経済成長

Highlights The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. The two main tail-risks are a messy Brexit and financial market volatility, but these are not our central case. Stay overweight the Eurostoxx50 versus the S&P500. Go underweight German bunds. Go overweight the German DAX versus German long-dated bunds. Add the German DAX as a new long position to the existing long basket holdings in France, Ireland and Switzerland. Maintain the short basket holdings in Norway and Denmark. Feature Chart of the WeekThe Underperformance Of German Equities Vs. German Bonds Is At A Euro Debt Crisis Extreme! Economies do not grow in straight lines. Rather, the process of economic expansion is a never-ending ebb and flow, creating clockwork-like oscillations in economic activity. As a perfect illustration, the growth in the euro area wage bill has trended higher through the past five years and is now running at very healthy 4 percent clip. Yet this strong uptrend has been interspersed with wobbles that have occurred with a remarkable regularity (Chart I-2). Chart I-2Economies Have Regular Wobbles... The recent setback in euro area activity has spooked some economy watchers. Even the ECB has just moved its risk assessment surrounding the growth outlook to the downside. But the downgrade was largely a result of its ‘data-dependency’ which, by definition, is always backward looking. This meant that the downgrade had a negligible effect on the financial markets which are always forward looking. For the markets, there is a much more important issue: is the recent setback the start of something serious, or can we expect a bounce back? The Setback The explanation for the regular wobbles in euro area growth comes from the oscillations in global economic activity (Chart I-3). But here we need to be wary of a potentially circular argument. As Europe is a dominant component of the global economy, euro area domestic demand setbacks could themselves be the root cause of the over-arching global growth oscillations. Chart I-3...Because Of Clockwork-Like Oscillations In Global Economic Activity Recently, Italy and Germany have suffered idiosyncratic ‘country and sector specific’ setbacks. The spat between Rome and Brussels over Italy’s 2019 budget caused Italian bond yields to soar and Italian bank lending to contract viciously (Chart I-4). Meanwhile, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German vehicle exports suffered a €20 billion hit which shaved 0.6 percent from the €3.4 trillion German economy (Chart I-5).  Chart I-4Italian Bank Lending Contracted Viciously, But Will Now Recover Chart I-5German Auto Exports Plunged, But Will Now Recover Despite all of this, the epicentre of the 2018 growth setback was not inside Europe, but outside Europe. The ECB correctly blames the recent down-oscillation not on domestic causes, but on softer external demand, specifically “vulnerabilities in emerging markets”. The central bank argues that once there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out.  Another very important driver of European growth oscillations is the oil price. In recent years, the growth in GDP in excess of wages has perfectly and inversely tracked oscillations in the oil price (Chart I-6). The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending. Chart I-6Oil: Another Driver Of European Growth Somewhat contrary to received wisdom, one thing that does not generally drive euro area growth oscillations is the euro exchange rate. When the euro weakens, it does of course make the euro area’s exporters more competitive. But working against this, a weaker euro also raises the prices of imported energy and food, thereby squeezing euro area consumers’ real incomes. And vice-versa when the euro strengthens. Hence, while the euro’s moves do create growth winners and losers within the euro area, these tend to cancel out at the aggregate economy level. The Bounce Back The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. Regarding the vulnerabilities in emerging markets, many ECB governors argue that “everything we know says that the Chinese government is taking strong measures to address its slowdown”. Recent improvements in China’s monetary statistics provide strong evidence for this view (Chart I-7). Chart I-76-Month Credit Impulses Are Bouncing Back Everywhere Meanwhile, credit growth in the euro area itself is also accelerating, albeit modestly. This is hardly surprising given that financing conditions are very favourable. Even though the ECB has done nothing to policy interest rates, more dovish forward guidance has effectively made euro area monetary policy more accommodative: since October, core euro area 10-year bond yields are down 40 bps. And with banks’ balance sheets stronger, the ECB claims “the conditions for a continuation of credit to the economy are in place.”  Over the same three month period, the crude oil price has plunged by 35 percent (Chart I-8). Draghi confirmed our observation above: lower energy prices support real disposable income for euro area households. Chart I-8Double Boost: Lower Bond Yields And Lower Oil Draghi also pointed out another positive impulse: fiscal policy in the euro area has now flipped from contractionary to slightly expansionary. As regards the idiosyncratic sector specific setbacks, the Italian 10-year BTP yield has unwound its budget spat spike, and is down 100 bps since October. It follows that Italian bank credit growth is likely to recover. And Draghi explained that “the specific episode of the car industry in Germany will soon wash out because there is going to be a rebound in the sector.” Still, two significant tail-risks could smother the bounce back: Uncertainties related to geopolitical factors and the threat of protectionism, specifically, a messy Brexit. Financial market volatility. The Investment Implications Our central case is that the tail-risks do not materialise. And that the recent combination of more favourable financing conditions in the euro area and globally, lower energy prices, fiscal thrust, and the removal of specific setbacks in Italy and Germany should engineer some sort of growth bounce back in the euro area.  One important implication is that the strong recent rally in German bunds is close to exhaustion, and even vulnerable to a short-term retracement. This is supported by our trusted technical indicator warning of an imminent liquidity shortage and a corrective price reversal (Chart I-9). Go underweight German bunds on a short term horizon. Chart I-9The Rally In The German Bund Is Exhausted A mirror-image implication is that the underperformance of the German DAX relative to German long-dated bunds is now at euro debt crisis extremes (Chart I-1 and Chart I-10). This relative performance also appears technically exhausted and ripe for a reversal. As an asset allocation position, go overweight the DAX versus German long-dated bunds on a tactical. Chart I-10The Extreme Underperformance Of The DAX Will Reverse In line with the growth rebound thesis, stock market selection – through the underlying sector exposures – should now have a modest tilt towards cyclicality. Stay overweight the Eurostoxx50 versus the S&P500. Within Europe, our current long positions in France, Ireland, and Switzerland combined with short positions in Norway and Denmark do provide the required tilt towards cyclicality. Nevertheless, today we are adding the oversold German DAX to our long stock markets basket. Fractal Trading System* In line with the fundamentals-based arguments in the main body of this report, this week’s recommended trade is to go long the DAX versus the 30-year bund. Set a profit target of 2.5 percent with a symmetrical stop-loss 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. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * 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, Senior Vice President Chief European Investment Strategist dhaval@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 Duration: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428  4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Corporates: The same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. Investors should tactically increase exposure to corporate bonds at the expense of Treasuries. Duration: Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. TIPS: The 10-year TIPS breakeven inflation rate has fallen too far, and it is now well below the fair value reading from our Adaptive Expectations model. Remain overweight TIPS versus nominal Treasury securities. Feature We continue to view the 2015/16 episode as the appropriate comparable for current market behavior, and the same indicators that called the early-2016 peak in credit spreads are once again sending a positive signal. As such, we recommend increasing portfolio allocations to both investment grade and high-yield corporate bonds at the expense of Treasury securities (see the Recommended Portfolio Specification Table on the last page of this report). Importantly, our cyclical view of the credit cycle has not changed. Elevated corporate debt balances and a relatively flat yield curve suggest that we are in the awkward middle phase of the cycle when excess returns from corporate credit tend to be positive, but low.1  However, recent spread widening has been excessive for this middle phase of the cycle, and we expect spreads to tighten from oversold levels during the next few months. Three Reasons To Upgrade Credit (& One Key Risk) Reason 1: Elevated Spreads The first reason to upgrade corporate credit is the attractive entry point (Chart 1). Outside of the Aaa space, 12-month breakeven spreads for every credit tier (encompassing both investment grade and junk) are above their respective historical medians. For example, the 12-month breakeven spread for the Baa credit tier is at 59%. This means that the spread has been tighter than its current level 59% of the time since 1988 and wider than its current level 41% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this middle phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart 1Corporate Bonds: Attractive Entry Point Reason 2: Fed Capitulation The 2015/16 roadmap is applicable to the current market because in both cases credit spread widening was driven by the combination of weaker global growth and relatively hawkish Fed policy.2 With that in mind, an important pre-condition for spread tightening is a shift in the market’s expectations for Fed policy. Investor psyche must change from viewing monetary policy as restrictive to viewing it as accommodative. Chart 2 shows the three indicators we’ve been monitoring to signal when this shift occurs. All three called the early-2016 peak in credit spreads, and all are sending a strong buy signal at the moment. Chart 2Fed Capitulation Indicators Send A Strong Signal... Our 12-month Fed Funds Discounter, the change in the fed funds rate that is priced into the overnight index swap curve for the next 12 months, has collapsed from an early-November peak of 66 bps all the way to -4 bps (Chart 2, top panel). The gold price has also rebounded smartly (Chart 2, panel 2). Gold tends to rally when the market perceives that monetary policy is becoming more accommodative because the increased risk of future inflation makes gold’s “store of value” characteristics more appealing.3 Finally, the trade-weighted dollar has started to depreciate (Chart 2, bottom panel). This signals that U.S. monetary policy is easing relative to the rest of the world, and is historically correlated with stronger global growth. Reason 3: Imminent Global Growth Rebound The high-frequency global growth indicators that called the early-2016 peak in credit spreads are not sending as strong a signal as the monetary policy indicators, but there has been some positive movement (Chart 3). Chart 3...While There Is Positive Movement In Global Growth Indicators The CRB Raw Industrials index has only flattened-off in recent weeks (Chart 3, top panel), but the Market-Based China Growth Indicator created by our China Investment Strategy team has been rising quickly (Chart 3, panel 2).4  Finally, the price of global industrial mining stocks is no longer in free-fall. Rather, it is showing some signs of stabilization (Chart 3, bottom panel). Of the six indicators shown in Charts 2 and 3, four are sending strong buy signals and the other two are more or less neutral. In sum, we think this is enough of a signal to upgrade exposure to corporate bonds. One Key Risk The key risk to our tactical upgrade is that there is no follow-through from Fed easing to stronger global growth. In 2016, Fed capitulation coincided with a ramp-up in Chinese stimulus efforts. Chart 4 shows that our China Investment Strategy team’s Li Keqiang Leading Indicator moved sharply higher in early 2016.5 Moreover, all six components of the indicator participated in the uptrend. At present, only some components of the Leading Index have rebounded and the overall index has merely leveled-off. Chart 4Chinese Growth Is The One Key Risk When it comes to Chinese growth, a trade deal with the U.S. would certainly help matters. However, the risk remains that Chinese policymakers continue to curb credit growth so much that the pass through from easier Fed policy to global growth is weaker than in 2016. Bottom Line: With Fed rate hikes priced out of the market and signs of stabilization in high-frequency global growth indicators, the toxic combination of tight Fed policy and weak global growth is disappearing. This should allow credit spreads to tighten from current oversold levels. The rapid shift in monetary policy expectations makes us think that spread tightening could occur over a relatively short timeframe. As such, we would recommend this upgrade only to tactical (3-6 month) investors. Those with longer investment horizons may be better served by waiting for spreads to tighten and then using that opportunity to reduce cyclical corporate bond exposure. A Note On Portfolio Duration As mentioned above, the market has completely priced out Fed rate hikes. At present, the overnight index swap curve discounts 4 bps of rate cuts over the next 12 months and 17 bps of rate cuts over the next 24 months. This shift in market rate expectations is the main reason for our rosier outlook on corporate spreads, but it’s important to remember that the causation between credit spreads and policy expectations runs both ways (Chart 5). It is the recent spread widening and sharp tightening in financial conditions that caused the Fed to adopt a more accommodative policy stance in the first place (Chart 6). In the background, the U.S. economic data remain robust. The New York Fed’s GDP Nowcast model projects above-trend real GDP growth of 2.5% in 2018 Q4 and 2.1% in 2019 Q1. The corollary is that once credit spreads tighten and financial conditions ease, the Fed will have no further reason to stay on hold. Chart 6Financial Conditions Likely Going To Ease Going Forward If financial conditions ease during the next few months, as we expect, then it is very likely that the Fed will be ready to lift rates again at the June FOMC meeting. The fed funds futures curve currently discounts less than a 20% chance of that happening.  Bottom Line: The U.S. economic data are solid. The sharp fall in rate hike expectations and Treasury yields is purely a reaction to tighter financial conditions. Treasury yields will rise in the coming months as credit spreads tighten and financial conditions ease. Maintain below-benchmark portfolio duration. Inflation & TIPS The main reason why the Fed feels comfortable responding to tighter financial conditions by adopting a more dovish policy stance is that inflation remains well contained. Last week’s CPI report showed that core CPI grew by 2.2% in 2018, somewhat below levels that are consistent with the Fed’s target (Chart 7).6 Chart 7Inflation Remains Well Contained Looking at the monthly changes, we also see that core CPI has increased by roughly 0.2% in each of the past three months. This translates to an annualized rate of approximately 2.4%, in line with the Fed’s target (Chart 8). The monthly changes shown in Chart 8 also reveal that the year-over-year growth rate in core CPI will almost certainly decline next month when the strong 0.35% print from last January falls out of the trailing 12-month sample. Chart 8Muted Inflationary Pressures For Now However, after next month base effects start to turn supportive. Our Base Effects Indicator, an indicator that compares rates of change in core CPI ranging from 1 to 11 months, predicts that year-over-year core CPI inflation will be higher six months from now (Chart 9). Chart 9Expect Higher Inflation Six Months From Now The conclusion is that inflationary pressures appear muted right now, and will continue to appear muted through the end of February. However, we expect them to ramp up again as we head into March. Come June, it is quite likely that the Fed will be feeling the pressure to lift rates as inflation approaches target. Coincident with a renewed uptick in inflation, TIPS breakeven inflation rates are also biased higher during the next six months. Slowing global growth and falling oil prices drove long-maturity breakevens lower during the past few months, with the result that the 10-year TIPS breakeven inflation rate is now 1.83%, 14 bps below the fair value reading from our Adaptive Expectations model (Chart 10).7  Chart 10Message From Our Adaptive Expectations Model Our Adaptive Expectations model contains three independent variables: The 10-year trailing rate of change in core CPI (Chart 10, panel 3) The 12-month trailing rate of change in headline CPI (Chart 10, panel 4) The New York Fed’s Underlying Inflation Gauge (Chart 10, bottom panel) Of those three variables, the 10-year trailing rate of change in core CPI carries the largest weight. This long-run measure of core inflation is currently running at an annualized pace of 1.83%. This translates roughly to an average monthly increase of 0.15%. In other words, as long as monthly core inflation prints above the 0.15% level, the fair value from our Adaptive Expectations model will continue to rise. Bottom Line: Core inflation has been steady during the past few months, but base effects will turn positive after next month’s report. This means that we will probably see higher year-over-year core CPI inflation in six months. With the 10-year TIPS breakeven inflation rate already well below the fair value reading from our Adaptive Expectations model, we expect TIPS will outperform nominal Treasuries during the next six months.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 4 For further details on how this indicator is constructed please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 5 The Li Keqiang Leading Indicator is a composite indicator of money and credit growth measures designed to predict changes in the Li Keqiang Index (a coincident indicator of Chinese economic activity). For further details on how the Leading Index is constructed please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 6 The Fed targets 2% PCE inflation. CPI inflation tends to run about 0.4%-0.5% higher than PCE, which means the Fed’s target is roughly 2.4%-2.5% for CPI. 7 For further details on the model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Are Markets Too Pessimistic On U.S. Growth & Inflation? What Is China’s Economic Pain Threshold To Trigger A Policy Response? Have Central Banks Become Less Concerned About Financial Markets? Feature Happy New Year! 2019 has started much like 2018 ended, with elevated global market volatility. The combination of more evidence of slowing global growth – fueled by spillovers from U.S.-China trade tensions – and central banks perceived to be overly hawkish has crushed investor sentiment. Money has flooded out of risk assets like equities and corporate debt and shifted into the traditional safe haven assets – government bonds, surplus currencies like the Japanese yen and even gold. U.S. equities and credit, which had been a refuge from the global market weakness for much of last year, have underperformed sharply as markets have moved to price in the global economic softness reaching U.S. shores. These market trends obviously run counter to our recommended positioning for overall portfolio duration (below benchmark) and credit exposure (neutral overall, favoring the U.S. over Europe and Emerging Markets). Yet we advise staying the course with our recommendations, as market pricing has become too pessimistic relative to likely global growth and inflation outcomes. The bulk of the recent decline in global bond yields has come from falling inflation expectations, which have been linked to the sharp fall in oil prices seen in the final months of 2018 (Chart of the Week). This is shown in Table 1, which presents the breakdown of the decline in the 10-year benchmark government bond yields for the major developed markets since the peak in U.S. Treasury yields back on November 8. Real yields have fallen by a more modest amount than inflation expectations in most countries, even with the pullback in cyclical indicators like the global PMI. Expected 2019 rate hikes are now fully priced out of money market curves, most notably in the U.S. Chart of the WeekSlowing Growth Is Not Why Yields Have Plunged   Table 1Decomposing 10-Year Yield Changes Since The November 2018 Peak In our view, there are three vital questions regarding the recent market turbulence that must be answered before determining the appropriate global fixed income investment strategy over the next 6-12 months. The answers lead us to maintain our current recommendations on duration, country allocation and credit exposure, even with the recent market turbulence. 1) Are Markets Too Pessimistic On U.S. Growth & Inflation? The December reading for the U.S. ISM Manufacturing purchasing managers’ index (PMI) released last week showed the largest single month deceleration since 2008 (Chart 2). All the main subcomponents of the ISM index fell, including the New Orders and Export indices which are now close to falling below the 50 threshold (Chart 3). Coming on the heels of China’s PMI dipping below 50, markets became more worried that the mighty U.S. economy was being dragged down to the weaker pace of growth seen outside the U.S. Chart 2Decomposing 10-Year Yield Changes Since The November 2018 Peak   Chart 3U.S. ISM Overstating U.S. Economic Weakness Yet when looking a broader array of U.S. indicators, the domestic economy still appears to be in good shape, albeit with some lost growth momentum. Consumer confidence remains solid, employment growth is accelerating, household incomes are growing at a faster pace and the personal savings rate remains elevated – all of which provide support for a faster pace of consumer spending (third panel). At the same time, the U.S. Conference Board leading economic indicator is still pointing to a healthy above-trend pace of GDP growth in 2019. U.S. Treasury yields have fallen to levels consistent with the drift lower in the ISM index (top panel), with the market now discounting one full 25bp rate cut to occur within the next twelve months. That will not happen given the tightness of the U.S. labor market and persistence of underlying domestic inflation pressures. The robust December gain reported in last Friday’s U.S. Payrolls report (+312k) may have surprised the markets, but our U.S. Employment Growth model had been signaling a faster pace of job growth for the past several months (Chart 4). The year-over-year growth in Average Hourly Earnings rose to 3.2%, the highest level in nearly a decade. With the overall unemployment still at a historically low 3.9% as labor demand is increasing, wages are likely to remain under upward pressure in the next 6-12 months. Chart 4U.S. Employment & Wages Are Accelerating Given this backdrop of economic growth that is likely to remain above-trend throughout 2019, it will be difficult to generate a sustained downturn in U.S. inflation this year, even given the lagged impact of the strong U.S. dollar and lower oil prices. While some decline in headline inflation measures is inevitable in the coming months given the rapid pace and magnitude of the 2018 oil plunge, BCA’s Commodity & Energy Strategy team continues to see a positive demand/supply balance helping push oil prices back towards the $80/bbl level in 2019.1 That would ensure that any decline in headline U.S. inflation would be short in duration, and of far less magnitude than the move that occurred after the 2014/15 oil plunge given the more robust domestic inflation backdrop (Chart 5). Chart 5This Is NOT A Repeat Of the 2015/16 Deflation Scare A sober assessment of the U.S. economic and inflation data leads us to conclude that U.S. interest rate markets have swung too far to the dovish side. The inflation expectations component of U.S. Treasury yields is now too low, and the Fed rate cut that is now discounted in money markets will not materialize. Rate hikes are the more likely outcome, the repricing of which will put renewed upward pressure on Treasury yields. 2) What Is China’s Economic Pain Threshold To Trigger A Policy Response? Of the potential catalysts that could turn the current investor pessimism into optimism, signs of improving Chinese growth would likely top the list. China’s economy has lost considerable momentum, with year-over-year real GDP growth slowing to 6.5% in the third quarter of last year and higher frequency data showing a further deceleration in the fourth quarter. The profit warning issued by Apple last week, prompted by an unexpectedly sharp slowing of Chinese mobile phone demand, is a sign that Chinese consumer spending may be faltering. There are several causes for the growth slump, both domestic and foreign. Chinese authorities have been clamping down on domestic leverage given elevated private debt levels, while also taking action to reduce domestic pollution levels – policies that all have helped dampen industrial activity. More recently, and more importantly, the U.S.-China tariff war has started to have a real economic impact on the economy through slowing trade activity and diminished business confidence. Given the Chinese government’s perpetual interest in maintaining domestic stability by limiting any cyclical increases in unemployment, the incentive is there for policymakers to provide renewed stimulus to put a floor under economic growth. The last such boost came in 2015/16, when the Chinese government implemented an aggressive expansion of fiscal spending alongside monetary policy measures such as interest rate cuts, reductions in reserve requirement ratios and currency depreciation. That package was enough to cause a sharp reacceleration of the Chinese economy, but only after nominal GDP growth had fallen to an 16-year low of 6.4% at the end of 2015 (Chart 6). Chart 6Nominal China Growth Less Than 7.5% Should Trigger More Stimulus … Policymakers will likely be forced into action again in 2019 if nominal GDP growth, which hit 9.6% in the third quarter of 2018, falls back below 7.5%. Forward-looking economic measures like our Li Keqiang leading indicator and the export orders component of China’s manufacturing PMI suggest that weaker growth outcome could occur by mid-2019. China’s policymakers are likely to announce some form of stimulus in the first half of the year help counteract the growth slump, which could help boost global investor confidence (especially if it is accompanied by a new trade agreement with the U.S.). While Chinese policymakers are now under more pressure to provide stimulus measures, the tools available to them are more limited than was the case in 2015/16 (Chart 7). Interest rate cuts could happen if growth continues to fall more rapidly than expected, but that would create a burst in private sector leverage that policymakers would seek to avoid. The currency could also be weakened further, but the USD/CNY exchange rate is already back to near the 7.0 level reached in the 2016 devaluation. Chart 7...Atlhough Policy Options Are More Limited Than 2016 That leaves additional cuts in the reserve requirement ratio and increases in fiscal spending as the two most likely means for China to stimulate its economy in the coming months. Yet even the fiscal channel has limits, given the much higher starting point for the budget deficit today (3.7% of GDP) than in 2015 (2%). So while the trigger for a China policy stimulus will likely be reached by mid-2019, the magnitude of the stimulus will be nowhere near as large as the 2015/16 measures. This will help stabilize global growth expectations, but likely not by enough to provide a major boost to global commodity prices or export demand from emerging market countries that are heavily dependent on China. This leads us to remain cautious on emerging market credit exposure, as we prefer to own U.S. corporate debt instead where the growth/profit outlook is better. 3) Have Central Banks Become Less Concerned About Financial Markets? A popular market narrative of late has been that the Fed “made a mistake” with its last rate hike in December. A similar argument was made for the ECB choosing the end its Asset Purchase Program last month with inflation still well short of its target and European growth decelerating. The idea that central banks had fallen “out of tune” with financial markets has spooked investors who fear that policymakers are carrying out a pre-conceived plan to normalize monetary policy without any regard to financial markets. We find this to be a highly dubious conclusion. Central bankers still care about financial markets – or, more accurately, financial conditions – but the hurdle for policymakers to respond to falling asset prices is higher now than in previous years because of a lack of spare economic capacity. Simply put, any tightening of financial conditions must be large enough to trigger a slowing of growth to a below-potential pace, resulting in rising unemployment and weaker inflation pressures. That has not been the case – yet – in the major developed economies. Financial conditions indices (FCIs) – which measure the combined impact of equity prices, credit spreads and currencies – typically lead economic growth by 2-3 quarters. The latest selloffs in equity and credit markets in the U.S. and Europe, while significant, have not been large enough to push FCIs for those regions to levels that would be consistent with below-trend growth, using the 2015/16 episode as a reference point (Chart 8). Chart 8Tightening Financial Conditions Not Signaling Below-Trend Growth...Yet Financial conditions in the U.S. are much closer to that 2015/16 reference point than in Europe, where bond yields remain very depressed and the euro is still an undervalued currency. Yet the domestic U.S. economy is in a much better state than was the case in 2015/16, as discussed earlier in this report. It is highly likely that the level of the U.S. FCI that would trigger a move to below-trend U.S. growth is much different today than in 2015/16. In other words, it would take a bigger widening of U.S. corporate credit spreads, or a sharper selloff in U.S. equity values, to generate the same type of drag on U.S. growth relative to 2015/16. Yet U.S. interest rate markets have already responded as if there was no such change in the amount of FCI tightening that would result in a more dovish Fed policy. The U.S. money markets have gone from pricing three rate hikes in 2019 to one rate cut, while bond investors have largely neutralized their bearish Treasury duration positioning (Chart 9). Chart 9USTs Now Discounting Too Much Fed Dovishness That swing in sentiment on the Fed’s next move flies in the face of the underlying health of the U.S. economic data, as well as our Fed Monitor which continues to signal the need for more Fed rate hikes (Chart 10). Our other Central Bank Monitors tell a similar story (outside of Australia), with the Monitors signaling no need for easier monetary policy but with money markets pricing out any probability of a rate hike over the next year. This leaves global government bond yields exposed to any sign that global growth momentum is stabilizing, particularly with the inflation expectations component of bond yields also vulnerable to a rebound in oil prices (Chart 11). Chart 10Bond Yields Are Now Exposed To A Repricing Of Rate Hikes   Chart 11Bond Yields Are Now Exposed To A Rebound In Oil Prices Our conclusion is that financial conditions in the major economies have not yet tightened by enough to end the process of normalizing global monetary policy from the extraordinarily accommodative settings seen in recent years. In other words, bond yields have not yet peaked for this cycle.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, “Oil Volatility Will Persist: 2019 Brent Forecast Lowered to $80/bbl”, dated January 3rd 2018, available at ces.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