BCA Indicators/Model

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth Chart I-1 Chart I-2 The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. Chart I-3 Chart I-4 When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Chart I-5 Chart I-6 Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation Chart I-7 Chart I-8 When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8). Chart I-9 Chart I-10   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions Chart I-11 Chart I-12 The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors Chart I-13   Chart I-14 We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates Chart I-15 Chart I-16   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions Chart I-17 Chart I-18   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2   Recent data in Switzerland has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Our non-consensus inflation and Fed views just got even more non-consensus: Media and sell-side commentators were quick to speculate about an end to the tightening cycle following Wednesday’s FOMC meeting, but we don’t see any basis for changing our stance. December and January have been a wild couple of months, … : It’s not unusual for a swing in one direction to be following by a swing in the other, but the S&P 500 went from the 2nd percentile in December to the 96th percentile in January. … and we’re turning to our equity checklist to regain our bearings: Checklists help us maintain a healthy distance from day-to-day swings and focus on the key swing factors. For now, we don’t think anything much has changed, but the scope for a repricing of the entire Treasury curve has gotten bigger: The wider the disparity between our terminal fed funds rate expectation and the market’s, the greater the potential for yields to readjust. We continue to believe markets are being complacent about inflation pressures; their presence will force the Fed off the sidelines and ultimately spell the end of the expansion. Feature Brutal arctic cold swept the Midwest and the Northeast Corridor last week as the polar vortex clamped down on Canada and the upper U.S. The weather didn’t do anything to cool investors’ revived ardor for stocks, however. After finally taking a break from its nearly uninterrupted four-week sprint from 2,350 to 2,670 (that’s nearly 14% in just 17 sessions), the S&P 500 hung around the 2,640 level that supported it repeatedly during its October, November and early December travails (Chart 1). Then came Wednesday’s FOMC statement and press conference, and the S&P even poked its head above the 2,700 level that would seem to present a fairly stiff challenge (Chart 2). Chart 12,640 Lent Support Once Again … 2,640 Lent Support Once Again … 2,640 Lent Support Once Again …   Chart 2... Will The Next Round Number Offer A Little Resistance? ... Will The Next Round Number Offer A Little Resistance? ... Will The Next Round Number Offer A Little Resistance? What Goes On One minute born, one minute doomed/ One minute up, and one minute down/ What goes on in your mind?/ I think that I am falling down If the conditions were polar out of doors, they were bipolar on traders’ screens. As much as the clients we spoke with in January were initially skeptical about our inflation view (it’s not dead) and our corresponding Fed call (at least three or four more hikes in response to budding price pressures), several of them seemed to come around before the meeting was over. They had a lot harder time with the two-part investment conclusion that risk assets would rally while the Fed was on hold, and the economy and corporate profits were able to gain a footing, before rolling over once the data become strong enough to bring the Fed back off the sidelines. Why would investors buy into the temporary part one? We offered the view that the selloff had gone too far, and seemed to have been founded upon a premise that the Fed had either already tightened into a recession, or had gotten uncomfortably close to doing so. We expect that a Fed pause will reveal that the market’s neutral-rate estimate had been way too low. Once the economy shows signs of life, and consensus earnings estimates stop declining and begin to rise again, stocks will rise, spreads will compress, and investors will get back to chasing performance. The renewed fundamental vigor could even allow the Fed to hike rates another couple of times without inspiring a new bout of market indigestion. After this week, we are the ones scratching our heads. The committee’s post-meeting statement did change more than it has since the gradual, 25-bps-per-quarter pace of hikes took hold at the end of 2016, but early January’s procession of Fed speakers who repeated “patience” like a mantra already telegraphed an extended pause. We did not read all that much into the substitution of “will be patient as it determines … [appropriate] adjustments” for “some further gradual increases,” even if the media and the markets did. We will have more to say about the Fed’s balance sheet in subsequent research, but suffice it to say for now that we do not think it will be terribly impactful. Bottom Line: While we were surprised by the intensity of the reaction to last week’s FOMC meeting, it remains our view that the pause in the Fed’s monetary tightening campaign will give equities and corporate bonds an opportunity to rally near their late September levels. Checking And Re-Checking Our Views Among our favorite trading-desk maxims is the advice to plan your trade, and trade your plan. Checklists help us plan and help establish a repeatable process. Having a process to fall back on when rapid-fire decisions have to be made allows an investor to react to conditions as they arise without suffering from analysis paralysis, just like a seasoned trader. Checklists aren’t magic, but they can help an investor keep his/her bearings in the midst of market tides that seem to sweep all before them. Confronting the combination of December’s despondency and January’s euphoria, we return to the equity downgrade checklist we rolled out in mid-October, and last formally reviewed in mid-November. The checklist attempts to look out for threats on four fronts: a looming recession, which would bring the curtain down on the bull market; earnings pressure independent of a full-fledged recession; inflation pressures that could compel the Fed to tighten policy with a renewed sense of urgency; and unsustainably positive sentiment, which could set equities up for a fall. At the moment, only the recession category could arguably be said to be flashing yellow. Recession Watch All three factors in our simple recession indicator are moving in the wrong direction, but the yield curve is the only one at a potentially problematic level (Chart 3, top panel). It would not be a disaster for equities or the economy if the curve inverted – it is habitually early, inverting a year before a recession, on average, and six months before the S&P 500 peaks – but we don’t think it will until markets begin pricing in new rate hikes. Assuming the three-month rate won’t move until they do, the curve could only invert if the 10-year Treasury yield were to fall into the 2.40s (Chart 3, bottom panel), which would be incompatible with our constructive economic view. By the time the Fed resumes hiking, the curve should have gained some breathing room, as an economy strong enough to require further tightening merits a 10-year Treasury yield at or above 3%. Chart 3The Curve Isn’t Ready To Invert Just Yet The Curve Isn’t Ready To Invert Just Yet The Curve Isn’t Ready To Invert Just Yet Year-over-year growth in the leading economic indicator decelerated sharply over the last three months of 2018 (Chart 4). It is a ways away from contracting, however, and only a series of hefty month-over-month drops could make it do so this quarter. Our estimate of the equilibrium fed funds rate remains 50 bps above the 2.5% target rate and our model projects that equilibrium will rise throughout the rest of the year. If its 3.25-3.5% year-end estimate is on the money, the Fed would have to hike three or four more times by year end to provide the restrictive backdrop required for a recession. Chart 4Decelerating, But Not Contracting Decelerating, But Not Contracting Decelerating, But Not Contracting Checking the final item in the recession section of the checklist, a 33-basis-point rise in the three-month moving average of the unemployment rate, would require a sharp hiring slowdown and/or a significant pickup in labor force participation. The January employment report makes a drop-off in hiring appear improbable, and we are skeptical that the participation rate can keep rising in spite of the drag from retiring baby boomers. If the unemployment rate were to rise because of a rising part rate, however, it might well be more likely to extend the expansion than end it. Bottom Line: The elements of our recession indicator are deteriorating, albeit slowly. A recession may not be more than a year away, but we can’t see it occurring until the Fed turns more hawkish. Earnings Pressure We have repeatedly offered our view that the labor market is as tight as a drum in print, calls and meetings. That is good for the economy because it increases households’ ability to consume, but it will eventually squeeze profit margins and induce the Fed to remove monetary accommodation. Compensation costs shouldn’t hurt margins if they grow at or below the sum of the rate of price-level and productivity gains. If inflation grows at the Fed’s 2% target, and productivity maintains its rough 1.25% growth pace, compensation growth of 3.25% shouldn’t pose a problem, but gains exceeding 3.5% might become problematic. The total compensation series of the employment cost index ticked up to 2.9% in the fourth quarter, but an assault on 3.25-3.5% does not appear to be at hand (Chart 5). Chart 5Wages Aren’t Pressuring Margins Yet Wages Aren’t Pressuring Margins Yet Wages Aren’t Pressuring Margins Yet Dollar strength is a margin headwind for any company competing with multinationals, at home or abroad. After peaking in mid-November and mid-December, the DXY index has rolled over and is back to its early October level (Chart 6). The fourth-quarter blowout in spreads had us poised to check the “rising corporate yields” box, but there’s no need following last month’s reversal (Chart 7). The savings rate has recovered enough to support spending, and there’s currently no sign that consumers are about to pull back (Chart 8). We are monitoring conditions in emerging markets for spillover into the U.S., but the dollar’s decline and the broad recovery in risk assets worldwide have taken pressure off of EM corporate and sovereign borrowers. Chart 6The Dollar's Backed Off … The Dollar's Backed Off … The Dollar's Backed Off …   Chart 7... And Bond Yields Have, Too ... And Bond Yields Have, Too ... And Bond Yields Have, Too   Chart 8Ready, Willing And Able Ready, Willing And Able Ready, Willing And Able Bottom Line: None of our proxy indicators suggests that corporate earnings face meaningful near-term pressure, either from tighter margins or lower revenues. Inflation Pressures Inflation poses a threat to equities if it makes the Fed uncomfortable enough to pull the plug on the expansion to keep the economy from overheating, or if it makes investors uncomfortable enough to apply a significant haircut to earnings multiples. Given the Fed’s “symmetric” target, we don’t think it will get anxious about core PCE inflation unless it threatens to exceed 2.5% (Chart 9). The 10-year and 5-year-on-5-year TIPS inflation breakevens have slid in lockstep with oil prices, and are nowhere near the 2.3-2.5% range that is consistent with the Fed’s 2% core PCE target (Chart 10); they offer no hint that longer-run inflation expectations might become unanchored. CPI is the go-to inflation series for investors and the media, and with both headline and core hanging around 2%, it is well short of levels that would promote anxiety among the public (Chart 11). Chart 9Realized Inflation Remains Contained … Realized Inflation Remains Contained … Realized Inflation Remains Contained …   Chart 10... And Expectations Have Only Fallen ... And Expectations Have Only Fallen ... And Expectations Have Only Fallen   Chart 11Nothing To See Here Nothing To See Here Nothing To See Here Bottom Line: We expect that unnecessary fiscal stimulus and an extremely tight labor market will eventually produce inflation, but they’re not testing investors’ complacency yet. Overexuberance Runaway sentiment could spark a nasty correction if it sets the bar for expectations so high that stocks inevitably disappoint. BCA’s composite sentiment indicator, which aggregates the results from surveys of individual investors, professional investors and advisors, is at the lower end of its range, though not yet at levels that have often marked equity bottoms (Chart 12, bottom panel). Before falling with the S&P 500 last January, the share of consumers expecting stock prices to rise over the next twelve months had reached a level consistent with past peaks (Chart 13, bottom panel). It has since fallen to the lower end of its range, and would seem to suggest that investors had nearly given up on stocks when the January survey was taken. Chart 12Investor Sentiment Is Muted … Investor Sentiment Is Muted … Investor Sentiment Is Muted …   Chart 13... And So Is The General Public’s ... And So Is The General Public’s ... And So Is The General Public’s Bottom Line: The fourth-quarter decline pushed investor sentiment from around the higher reaches of its historical range to a position well below the mean. From a contrarian perspective, washed-out sentiment could help extend the rally. Investment Implications Our equity downgrade checklist gives U.S. equities a clean bill of health. Although potential gains are lower now with the S&P 500 trading above 2,700 than they were when it was trading below 2,500 at the beginning of the year, we do not see a fundamental reason to downgrade equities from overweight. The multiple expansion required to produce a new closing high might be a stretch, but we believe the S&P 500 can advance well into the 2,800s. We upgraded corporate credit last week, and expect that spreads will narrow as the Fed stays on the sidelines. One should not expect new tights in spreads, but there is potential for investors to augment their coupon spreads with some modest capital appreciation. We dislike Treasuries, especially at longer maturities, even more than we did before last week’s bull flattening of the yield curve. With rate hikes fully priced out, the only way the 10-year Treasury yield could fall even further would be if the Fed cut rates, and that scenario is flatly incompatible with our assessment of the economy’s strength.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com

Feature The GAA DM Equity Country Allocation model is updated as of January 31st, 2019. The quant model slightly reduced the size of the underweight to the U.S. equities, but U.S. remains the largest underweight in the model and no directional changes among all the countries compared to last month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI world benchmark by 11 bp in January, with a 52 bps of outperformance from Level 2 model offset by a 17 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 118 bps, with Level 2 outperforming by 192 bps and level 1 outperforming by 40 bps. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates   Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World   Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1) GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com

Highlights We recently upgraded our recommended investment stance on global corporate bonds to overweight on a tactical (3 to 6 months) basis.1 Feature That change was mostly based on our view that global financial conditions had tightened enough in late 2018 – both through lower equity prices and wider corporate credit spreads – to force central banks (most notably, the Fed) to shift to a less hawkish policy bias. Our opinion that global growth expectations had grown too pessimistic, particularly in the U.S., also played a role in the upgrade (Chart 1). Chart 1Global Corporates: Too Much Bad News Now Discounted Global Corporates: Too Much Bad News Now Discounted Global Corporates: Too Much Bad News Now Discounted One other supporting factor for the upgrade to corporates: the prior bout of spread widening was not justified by a significant worsening of the underlying financial health of companies. With that in mind, this week we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on Pages 15-16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement, but with divergences starting to open up among individual regions. The U.S. has delivered the biggest improvement in corporate health, thanks largely to the boost to profitability from the Trump corporate tax cuts. Euro area corporates still appear to be in decent health, but are now exposed to the sharp slowing of European growth and the end of the ECB’s buying of corporates through its Asset Purchase Program. Meanwhile, corporate health in the U.K. and Japan is showing some strain from weaker growth in both countries. Given those regional divergences, we continue to prefer U.S. corporates over non-U.S. equivalents, even within that tactical overweight recommendation on global corporate exposure. Beyond that tactical timeframe, however, there are growing risks for corporate bond performance. Our base case scenario is that resilient U.S. growth and inflation will prompt the Fed to restart the rate hike cycle later in the year, creating a more challenging backdrop for corporates from U.S. growth uncertainty and rising volatility. Yet if the U.S. (and global) economy surprises to the downside, that is even worse for corporate bond returns given how the only real improvements in our global CHMs have come from cyclical variables like profit margins and interest coverage. U.S. Corporate Health Monitors: Strong Profits “Trump” High Leverage Our top-down CHM for the U.S. has ever so slightly flipped into the “improving health” zone, after flashing “deteriorating health” since mid-2014 (Chart 2). The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. Chart 2Top-Down U.S. CHM: Supported By Cyclically Strong Profits Top-Down U.S. CHM: Supported By Cyclically Strong Profits Top-Down U.S. CHM: Supported By Cyclically Strong Profits There are clear uptrends in the ratios that go into the top-down CHM that are directly related to corporate profits – return on capital, profit margins, interest coverage and debt coverage. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. The bottom-up versions of the U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4) have also shown meaningful cyclical progress, with the HY indicator now firmly in “improving health” territory. This confirms that the signal from our top-down CHM is being reflected in both higher rated and lower quality companies. Yet the longer-term issues related to high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. Chart 3Bottom-Up U.S. IG CHM: Steady, But Have Margins Peaked? Bottom-Up U.S. IG CHM: Steady, But Have Margins Peaked? Bottom-Up U.S. IG CHM: Steady, But Have Margins Peaked?   Chart 4Bottom-Up U.S. High-Yield CHM: Only A Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Only A Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Only A Cyclical Improvement Interest coverage remains the key ratio to watch in both the IG and HY bottom-up U.S. CHMs. For IG, the fact that interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates, is worrisome. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate revenues, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to increase significantly or if U.S. earnings growth slows sharply – likely from rising labor costs eroding high profit margins. For HY, interest coverage remains depressed by historical standards, with the liquidity ratio down to levels last seen prior to the 2009 recession. This suggests that U.S. HY companies are at risk of a severe default cycle when the current U.S. economic expansion ends, with fewer liquid assets available to meet current liabilities. Given these more medium-term fundamental concerns, we do not plan on overstaying our current tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). We anticipate cutting our recommended exposure once the Fed begins signaling a need to restart the rate hikes, likely around mid-year. For those with an investment horizon beyond the next six months, the more prudent decision may be to sell into the corporate bond outperformance that we are expecting. The medium-term outlook for U.S. corporates is far more challenging given the advanced age of the U.S. monetary, business and credit cycles. Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY U.S. Corporates: Stay Tactically Overweight IG & HY U.S. Corporates: Stay Tactically Overweight IG & HY Euro Corporate Health Monitors: Stable, But Slowing Growth Is A Problem The CHMs remain a core part of our suite of bond market indicators, reliably proving their usefulness in helping evaluate the fundamental risks in owning corporate bonds. That does not, however, mean that there is no room for improvement in the CHM methodology from time to time. This is the case for our top-down CHM for the euro area, which has been behaving in a manner inconsistent with our bottom-up CHMs for the region – which are based on actual reported financial data from publicly traded companies – for some time. This is not the case in the U.S., where our bottom-up and top-down CHMs continue to move broadly in lockstep. Thus, we are taking our top-down euro area CHM “into the garage” for repairs. We will revisit all aspects of the methodology, from calculations to data sources, to try and improve the signal from the top-down euro area CHM. We plan on introducing a new and (hopefully) improved indicator sometime in the next few months. The message from our bottom-up CHMs for euro area IG and HY is still generally positive for overall European corporate health. Yet there are noticeable divergences within the sub-components of those individual CHMs that paint a more worrisome picture. For IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former worsening on the margin (Chart 6). While interest/debt coverage has improved for domestic issuers, operating margins and return on capital remain low and leverage has been inching higher. These trends have not been matched by foreign issuers. Perhaps most ominously, the short-term liquidity ratio has fallen quite sharply for domestic IG issuers in the euro area. Chart 6Bottom-Up Euro Area IG CHMs: Stable, But Watch Liquidity Ratios Bottom-Up Euro Area IG CHMs: Stable, But Watch Liquidity Ratios Bottom-Up Euro Area IG CHMs: Stable, But Watch Liquidity Ratios For HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined and operating margins have improved for both sets of issuers, but interest/debt coverage and liquidity are worse for domestic issuers. Chart 7Bottom-Up Euro Area High-Yield CHMs: Cyclically Healthier Bottom-Up Euro Area High-Yield CHMs: Cyclically Healthier Bottom-Up Euro Area High-Yield CHMs: Cyclically Healthier Within the euro area, our bottom-up IG CHMs for Core and Periphery countries show that both remain in the “improving health” zone (Chart 8). Yet the CHM for the Core now sits on the edge of the “deteriorating health” zone, led by higher leverage, lower debt coverage and a sharply falling liquidity ratio. Notably, there is no gap between the profitability metrics of the Core and Peripheral companies used in our bottom-up CHMs. Chart 8Bottom-Up Euro Area IG CHMs: Trending In Wrong Direction Bottom-Up Euro Area IG CHMs: Trending In Wrong Direction Bottom-Up Euro Area IG CHMs: Trending In Wrong Direction Peripheral European issuers continue to have much higher leverage and much lower interest coverage, the latter suggesting that Core issuers have benefitted more from the ECB’s super-easy monetary policies that have lowered borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Despite the lack of a major negative signal from the CHMs, we are concerned that the combination of slowing euro area economic growth and the end of ECB corporate bond buying will negatively impact the performance of euro area corporates (Chart 9). We are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates. In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Euro Area Corporates: Stay Tactically Neutral IG & HY Euro Area Corporates: Stay Tactically Neutral IG & HY Euro area corporates have not enjoyed the same rally that U.S. corporates have seen so far in 2019, and for good reasons. In Chart 10, we show an overall bottom-up CHM for the U.S. and euro area, combining both IG and HY are combined into a single measure for each region.2 The obvious visible trend is that U.S. corporate health has been steadily improving, while it is starting to worsen in the euro area. The gap between those two CHMs is strongly correlated to the difference in credit spreads between European and U.S. issuers (middle panel), suggesting that relative corporate health is favoring U.S. names. At the same time, the relatively stronger U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe U.K. Corporate Health Monitor: A Brexit-Fueled Deterioration Our top-down U.K. CHM indicates that U.K. companies remain in the “improving health” zone, but just barely as the indicator has been drifting towards “deteriorating health” over the past two years. All the components of the U.K. CHM have contributed to this worsening trend (Chart 11). Even short-term liquidity, which has been in a powerful uptrend for almost a decade, has started to roll over. Chart 11U.K. Top-Down CHM: Cyclical Hit From Brexit Worries U.K. Top-Down CHM: Cyclical Hit From Brexit Worries U.K. Top-Down CHM: Cyclical Hit From Brexit Worries The cause for this deterioration can be reduced to six letters: B-R-E-X-I-T. Two years of political uncertainty over the details of the U.K.’s future relationship with the European Union have eroded confidence among U.K. businesses and consumers. The result is slowing economic growth and diminished corporate profitability that has hit all earnings-related ratios in the U.K. CHM. Perhaps most disturbingly for U.K. credit performance, even the interest coverage ratio has rolled over – at a historically low level – despite the Bank of England keeping U.K. interest rates at deeply depressed levels. The toxic combination of political uncertainty and weaker economic growth has resulted in a substantial widening of U.K. credit spreads. The spread on U.K. HY corporates has widened by 293bps since September 2017 and now sits at the widest level since September 2012. U.K. IG has not seen the same degree of spread widening, but has underperformed even more on an excess return basis versus duration-matched U.K. Gilts (Chart 12). Chart 12U.K. Corporates: Brexit Uncertainty = Stay Underweight U.K. Corporates: Brexit Uncertainty = Stay Underweight U.K. Corporates: Brexit Uncertainty = Stay Underweight We are currently recommending an underweight stance on U.K. corporates, even as we have become more tactically positive on overall global corporate exposure. While credit spreads have widened to levels that appear to offer value, U.K. economic momentum is fading steadily and leading economic indicators are pointing to even slower growth in 2019. With Conservative Prime Minster Theresa May now in a dramatically weakened position after losing the recent vote on her Brexit deal with the EU, there are no immediate options that will solve the Brexit uncertainty in a way that will provide a lasting boost to U.K. business confidence. In fact, the only realistic options – postponing Brexit, fresh U.K. elections, even a second Brexit referendum – all involve a period of even more uncertainty that will weigh on the performance of U.K. corporate debt.  Japan Corporate Health Monitor: A Negative Signal Our bottom-up Japan CHM3 has consistently stayed in the “Improving health” zone since 2010; however, the most recent data shows that the health of Japanese corporates has started to deteriorate as the last data point from Q3/2018 is just above the zero line (Chart 13). The overall Japanese economy has generally performed well (by Japanese standards) over the past few years, boosted by “Abenomics” economic stimulus combined with the extraordinarily easy monetary policies of the Bank of Japan. Yet the slowing of global growth momentum seen in 2018 has weighed on the performance of the Japanese corporate sector, which is still heavily geared to exports and global growth. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Looking at the components of the CHM, there was a modest deterioration of all the ratios last year, except for profit margins which have been virtually unchanged since 2015. On an absolute basis, the CHM components do not suggest any major problems with Japanese credit quality. Japanese companies are not highly levered and liquidity remains near the highest level seen since at least the mid-2000s. Interest coverage is still high on a historical basis and is much higher than the ratios seen in the other major developed markets. Yet at the same time, return on capital and profit margins remain very low compared to those same other major economies. Japanese companies remain cash-rich with low debt levels – a sharp contrast to the other countries show in this report. There are many potential cyclical risks for Japanese corporates in 2019: even weaker demand for Japanese exports, the drag on Japanese capital spending from firms worried about slowing global growth and the spillover effects from the U.S.-China trade war, even a possible hike in the consumption tax that the Abe government is still considering for October of this year. Yet these all would prevent any adjustment of the interest rate policy of the Bank of Japan, which remains the biggest factor to consider when looking at the investment prospects of Japanese corporate bonds. Japanese corporate spreads did not widen much compared to other countries’ corporate spreads in the 2018 selloff, due to their relative illiquidity and the extreme low level of interest rates in Japan. As the central bank is under no pressure to move off its current hyper-easy monetary policy settings, government bond yields and corporate spreads will remain low, even if the Japanese economy continues to slow. Therefore, for those investors who have access to the relatively small Japanese corporate debt market, we continue to recommend an overweight stance on Japanese corporates vs Japanese government bonds (Chart 14). Chart 14Japan Corporates: Stay Overweight Vs JGBs Japan Corporates: Stay Overweight Vs JGBs Japan Corporates: Stay Overweight Vs JGBs Canada Corporate Health Monitor: Now Even Healthier Both our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health (Chart 15). Steady above-trend economic growth, combined with some increases in realized inflation, have helped boost the profitability and interest/debt coverage ratios. Yet not all the news is good - leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are low. This may be building up risks for the next Canadian economic downturn but, for now, Canadian companies look in decent shape. Chart 15Canada CHMs: Supported By Solid Growth Canada CHMs: Supported By Solid Growth Canada CHMs: Supported By Solid Growth With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next 6-9 months, which will further underpin the health of Canadian oil companies. Canadian corporates were not immune to the period of global spread widening seen at end of 2018, but the magnitude of the move was modest (Chart 16). This is a function of the still-low interest rate environment in Canada, where the Bank of Canada has not yet lifted policy rates to its own estimate of neutral (2.5-3.5%). Easy monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds on a tactical basis. Spreads have been in a very stable range since the 2009 recession, ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a sharp deterioration of Canadian economic growth or several more rate hikes from the Bank of Canada – neither outcome is likely over at least the next six months. Yet given how closely the Bank of Canada has been tracking the Fed’s current tightening cycle, we anticipate downgrading Canadian corporates at the same time do the same for U.S. corporates, likely around mid-2019.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: Still OK … For Now BCA Corporate Health Monitor Chartbook: Still OK … For Now Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Image Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th, 2019, available at gfis.bcaresearch.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 3 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 4 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: Still OK … For Now BCA Corporate Health Monitor Chartbook: Still OK … For Now ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights 2018 Performance Breakdown: Our recommended model bond portfolio generated a modest outperformance versus the custom benchmark index of +6bps for all of 2018. Winners & Losers: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Scenario Analysis For 2019: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates. Feature 2019 has gotten off to a very busy start, with significant news and market moves forcing us to devote our first two Weekly Reports of the year to analysis and even changes to our views. This week, we belatedly take care of one final piece of housekeeping for 2018 – reporting the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio for the fourth quarter and for the entire calendar year. We also present an updated scenario return analysis for the next six months after the tactical upgrade to global corporate bonds that we initiated last week.1 As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. A Quick Summary Of The Full Year Performance For 2018 The 2018 performance of the model portfolio can really be broken up into two periods: the first ten months of the year and November/December. This is an unsurprising consequence of the severe market moves around year-end that went contrary to our two most significant recommendations – maintaining a below-benchmark stance on overall portfolio duration and overweighting U.S. investment grade corporate debt versus non-U.S. equivalents in Europe and emerging markets (EM). The overall portfolio return in 2018 was +1.10% (hedged into USD), which outperformed our custom benchmark index by +6bps (Chart of the Week).2 That outperformance was considerably higher before the year-end plunge in global bond yields, reaching a peak of +32bps on November 20. In terms of the breakdown of outperformance, our recommended positioning on government bonds (duration and country allocation) contributed +22bps, while our credit tilts (by country and broadly defined credit sectors) were a drag on performance to the tune of -16bps. Chart of the WeekA Small Gain For 2018 After A Q4 Round-Trip A Small Gain For 2018 After A Q4 Round-Trip A Small Gain For 2018 After A Q4 Round-Trip The full breakdown of the full-year 2018 performance can be found in the Appendix tables and charts on Pages 14-16. For the government bond portion of the portfolio the full-year outperformers by country were the U.S. (+18bps), Germany (+10bps), Australia (+4bps) and the U.K. (+3bps). These are in line with our long-standing underweight position on the U.S. versus Germany, and our recommended overweights on Australia and the U.K. The laggards were relatively modest, led by our overweight stance on Japan (-4bps) and underweights on France (-3bps) and Italy (-3bps). For the credit portion of the portfolio, the winners were EM USD-denominated corporates (+7bps), U.S. B-rated high-yield (HY) corporates (+3bps) and U.S. Caa-rated high-yield (HY) corporates (+2bps). This was in line with our long-standing bias to favor U.S. junk bonds over EM credit. The losers were our overweights on U.S. investment grade (IG) financials (-15bps), U.S. IG industrials (-8bps), U.S. Ba-rated HY (-4bps), and euro area IG corporates (-2bps). Our overweight tilts on U.S. IG were the issue here. Q4/2018 Model Portfolio Performance Breakdown: A “Risk-Off” Hit To Our Core Recommendations The detailed data on our model bond performance for Q4/2018 only can be found in Table 1. Table 1GFIS Model Bond Portfolio Q4/2018 Overall Return Attribution 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line The total return of the GFIS model bond portfolio was +1.5% (hedged into USD) in Q4, which underperformed the custom benchmark index by a mere -1bp. The main cause for the slight underperformance is from our below-benchmark duration positioning with the Bloomberg Barclays Global Treasury Index yield falling by 20bps over the full quarter. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated -2bps of underperformance versus our custom benchmark index while the latter outperformed by just +1bp. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2   Chart 3 The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Underweight U.S. government bonds with maturities between 5-7 years (+12bps) Overweight Japanese government bonds (JGBs) with maturities between 7-10 years (+5bps) Underweight Germany government bonds with maturities between 7-10 years (+3bps) Overweight U.K. government bonds with maturities between 5-7 years (+2bps) Biggest underperformers Overweight Japanese government bonds (JGBs) with maturities beyond 10 years (-15bps) Underweight U.S. government bonds with maturities beyond 10 years (-8bps) Underweight Italy government bonds with maturities beyond 10 years (-3bps) Underweight France government bonds with maturities beyond 10 years (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q4/2018. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q4/2018 (red for underweight, blue for overweight, gray for neutral). Chart 4 Government bonds are dominating the left half of the chart, as yields declined in the final months of 2018. This was a drag on our model portfolio performance. However, the best performing sector was U.K. government bonds, generating a total return of 4.7% in Q4/2018 (on a currency-hedged and duration-matched basis). The GFIS model portfolio benefited from this move, given our long-standing overweight bias for U.K. Gilts. The right side of Chart 4 is occupied by global spread product, where currency-hedged returns were flat-to-negative in Q4. This was due to credit spread widening as investors feared both slower global growth and additional Fed tightening. The riskier parts of the corporate bond universe – high-yield, EM corporates – suffered the largest losses. The total return of Bloomberg Barclays U.S. High-Yield Index (currency-hedged into USD) for Q4 was -2.7%, as the option-adjusted spread (OAS) widened by +206bps. Unfortunately for our model portfolio, our preference for U.S. corporate bonds over European and EM credit hurt performance, although not by as much as the below-benchmark duration stance. We are disappointed by the final result for the year, although we are still pleased to generate even a small positive outperformance given the ferocity of the market moves seen at the end of 2018. We can attribute that to lingering gains from good calls made earlier in 2018, but also from our recommended cautious stance on overall portfolio risk (i.e. tracking error) in a more-volatile investment environment. Bottom Line: The outperformance of our model bond portfolio in 2018 mostly came from country selection on our government bond portfolio (underweight U.S. Treasuries, overweight the U.K. and Australia). However, our below-benchmark overall duration stance, as well as our bias favoring U.S. credit over non-U.S. corporates, were drags on performance during the risk-off moves at the end of 2018. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will benefit from two main factors: our below-benchmark duration bias and our underweight stance on global government bonds versus corporate debt. In terms of specific weighting in the GFIS model bond portfolio, we now have a tactical bias favoring global corporate debt over government debt coming on top of our below-benchmark duration stance (Chart 5). We are sticking with the latter position, about one full year short of the duration of our benchmark index, with global yield curves priced for inflation expectations that are too low and with no rate hikes discounted for 2019 in all major developed markets. Chart 5Portfolio Duration: Staying Below-Benchmark Portfolio Duration: Staying Below-Benchmark Portfolio Duration: Staying Below-Benchmark However, we are also keeping our current country allocations on the government bond side of the model portfolio, even after our tactical credit upgrade. That means staying underweight countries where policymakers are only pausing on rate hiking cycles (U.S. and Canada), while overweighting countries that are likely to keep rates on hold for all of 2019 (Japan, U.K., Australia). Our decision to upgrade global credit exposure helps boost the yield of our model portfolio (Chart 6). However, the portfolio is still yielding less than the benchmark thanks to our bear-steepening bias on government yield curves that involves underweights to longer-maturity bonds with higher yields. Chart 6Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Portfolio Yield: Credit Upgrade Helps Offset Defensive Duration Tilt Importantly, all the changes that were made to our portfolio allocations last week – raising weights on all global corporate bond markets, cutting exposure to government debt in the U.S., Germany and France – did not materially change the tracking error (relative volatility versus the benchmark) of the model portfolio. We do not see the current backdrop as being conducive to taking high levels of overall portfolio risk, even given our tactical view that the U.S. monetary policy will be on hold for the next 3-6 months. We prefer to recommend more relative value positioning via country and credit allocations that help dampen overall portfolio risk and reduce exposure to the kind of volatility spikes that became more frequent in 2018. Thus, we will continue to target a tracking error for the model portfolio of 40-60bps, well below our self-imposed 100bps ceiling (Chart 7). Chart 7Portfolio Risk Budget Usage: Staying Cautious Portfolio Risk Budget Usage: Staying Cautious Portfolio Risk Budget Usage: Staying Cautious Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.3 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. Chart   Chart In Tables 3A & 3B, we present three differing scenarios, with all the following changes occurring over a six-month horizon. Note that this differs from how we have typically presented these scenario analyses, with projections over the subsequent twelve months. Given that the changes to our recommended allocations introduced last week were tactical in nature (i.e. up to six months), we are shortening our forecast window for this particular scenario analysis to line up with that shorter investment horizon. Chart   Chart The scenarios are all driven by what we believe will be the most important driver of market returns in 2019 – the path of U.S. monetary policy. Our Base Case: the Fed stays on hold, the U.S. dollar remain flat, oil prices rise by +10%, the VIX index falls to 15, and there is a bear-steepening of the U.S. Treasury curve. This scenario is the one we laid out in last week’s report, with the Fed taking a pause through at least the March FOMC meeting, allowing market volatility to drift lower as U.S. monetary and financial conditions ease. A Very Hawkish Fed: the Fed does a surprise +25bps rate hike in March, the U.S. dollar rises by +5%, oil prices increase +20%, the VIX index climbs to 25 and there is a sharp bear-flattening of the U.S. Treasury curve. This would be the case if the U.S. economy maintains firm growth, the global growth downturn stabilizes, U.S. inflation expectations increase and market volatility increases from a surprisingly hawkish Fed. A Very Dovish Fed: the Fed cuts the funds rate by -25bps, the U.S. dollar falls by -5%, oil prices decline -20%, the VIX index increases to 35 and there is a sharp bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth slows rapidly from the current pace and the Fed has no choice but to ease monetary policy as market volatility surges alongside elevated recession risks. The model bond portfolio is expected to outperform the custom benchmark index by +19bps in our Base Case scenario. This comes from the relative outperformance of credit versus government bonds in an environment of rising bond yields (which also benefits our below-benchmark duration stance), and tighter credit spreads. In the Very Hawkish Fed scenario, our model portfolio is expected to outperform the benchmark by +29bps. This is not only due to our duration tilt and our corporates-versus-governments bias. As in the Base Case, the relative stance favoring U.S. corporates over EM credit would benefit from a backdrop of tightening U.S. monetary conditions and rising market volatility (Chart 8) – both of which are worse for EM credit. Chart 8Risk Factors Assumptions For The Scenario Analysis Risk Factors Assumptions For The Scenario Analysis Risk Factors Assumptions For The Scenario Analysis In the Very Dovish Fed scenario, our portfolio is projected to underperform the benchmark index by -26bps, with falling bond yields (Chart 9) hitting both our defensive duration bias and the overweight on corporates relative to governments. Chart 9UST Yield Assumptions For The Scenario Analysis UST Yield Assumptions For The Scenario Analysis UST Yield Assumptions For The Scenario Analysis In all three scenarios, there is a drag on expected performance from the relative carry of the model portfolio versus the benchmark (-17bps). This comes mostly from the below-benchmark overall duration stance that involves reduced exposure to longer-maturity government bonds with higher yields. The drag on carry also comes from the underweight positioning on high-yielding EM debt. We are maintaining that tilt given our concerns that China’s policymakers will be unable to provide enough stimulus to benefit EM economies through greater Chinese demand. Importantly, our recommended allocations win in scenarios that do not involve Fed rate cuts, a very low probability outcome in 2019, in our view. Thus, we expect our current allocations to generate alpha in the first half of the year, even if the Fed returns to a hawkish bias faster than we currently anticipate. Bottom Line: The tactical upgrade to global corporates that we initiated last week is projected to generate outperformance versus the model portfolio benchmark index in the next six months - both from below-benchmark duration positioning and higher exposure to U.S. corporates.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis”, dated January 15th 2019, available at gfis.bcareseach.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Appendix Image   Image   Image Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line 2018 GFIS Model Bond Portfolio Performance Review: Fading At The Finish Line Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns