Economy

Special Report

Highlights So what? The U.S.-China deal is not shaping up as well as the consensus holds. Why? The odds of reaching a deal by June are rising, but no higher than 50%. Unemployment is a constraint on the Chinese side but stimulus reduces urgency. Structural concessions on currency and foreign investment are limited in scope. Strategic concessions are limited to North Korea; Taiwan risks are rising. Stay overweight U.S. and Chinese equities on a relative basis at least until the deal is signed.   Feature Once again investors are faced with a stream of headlines suggesting that a U.S.-China trade deal is all but finished, only to find critical caveats buried on page six. For instance, President Donald Trump and President Xi Jinping have not yet scheduled a summit to sign a trade agreement, though Trump insists a summit is necessary. Chief U.S. negotiator Robert Lighthizer says that he is “hoping but not necessarily hopeful.”1 There is still room for U.S. and Chinese bourses to outperform on a relative basis while negotiations continue. Still, the news flow is encouraging. Trump has said “we’ve agreed to far more than we have left to agree to,” while Xi Jinping has called for an “early conclusion of negotiations.” The other negotiators are also making positive sounds, with Vice Premier Liu He saying that a “new consensus” has been reached on a text of the trade agreement. National Economic Council Director Larry Kudlow says that key structural issues are on the table and that negotiations are continuing by videoconference after two successful rounds of direct talks in Beijing and Washington. Even the notorious China hawk, Peter Navarro, Director of the U.S. National Trade Council, has begrudgingly admitted that the two sides are in the final stage of the talks, saying, “the last mile of the marathon is actually the longest and the hardest.”2 Readers know that we take a pessimistic view of U.S.-China relations over the long run. We were skeptical about the possibility of a tariff truce on December 1. However, the signs are stacking up in favor of a deal. While we would not be surprised if talks extended to the June 28-29 G20 summit in Osaka, Japan, President Trump has suggested that a summit could come as early as May 5-19. Chart 1Still Some Room To Run Judging by the performance of U.S. and Chinese equities relative to the rest of the world since the first tariffs were imposed on June 14, 2018, there is still room for these two bourses to outperform on a relative basis while negotiations continue. Relative to global equities excluding China and U.S., Chinese stocks have retraced 78% of the ground they lost, while U.S. stocks have not surpassed the high points reached at the peak of the global economic divergence in 2018 (Chart 1). Once a deal is reached, will investors that bought equities on the rumor sell the news? We would buy, though equity leadership should rotate away from the U.S. and China depending on the timing and external conditions discussed below. As a House we are overweight global equities on a 12-month horizon. Xi Is Not Mao China’s economic stimulus is a key swing factor for global growth and the corporate earnings outlook this year. Our China Investment Strategy has highlighted that the BCA Activity Indicator has now fully registered the negative impact of trade tariffs as well as the broader slowdown (Chart 2). Chart 2Slowdown Fully Priced In Previously it was more buoyant than our leading indicator suggested it should be, largely because companies placed orders throughout the second half of 2018 to front-run Trump’s tariffs and this artificially boosted China’s exports and manufacturing activity. Now that this front-running is over, any improvement or deterioration in underlying monetary conditions, money supply, and lending should be reflected in the BCA Activity Indicator itself. Hence a stout credit number for March will cause an uptick that will confirm that China’s economy is recovering. We expect this to occur because, to be blunt, President Xi Jinping is not truly a modern-day Chairman Mao Zedong. While he has revived aspects of Maoism, he has responded pragmatically, rather than ideologically, to the Communist Party’s Number one political constraint: the tradeoff between productivity and employment. When Xi consolidated power in 2017, he launched a deleveraging campaign and doubled down on various structural reforms in order to make progress in rebalancing China’s economy. The result was renewed weakness in the labor market as the stimulus measures of 2015-16 wore off (Chart 3). Labor “incidents,” or protests, particularly those sparked by the relocation of workers from closed factories, began to rise again (Chart 4). Significantly, the number of bankruptcies also increased, demonstrating that the government was willing to tolerate some economic pain in order to make the allocation of capital more efficient (Chart 5). Chart 3A Key Constraint On Xi Jinping Chart 4Labor Incidents On The Rise China’s policymakers pursued these reforms while believing that President Trump’s threat of a trade war was largely bluster. But when Trump proceeded to impose tariffs, confidence collapsed and China’s private sector found itself sandwiched between stricter government at home and an impending squeeze of demand abroad. The labor and business indicators in Charts 3-5 suffered further deterioration in 2018 as animal spirits evaporated across the economy. President Xi’s response could have been to close China’s doors to trade and to the West and undertake an even more aggressive purge of “capitalist roaders.” The possibility is inherent in his cult of personality, aggressive anti-corruption campaign, and cyber-security state apparatus. This would have meant a dramatic reckoning with the country's economic and financial imbalances, but it would have given the hardliners in the Communist Party an opportunity to establish absolute control and national “self-sufficiency.” Instead, Xi entered into talks with Trump and launched supply-side, tax-and-tape-cutting measures to stimulate private economic activity, and boosted fiscal spending. He chose reflation rather than revolution. Chinese stimulus does not make a trade deal more likely in itself, as it gives President Xi more leverage in negotiations. But without a trade deal, private sector sentiment and animal spirits will remain depressed and stimulus measures will eventually falter. So it makes sense that Xi wants a deal. China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. To put this into context: if China’s credit impulse turns positive it will push the overall fiscal-and-credit impulse higher than 2% of GDP (Chart 6), foreshadowing a rebound in Chinese imports and global growth and enabling China’s own corporate earnings to recover. Our China Investment Strategy estimates that if the past three months’ rate of credit growth continues, while manufacturing sentiment improves on a trade deal and the renminbi remains flat, then the probability of an earnings recession on the MSCI China Index falls from 92% to 21%, as shown in Chart 7. From a policy perspective this looks conservative, as the actual rate of credit growth will probably be faster than that of the past three months. Chart 6Credit Will Add To Fiscal Boost Chart 7Earnings Unlikely To Contract Of course, President Trump has even more acute political constraints than President Xi urging him toward a deal. A deterioration in the U.S. manufacturing sector is a serious liability, especially in the Midwestern battleground states (Chart 8), and Trump has apparently calculated that a tailored infusion of Chinese cash and promises is a better reelection strategy than a continuation of trade war amid a slowdown.   Chart 8A Key Constraint On Donald Trump The implication of all of the above is that China will be the center of two market-positive outcomes in the near term: more domestic reflation and less conflict with the United States. The former is not yet consensus, while the latter is lacking in specifics. Yet both are beneficial for Chinese equities on an absolute and relative basis. And once there is a concluded trade deal and clarity over stimulus, emerging markets can also outperform their developed market counterparts. Note that we do not expect China to launch a massive 2008-09-style stimulus unless the tariff war reignites. Such an outcome would only be bullish for some EMs, since beneath the initial surge in Chinese imports would lie the disruption of the global supply chain and broader de-globalization. Bottom Line: Unemployment is a key political constraint suggesting both that China’s stimulus will surprise to the upside and that a trade deal is forthcoming. We are reducing the odds of an extension of trade talks beyond June from 35% to 20%, leaving a 50% chance for some kind of trade deal to emerge by the end of that month (Table 1). Table 1Updated Trade War Probabilities (April 2019) Trump Is Not Nixon If Xi is not Mao, then Trump is not Nixon. Despite a likely trade deal, we are not on the verge of a historic 1972-esque “grand compromise” that will usher in a new era of U.S.