nobody called for more than 50 bps of cuts in 2019, it seems unlikely that the board could achieve consensus on more than a 25 bps cut this month. Beyond this month, if global growth improves in the second half of this year as we expect, we see high odds that the Fed might only deliver a single 25 bps rate cut in July. With that in mind we continue to recommend a short position in the February 2020 fed funds futures contract (Chart B1). That position will earn 52 bps in the event of only one rate cut over the next five FOMC meetings, 26 bps in the event of two rate cuts, and 1 bp in the event of three rate cuts. Chart 1 on page 1 shows that the 10-year Treasury yield’s recent jump was driven entirely by the compensation for inflation protection. The 10-year real yield, meanwhile, is barely off its lows. The divergence makes perfect sense. A recent spate of stronger-than-expected inflation data has lifted inflation expectations, but the Fed is signaling that it will not respond by running a tighter monetary policy. That dovish forward guidance is capping the upside in real yields. If recent history repeats itself, core PCE should gradually move higher, eventually re-converging with the trimmed mean. In this week’s report we consider the outlooks for inflation and TIPS over the remainder of the year. Inflation: Modest Upside In H2 2019 As noted above, core inflation has rebounded from the extremely low readings seen earlier in the year. In fact, month-over-month core PCE came in above the Fed’s 2% target in both April and May (Chart 2). We also continue to observe a wide divergence between year-over-year core and trimmed mean PCE measures (Chart 2, top panel). If recent history repeats itself, core PCE should gradually move higher, eventually re-converging with the trimmed mean. While we only have PCE inflation data up to May, the June core CPI print was also strong (Chart 2, bottom panel). However, a closer look reveals that the bulk of June’s increase was driven by the core good component (Chart 3). We should not expect core goods to be a major driver of U.S. inflation going forward. Imports make up a large portion of consumer goods, and import prices tend to lead fluctuations in the core goods CPI. Despite the federal government’s push toward protectionism, import prices are currently contracting. This means that any strength in the core goods CPI will be transitory. Chart 2A Rebound In Core Inflation Chart 3Core CPI Components   Chart 4Shelter CPI Still Has Upside On the flipside, shelter – the largest component of core CPI – also increased in June (Chart 3, top panel), and we expect further acceleration in the second half of the year. The apartment rental vacancy rate is the main driver of shelter inflation, and it remains at a very low level despite the fact that a lot of multi-family units have been built during the past few years (Chart 4). The depressed vacancy rate suggests that the rental market is still not oversupplied, a message confirmed by the most recent reading from the National Multifamily Housing Council’s Apartment Market Tightness index (Chart 4, panel 2). This index has been above 50 for the past two months. Readings above 50 usually coincide with a falling vacancy rate. Overall, we conclude that core inflation will rise modestly in the second half of the year and that core PCE will eventually re-converge with the trimmed mean. Stronger inflation will be driven by the shelter and core services components. Any near-term strength in core goods inflation should be faded. Stay Overweight TIPS Versus Nominals We noted above that 10-year nominal yield’s recent jump was driven by the cost of inflation protection, rather than the real component. We can gain a broader perspective on the breakdown between the real and inflation components of Treasury yields by looking at the TIPS beta (Chart 5). The 10-year TIPS beta is calculated by regressing monthly changes in the 10-year TIPS yield on monthly changes in the 10-year nominal yield. It has been close to 0.6 for the past few years, meaning that a 1% move in the 10-year nominal yield can be roughly split between a 60 bps move in the real yield and a 40 bps move in the cost of inflation protection. The 10-year TIPS beta has been close to 0.6 for the past few years, meaning that a 1% move in the 10-year nominal yield can be roughly split between a 60 bps move in the real yield and a 40 bps move in the cost of inflation protection. We expect the TIPS beta to remain at or below current levels for the next few months. The TIPS beta tends to be low when long-maturity TIPS breakeven inflation rates are well below target. This is because the Fed will usually deploy dovish forward guidance during these periods in an attempt to goose inflation. Dovish Fed guidance makes the market less likely to price-in future monetary tightening in response to better economic data. This means that a greater proportion of the change in nominal yields will be driven by inflation expectations. Eventually, once long-maturity TIPS breakeven inflation rates move back into a “well-anchored” range between 2.3% and 2.5% (Chart 5, bottom two panels), the Fed will turn increasingly hawkish and the TIPS beta will rise. It will be some time before the 10-year TIPS breakeven inflation rate returns to its 2.3% - 2.5% range. However, our Adaptive Expectations model suggests that the rate will move higher during the next few months (Chart 6).3 Our model considers the 10-year TIPS breakeven inflation rate relative to the trailing 10-year rate of change in core CPI, the trailing 12-month rate of change in headline CPI and the New York Fed’s Underlying Inflation Gauge, with the trailing 10-year rate of change in core CPI being the most important variable. At present, our model pegs fair value for the 10-year breakeven at 1.93%, 12 bps above the current level. Chart 5Fed Guidance Keeps TIPS Beta Low Chart 6Adaptive Expectations Model   Chart 7Inflation & Commodities Further, every monthly core CPI print that comes in above 1.83% - the current trailing 10-year rate of change – puts slight upward pressure on our model’s fair value reading. In light of current inflation trends, further upside in the 10-year breakeven rate seems likely in the second half of the year. Finally, the 10-year TIPS breakeven inflation rate has also taken cues from oil and commodity markets in recent years (Chart 7). Our preferred broad commodity index – the CRB Raw Industrials index – remains in a tailspin, but should recover in the second half of the year alongside global growth (see section titled “Monitoring The Manufacturing Recession” below). As for oil, our commodity strategists also see upside in the second half of the year, and hold a $70/bbl price target for Brent crude.4  Bottom Line: Stay overweight TIPS versus nominal Treasury securities. Our model shows that the 10-year TIPS breakeven inflation rate is 12 bps too low, and core inflation should gradually move higher in the second half of the year. Cut Municipal Bonds To Neutral Municipal / Treasury yield ratios have tightened dramatically during the past few weeks, and municipal debt now looks quite expensive. 2-year, 5-year and 10-year Aaa-rated Municipal / Treasury yield ratios are all more than one standard deviation below average pre-crisis levels (Chart 8). Only 20-year and 30-year Aaa munis still look cheap, with yield ratios above average pre-crisis levels (Chart 8, bottom two panels). 