Economic Growth

Highlights Driven by its fear that deflation is a more intractable danger than inflation, the Federal Reserve has enshrined its pause for the remainder of 2019 in order to lift inflation expectations. Since the U.S. business cycle expansion is not over, the Federal Reserve’s plan to put policy on hold this year raises the odds that the economy will overheat. Global growth is set to bottom during the second quarter in response to easier financial conditions. Accommodative policy, rebounding global economic activity and a softening dollar will boost risk asset prices during the remainder of the year. Safe-haven bonds, including Treasurys, will underperform cash over the coming 12 to 18 months. The rally in risk assets will ultimately prove the last hurrah as the Fed will resume tightening later this year or in 2020, and a bear market lies down the road. Only investors with tactical investment horizons should aggressively play this rally. Those with longer investment horizons should use this rally to lighten up their exposure to risk. Feature Introduction Following the introduction of the word “patience” into the Federal Reserve’s lexicon, a move lower in the so-called Fed dots was to be anticipated. The FOMC now expects no rate increases in 2019 and only one hike in 2020. The interest rate market remains skeptical that the Fed will be able to deliver on its forecast. For now, the OIS curve is pricing in a 75% probability of a cut this year, and rates at 1.9% by the end of 2020. With the 10-year/3-month yield curve inverting last week and the U.S. Leading Economic Indicator still decelerating, it is no wonder that investors are betting on the Fed becoming ever more dovish (Chart I-1). BCA is inclined to take the Fed at its word – the next move will be a hike, not a cut. This call rests on our view of the business cycle: The fed funds rate is still somewhat below neutral, U.S. economic activity can expand further, and global growth is likely to trough soon. The current dovish inclination of global central banks will only nurture the cycle a little bit longer. Consequently, we continue to recommend a positive stance on stocks for the coming quarters, while keeping in mind that the cycle is long in the tooth, and that beyond this last climb lies a significant bear market. The U.S. Business Cycle Has Further To Run… The Fed remains data dependent, but this now means that depressed inflation expectations in the private sector need to be vanquished before the hiking can resume (Chart I-2). With the view that low realized inflation has curtailed expectations now common across major central banks, this implies that a temporary overshoot in actual core PCE will be tolerated in order to lift expectations. Chart I-1Worrisome Signs For Growth Worrisome Signs For Growth Worrisome Signs For Growth Chart I-2The Fed Wants To Lift Inflation Expectations The Fed Wants To Lift Inflation Expectations The Fed Wants To Lift Inflation Expectations   Since consumer prices are a lagging variable, lifting both realized and anticipated inflation will only be possible if we move ever further along the business cycle, further pressuring the economy. Our base case remains that the risk of a recession is low in 2019, and is even receding in 2020. First, U.S. credit-dependent cyclical spending currently constitutes only 25.3% of potential GDP. As Chart I-3 illustrates, this is in line with its historical average, and well below the levels recorded near the end of previous business cycles. This suggests that the amount of vulnerability caused by misallocated capital is not yet in line with previous cycles. It also indicates that the share of output generated by the sectors most sensitive to higher rates is also low. Chart I-3U.S. Cyclical Spending: Limited Signs Of Vulnerability U.S. Cyclical Spending: Limited Signs Of Vulnerability U.S. Cyclical Spending: Limited Signs Of Vulnerability Second, the consumer remains in good shape. Households have deleveraged, and debt-service payments relative to disposable income are still near multi-generational lows (Chart I-4). Moreover, thanks to a saving rate of 7.6%, consumer spending is likely to move in line or even outperform income growth. On this front, the outlook is also good. As Chart I-5 demonstrates, the link between wages and salaries relative to the employment-to-population ratio for prime-age workers – a measure of labor utilization unaffected by the demographic changes that have muddied the interpretation of the unemployment rate – is still as tight as it was 20 years ago. Thus, as long as the labor market does not suddenly collapse, wage growth will continue to accelerate, supporting household income and consumption.   Chart I-4Household Balance Sheets Are Solid Household Balance Sheets Are Solid Household Balance Sheets Are Solid Chart I-5 Third, at 0.4% of GDP, the fiscal thrust remains positive. In other words, fiscal policy will still add to GDP in 2019. Fourth, we do not see the traditional symptoms associated with a fed funds rate above neutral. After dipping sharply in the second half of 2018, mortgage for purchase applications are back near their cycle highs (Chart I-6). Moreover, the performance of homebuilders’ equities relative to the broad market has begun to rebound, which is inconsistent with a fed funds rate above neutral. Chart I-6Mortgage Applications Do Not Suggest Policy Is Tight Mortgage Applications Do Not Suggest Policy Is Tight Mortgage Applications Do Not Suggest Policy Is Tight Fifth, there is scope for the contribution from housing sector activity to morph from a negative to a positive. A fed funds rate below neutral historically is correlated with an improving housing market. Rising mortgage rates from 3.8% to 4.6% depressed home sales and construction output, and the fall in mortgage rates over the past x month 4.3% should stimulate housing activity (Chart I-7). Chart I-7Residential Activity Will Rebound This Year Residential Activity Will Rebound This Year Residential Activity Will Rebound This Year Bottom Line: U.S. first-quarter GDP growth will be dismal, but one quarter does not make a trend. The low degree of economic vulnerability in the U.S., and the likelihood that the fed funds rate will stay below neutral for a while suggest that growth should rebound to the 2-2.5% range and should remain above-trend for the remainder of 2019. … And Global Growth Will Soon Trough As the cliché goes, it is darkest before the dawn. This is a fitting description of the world economy outside the U.S. right now. Global trade is depressed, global PMIs are moribund and nothing feels good. But it is exactly when nothing is going well that one needs to wonder what may cause the outlook to turn for the better. Thankfully, green shoots are emerging. To begin with, central banks around the world have taken a more dovish slant. This dovish forward guidance is nurturing global activity via a significant easing in global financial conditions, which is undoing the severe brake-pumping imposed on global growth in the fourth quarter of 2018 (Chart I-8). Chart I-8Global Financial Conditions Are Easing Global Financial Conditions Are Easing Global Financial Conditions Are Easing This more dovish forward guidance has helped our Financial Liquidity Index, which sharply deteriorated through 2009, rebound. Historically, this presages an improvement in the BCA Global Leading Economic Indicator (Chart I-9). Improving liquidity conditions have already been reflected in lower real rates around the globe, creating a reflationary impulse. EM financial conditions are responding positively, pointing to an upcoming pick-up in industrial activity, as measured by our Global Nowcast (Chart I-10). Chart I-9Improving Global Liquidity Backdrop Improving Global Liquidity Backdrop Improving Global Liquidity Backdrop Chart I-10A Tailwind From EM? A Tailwind From EM? A Tailwind From EM? Our Global LEI diffusion Index has begun to reflect some of these developments. After forming a trough in 2018, more than 50% of the countries in our Global LEI are currently experiencing a sequential improvement in their LEIs. We are now entering the normal lag after which a broadening growth impulse converts into aggregate activity moving higher (Chart I-11). Most interestingly, investors do not seem to be anticipating such a rebound. There is therefore room for growth surprises around the world. Chart I-11Scope For Growth Surprises Scope For Growth Surprises Scope For Growth Surprises China has a role to play in this story, will likely morph from a headwind to global growth to a positive. Positive may be a strong word, but at the very least, we expect China to stop detracting from global growth. Premier Li-Keqiang recently put the accent on stability and preserving employment, suggesting Chinese policymakers are likely to de-emphasize deleveraging over the coming 12-18 months. For Chinese growth to improve, deleveraging does not even have to stop. As both theory and history have shown, a slower pace of deleveraging means that the credit impulse moves back into positive territory and growth re-accelerates, even if only temporarily (Chart I-12). Chart I-12Growth Can Improve Even If Deleveraging Continues Growth Can Improve Even If Deleveraging Continues Growth Can Improve Even If Deleveraging Continues As a thought experiment, if Chinese leverage were to stabilize this year and nominal growth were to hit 8% – the lower bound of the real GDP target of 6-6.5% and inflation of 2% – the Chinese credit impulse would surge to more than 10% of GDP (Chart I-13)! We are not forecasting such a large rebound in the impulse, but this exercise clearly shows that if the Chinese authorities – who are cutting taxes and trying to ease credit conditions for small- and medium-sized enterprises – want to favor stability and employment for just one year, the impact on growth will be non-negligible, even if deleveraging continues. Since domestic demand responds to the credit impulse, and imports sport an elevated beta to domestic demand, Chinese imports are likely to soon morph from a negative to something more neutral – maybe even a small positive for the rest of the world. Chart I-13A Thought Experiment A Thought Experiment A Thought Experiment Finally, as weak as Europe is right now, it will likely be an important source of positive surprises in the second half of the year. To begin with, Europe is much more sensitive to EM growth conditions than the U.S. (Chart I-14). In the same way as Europe felt the full force of the deceleration in global trade last year, it will benefit from any improvement in trade this year. Chart I-14 A myriad of idiosyncratic shocks rammed through the euro area last year, worsening an already difficult situation. The new WLTP emission standards caused German auto production to collapse by nearly 20%. Nonetheless, as contracting domestic manufacturing orders and a large inventory pullback in the final quarter of last year suggest, the inventory overhang has been worked off (Chart I-15, top panel). Chart I-15Passing European Idiosyncratic Shocks Passing European Idiosyncratic Shocks Passing European Idiosyncratic Shocks Just as critically, Italy’s technical recession should end soon. The country’s economic malaise reflected the tightening in financial conditions that followed the violent battle between Rome and Brussels early last year. Ultimately, Rome folded: The budget deficit is 2.3% of GDP, not above 6%, and threats of leaving the union have been abandoned. Consequently, financial conditions are easing. Italian bond auctions are massively oversubscribed this year, and rising bond prices are supporting the solvency of the Italian banking system. The last hurdle affecting Europe was the fact that funding stress in the Italian and Spanish banking systems have been directly addressed by the TLTRO-III announced three weeks ago by the European Central Bank. Spanish and Italian banks have to refinance EUR 425 billion of TLTRO-II this June, in a year where a sizeable amounts of European bank bonds also needs to be refinanced. This is simply too much. With the ECB again bankrolling Italian and Spanish financial institutions, funding stress in the periphery can decline. Consequently, the European credit impulse, which had formed a valley in 2018 Q1, can continue its ascent (Chart I-15, bottom panel). Bottom Line: Investors expect little from the global economy outside the U.S., yet easing liquidity and financial conditions, a temporary shift in Chinese policy preferences and passing idiosyncratic shocks in Europe all point to improvement in global economic activity. U.S. Inflation Expectations Will Allow The Fed To Resume Rate Hikes Above-potential growth in the U.S. and rebounding economic activity in the rest of the world are consistent with higher – not lower – U.S. inflation. First, rebounding global growth is normally associated with a weakening dollar (Chart I-16). This time will not be different, especially as U.S. equity valuations relative to global stocks suggest that investors are particularly pessimistic on non-U.S. growth. A weaker dollar will lift import prices, commodity prices, and goods prices, helping inflation move higher. Chart I-16The USD Is Counter-Cyclical The USD Is Counter-Cyclical The USD Is Counter-Cyclical Second, the change in the velocity of the money of zero maturity in the U.S. is consistent with a further strengthening in core inflation (Chart I-17). Chart I-17The Fisher Equations Points To Gently Rising Inflation The Fisher Equations Points To Gently Rising Inflation The Fisher Equations Points To Gently Rising Inflation Third, above-trend U.S. growth in the context of elevated capacity utilization is also consistent with rising inflation (Chart I-18). Chart I-18Elevated U.S. Capacity Utilization Elevated U.S. Capacity Utilization Elevated U.S. Capacity Utilization If these three forces can cause core PCE inflation to move slightly above 2% in the second half of 2019, this will likely result in inflation expectations firming. Moreover, the combination of positive growth surprises around the world and easy monetary and liquidity conditions will prove supportive of asset prices globally, implying further easing in global and U.S. financial conditions. This set of circumstances will allow the Fed to shift its tone toward the end of 2019, in order to crystalize additional hikes in 2020. Additionally, we estimate the U.S. terminal policy rate to be around 3.25%. In fact, a longer-than-originally-anticipated Fed pause reinforces confidence in this assessment, even if it means that it will take longer to reach the terminal level than we previously thought. Bottom Line: Our growth outlook is consistent with robust inflation and improving inflation expectations. This means we disagree with interest rate markets and anticipate the Fed will resume its hiking campaign instead of cutting rates next year. Moreover, easier-for-longer policy also strengthens our view that the fed funds rate can end this cycle near 3.25%. Stay Positive On Risk Assets For Now… Most bear markets are linked to recessions. It follows that if the U.S. business cycle can be extended and the Fed remains on the easy side of neutral for longer, then the S&P 500 has more upside (Chart I-19). So do global equities. Chart I-19Low Bear-Market Risk Low Bear-Market Risk Low Bear-Market Risk This view is reinforced by the fact that buy-side analysts and investors alike have aggressively curtailed their expectations for EPS growth this year, to 3.9% for the U.S. and 4.9% outside the U.S. Yet, our profit model suggests that U.S. EPS growth is likely to come in at around 8.1% this year. Earnings revisions are pro-cyclical. Hence, our expectation that the BCA global Leading Economic Indicator meaningfully revives in the second half of 2019 points toward analysts having ample room to revise global earnings higher in the second half of the year (Chart I-20). Chart I-20Global Profit Margins Will Improve If Growth Rebounds Global Profit Margins Will Improve If Growth Rebounds Global Profit Margins Will Improve If Growth Rebounds Moreover, global valuations experienced a reset last year. Despite a rebound, the forward P/E ratio for the MSCI All-Country World Index remains in line with 2014 levels, 12.5% lower than at their apex last year. When looking at the U.S., our composite valuation index has also improved meaningfully (Chart I-21). This improvement in valuations increases the probability that a bottom in global growth will lift stock prices. Chart I-21Large Improvement In The Equity / Risk Reward Ratio Large Improvement In The Equity / Risk Reward Ratio Large Improvement In The Equity / Risk Reward Ratio Our Monetary Indicator further reinforces this message. After being a headwind for stocks over the past eight quarters, now that the Fed has paused and is essentially guaranteeing low real rates for an extended period, this gauge is growing more supportive of further equity price gains (Chart I-22). Chart I-22Stock-Friendly Monetary Backdrop Stock-Friendly Monetary Backdrop Stock-Friendly Monetary Backdrop A below-benchmark duration exposure for fixed-income portfolio still makes sense, even if the Fed has prolonged its pause. As per our U.S. Bond Strategy service’s “Golden Rule Of Treasury Investing,” if the Fed increases rates more than the market has priced in 12 months prior, Treasurys underperform cash (Chart I-23). Even if the Fed does nothing this year, it will still be more than the OIS curve is currently pricing in. Moreover, the dollar is likely to soften and the Fed is increasingly taking the risk of falling behind the realized inflation curve. This should create upside not only for inflation breakevens but also for term premia, which are depressed everywhere across the G-10. The yield curve should modestly steepen in this environment. It may take a bit more time than we originally expected, but safe-haven bond yields are trending higher, not lower. Chart I-23The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing The Golden Rule Of Treasury Investing Spread products are also likely to continue to do well. Easy monetary policy, a soft U.S. dollar, an ongoing U.S. business expansion, an upcoming rebound in global growth and rising asset values all point toward a delay of the inevitable wave of defaults. Corporate bonds may offer poor value and credit quality has deteriorated, but an end to the business cycle and a tighter Fed will be key to catalyzing these poor fundamentals. We are not there yet. The Brexit saga continues to have the potential to unsettle markets. Nonetheless, we would fade any broad market sell-off linked to poor British headlines. As Marko Papic writes in this month's Special Report, despite continued political uncertainty in Westminster this year, the risk of a no-deal Brexit is dwindling by the minute, and political logic suggests that there is a high probability that the U.K. will ultimately remain in the EU in two to three years. Bottom Line: After the reset in valuations and earning expectations last year, markets should continue their ascent. The Fed has showed that its “put” is alive and well. This will both favor risk-taking and extend the duration of the business cycle. If global growth can rebound in the second quarter, it will create fertile ground for strong asset prices over the bulk of 2019. Treasury yields will also exhibit upside, even if achieving these higher rates will take more time now. … But Beware What Lurks Below The benign outlook for this year masks that the rally in risk assets is living on borrowed time. A Fed willingly falling behind the curve may fan speculative flames this year, but it doesn’t mean that policy will stay easy forever. On the contrary, the inevitable rise in inflation will push rates higher down the road and the unavoidable recession will ultimately materialize, most likely somewhere around 2021. Since asset valuations will only grow more inflated between now and then, a bigger fall will ultimately ensue. Our Composite Valuation Indicator may currently be flashing a positive signal, but dynamics within its components already point to brewing trouble down the road (Chart I-24). First, the balance sheet group of indicators has showed no improvement. In other words, without last year’s rebound in profitability, stocks would not be as attractively valued as the overall indicator suggests. Chart I-24Disconcerting Internal Dynamics Disconcerting Internal Dynamics Disconcerting Internal Dynamics Second, the interest rate group is currently flattering aggregate valuations. To remain supportive of higher returns ahead, this group depends on interest rates staying constrained. Here, the Fed will play a particularly perverse role. Its willingness to tolerate inflationary pressures right now means lower rates today at the price of a higher cost of capital tomorrow. Once it becomes obvious that the Fed is falling behind the curve – something more likely to happen once inflation expectations normalize – safe-haven yields will rise sharply. The interest rate group will suddenly look a lot less supportive than it does today. Third, the profit components of our valuation indicator may look healthy today, but this will not remain the case. At 31.7%, EBITD margins are currently extraordinary elevated. In fact, if the profit margins were to normalize to their historical average, the Shiller P/E would skyrocket to 40.3 from 29.9 today, implying the stock market may be just as expensive as it was at the start of 2000. For margins to remain wide, wages will have to stay depressed relative to selling prices (Chart I-25). However, the combination of an economy at full employment and the Fed goosing economic growth points to rising wages. Since the pass-through from wages to prices is below 100%, unless productivity rises more than labor costs, profitability will suffer and P/E ratios will start sending the same message as the price-to-sales ratio, a multiple that currently stands near record highs. Chart I-25Rising Wages Will Ultimately Hurt Profits Rising Wages Will Ultimately Hurt Profits Rising Wages Will Ultimately Hurt Profits Valuations are not the only danger lurking for stocks: Spread products will morph from a tailwind to a headwind for equities. Whether or not it steepens a bit this year, the yield curve’s previous big flattening already points toward rising financial market volatility (Chart I-26). The Fed’s recent dovish tilt can keep the VIX and the MOVE compressed for a while longer. However, since inflation expectations will ultimately move higher, likely within a year or so, the Fed will once again tilt to the hawkish side, and volatility will follow its path of least resistance higher. Carry trades of all kinds will suffer, and spreads will widen. The deteriorating credit quality this cycle, with BBB and lower-rated issues constituting 60.1% of the corporate universe, could make this widening more violent than normal. This phenomenon will hurt stocks. Chart I-26Volatility Is A Coiled Spring Volatility Is A Coiled Spring Volatility Is A Coiled Spring Finally, the improvement in global growth this year is likely to prove temporary. China may want to slow the pace of deleveraging this year, but pushing debt loads lower and reforming the economy remains Beijing’s number one priority on a multi-year horizon. China has created USD 26 trillion worth of yuan since 2008, making the Chinese money supply larger than the euro area’s and the U.S.’s together. As a result, China’s incremental output-to-capital ratio continues to trend lower, implying large misallocation of capital (Chart I-27). State-owned enterprises, the recipients of much of the credit created over the past 10 years, now generate lower RoAs than their cost of borrowing, an unmistakable sign of poorly allocated funds. Chart I-27The Biggest Threat To China's Long-Term Prosperity The Biggest Threat To China's Long-Term Prosperity The Biggest Threat To China's Long-Term Prosperity Correcting this structural impediment will require the Chinese credit impulse to once again move back into negative territory. This means that unless Chinese policymakers abandon their efforts to prise the country off easy credit, Chinese growth will morph back into a headwind for the world somewhere in 2020, i.e. not so late as to encourage excesses, but not so early as to sharply slow the economy ahead of the Communist Party’s one-hundredth birthday in July 2021. In 2018, the global economy nearly ground to a halt after China had shifted from stimulus to policy tightening. The next time around, we doubt that a global recession will be avoided. The second half of 2020 may set up to be one tumultuous period. Bottom Line: In all likelihood, global risk assets should perform well this year, but we are living on borrowed time. In the background, equity valuations are deteriorating meaningfully, a phenomenon that will worsen once the Fed’s desired outcome comes to fruition: higher inflation. Wage pressures and higher interest rates will reveal how fully rotten stock valuations genuinely are. Compounding this effect, higher volatility and a resumption of China’s deleveraging efforts will likely achieve the coup de grace for stocks in the second half of 2020. Conclusion The FOMC wants to lift inflation expectations in order to defuse any lingering deflationary risk. Consequently, the Fed’s pause will last longer than we originally anticipated, but terminal rates are likely to climb higher than would have otherwise been the case. Before last week’s Fed meeting, the U.S. was already set to grow above trend. Now, the Fed will only extend the business cycle further, fanning greater inflationary pressures in the process. This potentially misguided reflationary impulse, which is echoed around the world, will contribute to a rebound in global growth that will become fully evident by the summer. Consequently, we expect risk assets to climb to new highs over the coming 12 months. Treasurys will likely underperform cash over that timeframe, as interest rate markets are currently too sanguine. Investors are facing a real dilemma. On one hand, the potential for elevated stock market returns is high over the coming 12 months. On the other, poor valuations will only grow more onerous, and the Fed will ultimately have to tighten policy even more following the on-hold period. Moreover, Chinese policymakers are unlikely to ignore the pressing danger created by misallocating capital for an extended period of time. Consequently, the outlook for long-term returns is deteriorating. As a result, we recommend more tactically minded investors to stay long stocks, with a growing preference for international equities that are both cheaper and more exposed to global growth than U.S. ones. However, longer-term asset allocators should use this period of strength to progressively move out of stocks and into safer alternatives. Mathieu Savary Vice President The Bank Credit Analyst March 28, 2019 Next Report: April 25, 2019   II. The State Of Brexit So What? It makes sense for long-term investors to buy the GBP. However, short-term investors should instead buy the 2-year call while selling 3-month ones. Why? The U.K. electorate is not staunchly Euroskeptic. In fact, Bregret has already set in. Volatility is the only sure bet over the tactical and strategic time horizons. The most likely scenario is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. Brexit is unsustainable over the secular time horizon. Our low-conviction view is that in the long term, the U.K. will remain inside the European Union. The hour is late in the ongoing Brexit saga. The original deadline, once spoken of with religious reverence, will be tossed aside for one, potentially two, extensions. In this analysis, we attempt to consider the state of Brexit from multiple time horizons. First, we offer our tactical view, what will happen in the next several weeks and months. Second, we offer our strategic view, surveying the Brexit process to the end of the year. Third, we consider the secular view and attempt to answer the question of whether the U.K. will ever fully exit the EU. We then assign investment recommendations across the three time horizons. How Did We Get Here? In March 2016, three months ahead of the fateful June referendum, BCA’s Geopolitical Strategy and European Investment Strategy published a joint report on the topic that drew three conclusions: The probability of Brexit was understated by the market. “According to our modeling results, roughly 64% of Tory undecided voters would have to swing to the “Stay” camp in order to ensure that the vote crosses the 50% threshold in favour of continued EU membership … Conventional wisdom suggests that the probability of Brexit is around 30%, anchoring to the 1975 referendum results. Our own analysis of current polling data suggests that it is much closer to 50%, as in too close to call.” The biggest loser of Brexit, domestically, would be the Conservative Party. “The risk is that the British populace realizes that leaving the EU was a sub-optimal result and that little sovereignty was recovered. As such, there could be a backlash against the Tories in the next general election. In this scenario, the winner would not necessarily be UKIP, but rather the Jeremy Corbyn-led Labour Party – as close to the Michael Foot-led opposition in the early 1980s as any Labour Leadership.” The EU would survive, intact, with no further “exits.” “European integration is therefore a gambit for relevance by Europe’s declining powers. Brexit will not create centrifugal forces that tear the EU apart, and could in fact enhance the sinews that bind EU member states in a bid for 21st century geopolitical relevance.” Thus far, all three predictions have proven prescient. Not only was the probability of Brexit understated, but the electorate actually voted to exit the EU.1 The Conservative Party has wrapped itself into an intellectual pretzel trying to deliver on a referendum that the pro-Brexit Tories – a minority in the party – promised would not mean losing access to the Common Market. And the EU has not only seen no other “exits,” but has held firm and united in the negotiations with the U.K. while witnessing an increase in the support for its troubled currency union, both in the Euro Area in aggregate as well as in crisis-ridden Italy (Chart II-1). Chart II-1The Euro Area Stands Unified The Euro Area Stands Unified The Euro Area Stands Unified The net assessment we conducted in 2016 correctly gauged what the Brexit referendum was about and what it was not about. Our view was that behind the angst lay factors too general to be laid at the feet of European integration. Decades of supply-side reforms combined with competition from emerging economies led to a sharp rise in U.K. income inequality (Chart II-2), the erosion of its manufacturing economy (Chart II-3), and the ballooning of the country’s financial sector (Chart II-4). As a result, the U.K.’s income inequality and social mobility were, in 2016 as today, much closer to those of its Anglo-Saxon peer America than to those of its continental European neighbors (Chart II-5). Chart II-2Brits Saw Inequality Surge Brits Saw Inequality Surge Brits Saw Inequality Surge Chart II-3Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Manufacturing Jobs Collapsed Chart II-4The Financial Bubble Burst The Financial Bubble Burst The Financial Bubble Burst Chart II-5 The underlying economic angst has continued to influence British politics since Brexit. Campaigning on an anti-austerity platform in the summer of 2017, the Labour Party leader Jeremy Corbyn nearly won the general election, only underperforming the Conservative vote by 2% (Chart II-6). The election was supposed to politically recapitalize Theresa May and allow her to lead the U.K. out of the EU. But the failure to secure a single-party majority created the political math in the House of Commons that is today preventing the prime minister from executing on Brexit. There are simply not enough committed Brexiters in Westminster to deliver on the relatively hard Brexit – no access to the EU Common Market or customs union – that Prime Minister May has put on offer (Chart II-7). Chart II-6 Chart II-7 The decision not to pursue a customs union arrangement with the EU is particularly disastrous. As our colleague Dhaval Joshi – Chief Strategist of BCA’s European Investment Strategy – has pointed out, remaining in the customs union would have protected the cross-border supply chains that are vital to many U.K. businesses and would have avoided a hard customs border on the island of Ireland.2 However, the slim margin of the Tory victory in 2017 has boosted the influence of the 20-to-40 hard-Brexiters in the party. They pushed Theresa May to the extreme, where a customs union arrangement – let alone access to the Common Market – became politically unpalatable. Had the British electorate genuinely wanted “Brexit über alles,” or the relatively hard Brexit on offer today, the margin of victory for Leave would have been greater. Furthermore, the electorate would not have come so close to giving the far-left Corbyn – who nonetheless supports the softest-of-soft Brexits – a majority in mid-2017. The slim margin of victory effectively tied May’s hands in her subsequent negotiations with both the EU and her own party. But there was more to the 2016 referendum than just general malaise centered on the economy and inequality. There were idiosyncratic events that provided tailwinds for the Leave campaign. Or, as we put it in 2016: Certainly, a number of ills have befallen the continent in quick succession: the euro area sovereign debt crisis, Russian military intervention in Ukraine, rampant migrant inflows from Africa and the Middle East, and terrorist attacks in France. It is no surprise that the U.K. populace wants to think twice about tying itself even more closely to a Europe apparently on the run from the Four Horsemen of the Apocalypse. The two issues we would particularly focus on were the migrant crisis and terrorist attacks in Europe. Data ahead of the referendum clearly gave credence to the view that the influx of migrants was raising “concerns about immigration and race.” This angst was primarily focused on EU migrants who came to the U.K. legally (Chart II-8), but the influx of millions of migrants into the EU in 2015 – peaking at 172,000 in the month of October – certainly bolstered the anxiety in the U.K. (Chart II-9).3 Chart II-8EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 EU Migrants A Source Of Anxiety In 2016 Chart II-9The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote The Refugee Crisis Boosted Brexit Vote Terrorism was another concern. In the 18 months preceding the referendum, continental Europe experienced 13 deadly terror attacks. Two were particularly egregious: the November 2015 Paris terror attack that led to 130 deaths, and the March 2016 Brussels terror attack that led to 32 deaths. Both the migration and terror crises, however, were temporary and caused by idiosyncratic variables with short half-lives. BCA’s Geopolitical Strategy argued that both would eventually abate. The migration crisis would subside due to firming European attitudes towards asylum seekers and the exhaustion of the supply of migrants as the Syrian Civil War drew to its tragic close. The extremist Islamic terror attacks would dwindle due to the decrease in the marginal utility of terror that has been observed in previous waves of terrorism (Chart II-10). Neither forecast was popular with our client base, but both have been spot on. Chart II-10Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror Fewer Attacks Due To Declining Marginal Utility Of Terror The point is that the British electorate was never as Euroskeptic as the Euroskeptics cheering on Brexit thought. Support for EU integration has waxed and waned for decades (Chart II-11). Instead, a combination of macro-malaise caused by the general plight of the middle class – the same factors that have given tailwinds to populist policymakers across developed markets – and idiosyncratic crises in the middle of this decade created the context in which the public voted to leave the EU. Whatever the vote was for, we can say with a high degree of certainty that it was not in favor of the current deal on offer, a relatively hard Brexit. After all, the pro-Leave Tories almost universally campaigned in favor of remaining in the Common Market post-Brexit.4 Chart II-11Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Data Does Not Support Euroskeptic U.K. Today, Bregret has clearly set in. Not only on the specific issue of whether the U.K. should leave the EU – where the gap between Bremorseful voters and committed Brexiters is now 8% (Chart II-12), a 12% swing since just after the referendum – but also on the more existential question of whether U.K. citizens feel European (Chart II-13). Chart II-12Bregret Has Set In... Bregret Has Set In... Bregret Has Set In... Chart II-13...And Brits Feeling More European ...And Brits Feeling More European ...And Brits Feeling More European The political reality of Bregret is the most important variable in predicting Brexit. Not only is it difficult for Prime Minister May to deliver her relatively hard Brexit in Westminster due to the mid-2017 electoral math, but it is especially the case when the electorate does not want it. Yes, the mid-2016 referendum is an expression of a democratic will that must be respected. But no policymaker wants to respect the referendum at the cost of disrespecting the current disposition of the median voter, which is revealed through polls. Doing so will cost them in the next election. Reviewing “how we got here” is essential in forecasting the tactical, strategic, and secular time horizons in the ongoing Brexit imbroglio. To this task we now turn. Bottom Line: The U.K. electorate is not staunchly Euroskeptic: data clearly support this fact. The Brexit referendum simply came at the right time for the Leave vote, as the secular forces of middle-class discontent combined with idiosyncratic crises of migration and terror. Three years following the referendum, the discontent remains unaddressed by British policymakers while the idiosyncratic crises have abated. As such, Bregret has set in, creating a new reality that U.K. policymakers must respond to if they want to retain political capital. Where Are We Going? The Tactical And Strategic Time Horizons The EU has offered a two-step delay to the Article 50 deadline of March 29. The first option is a delay until May 22, but only if Theresa May successfully passes her Brexit plan through Westminster. The second option is a delay until April 12. This would come in effect if the House of Commons rejects the deal on offer. The short time frame is supposed to pressure London to come up with the next steps, which the EU has inferred would either be to get out of the bloc without a deal or to plan for a long-term extension. Although there are no official conditions to awarding a long-term extension, it is clear that the EU only envisages three options: Renegotiate the terms of Brexit, to include either a customs union or full Common Market membership (a softer Brexit); Hold a general election to break the impasse; Hold another referendum. The EU is suggesting that it could deny the U.K. an extension if London does not come back with a plan. There are two reasons why we would call the EU’s bluff. First, it is likely an attempt to help May get the deal through the House of Commons by creating a sense of urgency. Second, the European Court of Justice (ECJ) ruled in December 2018 that the U.K. could “revoke that notification unilaterally, in an unequivocal and unconditional manner, by a notice addressed to the European Council in writing.”5 The only requirement is that the notification be sent to Brussels prior to March 29 (or, in the case of a mutually agreed upon extension, prior to April 12). It is increasingly likely that, after the deal on offer fails, Theresa May will have to go “hat-in-hand” to the EU to ask for a much longer extension. She will have until April 12 to ask for that extension, but it would require participation in the European Parliamentary (EP) elections on May 23. Prime Minister May has said that the U.K. will not hold those elections. We beg to differ. Not holding the election would allow the EU to end the U.K.’s membership in the bloc, which would by default mean contravening the Parliament’s will to reject a no-deal Brexit (which it did in a rebuke to the government in March). As such, the U.K. will absolutely hold an EP election in May. Yes, it will be a huge embarrassment to the Conservative government. And we would venture that the election would turn out a huge pro-EU majority from the U.K., given that it is the Europhile side of the aisle that is now excited and activated, further embarrassing the ruling government. The most likely scenario, therefore, is that Theresa May either resigns and is replaced by a soft-Brexit Tory, or that she agrees to a long-term extension to give the U.K. time to call a new election. As we have been arguing throughout the year, the only way to break the impasse without calling a referendum – is to call a new election. A new election would be contested almost exclusively on the issue of Brexit – unlike the 2017 election, which Jeremy Corbyn managed to be almost exclusively contested on the issue of austerity. As such, the winner would have a clear political mandate to pursue the Brexit of their choice. If it is Jeremy Corbyn, this would mean a second referendum, given his recent conversion to supporting one. If Theresa May remains prime minister, it would be her relatively hard Brexit option; if another Tory replaces her, it would potentially be a softer Brexit. Intriguingly, Theresa May is coming up to the average “expiry date” of a “takeover” prime minister, which is 3.3 years (Chart II-14). Chart II-14 Why do we think that Theresa May would be replaced with a soft Brexit Tory? Because there are simply not enough members of parliament in the Conservative Party caucus to elect a hard Brexiteer. Furthermore, the current deal on offer, which is a form of hard Brexit, clearly has no chance of passing in the House of Commons. Theresa May herself did not support the Leave campaign, but she converted into a hard Brexiteer due to the pressures in the Conservative Party caucus. If, on the other hand, we are wrong and the Conservative Party elects a hard Brexit Tory as leader, the odds of losing the election to the Labour Party would increase. Furthermore, the impasse in the House of Commons would not be resolved as Theresa May would be replaced by a prime minister with essentially the same approach to Brexit. Confused? You are not alone. Diagram II-1 illustrates the complexity of the tactical (0-3 months) and strategic (3-12 months) time horizons. There are so many options over the next six months alone that we ran out of space in our diagram to consider the consequences of the general election. Chart II- Needless to say, an election would induce volatility in the market as it would put Jeremy Corbyn close to the premiership. While he has now promised a second referendum, his government would also implement policies that could, especially in the short term, agitate the markets. Our forecasts of the currency moves alone suggest that volatility is the only sure bet over tactical and strategic time horizons. We do not have a high-conviction view on a directional call on the pound or U.K. equities. However, global growth concerns, combined with political uncertainty, should create a bond-bullish environment. Bottom Line: Over the course of the year, political uncertainty will remain high in the United Kingdom. A general election is the clearest path to breaking the current deadlock. However, it is not guaranteed, as Labour’s recent decline in the polls appears to be reversing since Jeremy Corbyn finally succumbed to the demands that he support a new referendum (Chart II-15). Chart II-15Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support Labour Party Revives On Referendum Support The Secular Horizon BCA Geopolitical Strategy believes that the median voter is the price maker in the political market place. Politicians are merely price takers. This is why Theresa May’s notion that the sanctity of the 2016 referendum cannot be abrogated is doubly false. First, she cannot truly claim from the slim 52%-48% result that U.K. voters want her form of Brexit. The referendum therefore may be a sacred expression of the democratic will, but her “no customs union” Brexit option is not holy water: It is an educated guess at best, pandering to hard Brexit Tories (a minority of the electorate) at worst. Given that 48% of the electorate wanted to remain in the EU and that a large portion of Brexit voters wanted a Common Market membership as part of Brexit, it is mathematically obvious that the softest of soft Brexit options was the desire of the median voter in June 2016. Furthermore, polling data (presented in Chart II-12 and Chart II-13 on page 28) now clearly show that the median voter is migrating away from even the softest of soft Brexit options to the “Stay” camp. Bregret has set in and a strong plurality of voters no longer supports Brexit. The question behind Chart II-12 is unambiguous. It clearly asks, “In hindsight, do you think Britain was right or wrong to vote to leave the EU?” What does all of this infer for the long term, or secular, horizon? First, an election this year could usher in a Labour government that delivers a new referendum. At this time, given the polling data and the geopolitical context, sans terror and migration crises, we would expect such a referendum to lead to a win for the Stay camp. Second, an election that produces a soft Brexit prime minister or negotiated outcome would allow the U.K. to leave the EU in an orderly fashion. A new Tory prime minister, pursuing a soft Brexit outcome, could even entice some Labour MPs to cross the aisle and support such an exit from the bloc. However, over a secular time horizon of the next two-to-three years, we doubt that a soft Brexit outcome would be viable. Investors have to realize that the vote on leaving the EU does not conclude the U.K. long-term deal with the bloc. That negotiating phase will last during the transition phase, over the next two-to-three years, and would conclude in yet another Westminster vote – and likely crisis – at the end of the period. If this deal entails membership in the Common Market, our low- conviction view over the long term is that it will ultimately fail. Take the financial community’s preferred soft Brexit option, the so-called super soft “Norway Plus” option. A Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.6 As such, the only viable option would be to switch to a customs union relationship. However, we fear that even this option may no longer be available to U.K. policymakers. Conservative Party leaders have wasted too much time and lost too much of the public’s good will. With only 40% of the electorate now considering Brexit the correct decision, it is possible that even a customs union arrangement will be unacceptable by the end of the transition period. Aside from the electorate’s growing Bregret, there is also the economic logic – or lack thereof – behind a customs union. A customs union would ensure the unfettered transit of goods between the U.K. and the continent, but not of services. This arrangement greatly favors the EU, not the U.K., as the latter has a wide (and growing) deficit in goods and an expanding surplus in services with the bloc (Chart II-16). Chart II-16Services Are Key For The U.K. Services Are Key For The U.K. Services Are Key For The U.K. The only logic behind selecting a customs union over the Common Market is that a customs union would allow the U.K. to conclude separate trade deals with the rest of the world. While that may be a fantasy of the few remaining laissez-faire free traders in the U.K. Conservative Party, the view hardly represents the desire of the median voter. Other than a potential trade deal with the U.S., it is practically inconceivable to expect the U.K. electorate to support a free trade agreement with China or India, both of which would likely entail an even greater loss of blue-collar jobs. Even a trade deal with the U.S. would likely face political opposition, given that the U.K. is highly unlikely to be given preferential treatment by an economy seven times its size.7 The fact of the matter is that the Conservative Party has wasted its window of opportunity to push a hard, or moderately hard (customs union), Brexit through Parliament. Bregret has set in, as the doyens of Brexit increasingly pursued an unpopular strategy. On the other hand, a Brexit that retains the U.K. membership in the Common Market has never had much logic to begin with. Where does this leave the U.K. in the long term? Given the time horizon and the uncertainty on multiple fronts, our low-conviction view is that it leaves the U.K. inside the European Union. Bottom Line: The combination of increasing Bregret, lack of economic logic behind a customs union membership alone, and the lack of a political logic behind a Common Market membership, suggests that Brexit is unsustainable over the secular time horizon. This imperils the ultimate deal between the U.K. and the EU, which we think will not be able to pass the House of Commons in two-to-three years when it comes up for approval. This is a low-conviction view, however, as political realities can change. Support for Brexit could turn due to exogenous factors, such as a global recession that renews the Euro Area economic imbroglio or a major geopolitical crisis. Both are quite likely over the secular time horizon. Investment Implications Today, cable is cheap, trading at an 18% discount to its long-term fair value as implied by purchasing-power parity models (Chart II-17). The growing probability that the U.K. may, down the road, remain in the European Union means that, at current levels the pound is indeed attractive, especially against the U.S. dollar. Chart II-17Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain Cable Attractive On Higher Odds Of Bremain However, when it comes to short-term dynamics, the picture is much murkier. The low probability of a no-deal Brexit implies limited downside. However, the path to get the U.K. to abandon the current relatively hard Brexit is also one that involves a new election. This implies that before a resolution is reached, multiple scenarios are possible, including one where Corbyn becomes the next prime minister. Jeremy Corbyn could be the most left-of center leader of any G-10 nation since Francois Mitterrand in France in the early 1980s. Mitterrand’s audacious nationalization and left-leaning policies were met with a collapse in the French franc (Chart II-18). Chart II-18A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency A Left-Wing Leader Bodes Ill For The Currency Global growth also has an impact on cable. Despite all the noise around Brexit, the reality remains that exports constitute 30% of U.K. GDP, a larger contribution to output than in the euro area. This means that if global growth deteriorates, GBP/USD will face another headwind. If, however, global growth improves, then cable would face a new tailwind. Since BCA is of the view that global growth will likely trough by the summer, we are inclined to be positive on the pound. Netting out all those factors, it makes sense for long-term investors to buy the GBP, using the dips along the way to build a larger position in this currency. Even on a six-to-twelve-month basis, the path of least resistance for cable is likely upward. The problem is that risk-adjusted returns are likely to be poor as volatility will remain very elevated. We therefore recommend that short-term investors instead buy the 2-year call while selling 3-month ones (Chart II-19). Chart II-19Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Volatility Will Be A Challenge For Short Term Investors Marko Papic Senior Vice President Chief Geopolitical Strategist Mathieu Savary Vice President The Bank Credit Analyst III. Indicators And Reference Charts Equities have had a volatile month of March, something that was bound to happen after the violent rally witnessed from the end of December to the end of February. When a rally is being tested, it always make sense to review our indicators to gauge whether or not a trend change is in the offing. Generally, our indicators remain broadly positive. Our Willingness-to-Pay (WTP) indicators for the U.S. and the euro area continue to improve. Meanwhile, it has begun to hook back up in Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The current readings in major advanced economies thus suggest that investors are still inclined to add to their stock holdings. Our Revealed Preference Indicator (RPI) has however once again deteriorated, suggesting that the period of churn in global equities prices could last a bit longer. This indicator is essentially saying that in order to resume their ascent, stocks need a bit more time to digest their previous surge. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. According to BCA’s Composite Valuation Indicator, an amalgamation of 11 measures, the U.S. stock market remains slightly overvalued from a long-term perspective. Nonetheless, despite this year’s rally, the S&P 500 offers a much more attractive risk/reward profile than it did in the fall. Moreover, our Monetary Indicator has shifted out of negative territory for stocks, and is now decisively in stimulative territory. The Fed’s dovish forward guidance last week only reinforces the message from this indicator. Our Composite Technical Indicator for stocks had broken down in December, but it is finally flashing a buy signal. This further confirms that the current period of churn is most likely to ultimately make way for a continued rally in the S&P 500. The 10-year Treasury yield remains within its neutral range according to our valuation model. Moreover, our technical indicator flags a similar picture. This means that without signs of improvements in global growth, price action alone will not be enough to lift bond yields higher. That being said, since BCA expects that over the next 24 months, the Fed will lift rates more than the OIS curve anticipates, and since the term premium is incredibly low, once green shoots for global growth become evident, bonds could suffer a violent selloff. The U.S. dollar is still very expensive on a PPP basis. Our Composite Technical Indicator is not as overbought as it once was, but it is far from having reached oversold levels either. This combination suggests that the greenback could experience further downside this year. However, for this downside to materialize, global growth will first have to stabilize. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       At the time of publication of our March report, we still had a low-conviction view that the vote would swing towards Stay at the last moment. 2       Please see BCA Research European Investment Strategy Weekly Report, “Important Message From The Currency Markets,” dated March 14, 2019, available at eis.bcaresearch.com. 3       Trying to play up the threat of unchecked migration, the U.K. Independence Party ran a famous campaign poster showing hundreds of refugees on a road under the title of “Breaking Point – The EU has failed us all.” Despite the fact that the U.K. accepted only around 10,000 Syrian refugees since the 2015 crisis. Germany has accepted over 700,000 while Canada – which is located across the Atlantic Ocean on a different continent – accepted over 40,000. Even the impoverished Serbia has accepted more Syrian refugees than the U.K. 4       One of the most prominent Leave supporters, Boris Johnson, famously quipped after the referendum result that “There will continue to be free trade and access to the single market.” 5       Please see The European Court of Justice, “Judgement Of The Court,” In Case C-621/18, dated December 10, 2018, available at curia.europa.eu. 6       Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. 7       President Donald Trump may want to give the U.K. preferential trade terms on the basis of the filial Anglo-Saxon relationship alone, but it is highly unlikely that the increasingly protectionist Congress would do the same. There is also no guarantee that President Trump will be around to bring such trade negotiations across the finish line. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights Duration: None of the economic indicators that have reliably signaled peak interest rates in prior cycles are sending a signal at the moment. This leads to the inevitable conclusion that further Fed rate hikes are likely at some point before the end of the cycle. With the Fed now projecting an essentially flat path for interest rates, the next surprise from the Federal Reserve will probably be a hawkish one. Fed: The Fed is currently waging a war on two fronts. It wants to keep interest rates low enough to send inflation expectations higher, back to levels consistent with its 2% target. But it also wants to avoid excessively easy financial conditions that could threaten the sustainability of the economic recovery. We expect that easier financial conditions will cause the Fed to shift back toward a tightening bias near the end of this year. Yield Curve: Inversion of the 3-month/10-year Treasury slope is cause for concern, if it persists. But we expect it to reverse in the coming months as global growth recovers and the Fed remains accommodative. Eventually, after financial conditions have eased sufficiently, the Fed’s next move will be a hawkish surprise. Investors can profit from this move by entering positive carry yield curve trades: short the 5-year or 7-year bullet and go long a duration-matched barbell. Feature The Last Dovish Surprise Or The Beginning Of The End? Treasury yields moved sharply lower following last week’s Fed meeting, as FOMC participants made larger-than-anticipated downward revisions to their interest rate projections. As of last December, 11 out of 17 Fed members expected to lift rates at least twice in 2019. Now, 11 out of 17 expect to keep rates flat (Chart 1). Chart 1Fed Sees No Hikes This Year Fed Sees No Hikes This Year Fed Sees No Hikes This Year Judging from the bond market’s reaction, the Fed clearly managed to deliver a dovish surprise at last week’s meeting. Now, the relevant question for investors becomes whether that dovish surprise can be repeated. With the Fed signaling an essentially flat path for interest rates, a dovish surprise from these levels would involve the suggestion of rate cuts. History tells us that rate cuts are only likely to occur if the economy is headed into recession, an event that still seems relatively far off. As such, we expect that the next surprise from the Fed will be a hawkish one, and that the next large move in Treasury yields will be higher. Our conviction that the economy is not yet close to recession comes from our analysis of economic markers that have reliably signaled peak interest rates in past cycles.1 For example, one such marker is when year-over-year nominal GDP growth falls below the 10-year Treasury yield (Chart 2). At present, year-over-year nominal GDP growth is running at 5.3%. That growth rate is bound to slow during the next few quarters, but it would need to slow a lot before it falls below the current 10-year Treasury yield of 2.40%. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative The New York Fed’s GDP Nowcast projects that real GDP growth will be 1.29% in the first quarter. Incorporating 2% inflation, that is roughly 3.3% in nominal terms. If Q1 turns out to be the trough in growth for the year, it suggests that interest rates still have considerable room to rise before the economic recovery ends. Second, we have observed that peak interest rates tend to coincide with material declines in the 12-month moving averages of single-family housing starts and new home sales. While the housing data weakened somewhat in 2018, the data have rebounded sharply since mortgage rates fell near the end of last year. Housing starts have already jumped back above their 12-month moving average, as has the weekly Mortgage Application Purchase index (Chart 3). Chart 3Housing & Employment Support Higher Rates Housing & Employment Support Higher Rates Housing & Employment Support Higher Rates Finally, we have noted that peak interest rates tend to coincide with an uptrend in initial jobless claims. Much like with housing, the initial claims data sent a warning near the end of last year. But that tentative increase in claims has already reversed course (Chart 3, bottom panel). None of those historically reliable indicators suggest that we have reached peak interest rates for the cycle.  We will continue to keep a close eye on nominal GDP growth, the housing data and initial jobless claims. But all in all, none of those historically reliable indicators suggest that we have reached peak interest rates for the cycle. This leads to the inevitable conclusion that further Fed rate hikes are likely at some point and that the next surprise from the Federal Reserve will probably be a hawkish one. Given this skewed risk/reward trade-off, we recommend that investors maintain below-benchmark duration in U.S. bond portfolios on the view that the next large move in Treasury yields will be higher. The difficult part is timing when that move will occur. In the remainder of this report we provide some thoughts on how to think about that timing, and also some trade ideas that should be profitable in the meantime. The New Battleground: Inflation Expectations Vs. Financial Conditions Recent remarks from Fed Chairman Jerome Powell and other FOMC participants have made it clear that an important rationale for the Fed’s pause is a desire to re-anchor inflation expectations at a level closer to the Fed’s target. For example, here is Chairman Powell from last week’s press conference: So, if inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to, you know, keep inflation at two percent … And here is what the Chairman said about inflation expectations in his recent congressional testimony: In our thinking, inflation expectations are now the most important driver of actual inflation. With that in mind, consider that long-maturity TIPS breakeven inflation rates have been below “well anchored” levels for pretty much the entire post-crisis period, as have long-term inflation expectations from the University of Michigan Consumer survey (Chart 4). Chart 4The Fed Wants Higher Inflation Expectations The Fed Wants Higher Inflation Expectations The Fed Wants Higher Inflation Expectations The Fed has clearly made the re-anchoring of inflation expectations a priority, meaning that we should monitor TIPS breakeven inflation rates and survey measures of inflation expectations to assess when rate hikes might re-start. However, we don’t think that higher inflation expectations are absolutely necessary before the Fed resumes hiking. Consider what Fed officials were saying as recently as December: Governor Lael Brainard on December 7, 2018:2 The last several times resource utilization approached levels similar to today, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation. Chairman Powell on June 20, 2018:3 Indeed, the fact that the two most recent U.S. recessions stemmed principally from financial imbalances, not high inflation, highlights the importance of closely monitoring financial conditions.   In other words, until recently the Fed seemed more concerned with financial conditions than with inflation expectations. What changed? Quite simply, financial markets sold off and financial conditions no longer appear excessively easy (Chart 5). Chart 5The Fed Doesn’t Want An Asset Bubble The Fed Doesn’t Want An Asset Bubble The Fed Doesn’t Want An Asset Bubble The Financial Conditions component of our Fed Monitor remains “easier” than its historical average, but shows that conditions have tightened significantly since last October (Chart 5, top panel). Junk spreads have widened since last October (Chart 5, panel 2), as has the excess corporate bond risk premium after accounting for expected default risk (Chart 5, panel 3). 4 The S&P 500’s 12-month forward Price/Earnings ratio is down to 16.5, from 17 last October and a 2018 peak of 18.8 (Chart 5, bottom panel). If financial markets rally during the next few months, then it is quite possible that financial conditions will once again force the Fed’s hand. In essence, financial asset valuations appear somewhat reasonable and are not an immediate cause for concern. This means that the Fed can turn its attention toward trying to drive inflation expectations higher. However, if financial markets rally during the next few months, then it is quite possible that financial conditions will once again force the Fed’s hand. The Outlook For Financial Conditions & Global Growth The Fed’s dovish policy shift should support a rally in risk assets in the coming months, though such a rally may also require evidence of improvement in global growth. Right now that evidence is scant. March Flash PMIs for the U.S. and Eurozone both fell last week, while Japan’s stayed flat below the 50 boom/bust line. This means that the Global Manufacturing PMI’s downtrend will almost certainly continue when the final March data are released next week (Chart 6). Chart 6Global Growth Is Weak ... Global Growth Is Weak ... Global Growth Is Weak ... However, while the coincident PMI data continue to soften, we have recently noticed some green shoots in leading global growth indicators (Chart 7). Chart 7... But Leading Indicators Are Improving ... But Leading Indicators Are Improving ... But Leading Indicators Are Improving First, our Global Leading Economic Indicator (LEI) Diffusion Index has moved above 50%, meaning that a majority of countries are seeing improvement in their LEIs for the first time since early 2018 (Chart 7, top panel). Second, our China Investment Strategy service’s Li Keqiang Leading Indicator – a composite of six indicators of Chinese money and credit growth – has stabilized. While a 2016-style surge in credit growth is unlikely, even a stabilization in this leading indicator will help prop up global growth in 2019 (Chart 7, panel 2). We do not think that 3-month/10-year curve inversion will last very long.  Finally, the CRB Raw Industrials index has rebounded smartly during the past few weeks, and is now threatening to break above its 200-day moving average (Chart 7, bottom panel). Investment Implications The Fed is currently waging a war on two fronts. It wants to keep interest rates low enough to send inflation expectations higher, back to levels consistent with its 2% target. But it also wants to avoid excessively easy financial conditions that could threaten the sustainability of the economic recovery. Asset prices are not extended at the moment, so the Fed can maintain an accommodative policy focused on driving inflation expectations higher. However, at some point the combination of accommodative policy and improving global growth will cause the Fed’s attention to turn back toward financial conditions. That will put rate hikes back on the table and send Treasury yields higher. Timing when that shift will occur is difficult, which is why we recommend that investors enter positive carry yield curve trades to boost returns while we await a hawkish surprise from the Fed later this year (see next section). What The Yield Curve Is Telling Us The Fed’s dovish surprise sent Treasury yields lower last week and also led to significant changes in the shape of the yield curve. In particular, investors have focused on the fact that the 10-year yield is now below the 3-month T-bill rate. That focus is not surprising, given that curve inversion has been a reliable leading indicator of recession in past cycles. We use the 2-year/10-year and 3-year/10-year slopes in our research into the phases of the cycle (Chart 8), and while both of those slopes remain positive – consistent with a “Phase 2” environment – we will keep a close eye on the 3-month/10-year slope in the coming weeks.5 Historically, inversion of the different curve segments has occurred at around the same time. Chart 8Still In Phase 2 Still In Phase 2 Still In Phase 2 Given that the Fed has already signaled a much more dovish policy stance and that global growth is likely to improve later this year, we do not think that 3-month/10-year curve inversion will last very long. However, if we are wrong and the 2-year/10-year and 3-year/10-year slopes are eventually pulled down into negative territory, then we may have to re-visit some of our asset allocation positions. But for now, we find the 5-year and 7-year maturities to be the most interesting points on the yield curve (Chart 9). In fact, the 5-year and 7-year yields are so low that investors can earn more yield by entering duration-matched barbells consisting of the long and short ends of the curve. For example, the 5-year Treasury note offers a lower yield than a duration-matched barbell consisting of the 2-year and 10-year notes. Similarly, the 7-year note offers less yield than a duration-matched barbell consisting of the 2-year note and 30-year bond (Chart 10). Chart 9 Chart 10Barbells Are Positive Carry Barbells Are Positive Carry Barbells Are Positive Carry Further, we have also observed that the 5-year and 7-year yields are most sensitive to changes in 12-month rate hike expectations. Chart 11 shows that when our 12-month discounter rises, the yield curve tends to steepen out to the 7-year maturity, and flatten thereafter. This means that the 5-year and 7-year yields have the most upside when rate hikes are eventually priced back into the curve. Chart 11Yield Curve Correlations Yield Curve Correlations Yield Curve Correlations Taken together, positive carry in the barbells and the sensitivity of 5-year and 7-year yields to 12-month rate expectations mean that investors should enter short positions in the 5-year or 7-year notes today, offset by long positions in duration-matched barbells (eg. the 2/10 or 2/30). These trades will earn significant capital gains when the Fed ultimately delivers a hawkish surprise, sending the 5-year and 7-year yields higher, and will also earn positive carry in the meantime, while we wait for financial conditions to ease enough to shift the Fed’s reaction function. We have also observed that the 5-year and 7-year yields are most sensitive to changes in 12-month rate hike expectations. These long barbell / short 5-year or 7-year bullet positions will only lose money if the market prices-in further rate cuts going forward. With the market already priced for 32 bps of cuts during the next 12 months, a further decline would be consistent with economic recession. This remains the least likely scenario. Bottom Line: Inversion of the 3-month/10-year Treasury slope is cause for concern, if it persists. But we expect it to reverse in the coming months as global growth recovers and the Fed remains accommodative. Eventually, after financial conditions have eased sufficiently, the Fed’s next move will be a hawkish surprise. Investors can profit from this move by entering positive carry yield curve trades: short the 5-year or 7-year bullet and go long a duration-matched barbell.   Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Running Room,” dated January 29, 2019, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20181207a.htm 3  https://www.federalreserve.gov/newsevents/speech/powell20180620a.htm 4 The Gilchrist and Zakrajsek (GZ) Excess Bond Premium is a measure of the excess spread available in a sample of nonfinancial corporate bonds, after removing a bottom-up estimate of expected default losses for each security. Default losses are estimated based on the Merton Default model, using each firm’s market value of equity and face value of debt. https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/files/… 5 Our research into the different phases of the cycle based on the slope of the yield curve can be found in U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income,” dated December 18, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Dovish Central Banks: Central bankers have successfully talked down bond yields, in an effort to prevent an even deeper pullback in global growth. Government bonds now look overvalued relative to likely outcomes on growth and inflation over the next year. A moderate below-benchmark medium-term duration exposure is warranted on a risk/reward basis, as the next large yield move from current levels is more likely up than down. U.S. Treasuries: The Fed is now signaling no more rate hikes for the rest of 2019, but this newly dovish language merely brings their own interest rate forecasts closer to current market pricing. Lower bond yields and easier financial conditions will help underwrite a recovery in U.S. growth, just as a stabilization of the global economy is starting to materialize. The current downturn in Treasury yields, which is looking technically stretched, should soon begin to bottom out. Feature Another Panic Hits Global Bond Markets The message from central banks to the financial markets is now very loud and clear – global monetary policy is firmly on hold for at least the rest of 2019. Fears over slowing global growth, persistent geopolitical uncertainty and underwhelming inflation have put policymakers on a more cautious footing. The messaging from central banks has become highly synchronized, with even the same buzz words (“patience”, “uncertainty”, “data dependent”) being bandied about in speeches and policy statements. Bond yields have responded to the dovish forward guidance in recent weeks from the Fed, the European Central Bank, the Bank of England, the Bank of Japan and others. Our “Major Countries” measure of 10-year government bond yields in the largest developed economies has fallen to 1.3%, the lowest level since May 2017. The 10-year U.S. Treasury yield now sits at 2.40%, below the fed funds rate and triggering investor angst over the traditionally negative economic message of an inverted yield curve. Global equity markets, however, seem less concerned. The MSCI World Equity Index is only 5% from the 2018 highs after rallying 16% so far from the late 2018 low. This gap between robust equity prices and depressed bond yields is unusual, but not unprecedented. Similar divergences have occurred as recently as 2016 and 2017 (Chart of the Week). During those episodes, central banks responded to uncertainty (the July 2016 Brexit vote followed by currency volatility in China) or sluggish inflation readings (the unexpected 2017 dip in U.S. core inflation) by shifting to an easier monetary stance. This was largely done through delayed interest rate hikes or more dovish forward guidance, with the result being lower bond yields, diminished market volatility and easier financial conditions. Better global growth and more stable inflation expectations soon followed. Chart of the WeekWill Bonds Lose This Battle Once Again? Will Bonds Lose This Battle Once Again? Will Bonds Lose This Battle Once Again? With tentative signs emerging that global growth momentum is bottoming out, the next major move in global bond yields is likely up. Those prior gaps between low bond yields and high stock prices were eventually resolved through higher yields – an outcome that we think will be repeated in the current episode. Already, bond markets have aggressively repriced expectations of future monetary policy with even some rate cuts now discounted in the U.S., Canada and Australia. With tentative signs emerging that global growth momentum will soon bottom out and recover in the latter half of 2019 (Chart 2), the next major move in global bond yields is likely up, not down. Chart 2Global Bond Yields Are Too Pessimistically Priced Global Bond Yields Are Too Pessimistically Priced Global Bond Yields Are Too Pessimistically Priced The decline in yields over the past few months has obviously challenged our recommended strategic below-benchmark global duration stance. The two primary factors that drive our medium-term duration calls on any country can be summed up by the following questions: Do we expect greater or fewer rate hikes than are discounted in money market curves? Do we expect bond yields to rise above or below the current pricing in forward yield curves? In aggregate, we do not expect the major central banks to deliver more monetary easing than is currently priced according to our 12-month discounters, although we think that is most likely in the U.S. where the market is pricing in -21bps of cuts over the next year. Also, the 12-month-ahead forwards for 10-year bond yields in the U.S. (2.51%), Canada (1.69%), Germany (0.13%), Japan (0.02%), U.K. (1.16%) and Australia (1.82%) are not particularly high. Although, once again, we have the greatest confidence that those yield levels will be surpassed in the U.S. The timetable to generate a positive payoff by positioning for higher yields has been stretched out by the renewed dovishness of central banks. By switching their focus from tight labor markets and accelerating wage growth to slowing economies and softening inflation expectations, policymakers are creating a backdrop of lower volatility and more market-friendly stock/bond correlations (Chart 3). Chart 3Stock/Bond Yield Correlation Negative Once Again Stock/Bond Yield Correlation Negative Once Again Stock/Bond Yield Correlation Negative Once Again The goal is to underwrite additional rallies in risk assets to ease financial conditions and stimulate economic activity. This will eventually sow the seeds for a return to a more hawkish bias, but the timing of that switch is uncertain and will most likely coincide with some evidence of faster Chinese economic growth and an end to the downturn in global trade activity – an outcome that is unlikely to occur until the latter half of 2019. Bottom Line: Central bankers have successfully talked down bond yields, in an effort to prevent an even deeper pullback in global growth. Government bonds now look overvalued relative to likely outcomes on growth and inflation over the next year. A moderate below-benchmark medium-term duration exposure is warranted on a risk/reward basis, as the next large yield move from current levels is more likely up than down. The Fed’s more dovish forward guidance only brought the Fed’s rate forecasts down closer to current market pricing. U.S. Treasury Yields Should Soon Bottom Out U.S. Treasury yields moved sharply lower following last week’s Fed meeting, as the FOMC delivered a dovish surprise with its new set of interest rate projections. As of last December, 11 out of 17 Fed members expected to lift rates at least twice in 2019. Now, 11 out of 17 expect to keep rates flat. This was enough to lower the median “dot” by 50bps for 2019, essentially forecasting an unchanged funds rate this year with only one hike expected in 2020. While these are significant dovish changes to the Fed’s forward guidance, it only brought the Fed’s forecasts down to current market pricing on interest rate expectations (Chart 4). Yet bond yields fell sharply in response, tipping the Treasury curve into inversion. The cautious language from Fed Chairman Powell in the post-meeting press conference, which included a reference to Japan-style deflation risks as a threat if the Fed ignored the message from below-target U.S. inflation expectations, likely helped fuel the bullishness of Treasury market participants. Chart 4Fed Is Just Catching Up To Market Pricing Fed Is Just Catching Up To Market Pricing Fed Is Just Catching Up To Market Pricing It seems clear that the arguments of the more dovish members of the FOMC (John Williams, Richard Clarida, James Bullard, Neil Kashkari) have won over the more pragmatic members of the committee, including Jay Powell. Yet our own Fed Monitor is still not suggesting that rate cuts are necessary (Chart 5), although the growth component of the Monitor is tracking the last downturn seen in 2014/15. More importantly, the inflation elements of the Monitor are not pointing to a need for easier policy, while financial conditions are still in the “tighter money required” zone. Chart 5Markets Pricing In Fed Easing That Is Not Required Markets Pricing In Fed Easing That Is Not Required Markets Pricing In Fed Easing That Is Not Required The Fed is likely to ignore the risks to financial stability stemming from the new dovish slant to its monetary policy, as financial conditions have not yet fully unwound the tightening seen in the risk asset selloff in late 2018. Does that mean that the Fed wants to see U.S. equities hit new highs and U.S. corporate credit spreads return to previous lows? If that means a deeper U.S. economic slowdown can be avoided, the answer is most likely “yes”. They can always return to targeting overvalued asset markets if and when the U.S. and global economy is on more stable footing. In terms of the U.S. economic outlook, we think the current concerns over the recession risks stemming from an inverted Treasury curve are overstated. In a Special Report we published last July, we looked at the relationship between monetary policy, yield curves and economic growth and came to the following conclusions:1 Curve inversion, on a sustained basis, occurs when the Fed lifts the real (inflation-adjusted) funds rate above the neutral rate of interest, “r-star” (Chart 6); Chart 6Too Soon For Sustained U.S. Treasury Curve Inversion Too Soon For Sustained U.S. Treasury Curve Inversion Too Soon For Sustained U.S. Treasury Curve Inversion Once the Treasury yield curve does invert on a sustained basis, a recession starts seventeen months later, on average; Curve inversion, on a sustained basis, occurs when the Fed lifts the real funds rate above the neutral rate of interest, “r-star” At the moment, the Fed has paused its rate hiking cycle with a real funds rate that is just shy of the Williams-Laubach estimate of r-star, which is 0.5%. Considering that the “Williams” in “Williams-Laubach” is the current president of the New York Fed and Number Two on the FOMC, we should not be surprised that the Fed chose to pause now! The more important point is that it seems too early to look for a classic late-cycle Treasury curve inversion with the Fed on hold – unless, of course, U.S. inflation falls and pushes the real fed funds rate above r-star. That would require a much sharper slowing of U.S. growth to a below-potential pace that is not indicated by current data. Reliable cyclical indicators like the ISM Manufacturing index have fallen from the heady 2018 peaks, but remain at levels consistent at least trend U.S. economic growth (Chart 7). Additionally, the Conference Board’s leading economic indicator, as well as our own models for U.S. employment and capital spending growth, are suggesting that only some cooling of U.S. growth should be expected in the next few quarters (Chart 8), but not to a below-potential pace (i.e. significantly less than 2%). Chart 7UST Yields Should Soon Stabilize UST Yields Should Soon Stabilize UST Yields Should Soon Stabilize Chart 8A Big U.S. Slowdown In 2019 Is Unlikely A Big U.S. Slowdown In 2019 Is Unlikely A Big U.S. Slowdown In 2019 Is Unlikely So how much lower can Treasury yields go in this current rally? Looking at the individual valuation components of yields, the answer is “not much”. The real component of Treasury yields has already fallen sharply since the 2018 peak, and is now approaching 2017 resistance levels. At the same time, 10-year inflation expectations are drifting higher and are now around 25bps below the highs seen in 2018 (Chart 9). At best, we can see real yields and inflation expectations fully offsetting each other and keeping yields unchanged. The more likely outcome, however, is that inflation expectations continue to move higher while real yields stabilize as the U.S. economy moves away from the Q1 growth slowdown, meaning that we are close to the floor in yields now. Chart 9Inflation Expectations Will Lead UST Yields Higher Inflation Expectations Will Lead UST Yields Higher Inflation Expectations Will Lead UST Yields Higher How much lower can Treasury yields go in this current rally? Looking at the individual valuation components of yields, the answer is “not much”. The current downturn in Treasury yields is already looking stretched from a technical perspective (Chart 10). The 26-week total return of the Bloomberg Barclays U.S. Treasury index is now approaching the highs seen during all previous Treasury rallies since the Fed ended its QE program in 2014. The same signal comes from the size of the deviation of the 10-year Treasury yield below its 200-day moving average. Duration positioning is quite long, as well, according to the J.P. Morgan client survey. Chart 10UST Rally Looking Stretched In The Near-Term UST Rally Looking Stretched In The Near-Term UST Rally Looking Stretched In The Near-Term Not all the technical indicators are as stretched, as the Market Vane Treasury sentiment survey remains depressed and net speculative positioning on 10-year Treasury futures is only neutral (after a very large short position was covered). On balance, however, the indicators suggest that the current Treasury rally is looking over-extended. One other factor to consider is global growth. Much of the current decline in Treasury yields is a result of the prolonged weakness in non-U.S. growth that has pulled down all global bond yields. Yet according to the latest readings from cyclical indicators like the ZEW survey, expectations of future economic growth are now bottoming out, even as current growth continues to slow (Chart 11). This bodes well for a potential bottoming of global growth momentum that could put a floor underneath bond yields. Chart 11Early Signs Of Growth Stabilization? Early Signs Of Growth Stabilization? Early Signs Of Growth Stabilization? One final note – any signs of stabilization of European growth could also help global bond yields find a floor. Not only are the ZEW surveys in Europe starting to bottom out, the widely-followed German IFO survey is also starting to show modest improvement. If these trends continue, that would help end the drag on global yields from weakening European growth which has pulled German Bunds back to the 0% level (Chart 12). Chart 12Bunds & JGBs Have Been A Drag On Global Yields Bunds & JGBs Have Been A Drag On Global Yields Bunds & JGBs Have Been A Drag On Global Yields Any signs of stabilization in European growth could also help global bond yields find a floor. Bottom Line: The Fed is now signaling no more rate hikes for the rest of 2019, but this newly dovish language merely brings their own interest rate forecasts closer to current market pricing. Lower bond yields and easier financial conditions will help underwrite a recovery in U.S. growth, just as a stabilization of the global economy is starting to materialize. The current downturn in Treasury yields, which is looking technically stretched, should soon begin to bottom out. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31st, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Forward Guidance On Steroids Forward Guidance On Steroids Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The FOMC managed to surprise investors at its March meeting after all, … : Everyone knew the Fed wasn’t going to hike rates last Wednesday, but the scope of the downward revision in the median dots was unexpected. … as it turns out that the median FOMC participant sees the pause as a lengthy hiatus: Not only does the median voter expect no rate hikes this year, s/he only expects one more in the entire tightening cycle. Rate-hike expectations have dwindled from three to a lonely one. The motivation for the Fed’s pivot is hardly crystal clear, … : The Fed may have turned more dovish because it fears the U.S. is losing momentum or that key major economies may be on the verge of a recession, it succumbed to pressure from the White House or financial markets, and/or it fears being unable to counter the next downturn. … but it looks to us like it has simply decided it can no longer stomach too-low inflation expectations: The zero lower bound will likely come into play when the next recession arrives, and higher inflation expectations will increase the Fed’s maneuverability by giving it the scope to reduce real rates more easily. Feature Wednesday’s FOMC meeting formalized the Fed’s turn to “patient” monetary policy. The dots revealed that the median FOMC participant’s estimates of the appropriate fed funds rate at year-end 2019 and 2020 are now 50 basis points lower than they were at the December meeting. At that meeting, the median participant expected the fed funds rate would be 2⅞% at the end of 2019, and 3⅛% at the end of 2020; the median participant now sees 2⅜% at the end of this year, the midpoint of the current 2.25 – 2.5% range, with a final hike to 2⅝% sometime in 2020. Uber-dovish St. Louis Fed President Bullard crowed in early January that the committee was starting to see things his way, and it seems that he was right. While presumably only Minneapolis President Kashkari voted with Bullard for no 2019 hikes in December, nine more participants came over to his side in the ensuing three months. The shift on the FOMC can be boiled down as follows: in December, two voters called for no hikes in 2019, and eleven called for a minimum of two hikes; in March, eleven voters called for no hikes, and two called for just two (Chart 1). The migration of nine out of seventeen voters from two or three hikes to zero hikes lopped 50 basis points off the FOMC’s median year-end projections through 2021, and has pushed our equilibrium fed funds rate model even further away from the consensus. What happened, and what does it mean for our S&P 500, Treasury and spread-product views? Chart 1 What Made The Fed More Patient? Our real-time view of the Fed’s turn to patience in early January was that it was a logical response to the sharp, sudden tightening of financial conditions imposed by the fourth-quarter sell-off in stocks and corporate bonds (Chart 2). We didn’t create a regression model to try to put a precise number on what the tightening in financial conditions meant, but it seemed fair to assume that it equated to at least one 25-basis-point hike in the fed funds rate. If that was as conservative an estimate as we thought, the Fed’s only rational course was to step aside, given that the financial markets had already done a quarter or two of its work for it. Chart 2Markets Tightened For The Fed In 4Q Markets Tightened For The Fed In 4Q Markets Tightened For The Fed In 4Q Slowing momentum in the rest of the world offered another reason for backing off. Chinese deceleration that began with domestic policymakers’ deleveraging drive has been exacerbated by the ongoing trade spat with the U.S. (Chart 3). Chinese imports are the most direct channel by which China impacts the rest of the world, and global trade has slid as China has decelerated (Chart 4). The first contraction in global export volumes since the global manufacturing slump in early 2016 has dragged on Europe, which took its 2018 cue from a soft China, rather than a robust U.S. Chart 3Deleveraging Started China's Slump ... Deleveraging Started China's Slump ... Deleveraging Started China's Slump ... Chart 4... Which Was Felt Around The World ... Which Was Felt Around The World ... Which Was Felt Around The World Within the U.S., ongoing data releases have fostered the notion that the Fed can well afford to be patient. Despite booming payroll expansion in December and January, which created 538,000 net new jobs, the unemployment rate ticked up to 4% from 3.7%.1 The data raised the possibility that there may be more labor market slack than previously estimated. Headline inflation is hardly alarming, though core measures that back out oil’s drag are hanging around the Fed’s 2% target (Chart 5). Chart 5Core Inflation Is Near Target, But Oil Has Weighed On Headline Inflation Core Inflation Is Near Target, But Oil Has Weighed On Headline Inflation Core Inflation Is Near Target, But Oil Has Weighed On Headline Inflation Is The Phillips Curve Dead? Is it possible that the Fed could turn away from rate hikes when the unemployment rate is a tenth of a point above its lowest level since 1969? Does the Fed really think the Phillips Curve is so flat that even 50-year lows in unemployment aren’t going to boost wages? Has it abandoned the idea that inflation and the unemployment rate are inversely related once the economy reaches full employment? We don’t think so; as we argued in our recent Special Report on the Phillips Curve,2 we are convinced that the Fed’s belief in the relationship between unemployment and inflation remains intact. Every mainstream macroeconomic inflation model incorporates an inverse relationship with the unemployment rate. We fully accept that the Phillips Curve is kinked, and that the point where it inflects is dependent on estimates of the unobservable natural rate of unemployment (NAIRU), but the economics profession has no widely accepted model that does not take as given the notion that sub-NAIRU unemployment is inflationary. Until the profession develops an alternative framework that achieves wide acceptance, the Phillips Curve will continue to be a keystone element of central bank policy. The path from higher wages to higher consumer prices may be indirect and uncertain, but the link between the unemployment gap and annual wage gains is alive and well, even in the post-Volcker, low-inflation era (Chart 6). Chart 6Wages Rise When Workers Are Hard To Find Wages Rise When Workers Are Hard To Find Wages Rise When Workers Are Hard To Find What Might The Fed See That We Don’t? We have been, and remain, constructive on the U.S. economy. The delayed December retail sales release was lousy, and the uninspiring advance January figure led the Atlanta Fed to knock nearly 40 basis points off of its estimate of consumption’s contribution to first-quarter GDP, but it seems incompatible with a roaring job market, rising wages, and an elevated household savings rate. First-quarter growth projects to be sickly, but it has been for the last few years, and the Atlanta Fed’s GDP Now model projects that real final domestic demand grew by 1.3%, in spite of the government shutdown. The FOMC seemed to err on the side of caution in trimming its growth estimates by 20 and 10 basis points (“bps”) for 2019 and 2020, respectively, and revising its unemployment rate projections 20 bps higher for both years. The global economy has surely slowed; ex-the U.S., its biggest constituents decelerated for nearly all of 2018, as Chair Powell noted. He also noted, however, that Chinese policy makers have taken several steps to support activity. That will help the rest of the world, including Europe, as an accelerating fiscal and credit impulse boosts Chinese imports (Chart 7). Brexit remains a risk the Fed would be irresponsible not to plan for, but given that a do-over referendum would probably lead to the U.K. remaining in the E.U. (Chart 8), it is a risk that may well not come to pass. Chart 7Chinese Policymakers Want To Boost Growth Chinese Policymakers Want To Boost Growth Chinese Policymakers Want To Boost Growth Chart 8Let's Call The Whole Thing Off Let's Call The Whole Thing Off Let's Call The Whole Thing Off We do not think that the Fed changed course based on White House pressure. As we have noted before, White House-Fed conflict is nothing new, and while the Arthur Burns-led Fed knuckled under during Nixon’s re-election campaign, pressure from the Johnson, Reagan and G.H.W. Bush Administrations all came to naught. We also do not think that the Fed took its cue from investors, even if its 2019 policy rate outlook now closely resembles the money market’s (Chart 9). If it is wary of inverting the yield curve, however, it may want to see long yields rise before it hikes again.3 Chart 9Seeing It The Markets' Way (At Least For 2019) Seeing It The Markets' Way (At Least For 2019) Seeing It The Markets' Way (At Least For 2019) Don’t Fence Me In Q: [B]elow-target inflation is a … phenomenon … across advanced economies, and I’d … like to … hear your thoughts about what kind of challenges that poses to policy makers like yourself and the global economy in general. Chair Powell: It’s a major challenge. It’s one of the major challenges of our time, really, to have … downward pressure on inflation[.] It gives central banks less room … to respond to downturns[.] [I]f inflation expectations are below two percent, they’re always going to be pulling inflation down, and we’re going to be paddling upstream and trying to … keep inflation at two percent, which gives us some room to cut, … when it’s time to cut rates when the economy weakens. … It’s … one of the things we’re looking into as part of our strategic monetary policy review this year. The proximity to the zero lower bound calls for more creative thinking about ways we can … uphold the credibility of our inflation target, and … we’re open-minded about ways we can do that. Our best guess is that the Fed has become frustrated by moribund inflation expectations ten years into a recovery. Now that it sees the potential for a recession in the not-so-distant future, it would prefer not to have to confront it with the zero lower interest-rate bound tying one hand behind its back. It would be reasonable if it would also prefer not to have to rely too heavily on asset purchases, given all the headaches that even a modest shrinking of the balance sheet has occasioned. The Fed’s ongoing monetary policy review may therefore turn out to be more than an academic exercise. It might be awfully nice to have strategies aiming to reverse past misses of the inflation objective in place before the next recession arrives. Those strategies would provide the Fed with more flexibility to reduce real interest rates via moves in the fed funds rate. Powell discussed the potential appeal of these sorts of strategies at Stanford University just a week and a half before the FOMC meeting,4 and despite all the times they’ve been bandied about, they just might come to something this time around. Investment Implications The Fed has made a significant pivot since October’s “long way from neutral,” and December’s post-FOMC press conference, when the chair seemed to be disconnected from the markets’ agita. We don’t think a 2019 rate hike is completely out of the question, but there is no doubt that the Fed’s reaction function has changed. We don’t yet see a reason to revise our terminal rate estimate down from 3.25%-3.5%, even if it’s evident that it will take a good bit longer for the Fed to get there than we initially expected. It seems to be more willing to let inflation get ahead of it – it may end up actively encouraging inflation to do so – before it completes its meandering journey to the terminal rate. Allowing the economy to run a little hotter should be equity-friendly. It’s hard to get earnings contraction without a recession, and recessions don’t occur when monetary policy is accommodative. If the Fed requires more evidence of improvement before it resumes hiking rates, the economy and corporate earnings should be able to build up more momentum than they otherwise would. The Fed’s newfound patience should also be spread-product-friendly, as borrowers become better credits as an expansion rolls along. The Treasury outlook is more nuanced. Yields fell as the Fed committed to remaining on hold for longer, but the Fed now seems to have exhausted its capacity for dovish surprises. Short of a recession or near-recession, it’s hard to see how yields can go much lower. Given markets’ seeming conviction that inflation is as dead as a doornail, however, Treasury bond yields may do no more than drift higher at the margin until the Fed’s efforts to put a floor underneath inflation expectations begin to bear some fruit. We still think risk-friendly positioning makes sense, and we reiterate our equity and spread-product overweights, our Treasuries underweight, and our below-benchmark-duration recommendation. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 At the other end of the spectrum, the unemployment rate fell two ticks in February, to 3.8%, despite a meager net increase of 20,000 jobs. Short-term disconnects can be explained by the fact that the unemployment rate (household) and net payrolls additions (business establishments) are calculated from separate surveys, but no one knows exactly how many people who aren’t working are available to work when they decide the time is ripe. 2 Please see the February 26, 2019 U.S. Investment Strategy Special Report, “The Phillips Curve: Science Or Superstition?” Available at usis.bcaresearch.com. 3 The Fed may not care a whit about the yield curve, but may simply want to hold its fire until it is convinced that the economy requires less accommodation so as not to overheat, which would get it to the same place: not hiking until long yields begin to price in the potential for overheating. 4 Please see the March 18, 2019 U.S. Investment Strategy Weekly Report, “Kinder, Gentler Central Banking.” Available at usis.bcaresearch.com.

Dear Client, I had the pleasure of visiting clients in Seattle, Anchorage, and Juneau last week. In this week’s report, I address some of the questions that routinely came up during our meetings. Among other things, the topics discussed include our optimistic global growth outlook, waning dollar bullishness, implications of a more dovish Fed on the business cycle, and where we think equities are headed. Next week we will be publishing our Quarterly Strategy Outlook, which will provide a detailed discussion of our key global macro and investment views. Best regards, Peter Berezin, Chief Global Strategist Feature Q: You have predicted that global growth will stabilize in the second quarter and then accelerate in the second half of the year. Are you seeing much evidence in support of this view? A: We are seeing signs of green shoots, but they are still fairly tentative. Current activity indicators appear to have stabilized (Chart 1). The global manufacturing PMI edged lower in February, but the services component increased. Consumer confidence has risen, although that may simply reflect the rebound in global equities. Chart 1Global Growth Appears To Have Stabilized Global Growth Appears To Have Stabilized Global Growth Appears To Have Stabilized The data on international trade has been quite soft. That said, the weekly Harpex shipping index, which measures global container shipping activity, has improved. The Baltic Dry Index has also shown some signs of bottoming (Chart 2). Chart 2Shipping Data Pointing To A Recent Pickup In Global Trade Shipping Data Pointing To A Recent Pickup In Global Trade Shipping Data Pointing To A Recent Pickup In Global Trade The diffusion index of our global leading economic indicator, which tracks the share of countries with rising LEIs, has also moved higher (Chart 3). It generally leads the global LEI. The fact that global financial conditions have eased significantly since the start of the year is also an encouraging sign. Chart 3The Uptick In The LEI Diffusion Index Suggests Global Growth Will Firm Up The Uptick In The LEI Diffusion Index Suggests Global Growth Will Firm Up The Uptick In The LEI Diffusion Index Suggests Global Growth Will Firm Up Q: What’s your take on the most recent Chinese economic data? A: It has been generally soft, but not abysmal. Manufacturing output continues to decelerate. Retail sales remain lackluster, with auto sales showing little evidence of improvement. Property prices are still rising, but floor space sold has begun to contract. Fixed-asset investment has held up so far this year. However, this is mainly due to a pickup in spending among state-owned companies. Both exports and imports contracted in February. In a rather unusual step, the government announced last week that exports increased by nearly 40% in the first nine days of March compared with the same period last year.1 Electricity production has also apparently rebounded. We would not place a huge weight on these statements, as the data probably has been skewed by the timing of the lunar new year, but it does seem that economic momentum may be starting to turn the corner. We are seeing signs of green shoots, but they are still fairly tentative. There is little doubt that the government is trying to jumpstart growth. Household and business taxes have been cut. The PBOC has reduced reserve requirements by 350 bps over the past year. Interbank rates have dropped. Despite the fact that the February credit data fell short of expectations, the six-month credit impulse has turned decisively higher. The Chinese credit impulse leads imports by about six-to-nine months (Chart 4). This bodes well for global trade in the second half of the year. Chart 4Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse Global Trade Will Benefit From A Chinese Reflationary Impulse Q: Given that Chinese debt levels are already quite high, by how much more can they realistically increase? A: We do not expect credit growth to rise by as much as it did in 2009 or 2016. However, this is because the economy is in better shape, not because there is some intrinsic constraint to increasing debt from current levels. China’s elevated savings rate has kept interest rates well below trend nominal GDP growth, which is the key determinant of debt sustainability (Chart 5).2 As long as the government maintains an implicit guarantee on most local and corporate debt, as it is currently doing, default risk will remain minimal. Chart 5China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth China's High Savings Rate Has Kept Interest Rates Well Below Trend Nominal GDP Growth In any case, given that debt now stands at 240% of GDP, a mere one percentage-point increase in credit growth would still produce a hefty 2.4% of GDP in credit stimulus. In this sense, China may be better off with a higher debt-to-GDP ratio since in steady state this will allow for a larger flow of credit-financed stimulus into the economy. Q: A revival in Chinese growth would presumably help Europe? A: Yes. Our conversations with clients revealed an ongoing negative bias towards Europe among investors (Chart 6). This is echoed in the latest BofA Merrill Lynch Global Fund Manager Survey which, for the first time in history, identified “short European equities” as the most crowded trade. Chart 6European Equities: Unloved And Unwanted European Equities: Unloved And Unwanted European Equities: Unloved And Unwanted We think that such deep pessimism about Europe is largely unwarranted. Faster global growth will help the European export sector later this year, while domestic demand will benefit from more accommodative fiscal policy and lower bond yields, especially in Italy. The ECB will not raise rates this year even if growth speeds up, but the market will probably price in a few more rate hikes in 2020 and beyond. This will allow for a modest re-steepening in the yield curves in core European bond markets, which should be positive for long-suffering bank profits. Political risk remains a concern. The Brexit saga has reached the farcical stage where: 1) The U.K. has voted to leave the EU; but 2) Parliament has voted to stay in the EU unless it reaches a satisfactory deal with Brussels; while 3) rejecting the only deal with Brussels that was on offer. Given that most British voters no longer want Brexit (Chart 7), we think that the government will kick the proverbial can down the road until a second referendum is announced or a “soft Brexit” deal is formulated. Either outcome would be welcomed by markets. Chart 7U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Q: You seem less bullish on the U.S. dollar than you were last year? A: That is correct. As we discussed last week, the dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth (Chart 8). If global growth strengthens later this year, the trade-weighted dollar will probably weaken. Chart 8The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Moreover, as this week’s FOMC meeting highlighted, the Fed’s reaction function has shifted in a more dovish direction. The median Fed dot now foresees no rate hikes this year and only one rate hike in 2020. In contrast, the December Summary of Economic Projections envisioned two rate hikes this year and one next year. The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of global growth. In a far cry from his October “rates are far from neutral” comment, Jay Powell stressed during this week's post-FOMC meeting press conference that the fed funds rate is currently in the “broad range of estimates of neutral.” While we would not rule out the possibility that the FOMC will raise rates at some point later this year, we now expect a more gradual pace of rate tightening than we had earlier envisioned. Q: Does a more dovish Fed imply that the economic expansion has even further to run? A: Yes. Expansions tend to end when monetary policy turns restrictive. We had previously thought that this point could be reached in late-2020, but it is now starting to look as though it will occur later than that. Broadly speaking, we see the Fed tightening cycle unfolding in two stages. In the first stage, which is the one we are in today, the Fed will raise rates in baby steps in response to better-than-expected growth and falling unemployment. In the second stage, the Fed will hike rates more aggressively as inflation starts to accelerate. Risk assets will be able to digest the first stage, but not the second. The good news is that most of our favorite indicators are not yet pointing to a major inflationary upswing (Chart 9): Despite higher tariffs, consumer import price inflation has slowed; core intermediate producer price inflation has decelerated; the prices paid components of the ISM and regional Fed surveys have plunged; inflation surprise indices have rolled over; and both survey and market-based measures of inflation expectations remain below where they were last summer. In keeping with these developments, BCA’s propriety Inflation Pipeline Indicator has fallen to a two-and-a-half-year low. Chart 9No Signs Of An Imminent Major Inflationary Upswing In The U.S. ... No Signs Of An Imminent Major Inflationary Upswing In The U.S. ... No Signs Of An Imminent Major Inflationary Upswing In The U.S. ... Wage growth has accelerated, but productivity growth has increased by even more. Unit labor cost inflation has actually been coming down since the middle of last year. Unit labor costs lead core CPI inflation by about 12 months (Chart 10). This implies that consumer price inflation is unlikely to reach uncomfortably high levels at least until the second half of next year. Chart 10... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being ... And Decelerating Unit Labor Costs Will Dampen Inflationary Pressures For The Time Being Beyond then, the risks are high that inflation will move up as the economy continues to overheat. This could force the Fed to start raising rates aggressively late next year, a course of action that will push up the dollar and cause equities and spread product to sell off. The resulting tightening in financial conditions will probably plunge the U.S. and the rest of the world into recession in 2021. Q: So stay overweight stocks for now, but consider selling at some point next year? A: Correct. The MSCI All-Country World Index (ACWI) has risen by over 14% since we upgraded it in December after having moved to the sidelines six months earlier. Given this run-up, we are not as bullish now as we were at the start of the year. Most of our favorite indicators are not yet pointing to a major inflationary upswing. Nevertheless, the path of least resistance for equities remains to the upside. While the forward P/E ratio for the MSCI ACWI has returned to where it was last September, analyst earnings expectations are currently much more conservative: Bottom-up estimates foresee EPS rising by 4.1% in the U.S. and 5.3% in the rest of the world in 2019 (Chart 11). The combination of faster growth, easier financial conditions, and ongoing corporate buybacks implies some upside to those estimates. Chart 11Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted Analyst Expectations Are Quite Muted Moreover, real yields have fallen over the past five months – the 10-year U.S. TIPS yield is 48 basis points below its Q4 average, for example. A simple dividend discount model would suggest that global equities are about 10%-to-15% cheaper than they were prior to last year’s autumn selloff. The path of least resistance for equities remains to the upside. Q: Aren’t you worried that rising labor costs will push down profit margins even if GDP growth accelerates? A: Not really. As noted above, productivity growth has picked up. Whether this is the start of a new trend remains to be seen, but at least for now, it is dampening unit labor costs. Historically, real unit labor costs – nominal unit labor costs divided by the corporate price deflator – have tracked economy-wide profit margins very closely (Chart 12). Chart 12Real U.S. Unit Labor Costs Historically Have Tracked Economy-Wide Profit Margins Very Closely Real U.S. Unit Labor Costs Historically Have Tracked Economy-Wide Profit Margins Very Closely Real U.S. Unit Labor Costs Historically Have Tracked Economy-Wide Profit Margins Very Closely In practice, it is very rare for earnings to contract outside of recessions (Chart 13). This is why recessions and equity bear markets generally overlap (Chart 14). With the next recession still two years away, it is too early to turn defensive. Indeed, as Table 1 shows, the second-to-last year of business-cycle expansions is often the most lucrative for stock market investors. Chart 13Earnings Rarely Contract Outside Of Recessions Earnings Rarely Contract Outside Of Recessions Earnings Rarely Contract Outside Of Recessions Chart 14Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Table 1Too Soon To Get Out Questions From The Road Questions From The Road Q: What do you recommend in terms of regional equity allocation? A: If global growth accelerates later this year and the dollar weakens, this will create an excellent environment for international stocks – EM and Europe in particular. Investors should prepare to overweight those regions at the expense of the United States (currency unhedged). Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Elaine Chan, “China spreading ‘positive news’ of strong export rebound in early March after February plunge,” South China Morning Post, March 11, 2019. 2      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 15 Tactical Trades Strategic Recommendations Closed Trades

Highlights Global Spread Product: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios. Feature Stick With A Tactical Overweight To Global Corporates We’ve dedicated our last few Weekly Reports to analyzing the outlook for government bond yields in the developed markets (DM), in light of the recent dovish shift in the policy stance of central banks. We concluded that yields had fully discounted a slower global growth backdrop, through lower inflation expectations and the pricing out of future interest rate hikes. Further declines in bond yields would require a deeper deceleration of activity than we are expecting, thus maintaining a below-benchmark medium-term duration stance is appropriate. That dovish shift by policymakers also took away a major roadblock for risk assets, namely the threat of a continued policy-induced rise in global yields at a time of slowing growth. The result has been sharp rallies in global equity and credit markets, with declining volatility (Chart of the Week). Chart of the WeekSlowing Growth Isn’t Always Bad For Risk Assets Slowing Growth Isn't Always Bad For Risk Assets Slowing Growth Isn't Always Bad For Risk Assets We upgraded global corporate debt, and downgraded global government bonds, on a tactical basis back on January 15 of this year.1 Since then, credit spreads have declined substantially across both DM and emerging markets (EM), most notably in Europe (Chart 2). Within our upgrade to overall global credit, we maintained a relative bias towards U.S. corporates versus non-U.S. equivalents, based on our expectation of relatively faster economic growth in the U.S. In our model bond portfolio, that meant moving U.S. corporates to an above-benchmark weighting, while reducing the size of the underweight in EM debt and only raising European credit to a neutral allocation. Chart 2 Looking at the performance of each of the major credit markets in excess return terms (versus duration-matched government bonds) since January 15, currency-hedged into U.S. dollars, there have not been huge differences between U.S. and non-U.S. returns. The exception is European high-yield which had an excess return of 4.4%, but only represents 0.8% of our custom benchmark index for our model portfolio (and where we are not underweight). Excess returns for investment grade and high-yield corporates in the U.S. have averaged 2.3%, compared to 2.2% for EM credit (averaging hard currency sovereign and corporate debt). We see the global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current overweight allocation to global corporates. With the benefit of hindsight, we know that the decision to upgrade overall global corporate debt versus government bonds has been far more important than adjusting any regional credit allocations. We see that global “risk-on” dynamic continuing in next few months, fueled by benign monetary policies, thus we are sticking with our current allocations to global corporates. Our cue to reverse our tactical overweight stance on corporates will come from the U.S. Any additional spread tightening and easing of overall financial conditions will keep U.S. economic growth above trend and eventually force the Fed to become more hawkish in the second half of 2019. This will turn global monetary policy from a tailwind for corporate credit to a headwind, justifying a downgrade of corporate allocations. In the meantime, we recommend continuing to earn carry in a policy-induced low volatility environment. Bottom Line: The current low-volatility backdrop, triggered by more dovish central banks, will be maintained until there is more decisive evidence that global growth is rebounding. That will not occur until the latter half of 2019, thus keeping the window for corporate credit outperformance open for a few more months. Stay overweight global corporates versus governments, favoring the U.S. Canada: Upgrade To Neutral Canadian government bonds have been clawing back much of the relative underperformance that occurred in 2017 and 2018 while the Bank of Canada (BoC) was delivering multiple rate hikes. The spread between the yields on the Bloomberg Barclays Canada Treasury index and the overall Global Treasury index has narrowed by -40bps since October 2018, after widening 69bps between May 2017 and October 2018 (Chart 3). Expressed as a relative return (duration-matched and currency-hedged into U.S. dollars), Canadian government debt has lagged the Global Treasury index by -232bps since May 2017. Chart 3Canadian Bonds No Longer Underperforming Canadian Bonds No Longer Underperforming Canadian Bonds No Longer Underperforming That underperformance was driven by the combination of a strong Canadian economy, accelerating inflation and tightening monetary policy. The year-over-year pace of real GDP growth reached 3.8% in mid-2017 and stayed above-trend for the following year. The unemployment rate fell to 5.8%, while core inflation accelerated back to the midpoint of the BoC’s 1-3% target band, alongside faster wage growth. The BoC – devotees of the Phillips Curve, like virtually every other DM central bank – took the message from the combination of tight labor markets and rising inflation and embarked on the long march away from a near-zero (0.5%) policy rate back in July 2017. Now, after 20 months and 125bps of rate hikes, Canada’s economy is weakening sharply. Real GDP only grew at a paltry 0.4% annualized pace in the 4th quarter of 2018, dragging the year-over-year pace to 1.6%. Inflation has followed suit, with headline CPI inflation falling from an early 2018 peak of 3% to 1.4% and the BOC’s median CPI index now growing at only a 1.8% pace. The most concerning part for the BoC is that the economy could be decelerating this rapidly with a policy rate of only 1.75%, which is well below the central bank’s estimated 2.5-3.5% range for the neutral rate. Our own BoC Monitor has rapidly fallen towards the zero line, indicating no pressure to either tighten or ease monetary policy (Chart 4). The more recent rapid decline in the BoC Monitor has been driven by the inflation-focused components of the indicator, while the growth-focused elements have been steadily drifting lower since that 2017 peak in real GDP growth. Chart 4Is The BoC Done, Well South Of Neutral? Is The BoC Done, Well South Of Neutral? Is The BoC Done, Well South Of Neutral? The BoC has been stunned by that shockingly weak Q4/2018 growth outturn. In the official policy statement released following the March 6 BoC meeting, the central bank’s Governing Council was forthright about how the growth uncertainty has put future rate hikes in question: “Governing Council judges that the outlook continues to warrant a policy interest rate that is below its neutral range. Given the mixed picture that the data present, it will take time to gauge the persistence of below-potential growth and the implications for the future inflation outlook. With increased uncertainty about the timing of future rate increases, Governing Council will be watching closely developments in household spending, oil markets and global trade policy.” Rising interest rates may be the big reason why growth has slowed so dramatically in Canada. The BoC’s economic projections for 2019 had already factored in some slowing global growth, as well a hit to business confidence and capital spending from global trade conflicts and last year’s decline in energy prices (a big deal for Canada’s huge oil industry). BoC officials, including Governor Stephen Poloz, have noted that a resolution of the U.S.-China trade tensions could therefore be a positive for the Canadian economy by removing a critical drag on Canadian business confidence and export demand. Yet when looking at the contribution to Canadian real GDP growth from the main components, there have been large drags on growth from consumer spending, capital spending and housing (Chart 5). That suggests that there is something more fundamental than just a series of external shocks at work here. Chart 5Broad-Based Weakness In Canadian Domestic Demand Broad-Based Weakness In Canadian Domestic Demand Broad-Based Weakness In Canadian Domestic Demand A look at the more interest-sensitive components of the Canadian economy suggests that rising interest rates may be a big reason why growth has slowed so dramatically. Consumer Durables Real consumer spending growth has plunged from a 4% pace in 2018 to 1.3% in Q4/2018, driven by a collapse in demand for consumer durables which contracted -1.2% year-over-year terms (Chart 6). Car sales plunged 7.5% on a year-over-year basis in Q4, suggesting that rising interest rates on auto loans may have been a major factor driving the weakness in durables spending. Softer incomes have also played a role, with wage growth rolling over even with the majority of evidence pointing to a very tight Canadian labor market that is getting even tighter (third panel). The fact that the drop was so focused on durables, however, suggests that higher interest rates were the more likely reason for the plunge in overall consumer spending. Chart 6Weak Canadian Consumption Concentrated In Durables Weak Canadian Consumption Concentrated In Durables Weak Canadian Consumption Concentrated In Durables Housing The overheated Canadian housing market has endured the double-whammy of rising mortgage interest rates and increasing macro-prudential changes to mortgage lending. House prices in the hottest Toronto and Vancouver markets – which should be most impacted by the changes in mortgage regulations – have stopped increasing, helping bring the growth in national house prices to only 1.9% (Chart 7). Yet the sharp deceleration of mortgage credit growth, alongside a contraction in housing starts and overall residential investment, suggests that higher mortgage rates could be the bigger driver of the housing weakness. Chart 7Some Long-Needed Cooling Of Canadian Housing Some Long-Needed Cooling Of Canadian Housing Some Long-Needed Cooling Of Canadian Housing The BoC has noted that it is difficult to disentangle the impact of regulatory changes in Canadian mortgages from that of rising interest rates. Yet the impact of higher mortgage rates on Canadian consumer spending power can be seen in the rising debt service ratio for Canadian households. As of Q4/2018, Canadians must now pay 14.5% of their household income to service their debts, an 0.53 percentage point increase over the past two years (Chart 8). For highly indebted Canadian households, who have mortgage debt equal to 107% of disposable income, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Chart 8Leveraged Canadian Consumers Pinched By Higher Rates Leveraged Canadian Consumers Pinched By Higher Rates Leveraged Canadian Consumers Pinched By Higher Rates Does the fact that consumer spending has fallen so rapidly mean that the interest sensitivity of the Canadian economy is far greater than the BoC has assumed? If so, then the neutral range of 2.5-3.5% for the BoC policy rate may be too high, and the central bank could be closer to, if not already at, the end of its hiking cycle. The low level of the household savings rate – currently only 1.1%, a product of the housing bubble and the associated wealth effects on spending activity – makes Canadian consumers even more vulnerable to rate increases that diminish their spending power. For highly indebted Canadian households, even a modest pickup in mortgage rates can have a big impact on spending power through higher interest costs. Capital Spending Canadian companies have seen a steady decline in corporate profit growth over the past couple of years, decelerating from a 23% pace in 2017 to 2% late in 2018 on a top-down basis. Yet even allowing for that, the -8% contraction in year-over-year real non-residential investment spending in Q4/2018 is a shock. Particularly since the BoC’s Senior Loan Officer Survey showed that credit conditions have been easing, and our own Canadian Corporate Health Monitor is flashing that Canadian companies are in solid financial condition (Chart 9). Chart 9An Unusually Sharp Fall In Canadian Capex An Unusually Sharp Fall In Canadian Capex An Unusually Sharp Fall In Canadian Capex Business surveys from the BoC and the Conference Board did both show a sharp plunge in confidence and future sales expectations (bottom panel). This suggests that worries about global trade tensions and diminished trade activity may have weighed on Canadian business confidence and capital spending – especially coming alongside a big drop in oil prices as was seen last year, which hinders the ability of Canadian energy producers to ramp up investment. Canadian exports accelerated over the final half of 2018 while business confidence was falling. However, oil prices have now stabilized and, more importantly, Canadian exports accelerated over the final half of 2018 while business confidence was falling (Chart 10). That acceleration was seen for both energy and non-energy exports, but was also heavily concentrated in exports to China, which are now growing 24% on a year-over-year basis (a pace that is wildly at odds with the overall growth in Chinese imports, suggesting that Canadian exporters have increased their market share in China). Chart 10Should Canadian Companies Be Worried About Global Trade? Should Canadian Companies Be Worried About Global Trade? Should Canadian Companies Be Worried About Global Trade? Could higher corporate borrowing rates, rather than worries about plunging export demand, be the true reason why Canadian companies have so drastically cut back on capital spending? It is no surprise that the BoC has chosen to take a pause on its rate hiking cycle, given all those conflicting messages from the Canadian economic data. The growth slump could be related to global trade uncertainty, or regulatory changes in the housing market, or past declines in oil prices, or previous interest rate increases. Or all of the above. The BoC can also take some time before considering its next interest rate move given cooling inflation and wage growth (Chart 11). The central bank has reduced its estimate of the Canadian output gap to -0.5%, based off the downside surprises already seen in Canadian economic growth. A closed output gap, combined with accelerating inflation, was the main argument the BoC had been using to justify its interest rate increases over the past two years. Now, neither of those conditions is currently in place, and the BoC can take its time to assess the underlying trend of economic growth without having to worry about above-target inflation. Chart 11Slowing Inflation = More Dovish BoC Slowing Inflation = More Dovish BoC Slowing Inflation = More Dovish BoC The Governing Council next meets in April, when a new Monetary Policy Report and updated economic projections will be published. The 2019 growth and inflation forecasts will surely be downgraded, perhaps heavily as the European Central Bank just did in response to the sharp growth slowdown in Europe – which led to a new round of monetary easing measures. What will be more interesting from the point of view of Canadian bond investors will be the Bank’s assessment of the size of Canada’s output gap, the pace of trend growth and, perhaps, even the appropriate neutral range for the BoC policy rate. The lowering of any of those three elements would be supportive of Canadian bond yields staying lower for longer. We have maintained an underweight in Canadian government bonds since July 2017, based on our view that the BoC would follow in the Fed’s footsteps and attempt to normalize interest rates. A strong economy and rising inflation would allow them to do that. Now, both the Fed and BoC are on hold, with small probabilities of rate cuts now priced into Overnight Index Swap (OIS) curves (Chart 12). Chart 12BoC Now Less Likely To Follow The Fed BoC Now Less Likely To Follow The Fed BoC Now Less Likely To Follow The Fed Given the BCA view that Fed rate hikes will resume later this year on the back of a rebound in U.S. and global growth, we had been sticking with the bearish view on Canadian government bonds as well. Yet given the stunning drop in Canadian growth that startled the BoC, the odds now favor the BoC staying on hold for longer, even once the Fed begins to hike again. This would also provide additional easing of Canadian financial conditions through a soft Canadian dollar (bottom two panels). We are upgrading our recommended allocation to Canadian bonds to neutral(3 out of 5) this week from underweight (2 out of 5).  In light of this uncertainty over the BoC’s next move given the weak economy, the underlying rationale for our underweight Canada position is no longer applicable. Thus, we are upgrading our recommended allocation to Canadian bonds to neutral (3 out of 5) this week from underweight (2 out of 5). The excess return of Canadian government bonds versus the Global Treasury index since we went to underweight back in July 2017 was -0.83%, so our bearish recommendation did generate positive alpha. In our model bond portfolio, we are funding that additional Canadian allocation from a reduction of the overweight in Japanese government bonds. We are also closing our tactical trade of being long 10-year Canadian Real Return Bonds versus nominal 10-year government debt, at a loss as 10-year inflation breakevens are now 1.6%, or 16bps below the entry level on our trade (Chart 13). Chart 13Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral Upgrade Canadian Government Bonds To Neutral We will contemplate any additional changes to our Canadian allocation after the releases of the latest BoC Business Outlook Survey and Senior Loan Officer Survey on April 15 and the new BoC Monetary Policy Report and economic projections at the April 24 monetary policy meeting. Bottom Line: Much weaker-than-expected Canadian economic growth has surprised the Bank of Canada. Rate hikes are now off the table for at least the rest of 2019, and possibly longer. Upgrade Canadian government debt to neutral (3 out of 5) in global currency-hedged government bond portfolios.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@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.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index March Calmness March Calmness Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Await the U.K. parliament to coalesce a majority on a on a credible strategy for Brexit that is also acceptable to the EU27. At that point, buy the pound, the FTSE250, and U.K. homebuilder shares. An eerie calm has descended over developed economy currencies. But the Chinese yuan has rebounded sharply. Stay tactically overweight emerging market currencies, cyclical equity sectors, and equities versus bonds. But don’t expect these rallies to last beyond the summer. Feature Chart of the WeekAn Eerie Calm Has Descended Over The Currency Markets. Why? An Eerie Calm Has Descended Over The Currency Markets. Why? An Eerie Calm Has Descended Over The Currency Markets. Why? End Of The Road For May From the moment almost three years ago that the U.K. voted to leave the EU, it was clear that a rational and measured Brexit would require the U.K. to remain in a customs union with the EU. Rational and measured because a customs union would protect the cross-border supply chains which are vital to so many U.K. businesses. Rational and measured because a customs union would avoid a hard customs border on the island of Ireland, and thereby prevent a break-up of the U.K. Rational and measured because a customs union would best deliver on the narrow 52:48 vote to leave the EU, which was driven by a desire to control migration and the supremacy of the European Court of Justice – both of which are compatible with remaining in a customs union – rather than a desire to strike independent trade deals – which is not. Yet Theresa May did not steer to this rational and measured Brexit, because she knew it would rip apart the Conservative party, a hard minority of which sees the sovereignty of trade policy as its Holy Grail. Beholden to this minority, May put her party interest above the national interest. But now, May has run out of road. Her Brexit deal has been rejected twice by huge parliamentary majorities. In the coming days, parliament, through a series of indicative votes, is likely to wrest control of the Brexit process from the government. So far, parliament has expressed what it is against (a no-deal Brexit), but it has yet to express what course of action it is for. We await the U.K. parliament to coalesce a majority on a credible strategy for Brexit that is also acceptable to the EU27. At that point, irrespective of the exact strategy, we will buy the pound, the FTSE250, and U.K. homebuilder shares. Important Message From The Currency Markets An unusually eerie calm has descended over the currency markets (Chart of the Week). For the past six months, GBP/USD has drifted within a tight 5 percent range, USD/JPY has also moved within a similarly narrow range, and EUR/USD has been trapped within an even tighter 3 percent range (Chart I-2 and Chart I-3). Chart I-2GBP/USD And EUR/USD Have Been Very Calm Recently GBP/USD And EUR/USD Have Been Very Calm Recently GBP/USD And EUR/USD Have Been Very Calm Recently Chart I-3USD/JPY Has Also Been Very Calm Recently USD/JPY Has Also Been Very Calm Recently USD/JPY Has Also Been Very Calm Recently The calm is eerie because Brexit tensions have actually intensified as the Article 50 clock has run down without a breakthrough; the Federal Reserve has made a dramatic volte-face from its sequential rate hikes; the ECB has pivoted back to dovish after the German economy narrowly avoided a technical recession; and the Japanese economy contracted sharply in the third quarter of 2018. Adding to the eeriness of the calm in currency markets, the equity and bond markets have experienced wild gyrations. Global equities plunged 20 percent before quickly recovering most of the losses, while long bond prices moved by close to 15 percent1 (Chart I-4 and Chart I-5).1 Chart I-4While Equities Have Been Turbulent, Currencies Have Been Calm While Equities Have Been Turbulent, Currencies Have Been Calm While Equities Have Been Turbulent, Currencies Have Been Calm Chart I-5While Bonds Have Been Turbulent, Currencies Have Been Calm While Bonds Have Been Turbulent, Currencies Have Been Calm While Bonds Have Been Turbulent, Currencies Have Been Calm Given all of this turbulence, why have currency markets remained a relative oasis of calm? The simple answer is that exchange rates are, by definition, relative prices. And in the major economies, growth and inflation rates have moved in the same direction by the same amount at roughly the same time. In fact, looking at quarter-on-quarter growth rates, the major economies have all recently experienced identical 1.5 percent slowdowns: from 4 to 2.5 percent in the U.S.; and from 2.5 percent to around 1 percent in both the euro area and the U.K.2  (Chart I-6 - Chart I-8). Chart I-6U.S. GDP Growth Slowed By 1.5 Percent U.S. GDP Growth Slowed By 1.5 Percent U.S. GDP Growth Slowed By 1.5 Percent Chart I-7Euro Area GDP Growth Slowed By 1.5 Percent Euro Area GDP Growth Slowed By 1.5 Percent Euro Area GDP Growth Slowed By 1.5 Percent Chart I-8U.K. GDP Growth Slowed By 1.5 Percent U.K. GDP Growth Slowed By 1.5 Percent U.K. GDP Growth Slowed By 1.5 Percent Markets do not care about the level of growth. They care much more about the change in growth. Financial markets are a discounting mechanism, and what matters most to the price is the change in the assumptions that are embedded within it. For example, if the price were discounting a major economy to grow at 4 percent and that rate of growth subsequently fell to 2.5 percent, then the seemingly benign outcome of respectable growth would cause interest rate expectations to decline. In another major economy, if growth slowed from 2.5 percent to 1 percent, it would precipitate a broadly similar decline in interest rate expectations.  In this situation of synchronised and meaningful slowdowns across major economies, and the consequent policy responses, equity and bond absolute prices would experience wild gyrations. By contrast, currencies are relative prices. So if the decline in major economy growth rates and interest rate expectations were broadly similar, currency markets would remain a relative oasis of calm. Which perfectly describes the observation of the last six months. This observation of near-identical slowdowns in the major economies supports our thesis that their genesis came from outside the developed economies, which we expounded in A European Cycle ‘Made In China’. And now we present the smoking gun. While an eerie calm has descended over developed economy currencies, all the action has been in emerging economy currencies, especially the Chinese yuan which has rebounded sharply. The message from the currency markets reinforces our thesis: last year’s growth downswing and the current upswing were made in China (see final chart). Never Focus On Levels Of Economic Growth It is worth repeating that a head-to-head comparison of growth rates across different economies is a meaningless exercise. Here’s a simple way to grasp this crucial point: a 1.5 percent growth rate would be a very pleasing outcome for Europe, it would be a very unpleasing outcome for the U.S., and it would be a catastrophic outcome for China. The reason is that if a population is growing, the economy needs to generate real growth well in excess of the rate of population growth to improve (per person) living standards. That excess comes from productivity growth which lifts standards of living and wellbeing. In the case of Germany or Japan where the population is not growing, or is indeed shrinking, the GDP growth rate that is consistent with these rising standards of living is much lower than in those economies where the population is growing (Chart I-9 and Chart I-10). Chart I-9The Same Productivity Growth In The Euro Area And The U.S. ... The Same Productivity Growth In The Euro Area And The U.S. ... The Same Productivity Growth In The Euro Area And The U.S. ... Chart I-10... Generates Different GDP Growth ... Generates Different GDP Growth ... Generates Different GDP Growth Necessarily, an economy with weaker demographics – like Germany or Japan – will flirt with technical recessions much more often than one with population growth – like the U.S. or China. But this is just Arithmetic 101. It doesn’t mean that Germany or Japan are in a fundamentally worse shape when it comes to all-important productivity growth and improving wellbeing. Just as important for investors, earnings per share (eps) growth depends on productivity growth and not on GDP growth. Granted, higher GDP from an increasing population will boost a firm’s sales, but without increasing productivity, the firm will have to hire more staff to produce those sales. In essence, the firm will have to employ more capital – issue more shares – which means than earnings per share will not grow. To reemphasise, levels of GDP growth, in themselves, do not drive financial markets. The Perils Of Data-Dependency Recently, the world’s major central banks have become even more wedded to ‘data-dependency’, for two reasons: first, under ever increasing external scrutiny, objectivity to the economic data boosts the transparency and rationale of central bank policy; second, data-dependency acts as a foil to politicians who might want to influence or interfere with the independence of monetary policy. No names mentioned! We applaud the central banks for their good intentions. Yet enhanced data-dependency also carries perils, as it increases the amplitude of the ever-present and natural oscillations in economic growth. The reason is that the high-profile hard data on which monetary policy ‘depends’ such as CPI inflation and GDP growth record what happened in the past, and sometimes in the distant past. Meanwhile, a monetary policy shift today will act on the economy in the future due to the unavoidable lags in transmission. It follows that enhanced data-dependency is akin to a crop farmer who uses last season’s depressed price, from oversupply, to justify planting much less seed for next season. The inevitable undersupply at next season’s harvest will then cause the crop price to surge. Making the farmer plant much more for the following season, at which point the price will collapse again. And the oscillations will continue ad infinitum. Unfortunately, the more backward the data on which policy actions depend, the higher the amplitude of the price and output oscillations.   Right now, growth sensitive investment positions are midway through exactly such an up-oscillation, justifying a near-term overweight in emerging market currencies, cyclical equity sectors, and equities versus bonds. But these rallies are highly unlikely to last beyond the summer (Chart I-11). Chart I-11The Recent Mini-Cycle Is ‘Made In China’ The Recent Mini-Cycle Is 'Made In China' The Recent Mini-Cycle Is 'Made In China' Stay tuned for the next turn. Fractal Trading System* We are pleased to report that long DAX versus the 30-year bund achieved its 2.5 percent profit target which is now crystallised and closed. This week we note that the sharp sell-off in AUD/CNY is close to the limit of tight liquidity that has signaled recent reversals in this cyclical currency cross. Accordingly, this week’s recommended trade is to go long AUD/CNY. Set a profit target of 1.5 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-12 Long AUD/CNY Long AUD/CNY 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,  Chief European Investment Strategist dhaval@bcaresearch.com Footnote 1 The German 30-year bund. 2 Based on annualised quarter-on-quarter real GDP growth rates. 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Dovish Central Banks & Duration: Bond markets have shifted rapidly in recent weeks, pricing out any and all rate hikes expected over the next year in the major developed economies. With global growth likely to rebound in the latter half of the year, bond yields are now exposed to a hawkish repricing and recovery in inflation expectations, especially in the U.S. Stay below benchmark on overall portfolio duration on a medium-term basis. Model Bond Country Allocations: We are sticking with our current country tilts in our model bond portfolio, as the recent shift in central banker biases has done little to change the relative fundamental drivers between countries. Stay underweight the U.S., Canada & Italy, and overweight core Europe, Japan, the U.K., Spain & Australia, in currency-hedged global government bond portfolios. Feature Well, That Escalated Quickly With global growth remaining soggy, an increasing number of major central banks have been forced to rapidly shift in a more dovish direction. This past week alone, the European Central Bank (ECB), the Bank of Canada (BoC) and the Reserve Bank of Australia (RBA) all signaled that interest rates would be on hold for some time. The ECB went the extra step of announcing a new bank funding program (TLTRO-3), as we predicted last week, to prevent a deeper euro area growth downturn at a time of, as ECB President Mario Draghi described it, “pervasive uncertainty”. Government bond yields declined sharply in all three regions, as markets digested the dovish message from more cautious policymakers. Our Central Bank Monitors for the major developed economies are all decelerating, in line with the soft patch of global growth. Yet only the RBA Monitor has fallen to a level clearly signaling a need for easier monetary policy in Australia. For the other major countries, the Monitors are indicating that an unchanged monetary policy stance is appropriate, and all for the same reason – the loss of economic momentum has not been enough to loosen tight labor markets and drive core inflation rates lower. Government bond yields have already responded to a loss of global growth momentum by pricing out any rate hikes that were expected over the next year, most notably in the U.S. and Canada. Inflation expectations have also adjusted downwards in response to both diminished growth expectations and last year’s sharp plunge in global energy prices. We expect global growth to rebound in the latter half of 2019, alongside higher oil prices, leaving bond yields exposed to upside data surprises and a repricing of expectations for inflation and rate hikes (Chart of the Week). We continue to recommend a below-benchmark overall portfolio duration stance on a 6-12 month horizon, as government bond yields are likely to rise above the very flat forwards in most markets. Chart 1A Bottoming Out Process For Bond Yields A Bottoming Out Process For Bond Yields A Bottoming Out Process For Bond Yields While maintaining a below-benchmark duration stance, the synchronized shift in central bank forward guidance justifies a review of the recommended country allocations in our model fixed income portfolio. Taking Stock Of Our Country Tilts In Our Model Bond Portfolio Global government bond yields peaked back in early November and have fallen in all of the major developed economies (Chart 2). Decomposing the move in benchmark 10-year yields into inflation expectations (using CPI swap rates) and real yields (the difference between nominal yields and CPI swap rates) shows that the bulk of that decline has come from lower real rates in the countries with positive policy rates (U.S., Canada, U.K. and Australia). For countries with zero or negative policy rates (core Europe, Japan), most of the yield decline has been due to falling inflation expectations. Yet the drivers of the decline in yields have changed from the latter two months of 2018 to the first few months of 2019. Generally speaking, the late-2018 bond market rally reflected falling inflation expectations, while recent changes have been a function of moves in real yields. Only in Australia have real yields and inflation expectations both declined steadily since the early November peak in global bond yields. Chart 2 The greater influence of the real component of yields makes sense, as markets now discount fewer rate hikes and more accommodative monetary policy. Currently, our recommended country allocation in the Governments portion of our model bond portfolio includes underweights in the U.S., Canada and Italy and overweights in Australia, the U.K., Japan, Germany, France and Spain (the latter is a position versus Italy within an overall underweight stance on Peripheral European debt). In light of the more ubiquitously neutral/dovish global policy bias, we are reevaluating those country tilts per the following indicators: 1. Cyclical growth indicators: Both manufacturing purchasing managers indices (PMIs) and the leading economic indicators (LEIs) produced by the OECD are well off the cyclical peaks (Chart 3). In terms of levels, the PMIs are holding above the 50 threshold, suggesting expanding manufacturing activity, in the U.S., U.K., Canada and Australia, but are below 50 in the euro area and Japan. Chart 3Growth Has Lost Momentum Everywhere Growth Has Lost Momentum Everywhere Growth Has Lost Momentum Everywhere 2. Market-based inflation expectations: 10-year CPI swap rates have generally stabilized alongside energy prices, after the sharp drops seen in the latter months of 2018 (Chart 4). Australia is the lone exception where expectations continue to drift lower. The correlations between CPI swap rates and oil prices denominated in local currency are strongest in the U.S. and Canada and weakest in Australia. There is great diversity of the levels of CPI swap rates, however, from as low as 0.2% in Japan to as high as 3.5% in the U.K. Chart 4Inflation Expectations Are Stabilizing Outside Of Japan & Australia Inflation Expectations Are Stabilizing Outside Of Japan & Australia Inflation Expectations Are Stabilizing Outside Of Japan & Australia 3. Our Central Bank Monitors vs. our 12-month discounters: Except for Australia, our Monitors are all hovering very close to the zero line, indicating no pressure on policymakers to move policy rates (Chart 5). Our 12-month discounters, which measure the interest rate changes over the next year priced into Overnight Index Swap (OIS), are all close to zero, as well (again, with the exception of Australia, where a full 25bp rate cut is already priced). Chart 5Our Central Bank Monitors Are Calling For Stable Policy (ex Australia) Our Central Bank Monitors Are Calling For Stable Policy (ex Australia) Our Central Bank Monitors Are Calling For Stable Policy (ex Australia) Just looking at these indicators, the ideal combination would be to underweight countries where yields are vulnerable to an upward repricing (PMIs still above 50, higher oil/CPI swaps correlations and no rate hikes priced) and to overweight countries where yields are less likely to rise (PMIs below 50, lower oil/CPI swaps correlations and where our 12-month discounters are not priced for rate cuts). Under these criteria, underweights in the U.S. and Canada are still justified, as are overweights in core Europe and Japan. The surprising firmness of the U.K. manufacturing PMI relative to the persistent downtrend in the U.K. LEI muddies the message a bit on Gilts, although the relatively high level of our 12-month discounter (still 13bps of hikes priced) is a bullish sign with our BoE Monitor now sitting right near zero. In Australia, the manufacturing PMI is also surprisingly firm but, the underlying weak momentum in overall Australian growth is leaving the door open to potential RBA rate cuts later this year. For all our country recommendations within our model bond portfolio framework, we always look at yields and returns on a currency-hedged basis in U.S. dollar terms. We do this to separate the fixed income component of global bond returns from the currency component. Yet when looking at the government bond yield curves in our model bond portfolio universe, hedged into USD, there is very little differentiation among those countries with the higher credit ratings (Chart 6). Only Spain (A-rated) and Italy (BBB-rated) have hedged yields that are outside the 2-3% range seen in the other major developed economies. Chart 6 From a fundamental point of view, those narrow yield differentials among the higher-rated markets largely reflect the convergence of trend economic growth rates. In a recent Weekly Report, we looked at the long-run growth rates of potential GDP and labor productivity for the U.S., euro area and Japan and noted that the differences between them were fairly modest.1 This justified narrow currency-hedged yield differentials between U.S. Treasuries, German Bunds and Japanese government bonds (JGBs). When we add Canada, Australia and the U.K. to the mix (Chart 7), we can see similar convergence of potential GDP growth to rates between 1-2% and long-run productivity growth around 0.5% (using OECD data for both). Chart 7No Major Differences In Long-Run Growth Rates No Major Differences In Long-Run Growth Rates No Major Differences In Long-Run Growth Rates The convergence is largely complete for all countries except Australia, where potential GDP growth is estimated to be 2.4%. Yet the long-run downtrend in potential growth is powerful and full convergence to the sub-2% levels seen in the other countries appears inevitable (and goes a long way in explaining the historically low level of Australian bond yields versus global peers). We can also see convergence in looking at the more recent history of the market pricing of the expected long-run neutral interest rate, using our real terminal rate proxy (the 5-year OIS rate, 5-years forward minus the 5-year CPI swap rate 5-years forward). Those measures for all of the major developed markets in our model bond portfolio are shown in Chart 8. The markets are pricing in real policy rate convergence, as well, with real rates expected to stay in a range between -0.5% (core Europe) and +0.5% (Canada). The U.K. is the one outlier, with the market pricing in a terminal real rate of -2%, although this likely reflects the markets discounting in the long-run effects of Brexit on the U.K. economy. Chart 8Markets Expect Near-Zero Real Terminal Rates (ex the U.K.) Markets Expect Near-Zero Real Terminal Rates (ex the U.K.) Markets Expect Near-Zero Real Terminal Rates (ex the U.K.) So what does all this mean for our recommended country allocations in our model bond portfolio? In Chart 9, we show the relative performance of the each country, hedged into U.S. dollars and duration-matched) versus the Bloomberg Barclays Global Treasury Index. Our overweight tilts are in the top panel, while our underweight tilts are in the bottom panel. Chart 9Sticking With The Country Allocations In Our Model Bond Portfolio Sticking With The Country Allocations In Our Model Bond Portfolio Sticking With The Country Allocations In Our Model Bond Portfolio Generally speaking, are recommendations have done well. Given our read on the indicators above, we see little reason to change the allocations. Our biggest concerns would be the underweights in Canada and Italy, given the sharp weakening of growth in both countries. For Italy, however, we view that as a negative given Italy’s high debt levels that require faster nominal growth to ensure debt sustainability. A more dovish ECB should help keep European bond volatility low, to the benefit of carry trades like Italian government bonds. However, we prefer to play that through our overweight in Spain while we await signs of stabilization in the Italian LEI before upgrading Italy in our model bond portfolio. As for Canada, we plan on doing a deeper dive on their economy and inflation trends in next week’s report before considering any changes to our allocation. Bottom Line: We are sticking with our current country tilts in our model bond portfolio, as the recent shift in central banker biases has done little to change the relative fundamental drivers between countries. Stay underweight the U.S., Canada & Italy, and overweight core Europe, Japan, the U.K., Spain & Australia, in currency-hedged global government bond portfolios.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com     1 Please see BCA Global Fixed Income Strategy Weekly Report, “Europe & Japan: The Anchor Weighing On Global Bond Yields”, dated February 26, 2019, available at gfis.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Pervasive Uncertainty, Persuasive Central Banks Pervasive Uncertainty, Persuasive Central Banks ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns