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Highlights We update our long-range forecasts of returns from a range of asset classes – equities, bonds, alternatives, and currencies – and make some refinements to the methodologies we used in our last report in November 2017. We add coverage of U.K., Australian, and Canadian assets, and include Emerging Markets debt, gold, and global Real Estate in our analysis for the first time. Generally, our forecasts are slightly higher than 18 months ago: we expect an annual return in nominal terms over the next 10-year years of 1.7% from global bonds, and 5.9% from global equities – up from 1.5% and 4.6% respectively in the last edition. Cheaper valuations in a number of equity markets, especially Japan, the euro zone, and Emerging Markets explain the higher return assumptions. Nonetheless, a balanced global portfolio is likely to return only 4.7% a year in the long run, compared to 6.3% over the past 20 years. That is lower than many investors are banking on. Feature Since we published our first attempt at projecting long-term returns for a range of asset classes in November 2017, clients have shown enormous interest in this work. They have also made numerous suggestions on how we could improve our methodologies and asked us to include additional asset classes. This Special Report updates the data, refines some of our assumptions, and adds coverage of U.K., Australian, and Canadian assets, as well as gold, global Real Estate, and global REITs. Our basic philosophy has not changed. Many of the methodologies are carried over from the November 2017 edition, and clients interested in more detailed explanations should also refer to that report.1 Our forecast time horizon is 10-15 years. We deliberately keep this vague, and avoid trying to forecast over a 3-7 year time horizon, as is common in many capital market assumptions reports. The reason is that we want to avoid predicting the timing and gravity of the next recession, but rather aim to forecast long-term trend growth irrespective of cycles. This type of analysis is, by nature, as much art as science. We start from the basis that historical returns, at least those from the past 10 or 20 years, are not very useful. Asset allocators should not use historical returns data in mean variance optimizers and other portfolio-construction models. For example, over the past 20 years global bonds have returned 5.3% a year. With many long-term government bonds currently yielding zero or less, it is mathematically almost impossible that returns will be this high over the coming decade or so. Our analysis points to a likely annual return from global bonds of only 1.7%. Our approach is based on building-blocks. There are some factors we know with a high degree of certainly: such as the return on U.S. 10-year Treasury yields over the next 10 years (to all intents and purposes, it is the current yield). Many fundamental drivers of return (credit spreads, the small-cap premium, the shape of the yield curve, profit margins, stock price multiples etc.) are either steady on average over the cycle, or mean revert. For less certain factors, such as economic growth, inflation, or equilibrium short-term interest rates, we can make sensible assumptions. Most of the analysis in this report is based on the 20-year history of these factors. We used 20 years because data is available for almost all the asset classes we cover for this length of time (there are some exceptions, for example corporate bond data for Australia and Emerging Markets go back only to 2004-5, and global REITs start only in 2008). The period from May 1999 to April 2019 is also reasonable since it covers two recessions and two expansions, and started at a point in the cycle that is arguably similar to where we are today. Some will argue that it includes the Technology bubble of 1999-2000, when stock valuations were high, and that we should use a longer period. But the lack of data for many assets classes before the 1990s (though admittedly not for equities) makes this problematic. Also, note that the historical returns data for the 20 years starting in May 1999 are quite low – 5.8% for U.S. equities, for example. This is because the starting-point was quite late in the cycle, as we probably also are now.   We make the following additions and refinements to our analysis: Add coverage of the U.K., Australia, and Canada for both fixed income and equities. Add coverage of Emerging Markets debt: U.S. dollar and local-currency sovereign bonds, and dollar-denominated corporate credit. Among alternative assets, add coverage of gold, global Direct Real Estate, and global REITs. Improve the methodology for many alt asset classes, shifting from reliance on historical returns to an approach based on building blocks – for example, current yield plus an estimation of future capital appreciation – similar to our analysis of other asset classes. In our discussion of currencies, add for easy reference of readers a table of assumed returns for all the main asset classes expressed in USD, EUR, JPY, GBP, AUD, and CAD (using our forecasts of long-run movements in these currencies). Added Sharpe ratios to our main table of assumptions. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in U.S. dollars). Table 1BCA Assumed Returns Unsurprisingly, given the long-term nature of this exercise, our return projections have in general not moved much compared to those in November 2017. Indeed, markets look rather similar today to 18 months ago: the U.S. 10-year Treasury yield was 2.4% at end-April (our data cut-off point), compared to 2.3%, and the trailing PE for U.S. stocks 21.0, compared to 21.6. If anything, the overall assumption for a balanced portfolio (of 50% equities, 30% bonds, and 20% equal-weighted alts) has risen slightly compared to the 2017 edition: to 4.7% from 4.1% for a global portfolio, and to 4.9% from 4.6% for a purely U.S. one. That is partly because we include specific forecasts for the U.K., Australia, and Canada, where returns are expected to be slightly higher than for the markets we limited our forecasts to previously, the U.S, euro zone, Japan, and Emerging Markets (EM). Equity returns are also forecast to be higher than 18 months ago, mainly because several markets now are cheaper: trailing PE for Japan has fallen to 13.1x from 17.6x, for the euro zone to 15.5x from 18.0x, and for Emerging Markets to 13.6x from 15.4x (and more sophisticated valuation measures show the same trend). The long-term picture for global growth remains poor, based on our analysis, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. We include Sharpe ratios in Table 1 for the first time. We calculate them as expected return/expected volatility to allow for comparison between different asset classes, rather than as excess return over cash/volatility as is strictly correct, and as should be used in mean variance optimizers. Chart 1Volatility Is Easier To Forecast Than Returns For volatility assumptions, we mostly use the 20-year average volatility of each asset class. As discussed above, historical returns should not be used to forecast future returns. But volatility does not trend much over the long-term (Chart 1). We looked carefully at volatility trends for all the asset classes we cover, but did not find a strong example of a trend decline or rise in any. We do, however, adjust the historic volatility of the illiquid, appraisal-based alternative assets, such as Private Equity, Real Estate, and Farmland. The reported volatility is too low, for example 2.6% in the case of U.S. Direct Real Estate. Even using statistical techniques to desmooth the return produces a volatility of only around 7%. We choose, therefore, to be conservative, and use the historic volatility on REITs (21%) and apply this to Direct Real Estate too. For Private Equity (historic volatility 5.9%), we use the volatility on U.S. listed small-cap stocks (18.6%). Looking at the forecast Sharpe ratios, the risk-adjusted return on global bonds (0.55) is somewhat higher than that of global equities (0.33). Credit continues to look better than equities: Sharpe ratio of 0.70 for U.S. investment grade debt and 0.62 for high-yield bonds. Nonetheless, our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. Over the past 20 years a global balanced portfolio (defined as above) returned 6.3% and a similar U.S. portfolio 7.0%. We expect 4.7% and 4.9% respectively in future. Investors working on the assumption of a 7-8% nominal return – as is typical among U.S. pension funds, for example – need to become realistic. Below follow detailed descriptions of how we came up with our assumptions for each asset class (fixed income, equities, and alternatives), followed by our forecasts of long-term currency movements, and a brief discussion of correlations. 1. Fixed Income We carry over from the previous edition our building-block approach to estimating returns from fixed income. One element we know with a relatively high degree of certainty is the return over the next 10 years from 10-year government bonds in developed economies: one can safely assume that it will be the same as the current 10-year yield. It is not mathematical identical, of course, since this calculation does not take into account reinvestment of coupons, or default risk, but it is a fair assumption. We can make some reasonable assumptions for returns from cash, based on likely inflation and the real equilibrium cash rate in different countries. After this, our methodology is to assume that other historic relationships (corporate bond spreads, default and recovery rates, the shape of the yield curve etc.) hold over the long run and that, therefore, the current level reverts to its historic mean. The results of our analysis, and the assumptions we use, are shown in Table 2. Full details of the methodology follow below. Table 2Fixed Income Return Calculations Projected returns have not changed significantly from the 2017 edition of this report. In the U.S., for the current 10-year Treasury bond yield we used 2.4% (the three-month average to end-April), very similar to the 2.3% on which we based our analysis in 2017. In the euro zone and Japan, yields have fallen a little since then, with the 10-year German Bund now yielding roughly 0%, compared to 0.5% in 2017, and the Japanese Government Bond -0.1% compared to zero. Overall, we expect the Bloomberg Barclays Global Index to give an annual nominal return of 1.7% over the coming 10-15 years, slightly up from the assumption of 1.5% in the previous edition. This small rise is due to the slight increase in the U.S. long-term risk-free rate, and to the inclusion for the first time of specific estimates for returns in the U.K., Australia, and Canada. Fixed Income Methodologies Cash. We forecast the long-run rate on 3-month government bills by generating assumptions for inflation and the real equilibrium cash rate. For inflation, in most countries we use the 20-year average of CPI inflation, for example 2.2% in the U.S. and 1.7% in the euro zone. This suggests that both the Fed and the ECB will slightly miss their inflation targets on the downside over the coming decade (the Fed targets 2% PCE inflation, but the PCE measure is on average about 0.5% below CPI inflation). Of course, this assumes that the current inflation environment will continue. BCA’s view is that inflation risks are significantly higher than this, driven by structural factors such as demographics, populism, and the advent of ultra-unorthodox monetary policy.2 But we see this as an alternative scenario rather than one that we should use in our return assumptions for now. Japan’s inflation has averaged 0.1% over the past 20 years, but we used 1% on the grounds that the Bank of Japan (BoJ) should eventually see some success from its quantitative easing. For the equilibrium real rate we use the New York Fed’s calculation based on the Laubach-Williams model for the U.S., euro zone, U.K., and Canada. For Japan, we use the BoJ’s estimate, and for Australia (in the absence of an official forecast of the equilibrium rate) we take the average real cash rate over the past 20 years. Finally, we assume that the cash yield will move from its current level to the equilibrium over 10 years. Government Bonds. Using the 10-year bond yield as an anchor, we calculate the return for the government bond index by assuming that the spread between 7- and 10-year bonds, and between 3-month bills and 10-year bonds will average the same over the next 10 years as over the past 20. While the shape of the yield curve swings around significantly over the cycle, there is no sign that is has trended in either direction (Chart 2). The average maturity of government bonds included in the index varies between countries: we use the five-year historic average for each, for example, 5.8 years for the U.S., and 10.2 years for Japan. Spread Product. Like government bonds, spreads and default rates are highly cyclical, but fairly stable in the long run (Chart 3). We use the 20-year average of these to derive the returns for investment-grade bonds, high-yield (HY) bonds, government-related securities (e.g. bonds issued by state-owned entities, or provincial governments), and securitized bonds (e.g. asset-backed or mortgage-backed securities). For example, for U.S. high-yield we use the average spread of 550 basis points over Treasuries, default rate of 3.8%, and recovery rate of 45%. For many countries, default and recovery rates are not available and so we, for example, use the data from the U.S. (but local spreads) to calculate the return for high-yield bonds in the euro zone and the U.K. Inflation-Linked Bonds. We use the average yield over the past 10 years (not 20, since for many countries data does not go back that far and, moreover, TIPs and their equivalents have been widely used for only a relatively short period.) We calculate the return as the average real yield plus forecast inflation. Chart 2Yield Curves Chart 3Credit Spreads & Default Rates     Bloomberg Barclays Aggregate Bond Indexes. We use the weights of each category and country (from among those we forecast) to derive the likely return from the index. The composition of each country’s index varies widely: for example, in the euro zone (27% of the global bond index), government bonds comprise 66% of the index, but in the U.S. only 37%. Only the U.S. and Canada have significant weightings in corporate bonds: 29% and 50% respectively. This can influence the overall return for each country’s index. Table 3Emerging Market Debt Emerging Market Debt. We add coverage of EMD: sovereign bonds in both local currency and U.S. dollars, and USD-denominated EM corporate debt. Again, we take the 20-year average spread over 10-year U.S. Treasuries for each category. A detailed history of default and recovery is not available, so for EM corporate debt we assume similar rates to those for U.S. HY bonds. For sovereign bonds, we make a simple assumption of 0.5% of losses per year – although in practice this is likely to be very lumpy, with few defaults for years, followed by a rush during an EM crisis. For EM local currency debt, we assume that EM currencies will depreciate on average each year in line with the difference between U.S. inflation and EM inflation (using the IMF forecast for both – please see the Currency section below for further discussion on this). After these calculations, we conclude that EM USD sovereign bonds will produce an annual return of 4.7%, and EM USD corporate bonds 4.5% – in both cases a little below the 5.6% return assumption we have for U.S. high-yield debt (Table 3).   2. Equities Our equity methodologies are largely unchanged from the previous edition. We continue to use the return forecast from six different methodologies to produce an average assumed return. Table 4 shows the results and a summary of the calculation for each methodology. The explanation for the six methodologies follows below. Table 4Equity Return Calculations The results suggest slightly higher returns than our projections in 2017. We forecast global equities to produce a nominal annual total return in USD of 5.9%, compared to 4.6% previously. The difference is partly due to the inclusion for the first time of specific forecasts for the U.K., Australia and Canada, which are projected to see 8.0%, 7.4% and 6.0% returns respectively. The projection for the U.S. is fairly similar to 2017, rising slightly to 5.6% from 5.0% (mainly due to a slightly higher assumption for productivity growth in future, which boosts the nominal GDP growth assumption). Japan, however, does come out looking significantly more attractive than previously, with an assumed return of 6.2%, compared to 3.5% previously. This is mostly due to cheaper valuations, since the growth outlook has not improved meaningfully. Japan now trades on a trailing PE of 13.1x, compared to 17.6x in 2017. This helps improve the return indicated by a number of the methodologies, including earnings yield and Shiller PE. The forecast for euro zone equities remains stable at 4.7%. EM assumptions range more widely, depending on the methodology used, than do those for DM. On valuation-based measures (Shiller PE, earnings yield etc.), EM generally shows strong return assumptions. However, on a growth-based model it looks less attractive. We continue to use two different assumptions for GDP growth in EM. Growth Model (1) is based on structural reform taking place in Emerging Markets, which would allow productivity growth to rebound from its current level of 3.2% to the 20-year average of 4.1%; Growth Model (2) assumes no reform and that productivity growth will continue to decline, converging with the DM average, 1.1%, over the next 10 years. In both cases, the return assumption is dragged down by net issuance, which we assume will continue at the 10-year average of 4.9% a year. Our composite projection for EM equity returns (in local currencies) comes out at 6.6%, a touch higher than 6.0% in 2017. Equity Methodologies Equity Risk Premium (ERP). This is the simplest methodology, based on the concept that equities in the long run outperform the long-term risk-free rate (we use the 10-year U.S. Treasury yield) by a margin that is fairly stable over time. We continue to use 3.5% as the ERP for the U.S., based on analysis by Dimson, Marsh and Staunton of the average ERP for developed markets since 1900. We have, however, tweaked the methodology this time to take into account the differing volatility of equity markets, which should translate into higher returns over time. Thus we use a beta of 1.2 for the euro zone, 0.8 for Japan, 0.9 for the U.K., 1.1 for both Australia and Canada, and 1.3 for Emerging Markets. The long-term picture for global growth remains poor, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. Growth Model. This is based on a Gordon growth model framework that postulates that equity returns are a function of dividend yield at the starting point, plus the growth of earnings in future (we assume that the dividend payout ratio stays constant). We base earnings growth off assumptions of nominal GDP growth (see Box 1 for how we calculate these). But historically there is strong evidence that large listed company earnings underperform nominal GDP growth by around 1 percentage point a year (largely because small, unlisted companies tend to show stronger growth than the mature companies that dominate the index) and so we deduct this 1% to reach the earnings growth forecast. We also need to adjust dividend yield for share buybacks which in the U.S., for tax reasons, have added 0.5% to shareholder returns over the past 10 years (net of new share issuance). In other countries, however, equity issuance is significantly larger than buybacks; this directly impacts shareholders’ returns via dilution. For developed markets, the impact of net equity issuance deducts 0.7%-2.7% from shareholder returns annually. But the impact is much bigger in Emerging Markets, where dilution has reduced returns by an average of 4.9% over the past 10 years. Table 5 shows that China is by far the biggest culprit, especially Chinese banks. Table 5Dilution In Emerging Markets BOX 1 Estimating GDP Growth We estimate nominal GDP growth for the countries and regions in our analysis as the sum of: annual growth in the working-age population, productivity growth, and inflation (we assume that capital deepening remains stable over the period). Results are shown in Table 6. Table 6Calculations Of Trend GDP Growth For population growth, we use the United Nations’ median scenario for annual growth in the population aged 25-64 between 2015 and 2030. This shows that the euro zone and Japan will see significant declines in the working population. The U.S. and U.K. look slightly better, with the working population projected to grow by 0.3% and 0.1% respectively. There are some uncertainties in these estimates. Stricter immigration policies would reduce the growth. Conversely, greater female participation, a later retirement age, longer working hours, or a rise in the participation rate would increase it. For emerging markets we used the UN estimate for “less developed regions, excluding least developed countries”. These countries have, on average, better demographics. However, the average number hides the decline in the working-age population in a number of important EM countries, for example China (where the working-age population is set to shrink by 0.2% a year), Korea (-0.4%), and Russia (-1.1%). By contrast, working population will grow by 1.7% a year in Mexico and 1.6% in India. For productivity growth, we assume – perhaps somewhat optimistically – that the decline in productivity since the Global Financial Crisis will reverse and that each country will return to the average annual productivity growth of the past 20 years (Chart 4). Our argument is that the cyclical factors that depressed productivity since the GFC (for example, companies’ reluctance to spend on capex, and shareholders’ preference for companies to pay out profits rather than to invest) should eventually fade, and that structural and technical factors (tight labor markets, increasing automation, technological breakthroughs in fields such as artificial intelligence, big data, and robotics) should boost productivity. Based on this assumption, U.S. productivity growth would average 2.0% over the next 10-15 years, compared to 0.5% since 1999. Note that this is a little higher than the Congressional Budgetary Office’s assumption for labor productivity growth of 1.8% a year. Chart 4AProductivity Growth (I) Chart 4BProductivity Growth (II) Our assumptions for inflation are as described above in the section on Fixed Income. The overall results suggest that Japan will see the lowest nominal GDP growth, at 0.9% a year, with the U.S. growing at 4.4%. The U.K. and Australia come out only a little lower than the U.S. For emerging markets, as described in the main text, we use two scenarios: one where productivity grow continues to slow in the absence of reforms, especially in China, from the current 3.2% to converge with the average in DM (1.1%) over the next 10-15 years; and an alternative scenario where reforms boost productivity back to the 20-year average of 4.1%.   Growth Plus Reversion To Mean For Margins And Profits. There is logic in arguing that profit margins and multiples tend to revert to the mean over the long term. If margins are particularly high currently, profit growth will be significantly lower than the above methodology would suggest; multiple contraction would also lower returns. Here we add to the Growth Model above an assumption that net profit margin and trailing PE will steadily revert to the 20-year average for each country over the 10-15 years. For most countries, margins are quite high currently compared to history: 9.2% in the U.S., for example, compared to a 20-year average of 7.7%. Multiples, however, are not especially high. Even in the U.S. the trailing PE of 21.0x, compares to a 20-year average of 20.8x (although that admittedly is skewed by the ultra-high valuations in 1999-2000, and coming out of the 2007-9 recession – we would get a rather lower number if we used the 40-year average). Indeed, in all the other countries and regions, the PE is currently lower than the 20-year average. Note that for Japan, we assumed that the PE would revert to the 20-year average of the U.S. and the euro zone (19.2), rather than that of Japan itself (distorted by long periods of negative earnings, and periods of PE above 50x in the 1990s and 2000s).  Earnings Yield. This is intuitively a neat way of thinking about future returns. Investors are rewarded for owning equity, either by the company paying a dividend, or by reinvesting its earnings and paying a dividend in future. If one assumes that future return on capital will be similar to ROC today (admittedly a rash assumption in the case of fast-growing companies which might be tempted to invest too aggressively in the belief that they can continue to generate rapid growth) it should be immaterial to the investor which the company chooses. Historically, there has been a strong correlation between the earnings yield (the inverse of the trailing PE) and subsequent equity returns, although in the past two decades the return has been somewhat higher that the EY suggested, and so in future might be somewhat lower. This methodology produces an assumed return for U.S. equities of 4.8% a year. Shiller PE. BCA’s longstanding view is that valuation is not a good timing tool for equity investment, but that it is crucial to forecasting long-term returns. Chart 5 shows that there is a good correlation in most markets between the Shiller PE (current share price divided by 10-year average inflation-adjusted earnings) and subsequent 10-year equity returns. We use a regression of these two series to derive the assumptions. This points to returns ranging from 5.4% in the case of the U.S. to 12.5% for the U.K. Composite Valuation Indicator. There are some issues that make the Shiller PE problematical. It uses a fixed 10-year period, whereas cycles vary in length. It tends to make countries look cheap when they have experienced a trend decline in earnings (which may continue, and not mean revert) and vice versa. So we also use a proprietary valuation indicator comprising a range of standard parameters (including price/book, price/cash, market cap/GDP, Tobin’s Q etc.), and regress this against 10-year returns. The results are generally similar to those using the Shiller PE, except that Japan shows significantly higher assumed returns, and the U.K. and EM significantly lower ones (Chart 6). Chart 5Shiller PE Vs. 10-Year Return Chart 6Composite Valuation Vs. 10-Year Return     3. Alternative Investments We continue to forecast each illiquid alternative investment separately, but we have made a number of changes to our methodologies. Mostly these involve moving away from using historical returns as a basis for our forecasts, and shifting to an approach based on current yield plus projected future capital appreciation. In direct real estate, for example, in 2017 we relied on a regression of historical returns against U.S. nominal GDP growth. We move in this edition to an approach based on the current cap rate, plus capital appreciation (based on forecasts of nominal GDP growth), and taking into account maintenance costs (details below). We also add coverage of some additional asset classes: global ex-U.S. direct real estate, global ex-U.S. REITs, and gold. Table 7 summarizes our assumptions, and provides details of historic returns and volatility. Table 7Alternatives Return Calculations It is worth emphasizing here that manager selection is far more important for many alternative investment classes than it is for public securities (Chart 7). There is likely to be, therefore, much greater dispersion of returns around our assumptions than would be the case for, say, large-cap U.S. equities. Chart 7For Alts, Manager Selection Is Key Hedge Funds Chart 8Hedge Fund Return Over Cash Hedge fund returns have trended down over time (Chart 8). Long gone is the period when hedge funds returned over 20% per year (as they did in the early 1990s). Over the past 10 years, the Composite Hedge Fund Index has returned annually 3.3% more than 3-month U.S. Treasury bills. But that was entirely during an economic expansion and so we think it is prudent to cut last edition’s assumption of future returns of cash-plus-3.5%, to cash-plus-3% going forward. Direct Real Estate Our new methodology for real estate breaks down the return, in a similar way to equities, into the current cash yield (cap rate) plus an assumption of future capital growth. For the cap rate, we use the average, weighted by transaction volumes, of the cap rates for apartments, office buildings, retail, industrial real estate, and hotels in major cities (for example, Chicago, Los Angeles, Manhattan, and San Francisco for the U.S., or Osaka and Tokyo for Japan). We assume that capital values grow in line with each’s country’s nominal GDP growth (using the IMF’s five-year forecasts for this). We deduct a 0.5% annual charge for maintenance, in line with industry practice. Results are shown in Table 8. Our assumptions point to better returns from real estate in the U.S. than in the rest of the world. Not only is the cap rate in the U.S. higher, but nominal GDP growth is projected to be higher too. Table 8Direct Real Estate Return Calculations REITs We switch to a similar approach for REITs. Previously we used a regression of REITs against U.S. equity returns (since REITs tend to be more closely correlated with equities than with direct real estate). This produced a rather high assumption for U.S. REITs of 10.1%. We now use the current dividend yield on REITs plus an assumption that capital values will grow in line with nominal GDP growth forecasts. REITs’ dividend yields range fairly narrowly from 2.9% in Japan to 4.7% in Canada. We do not exclude maintenance costs since these should already be subtracted from dividends. The result of using this methodology is that the assumed return for U.S. REITs falls to a more plausible 8.5%, and for global REITs is 6.2%. Private Equity & Venture Capital Chart 9Private Equity Premium Has Shrunk Around It makes sense that Private Equity returns are correlated with returns from listed equities. Most academic studies have shown a premium over time for PE of 5-6 percentage points (due to leverage, a tilt towards small-cap stocks, management intervention, and other factors). However, this premium has swung around dramatically over time (Chart 9). Over the past 10 years, for example, annual returns from Private Equity and listed U.S. equities have been identical: 12%. However, there appears to be no constant downtrend and so we think it advisable to use the 30-year average premium: 3.4%. This produces a return assumption for U.S. Private Equity of 8.9% per year. Over the same period, Venture Capital has returned around 0.5% more than PE (albeit with much higher volatility) and we assume the same will happen going forward.   Structured Products In the context of alternative asset classes, Structured Products refers to mortgage-backed and other asset-backed securities. We use the projected return on U.S. Treasuries plus the average 20-year spread of 60 basis points. Assumed return is 2.7%. Farmland & Timberland Chart 10Farm Prices Grow More Slowly Than GDP As with Real Estate and REITs, we move to a methodology using current cash yield (after costs) plus an assumption for capital appreciation linked to nominal GDP forecasts. The yield on U.S. Farmland is currently 4.4% and on Timberland 3.2%. Both have seen long-run prices grow significantly more slowly than nominal GDP growth. Since 1980, for example, farm prices have risen at a compound rate of 3.9% per acre, compared to U.S. nominal GDP growth of 5.2% and global GDP growth of 5.5% (Chart 10). We assume that this trend will continue, and so project farm prices to grow 1.5 percentage points a year more slowly than global GDP (using global, not U.S., economic growth makes sense since demand for food is driven by global factors). This produces a total return assumption of 6%. For timberland, we did not find a consistent relationship with nominal GDP growth and so assumed that prices would continue to grow at their historic rate over the past 20 years (the longest period for which data is available). We project timberland to produce an annual return of 4.8%. Commodities & Gold For commodities we use a very different methodology (which we also used in the previous edition): the concept that commodities prices consistently over time have gone through supercycles, lasting around 10 years, followed by bear markets that have lasted an average of 17 years (Chart 11). The most recent super-cycle was 2002-2012. In the period since the supercycle ended, the CRB Index has fallen by 42%. Comparing that to the average drop in the past three bear markets, we conclude that there is about 8% left to fall over the next nine years, implying an annual decline of about 1%. Our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. We add gold to our assumptions, since it is an asset often held by investors. However, it is not easy to project long-term returns for the metal. Since the U.S. dollar was depegged from gold in 1968, gold too has gone through supercycles, in the 1970s and 2002-11 (Chart 12). We find that change in real long-term interest rates negatively affects gold (logically since higher rates increase the opportunity cost of owning a non-income-generating asset). We use, therefore, a regression incorporating global nominal GDP growth and a projection of the annual change in real 10-year U.S. Treasury yields (based on the equilibrium cash rate plus the average spread between 10-year yields and cash). This produces an assumption of an annual return from gold of 4.7% a year. We continue to see this asset class more as a hedge in a portfolio (it has historically had a correlation of only 0.1 with global equities and 0.24 with global bonds) rather than a source of return per se.  Chart 11Commodities Still In A Bear Market Chart 12Gold Also Has Supercycles   4. Currencies Chart 13Currencies Tend To Revert To PPP All the return projections in this report are in local currency terms. That is a problem for investors who need an assumption for returns in their home currency. It is also close to impossible to hedge FX exposure over as long a period as 10-15 years. Even for investors capable of putting in place rolling currency hedges, GAA has shown previously that the optimal hedge ratio varies enormously depending on the home currency, and that dynamic hedges (i.e. using a simple currency forecasting model) produce better risk-adjust returns than a static hedge.3  Fortunately, there is an answer: it turns out that long-term currency forecasting is relatively easy due to the consistent tendency of currencies, in developed economies at least, to revert to Purchasing Power Parity (PPP) over the long-run, even though they can diverge from it for periods as long as five years or more (Chart 13). We calculate likely currency movements relative to the U.S. dollar based on: 1) the current divergence of the currency from PPP, using IMF estimates of the latter; 2) the likely change in PPP over the next 10 years, based on inflation differentials between the country and the U.S. going forward (using IMF estimates of average CPI inflation for 2019-2024 and assuming the same for the rest of the period). The results are shown in Table 9. All DM currencies, except the Australian dollar, look cheap relative to the U.S. dollar, and all of them, again excluding Australia, are forecast to run lower inflation that the U.S. implying that their PPPs will rise further. This means that both the euro and Japanese yen would be expected to appreciate by a little more than 1% a year against the U.S. dollar over the next 10 years or so. Table 9Currency Return Calculations PPP does not work, however, for EM currencies. They are all very cheap relative to PPP, but show no clear trend of moving towards it. The example of Japan in the 1970s and 1980s suggests that reversion to PPP happens only when an economy becomes fully developed (and is pressured by trading partners to allow its currency to appreciate). One could imagine that happening to China over the next 10-20 years, but the RMB is currently 48% undervalued relative to PPP, not so different from its undervaluation 15 years ago. For EM currencies, therefore, we use a different methodology: a regression of inflation relative to the U.S. against historic currency movements. This implies that EM currencies are driven by the relative inflation, but that they do not trend towards PPP. Based on IMF inflation forecasts, many Emerging Markets are expected to experience higher inflation than the U.S. (Table 10). On this basis, the Turkish lira would be expected to decline by 7% a year against the U.S. dollar and the Brazilian real by 2% a year. However, the average for EM, which we calculated based on weights in the MSCI EM equity index, is pulled down by China (29% of that index), Korea (15%) and Taiwan (12%). China’s inflation is forecast to be barely above that in the U.S, and Korean and Taiwanese inflation significantly below it. MSCI-weighted EM currencies, consequently, are forecast to move roughly in line with the USD over the forecast horizon. One warning, though: the IMF’s inflation forecasts in some Emerging Markets look rather optimistic compared to history: will Mexico, for example, see only 3.2% inflation in future, compared to an average of 5.7% over the past 20 years? Higher inflation than the IMF forecasts would translate into weaker currency performance. Table 10EM Currencies In Table 11, we have restated the main return assumptions from this report in USD, EUR, JPY, GBP, AUD, and CAD terms for the convenience of clients with different home currencies. As one would expect from covered interest-rate parity theory, the returns cluster more closely together when expressed in the individual currencies. For example, U.S. government bonds are expected to return only 0.8% a year in EUR terms (versus 2.1% in USD terms) bringing their return closer to that expected from euro zone government bonds, -0.4%. Convergence to PPP does not, however, explain all the difference between the yields in different countries. Table 11Returns In Different Base Currencies 5. Correlations Chart 14Correlations Are Hard To Forecast We have not tried to forecast correlations in this Special Report. As discussed, historical returns from different asset classes are not a reliable guide to future returns, but it is possible to come up with sensible assumptions about the likely long-run returns going forward. Volatility does not trend much over the long term, so we think it is not unreasonable to use historic volatility data in an optimizer. But correlation is a different matter. As is well known, the correlation of equities and bonds has moved from positive to negative over the past 40 years (mainly driven by a shift in the inflation environment). But the correlation between major equity markets has also swung around (Chart 14). Asset allocators should preferably use rough, conservative assumptions for correlations – for example, 0.1 or 0.2 for the equity/bond correlation, rather than the average -0.1 of the past 20 years. We plan to do further work to forecast correlations in a future edition of this report.  But for readers who would like to see – and perhaps use – historic correlation data, we publish below a simplified correlation matrix of the main asset classes that we cover in this report (Table 12). We would be happy to provide any client with the full spreadsheet of all asset classes . Table 12Correlation Matrix Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Special Report, “What Returns Can You Expect?”, dated 15 November 2017, available at gaa.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated 22 May 2019, available at gaa.bcaresearch.com 3      Please see GAA Special Report, “Currency Hedging: Dynamic Or Static? A Practical Guide For Global Equity Investors,” dated 29 September 2017, available at gaa.bcaresearch.com  

Highlights Fed: The Fed will cut rates in July, and possibly once more this year. This extra stimulus will help boost global growth in the second half of 2019. Credit: With inflation expectations low, the Fed will not risk upsetting financial markets by striking a hawkish tone. This will be a boon for corporate bonds. We no longer advocate a cautious near-term allocation to corporate credit. Spreads have likely peaked. Duration: The economic environment bears a greater resemblance to prior mid-cycle slowdowns than to prior pre-recession periods. As such, the Fed will not deliver more than the 89 basis points of rate cuts that are already discounted for the next 12 months. Maintain below-benchmark portfolio duration. Feature More Houdini Than Bullwinkle When Fed Chair Jay Powell reached into his hat at last week’s FOMC meeting, most – including us – thought he might emerge looking like Bullwinkle the cartoon moose.1 Instead, he pulled a rabbit, delivering a dovish surprise to markets that already expected a lot. The yield curve was discounting 80 basis points of rate cuts over the next 12 months heading into last Wednesday’s announcement. Then, the Fed’s statement and Powell’s press conference pushed our 12-month discounter all the way down to -94 bps (Chart 1). The 10-year Treasury yield also dropped 8 bps post-FOMC, while the 2-year yield fell a whopping 14 bps. The Fed will go to great lengths to signal that monetary conditions remain accommodative. The Fed communicated its dovish pivot through both the post-meeting statement and its interest rate projections. In the post-meeting statement, the Fed replaced its pledge to be “patient” with a promise to “act as appropriate to sustain the expansion”. A re-phrasing that is clearly designed to signal a rate cut in July. FOMC participants also revised their interest rate projections sharply lower (Chart 2). In March, 11 out of 17 participants expected the Fed to stay on hold for the balance of 2019, while 4 participants called for one rate hike and 2 called for two rate hikes. Now, 8 out of 17 participants continue to expect a steady fed funds rate, but 7 are calling for two rate cuts this year. Only one participant is still looking for a 2019 hike. Chart 1A Dovish Magic Show Chart 2Dots Revised Lower   In his press conference, Chair Powell explicitly linked the Fed’s dovish pivot to “trade developments” and “concerns about global growth”. Bond investors will undoubtedly heed this message, and Treasury yields will be extra sensitive to any trade-related news that comes out of this weekend’s G20 summit, as well as to any fluctuations in the global growth data (see section titled “No PMI Recovery Yet” below). Ultimately, our baseline expectation is that there will be enough progress in trade negotiations at the G20 summit to keep the U.S. from imposing a further $300 billion in tariffs on Chinese imports. However, an all-encompassing deal, which rolls back existing tariffs, is not in the cards. Table 1Fed Funds Futures: What's Priced In? But even such a muddle-though scenario, when combined with a Fed rate cut in July and continued credit easing out of China, will be sufficient to support global growth in the second half of this year. This will prevent the Fed from delivering the 79 bps of rate cuts that are priced-in for between now and next February (Table 1). We remain short the February 2020 fed funds futures contract. And Now Here’s Something We Hope You’ll Really Like Our main takeaway from the FOMC meeting is that the Fed will go to great lengths to signal that monetary conditions remain accommodative. We posited back in March that the new battleground for monetary policy is between inflation expectations and financial conditions.2 That is, the Fed will only move to a restrictive policy stance in response to above-target inflation expectations or “bubbly” financial asset prices. While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. At present, long-maturity TIPS breakeven inflation rates remain well below target levels and financial markets are far from “bubbly” (Chart 3): The Financial Conditions component of our Fed Monitor is close to neutral (Chart 3, panel 2). The S&P 500 12-month forward P/E ratio has rebounded this year, but is not close to the highs seen in late-2017/early-2018 (Chart 3, panel 3). The GZ measure of the excess premium in corporate bond spreads after accounting for expected default losses is low, but above where it traded throughout most of the 2000s (Chart 3, bottom panel). The upshot is that the Fed will continue to act as a tailwind for risk assets, and we therefore remove our prior recommendation to stay cautious on credit spreads in the near-term. It is now likely that credit spreads have peaked, a message confirmed by our list of “peak credit spread” indicators (Chart 4): Chart 3No Rush For Fed To Tighten Chart 4Credit Spreads Have Likely Peaked   The price of gold has decisively broken-out to the upside, a sign that the market views monetary policy as reflationary (Chart 4, panel 2). Such a breakout has preceded the last two peaks in corporate bond spreads. The dollar’s uptrend has abated, signaling that the market views U.S. monetary policy as less out of step with the rest of the world (Chart 4, panel 3). Global industrial mining stocks have rebounded (Chart 4, panel 4). The CRB Raw Industrials index is the sole holdout (Chart 4, bottom panel). A rebound in this index would confirm our intuition that credit spreads have peaked. Chart 5Waiting For Improving Global Growth While the Fed’s reflationary efforts will cause corporate bond spreads to tighten in the coming months, they will not immediately translate into a higher 10-year Treasury yield. The ratio between the CRB Raw Industrials index and Gold correlates very tightly with the 10-year yield, and it continues to plummet (Chart 5). The CRB/Gold ratio will only rise when gains in the CRB index start to outpace gains in Gold. In other words, the Fed’s reflationary policy stance needs to translate into an improving global growth outlook. This could take a few months, though we ultimately continue to think that Treasury yields will be higher on a 6-12 month horizon. As explained in the next section, as long as the U.S. economy avoids recession, mid-cycle rate cuts tend to be followed by higher Treasury yields. A History Of Rate Cuts Part 2 In last week’s report we looked at every Fed rate cut since 1995 and showed how the 10-year Treasury yield reacted during the subsequent 21-day, 65-day, 130-day and 261-day periods.3 Our main conclusion was that the 10-year Treasury yield tended to rise following mid-cycle rate cuts, such as those that occurred in 1995-98 and 2003, and decline following rate cuts that led into a U.S. recession. For reference, we have attached last week’s analysis as an Appendix to this report, along with a new table showing how the Bloomberg Barclays Treasury Master index performed relative to cash following each post-1995 rate cut. The 2/10 Treasury slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. This week, we delve a little deeper and look at the market’s interest rate expectations around each prior cut, and also at how the 2/10 Treasury slope responded in each case. Rate Expectations At The Time Of Fed Rate Cuts Table 2 shows the 12-month change in the fed funds rate that the market was discounting prior to each Fed rate cut announcement since 1995. It also shows the actual change in the fed funds rate that occurred over the subsequent 12-month period, and the difference between what occurred and what was expected – the 12-month fed funds surprise. Table 2A History Of Rate Cuts: Rate Expectations According to our Golden Rule of Bond Investing, a dovish surprise (actual change < expectations) should coincide with a falling 10-year Treasury yield, and a hawkish surprise (actual change > expectations) should coincide with a rising 10-year yield.4 The table shows that this indeed occurred in 26 out of 29 episodes. As was the case last week, the mid-1990s rate cuts immediately capture our attention. We have previously noted the resemblance between today’s economic environment and that of the mid-1990s.5 It’s interesting that the market is currently priced for a similar number of rate cuts as at that time. Once again, we expect those expectations will be disappointed. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield. Yield Curve: Steeper Now = Flatter Later Another interesting trend is that the 2/10 Treasury slope steepened dramatically in the run-up to, and following, last week’s FOMC meeting. It is now back up to 29 bps after having troughed at 11 bps near the end of last year (Chart 6). It is also worth noting that the 2/10 Treasury slope has yet to invert this cycle. Such an inversion has occurred prior to every U.S. recession since at least 1960. Table 3 shows how the 2/10 Treasury slope has responded to Fed rate cuts in the past, and it reveals an interesting pattern. The slope tends to steepen quite sharply in the immediate aftermath of a mid-cycle rate cut, before starting to flatten after a few months have passed. The 2003 episode is a prime example. The 2/10 slope steepened by 62 bps in the month following the rate cut, but a year later it was 14 bps below where it started. Chart 6The Fed Steepens The Curve Table 3A History Of Rate Cuts: 2/10 Treasury Slope   In contrast, the 2/10 steepening that immediately follows a “pre-recession” rate cut tends to be milder, but the steepening then accelerates as time passes and the Fed eases further.  The observed yield curve patterns line up well with theory. We would expect rapid curve steepening immediately following a mid-cycle rate cut, as the market prices in a quick return to tighter policy settings. Then, the curve should eventually flatten as the Fed reverses its initial cuts. In contrast, a rate cut that precedes a recession should not lead to much initial steepening, because the market would not be expecting a quick recovery. The steepening would then accelerate as more rate cuts are eventually delivered. The fact that the 2/10 slope has steepened a lot in recent weeks is another datapoint in favor of “mid-cycle” rather than “pre-recession” market behavior. No PMI Recovery Yet We remain confident that the combination of a July Fed rate cut and Chinese credit stimulus will put a floor under global growth in the second half of the year. However, no such global growth rebound is yet evident in the crucial manufacturing PMI data. The Global Manufacturing PMI is the measure of global growth that lines up best with the 10-year Treasury yield, and it remains in a free-fall, even breaking below the 50 boom/bust line in May (Chart 7). Flash PMI data paint an equally dim picture for June: The Euro Area Manufacturing PMI is expected to tick up in June, but only to 47.8 from 47.7 in May (Chart 7, panel 2). The U.S. Manufacturing PMI is expected to fall to 50.1 in June, from 50.5 in May (Chart 7, panel 3). The Japanese Manufacturing PMI is expected to fall to 49.5 in June, from 49.8 in May (Chart 7, bottom panel). There is no Flash PMI data for China, but the Chinese index stood at 50.2 in May, only a hair above the 50 boom/bust line. On the bright side, financial markets are starting to price-in the beginnings of a reflation trade. Gold is rallying strongly, as we noted above, and an index of high-beta currency pairs (RUB/USD, ZAR/USD and BRL/USD) is off its lows. Both of these moves signal that the policy backdrop is becoming more supportive, and both have led upswings in the Global Manufacturing PMI in the past (Chart 8). Chart 7No Rebound In Sight Yet... Chart 8...But Financial Markets Are Already Looking Ahead   Bottom Line: Treasury yields will probably need to see a rebound in the Global Manufacturing PMI before moving higher, but a few reflationary indicators suggest that such a rebound will occur in the second half of the year. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com     Appendix Table 4A History Of Rate Cuts: 10-Year Treasury Yield Table 5A History Of Rate Cuts: Treasury Excess Returns   Footnotes 1      https://www.youtube.com/watch?v=kx3sOqW5zj4 2      Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 3      Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com 4      Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 5      Please see U.S. Bond Strategy Weekly Report, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We are searching for evidence of an imminent end to this business cycle, … : Investors who recognize the onset of the recession in a timely fashion will have a leg up on the competition all the way through the intermediate term. … but the data do not support the increasingly popular conclusion that it is nearly at hand, … : The U.S. economy is doing quite well and contradicts the message from the inverted yield curve, which may well be a less powerful signal than it has been in the past. … and it’s hard to see the end of the expansion when the Fed’s trying its utmost to sustain it: Restrictive monetary policy is a necessary, if not sufficient, condition for a recession. Last week’s FOMC meeting pushed that eventuality beyond the visible horizon. Maintain a pro-risk portfolio positioning. Feature What if you gave a party and nobody came? The U.S. economy is finding out as we speak. The expansion that began in July 2009 turns ten years old at the end of the week, and no one seems to care. An expansion and bull market that have been derided from the get-go as “artificial,” “manufactured,” and “propped up by money printing” continue to be unloved, yet manage to keep chugging along like the Energizer bunny. The expansion has been no more pleasing to the eye than the famous toy in the battery commercials, plodding along at an often sluggish pace, but that may be the secret to its longevity. It has never been able to achieve a high enough rate of speed to give rise to unsustainable activity in the most cyclical segments of the economy. Ditto the bull markets in equities and spread product. Held in check by a deficiency of animal spirits, they have failed to breed valuation excesses. In the absence of a clearly approaching catalyst for reversal, internal or external, there is no reason to expect that the U.S. economy cannot continue to expand at its meandering post-crisis pace. An increasing number of market participants, including some within BCA, cite the inverted yield curve, disappointing May employment report, and weakening manufacturing activity at home and abroad as ill portents for the economy. On the face of it, these factors are surely inauspicious. Upon further examination, though, they aren’t as bad as they’ve been made out to be. An investor who sniffs out the next recession, and shifts asset allocation aggressively in line with that recognition, will have a very good chance of outperforming over both the near and intermediate term. Timely recognition of inflection points is how macro analysis most clearly benefits money managers. Since equity bull markets tend to be highly potent in their final stages, however, crying wolf can be especially damaging to relative performance. In our view, the available evidence does not support the conclusion that the end of the cycle is at hand and that investors should de-risk their portfolios. The Yield Curve Isn’t What It Used To Be We do not know how many basis points can dance on the head of a pin, and neither do the battalions of central bank economists who have been unable to settle exactly how large-scale asset purchases hold down interest rates. Those purchases’ flow effect (the share of newly-issued bonds purchased by a central bank), stock effect (the share of outstanding bonds held by a central bank), and forward guidance’s muzzling of bond and inflation volatility may all play a role. At the end of the day, it appears quite likely that QE has depressed the term premium on the 10-year Treasury bond, which recently made 50-year lows. The term premium is the compensation investors receive for tying up their money in a longer-maturity instrument, and it is a whopping 250 basis points below its long-run mean (Chart 1). Chart 1The Bombed-Out Term Premium ... Yield curve has been a reliable, if often early, leading indicator of recessions for the last 50 years. The unprecedentedly low 10-year term premium renders the definitive 3-month/10-year segment of the yield curve considerably more prone to invert. The only sustained yield-curve inversion that issued a false recession signal in the 57-year history of the Adrian, Crump and Moench term-premium estimate occurred in late 1966/early 1967,1 when the term premium skittered around both sides of the zero bound (Chart 2). If investors had received no additional compensation for holding the 10-year Treasury over the last five decades, an inverted curve would be a regular feature of the investment landscape (Chart 3). Chart 2... Is Distorting The Signal From The Yield Curve, ... Chart 3... Which Wouldn't Slope Upward Without It Leading Data Do Not Confirm The Yield Curve’s Signal Chart 4Only Manufacturing Looks Recession-ish Investors ignore the yield curve at their own risk. It has been a reliable, if often early, leading indicator of recessions for the last 50 years. We view its current inversion as a yellow light, and it is making us more vigilant about seeking out evidence of a slowdown. Given that the negative term premium weighs heavily on long-dated yields, however, investors should not de-risk portfolios unless the flow of data corroborates its signal. Our Global Fixed Income Strategy colleagues sought that corroboration by performing a cycle-on-cycle analysis of a selection of data series with leading properties – the Conference Board’s LEI, initial unemployment claims, the manufacturing ISM’s new-orders-to-inventories ratio and the Conference Board’s consumer confidence index. The analysis compares the current position of each indicator with its average position in the run-up to the last five recessions (January-July ’80 through December ’07-June ’09). With the exception of the weak new-orders-to-inventories ratio (Chart 4, third panel), none of the indicators are in a position that suggests trouble lies ahead (Chart 4). For the time being, the incoming data flow only confirms the concerns about the weak manufacturing outlook. Is Economic Activity Really Slowing? The course of GDP growth makes it appear as if the U.S. is slowing pretty quickly. After the first quarter’s surprisingly strong 3.1% growth, consensus second-quarter estimates are hovering around 1.75%. Viewed alongside the sizable shortfall in May payroll gains, uninspiring housing activity and a sharp global manufacturing downturn, the deceleration in GDP growth seems to confirm the notion that the U.S. economy is weakening fast. We are not overly concerned about the labor market, housing or manufacturing, however, and the GDP trend is not what it appears to be at first blush. Real final domestic demand growth at 3% is well above the economy’s long-run potential and is hardly the sign of an economy that’s gasping for air, or staggering under the weight of an overly high fed funds rate. To get the best read on the underlying state of the domestic economy, we adjust GDP data to back out net exports and inventory adjustments. Backing out net exports puts the focus on domestic conditions, while removing inventory adjustments isolates sales to end consumers. The result is real final domestic demand, and according to the Atlanta Fed’s GDPNow model, it accelerated sharply between the first and second quarters. The first quarter was flattered by a 60-basis-point (“bps”) inventory build and a highly-unlikely-to-be-repeated 100-bps contribution from net exports. After backing those components out of the headline 3.1% gain, first quarter growth slips to 1.5%. That may not look like much against 2-2.25% trend growth, but it was not at all bad given the body blows the economy sustained in the first quarter: the federal government shutdown that stretched across nearly all of January, and the severe tightening in financial conditions resulting from the fourth quarter’s sharp sell-offs in equities and risky bonds. Following last week’s stronger-than-expected May retail sales report (and upwardly revised April data), the GDPNow model is projecting 2% growth in the second quarter. Per the model’s detailed projections, the headline gain is being held back by a 100-bps inventory runoff. Removing the inventory adjustment, real final domestic demand is projected to grow at 3% (net exports are projected to make zero contribution). 3% growth is well above the economy’s long-run potential and is hardly the sign of an economy that’s gasping for air, or staggering under the weight of an overly high fed funds rate. Per the current GDPNow projections, real final domestic demand growth is above the expansion’s mean growth rate, casting some doubt on whether the yield curve’s signal has been overwhelmed by a pickup in risk aversion and the factors that have flipped the term premium on its head. 3% real final domestic demand represents a quickening in the pace of growth that has prevailed across the 40 quarters of the expansion (Chart 5), and is incompatible with the message from the New York Fed’s yield curve-based recession probability indicator (“RPI”). To evaluate the current warning, we compared the standardized value of real final domestic demand growth during the previous quarters of the expansion when the New York Fed’s RPI was above the 33% level that has accurately foretold every recession over the last 50 years (Chart 6). When all of the previous RPI warning signals were issued, real final domestic demand growth was slower than its expansion average (z-score less than zero), and in all but one case considerably slower, clustering around one standard deviation below the mean (Table 1). Per the current GDPNow projections, real final domestic demand growth is above the expansion’s mean growth rate, casting some doubt on whether the yield curve’s signal has been overwhelmed by a pickup in risk aversion and the factors that have flipped the term premium on its head. Chart 5Real Final Domestic Demand Is Still Vigorous Chart 6The New York Fed's Yield-Curve-Based Recession Model Is Flashing Red The Labor Market Is Still Roaring Table 1New York Fed Recession Warnings And Economic Conditions Consumption plays an outsized role in the U.S. economy, accounting for over two-thirds of GDP. As macro analysts are well aware, if you have an accurate read on consumption, you’ll know where the U.S. economy is headed. Extending the relationship to encompass household income’s impact on spending, and employment’s impact on income, the expression can be rewritten as: If you get the labor market right, you’ll get consumption right. The May employment situation report was roundly disappointing, as May net hirings fell short of expectations by about 100,000 and March and April gains were revised down by 75,000. Chart 7Employees Are Gaining The Upper Hand     The three-month moving average of net payroll additions slipped to just over 150,000. 110,000 monthly net additions is all it takes to keep the unemployment rate at a steady state, however, and there is some evidence that Midwestern flooding held down the May figure. With the job openings rate at a series high well above the 2006-07 peak and (most likely) above the peak in 1999-2000 (Chart 7, top panel), there is quite a lot of demand for new workers, as confirmed by the sizable margin of consumers who report that jobs are plentiful over those who report they’re hard to get (Chart 7, middle panel). The elevated quits rate (Chart 7, bottom panel) indicates that employers are competing fiercely to fill that demand. Given that almost no one quits a job unless s/he already has another one lined up, the quits rate reveals that employers are poaching employees from each other. When Employer A, after losing an employee to Employer B, plucks a replacement away from Employer C or Employer D, a self-reinforcing cycle quickly springs up that endows employees with some bargaining power. The budding dynamic is good for household income and good for consumption. Manufacturing’s Softness Isn’t Such A Big Deal The weakness in manufacturing PMI surveys around the world reveals that there has clearly been a significant global manufacturing slowdown, if not a full-on global manufacturing recession. The steep slide in the U.S. manufacturing PMI shows that it has not been immune. Manufacturing only accounts for about one-sixth of U.S. output and employment, however, and the level of the PMI series, which has simply returned to its mean level across the last three complete cycles, is not a cause for concern (Chart 8). The trend is worrisome, though, and we are watching to see if it breaks through the 50 boom-bust line. Manufacturing is weakening, but it’s not in dire straits yet. Chart 8Manufacturing Is Weakening, But It's Not In Dire Straits Yet Refilling The Punch Bowl This week’s FOMC meeting delivered on the change in tone intimated by Fed speakers at the beginning of the month. It appears that a couple of rate cuts may be forthcoming, whether the economy needs them or not. We had advised clients that the chances of a July rate cut were slightly more than fifty-fifty, but the probability now appears to be much higher. A follow-up cut in September also seems likely. The Fed’s move to insure against an economic shock pushes out our recession timetable yet again. If the fed funds rate is headed to 2% from its current 2.5%, the road to a restrictive policy setting in the mid-3s just got longer. The good news for our recommendations is that they were already decidedly risk friendly, on the grounds that there’s no need to de-risk until a recession is around six months away. Assuming no exogenous event intrudes on U.S. economic activity, neither the expansion nor the bull markets in risk assets will end until the Fed takes away the punch bowl. Right now, it seems intent on refilling it. As a client in Western Canada put it in a meeting with us last week, “Game on!” Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 On the basis of monthly rate/yield data, the 1998 false positive comprised just one observation (September).

Highlights As long as the global long bond yield stays near 2 percent or below, European equities will end the year at broadly the same level as now… …but they will experience a dip of at least 4-5 percent along the way. All central banks have pivoted to dovish but the Fed has more easing armoury than the ECB. This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. Feature At the start of this year we explained Why 2019 Is A Pivotal Year For Monetary Policy. Today we want to elaborate on that report, and its key observations: Since 2008, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before needing to take a breather… and then reverse course. The current vulnerability to tightening emanates from the hyper-sensitivity of financial conditions to rate hikes, rather than from the direct impact on rate-sensitive sectors in the economy. Since October 2017, no stock market rally or sell-off has lasted more than three months or so (Chart Of The Week). These observations are as relevant – or more relevant – now, as they were at the time of our original report.1 Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent. Chart Of The WeekSince October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months A 2 Percent Tightening Is The Post-2008 Limit Since the Global Financial Crisis, no developed economy central bank has been able to hike interest rates sequentially by more than 2 percent before having to reverse course (Chart I-2 and Chart I-3). Chart I-2A 2 Percent Sequential Tightening Is The Post-2008 Limit Chart I-3A 2 Percent Sequential Tightening Is The Post-2008 Limit     In 2008, Swedish interest rates peaked near 5 percent before collapsing to the zero bound in the financial crisis. But when the Riksbank started its so-called ‘policy normalisation’ in 2010, the interest rate could only reach 2 percent before the central bank had to backtrack; Norway could manage just 1 percent of tightening before its volte-face. Though admittedly, both Sweden and Norway were caught in the maelstrom of the euro debt crisis in 2011-12. However, on the other side of the world and relatively immune to the crisis in Europe, New Zealand could achieve a tightening also of only 1 percent; Korea could manage just 1.25 percent; the Reserve Bank of Australia marched interest rates up by 1.75 percent before taking a breather… and then marched them down again. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. The Federal Reserve raised interest rates sequentially by 2 percent through December 2016 to December 2018, and guess what – it is now on the cusp of reversing course. The ultimate course will have a huge bearing on investment strategy for European equities, bonds and currencies. The Neutral Real Rate Of Interest Is Zero Many economists and strategists expected the Fed to continue hiking through 2019, but this publication pushed back hard. The consensus was taking far too rosy a view on the global financial system’s capacity to tolerate further tightening. Central to this publication’s resistance was, and is, a high-conviction view that the so-called ‘neutral’ real rate of interest – the real interest rate that is neither accommodative nor restrictive, the real interest rate consistent with an economy maintaining full employment while keeping inflation constant – is zero. The neutral rate of interest is very low. In our Special Report Why The Neutral Rate Of Interest Is Zero we proposed that the neutral rate is global rather than region-specific, that it refers to the bond yield rather than to the policy rate, and that it is extremely low. As it happens, the Fed broadly concurs. With the policy rate, bond yield, and inflation all at around 2 percent, the real policy rate and real bond yield are both near zero. At this level the central bank claims that “the policy stance is now in the Committee’s estimates of neutral… and when you get to that range we have to let the data speak to us.”2  However, the data that is speaking most loudly is not necessarily the economic data, it is the financial market data. Jay Powell has said that if there is a sustained change in financial conditions through any one or more of its components then “that has to play into our thinking.” We think it has (Chart I-4). Comparing Today’s Rich Valuations With 2007 In the aftermath of the dot com bubble burst in 2000, policy interest rates collapsed to very low levels but, crucially, long bond yields did not. This contrasts with the aftermath of the Global Financial Crisis in 2008, during which both policy interest rates and bond yields have plunged to all-time lows (Charts I-5 - I-7). Funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. Chart I-5In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did Chart I-6In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did   Chart I-7In The Aftermath Of 2000, Bond Yields Did Not Collapse; But In The Aftermath Of 2008, They Did The difference between the post-2000 and post-2008 policy responses can be summarized in two letters: QE. For all its apparent complexity, QE is actually a very simple monetary policy tool. It is just a mechanism for signalling that the policy interest rate will remain low for an extended period. Thereby, QE pulls down the long-term interest rate, which is to say the long bond yield. The double-digit rally over the past six months is technically extended. But as we have consistently pointed out on these pages, funny things happen when the long bond yield gets to, and remains, at ultra-low nominal levels. We refer readers to our other reports for the details, but in a nutshell the risk of owning bonds converges to the risk of owning equities and other so-called ‘risk-assets’. The upshot of this risk convergence is that investors price these risk-assets to deliver the same ultra-low nominal return as bonds, meaning that the valuation of the risk-assets soars.3   Chart I-8Since 2015, The Global Long Bond Yield Has Been Unable To Remain Above 2.5 Percent All of which brings us to the crucial point. The post-2000 extreme policy easing distorted the real economy. It engineered a credit boom. So the fragility to the subsequent policy tightening emanated from the real economy, and particularly the most rate-sensitive sectors in the economy such as mortgage lending and housing. In contrast, the post-2008 extreme policy easing – driven by QE – has distorted the valuation of risk-assets. Moreover, the value of global risk-assets, at $400 trillion dwarfs the $80 trillion global economy by five to one. So the current fragility to policy tightening does not emanate from the real economy, it emanates from the hyper-sensitivity of financial conditions to higher bond yields (Chart 8). Some European Investment Implications The integration of global capital markets means that the valuation anchor for European – and all regional – stock markets now comes from the global long bond yield, which we define as the simple average of the 10-year yields in the euro area, U.S., and China. Through the past five years, the inability of the global long bond yield to remain above 2.5 percent confirms the hyper-sensitivity of financial conditions to higher interest rates. And it suggests that the ‘neutral’ rate on this measure is around 2 percent. The good news is that this measure now stands slightly below neutral at 1.9 percent. The euro has a sound structural underpinning versus the dollar. At around this level of the global long bond yield, the rich valuation of European equities has some support. That said, the double-digit rally over the past six months is technically extended, as most of the things that could go right did go right – central banks pivoted to dovish, euro area growth rebounded, and, until recently, geopolitical risks were easing. Hence, as long as the global long bond yield stays near 2 percent or below, we expect European equities to end the year at broadly the same level as now, though our technical signals do strongly suggest a dip of at least 4-5 percent along the way (Chart I-9). Chart I-9The Double-Digit Rally In Stock Markets Over The Past Six Months Is Technically Extended Chart I-10The Fed Has More Easing Armoury Than The ECB As regards bonds and currencies, all central banks have pivoted to dovish but the Fed has more easing armoury than the ECB (Chart I-10). This means that the recent outperformance of 10-year U.S. T-bonds versus 10-year German bunds can continue. It also means that the euro has a sound structural underpinning versus the dollar. However, this structural underpinning also applies to the yen, and until we get some clarity on Brexit we prefer the yen over the euro.   Fractal Trading System* In line with the main body of this report and Chart 9, we see evidence that the double-digit rally in stock markets over the past six months is technically extended. Accordingly, this week’s recommended trade is to short the MSCI All-Country World index, setting the profit target at 4 percent with a symmetrical stop-loss. This leaves us with four open positions.  For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. *      For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1      Please see the European Investment Strategy Weekly Report ‘Why 2019 Is A Pivotal Year For Monetary Policy’ February 7, 2019 available at eis.bcaresearch.com. 2      Please see the European Investment Strategy Special Report ‘Why The Neutral Rate Of Interest Is Zero’ June 6, 2019 available at eis.bcaresearch.com. 3      Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’ October 25, 2018 available at eis.bcaresearch.com. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations      

Highlights Fed: Depressed U.S. Treasury yields now discount more rate cuts than the FOMC is likely to deliver, even for “insurance” purposes to offset the negative growth impacts from trade policy uncertainty. Maintain a below-benchmark strategic U.S. duration stance, and stay underweight the U.S. in global hedged government bond portfolios. JGBs: The low yield beta of Japanese government bonds can be a useful diversifier of duration risk in global government bond portfolios. We recommend taking advantage of this by increasing allocations to Japan, out of U.S. Treasuries, on a currency-hedged basis (in USD). Feature June FOMC Preview: Hawks & Doves, Living Together, Mass Hysteria! The next two days will be critical for global bond markets, with the U.S. Federal Reserve set to update its outlook for U.S. monetary policy. The only logical interpretation of current market pricing is that bond investors now expect a major hit to U.S. (and global) business confidence and economic growth from a U.S.-China trade war - without any lasting pickup in U.S. inflation from the tariffs. The Fed is stuck in a difficult position at the moment. Looking purely at the state of the economy, there is no immediate need for rate cuts. The unemployment rate is still low at 3.6%; real GDP growth was a solid 3.1% in Q1 and the Atlanta Fed’s GDPNow model estimates Q2 growth will be a trend-like 2.1%; and consumer confidence remains healthy. Our Global Duration Indicator has hooked up, driven by an improving global leading economic indicator and stabilizing economic sentiment surveys. Yet despite this, U.S. Treasury yields have melted down to levels consistent with much weaker economic growth and inflation, with -83bps of Fed rate cuts now discounted over the next twelve months (Chart of the Week). Chart of the WeekToo Much Economic Pessimism Now Discounted In U.S. Treasury Yields Chart 2U.S. Business Confidence: Fraying On The Edges The only logical interpretation of current market pricing is that bond investors now expect a major hit to U.S. (and global) business confidence and economic growth from a U.S.-China trade war - without any lasting pickup in U.S. inflation from the tariffs. Reducing interest rates now would be the appropriate pre-emptive policy response, even if the current health of the economy does not justify a need to ease. A look at various U.S. business confidence surveys confirms that interpretation. Both the NFIB Small Business Confidence index and the Duke CFO U.S. Economic Outlook index are still at fairly high levels, but have clearly softened in recent months (Chart 2, top panel). The deterioration in the Duke CFO measure has come from a sharp fall in the percentage of respondents who are more optimistic on the U.S. economic outlook – a move mirrored by the deterioration in the Conference Board’s survey of CEO Confidence (second panel).   On the inflation side, the Duke CFO survey shows that companies have dramatically cut back on their planned increases for labor compensation over the next year, from 5.1% in the March survey to 3.8% in the June survey (third panel). Plans for price increases over the next year have also collapsed from 2.7% to 1.4% in the June survey (bottom panel). As the FOMC deliberates, the doves will make the following case for an insurance rate cut now (Chart 3): The U.S. manufacturing sector has caught up with the global downturn. Market-based inflation expectations remain below levels consistent with the Fed’s 2% PCE inflation target (between 2.3% and 2.4% using CPI-based TIPS breakevens). The 10-year/3-month U.S. Treasury yield curve remains inverted, typically a sign that monetary policy has become restrictive. The trade-weighted dollar remains near the post-crisis highs, even as U.S. bond yields have plunged. Global economic policy uncertainty remains elevated. Meanwhile, the hawks on the FOMC will argue that easing would be premature (Chart 4): Chart 3The Case For Fed Rate Cuts Chart 4The Case Against Fed Rate Cuts U.S. equities are only 2% below the all-time high. High-yield spreads are stable and nowhere close to the peaks seen during previous bouts of market turmoil. A similar argument applies for market volatility, with the VIX index also relatively subdued in the mid-teens. Global leading economic indicators are bottoming out. Underlying realized inflation trends – average hourly earnings growth, trimmed mean inflation measures – are sticky, at cyclical highs. Given the compelling arguments on both sides, the most likely outcome tomorrow will be the Fed holding off on cutting rates, but making a clear case for what it will take to ease at the July 30-31 FOMC meeting. We imagine that checklist to include: a) Failure of U.S.-China trade talks at the G-20 summit later this month to progress toward an agreement. b) The June U.S. Payrolls report, to be released on July 5th, confirming that the soft May reading was not a one-off. c) The June Consumer Price Index report to be released on July 11th, and the May PCE deflator reading out on July 28th, showing no acceleration of some of the “transitory” components that the Fed believes has been dampening U.S. core inflation. d) A major pullback in U.S. equities and/or a widening of U.S. corporate bond spreads, leading to tighter U.S. financial conditions. Chart 5The Market & FOMC Disagree On The Terminal Rate A new set of FOMC economic projections will be unveiled at this meeting, providing the intellectual cover for the Fed to signal that a rate cut is imminent. A new set of interest rate projections will also be provided. While this current edition of the FOMC has been downplaying the importance of the message implied by those interest rate projections, any movement in the “dots” will be noticed by the markets. The dot plot has only existed in a phase of expected Fed tightening. A shift to a projected ease would be momentous. In particular, any shift in the longer run “terminal rate” dot would be critical to ascertaining the Fed’s reaction function (Chart 5). This is especially true given the wide gap between our estimate of the market expectation of the terminal funds rate for this cycle (the 5-year U.S. Overnight Index Swap rate, 5-years forward, which is currently at 2%) and the median FOMC member estimate of the terminal rate from the last set of economic projections in March (2.8%). If the Fed were to make the case for an insurance rate cut tomorrow, while also lowering the terminal rate estimate, this would suggest that the FOMC was growing more concerned over the medium-term economic outlook as fewer future rate hikes would be needed. More dovish guidance on near-term rate moves, but without any change in the terminal rate projection, would imply that the Fed would view any insurance rate cut as a temporary measure that would need to be reversed at a later date if global uncertainty abates, U.S. growth recovers and U.S. inflation rebounds. Whatever the outcome of this week’s FOMC meeting, U.S. Treasury yields now discount a lot of bad news on both growth and inflation. Both the real and inflation expectations component of the benchmark 10-year Treasury yield are at critical support levels (Chart 6), suggesting that yields can only decline further in the face of incrementally more bearish economic data. Given the risk/reward tradeoff of yields at current levels, we do not recommend chasing this Treasury market rally, and prefer to position for an eventual rebound in yields. Chart 6Not Much Downside Left For Treasury Yields It is possible that the Fed gives a message this week that is more hawkish than the market expects, similar to last December, leading to a sharp selloff in risk assets that temporarily pushes the 10-year Treasury yield to 2%. Such an outcome would eventually force the Fed’s hand to cut rates down the road to offset the tightening of financial conditions and stabilize equity and credit markets. This will eventually trigger a rebound in Treasury yields via rising inflation expectations and investors’ moving out of bonds into risky assets. Given the risk/reward tradeoff of yields at current levels, we do not recommend chasing this Treasury market rally, and prefer to position for an eventual rebound in yields. Bottom Line: Depressed U.S. Treasury yields now discount more rate cuts than the FOMC is likely to deliver, even for “insurance” purposes to offset the negative growth impacts from trade policy uncertainty. Maintain a below-benchmark strategic U.S. duration stance, and stay underweight the U.S. in global hedged government bond portfolios. JGBs As A Duration Management Tool In Global Bond Portfolios It has been quite some time since we have discussed Japanese government bonds (JGBs) in this publication. That is for a good reason – they are an incredibly boring asset. We can think of many more interesting investments than a bond market with no yield, no volatility, no inflation and a central bank with no other viable policy options. Yet low Japanese interest rates make borrowing in yen a good source of funding for carry trades. JGBs also offer the usual safe-haven appeal during periods of risk aversion and recessions. JGBs are a low-beta sovereign bond market, making them a useful way to manage duration risk in a global bond portfolio – especially in environments like today, where JGB yields are higher than U.S. Treasury yields on a currency hedged basis (in U.S. dollars). Chart 7JGBs Are Essentially A 'Global Duration' Bet Most relevant for global bond investors - JGBs typically outperform their developed market peers during periods of rising global bond yields, and vice versa. That can be seen in Chart 7, where we show the total return of the Barclays Bloomberg Japan government bond index, hedged into U.S. dollars, on a duration-matched basis to the Global Treasury index. That return is plotted versus the overall Global Treasury index yield-to-maturity. The correlation is clear from the chart: JGBs outperform when the global yield rises, and underperform when the global yield is falling. In other words, JGBs are a low-beta sovereign bond market, making them a useful way to manage duration risk in a global bond portfolio – especially in environments like today, where JGB yields are higher than U.S. Treasury yields on a currency hedged basis (in U.S. dollars). For bond investors with a view that U.S. Treasury yields have fallen too far and are likely to begin rising again, JGBs are a compelling alternative. Selling Treasuries for JGBs, and hedging the currency risk back into U.S. dollars, can be a way to gain a yield pickup while reducing sensitivity to U.S. bond yield changes (i.e. duration) by owning an asset with a low, or even negative, beta to Treasuries. Chart 8BoJ Needs To Ease, But Options Are Limited Japan’s export-led economy is sputtering on worries over U.S.-China trade tensions which are dampening global growth sentiment more broadly. The Bank of Japan’s (BoJ) widely-watched Tankan survey shows that business confidence has turned more pessimistic; the manufacturing PMI has fallen below 50; and the OECD leading economic indicator for Japan is falling sharply. Even with the unemployment rate at a multi-decade low of 2.4%, wage growth remains muted and consumer confidence is softening. Our own BoJ Monitor is signaling the need for easier monetary policy, and there are now -9bps of rate cuts discounted in the Japanese Overnight Index Swap curve (Chart 8). The BoJ’s policy options, however, are limited. The official policy rate (the discount rate) is already negative, and pushing that lower risks damaging Japanese bank profitability even further. More dovish forward guidance is of limited impact with markets already priced for a prolonged period of low rates. The BoJ cannot pursue more quantitative easing (QE) either, as it already owns nearly 50% of all outstanding JGBs - a massive presence that has, at times, disrupted functionality in the JGB market. There is nothing on the horizon indicating that JGB yields will move much from current levels, allowing JGBs to maintain their defensive status in global bond portfolios. The only real policy tool left is Yield Curve Control (YCC), where the BoJ has been targeting a 10-year JGB yield close to 0% and managing purchases to sustain the yield target. In our view, any upward adjustment of that yield target range (currently 0-0.2% on the 10yr JGB) would require a combination of three factors: The USD/JPY exchange rate must increase back to at least the 115-120 range, to provide a lower starting point for the likely yen appreciation that would occur if the BoJ targeted a higher bond yield. Japanese core CPI inflation and nominal wage growth must both rise and remain above 1.5%, which is close enough to the BoJ’s 2% inflation target to justify an increase in nominal bond yields. The momentum in the yield differential between 10-year Treasuries and JGBs must be overshooting to the upside; the BoJ would not want to keep JGB yields too depressed for too long if the global economy was strong enough to boost non-Japanese yields at a rapid pace. Chart 9BoJ Yield Curve Control Is Here To Stay Currently, none of those criteria is in place (Chart 9). USD/JPY is down to 108; core CPI inflation is 0.6%; real wage growth is effectively zero; and the 10yr U.S.-Japan bond spread is contracting. There is nothing on the horizon indicating that JGB yields will move much from current levels, allowing JGBs to maintain their defensive status in global bond portfolios. Changes to our model bond portfolio We have been recommending an overweight stance on JGBs in our model portfolio for much of the past two years. This is in line with our long-held view that global bond yields had to rise on the back of improving global growth and the slow normalization of interest rates by the Fed and other central banks not named the Bank of Japan. Events this year have obviously challenged that view and we have reduced the size of our recommended overweight in our model bond portfolio. Given our view that U.S. Treasury yields are likely to grind higher in the next few months, we see a need to turn to Japan as a way to play defense against a rebound in global bond yields. That means increasing the Japan allocation, and decreasing the U.S. allocation, in our model bond portfolio. We can fine-tune that allocation shift based on the empirical yield betas of U.S. Treasuries to JGBs across different maturity buckets. In Chart 10, we show the rolling 52-week yield beta of JGBs to the other major developed bond markets, shown at the four critical yield curve points (2-year, 5-year, 10-year and 30-year). In all cases, the yield beta is low and fairly consistent across all maturities. When looking at those same rolling betas using yields hedged into U.S. dollars, shown in Chart 11, the story changes (note that we are using hedged yield data from Bloomberg Barclays, so the maturity buckets correspond to those used in the benchmark indices). The yield betas between JGBs and other markets are at or below zero in the 3-5 year and 7-10 year maturity buckets, with particularly large negative betas versus U.S. Treasuries. This implies that there is a gain to be made by focusing any Japan-for-U.S. switch in currency-hedged global bond portfolios on bonds with maturities between three and ten years. Chart 10JGBs Are Low-Beta To Global Yields... Chart 11...And Even Negative-Beta After Hedging Into USD Based on this analysis, and our view on U.S. Treasuries laid out earlier in this report, we are making a shift in our model bond portfolio on page 12 – cutting the weight in the maturity buckets in the middle of the Treasury curve and placing the proceeds into similar maturity buckets in Japan. Bottom Line: The low yield beta of Japanese government bonds can be a useful diversifier of duration risk in global government bond portfolios. We recommend taking advantage of this by increasing allocations to Japan, out of U.S. Treasuries, on a currency-hedged basis (into USD).   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights June FOMC Meeting: To appease markets, the Fed will at least have to signal that it stands ready to cut rates in July. While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit spreads in the near-term (0-3 months). Rate Cuts: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates in June or July. Treasury Yields: Yields have fallen a lot since the beginning of November, but the move isn't terribly anomalous relative to history. We use statistics to place recent price action in its appropriate historical context. Feature The Fed This Week Chart 1Credit Spreads At Risk Tomorrow’s FOMC meeting is the main event in financial markets this week, with investors of all stripes eager to learn whether the Fed will deliver on the rate cut expectations that have already been priced into bond yields. As we’ve written in prior reports, our immediate concern is that the Fed may not sound dovish enough to appease markets, leading to further near-term widening in corporate bond spreads.1 Corporate bond excess returns have far outpaced commodity prices of late (Chart 1), leaving the sector vulnerable to any hawkish surprise. What’s Priced In, And Can The Fed Deliver? How dovish must the Fed be to prevent a sell-off in corporate credit? A look at current fed funds futures pricing shows that the market is looking for nearly three 25 basis point rate cuts spread over the next six FOMC meetings (Table 1). Roughly, the market expects one rate cut at either the June or July meeting, a second rate cut in either September or October, and a third rate cut in either December or January. To appease markets, the Fed will at least have to revise its 2019 funds rate projections down and signal that it stands ready to cut rates in July (Chart 2). While this is possible, there is a significant risk that the committee fails to deliver. We continue to advocate a cautious approach to corporate credit markets in the near-term (0-3 months). Table 1Fed Funds Futures: What's Priced In? Chart 2Watch For Dot Plot Revisions   Fed Rate Cuts: A Track Record While we are cautious on corporate spreads in the near-term, we are also not willing to chase Treasury yields lower from current levels. Our view is that while the Fed might deliver a rate cut at one of the next few meetings, it is unlikely to lower rates by more than the 84 bps that are priced into the yield curve for the next 12 months. Ultimately, we expect Treasury yields to be higher on a 6-12 month horizon, even if the Fed cuts rates during the next few months. In response to this outlook, a few clients have asked whether it is possible for Treasury yields to rise so soon after a Fed rate cut. While we see no theoretical reason why it shouldn't be possible, it is always a good idea to stress test a theory against the historical track record. We therefore compiled a list of every Fed rate cut since 1995, and looked at how the 10-year Treasury yield reacted to each event. The results are displayed in Tables 2A-2D.   Table 2A shows the rate cuts that the Fed delivered in the mid-1990s, in response to persistently low U.S. inflation and slowing growth in the rest of the world. At the time, overall U.S. economic growth was quite solid and the U.S. economy didn’t fall into recession until 2001. The divergence between relatively strong U.S. economic growth and slower growth in the rest of the world makes the period look very similar to today, and we have long argued that the current cycle should be viewed in the context of the mid-1990s.2 Table 2A reveals that, on average, the 10-year Treasury yield tended to rise in the months following a rate cut, often even in the first 21 days. The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. Table 2C shows the rate cuts that were delivered during the economic recovery of the mid-2000s, and it paints a similar picture as Table 2A. In particular, the 10-year Treasury yield rose dramatically following the 2003 rate cut, and the Fed actually started to hike interest rates almost exactly one year after the 2003 cut. Tables 2B & 2D show the rate cuts that led into the 2001 and 2008 recessions. Not surprisingly, yields were much more likely to fall after the Fed cut rates in those episodes. Bottom Line: The historical track record suggests that the 10-year Treasury yield can rise or fall in the immediate aftermath of a Fed rate cut. The yield is much more likely to fall if the cut occurs in the run-up to a recession. With a U.S. recession still far off, we see a good chance that Treasury yields will rise during the next 6-12 months, even if the Fed lowers rates at one of the next few FOMC meetings. Treasury Yield Moves: A Track Record In recent weeks a BCA client who had been shaking his head at the large drop in Treasury yields reached out to see if we could put the recent moves in historical context. Specifically, he wondered how often such large yield moves have occurred in the past, and whether there is a tendency for moves of this magnitude to mean-revert. Our U.S. Investment Strategy team took a stab at answering these questions. The below analysis first appeared in last week's U.S. Investment Strategy report, but is re-printed here for the interest of U.S. bond clients.3 The ongoing decline in bond yields has felt like a big deal in real time, but it isn’t historically. The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 3). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 3). Chart 3The Path To 2.07% Table 3A Lower 10-Year Treasury Yield In Three Steps Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 4). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 4Standardized Values Of Nominal 10-Year Treasury Yield Declines The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 4). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 5). Chart 4No Historical Anomaly In The Current Market Chart 5Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.4 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The standardized moves in real yields and Treasury index returns haven’t been a big deal. Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 6). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 6Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 7). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 8). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. Chart 7... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 8... And Long-Maturity Returns Have Been Elevated The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, and history suggests it will be partially unwound over the next six to twelve months. Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 5). Table 5Standardized Values Of Future Long-Maturity Treasury Index Returns Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 6). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. Table 6Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief U.S. Investment Strategist dougp@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, “Tracking The Mid-1990s”, dated June 11, 2019, available at usbs.bcaresearch.com 3      Please see U.S. Investment Strategy Weekly Report, “Context”, dated June 10, 2019, available at usis.bcaresearch.com 4      If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%). Fixed Income Sector Performance Recommended Portfolio Specification