2-year, 5-year and 10-year Aaa-rated Municipal / Treasury yield ratios are all more than one standard deviation below average pre-crisis levels. Municipal debt looks even more expensive relative to corporate credit. Chart 9 shows the average yield from the Bloomberg Barclays Investment Grade Corporate index and the yield of a Aaa muni bond with the same duration. The Muni / Corporate yield ratio is extremely stretched, and is actually close to levels that have preceded periods of strong corporate bond performance in the past. Chart 8Munis Look Expensive Chart 9Favor Corporate Credit Over Municipals   Bottom Line: We downgrade our recommended allocation to municipal bonds from overweight to neutral, based on valuations that have become historically expensive. We continue to recommend an overweight allocation to 20-year and 30-year Aaa munis, where yields are more reasonable. We may be seeing the first signs that manufacturing is rebounding as we head into the third quarter. We prefer corporate credit over municipals in this environment, and note that corporate bonds tend to perform well when they are as attractively valued relative to munis as they are now. Monitoring The Manufacturing Recession Chart 10Early Signs Of A Manufacturing Rebound? Much like in 2015/16, the ongoing global growth slowdown has taken its toll on the U.S. manufacturing sector. In fact, the National ISM Manufacturing PMI fell to 51.7 in June, from a 2018 peak of 60.7. We’ve noted in prior research that, as was the case in 2016, the global manufacturing data will likely rebound now that the Fed has adopted a more dovish policy stance and China has stepped up its rate of credit growth.5 In fact, as the Regional Fed Manufacturing PMIs have come in during the past two weeks, we may be seeing the first signs that manufacturing is rebounding as we head into the third quarter (Chart 10). The New York Fed’s PMI, released July 15, rose from -8.6 to 4.3, and three days later the Philadelphia Fed’s PMI jumped from 0.3 to 21.8. Release dates for the remaining four regional Fed surveys are shown in parentheses in Chart 10, and we will be monitoring these releases closely to see if the tentative rebound observed in the New York and Philadelphia manufacturing surveys is confirmed. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com   1 https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20190619.pdf 2 https://www.newyorkfed.org/newsevents/speeches/2019/wil190718 3 For more details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, “Weak 1H19 Oil Demand Data Fuels Market Uncertainty”, dated July 18, 2019, available at ces.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com   Fixed Income Sector Performance Recommended Portfolio Specification  

Highlights Chart 1Looks Like 2016 & 1998 The Treasury market continues to price-in a recession-like outcome for the U.S. economy, embedding 83 basis points of Fed rate cuts over the next 12 months. But last week’s economic data challenge that narrative. First, the ISM Non-Manufacturing PMI held above 55 in June, even as its Manufacturing counterpart plunged toward the 50 boom/bust line (Chart 1). This divergence between a strong service sector and weak manufacturing sector is more reminiscent of prior mid-cycle slowdowns in 2016 and 1998 than of any pre-recession period. Second, nonfarm payrolls added 224k jobs in June, a strong rebound from the 72k added in May and enough to keep the 12-month growth rate at a healthy 1.5% (bottom panel). Still-low inflation expectations provide sufficient cover for the Fed to cut rates later this month, likely by 25 bps. But beyond that, continued strong economic data could prevent any further easing. Keep portfolio duration low and stay short the February 2020 fed funds futures contract. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 144 basis points in June, bringing year-to-date excess returns up to +368 bps. We removed our recommendation to hedge near-term corporate credit exposure after the Fed’s clear dovish pivot at the June FOMC meeting.1  At that time, we also noted that the surging gold price, weakening trade-weighted dollar and outperformance of global industrial mining stocks were all signaling that corporate spreads have peaked (Chart 2). Of our “peak credit spread” indicators, only the CRB Raw Industrials index has yet to turn the corner. The macro environment supports tighter spreads. But in the investment grade space, value only looks attractive for Baa-rated securities. Baa spreads remain 7 bps above our target (panel 3), while Aa and A-rated spreads are 1 bp and 4 bps below, respectively (panel 4). Aaa bonds are even more expensive, with spreads 19 bps below target (not shown).2  Investors should focus their investment grade corporate bond exposure on Baa-rated securities. Our measure of gross leverage – total debt over pre-tax profits – jumped in Q1, as corporate debt grew at an annualized pace of 8.5% while corporate profits contracted by an annualized 18% (bottom panel). Leverage will likely rise again in Q2, as profit growth will almost certainly remain weak, but should then level-off as global growth recovers. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 154 basis points in June, bringing year-to-date excess returns up to +603 bps. The average index option-adjusted spread tightened 56 bps on the month. At 366 bps, it remains well above the cycle-low of 303 bps. As with investment grade credit, we removed our recommendation to hedge near-term exposure following the June FOMC meeting (see page 3). Further, we see the potential for much more spread tightening in high-yield than in investment grade. Within investment grade, only the Baa credit tier carries a spread above our target. In High-Yield, Ba-rated spreads are 42 bps above our target (Chart 3), B-rated spreads are 108 bps above our target (panel 3) and Caa-rated spreads are 263 bps above our target (not shown).3  Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.7% over the next 12 months, not far from our own projection.4 This would translate into 224 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. We will continue to monitor job cut announcements, which have moderated so far this year (bottom panel), and C&I lending standards, which remain in net easing territory, to assess whether our default expectations need to be revised. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to -11 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 4 bps widening in the option-adjusted spread (OAS) was partially offset by a 3 bps decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS has risen all the way back to its average pre-crisis level (panel 3). However, as we noted in last week’s report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment our recommended allocation to MBS, especially given the favorable environment for corporate bonds, where expected returns are higher. We are equally disinclined to downgrade MBS, given that refi activity could be close to peaking. All in all, we expect that the next move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise in the second half of the year. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in June, bringing year-to-date excess returns up to +133 bps. Sovereign debt outperformed duration-equivalent Treasuries by 208 bps on the month, bringing year-to-date excess returns up to +419 bps. Local Authorities underperformed the Treasury benchmark by 6 bps, dragging year-to-date excess returns down to +213 bps. Meanwhile, Foreign Agencies underperformed by 26 bps, dragging year-to-date excess returns down to +103 bps. Domestic Agencies underperformed by 4 bps in June, dragging year-to-date excess returns down to +25 bps. Supranationals outperformed by 1 bp on the month, bringing year-to-date excess returns up to +28 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario, given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 73 basis points in June, dragging year-to-date excess returns down to -44 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 2% in June, and currently sits at 81% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but exactly equal to the average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Recent muni underperformance has been broad-based across the entire maturity spectrum, but long-end (20-year and 30-year) yield ratios continue to look attractive relative to the rest of the curve. 20-year and 30-year Aaa-rated yield ratios are more than one standard deviation above their respective pre-crisis averages. Meanwhile, 10-year, 5-year and 2-year Aaa yield ratios are very close to average pre-crisis levels. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.6 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened in June, alongside a large drop in our 12-month Fed Funds Discounter from -75 bps to -90 bps (Chart 7). June’s bull-steepening was reversed last week, as the strong employment report caused our discounter to jump back up to -83 bps, resulting in a bear-flattening of the Treasury curve. All in all, the 2/10 Treasury slope steepened 6 bps in June, then flattened 8 bps in the first week of July. It currently sits comfortably above zero at 17 bps. The 5/30 slope steepened 11 bps in June, then flattened 6 bps last week. It currently sits at 70 bps. In last week’s report we reviewed the case for barbelling your U.S. bond portfolio.7 That is, favoring the short and long ends of the yield curve while avoiding the 5-year and 7-year maturities. This positioning continues to make sense. Not only does the barbell increase the average yield of your portfolio, but our butterfly spread models all show that barbells are cheap relative to bullets (see Appendix B). The 5-year and 7-year yields will also rise more than long-end and short-end yields when the market eventually moves to price-in fewer Fed rate cuts. In addition to our recommended barbell positioning, we advocate keeping a short position in the February 2020 fed funds futures contract. That contract is currently priced for a fed funds rate of 1.69% next February, the equivalent of three 25 basis point rate cuts spread over the next five FOMC meetings. The Fed is unlikely to deliver that much easing. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +28 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month and currently sits at 1.69% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate fell 4 bps on the month and currently sits at 1.83%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.8 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 2.3% (annualized) clip in May, following an even higher 3% (annualized) rate in April. However, it has only grown 1.6% during the past year. 12-month trimmed mean PCE is running almost exactly in line with the Fed’s target at 1.99%. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.9   ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to +51 bps. The index option-adjusted spread for Aaa-rated ABS widened 9 bps on the month, moving back above its minimum pre-crisis level (Chart 9). At 36 bps, the spread remains well below its pre-crisis mean of 64 bps. In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. Second quarter data will be made available in early August, but current trends are not promising. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in June, dragging year-to-date excess returns down to +191 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 68 bps, below its average pre-crisis level but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation relative to other similarly-rated fixed income sectors.10  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to +93 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 50 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 83 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of July 5, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of July 5, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the 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 of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 10  Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Chart 1Bond Rally Supports Stocks Financial markets are pricing-in an intensifying global growth slowdown, but not all assets are responding equally. U.S. Treasuries have rallied strongly, while equities and credit spreads remain resilient. Case in point, the S&P 500 is only 5.9% off its Q3 highs in absolute terms, but is down 11.3% versus bonds (Chart 1). The markets are pricing-in that the Fed will react to slower growth by cutting rates and that easier Fed policy will keep risk assets supported. But consider what will happen if, at the June FOMC meeting, the Fed doesn’t seem as eager to cut rates as the market would like. The perception of less monetary support could prompt a sharp sell-off in equities and credit spreads. That tightening of financial conditions could then be enough to force the Fed’s hand, ultimately leading to the rate cut that the market has already come to expect. The odds of the above scenario are rising by the day, especially since the President’s decision to expand the trade war to Mexico. We recommend a cautious near-term (0-3 month) stance on credit spreads as a hedge against this mounting risk.  Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 139 basis points in May, dragging year-to-date excess returns down to +221 bps. As we noted in last week’s report, corporate bond spreads have not responded as aggressively as some other assets – commodities and Treasuries – to the escalating trade war and the deteriorating global growth data.1 This leaves the sector vulnerable to a near-term sell-off, especially if the Fed doesn’t validate the market’s dovish expectations at this month’s FOMC meeting. We advise investors to hedge their exposure to credit spreads on a 0-3 month horizon. Beyond that, assuming that the U.S. government’s tariff announcements eventually reach a plateau, the outlook for corporate bond excess returns is positive on a 6-12 month investment horizon. Spreads are comfortably above levels typically seen at this stage of the economic cycle (Chart 2) and, tariffs aside, the U.S. economy is growing at a reasonable clip. As for balance sheets, corporate profit growth contracted in the first quarter, dragging the year-over-year growth rate down to 7%. That is roughly equivalent to the trend rate in corporate debt growth, meaning that if profit growth stabilizes near that level our measure of gross leverage will stay flat (panel 4). We are also keeping a close eye on C&I lending standards. While the most recent data showed an easing in Q1, the continued contraction in loan demand poses a risk (bottom panel). High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 250 basis points in May, dragging year-to-date excess returns down to +443 bps. As with investment grade corporates, the risk of near-term spread widening is high. We noted in last week’s report that excess junk returns versus Treasuries outpaced the CRB Raw Industrials index by 9% during the past 12 months, a historically wide divergence that is bound to fade.2 Looking further out, high-yield bonds still look like a good bet on a 6-12 month investment horizon. Spreads are comfortably above typical levels from past cycles and the excess spread available in the junk index after accounting for expected default losses has risen to 325 bps, well above its historical average (Chart 3). Assuming historically average excess compensation and a 50% recovery rate, current junk spreads discount