-China engagement. This should temper enthusiasm regarding the long-term durability of the trade truce, highlighting that China’s credit data is the more important factor for the 12-month horizon, though the trade issue is an impediment that needs to be removed for a sustainable rally. China may be increasingly willing to embrace structural concessions, but the depth of the structural change should be doubted until the details of the trade deal prove otherwise. For example, at the moment there is still no agreement on tariff levels. And there can be no “enforcement mechanism” to satisfy the U.S. side other than the perpetual threat of tariffs, which erodes trust and discourages Chinese implementation of structural changes. Two structural issues highlight the conundrum: currency and foreign investment. First, while the details of the currency agreement are unknown, the U.S. will definitely not get anything comparable to what it got from Japan after the Plaza Accord in 1985. The Japanese were a subordinate ally to the U.S. in the midst of the Cold War; they did not negotiate with the suspicion that the U.S. secretly wanted to destroy their economy. China has neither the security guarantee nor the economic trust. The implication is that the CNY-USD may rise by about 10% or so from current levels (Chart 9), as opposed to the 54% that the JPY-USD witnessed from 1985-88. The upside for the U.S. is that Trump may get some yuan appreciation, while the upside for China is that limited appreciation means no excessively deflationary impact. Chart 9Currency Agreement: Far From A Plaza Accord Second, China’s new foreign investment law, which received a rubber stamp from the legislature in March, is not an unqualified success for American negotiators. We have illustrated this in Table 2 by denoting white flags for aspects of the law that are genuine concessions and red flags for aspects that will raise new suspicions about China’s foreign investment framework. It is a mixed bag. Moreover, the law itself has no power and will depend entirely on the central government’s dedication to imposing strict adherence down through the local layers of government, where forced technology transfer actually takes place. Table 2New Foreign Investment Law: A Mixed Bag American negotiators will also want bilateral agreements on tech transfer and intellectual property protection since otherwise they will not receive any particular benefit from a law that applies equally to all foreign investors (e.g. Europeans). But it is not yet clear that they will get anything more concrete. The upside for the U.S. is that it will have some means of redress for forced tech transfer and intellectual property theft, while the upside for China is that foreign direct investment should improve. The strategic conflicts between the U.S. and China are even less likely to be dealt with than the economic issues. How can we be sure? Peer Competition: The U.S.-China détente under Nixon occurred at a time when a vast asymmetry between U.S. and Chinese national power existed, whereas today China’s power increasingly rivals that of the U.S., making it easier for China to write its own rules for global interactions and to resist U.S. pressure (Chart 10). Unilateralism: Trump did not leverage American alliances and partnerships across the world to create a “coalition of the willing” to confront China over its mercantilist trade and investment practices. There is some cooperation but it has been inconsistent and tentative, even on deep national security concerns like Huawei’s involvement in 5G networks and the Internet of Things. Had the U.S. created such a coalition and then set out to prosecute its claims, the threat to China’s economy would have been so immense that much greater structural changes could be expected than is the case today (Chart 11). Chart 10The Era Of U.S.-China Detente Is Over Chart 11Trump Eschewed A Coalition Of The Willing Core Interests: The trade talks only nominally address dangerous conflicts in China’s near abroad. China’s enforcement of sanctions on North Korea has produced limited results so far but we ultimately expect diplomacy to bear fruit (Chart 12). However, Taiwan is more rather than less likely to be the site of conflict. This is not because of pro-independence sentiment, which is actually on decline in public opinion relative to pro-unification sentiment (Chart 12, second panel). It is because the lame duck Tsai Ing-wen administration may attempt to secure last-minute benefits from the U.S., while an unexpected primary election challenge could lead to the nomination of Lai Ching-te (William Lai), a more outspoken pro-independence candidate, on April 24. Either could provoke Beijing. There is zero chance that any trade deal in the coming months will reduce the threat of reunification of Taiwan by force. Underlying distrust will remain. Chart 12Geopolitical Risk Down In Korea But Up In Taiwan Furthermore, the South China Sea is not a “red herring” but a potential “black swan,” as it is connected to Taiwan’s security and more broadly to U.S. alliance security. After all, 96%-97% of Taiwan’s, South Korea’s, and Japan’s oil imports flow through these sea lanes. Critical supplies become vulnerable if China expands its military’s capabilities there (Diagram 1). The U.S. and China will likely be just as provocative as before in this area after they sign a deal. Technology: The tech conflict is more likely to limit the trade deal than vice versa. The sanctions and embargoes on Chinese companies like ZTE, Fujian Jinghua, and Huawei have operated on a separate track from the trade talks, and it is not at all clear that the U.S. will embrace Huawei as part of any final deal. The initial actions of the newly beefed-up Committee on Foreign Investment in the United States (CFIUS) send warning signals. CFIUS is largely a vehicle for U.S. oversight of China (Table 3) and, if anything, that country-specific focus is intensifying. For instance, the U.S. has deemed Chinese ownership of a gay and lesbian hook-up app, Grindr, to pose an excessive national security risk.3 This is not a high bar for intervention and it suggests that any trade deal will fail to improve China’s investment options in the U.S. tech sector. Diagram 1South China Sea As Traffic Roundabout Table 3CFIUS Is Mostly About China The takeaway is that while both sides want a deal over the short term, it will not mark the end of the trade war. It is more likely the end of the beginning of a cold war. As long as China’s economy and industrial capabilities continue to grow relative to the United States, its geographic periphery remains a cauldron of geopolitical risks, and its technological advancement remains rapid, the competition will continue. Bottom Line: There is no substantial evidence from the current trade talks that underlying strategic conflicts will be resolved. This implies that the U.S. and China will shift their focus to these conflicts in the weeks and months after any trade deal. That process will be a nuisance to global equity markets expecting a clean deal; Chinese and American tech stocks in particular will remain exposed to tail risks. The status of Chinese tech companies is a critical risk, as a deal for the U.S. to admit Huawei would be a game-changer. Investment Conclusions Ironically, an early resolution of the trade war – in April or May – offers less of a benefit for Chinese equities and other risk assets than a later resolution in June or thereafter. While we expect to have greater clarity on China’s stimulus magnitude from the March data, it is still possible that stimulus will remain mixed or disappointing. Stimulus measures may also be toned down after a deal is approved, which means that an earlier deal would reduce the total stimulus by the end of 2019. The Trump administration will use the new flexibility gained from a China deal to toughen its policies in other areas, potentially with negative market consequences. The decision to designate the Iranian Revolutionary Guard Corps (IRGC) as a foreign terrorist organization is an important example. This decision is squarely within the Trump administration’s policy of pressuring Iran, which is a high-risk policy with substantial market-relevance. Trump may have made the decision in order to save face while planning to renew waivers on Iranian oil sanctions on May 4 – we would be extremely surprised if he did not renew. Sanctioning the IRGC involves a string of consequences but it is not a direct attack on oil supply that could produce an oil shock dangerous to Trump’s re-election prospects in 2020 (Chart 13). Of course, Iran will retaliate to the IRGC blacklisting – and one way it could do so would be through oil production in various places, including Iraq. The result would be oil volatility and higher prices. Further, an early deal could encourage Trump to instigate a trade war with Europe. Trump’s four-to-six week time frame for the conclusion of talks with China is conspicuously close to the tentative May 18 deadline by which he is required to determine whether to impose tariffs on foreign auto and auto part imports (Chart 14). Such tariffs would be pursuant to the Section 232 investigation that likely found such imports a threat to national security. We have argued that a U.S.-China deal raises the risk of tariffs on European cars to 35%, with Japanese and Korean cars less at risk, progressively. The EU is ready to retaliate so this would be a drawn-out trade conflict.   By contrast, we are less concerned about the market impact of Trump’s recent threats to close the border with Mexico or include Mexico in car tariffs (Chart 15). True, Trump could close the border and generate a temporary drag on trade and the border economy. However, the Republicans have limited patience for the economic blowback of an extended border closure, and Trump cannot afford to jeopardize passage of his USMCA trade deal as long as he has alternative ways of looking tough on the border. Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. What about a later resolution of the trade deal, in June or later in the summer? This would remove some risks. By that time, the Iran decision and possibly the car tariff decision will be past and there will be greater clarity on the magnitude of China’s stimulus. More extensive negotiations could also suggest that the ensuing trade deal will resolve deeper disagreements – unless the talks drag on without consequence amid signs of declining trust. Given the risk of trade war with Europe, oil volatility, and uncertainties about China’s stimulus, Geopolitical Strategy would view the U.S. and China as good overweights relative to global equities and within their respective developed and emerging market contexts. When and if the above political hurdles are cleared, the emphasis can shift to other bourses. Geopolitical Strategy’s preferred emerging market plays are EM energy producers and EM Asian states like Thailand and Indonesia.   Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See Ailsa Chang, “U.S. Trade Representative Robert Lighthizer Discusses Ongoing Trade Talks With China,” National Public Radio, March 25, 2019, www.npr.org. 2 For the above quotations see Andrew Mayeda, Xiaoqing Pi, and Margaret Talev, “Kudlow Sees No Letup in China Talks as Both Sides Cite Progress,” Bloomberg, April 4, 2019, www.bloomberg.com. 3 See David E. Sanger, “Grindr Is Owned by a Chinese Firm, and the U.S. Is Trying to Force It to Sell,” March 28, 2019, www.nytimes.com.

Highlights 10-Year Yield: In this week’s report we run through different macro factors that could be used to create a macroeconomic model of the 10-year Treasury yield, and describe the current outlook for each one. On balance, the indicators suggest that the 10-year Treasury yield is near its floor. Global Growth: Leading indicators have hooked up recently, suggesting that the Global Manufacturing PMI – a key driver of the 10-year Treasury yield – may rise in the coming months. Wages: Average hourly earnings softened in March, but survey measures suggest that wage growth remains in an uptrend. We show that rising wages have put considerable upward pressure on the 10-year yield in recent years, and should continue to do so going forward. Sentiment: The depressed Economic Surprise Index suggests that investor economic sentiment is downbeat. This means that the bar for positive data surprises (and higher bond yields) is relatively low. Feature Chart 1CRB/Gold Ratio On The Rise Treasury yields stabilized during the past week, and investors are trying to figure out whether the next big move will be higher or lower. We’re on the record as predicting that yields will eventually head higher, and have flagged the CRB Raw Industrials / Gold ratio as an important indicator to watch to time the next big move.1  Encouragingly, this indicator has risen during the past few weeks (Chart 1). Though the message from the CRB/Gold index is promising, the outlook for the 10-year Treasury yield remains uncertain. To shed some light on this important investment question, in this week’s report we run through different macroeconomic indicators that could be used to create a model of the 10-year Treasury yield. By performing this exercise out in the open, our goal is to present readers with a good way to think about the linkages between the economy and the 10-year Treasury yield. Recipe For A 10-Year Treasury Yield Model Ingredient #1: Growth Factors The first logical factor to include in any model of the 10-year Treasury yield is some measure of economic growth. We have found that the Global Manufacturing PMI is often highly correlated with the 10-year yield (Chart 2). Interestingly, the manufacturing PMI correlates more strongly with the 10-year yield than do the services or composite (manufacturing + services) PMIs. The Global PMI also correlates more strongly with the U.S. 10-year yield than does the U.S. PMI. It only takes a quick glance at the Global Manufacturing PMI to see why the 10-year Treasury yield fell this year. The Global PMI has been in a sharp downtrend for some time, driven mostly by the Euro Area and China. U.S. PMIs have also weakened in recent months, though they remain above levels seen in Europe and China. Another global growth indicator that correlates tightly with the 10-year Treasury yield is investor sentiment toward the U.S. dollar (Chart 3). Since the dollar is a countercyclical currency that appreciates when global growth slows and depreciates when it quickens, we observe that the 10-year Treasury yield tends to be lower when investors are extremely bullish on the U.S. dollar and higher when they are more bearish on the dollar. Chart 2Growth Factor Ingredient 1: Global Manufacturing PMI Chart 3Growth Factor Ingredient 2: Dollar Bullish Sentiment     Notice in Charts 2 and 3 that the Global Manufacturing PMI and dollar bullish sentiment are both close to levels seen near the 10-year yield’s mid-2016 trough. At 50.6, the PMI is only slightly above its 2016 low of 49.9. Meanwhile, dollar bullish sentiment is currently 79%. It maxed out at 82% in 2016. Interestingly, despite the fact that our economic growth indicators paint a similar growth back-drop as 2016, the 10-year yield remains well above its mid-2016 low of 1.37%. Logically, we must conclude that some other “non-growth” factor is propping yields up (more on this below). The 10-year Treasury yield tends to be lower when investors are extremely bullish on the U.S. dollar and higher when they are more bearish on the dollar.  Looking ahead, we remain optimistic that the most important global growth indicators (Global Manufacturing PMI and dollar bullish sentiment) will soon reverse course, as some leading global growth indicators have recently turned a corner. We already saw that the CRB Raw Industrials index has broken out (Chart 1). Additionally: Chart 4The Worst Is Behind Us? The Global ZEW Economic Sentiment index has risen in two consecutive months (Chart 4, top panel). Our Global LEI Diffusion Index shows that more than half of the countries in our sample now have improving leading economic indicators (Chart 4, panel 2). Our BCA Boom/Bust Indicator – an indicator based on the CRB index, Global Metals equities and U.S. unemployment claims – has also jumped (Chart 4, bottom panel). Ingredient #2: Output Gap As noted above, the 10-year Treasury yield looks too high relative to our preferred economic growth indicators. This could be because yields haven’t yet caught up to the deteriorating global economy, but more likely it is because our bond model is still missing some key ingredients. The next most obvious factor to incorporate into our model is some measure of the output gap. If an economy is operating at very close to its peak capacity, with a small output gap, then it doesn’t take much additional growth to spark inflation. Conversely, even rapid economic growth will not be inflationary if the output gap is large. As long as the central bank is expected to lean against rising inflation with higher interest rates, then some measure of the output gap should be included in our bond model. Unfortunately, appropriate output gap measures are difficult to find. We could rely on the CBO or IMF’s output gap estimates, but those are often subject to large ex-post revisions – not ideal if we want to create a bond model that is useful in real time. Since the Fed tends to lift rates when the output gap closes, another option would be to include the fed funds rate as an independent variable in our model. However, this is also not ideal since we would expect the macroeconomic data and the 10-year yield to lead changes in the policy rate. Some measure of inflation might be the best factor to include. However, we find that the correlation between different price inflation measures and the 10-year Treasury yield is incredibly unstable over time. This is likely because the Fed targets price inflation explicitly, making its correlation with bond yields less empirically apparent. Wage growth is the best “output gap” measure to include in a 10-year Treasury yield model.  In fact, our analysis reveals that wage growth is the best “output gap” measure to include in a 10-year Treasury yield model. Specifically, average hourly earnings from the monthly employment report. Not only does the fed funds rate respond – with a lag – to changes in average hourly earnings, but average hourly earnings also line up reasonably well with the 10-year yield over time (Chart 5). Looking at Chart 5, we can now clearly see why the 10-year yield is above its mid-2016 low, despite the poor readings from our growth indicators. Wages have risen sharply since mid-2016, indicating that the output gap has closed, and the Fed has hiked rates 8 times as a result. The obvious conclusion is that in the present situation, with a much smaller output gap than in 2016, it would require a Global Manufacturing PMI well below 50 to produce a 10-year yield near 2% or below. Going forward, we see the uptrend in wage growth continuing for some time. The proportion of workers quitting their jobs each month, a signal of worker bargaining power, remains very high relative to history. Meanwhile, many more households continue to describe jobs as “plentiful” as opposed to “hard to get” (Chart 6). Chart 5Output Gap Ingredient: Average Hourly Earnings Chart 6More Room For Wages To Grow Ingredient #3: Policy Uncertainty The third ingredient we’ll add to our 10-year Treasury yield model is a measure of policy uncertainty. Specifically, the index of Global Economic Policy Uncertainty created by Baker, Bloom and Davis.2  Investors often flock to the safety of U.S. Treasuries in times of economic distress. But Treasuries can also benefit from flight-to-quality flows during periods of stable economic growth but heightened political turmoil. In other words, elevated political uncertainty can make investors fear a downturn in the future, and drive a flight into the safety of U.S. Treasuries. The Global Economic Policy Uncertainty index also shows a relatively strong correlation with the 10-year Treasury yield over time (Chart 7). Chart 7Policy Uncertainty Ingredient: Global Economic Policy Uncertainty Index Looking more closely at Chart 7, we see that global policy uncertainty is currently as high as it was in mid-2016, when the 10-year Treasury yield hit its cycle low. This lines up pretty well with intuition, since investors are understandably quite nervous about the state of Brexit negotiations and U.S./China trade relations. In that context, it is reasonable to expect that some geopolitical risk premium is currently priced into the 10-year Treasury yield, though a smaller output gap than in 2016 is preventing the 10-year yield from reaching mid-2016 levels. Going forward, though political uncertainty will probably stay elevated compared to history. It seems increasingly likely that a “hard Brexit” will be avoided and that President Trump will seek some sort of agreement with China in advance of the 2020 U.S. election.3 The political risk premium in 10-year notes could unwind somewhat in the coming months. Ingredient #4: Sentiment The fourth and final ingredient we’ll add to our 10-year Treasury yield model is a component related to investor sentiment. Our favorite being the U.S. Economic Surprise Index. Chart 8Sentiment Ingredient: Economic Surprise Index Investors don’t often think of the Surprise index as a sentiment indicator, but in fact that’s exactly what it is. It measures whether the economic data exceeded or fell short of expectations during the past 30 days, a measurement that is heavily influenced by whether investor expectations are optimistic or pessimistic. When economic expectations are extremely downbeat it doesn’t take much good news to generate a positive surprise, and vice-versa. Also, investor expectations are influenced in one direction or the other by whether the recent economic data are positive or negative. This behavioral dynamic causes the Economic Surprise Index to be a mean-reverting series, one that we can even describe with a simple auto-regressive model, as shown in Chart 8. More importantly, we have found that the Economic Surprise Index is tightly correlated with the change in the 10-year Treasury yield. A given month that ends with the Surprise index above zero is usually a month when the 10-year Treasury yield increased, and vice-versa (Chart 9). This correlation also holds relatively well over 3-month and 6-month horizons (Charts 10 & 11), but breaks down beyond that.4   The U.S. data surprise index is deeply negative at present, and has been for several weeks. But the longer the data continue to disappoint, the more downbeat investor expectations become and the more likely it is that the surprise index will rise in the future. Right now, our simple auto-regressive model projects that the surprise index will be slightly higher in one month’s time, though still deeply negative. Nevertheless, the Surprise index suggests we are approaching a turning point in investor sentiment. Mix Well, Cover, Stir Occasionally We’ve now presented what, in our view, is a fairly complete list of factors that should be included in a macroeconomic model of the 10-year Treasury yield. Importantly, each factor complements the other ones in the sense that they each capture a different element of the economic landscape. At this stage, it would be nice to weight all of the factors together and arrive at a fair value estimate for the 10-year yield. Unfortunately, we won’t be performing that exercise in this report (we may do so in the future). The key challenge in combining all of the indicators together is that the sensitivity of the 10-year yield to each of the above factors changes over time. For example, there are periods when policy uncertainty appears to be a very significant driver of the 10-year yield, and other times when it appears to not matter much at all. The macro indicators listed in this report generally signal that the 10-year yield is near its trough. While it is often useful to boil all of the important drivers down into a point estimate of the 10-year yield, such an exercise can also create problems if it causes us to zero-in on the model’s output and avoid thinking critically about what the different macro inputs are telling us. As of today, we think the macro indicators listed above generally signal that the 10-year yield is near its trough. Leading global growth indicators have hooked up, suggesting that the Global Manufacturing PMI will improve during the next few months and that bullish dollar sentiment could soften. Survey indicators suggest that the labor market remains tight, and that wage growth will stay in an uptrend. Policy uncertainty will probably continue to apply some downward pressure to yields, but a long Brexit extension and/or trade agreement between the U.S. and China could cause that impact to wane in the next few months. Economic sentiment is likely quite depressed, meaning that the bar for positive surprises is low. All in all, our investment strategy is unchanged. We recommend that investors maintain below-benchmark duration in U.S. bond portfolios, while focusing short positions on the 5-year and 7-year maturities.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 The rationale for tracking the CRB/Gold ratio can be found in U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 www.policyuncertainty.com 3 Please see Global Investment Strategy Quarterly Outlook, “From Dead Zone To End Zone”, dated March 29, 2019, available at gis.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “How Much Higher For Yields?”, dated October 31, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration: A growing list of leading global growth indicators are either climbing or are in the process of bottoming. This is putting a floor under global bond yields, as signaled by our new GFIS Duration Indicator. Maintain a below-benchmark overall duration stance in global bond portfolios. New Zealand: The RBNZ has signaled that the next move in policy rates is down in New Zealand, a move that would be justified by slowing domestic growth and below-target inflation. Stay long New Zealand 5-year government bonds versus equivalent maturity U.S. Treasuries and German debt, but set fairly tight stops to protect profits given how far spreads have already compressed. Feature A New Duration Indicator … But No Change In Our Duration Stance The downward pressure on global government bond yields looks to be losing steam. The “inversion panic” in the U.S. Treasury market has subsided with the 10-year Treasury yield climbing back above 2.50% last week. Yields have bounced well off the lows in the major markets, as well, including the 10-year German Bund which is no longer in negative yield territory. Some tentative signs of stabilization in global growth indicators has helped stem the flow of bond-bullish news, coming alongside a pickup in commodity prices. The new rising trend in our GFIS Duration Indicator suggests that investors should maintain a strategic below-benchmark overall duration stance in global bond portfolios. We have combined some of those growth indicators, which have been reliably correlated with global bond yields over the past several years, into our new Global Fixed Income Strategy (GFIS) Duration Indicator (Chart of the Week). This indicator is a combination of the standardized levels of our global leading economic indicator (LEI), our global LEI diffusion index (the relative share of countries in our global LEI where the LEI is rising versus where it is falling) and the global ZEW economic expectations index (a combination of the individual country indices produced by the German ZEW Institute). Chart of the WeekOur New GFIS Global Duration Indicator Has Bottomed Out Chart 2Early Signs Of A Global Growth Recovery   The GFIS Duration Indicator has provided a reliable directional signal for global bond yields since 2012, with a lead of six months. The indicator bottomed back in October 2018 and, with that six month lead, signals that global bond yields should be bottoming now (April 2019). Two of the three components of the GFIS Duration Indicator – the global LEI diffusion index and the global ZEW expectations index – have both clearly bottomed and are the main reason why the Indicator has started to move higher (Chart 2). The global LEI has stopped falling, as well, and is no longer putting downward pressure on the Indicator. Combined with the readings on price momentum for global government bonds (very overbought) and duration positioning among bond investors (well above-benchmark), it is no surprise that bond yields have finally had a chance to stabilize. Looking at the individual country components of these indicators, it is clear that the pickup in sentiment seen in the U.S., euro area, Japan and the U.K. has not been matched by a pickup in their individual LEIs (Chart 3). Interestingly, there are signs of life in some of the individual emerging market (EM) LEIs in places like Mexico.1 The biggest country to watch for improvement, of course, is China and, even here, the sharp deceleration of the OECD LEI appears to be losing steam. The new rising trend in our GFIS Duration Indicator suggests that investors should maintain a strategic below-benchmark overall duration stance in global bond portfolios. Yields may not come roaring back quickly until there is more decisive evidence of improving global growth. On a risk/reward basis, though, betting on higher bond yields from current levels appears prudent. Our new GFIS Duration Indicator may also prove to be useful in guiding fixed income allocation between government bonds and corporate debt in the future. In Chart 4, we show the performance of global government bond yields, corporate bond spreads and corporate excess returns (over duration-matched government debt) since the start of 2018. The shaded region represents the time frame when we moved to a more cautious stance on global corporates versus governments (from June 26, 2018 to Jan 15, 2019). Chart 3Could EM Lead DM Out Of The Slump? Chart 4Our Duration Indicator Can Help With Asset Allocation Our decision to downgrade corporates was based on our concern that slowing global growth, tighter U.S. monetary policy and growing U.S.-China trade tensions would result in a risk-off pullback in global risk assets like corporate bonds and equities. Yet we could have made a similar decision when looking at only the GFIS Duration Indicator. The most recent peak in the Indicator occurred in October 2017, occurring about one full year before the blowout in credit spreads. In a future report, we will investigate the potential links and optimal lead/lag relationships between the GFIS Duration Indicator and fixed income allocation. Bottom Line: A growing list of leading global growth indicators are either climbing or are in the process of bottoming. This is putting a floor under global bond yields, as signaled by our new GFIS Duration Indicator. New Zealand Spread Trade Update – Too Soon To Take Profits Chart 5Impressive Outperformance From NZ Bonds One of our more successful calls over the past two years has been to go long New Zealand (NZ) government bonds versus U.S. Treasuries and German sovereign debt. Since we initiated that recommendation back on May 30, 2017, the 5-year NZ-US spread has tightened from +74bps to -74bps, while the 5-year NZ-Germany yield differential has narrowed from +289bps to +213bps (Chart 5). Relative to the Bloomberg Barclays Global Treasury index (on a duration-matched basis, hedged into U.S. dollars), NZ government bonds have outperformed by +413bps, compared to +289bps for euro area debt and -269bps for U.S. debt. Our original thesis was that market expectations for the Reserve Bank of New Zealand (RBNZ) were too hawkish relative to decelerating NZ economic growth and inflation persistently coming in below the central bank’s 2% target. Any rate hikes discounted in the NZ yield curve were unlikely to be delivered against that backdrop, keeping NZ bond yields contained. We preferred to position this benign view on NZ rates as a bond spread trade versus the U.S., where the Fed was in a tightening cycle, and versus Germany where a cyclical growth upswing was shifting the ECB in a less-dovish direction. The returns on our NZ recommendation have far exceeded our expectations, with the benchmark 10-year NZ bond yield having fallen -82bps since we initiated the position. The more recent part of that decline has come from the markets moving to price in RBNZ rate cuts over the next year. The bigger driver of the yield move, however, has been due to markets discounting a lower medium-term neutral level of the RBNZ’s policy rate, the Official Cash Rate (OCR). Our proxy for the market expectation of the real terminal rate (the inflation-adjusted level of interest rates derived from forward pricing in the NZ overnight index swap (OIS) curve and medium-term inflation expectations taken from inflation-linked bonds) has fallen from 2.2% in May 2017 to 1.4% today (Chart 6). This is in sharp contrast to the pricing of the real terminal rate in the U.S. and core Europe, which has remained in a narrow range near 0% over the same period. As we discussed in a recent Weekly Report, there has been a trend in recent years towards convergence of real terminal rate expectations across most developed economies – a move driven by a narrowing of differentials in medium-term labor productivity and inflation.2 In the case of NZ, however, the sharp downward adjustment of interest rate expectations also had a cyclical component. Investors are seeing a steady deceleration of NZ growth, even with the RBNZ keeping policy rates at historically-low levels. The result: a reduction of expectations for the terminal (or “neutral”) interest rate. One of our more successful calls over the past two years has been to go long New Zealand (NZ) government bonds versus U.S. Treasuries and German sovereign debt. The economy has faced a broad-based deceleration since the middle of 2016 and is now growing at a below-trend pace of 0.9%. A slower global economy has hit NZ exporters hard, with the annual pace of export growth having slowed from 20% to 4% since last December. The NZ manufacturing PMI has also fallen over the same period, but at 54 remains above the boom/bust 50 level (Chart 7). The RBNZ’s own business surveys show huge declines in confidence, capacity utilization and the outlook for export demand. Chart 6A Big Convergence Of Interest Rate Expectations Chart 7Slowing Global Growth Has Hit NZ Hard   Monetary conditions had to become easier to help mitigate the external shock to NZ growth. This did happen through a weaker New Zealand dollar (NZD) – which fell -8% on a trade-weighted basis from the most recent peak in March 2014 – but not through interest rates, as the RBNZ has kept the OCR steady at 1.75% since November 2016. Looking across the NZ economy, a case can be made for introducing additional monetary stimulus. Could the next move to ease monetary conditions be actual rate cuts from the RBNZ? There are now -40bps of cuts over the next twelve months discounted in the NZ OIS curve. RBNZ Governor Adrian Orr stated last month that, given weaker global growth with reduced momentum in domestic spending and core inflation remaining below target, the next move for the OCR is likely down. Looking across the NZ economy, a case can be made for introducing additional monetary stimulus: Chart 8NZ Growth Has Slowed A Lot From The 2015/16 Boom   Growth: Real consumer spending has decelerated sharply from the 2015/16 boom years, with the annual growth falling from a peak of 6.1% in 2016 to 3.5% in Q4/2018 (Chart 8). A weaker housing market, fueled by slower inflows of new immigrants, has been an important factor underlying the softer pace of consumer spending. Capital spending by NZ companies has also slowed substantially from the robust 2015/16 pace, a consequence of weaker global demand (both from China and Australia, the most important export markets for NZ) and stagnant prices for important NZ commodities like dairy products. Importantly, the broad-based deceleration of NZ economic growth appears to have stabilized, although there is little sign of an imminent reacceleration in domestic demand. Labor Markets & Inflation: NZ’s labor market has been very strong. The unemployment rate of 4.3% sits well below both the RBNZ and OECD estimates of full employment. The labor force participation rate has climbed a full three percentage points since 2015 and is now stable around 71% (Chart 9). Job vacancies were up 7.2% on a year-over-year basis in Q4 2018, with full-time employment growth holding stable at 3.1% even as part-time employment growth has been contracting. This all suggests that the pool of available workers has become tight enough to allow part-time workers to find full-time work and wages to accelerate. Yet despite +3% wage growth persisting over the past year, both headline and core CPI inflation has remained stubbornly below 2% (the midpoint of the RBNZ 1-3% target band) since the end of 2014. Chart 9Tight NZ Labor Markets, But Where's The Inflation?   Against this backdrop of slowing growth but underwhelming inflation, the RBNZ would be justified in delivering a rate cut or two to provide a boost to the economy. The RBNZ’s latest set of economic forecasts are not overly pessimistic with real GDP expected to grow at a 3% pace in 2019 and 2020. Governor Orr has noted, however, that the weakness in consumer spending is the biggest downside threat to the central bank’s growth forecasts. More importantly, despite forecasting that the NZ labor market will remain tight (i.e. beyond full employment), and the output gap will remain above zero (i.e. no spare capacity), the central bank does not expect inflation to return to the 2% target until 2021. Pricing in inflation-linked NZ government bonds is even more pessimistic, with longer-term inflation breakevens now sitting below 1%. Adding to the dovish bias of the RBNZ is the revised mandate for the central bank from the NZ government. The RBNZ now has a dual mandate similar to the U.S. Federal Reserve, targeting both stable inflation and maximum sustainable employment. The central bank has also moved away from having the RBNZ Governor solely make decisions, with a new seven-person monetary policy committee now voting on policy changes.3 Governor Orr stated last week that the RBNZ’s new dovish bias introduced in March will be “the starting point” for deliberations by the enlarged monetary policy committee. Such a candid statement suggests that the committee’s first formal policy meeting on May 8 will be dedicated to discussing the need for a rate cut. Yet even if the RBNZ does ease in May, the markets are already priced for such an outcome. The NZ OIS curve discounts -32bps of cuts within the next six months, and -18bps of cuts in the next three months. So what does this all mean for our NZ spread trades? In Charts 10 & 11, we present a “fair value” regression model for the 5-year NZ-US and 5-year NZ-Germany bond spreads. The independent variables in the model are based on relative monetary policy, relative growth and relative inflation between NZ and the U.S. and Germany. The logic is that the bond spread should be a function of the differentials between policy interest rates, unemployment rates and inflation rates.   Chart 10Our NZ-US 5-Year Spread Model Chart 11Our NZ-Germany 5-Year Spread Model The model is indicating that the NZ-US spread is far too tight, although this is not unusual when looking at the very wide spreads between U.S. Treasury yields and bonds from other countries which are also historical extremes (i.e. Germany, Australia and the U.K.). As discussed earlier, the market pricing of NZ neutral real interest rates has converged substantially towards the lower levels seen in other developed countries. This suggests that the unusually narrow spreads reflect a structurally lower interest rate environment in NZ, which has historically been a country with some of the highest nominal rates and bond yields in the developed world. Adding it all up, we think that the conditions for a widening of NZ-US and NZ-German spreads is not yet in place. Thus, we are sticking with our recommended spread trades. Our model for the NZ-Germany spread also suggests that the spread is getting too tight, although it is still within the normal ranges (+/- 1 standard deviation) of fair value. So on the basis of valuation, the period of NZ bond outperformance looks stretched. In terms of what is discounted in NZ money markets, it is unlikely that the RBNZ will deliver on the -39bps of rate cuts currently discounted in the OIS curve over the next year without a sharper downleg in both growth and inflation (that also pushes up unemployment). Yet at the same time, the backdrop for global bond yields is shifting due to bottoming global growth that is likely to put more upward pressure on U.S. and German yields than NZ yields, which have already fallen substantially. Adding it all up, we think that the conditions for a widening of NZ-US and NZ-German spreads is not yet in place. Thus, we are sticking with our recommended spread trades. Given the overvaluation signals from our new fair value models, however, we do recommend setting a stop on these spread positions to protect profits. For the 5-year NZ-US spread, which is currently at -74bps, we are setting a fairly tight stop at -60bps given how overvalued that spread looks in our model. For 5-year NZ-Germany, which is currently at +207bps, we are setting a slightly wider stop at +230bps. Bottom Line: The RBNZ has signaled that the next move in policy rates is down in New Zealand, a move that would be justified by slowing domestic growth and below-target inflation. Stay long New Zealand 5-year government bonds versus equivalent maturity U.S. Treasuries and German debt, but set fairly tight stops to protect profits given how far spreads have already compressed.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Footnotes 1 Note that we are using the OECD set of leading economic indicators in this analysis. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “Pervasive Uncertainty, Persuasive Central Banks”, dated March 12th 2019, available at gfis.bcaresearch.com. 3 A lengthy but detailed Monetary Policy Handbook, highlighting the philosophy and new policy framework for the Reserve Bank of New Zealand, can be found here. https://www.rbnz.govt.nz/monetary-policy/about-monetary-policy/monetary-policy-handbook Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Feature This week, instead of our regular Weekly Report, we will answer clients’ most frequently asked questions (FAQs) from our recent marketing trip to the old continent. Table 1 lists these questions and below we will attempt to weave a cohesive piece and answer all of these interesting questions. Clients inquiring about “how is everyone else positioned” or the related “what is the general investor sentiment like” is by far the most FAQ we always get from the road and we purposefully omit it from Table 1. Table 1Most FAQs From The Road During our last three developed markets (DM) trips, while we cannot comment on the positioning question, with regard to general investor sentiment, Australia and New Zealand are off the charts bullish. On the opposite end of the spectrum, Europe is extremely bearish, especially continental Europe. The U.S. is somewhere in the middle. Chart 1Fed’s Pivot On Display With that out of the way, the recent broadening out of the U.S. yield curve inversion to the 10/fed funds rate took center stage in our client interactions, especially the implications of the inversion for sector positioning and the duration of the business cycle. To set the record straight, a yield curve inversion does not forecast recession. Instead, it explicitly signals that the market expects the Fed’s next move to be an interest rate cut (top panel, Chart 1). In that context, the yield curve has never had a false-positive reading. Even in May 1998, it accurately forecast that the Fed would decrease the fed funds rate as it actually did in the fallout of the LTCM meltdown later that year (bottom panel, Chart 1). As equity investors, what consumes us is the SPX’s performance following the yield curve inversion. On that front, mid-December last year we showed the results of our research and made a simple observation that the yield curve inversion almost always takes place prior to the S&P peak (Table 2, Charts 2 & 3). Table 2Yield Curve Inversions And S&P 500 Peaks Chart 3…And Then The SPX Peaks In addition, today we show the S&P 500’s return and the sector returns from the time the 10/2 yield curve slope inverts until the S&P peaks, and we summarize the results in Table 3. Table 3Sector Returns From Y/C Inversion To SPX Peak While every cycle is different, clearly it pays to have energy exposure more often than not. In contrast, high-yielding defensive sectors like utilities and telecom services fare poorly in these late-cycle iterations. Meanwhile, Table 4 highlights sector performance from the SPX peak until the U.S. recession hits. We first showed these results on May 22, 2018, and we are on track to publish a Special Report on May 5 on how to position portfolios at the onset of a Fed easing cycle, so stay tuned. Table 4Defensive Stocks Beat Late Investors remain infatuated with the recession signal that the yield curve inversion emits. Moreover, recent news of an onslaught of Unicorn IPOs that would bring stock supply to the equity market, near the $100bn mark on an annualized basis according to some estimates, have also brought forward recession fears, as smart money is cashing in on their investments. Chart 4 shows that $100bn per annum in IPOs has coincided with the SPX peak in the previous two cycles. Our long-held view remains that either a mega M&A deal in the tech or biotech space or Uber’s IPO at a stratospheric valuation could serve as the anecdote that confirms the current cycle’s peak. On the yield curve front specifically, the top panel of Chart 5 shows that the most important yield curve, the 10/2, has not yet inverted. Moreover, the 30/10 and the 30/5 slopes are steepening. True, we are late cycle, but we need all the slopes to invert to get a confirmation that the recession is a foregone conclusion. Chart 4Mind The Excess Supply Chart 510/2 Y/C Has Yet To Invert The Fed’s tightening cycle has not only inverted most parts of the yield curve starting early last December, but has inflicted some damage on profit margins. Following up from our recent profit margin work highlighting nil corporate pricing power at a time when wage costs are perking up, BCA’s Monetary Indicator signals more SPX margin pain in the coming months (Chart 6). In fact, sell-side estimates call for another three consecutive quarters of a year-over-year contraction in profit margins. Chart 6Margin Trouble In more detail, the earnings deceleration that commenced in Q4 2018 and is gaining steam is disconcerting. As a reminder, Q4 included the lower corporate tax rate and the Q/Q deceleration is not solely due to the tech sector profit warnings. Eight out of the 11 GICS1 sectors sharply decelerated, two modestly accelerated and only industrials steeply accelerated to a cyclical EPS peak growth rate (Table 5). This EPS breadth deterioration is eerily reminiscent of early-2015 (Chart 7) and is disquieting. Short-term caution is also warranted given the increase in investor complacency. The one sided positioning in the VIX futures market is worrisome. As a reminder, net speculative positions are now at a lower low than the February 2018 level when the VIX snapped to over 50 and caused a massive tremor in the equity market (net speculative positions shown inverted, Chart 8). Table 5Historical/Current/Future Earnings Growth Rates Chart 7Bad Breadth Chart 8Too Complacent But, before getting overly bearish there are some growth green shoots that suggest that Q2-to-Q3 will likely mark the trough in EPS/EBITDA growth and margins (Chart 9). Beyond these positive leading profit indicators, a resolution to the U.S./China trade tussle and China’s trifecta of policy easing measures will also aid in turning profit growth around and really power up U.S. cyclicals’ EPS growth rates. Following up from the January Fed meeting, on February 4 we penned a report titled “Don’t Fight The PBoC” and it is now clear with the recent manufacturing PMI release that China’s easing on all three fronts – credit (Chart 10), monetary (Chart 11) and fiscal (Chart 12) – is starting to pay some dividends. In that light, the U.S. cyclicals vs. U.S. defensives recent outperformance has more room to run. Chart 9Growth Green Shoots Chart 10Chineasing… Chart 11...On All… Chart 12…Fronts   Deep cyclicals have another major advantage this cycle compared with defensives. While at this stage of the business cycle one would expect capital intensive businesses to become debt saddled, cyclicals are still de-levering from the depths of the late-2015/early-2016 manufacturing recession, i.e. paying down debt and increasing cash flow. Defensives, however, are doing the exact opposite with relative cash flow growth problems and piling on debt. Thus, on a relative basis Chart 13 shows that the indebtedness profile clearly favors deep cyclicals vs. defensives. From a bigger picture perspective, while the U.S. has not really purged any debt and it has just shifted it around from the financial and household sectors to the non-financial business and government sectors (Chart 14), the near all-time high in non-financial business sector credit as a share of GDP is disconcerting (top panel, Chart 14). Clearly the excesses are in this segment of U.S. debt and it is unsurprising that debt saddled stocks have been underperforming equities with pristine balance sheets since the 2016 presidential elections (top panel, Chart 15). Such outperformance has staying power, especially given that we are late in the cycle and the Fed has raised interest rates to the point where parts of the yield curve are inverted and a default cycle looms large (bottom panel, Chart 15). Chart 13Cyclicals Have The Upper Hand Chart 14U.S. Debt Profile Breakdown One sub-sector that epitomizes the current cycle’s excesses is commercial real estate (CRE). CRE prices have overshot the historical time trend by almost two standard deviations and it has already been three and a half years since they surpassed the previous all-time high (Chart 16). The recent pullback in the 10-year Treasury yield has pushed cap rates even lower and the bubble in CRE is further inflated. Looking back at the late-1980s pricking of that CRE bubble is instructive and when this cycle ends a big deflationary impulse will likely deal a blow to the CRE market.       Chart 15Hide In Pristine Balance Sheets Chart 16CRE Excesses Are A Yellow Flag Speaking of bubbles, the biggest bubble we currently see is not in equities, but in bonds. Table 6 shows that red is taking over and is reminiscent of mid-year 2016 when the 10-year U.S. Treasury yield troughed a hair above 1.3%. Globally, negative yielding debt is near all-time highs (Chart 17) and the excesses are even larger in the EM sovereign space and in select DM corporates. Mexico raising century debt in U.S. dollars, in cable and in euros is perplexing, as Mexico was at the epicenter of the 1982 LatAm crisis and again in 1994 with the Tequila crisis. Argentina also raising century debt recently in hard currency speaks to the magnitude of the current bond bubble. On the corporate side, Sanofi and LVMH placing negative yielding debt is beyond our understanding, or Total issuing a perpetual bond with a 1.75% coupon. Table 6Red Takes Over   Chart 17Bonds Are In A Bubble All of this is likely linked to the unintended consequences of global QE where fixed income investors are pushed out the risk spectrum and are forced into buying riskier credit. When this bond bubble gets pricked it will end in tears as it always does and the catalyst will likely be the next U.S. recession that will cause a global recession. While our cyclical 9-to-12 month equity market view is constructive and we believe the U.S. will avoid recession, our structural 1-to-3 year view is negative. Nevertheless, we constantly challenge our thesis and the biggest pushback to the negative structural view is the following: What if the Fed can engineer a soft landing in the U.S. as it did twice in the mid-1990s, and the business cycle runs hot for another 5 years (Chart 18)? What if the starting point of low interest rates with the real fed funds rates still close to zero is very stimulative for the U.S. economy as no recession has ever started with a fed funds rate perched near zero (Chart 19)? Finally, what if the late-2015/early-2016 manufacturing recession was actually an economic recession despite the fact that the NBER did not designate it as such and the business cycle got reignited, especially with President Trump’s election that lifted animal spirits? As a reminder, while S&P profits have contracted outside of an economic recession twice before, SPX sales had never achieved that feat, until late-2015/early-2016 (Chart 20). In other words, the revenue recession we had was unprecedented and felt like an economic recession. Chart 18The Fed Has Engineered A Soft Landing Chart 19Stimulative Real Rates Chart 20There Is Always A First Time If that were the case and the cycle were to extend into the 2020s, then the risk is that SPX EPS vault to $200 and valuations overshoot, i.e. the forward P/E multiple spikes to a 20 handle and the SPX catapults to 4,000. In that case, we would leave 1,000 points on the table and our SPX 3,000 view would be way offside. While this is a risk to our negative structural view, there are two sectors we really like for the long-term as we deem them secular growth plays and should do exceptionally well on a 10-year horizon: software and defense stocks. Three key drivers underpin our bullish view on software: galloping higher private and public sector software outlays, a structurally enticing software demand backdrop and ongoing industry M&A (Chart 21). Most importantly, the move to cloud computing and SaaS, the proliferation of AI, machine learning and augmented reality are not fads but enjoy a secular growth profile, and signal that capital outlays on software are in a structural uptrend. With regard to defense stocks, the three key pillars we highlighted in our “Brothers In Arms” Special Report on October 31, 2016 remain intact: the global rearmament is still gaining steam, a space race with manned missions to the moon now includes the U.S., China and India, and cybersecurity is a real threat for governments around the world (Chart 22). On all three fronts, defense stocks stand to benefit as they have beefed up their offerings to provide governments with a one-stop shop solution covering most of these needs. Chart 21Buy The Software Breakout Chart 22Defense Stocks Remain A Long-term Buy     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com

Highlights We remain constructive on the U.S. economy, …: It was another uneven week, but conditions remain broadly favorable for the U.S., and the expansion is intact. … and things seem to be perking up in the rest of the world, in line with BCA’s house view, …: China’s PMI data gave global markets a boost and European PMIs hinted at the potential for green shoots on the continent. … but money managers get paid to worry for their clients, and we get paid to worry for the managers, …: We would be remiss if we didn’t explore alternative scenarios, especially around an unobservable variable like the equilibrium fed funds rate. … so we’re always looking for the ways that we could be getting it wrong: This week’s report explores how the landscape would look from the perspective of consumption, investment, and government spending if a recession were at hand. Feature Chart 1Selloff, What Selloff?   Last week’s data were mixed, but there is no doubt, as we’ve acknowledged throughout 2019, that the U.S. economy is decelerating. The deceleration has fanned recession fears, and the yield curve’s fleeting inversion two weeks ago added fuel to the fire.1 The sell-off in financial markets in the fourth quarter seemed largely to have been animated by concerns that the Fed was pushing the fed funds rate into restrictive territory. The sharp decline in equities, and the sharp rise in corporate bond yields, amounted to a material tightening in financial conditions that threatened to become a self-fulfilling prophecy. What a difference a quarter makes. The potent first-quarter rally has reversed much of the fourth quarter’s tightening of financial conditions (Chart 1), while the FOMC’s March meeting indicated that the Fed has pivoted from defending against inflation overshoots to trying to correct its extended post-crisis undershoot. The threat that the Fed would follow the typical path of tightening into a recession has now receded, at least for the rest of 2019. As long as inflation doesn’t suddenly flare up, the expansion should remain intact, provided that the Fed hasn’t already lifted short rates into restrictive territory. We have contended that it hasn’t, as the fed funds rate is comfortably below our current estimate of the equilibrium rate, and is even further below our year-end equilibrium projection. We are well aware that the equilibrium rate cannot be directly observed, and that our estimate may be off the mark. We therefore devote this week’s report to considering what the building blocks of GDP might look like if a recession were about to begin. We particularly focus on consumption, which accounts for the lion’s share of U.S. activity, and indirectly affects both investment and government spending.2 Is Consumption On A Recession Path? Retail sales contracted month-over-month in February, though upward revisions to the January data made the release something of a wash. Year to date, though, retail sales growth has not been strong enough to erase the disappointment from December’s lousy print. From a longer-term perspective, real retail sales don’t suggest anything definitive about the business cycle: although they’re in a mini downtrend, previous pre-recession slides have been steeper and/or longer (Chart 2, top panel). Growth in real personal consumption expenditures (PCE), the consumption input to GDP, has been trendless for the last three years, but is not in the extended slide that preceded other recessions, nor has it yet become stretched in this cycle (Chart 2, bottom panel). Chart 2Neither Here Nor There   Chart 3Steady As She Goes We find that consumption fundamentals are sending a clearer message than the retail sales or PCE series themselves. We segment the fundamentals into three components: ongoing demand for workers, the prospects for wage increases, and households’ capacity to borrow to support spending. The labor market is currently quite strong and net payroll growth has been remarkably steady for the last four years (Chart 3). Our payrolls model, which incorporates initial unemployment claims, temporary workers and NFIB small business hiring plans, projects no more than modest slowing (Chart 4). Chart 4No More Than Mild Deceleration Ahead     Prices rise when demand outpaces supply, and the excess of job openings over unemployed workers (Chart 5) bodes well for wage growth. The elevated rate of employees quitting their jobs is also a positive sign (Chart 6). A worker doesn’t quit one job unless s/he has a higher-paying one lined up. We therefore read the elevated quits rate as an indication that the competition to attract employees is fierce, and that workers have regained some measure of bargaining power. Chart 5More Jobs Than Candidates ... Chart 6... Makes For A Johnny Paycheck Labor Market ...   The combination of rising household income and a light debt-servicing burden augurs well for consumption. A negative unemployment gap (an unemployment rate below the estimated natural rate of unemployment) also tends to be good for compensation growth. Over the last 30 years, annualized average hourly earnings (AHE) have grown one-and-a-half times faster when the unemployment gap is negative than when it is positive, and the earnings growth rates have been remarkably consistent (Chart 7). Household income will have a solid tailwind behind it if AHE gains can catch up to the nearly 4% level consistent with negative gaps in the late ‘80s, late ‘90s and mid-aughts. Chart 7... Where Employers Have To Keep Employees Happy Employment and wage gains suggest that rising household incomes will support spending, but the support would be undermined if households chose to use the income gains to pay down debt. Households have been shoring up their balance sheets ever since the crisis, more than tripling the savings rate from its summer 2005 low (Chart 8, top panel), and have now unwound nearly all of the debt (as a share of GDP) they took on in the ’01-’07 expansion (Chart 8, second panel). They may not yet be done, but the pace at which they’ve been deleveraging has slowed considerably over the last few years. With today’s still-low interest rates, servicing households’ debt burden is easier than it has been at any time in the last 40 years (Chart 8, bottom panel). Households are positioned to take on more debt if they so choose. Chart 8Low Rates Make For A Light Burden Bottom Line: Prospects for continued payroll expansion and wage gains are good, and households have the capacity to borrow to augment spending. We therefore expect that consumption is not on a recessionary path. The fundamentals underlying the U.S. economy’s largest pillar are solid. Could Investment Tip The Economy Into A Recession? Consumption is clearly the 800-pound gorilla of the U.S. economy. It accounted for close to 70% of GDP in the fourth quarter, and when it sneezes, the overall economy catches a cold. It has been a relatively stable series over time, however, and its infrequent contractions tend to be pretty modest. The story is quite different for private domestic investment, which routinely makes wild swings, and tends to seize up during recessions (Chart 9). Even though investment and government spending each account for just a quarter of consumption’s weight, it’s statistically easiest for investment to negate 2% growth in the rest of the economy (Table 1). Chart 9Consumption May Be Larger, But Investment Punches Harder Table 1The Road To Recession We have previously demonstrated that consumption leads capex. It turns out that fixed investment is the opposite of the if-you-build-it-they-will-come “Field of Dreams” mantra; corporations will only build if the customers have already come (Chart 10). Consumption is gently slowing right now, which suggests that corporate investment is not about to boom. To induce a recession, though, fixed private investment would have to crater, and nothing in consumption’s current trend, the employment outlook, the compensation outlook, or households’ borrowing capacity suggests that consumption is at risk of plunging. Chart 10Consumption Drives Capex Surveys asking corporations about their investment plans have been decent coincident indicators of corporate fixed investment. The dip in capital spending plans from the NFIB survey suggests that demand for non-defense capital goods is headed lower (Chart 11, top panel), as does the decline in capex plans in the regional Fed surveys (Chart 11, bottom panel). Neither implies the sharp decline that would be required to offset trend growth in the rest of the economy, however. The corporate tax cut does not appear to have inflated 2018 capex, so 2019 investment should not be at risk of suddenly unwinding. Chart 11Capex May Soften, But It's Not About To Melt Residential investment accounts for around a fifth of private domestic investment. We have written about housing at length over the last several months and will not rehash the discussion here, other than to note that permits and starts remain in a broad uptrend (Chart 12, top panel), as do new and existing home sales (Chart 12, middle panel). Affordability has revived with the decline in mortgage rates, and is once again above its pre-crisis peaks. The inventory of homes for sale is also at multi-year lows (Chart 12, bottom panel). With the Fed sidelined for an extended period, housing demand appears as if it will hold up, and there’s nothing to worry about from a supply perspective. Chart 12The Housing Market Is Fine Bottom Line: The investment component of GDP does not appear as if it is about to contract in a significant way. It is unlikely to be the source of a cyclical inflection. Government Spending By virtue of its modest size and muted volatility relative to consumption and investment, government spending is the least likely component of GDP to extinguish the expansion. The prospects for a negative-two-standard-deviation event that could trigger a recession look especially slim. With employment and household incomes rising, and home values still appreciating, state and local tax receipts should be well supported. Pro-cyclical federal fiscal policy is an anomaly (Chart 13), but we see no signs that the current administration will reverse course with a presidential election on the horizon. Although defense has accounted for a shrinking share of federal spending ever since the end of the Cold War, it still accounts for 60% of federal spending (Chart 14, bottom panel), and a quarter of aggregate government spending. Consistent with CBO projections, we expect defense spending will continue to expand through 2020, as it remains a Republican priority. Federal entitlements were a sacred cow in the 2016 Trump campaign and will remain so in the 2020 campaign, given their importance to the administration’s aging rural base. Chart 13Fiscal Policy Has Turned Pro-Cyclical   State and local spending account for the majority of aggregate government spending (Chart 14, top panel). Healthcare and education are the biggest line items in state budgets, and healthcare reforms have the potential to alter budget composition, but aggregate spending moves in lockstep with aggregate revenues, as many states are constitutionally mandated to maintain balanced budgets. The main sources of state revenues are income taxes and sales taxes. Municipalities rely heavily on property taxes. Chart 14State Spending Matters ... State income tax receipts are clearly a function of employment, though the link has come and gone this cycle as the expansion has matured (Chart 15, top panel). Sales tax receipts move with employment as well, because consumption is tied to income (Chart 15, second panel). Property taxes are a function of appraised property values, for which home prices are a solid proxy (Chart 15, third panel). If demand for labor remains robust, wages face upward pressure, and home prices don’t contract, state and local government spending is unlikely to dry up anytime soon. Chart 15... And It's Tied To Income, Consumption, And Property Prices   As long as the expansion remains intact (and valuations don’t get silly), risk-friendly positioning remains appropriate. Bottom Line: Nothing points to a sudden decline in government expenditures on the order of the negative-two-standard-deviation move which would be required to induce a recession. Weakness in employment and wage growth would hurt state tax revenues, reinforcing a slowdown in consumption, but that is not our base-case scenario for 2019. Investment Implications Investors should stay the course and remain overweight equities, given that a recession is not imminent. Although we think the Fed’s largesse will ultimately be reversed in potentially heavy-handed fashion, its implicit pledge to remain on the sidelines into the second half of this year extends the runway for risk asset outperformance. We are not in love with the S&P 500 at current levels, and will be surprised if it continues to appreciate at its current pace, but the policy climate – monetary and fiscal – is conducive to outperforming cash and high-quality fixed income. We would hold some capital in reserve to deploy in the event of a pullback, but continue to advocate a risk-friendly portfolio tilt.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Jennifer Lacombe Senior Analyst, Global ETF Strategy jenniferl@bcaresearch.com Footnotes 1 With the yield curve clawing its way back to positive territory by March 29’s close, it actually has yet to invert on a monthly basis. We have heard its downbeat growth message loud and clear, however, and are on alert for further potential weakness. 2 We leave net exports out of our analysis, as they’re not consequential to the comparatively closed U.S. economy.