an expected 12-month default rate of 3.1%. This is well above the Moody’s baseline projection of 1.5% and even above the 2.7% default rate seen during the past 12 months. The spread-implied default rate should be easy to beat, though a persistent increase in job cut announcements could pose a risk (bottom panel). MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in May, dragging year-to-date excess returns down to -13 bps. The conventional 30-year zero-volatility spread widened 6 bps on the month, the combination of a 4 bps widening in the option-adjusted spread (OAS) and a 2 bps increase in the compensation for prepayment risk (option cost). At 49 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains slightly below its pre-crisis mean (Chart 4). Nonetheless, we see high odds that the MBS/Treasury basis will contract going forward. Falling mortgage rates and an uptick in refinancing activity led to the recent widening in MBS spreads. But with the housing activity data showing signs of improvement, we anticipate that mortgage rates are close to a trough and that refis will soon peak (panel 2). If the “risk off” sentiment in financial markets prevails in the near-term, then MBS will outperform corporate credit. But expected 6-12 month excess returns remain higher for corporate bonds than for MBS. We therefore maintain only a neutral allocation to MBS, despite increasingly attractive valuations. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to +107 bps. Sovereign debt underperformed duration-equivalent Treasuries by 205 bps on the month, dragging year-to-date excess returns down to +206 bps. Local Authorities outperformed the Treasury benchmark by 11 bps, bringing year-to-date excess returns up to +219 bps. Meanwhile, Foreign Agencies underperformed by 61 bps, dragging year-to-date excess returns down to +130 bps. Domestic Agencies underperformed by 1 bp in May, bringing year-to-date excess returns up to +28 bps. Supranationals outperformed by 4 bps on the month, bringing year-to-date excess returns up to +27 bps. Sovereign debt remains expensive relative to equivalently rated U.S. corporate credit (Chart 5), and the dollar’s relentless march higher presents a further headwind for the sector. We continue to recommend an underweight allocation. Previously, we made an exception for Mexican sovereign bonds, which trade cheap relative to U.S. corporates (bottom panel). However, with the U.S. government now threatening tariffs on imported Mexican goods, the peso will likely see heightened volatility in the coming months. We recommend standing aside on Mexican sovereigns for the time being. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 75 basis points in May, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in May, and currently sits at 80% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, but close to the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) have outperformed short-dated munis (2-year and 5-year) by a wide margin since the beginning of the year, but long-end yield ratios remain relatively attractive. 20-year and 30-year Aaa-rated municipal bonds are particularly alluring. Yield ratios for those bonds remain above their pre-crisis averages, whereas 10-year, 5-year and 2-year Aaa yield ratios are close to one standard deviation below their respective pre-crisis means. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.3 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in May, with yields falling by more than 30 basis points for all maturities beyond 1 year. The 2/10 Treasury slope flattened 5 bps on the month and currently sits at 19 bps. The 5/30 slope was unchanged on the month and currently sits at 65 bps (Chart 7). The belly (5-year/7-year) of the curve looks particularly expensive relative to the wings (see Appendix B) and we continue to recommend a barbell curve positioning: Investors should overweight the long and short ends of the curve and avoid the belly.4 Further, this week we recommend an additional fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract. The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if 3 or more rate cuts occur between now and then. We would expect our spread trade to return +48 bps in a scenario where the Fed keeps rates flat until next March and +23 bps in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 116 basis points in May, dragging year-to-date excess returns down to +39 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.74%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps on the month and currently sits at 1.90%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.5 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 3% (annualized) clip in April, but has only risen 1.6% during the past year. 12-month trimmed mean PCE inflation has been higher, and actually just moved above the Fed’s target following last week’s April data release (Chart 8). In last week’s report we noted that core PCE inflation has a track record of converging toward the trimmed mean.6 As such, we recommend that investors remain overweight TIPS versus nominal Treasuries in U.S. bond portfolios. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +64 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and actually hit a new all-time low of 26 bps in mid-May, before settling at 28 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +195 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 69 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst waning demand (bottom panel) and decelerating prices (panel 3). However, CMBS still offer reasonable compensation for this risk. Especially compared to other similarly-rated fixed income sectors.7 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in May, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread widened 3 bps on the month and currently sits at 51 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread product. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 75 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of May 31, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of May 31, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +56 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the 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 of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 4 We have specifically been recommending a position short the 7-year bullet and long a duration-matched 2/30 barbell. 5 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Bank Credit Analyst

Highlights U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Feature Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. U.S. Treasuries U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. U.S. REITs While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Commodity Futures Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. U.S. Inflation-Protected Bonds While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Sub-Asset Classes Global Equity Sectors For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel).   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation Footnotes 1       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 2       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 3       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 4       Excess returns are defined as asset return relative to a 3-month Treasury bill. 5       Sector classification does not take into account GICS changes prior to December 2018.  6       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 7       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 8       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.

Bank Credit Analyst

Highlights The Federal Reserve’s monetary policy stance is slightly accommodative for the U.S., but it is too tight for the rest of the world. Inflation is likely to slow further before making a durable bottom toward year-end. The Fed will remain on an extended pause, maybe all the way through to December 2020. The trade war is not going away, and investors should not be complacent. However, it also guarantees that Chinese policymakers will redouble on their reflationary efforts. As a result, global growth is still set to improve in the second half of 2019. The dollar rally is in its last innings; the greenback will depreciate in the second half of this year. Treasury yields have limited downside and their recent breakdown is likely to be a fake-out. Use any strength in bond prices to further curtail portfolio duration. The correction in stocks is not over. However, the cycle’s highs still lie ahead. Feature Ongoing Sino-U.S. tensions and weakness in global growth are taking their toll. The S&P 500 has broken below its crucial 2,800 level, EM equities are quickly approaching their fourth-quarter 2018 lows, U.S. bond yields have fallen to their lowest readings since 2017, copper has erased all of its 2019 gains and the dollar is attempting to break out. In response, futures markets are now pricing in interest rate cuts by the Fed of 54 bps and 64 bps, over the next 12 and 24 months, respectively. Will the Fed ratify these expectations? Last week’s release of the most recent Fed’s Federal Open Market Committee meeting minutes, as well as comments from FOMC members ranging from Jerome Powell to Richard Clarida, are all adamantly clear: U.S. monetary policy is appropriate, and a rate cut is not on the table for now. However, the avowed data-dependency of the Fed implies that if economic conditions warrant, the FOMC will capitulate and cut rates. Even as U.S. inflation slows, a recession is unlikely. Moreover, the Sino-U.S. trade war will catalyze additional reflationary policy from China, putting a floor under global growth. In this context, the Fed is likely to stay put for an extended period, but will not cut rates. While the S&P 500 is likely to fall toward 2,600, the high for the cycle is still ahead. We therefore maintain our positive cyclical equity view, especially relative to government bonds, but we are hedging tactical risk. Fed Policy Is Neutral For The U.S…. If the fed funds rate was above the neutral rate – the so-called R-star – we would be more inclined to agree with interest rate markets and bet on a lower fed funds rate this year. However, it is not clear that this is the case. Chart I-1Mixed Message From The R-Star Indicator Admittedly, the inversion of the 10-year/3-month yield curve is worrisome, but other key variables are not validating this message. Currently, our R-star indicator, based on M1, bank liquidity, consumer credit, and the BCA Fed monitor, is only in neutral territory (Chart I-1). Moreover, we built a model based on the behavior of the dollar, yield curve, S&P homebuilding relative to the broad market and initial UI claims that gauges the probability that the fed funds rate is above R-star. Currently, the model gives a roughly 40% chance that U.S. monetary policy is tight (Chart I-2). Historically, such a reading was consistent with a neutral policy stance.   Chart I-2Today, Fed Policy Is At Neutral Models can be deceiving, so it is important to ensure that facts on the ground match their insights. Historically, housing is the sector most sensitive to monetary policy.1 Key forward-looking activity measures are not showing signs of stress: mortgage applications for purchases have jumped to new cyclical highs, and the NAHB homebuilders confidence index has smartly rebounded after weakening last year (Chart I-3). Also, homebuilder stocks have been in a steady uptrend relative to the S&P 500 since last October (Chart I-3, bottom panel). These three developments are not consistent with tight monetary policy. Chart I-3This Would Not Happen If Policy Were Tight The corporate sector confirms the message from the housing sector. While capex intentions have weakened, they remain at elevated levels, despite slowing profit growth and elevated global uncertainty. Moreover, the latest Fed Senior Loan Officer Survey shows that banks have again eased credit standards for commercial and industrial loans. Netting out all these factors, we are inclined to agree with the Fed that monetary policy in the U.S. is broadly neutral. If anything, the rebound in leading indicators of residential activity would argue that policy is even slightly accommodative. … But Not For The Rest Of The World Congress gave the Fed a U.S.-only mandate, but the U.S. dollar is the global reserve currency. Because the dollar is the keystone of the global financial architecture, between US$12 trillion and US$14 trillion of foreign-currency debt is issued in USDs, and the greenback is used as a medium of exchange in roughly US$800 trillion worth of transaction per year.2 Therefore, the Fed may target U.S. monetary conditions, but it sets the cost of money for the entire world. While U.S. monetary conditions may be appropriate for the U.S., they are not entirely appropriate for the world as a whole. Indeed, the green shoots of growth we highlighted two months ago are rapidly turning brown: Korean and Taiwanese exports, which are highly sensitive to the global and Asian business cycles, are still contracting at a brisk pace (Chart I-4, top panel). Japan, an economy whose variance in GDP mostly reflects global gyrations, is weakening. Exports are contracting at a 4.3% yearly pace, machine tool orders are plunging at a 33% annual rate and the coincident indicator is below 100 – a sign of shrinking activity. The semiconductor space is plunging (Chart I-4, second panel). Our EM Asia diffusion index, which tallies 23 variables, is near record lows (Chart I-4, third panel). Europe too is feeling the pain, led by Germany, another economy deeply dependent on global activity. The flash estimate for the euro area manufacturing PMI fell to 47.7 and plunged to 44.3 in Germany, its lowest level since July 2012 (Chart I-4, bottom panel). These developments show that the world economy remains weak, in part because the Chinese economy has yet to meaningfully regain any traction. The rebound in Chinese PMI in March proved short lived; in April, both the NBS and Caixin measures fell back to near the 50 boom/bust line. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor. A strong dollar is a natural consequence of an outperforming U.S. economy, especially when global growth weakens. Thus, the rally in the Fed’s nominal trade-weighted dollar to its highest level since March 2002 is unsurprising (Chart I-5). A strong Greenback will have implications for inflation, and thus the Fed. Chart I-4Global Growth: No Green Shoots Here Chart I-5A Strong Dollar Is A Natural Consequence Of Weak Growth   Transitory Inflation Weakness Is Not Over The Fed believes the current inflation slowdown is transitory. We agree. With a tight labor market and rising wages, the question is not if inflation will rise, but when. In the current context, it could take some time. As Chart I-6 shows, inflation has been stable for more than 20 years. From 1996 to today, core PCE has oscillated between 0.9% and 2.6%, while core CPI has hovered between 0.6% and 2.9%, with the peaks and troughs determined by the ebbs and flows of global growth. Since inflation lags real activity and global growth has yet to bottom, it could take some time before inflation finds a floor, likely around 1.3% and 1.5% for core PCE and core CPI, respectively. Chart I-6Stable U.S. Inflation Since 1996 A few dynamics strengthen this judgment: The strength in the dollar is deflationary (Chart I-7, top panel). Not only does an appreciating greenback depress import prices, it tightens U.S. and global financial conditions. It also undermines dollar-based liquidity, especially if EM central banks try to fight weakness in their own currencies. All these forces harm growth, commodity prices and ultimately, inflation. Chart I-7More Downside Ahead In Inflation For Now After adjusting for their disparate variance, the performance of EM stocks relative to EM bonds is an excellent leading indicator of global core inflation (Chart I-7, second panel). This ratio is impacted by EM financial conditions, explaining its forecasting power for prices. Since goods inflation – which disproportionally contributes to overall variations in core CPI – is globally determined, U.S. inflation will suffer as well. U.S. capacity utilization is declining (Chart I-7, third panel). The U.S. just underwent a mini inventory cycle. The 12-month moving averages of the Philadelphia Fed and Empire State surveys’ inventory indexes still stand above their long-term averages. U.S. firms will likely use discounts to entice customers, especially as a strong dollar and weak global growth point to limited foreign outlets for this excess capacity. Finally, the growth in U.S. unit labor costs is slowing sharply, which normally leads inflation lower (Chart I-7, bottom panel). Average hourly earnings may now be growing at a 3.2% annual pace, but productivity rebounded to a 2.4% year-on-year rate in the first quarter, damping the impact of higher salaries on costs. If global growth is weak and U.S. inflation decelerates further, the Fed is unlikely to raise interest rates anytime soon. As the Fed policy remains modestly accommodative and the labor market is at full employment, the balance of probability favors an extended pause over a cut. But keep in mind, next year’s elections may mean this pause could last all the way to December 2020. How Does The Trade War Fit In? An additional irritant has been added to the mix: the growing trade tensions between the U.S. and China. The trade war has resurrected fears of a repeat of the 1930 Smoot-Hawley tariffs, which prompted a wave of retaliatory actions, worsening the massive economic contraction of the Great Depression. There is indeed plenty to worry about. Today, global trade represents 25% of global GDP, compared to 12% in the late 1920s. Global growth would be highly vulnerable to a freeze in world trade. Besides, global supply chains are extremely integrated, with intra-company exports having grown from 7% of global GDP to 16% between 1993 and 2013. If a full-blown trade war were to flare up, much of the capital invested abroad by large multinationals might become uneconomic. As markets price in this probability, stock prices would be dragged down. Chart I-8Trade Uncertainty Alone Will Delay The Recovery The fear of a full-fledged trade war is already affecting the global economy. The fall in asset prices to reflect the risk of stranded capital is tightening financial conditions and hurting growth. Moreover, the rise in U.S. and global economic uncertainty is depressing capex intentions (Chart I-8). Since capex intentions are a leading variable for actual capex, global exports and manufacturing activity, the trade war is deepening and lengthening the current soft patch. Markets need to be wary of pricing in a quick end to the Sino-U.S. trade conflict. Table I-1 presents BCA’s Geopolitical Strategist Matt Gertken’s odds of various outcomes to the trade negotiations and their implications for stocks. Matt assigns only a 5% probability to a grand compromise between the U.S. and China on trade and tech. He also foresees a 35% chance that a deal on trade excluding an agreement on tech will be reached this year. This leaves 10% odds that the two sides agree to extend the negotiation deadline beyond June, 20% odds of no deal at all and a minor escalation, and 30% odds of a major escalation. In other words, BCA is currently assigning 60% odds of a market-unfriendly outcome, and only a 40% chance of a genuinely market-friendly one.3 Why the gloom? The U.S. and China are geopolitical rivals in a deadlock. Moreover, both parties are feeling increasingly emboldened to play hardball. On the U.S. side, President Donald Trump has threatened to expand his tariffs to all of China’s exports to the U.S., which would represent a major escalation in both the conflict and its cost (Chart I-9). However, despite the scale of the threat, even if it were fully borne by U.S. households, its impact should be kept in perspective. Imports of consumer goods from China only represent 2% of total household spending (Chart I-10, top panel). Moreover, households are not currently overly concerned with inflation, as goods prices are already muted (Chart I-10, middle panel) and family income is still growing (Chart I-10, bottom panel). Finally, a weak deal could easily be decried as a failure in the 2020 election. On the Chinese side, the 9.5% fall in the yuan is already absorbing some of the costs of the tariffs, and the RMB will depreciate further if the trade war escalates. Additionally, Chinese exports to the U.S. represent 3.4% of GDP, while household and capital spending equals 81% of output. China can support its domestic economy via fiscal and credit policy, greatly mitigating the blow from the trade war. The outlook for Chinese reflationary efforts is therefore paramount. In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. Not only do Chinese policymakers have the room to stimulate, they also have the will. In the first four months of 2019, Chinese total social financing flows have amounted to CNY 9.6 trillion, which compares favorably to the same period during the 2016 reflation campaign. Yet, the economy has not fully responded to the injection of credit and previously implemented tax cuts amounting to CNY 1.3 trillion or 1.4% of GDP. Consequently, GDP per capita is now lagging well behind the required path to hit the government’s 2020 development targets (Chart I-11). Moreover, Chinese policymakers’ recent comments have increasingly emphasized protecting employment. This combination raises the likelihood of additional stimulus in the months ahead. Chart I-10...But Do Not Overstate Trump's Constraints Chart I-11Chinese Stimulus: Scope And Willingness   Therein lies the paradox of the trade war. While its immediate effect on world growth is negative, it also increases the chance that Chinese authorities pull all the levers to support domestic growth. A greater reflationary push would thus address the strongest headwind shaking the global economy. It could take two to six more months before the Chinese economy fully responds and lifts global growth. Ultimately, it will. Hence, even as the trade war continues, we remain skeptical that the Fed will cut interest rates as the market is discounting. We are therefore sticking to our call that the Fed will not cut rates over the next 12 months and will instead stay on an extended pause. Investment Conclusions The Dollar So long as global growth remains soft, the dollar is likely to rally further. That being said, the pace of the decline in global growth is decelerating. As a corollary, the fastest pace of appreciation for the greenback is behind us (see Chart I-5 on page 6). The risk to this view is that the previous strength in the dollar has already unleashed a vicious cycle whereby global financial conditions have tightened enough to cause another precipitous fall in world growth. The dollar’s strong sensitivity to momentum would then kick in, fomenting additional dollar strength in response to the greater growth slowdown. In this environment, the Fed would have no choice but to cut interest rates. However, growing reflationary efforts around the world currently confine this scenario to being a risk, not a central case. Additional factors also limit how far the dollar can rally. Speculators have already aggressively bought the greenback (Chart I-12). The implication is that buyers have moved in to take advantage of the dollar-friendly fundamentals. When looking at the euro, which can be thought of as the anti-dollar, investors are imputing a large discount in euro area stocks relative to U.S. ones, pointing to elevated pessimism on non-U.S. growth (Chart I-13). It would therefore require a much graver outcome in global growth to cause investors to further downgrade the outlook for the rest of the world relative to the U.S. and bring in new buyers of greenbacks. Chart I-12USD: Supportive Fundamentals Are Already Reflected Chart I-13Plenty Of Pessimism In European Assets...   In sharp contrast to its limited upside, the dollar’s downside will be much more significant once global growth improves. The same factors that are currently putting the brakes on the dollar’s rise will fuel its eventual downturn. As global growth bounces, a liquidation of stale long-dollar bets will ensue. European growth will also rebound (Chart I-14), and euro pessimism will turn into positive surprises. European assets will be bought, and the euro will rise, deepening the dollar’s demise. We are closely following the Chinese and global manufacturing PMIs to gauge when global growth exits its funk. At this point, it will be time to sell the USD. Government Bonds Bonds are caught between strong crosscurrents. On the one hand, rising economic uncertainty caused by the trade war, slowing global economic activity and decelerating inflation are all bond-bullish. On the other hand, bond prices already reflect these tailwinds. The OIS curve is baking in 54 basis points of Fed cuts over the next 12 months, as well as a further 10 basis points over the following 12 months (Chart I-15, top panel). Meanwhile, term premia across many major bond markets are very negative (Chart I-15, middle panel). Finally, fixed-income investors have pushed their portfolio duration to extremely high levels relative to their benchmark (Chart I-15, bottom panel). Chart I-14...Creates Scope For Positive Surprises Chart I-15Fade The Treasury Rally   Last week, Treasury yields broke down below 2.34%. For this technical break to trigger a new down-leg in yields, investors must curtail their already-depressed expectations of the fed funds rate in 12-months’ time. However, the fed funds rate is not yet restrictive, and global growth should soon find a floor in response to expanding Chinese stimulus. Under these circumstances, the Fed is unlikely to cut rates, and will continue to telegraph its intentions not to do so. Hence, unless the S&P 500 or the ISM manufacturing fall below 2,500 and 50, respectively, any move lower in yields is likely to be transitory and shallow. Cyclically, yields should instead move higher. Our Global Fixed Income Strategy service’s duration indicator has already turned the corner (Chart I-16). Moreover, in the post-war period, Treasury yields have, on average, bottomed a year before inflation. Expecting an inflation trough in late 2019 or even early 2020 is therefore consistent with higher yields by year-end. Finally, when the Fed does not cut interest rates as much as the markets had been anticipating 12-months’ prior, Treasurys underperform cash. This is exactly BCA’s current Fed forecast. Chart I-16Global Yields Now Have More Upside Than Downside While we expect the bond-bearish forces to emerge victorious, yields may only rise slowly. The list of aforementioned supports for Treasury prices is long, the equity market will remain volatile and has yet to trough, and the trade war is likely to linger. We continue to closely monitor the AUD, the SEK versus the EUR, and copper to gauge if our view is wrong. These three markets are tightly linked to Chinese growth. If China’s stimulus is working, these three variables will rebound, and our bond view will be validated. If these three variables fall much further, U.S. yields could experience significantly more downside. Equities Equities are at a difficult juncture. The trade war is a bigger problem for Wall Street than for Main Street, as 43.6% sales of the S&P 500’s are sourced abroad. Moreover, the main mechanism through which trade tensions impact the stock market is through the threat that capital will be stranded – and thus worthless. This is a direct hit to the S&P 500, especially as global growth has yet to clearly stabilize and the Chinese are only beginning to make clearer retaliatory threats. Oil could also hurt stocks. Energy prices have proven resilient, despite weaker global economic activity. OPEC and Russia have been laser-focused on curtailing global crude inventories; even after the U.S. declined to extend waivers on Iranian exports, the swing oil producers have not meaningfully increased supply. Problems in Venezuela, Libya, and potential Iranian adventurism in Iraq could easily send oil prices sharply higher, especially as the U.S. does not have the export capacity to fulfill foreign demand. Thus, the oil market could suddenly tighten and create a large drag on global growth. This backdrop also warrants remaining overweight the energy sector. Stocks remain technically vulnerable. Global and U.S. stock market breadth has deteriorated significantly, as shown by the number of countries and stocks above their 200-day moving averages (Chart I-17). Moreover, since March, the strength in the S&P 500 has been very narrow, as shown by the very poor performance of the Value Line Geometric Average Index (Chart I-18). Meanwhile, the poor relative performance of small-cap stocks in an environment where the dollar is strong, where U.S. growth is holding steady compared to the rest of the world and where multinationals have the most to lose from a trade war, is perplexing. Chart I-17Stocks Remain Technically Fragile Chart I-18Dangerous Internal Dynamics   The U.S. stock market has the most downside potential in the weeks ahead. Like last summer, U.S. equity prices remain near record highs while EM and European stocks, many commodities and bond yields have been very weak. Moreover, the broad tech sector, the U.S.’s largest overweight, has defied gravity, despite weakness in the semiconductor sector, the entire industry’s large exposure to foreign markets, and the consequential slowdown in our U.S. Equity Strategy service's EPS model (Chart I-19).4 Thus, any bad news on the trade front or any additional strength in the dollar could prove especially painful for tech. This would handicap U.S. equities more than their already beaten-up foreign counterparts. Chart I-19The Tech Sector Profit Outlook Remains Poor These forces mean that the global equity correction will last longer, and that U.S. equities could suffer more than other DM markets. However, we do not see the S&P falling much beyond the 2,700 to 2,600 zone. Again, the fed funds rate is slightly accommodative and a U.S. recession – a prerequisite for a bear market (Chart I-20) – is unlikely over the coming 12 months. Moreover, global growth should soon recover, especially if China’s reflationary push gathers force. Additionally, an end to the dollar’s rally would create another welcomed relief valve for stocks. Chart I-20The Absence Of A Recession Means This Is A Correction, Not A Bear Market In this context, we recommend investors keep a cyclical overweight stance on stocks. Balanced portfolios should also overweight stocks relative to government bonds. However, the near-term risks highlighted above remain significant. Consequently, we also recommend investors hedge tactical equity risks, a position implemented by BCA’s Global Investment Strategy service three weeks ago.5 As a corollary, if stocks correct sharply, the associated rise in implied volatility will also cause a violent but short-lived pick up in credit spreads. In Section II, we look beyond the short-term gyrations. One of BCA’s long-term views is that inflation is slowly embarking on a structural uptrend. An environment of rising long-term inflation is unfamiliar to the vast majority of investors. In this piece, Juan-Manuel Correa, of our Global Asset Allocation team, shows which assets offer the best inflation protection under various states of rising consumer and producer prices. Mathieu Savary Vice President The Bank Credit Analyst May 30, 2019 Next Report: June 27, 2019 II. Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. U.S. Treasuries U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. U.S. REITs While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Commodity Futures Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. U.S. Inflation-Protected Bonds While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Sub-Asset Classes Global Equity Sectors For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel).   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation   III. Indicators And Reference Charts Last month, we argued that the S&P 500 would most likely enter a period of digestion after its furious gains from December to April. This corrective episode is now upon us as the S&P 500 is breaking below the crucial 2,800 level. Moreover, our short-term technical indicators are deteriorating, as the number of stocks above their 30-week and 10-week moving averages have rolled over after hitting elevated levels, but have yet to hit levels consistent with a durable trough. This vulnerability is especially worrisome in a context where pressure will continue to build, as Beijing is only beginning to retaliate to the U.S.’s trade belligerence. Our Revealed Preference Indicator (RPI) is not flashing a buy signal either. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. It will require either cheaper valuations, a pick-up in global growth or further policy easing before stocks can resume their ascent. On the plus side, our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Hence, stock weaknesses are likely to prompt buy-the-dip behaviors by investors. Therefore, the expected downdraft will remain a correction and stocks have more cyclical upside. Our Monetary Indicator remains in stimulative territory, supporting our cyclical constructive equity view. The Fed is firmly on hold and global central banks have been opening the monetary spigots, thus monetary conditions should stay supportive. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message of our Monetary Indicator, especially as our Composite Technical Indicator has moved back above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are slightly expensive. Moreover, our technical indicator flags a similar picture. However, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Taking this positioning into account, BCA’s economic view is consistent with limited yield downside in the short-run, and higher yields on a 6 to 12 month basis. On a PPP basis, the U.S. dollar is only getting ever more expensive. Additionally, our Composite Technical Indicator is not only in overbought territory, it is also starting to diverge from prices. Normally, this technical action points to a possible trend reversal, especially when valuations are so demanding. However, this downside will only materialize once global growth shows greater signs of strength. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes   Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Edward E. Leamer, "Housing is the business cycle," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 149-233, 2007. 2       This includes both real and financial transactions. 3       Please see Geopolitical Strategy Weekly Report, “How Trump Became A War President,” dated May 17, 2019, available at gps.bcaresearch.com 4       Please see Global Investment Strategy Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Trader's Paradise,” dated January 28, 2019, available at uses.bcaresearch.com 6       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 7       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 8       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 9       Excess returns are defined as asset return relative to a 3-month Treasury bill. 10       Sector classification does not take into account GICS changes prior to December 2018.  11       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 12       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 13       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: