Fixed Income

Highlights We expect tensions from the Sino-US trade war to marginally ease in 2020, in the run-up to the US presidential election. The “Phase One” trade deal will likely be signed with a good possibility of some tariff rollbacks. Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the domestic economy and exports to only modestly accelerate. During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks, while keeping in mind that relative outperformance, particularly for A-shares, could be frontloaded in the first half of the year. Despite sharply rising amount of defaults, Chinese onshore bonds are priced at a much higher premium than warranted by their default risk. We continue to favor Chinese onshore corporate bonds in both absolute terms and in relative to duration-matched government bonds. Feature BCA Research recently published its special year end Outlook report for 2020, which described the macro themes that are likely to drive global financial markets over the coming year. In this week’s China Investment Strategy report we elaborate on the Outlook, by reviewing our four key themes for China in the year ahead. Key Theme #1: Tension From The Trade War With The US Will Ease In 2020 Despite the harsh rhetoric and threats of retaliation from both the US and China, we expect that the real risks to the global economy from the Sino-US trade war will decline in 2020. In trade negotiations next year, both President Trump and President Xi will need to adjust to their respective constraints. Both President Trump and President Xi will need to adjust to their respective constraints next year. Trump must sustain a strong domestic economy to increase his re-election odds. He will cater to the US economy and financial markets, by trying to de-escalate trade tensions and keeping negotiations going with China. This means he is likely to hold off on tariffs on China, and quite possibly even agree to roll back tariffs to August 2019 or April 2019 levels (Chart 1). Chart 1Some Tariff Rollback Is Possible Some Tariff Rollback Is Possible Some Tariff Rollback Is Possible President Xi also faces economic constraints as the Chinese economy is on an unsure footing.  The buildup in leverage in the non-financial sector over the past decade has prevented Chinese policymakers from aggressively stimulating the economy by relying on the old debt-oriented policies. Chinese policymakers are concerned about employment stability.1 The private sector, which accounts for 80% of all job creation in China, has been disproportionally hit by the trade war and tariffs compared to the more domestically oriented state-owned enterprises. These economic constraints suggest that it is in China’s best interest to avoid any further friction with the US. Therefore, the “Phase One” trade deal will likely be signed, with a good possibility of some tariff rollbacks. Trade talks will continue in the run-up to the US presidential election, and any escalation will probably occur in non-trade, non-tariff areas. This means that policy uncertainty surrounding the Sino-US trade war will decline in 2020. Bottom Line: We expect tensions from the Sino-US trade war to marginally ease in 2020. However, the risk to this base case view is high and geopolitical uncertainty remains elevated, as suggested by our Geopolitical Strategy team.2 Trade war tensions could re-emerge, which potentially could end the global business cycle and equity bull market. Key Theme #2: Stimulus Versus Shock: Approaching An Inflection Point We presented some simple “arithmetic” in May showing that in order for investors to be bullish on Chinese stocks, the impact of China’s reflationary efforts needed to more than offset the negative shock to the economy from tariffs.3 In other words, a bullish Chinese equity scenario required Stimulus – Shock > 0. In terms of China’s real economy, 2019 essentially panned out to be a Stimulus – Shock =0 scenario, with a “half strength” reflationary response (measured by its credit impulse) barely offsetting the trade shock to the economy (Chart 2). So far on an aggregate level, the shock from tariffs on China’s economy has had a limited direct impact.  This is because exports to the US account for only 3.6% of China’s aggregate economy, whereas domestic capex accounts for more than 40% (Chart 3). Our calculation suggests a 10% annualized decline in export growth to the US would shave off 0.4 percentage points from China’s nominal GDP growth. Chart 2This Year, Measured Stimulus Has Just Offset Shocks To The Economy This Year, Measured Stimulus Has Just Offset Shocks To The Economy This Year, Measured Stimulus Has Just Offset Shocks To The Economy Chart 3Domestic Demand Much More Important Than Exports To The US Domestic Demand Much More Important Than Exports To The US Domestic Demand Much More Important Than Exports To The US Additionally, evidence suggests that a large portion of China’s exports to the US has been rerouted through peripheral countries, such as Taiwan and Vietnam (Chart 4). This fact explains why China’s exports have been in-line with the trend of global trade this year (Chart 5). Chart 4Chinese Exports Finding Alternative Routes To The US... Chinese Exports Finding Alternative Routes To The US... Chinese Exports Finding Alternative Routes To The US... Chart 5...And Total Exports Have Been Holding Up ...And Total Exports Have Been Holding Up ...And Total Exports Have Been Holding Up Chart 6China's Economic Slowdown Predates The Trade War China's Economic Slowdown Predates The Trade War China's Economic Slowdown Predates The Trade War It is important for investors to remember that China’s current economic slowdown predates the trade war and is due to its domestic financial deleveraging campaign that began in early 2017. The trade war exacerbated an existing downward trend in the economy, but was not the cause of it (Chart 6).  In 2020, while we expect a ceasefire in the trade war and a potential rollback of tariffs would ease the shock to China’s economy, we also believe that more pro-growth policy support is underway.4 From an investment perspective, this means both China’s economic conditions and corporate earnings will improve, supporting a bullish cyclical outlook for China-related assets. Still, several reasons point to the overall scale of stimulus being less than that of 2015-16, and the upside to China’s export growth will likely be limited given elevated geopolitical uncertainties. Therefore, it is unrealistic to expect a material acceleration in Chinese economic growth in 2020: China is still falling short of its target to double urban income by 2020. Chart 7A 6% Growth Next Year May Just Make The Cut A 6% Growth Next Year May Just Make The Cut A 6% Growth Next Year May Just Make The Cut Next year will mark the final year for Chinese policymakers to accomplish the goal of “Doubling GDP by 2020”. Without the recent upward revision to the level of its 2018 nominal GDP by 2.1%, China's economy would have to expand by at least 6.1% in 2020 to achieve the goal. The upward revision allows a lower economic growth rate in 2020 to reach the goal (Chart 7). China is still falling short of its target to double urban income by 2020 (Chart 8). While keeping economic growth and employment stable remains a top priority, the recent slight improvement in employment should provide some relief to Chinese policymakers (Chart 9). Chart 8China Is Falling Short Of Urban Income Target... China Is Falling Short Of Urban Income Target... China Is Falling Short Of Urban Income Target... Chart 9...But There Is Some Relief In The Labor Market ...But There Is Some Relief In The Labor Market ...But There Is Some Relief In The Labor Market     Monetary policy will remain accommodative, with room for further cuts to interest rates and the reserve requirement ratio (RRR). Nonetheless, we think Chinese policymakers will only allow monetary policy to loosen incrementally and modestly, while keeping a lid on corporate leverage. According to a recent article published by Yi Gang, the governor of China’s central bank, the PBoC will be keen to avoid another boom-bust cycle.5  Fiscal stimulus will continue to take the center stage in supporting growth in 2020, as noted in our November 20th China Investment Strategy Weekly.6  We expect that the National People’s Congress in March 2020 will approve higher quotas on issuing local government bonds, and loosened capital requirements will likely further boost local governments’ infrastructure project funding and expenditures. Transportation and urban development infrastructure projects will likely to continue receiving the most policy support in 2020. Other areas such as environmental protection, education, and social security will continue to be the Chinese government’s focus. These areas are unlikely to translate into immediate economic growth, but will improve China’s long-term economic and social structures. In contrast, compared to the 2015-2016 cycle, housing construction will receive less fiscal support (Chart 10). Overall, we expect the Chinese government to set next year’s real GDP growth target between 5.5 - 6.0%, a half of a percentage point lower than the growth target for 2019. Despite slower real output growth, nominal GDP and economic conditions will bottom in the first quarter of 2020, subsequently pushing up core inflation and reversing an ongoing deflation in the industrial sector (Chart 11). Chart 10Transportation And Urban Development Projects Are Again In Favor 2020 Key Views: Four Themes For China In The Coming Year 2020 Key Views: Four Themes For China In The Coming Year Chart 11Nominal Output Will Tick Up Soon Nominal Output Will Tick Up Soon Nominal Output Will Tick Up Soon   Bottom Line: Chinese policymakers will roll out more stimulus to secure an economic recovery in 2020, and external demand will improve. But we expect growth in both the economy and export to only modestly accelerate. Key Theme #3: Improved Earnings Outlook Supports A Cyclically Bullish View On Chinese Stocks A combination of further policy support, improved earnings and decreased trade tensions should provide tailwinds to Chinese stocks in 2020. Chinese stocks will outperform the global benchmark over a cyclical time horizon (6- to 12-months), for the following reasons:   Valuations are depressed relative to global averages: the forward P/E ratios of both China’s onshore A-shares and offshore investable stocks are well below the global benchmark (Chart 12).  While the forward P/E ratio of the A-share index is hovering around 12 times, the investable market has particularly suffered a setback from uncertainties surrounding the trade war. Even taking into account that structural weakness in the Chinese corporate earnings growth justifies for a lower multiple than the global average, both Chinese onshore and offshore stocks are offering even deeper discounts than their peaks in 2018, compared to global benchmarks. Chart 12Valuations Of Chinese Stocks Are Depressed Valuations Of Chinese Stocks Are Depressed Valuations Of Chinese Stocks Are Depressed Chart 13Chinese Corporate Earnings Closely Track Economic Conditions Chinese Corporate Earnings Closely Track Economic Conditions Chinese Corporate Earnings Closely Track Economic Conditions Both the economy and earnings growth will improve: We expect the Chinese economy to bottom in the first quarter of 2020. Given the close correlation between the coincident economic activity and earnings cycle, we expect earnings to also improve in 2020 (Chart 13).  Improved corporate earnings next year will be the catalyst for the currently cheap multiples in Chinese stocks to re-rate, and re-approach their early 2018 high. Our Earnings Recession Probability Model shows that the probability of an upcoming earnings recession has dropped to 35% from its peak of 85% in early 2019 (Chart 14).  Additionally, Chart 15 highlights that the 12-month forward EPS momentum has turned modestly positive. Chart 14Probability Of An Upcoming Earnings Recession Has Significantly Dropped Probability Of An Upcoming Earnings Recession Has Significantly Dropped Probability Of An Upcoming Earnings Recession Has Significantly Dropped Chart 1512-Month Forward EPS Momentum Has Turned Modestly Positive 12-Month Forward EPS Momentum Has Turned Modestly Positive 12-Month Forward EPS Momentum Has Turned Modestly Positive There are, however, a few caveats to our bullish cyclical view on Chinese stocks. First, while it is not our base case view, geopolitical risks, particularly the Sino-US trade war, could end the global business cycle and equity bull market in 2020. Within the context of falling global stocks, we think Chinese domestic A shares would passively outperform global benchmarks, as A shares are mostly driven by China’s domestic credit and economic growth, and are less sensitive to trade frictions. But investable stocks would clearly underperform in this scenario. The odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. Secondly, the odds are decent that all of the outperformance of Chinese stocks in 2020 will be frontloaded in the first half of the year. We expect credit growth, infrastructure spending and the economy to improve in the first quarter. If the “Phase One” trade deal is also signed during that period, onshore A shares and investable stocks will significantly outperform their global counterparts in the first and possibly the early part of the second quarter. However, in the second half of next year, if the Chinese economy stabilizes but stimulus does not ramp up further, then the upside potential in both bourses may be capped as investors will question whether Chinese stocks will continue to gain ground in relative terms. We will closely monitor Chinese credit growth and trade negotiations throughout 2020 to determine if there is more eventual upside potential to economic growth, and thus Chinese earnings prospects, than we currently believe.  While we recommend a cyclically bullish stance towards Chinese stocks for next year, our tactical (i.e. 0-3 month) stance remains neutral. We expect to align our tactical and cyclical stances soon, and are awaiting confirmation of a hard data improvement alongside a breakout of key technical conditions to do so.7 Bottom Line: During the next 6 to 12 months, investors should remain bullish on both Chinese A shares and investable stocks within a global equity portfolio. However, investors should also keep in mind that the relative outperformance, particularly for the A-share market, could be frontloaded in the first half of 2020. Key Theme #4: We Continue To Favor Chinese Onshore Bonds, Despite Default Concerns  Chart 16Global Investors Are Piling Into The Chinese Bond Market Global Investors Are Piling Into The Chinese Bond Market Global Investors Are Piling Into The Chinese Bond Market Despite sharply rising defaults, Chinese onshore bonds are still priced at a much higher premium than warranted by their default risk. This view is increasingly shared by global investors, as evident in the capital flows into China’s onshore bond market (Chart 16). While the total amount of bond defaults in the first eleven months of 2019 was an astonishing 120.4 billion yuan, they account for only half percent of China’s total onshore bonds issued.  A 0.5 percent default rate is in line with global ex-US, and 160 bps below the default rate in the US (Chart 17). Yet, Chinese corporate bond spreads are about 150-175 bps higher than their US counterparts, an overpriced risk premium in our view (Chart 18). Recently, despite mounting defaults, China’s corporate bond spreads have continued to narrow. This suggests that investors do not expect the record-high level of defaults in the past two years to damage China’s corporate sector in the near future. Moreover, China’s monetary policy remains ultra-loose, liquidity conditions have been largely stable, RMB devaluation and capital outflows have both been under control, and the Chinese economy is expected to bottom in the next quarter. Chart 17Chinese Default Rate Well Below Global Average Chinese Default Rate Well Below Global Average Chinese Default Rate Well Below Global Average Chart 18The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone The Risk Premium Assigned To Chinese Corporate Bonds Seems Overdone Bottom Line: We continue to favor Chinese onshore corporate bonds in both absolute terms, and in relative to duration-matched government bonds.   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1    “China to take multi-pronged measures to keep employment stable,” State Council Executive Meeting, December 4, 2019. 2   Please see Geopolitical Strategy Special Report "2020 Key Views: The Anarchic Society," dated December 6, 2019, available at gps.bcaresearch.com 3   Please see China Investment Strategy Weekly Report "Simple Arithmetic," dated May 15, 2019, available at cis.bcaresearch.com. 4, 6, 7   Please see China Investment Strategy Weekly Report "Questions From The Road: Timing The Turn," dated November 20, 2019, available at cis.bcaresearch.com. 5   https://www.chainnews.com/articles/745634370915.htm Cyclical Investment Stance Equity Sector Recommendations

Highlights Global growth will rebound in 2020, led by the US and China, putting upward pressure on global bond yields. Maintain below-benchmark overall duration exposure. Central banks will stay dovish until policy reflation has clearly turned into inflation, limiting how high bond yields can climb in 2020 but sowing the seeds for a far more bond-bearish backdrop in 2021. Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. Accommodative monetary policy and faster growth will delay the peak in the aging global credit cycle. Stay overweight global corporate debt versus sovereign bonds. Returns on global fixed income will be far lower in 2020 than in 2019, given rich valuation starting points. Country and sector selection will be more important in driving fixed income outperformance. For sovereign bonds, favor countries where yields are less sensitive to change in overall global yields; for credit, favor sectors with lower interest rate durations and lower spread volatility. Feature BCA Research’s Outlook 2020 report, outlining the main investment themes for next year from the collective mind of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2020. In a follow-up report to be published in the first week of the new year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2020 Outlook Chart 1Expect A Cyclical Rise In Global Yields In 2020 Expect A Cyclical Rise In Global Yields In 2020 Expect A Cyclical Rise In Global Yields In 2020 The main conclusions from the Outlook 2020 report were cyclically bullish looking out over the next twelve months, but more cautious beyond that. The downturn in global growth seen in 2019 is projected to end in response to several headwinds that have become tailwinds: a small wave of Chinese stimulus and reflation; more stimulative global monetary policies; the substantial easing of global financial conditions as risk assets have rallied worldwide; a fading drag on global manufacturing from inventory destocking; both China (weak growth) and the US (the 2020 US election) have good reasons to de-escalate the trade war in 2020. This backdrop should push global bond yields moderately higher in 2020, while maintaining a backdrop that is once again favorable for risk assets on a relative basis versus government debt (Chart 1). A critical element to this story is the supportive monetary policy backdrop. Central banks worldwide, led by interest rate cuts from the US Federal Reserve and a resumption of asset purchases from the European Central Bank (ECB), are now running more stimulative policies in response to this year’s global manufacturing slump and elevated level of political uncertainty. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy. A repeat of the spectacular total return numbers seen across the majority of asset classes in 2019 is unlikely, but global equity and credit markets should solidly outperform government bonds. Yet all that monetary stimulus does not come without a price. Policymakers will maintain accommodative monetary policy through 2020 to try and bring depressed inflation expectations back up to central bank targets. This will create a “sweet spot” for global risk assets, with improving economic growth and accommodative monetary policy.  A revival of inflationary pressures in 2021 will force central banks to raise rates much more aggressively. Combined with a China that remains wary of promoting excess leverage, this will drive the current prolonged global business cycle expansion to its recessionary endgame, taking equity and credit markets down with it. This will eventually trigger a new decline in global bond yields as policymakers shift back to easing mode, but from much higher levels than today. Our Four Main Key Views For Global Fixed Income Markets In 2020 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall duration exposure. The pickup in global growth that we expect in 2020 has its roots in two locations: China and the US. For China, policymakers are keenly aware that the current growth slowdown cannot continue, as it has already pushed nominal GDP growth below 8% (Chart 2). For an economy as highly leveraged as China, slowing nominal growth is lethal and must be avoided to prevent a surge in private sector defaults and rising unemployment. Already, China has delivered significant policy stimulus in 2019: the reserve requirement ratio has been cut by 400bps; taxes have been cut by 2.8% of GDP; capital spending at state-owned enterprises has increased; the currency has depreciated; and, more recently, monetary policy has been eased via traditional interest rate cuts. These measures have eased our index of Chinese monetary conditions and triggered a surge in the China credit impulse, which leads Chinese import growth (i.e. China’s most direct impact on the global economy) by nine months. There are signs that Chinese growth is already bottoming out, as evidenced by the recent pickup in the China manufacturing PMI. Expect more signs of improvement in the first half of 2020. The BCA global leading economic indicator (LEI) has been rising since January of this year, and the global LEI diffusion index is signaling that the upturn will continue in 2020 (Chart 3). With global financial conditions at highly stimulative levels thanks to the robust performance of risk assets in 2019, the backdrop is already conducive to faster global growth. BCA’s geopolitical strategists are of the view that a “détente” in the US-China trade war is still the most likely base case scenario, which would go a long way in reducing the growth-inhibiting effects of elevated uncertainty (bottom panel). Chart 2A Boost To Global Growth From China In 2020 A Boost To Global Growth From China In 2020 A Boost To Global Growth From China In 2020 Chart 3Lower Uncertainty + Easy Financial Conditions = Faster Growth Lower Uncertainty + Easy Financial Conditions = Faster Growth Lower Uncertainty + Easy Financial Conditions = Faster Growth As for the US, the lagged impact of the Fed’s 75bps of rate cuts this year has boosted domestic liquidity conditions in a pro-growth fashion. The BCA US Financial Liquidity Indicator, which leads not only US growth but also leads the BCA global LEI and commodity prices by 18 months, is already signaling that US economic momentum is set to bottom out in early 2020 (Chart 4). This signal is in addition to the leading properties of US financial conditions (middle panel), which suggests a reacceleration of real GDP growth back above trend is about to unfold. Chinese policy reflation has typically been a good leading indicator for US capex and is heralding a rebound in investment spending (bottom panel). The pickup in global growth would also help revive the dormant euro zone economy, which has been hit hard though plunging export demand and overall weakness in the manufacturing sector. The entire slump in euro area real GDP growth since the start of 2018 can be attributed to plunging net exports, while domestic demand has held steady (Chart 5). The increase in the China credit impulse and our global LEI diffusion index – both leading indicators of euro area export growth – are signaling that euro area export demand is already in the process of bottoming out (bottom two panels) and should gain momentum in the first half of 2020. Chart 4US Growth Is Poised To Accelerate US Growth Is Poised To Accelerate US Growth Is Poised To Accelerate Chart 5The Drag On European Growth From Trade Will Soon End The Drag On European Growth From Trade Will Soon End The Drag On European Growth From Trade Will Soon End This better growth backdrop will put moderate upward pressure on global bond yields in 2020. This better growth backdrop will put moderate upward pressure on global bond yields in 2020. Key View #2: Expect mild bear-steepening pressure on global yield curves, led by rising inflation expectations. While we expect bond yields to drift higher in the next 6-12 months, the upside will be capped with central banks likely to stay dovish until policy reflation has clearly turned into higher inflation. Interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up. The Fed, ECB, Bank of Japan and other central banks have all stated publicly that they will maintain current accommodative policy settings until realized inflation has sustainably returned to target levels, typically around 2%. This would be a major change in the modus operandi of these policymakers, who have typically signaled rate hikes based simply on forecasts of higher inflation. The implication is that interest rate markets will not begin to price in expectations of tighter monetary policy without evidence of actual inflation picking up (Chart 6). Chart 6Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates Central Banks Will Stay Dovish Until Inflation Sustainably Accelerates A critical ingredient for global inflation to begin moving higher again is a softer US dollar (USD). The year-over-year growth rate of the trade-weighted USD is correlated to global export price inflation and commodity price inflation, more generally (Chart 7). The typical drivers of the USD are all pointing in a more bearish direction: Chart 7The USD Is Critical For Global Reflation The USD Is Critical For Global Reflation The USD Is Critical For Global Reflation Chart 8Global Real Yields & Inflation Expectations Will Drift Higher In 2020 Global Real Yields & Inflation Expectations Will Drift Higher In 2020 Global Real Yields & Inflation Expectations Will Drift Higher In 2020 the Fed has cut interest rates multiple times since the summer and is expanding its balance sheet via repo operations and treasury bill purchases; global (non-US) growth is bottoming out, and capital tends to flow out of the USD into more cyclical currencies in Europe and EM when global growth is accelerating; elevated policy uncertainty, which tends to attract inflows into the safety of the USD, is starting to diminish. The combination of improving global growth and a softer USD would normally be enough to generate a significant increase in global bond yields. Yet we do not expect the sort of move higher in the real component of bond yields signaled by our global LEI diffusion index in 2020 (Chart 8, top panel). While real yields should move higher alongside faster growth, if there is no expected tightening of monetary policy as well, the move in real yields will be more limited. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. The grind higher in global bond yields that we expect in 2020 will come first through faster inflation expectations and, much later in the year, higher real bond yields when central bankers (starting with the Fed) begin to signal a need to turn more hawkish. This suggests that inflation-linked bonds should perform reasonably well in countries where inflation is likely to accelerate the fastest, like the US. Faster inflation expectations will also result in some bear-steepening of global government bond yield curves in the first half of 2020 (Chart 9). There is very little curve steepening discounted in bond forward rates in the developed markets – a consequence of the general flatness of yield curves – which suggests that yield curve steepening trades could prove to be profitable in 2020. Chart 9Expect A Mild Bear-Steepening Of Global Yield Curves Expect A Mild Bear-Steepening Of Global Yield Curves Expect A Mild Bear-Steepening Of Global Yield Curves Chart 10The Fed Has Dis-Inverted The Treasury Curve The Fed Has Dis-Inverted The Treasury Curve The Fed Has Dis-Inverted The Treasury Curve In the case of the US, the Fed’s recent easing actions have pushed short-term interest rates below longer-term Treasury yields, removing the yield curve inversion that sparked recession fears among investors during the summer of 2019 (Chart 10). With the Fed likely to sit on its hands for most of next year, even as US growth and inflation are likely to improve, this will put additional bear-steepening pressure on the US Treasury curve. In Europe, bond markets have already discounted a very significant impact from the ECB restarting its Asset Purchase Program, which only began last month. Investment grade corporate bond spreads, as well as Italy-Germany government bond spreads, have narrowed substantially despite a weak euro area economy (Chart 11, bottom panel). Meanwhile, the term premium on 10-year German bunds is back to the deeply negative levels middle panel) seen when the ECB was expanding its balance sheet at a 30-40% pace, rather than the 5% pace implied by the current announced pace of purchases of 20 billion euros per month (top panel). This potentially leaves longer-term European yields exposed to the same bear-steepening pressures seen in other bond markets, even within the context of a renewed ECB bond-buying program. Chart 11European Bonds Already Discount A Very Dovish ECB European Bonds Already Discount A Very Dovish ECB European Bonds Already Discount A Very Dovish ECB Chart 12The Wild Card For Bonds Markets In 2020: Fiscal Policy The Wild Card For Bonds Markets In 2020: Fiscal Policy The Wild Card For Bonds Markets In 2020: Fiscal Policy A potentially big wild card for global bond markets next year will be fiscal policy, which can also exacerbate yield curve steepening pressures. Any sign of a push toward more government spending, particularly in Europe where there has been such reluctance to open the fiscal taps, would result in a sharper upward move in global bond yields than we are expecting. This is not because of a supply effect related to more government bond issuance that would require higher yields to attract buyers. It is because fiscal stimulus (Chart 12) would push growth to an even faster pace that would bring forward the date when inflation returns to policymaker targets and tighter monetary policy could commence. This would follow a similar path to the curve steepening dynamics described earlier, with a fiscal boost to growth pushing up longer-term inflation expectations before starting to push up short-term interest rate expectations. Key View #3: Stay overweight global corporate debt versus sovereign bonds. Investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. The combination of faster global growth, somewhat higher inflation and accommodative monetary policies laid out in the BCA Outlook 2020 report will delay the peak in the aging global credit cycle. This means investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Low borrowing rates are already helping to extend the credit cycle by making it easier for highly indebted borrowers to service their debts. This can be seen in the US, where interest coverage ratios (using top-down data for the non-financial corporate sector) remain above the levels that have preceded previous recessions (Chart 13). Low borrowing rates are also helping indebted borrowers in Europe, particularly in Italy and Spain where the banking system is now far less exposed to non-performing loans than during the peak years of the 2011-12 European Debt Crisis (Chart 14). Chart 13Low Rates Helping Extend The US Credit Cycle Low Rates Helping Extend The US Credit Cycle Low Rates Helping Extend The US Credit Cycle Chart 14Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Low Rates Helping Ease Stress In European Banks Declining Non-Performing Loans Are A Positive For The European Periphery Chart 15A Cyclically Positive Backdrop For Global Corporates A Cyclically Positive Backdrop For Global Corporates A Cyclically Positive Backdrop For Global Corporates According to our checklist of indicators to watch for an end of the corporate credit cycle in the US – tight monetary policy, deteriorating corporate sector financial health, and tightening bank lending standards – only corporate financial health is flashing a warning signal according to our Corporate Health Monitor as we discussed in a recent report.2 In fact, our global Corporate Health Monitor is rolling over – a trend that should continue as growth improves in 2020 – which should support global corporate bond outperformance versus government debt next year (Chart 15). Key View #4: Returns on global fixed income will be far lower in 2020 than in 2019. Country and sector selection will be more important in driving fixed income outperformance in 2020. The start of 2020 looks far different in terms of fixed income valuations compared to the beginning of 2019. For example, the 10yr US Treasury yield started the year at 2.72% and is now 1.83%, while the 10yr German bund yield started this year at 0.24% and is now MINUS-0.31%. These lower yields reflect the slower pace of global economic growth and monetary policy easing delivered by the Fed and ECB. Yet at the same time, corporate credit spreads have narrowed in both the US (the high-yield index OAS is down from 526bps to 360bps) and the euro area (the investment grade index OAS is down from 152bps to 100bps). These massive rallies in global bond markets this year resulted in both lower government bond yields and tighter credit spreads - even with slower global growth that would normally be a trigger for wider spreads/higher risk premiums. Looking at the current valuation of government bond yields in the major developed markets from a long-run perspective, it is difficult to make the case that it is attractive. Medium-term real bond yields remain well below potential GDP growth rates, a consequence of central banks keeping policy rates well below neutral levels suggested by measures like the Taylor Rule (Chart 16). Chart 16Global Government Bonds Are Expensive 2020 Key Views: Delay Of Reckoning 2020 Key Views: Delay Of Reckoning Without the initial starting point of cheap valuations, fixed income return expectations for 2020 should be tempered. This means that rather than loading up on maximum duration risk and/or credit risk to capture big yield and spread moves, bond investors should be more selective in country, maturity and credit exposure to generate outperformance in 2020. Chart 17Favor Lower-Beta Government Bond Markets In 2020 Favor Lower-Beta Government Bond Markets In 2020 Favor Lower-Beta Government Bond Markets In 2020 For government bonds, that means focusing country exposures on lower-beta markets where yields are less correlated to moves in the overall level of global bond yields. Our preferred way to measure this is to look at the beta of monthly yield changes for the benchmark 10-year government yields of the major developed market countries to the overall Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket, over a rolling three-year window. We define a “high-beta” bond market as having a yield beta of 1.25 or higher, and a “low-beta” bond market as having a yield beta of 0.75 or lower. Under that definition, global bond investors should underweight higher-beta Canada, the US and Italy, and overweight low-beta Japan and Spain (Chart 17). Bond markets with betas between 1.25 and 0.75 (Germany, Australia, Sweden, the UK) can also be considered on their own fundamental merits. Of that list, we see Germany and Australia having a better chance of outperforming the UK and Sweden, given the greater odds that the Bank of England or Riksbank could signal a need to hike rates in 2020 compared to the ECB or Reserve Bank of Australia. Chart 18Stay Overweight Global Spread Product In 2020, But Be Selective 2020 Key Views: Delay Of Reckoning 2020 Key Views: Delay Of Reckoning For spread product, that means focusing exposure on sectors that are less risky, either defined by interest rate duration or spread volatility (i.e. spread duration). With credit spreads remaining near the low end of long-run historical ranges for nearly all major markets (Chart 18), it is hard to find examples of spread product being cheap in absolute terms. On a risk-adjusted basis, however, negatively-convex spread product like US and euro area high-yield debt and US agency MBS actually look more interesting in the rising yield environment we expect in 2020, since the interest rate durations of those fixed income sectors fell as bond yields declined in 2019. Thus, we recommend owning high-yield corporates over higher-duration investment grade corporates in the US and euro area, while also favoring US agency MBS over higher-quality credit tiers of US investment grade corporate credit.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, “The Lowdown On Low-Rated High-Yield”, dated November 27, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2020 Key Views: Delay Of Reckoning 2020 Key Views: Delay Of Reckoning Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Below-Benchmark Duration In 2020 H1. Improving global growth and the de-escalation of US/China trade tensions will put upward pressure on bond yields in the first half of 2020, making below-benchmark portfolio duration appropriate. US political risks could re-assert themselves as we head into 2020 H2, leading to a risk-off environment that causes bond yields to fall. We will likely recommend increasing portfolio duration in mid-2020 if the political situation plays out as we expect, or if the 5-year/5-year forward Treasury yield and 12-month Fed Funds Discounter reach our targets. Barbell Your Treasury Portfolio. The 2/10 Treasury slope will steepen modestly in the coming months, but will remain in a range between 0 bps and 50 bps in 2020. Any steepening will be concentrated in the real yield curve. The TIPS breakeven inflation curve is likely to flatten. Our valuation models suggest that a barbelled Treasury portfolio is the best way to position for this environment. Specifically, we recommend shorting the 5-year bullet and buying a duration-matched barbell consisting of the 2-year note and 30-year bond. Overweight Spread Product. Low inflation expectations will keep the Fed on hold in 2020. This accommodative monetary environment will keep defaults low and credit spreads tight. Spread product will outperform Treasuries in duration-matched terms. Favor High-Yield Versus Investment Grade. Appropriate valuation measures show that high-yield corporate spreads are very attractive in the current environment, while investment grade corporate spreads are tight compared to our fair value estimates. Overweight Mortgage-Backed Securities. Agency MBS look attractive compared to investment grade corporate bonds, especially in risk-adjusted terms. The risk of a refinancing surge in 2020 is minimal and mortgage lending standards are more likely to ease than tighten. MBS spreads have room to tighten in 2020. Overweight TIPS Versus Nominal Treasuries. TIPS breakeven inflation rates are well below our target range of 2.3%-2.5%. It will take some time, and likely an overshoot of the Fed’s 2% inflation target, for them to reach that range as expectations adapt only slowly to rising core inflation. But even if they don’t make it back to target, breakevens should still grind higher as the economy recovers in 2020. Feature BCA published its 2020 Outlook on November 22. That report lays out the main macroeconomic themes that our strategists see driving markets next year. This Special Report explains how investors can profit from those themes in US fixed income markets. Specifically, we offer six key US fixed income views for 2020. This report is limited to the six key investment views listed on page 1, and only discusses Fed policy in the context of how it influences those views. Next week we will publish a more comprehensive “Fed In 2020” report that will delve into our outlook for the Fed next year. Outlook Summary First, a brief summary of the main economic views presented in BCA’s 2020 outlook:1 The global manufacturing downturn that persisted throughout 2019 is quickly coming to an end. The following factors will cause global growth to rebound in early 2020: China eased economic policy significantly in 2019. Policymakers cut the reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. The Fed cut rates by 75 bps, and other central banks also eased monetary policy in 2019. The global inventory purge that magnified the industrial sector’s pain in 2019 is exhausted. Both the US and China have incentives to de-escalate the trade war in the first half of 2020. Investors should remain invested in risk assets to take advantage of this favorable global macro environment. But 2020 is likely to be the last year of risk asset outperformance. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will then be forced to lift rates much more aggressively. China will also continue to resist excess leverage. Neither the business cycle nor the equity bull market will withstand those final assaults in 2021. Key View #1: Below-Benchmark Duration In 2020 H1 Improving global growth and the de-escalation of US/China trade tensions will put upward pressure on bond yields in the first half of 2020, making below-benchmark portfolio duration appropriate. US political risks could re-assert themselves as we head into 2020 H2, leading to a risk-off environment that causes bond yields to fall. We will likely recommend increasing portfolio duration in mid-2020 if the political situation plays out as we expect, or if the 5-year/5-year forward Treasury yield and 12-month Fed Funds Discounter reach our targets. In prior research we identified the five macroeconomic factors that determine trends in US bond yields.2 They are: (i) global growth, (ii) the output gap, (iii) the US dollar, (iv) policy uncertainty and (v) sentiment. On global growth, the three measures that correlate most strongly with the 10-year Treasury yield are the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index. As mentioned above, we expect all three of these indicators to move higher in the first half of 2020, but so far we have seen only tentative signs of a rebound. The Global PMI is back above 50 after bottoming at 49.3 in July, but the US ISM remains in contractionary territory and the CRB Raw Industrials index is in a downtrend (Chart 1). All three of these indicators will have to increase for our call to play out. The global manufacturing downturn that persisted throughout 2019 is quickly coming to an end. The same amount of economic growth is more inflationary when the output gap is small than when it is wide. For this reason, we also need some sense of the output gap to make a call on Treasury yields. We have found wage growth to be a useful indicator of the output gap, as evidenced by its strong correlation with the fed funds rate (Chart 2). As long as recession is avoided, strong wage growth will make it difficult for the Fed to aggressively cut rates. The upshot is that Treasury yields will not re-visit their mid-2016 lows until the next recession hits and wage pressures wane. For now, all leading wage growth indicators continue to point up (Chart 2, bottom 2 panels). Chart 1Factor 1: Global Growth Factor 1: Global Growth Factor 1: Global Growth Chart 2Factor 2: The Output Gap Factor 2: The Output Gap Factor 2: The Output Gap   The US dollar is the third important macro factor we consider. A strengthening dollar signals that US yields are de-coupling too far from yields in the rest of the world, making them more likely to fall back down. Conversely, an uptrend in US bond yields is likely to last longer in an environment of dollar weakness. The trade-weighted dollar has been rangebound during the past few months and bullish sentiment toward the dollar has declined significantly (Chart 3). This suggests that US yields have room to move higher. However, we will watch the dollar closely as bond yields rise in 2020 H1. A rapidly appreciating dollar would make us more inclined to fade any increase in US bond yields. The fourth factor we consider is policy uncertainty. It’s no secret that US Treasury securities benefit from flight to safety flows in times of heightened political stress. The tight correlation between the 10-year Treasury yield and the Global Economic Policy Uncertainty index demonstrates this nicely (Chart 4). In fact, it is now clear that uncertainty about the US/China trade war caused US yields to reach lower levels this year than was implied by the economic fundamentals alone. Chart 3Factor 3: The US Dollar Factor 3: The US Dollar Factor 3: The US Dollar Chart 4Factor 4: Policy Uncertainty Factor 4: Policy Uncertainty Factor 4: Policy Uncertainty   We see trade tensions continuing to die down as we head into the New Year. President Trump faces an election in November 2020, and he no doubt realizes that an incumbent President with a strong economy has a good chance of winning re-election. He therefore has a strong incentive to support economic growth. However, by the second half of next year, we see two potential political risks that could flare, causing bond yields to fall. First, if Trump finds himself behind in the polls by mid-summer, then he may change his strategy and re-escalate tensions with China or some other foreign policy target. Second, if one of the progressive candidates – Elizabeth Warren or Bernie Sanders – secures the Democratic nomination, stocks will likely sell off, precipitating a flight-to-quality into US bonds. All in all, we see the ebbing of policy uncertainty in the first half of 2020 helping to push bond yields higher. But risks could flare again in the 2020 H2, sending yields back down. Chart 5Factor 5: Sentiment Factor 5: Sentiment Factor 5: Sentiment The final factor we consider when forecasting bond yields is sentiment, and we find the Economic Surprise Index to be the most useful sentiment measure. Chart 5 shows that positive data surprises tend to coincide with rising Treasury yields and vice-versa. We also know that long periods of positive data surprises are more likely to be followed by disappointments, and vice-versa. Though the Surprise Index’s message can change quickly, it is currently close to neutral, sending no strong signal for bond yields. Considering our five macro factors together, we conclude that a rebound in global growth and waning political uncertainty will send bond yields higher in the first half of 2020. Investors should keep portfolio duration low in this environment. We may recommend increasing portfolio duration as we approach mid-year if political uncertainty looks set to rise, or if the dollar is appreciating strongly, or if yields reach the targets outlined below. Yield Target #1: The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing asserts that you should keep portfolio duration low if you expect the Fed to be more hawkish than market expectations, and high if you expect the Fed to be more dovish.3 At present, the overnight index swap (OIS) curve is priced for 22 basis points of rate cuts over the next 12 months. While economic growth is poised to improve in 2020, the Fed is in no rush to tighten monetary policy with inflation expectations still low. We therefore expect the fed funds rate to stay flat next year. With the market still priced for cuts, this forecast implies that we should maintain below-benchmark portfolio duration, at least until our 12-month Fed Funds Discounter – the change in the fed funds rate priced into the OIS curve for the next 12 months – rises to zero or above. A rebound in global growth and waning political uncertainty will send bond yields higher in the first half of 2020. Investors should keep portfolio duration low in this environment. Table 1 uses our Golden Rule framework to forecast Treasury index returns in different monetary policy scenarios. Our base case of a flat fed funds rate is consistent with Treasury index total returns of +0.67% to +0.88% in 2020, and excess returns versus cash of between -0.91% and -0.70%. The Appendix at the end of this report discusses how our Golden Rule framework performed in 2019 and in years past. Table 1Treasury Return Projections 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Yield Target #2: Long-Run Fed Funds Rate Expectations Chart 6Target 2.25% To 2.5% Target 2.25% To 2.5% Target 2.25% To 2.5% A second catalyst for increasing portfolio duration would be if the 5-year/5-year forward Treasury yield converged with estimates of the longer-run neutral fed funds rate. Once recessionary risks move to the backburner, it would be logical for long-dated forward rates to converge to levels that are consistent with market expectations for the long-run neutral fed funds rate. Indeed, this is precisely what happened in 2014 and 2017/18, the last two periods of strong global growth (Chart 6). At present, the Fed’s median long-run neutral rate estimate is 2.5%. The New York Fed’s Survey of Market Participants estimates a range of 2.19% to 2.50% and its Survey of Primary Dealers estimates a range of 2.25% to 2.56%. A 5-year/5-year forward Treasury yield in the range of 2.25% to 2.5% would be a second catalyst for us to increase recommended portfolio duration. For Treasury yields to move sustainably above 2.5% in this cycle, it will be necessary for investors to revise their long-run neutral rate estimates higher. This could very well occur, but probably not within the next six months. Nonetheless, investors should pay close attention to the price of gold and the US housing market for signals that neutral rate estimates might undergo upward revisions. The gold price tends to rise when investors view monetary policy as becoming increasingly accommodative. This can occur because the Fed is cutting rates while neutral rate estimates are unchanged, or because neutral rate estimates are rising and the fed funds rate is unchanged. Chart 7 shows that a drop in the gold price foreshadowed downward revisions to the neutral rate in 2013. A further breakout in gold in 2020 could signal that the neutral rate needs to be revised higher again. The housing market will also provide important clues about the neutral fed funds rate. Last year, housing activity slowed considerably once the 30-year mortgage rate rose about 4% (Chart 8). Activity bounced back this year after rates fell, but it will be important to see what happens to housing once the mortgage rate rises back to 4% and above. If an above-4% mortgage rate leads to another downdraft in housing, it would send a strong signal that current neutral rate estimates are roughly correct. However, if housing activity continues to improve with a mortgage rate above 4%, it would suggest that upward neutral rate revisions are required. Chart 7Gold Leads The Neutral Rate... Gold Leads The Neutral Rate... Gold Leads The Neutral Rate... Chart 8...And So Does Housing ...And So Does Housing ...And So Does Housing   There is at least one good reason to think that housing activity might not slow once the mortgage rate rises above 4%. There is currently an excess of supply at the upper-end of the housing market, and a lack of supply at the low-end. This has resulted in price deceleration for new homes, as homebuilders shift construction to the lower-end of the market where demand is stronger (Chart 8, bottom panel). This supply side re-adjustment could make the housing market more resilient to higher mortgage rates in 2020. Key View #2: Barbell Your Treasury Portfolio The 2/10 Treasury slope will steepen modestly in the coming months, but will remain in a range between 0 bps and 50 bps in 2020. Any steepening will be concentrated in the real yield curve. The TIPS breakeven inflation curve is likely to flatten. Our valuation models suggest that a barbelled Treasury portfolio is the best way to position for this environment. Specifically, we recommend shorting the 5-year bullet and buying a duration-matched barbell consisting of the 2-year note and 30-year bond. In thinking about how the slope of the Treasury curve will respond as global growth improves in 2020, it’s useful to look at what happened in two recent episodes of strengthening global growth – 2012/13 and 2016/17. Charts 9A, 9B and 9C illustrate how the 2/10 slope responded in those periods, and show the breakdown between changes in the real and inflation components of yields. The actual slope changes are provided in Table 2. In 2012/13, the 2/10 slope steepened dramatically as global growth rebounded, with almost all of the steepening coming from the real yield curve. It’s not difficult to understand why. The economic outlook was improving, but the Fed was still two years away from lifting interest rates. As such, the Fed’s dovish forward guidance kept a firm lid on short-maturity yields even as long-dated yields rose. In contrast, we can look at the 2016/17 episode. The 2/10 slope steepened somewhat early in the 2016/17 global growth recovery, but ended up 45 bps flatter by the time that the Global PMI peaked. This time, both the real and inflation components contributed to curve flattening. The key difference in this episode was that the Fed was quick to turn more hawkish as growth improved. It lifted the funds rate four times, and short-dated yields rose more quickly than those at the long-end. If housing activity continues to improve with a mortgage rate above 4%, it would suggest that upward neutral rate revisions are required. What can be applied from these two episodes to today? One thing that’s clear is that the Fed will not be as quick to tighten policy as it was in 2016/17. As will be discussed in more detail in next week’s report, the Fed wants to keep policy accommodative until inflation expectations are firmly re-anchored around its target. We think the 5-year/5-year forward TIPS breakeven inflation rate needs to rise from its current 1.8% to above 2.3% before that goal is met. However, it’s also conceivable that inflationary pressures will emerge as soon as late-2020, necessitating rate hikes in 2021. If that’s the case, then short-dated yields will sniff that out in advance, imparting some flattening pressure to the curve. All in all, we’re looking for modest curve steepening in the first half of 2020. But with the Fed not completely out of the picture – as was the case in 2012/13 – the 2/10 slope will not rise above 50 bps. We would also recommend positioning for curve steepening via real yields. The cost of 2-year inflation protection is currently below the cost of 10-year inflation protection (Chart 9C), but will probably lead the 10-year higher as inflation expectations slowly adapt to the incoming data. We recommend TIPS breakeven curve flatteners. Chart 9ANominal 2/10 Slope Nominal 2/10 Slope Nominal 2/10 Slope Chart 9BReal 2/10 Slope Real 2/10 Slope Real 2/10 Slope Chart 9CInflation Compensation: 2/10 Slope Inflation Compensation: 2/10 Slope Inflation Compensation: 2/10 Slope Table 22/10 Slope Changes During Two Recent Global Growth Upturns 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Interestingly, we also do not recommend the typical 2/10 steepening trade of going long the 5-year bullet against a duration-matched 2/10 barbell. This is because the 2/5/10 butterfly already discounts a huge amount of 2/10 steepening. The 5-year bullet appears 6 bps expensive on our model, meaning that the 2/10 slope needs to steepen by 26 bps during the next six months for a long 5-year, short 2/10 trade to profit (Chart 10).4 Chart 102/5/10 Butterfly Valuation Model 2/5/10 Butterfly Valuation Model 2/5/10 Butterfly Valuation Model Against this valuation backdrop, we recommend owning a duration-matched barbell consisting of the 2-year note and the 30-year bond, while shorting the 5-year note. This heavily barbelled Treasury allocation adds positive carry to a bond portfolio, and will earn positive returns as long as the 5/30 slope steepens by less than 61 bps during the next six months.5 Further, recent correlations suggest that the 5-year yield will rise by more than either the 2-year or 30-year yields if the market starts to price-in fewer Fed rate cuts, as we expect. Table 3 shows that there has been a positive correlation between changes in the 2/5 Treasury slope and our 12-month discounter during the past six months, and a negative correlation between our discounter and the 5/30 slope. Table 3Correlation Of Monthly Changes In 12-Month Discounter With Monthly Changes In Treasury Curve Slopes 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Key View #3: Overweight Spread Product Low inflation expectations will keep the Fed on hold in 2020. This accommodative monetary environment will keep defaults low and credit spreads tight. Spread product will outperform Treasuries in duration-matched terms. In last year’s Key Views report, we presented a method for splitting the economic cycle into three phases based on the slope of the yield curve.6 We observed that spread product excess returns versus Treasuries tend to be highest in Phase 1 of the cycle, when the 3-year/10-year Treasury slope is above 50 bps. Spread product excess returns tend to be low, but still positive, in Phase 2 of the cycle when the slope is between 0 bps and 50 bps, and only turn negative in Phase 3 after the 3-year/10-year slope inverts. By our criteria, we remained in Phase 2 of the cycle throughout all of 2019 and spread product did in fact deliver small, but positive, excess returns relative to Treasuries. We expect to remain in Phase 2 throughout most (if not all) of 2020, and therefore advise investors to maintain overweight allocations to spread product versus duration-matched Treasuries. We are looking for modest curve steepening in the first half of 2020. The principal rationale for our call is that accommodative Fed policy will keep the yield curve positively sloped in 2020. It will also give banks the confidence to continue extending credit. And as long as lending standards are sufficiently easy, defaults will remain low and spreads will stay tight. Yes, there are some early indications that we might be transitioning into a Phase 3 environment, an environment that would merit a more defensive stance. For one thing, some parts of the Treasury curve inverted in August, though the specific measure we use in our credit cycle analysis – the monthly average of daily closes of the 3-year/10-year Treasury slope – remained above zero (Chart 11). Also, commercial & industrial (C&I) lending standards tightened in the third quarter. Chart 11Still In Phase 2 Still In Phase 2 Still In Phase 2 However, we expect both of these warning signs to dissipate in the near future. The yield curve has already re-steepened, and while loan officers indicated that they had tightened overall standards on C&I loans in Q3, they continued to loosen the terms on those loans (Chart 11, panel 3). But most importantly, we continue to observe inflation expectations that are far below the Fed’s comfort zone (Chart 11, bottom panel). As long as this is the case, the Fed will do its best to keep interest rates low and monetary conditions accommodative. In that environment, the yield curve should stay upward sloping and banks will keep the credit taps open. Phase 2 will stay in place and spread product will outperform Treasuries. The poor health of nonfinancial corporate balance sheets is another risk to our positive spread product view. We track corporate balance sheet health using both aggregate top-down data from the US Financial Accounts (Chart 12A) and by looking at the median firm in our own bottom-up sample of high-yield issuers (Chart 12B). In both cases, we see that debt-to-profit and debt-to-asset ratios are elevated, indicating that firms are carrying a lot of debt on their balance sheets relative to history. However, both samples also show that interest coverage ratios are strong. Solid interest coverage is the result of low interest rates and the Fed’s accommodative monetary policy. It tells us that defaults won’t occur until inflation expectations rise and the Fed turns more restrictive. That may not happen until 2021. Chart 12ACorporate Health: Top-Down Corporate Health: Top-Down Corporate Health: Top-Down Chart 12BCorporate Health: Bottom-Up Corporate Health: Bottom-Up Corporate Health: Bottom-Up   The downside is that an extended period of accommodative monetary policy and few defaults means that firms will continue to build up debt and whittle away the equity cushion in corporate capital structures. The end result will be greater losses during the next default cycle. Our Preferred Spread Sectors Within US spread product, we recommend an overweight allocation to high-yield corporate bonds to take advantage of the favorable macro environment. Within investment grade sectors, we advise only a neutral allocation to corporate bonds (see Key View #4), but recommend overweighting Agency Mortgage-Backed Securities (see Key View #5), Agency Commercial Mortgage-Backed Securities, Local Authority and Foreign Agency debt. Chart 13 shows a snapshot of the risk/reward trade-off between investment grade spread products. The vertical axis displays the option-adjusted spread as a simple proxy for 12-month expected excess returns. The horizontal axis displays our own risk measure called the Risk Of Losing 100 bps.7 This measure calculates the spread widening required for each sector to lose 100 bps or more versus duration-matched Treasuries, then adjusts for each sector’s historical spread volatility. Chart 13Excess Return Bond Map: Main Investment Grade Sectors 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart 13 imposes no macro view, but it does reveal that Foreign Agency debt offers an attractive expected return for its level of risk. Agency CMBS and Agency MBS also offer attractive expected returns for their respective risk levels. USD-denominated Sovereign bonds offer high expected returns, but are also the riskiest of the sectors in Chart 13. We recommend an underweight allocation to USD-denominated Sovereigns with the exception of Mexican and Saudi Arabian bonds, which look attractive on a risk/reward basis. Chart 14 replicates Chart 13 but with the USD-denominated Sovereign bonds of different countries. Only Mexico and Saudi Arabia stand out as being attractively priced. Chart 14Excess Return Bond Map: USD-Denominated EM Sovereigns 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart 15Favor Long-Maturity Munis Favor Long-Maturity Munis Favor Long-Maturity Munis We also maintain a positive outlook on Municipal bonds, particularly at the long-end of the Aaa-rated curve. Municipal / Treasury yield ratios look attractive compared to history, especially at long maturities (Chart 15). While many state and local governments face long-run problems related to underfunded pensions, these issues won’t be exposed until revenue growth falters in the next downturn. For now, state & local government balance sheets are healthy enough to keep muni upgrades outpacing downgrades (Chart 15, bottom 2 panels). Key View #4: Favor High-Yield Over Investment Grade Appropriate valuation measures show that high-yield corporate spreads are very attractive in the current environment, while investment grade corporate spreads are tight compared to our fair value estimates. We noted above that, despite the favorable macro environment for spread product, we recommend an overweight allocation to high-yield corporate bonds but only a neutral allocation to investment grade corporates. The reason for the disparity is valuation. Our preferred valuation measure is the 12-month breakeven spread. This is the spread widening required for the sector to lose money versus Treasuries on a 12-month horizon. This measure is superior to the simple index option-adjusted spread because it controls for time-varying index duration. We also re-calculate the investment grade and high-yield bond indexes so that they have constant distribution between the different credit tiers over time. Charts 16A and 16Bshow 12-month breakeven spreads for our re-constituted investment grade and high-yield indexes as percentile ranks versus history. The investment grade spread has been tighter only 11% of the time since 1995, while the high-yield spread has been tighter 67% of the time. Chart 16AIG Valuation IG Valuation IG Valuation Chart 16BHY Valuation HY Valuation HY Valuation   From our analysis of the three phases of the cycle, we also know that spreads tend to tighter in Phase 2 of the cycle than in Phases 1 or 3. Since we are currently in Phase 2, we would expect spreads to be near the bottom of their historical distributions. With this knowledge, we derive spread targets for each corporate credit tier based on the median breakeven spreads witnessed in prior Phase 2 periods. We then use current index duration to calculate option-adjusted spread targets for each credit tier and the overall investment grade and high-yield indexes (Charts 17A and 17B). Notice that all investment grade spreads are below their Phase 2 targets, while high-yield spreads are well above. Chart 17AIG Spread Targets IG Spread Targets IG Spread Targets Chart 17BHY Spread Targets HY Spread Targets HY Spread Targets   We also observe that Caa-rated spreads are extremely cheap relative to target, and have been widening rapidly. We are more inclined to view this as an opportunity to buy Caa-rated bonds than as a warning sign for overall corporate bond performance, as we discussed in a recent report.8 Key View #5: Overweight Mortgage-Backed Securities Agency MBS look attractive compared to investment grade corporate bonds, especially in risk-adjusted terms. The risk of a refinancing surge in 2020 is minimal and mortgage lending standards are more likely to ease than tighten. MBS spreads have room to tighten in 2020. We noted above that Agency MBS offer an attractive trade-off between risk and expected return. Specifically, Chart 13 shows that MBS offer expected returns that are similar to Aa and Aaa corporates, but with less risk of losing 100 bps versus Treasuries. For further evidence of the attractiveness of MBS spreads, we note that while the zero-volatility spread for conventional 30-year Agency MBS is not all that elevated compared to history, it is being held down by very low expected prepayment losses (aka option costs) (Chart 18). The OAS, the best proxy for MBS expected return, stands at 48 bps. This is reasonably elevated compared to history and very close to the spread offered by Aa-rated corporate bonds. Past periods when the MBS OAS was close to the Aa-rated corporate bond spread were followed by MBS outperformance (Chart 18, bottom panel). We recommend an overweight allocation to high-yield corporate bonds but only a neutral allocation to investment grade corporates. The reason for the disparity is valuation. We noted that expected prepayment losses are low, and this is for good reason. Mortgage refinancing activity will remain depressed throughout 2020. First, with the Fed likely to go on hold for 2020 and then lift rates in 2021, the mortgage rate is more likely to rise than fall. Higher mortgage rates will keep refis down. Second, most homeowners have already had multiple opportunities to refinance their mortgages during the past few years, as evidenced by the fact that the MBA Refinance Index didn’t rise that much in 2019, even as the mortgage rate declined 106 bps (Chart 19). Chart 18MBS Spreads MBS Spreads MBS Spreads Chart 19Refi Risk Is Minimal Refi Risk Is Minimal Refi Risk Is Minimal   Tightening bank lending standards for residential mortgages can also lead to wider MBS spreads, but lending standards are more likely to ease than tighten in 2020. FICO scores for approved mortgages have not come down at all since the financial crisis (Chart 19, panel 3), and loan officers consistently claim that lending standards are tighter than the average since 2005 (Chart 19, bottom panel). With standards already so tight, modest easing is more likely than rapid tightening. Key View #6: Overweight TIPS Versus Nominal Treasuries TIPS breakeven inflation rates are well below our target range of 2.3%-2.5%. It will take some time, and likely an overshoot of the Fed’s 2% inflation target, for them to reach that range as expectations adapt only slowly to rising core inflation. But even if they don’t make it back to target, breakevens should still grind higher as the economy recovers in 2020. Our target range for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates remains 2.3%-2.5%. But it could take quite some time for that target to be met. The reason is that inflation expectations adapt only slowly to changes in the actual inflation data. We explained this dynamic in a report from last year, and also created a fair value model for the 10-year TIPS breakeven inflation rate based on long-run trends in the actual inflation data.9 At present, our Adaptive Expectations Model pegs fair value for the 10-year breakeven rate at 1.9%, 20 bps above the current level of 1.7%, but well short of our end-of-cycle 2.3%-2.5% target (Chart 20). We could see the 10-year breakeven reaching 1.9% in the coming months as global growth recovers, but it will take a more sustained uptrend in the actual inflation data to move higher than that. A more sustained uptrend in actual inflation could take some time to develop. This year’s increase in core CPI inflation has been concentrated in the core goods component (Chart 21). This component of core inflation tracks import prices with a lag, and it is very likely to fall back down in 2020. Any sustained breakout in core inflation will require more strength from the core services (ex. Shelter and medical care) component (Chart 21, panel 3), something that hasn’t happened yet this cycle. Chart 20Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model Chart 21The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI   Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix: The Golden Rule Of Bond Investing Our Golden Rule of Bond Investing says that we should determine what change in the fed funds rate is priced into the overnight index swap curve for the next 12 months, and then decide whether the Fed will deliver a hawkish or dovish surprise relative to that expectation. We contend that if the Fed delivers a hawkish surprise, then a below-benchmark portfolio duration positioning will pay off. Conversely, if the Fed delivers a dovish surprise, then an above-benchmark portfolio duration positioning will profit. Chart A1 shows how the Golden Rule has performed in every calendar year going back to 1990. We include year-to-date performance for 2019. In 30 years of historical data, our Golden Rule performed well in 22. It provided the wrong recommendation in 8 years, though 3 of those years were during the zero-lower-bound period between 2009 and 2015 when 12-month rate expectations were essentially pinned at zero.10 At the beginning of this year, the market was priced for 7 bps of rate cuts in 2019. The funds rate actually fell by 84 bps, leading to a dovish surprise of 77 bps. Based on a historical regression, we would expect a dovish surprise of 77 bps to coincide with a Treasury index yield that falls by 52 bps. In actuality, the index yield fell by 81 bps, more than our Golden Rule predicted. Chart A2 shows how close changes in the Treasury index yield have been to our Golden Rule’s prediction in each of the past 30 years. This regression between the change in Treasury index yield and the monetary policy surprise is the main source of error in our Treasury return forecasts. Based on our expected -52 bps index yield change, we would have expected the Treasury index to deliver 5.9% of total return in 2019 and to outperform cash by 3.4%. In actuality, the index earned 7.9% of total return and outperformed cash by 5.6%. Charts A3 and A4 show how index total and excess returns have performed relative to our Golden Rule’s expectations in each of the past 30 years. Chart A1The Golden Rule’s Track Record The Golden Rule's Track Record The Golden Rule's Track Record Chart A2Treasury Index Yield Changes Versus Fed Funds Surprises 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart A3Treasury Index Total Returns Versus The Golden Rule’s Predictions 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income Chart A4Treasury Index Excess Returns Versus The Golden Rule’s Predictions 2020 Key Views: US Fixed Income 2020 Key Views: US Fixed Income   Footnotes 1    Please see The Bank Credit Analyst, “Outlook 2020: Heading Into The End Game”, dated November 22, 2019, available at bca.bcaresearch.com 2   Please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 3   Please see US Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4   For more details on our butterfly spread valuation models please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5   The 2/5/30 valuation model is not shown in this report. Please see US Bond Strategy Portfolio Allocation Summary, “Mixed Messages”, dated December 3, 2019, for a recent update of all our yield curve models. 6   Please see US Bond Strategy Special Report, “2019 Key Views: Implications For US Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 7   For further details on how this measure is calculated please see US Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8   Please see US Bond Strategy Weekly Report, “Caa-Rated Bonds: Warning Sign Or Buying Opportunity?”, dated November 26, 2019, available at usbs.bcaresearch.com 9   For further details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 10  We say the Golden Rule “worked” if a dovish surprise coincided with positive Treasury index excess returns versus cash, or if a hawkish surprise coincided with negative Treasury excess returns versus cash.

Highlights Our take on the key macro drivers of financial markets is quite similar to last year’s, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... because the Fed and other central banks have reset the monetary policy clock, … : At this time last year, we projected that the Fed would be on the cusp of tightening monetary policy enough to induce a recession by the middle of 2020. Three rate cuts later, we now expect that policy won’t become restrictive until 2021. … pushing the inflection points investors care about further out into the future: The next recession won’t begin before monetary policy settings are tight, and stocks won’t peak until about six months before the recession starts. We are keeping close tabs on the trade negotiations and potential election outcomes, but we expect that 2020 will be another rewarding year for riskier assets: The equity bull market is likely to last for all of next year, and spread product will keep cranking out excess returns over Treasuries and cash for a while longer, too. Overweight equities and spread product. Feature Mr. and Ms. X made their annual visit to BCA last month, giving us an opportunity to gather our thoughts for 2020, while reviewing how our calls turned out in 2019. Both BCA and US Investment Strategy got the asset allocation conclusion right – overweight equities and spread product, while underweighting Treasuries – but the Fed did the opposite of what we expected heading into 2019, putting us on the wrong side of the Treasury duration call for most of the year. We still think investors are overly complacent about the potential for future inflation, but we concede that the future remains further off than we initially expected. Monetary policy settings got more accommodative nearly everywhere in the world in 2019, ... Our Outlook 2020 theme, as detailed in the year-end edition of The Bank Credit Analyst, is Heading into the End Game,1 and it is clear that the expansion is in its latter stages. We do not think that the end of the expansion, the equity bull market, or credit’s extended stretch of positive excess returns is at hand, however. The full-employment/low-inflation sweet spot is still in place, and the Fed has no plans to get in the expansion’s way, even if inflation begins to gain some traction. Its biggest policy priority is trying to get inflation expectations back to the 2.3 – 2.5% range consistent with its inflation target. Chart 1Globalization Hits A Wall Globalization Hits A Wall Globalization Hits A Wall Central banks around the world followed the Fed’s lead this year, cutting their policy rates in an attempt to shield their economies from potentially worsening trade tensions. Though no central banker would say it out loud, joining the rate-cutting parade also helped to defend against currency appreciation, as no one wants a strong currency when growth is in such short supply. The upshot is that global central banks are deliberately promoting reflation. That’s a supportive policy backdrop for risk assets, and while it may well lead to a bigger hangover down the road, it will ramp up the party now. Exogenous challenges remain. Trade tensions are a thorn in businesses’, consumers’ and investors’ sides. Even if US-China tensions die down, a belligerent US administration appears bent on using tariffs and other trade barriers as a cudgel to force concessions from other nations. The trade tailwind that boosted economic growth and investment returns across the last two decades has been stilled (Chart 1). Saber rattling by the US, or mischief from the usual rogue-state and non-state suspects, could also keep markets on edge. The looming election could give investors heartburn, and clients around the world remain anxious about the prospects of a Warren administration. Exogenous risks abound, but it is not our base case that a critical mass will coalesce to disrupt our view that generous-to-indulgent monetary policy settings will delay the day of reckoning, and keep the bull market going all the way through the coming year. As The Cycles Turn From our perspective, the practice of investment strategy is properly founded on the study of cycles. The key cycles – the business cycle, the credit cycle, and the monetary policy cycle – determine how receptive the macroeconomic backdrop is for taking investment risk. Investments made when the backdrop supports risk taking have a much better likelihood of generating excess returns over Treasuries and cash than investments made against an unfriendly macro backdrop. We therefore start every investment decision with an assessment of the key cycles. Determining whether the economy is expanding or contracting may seem like an academic debate with little practical application when the official business cycle arbiters don’t even determine the beginning and ending dates of recessions until well after the fact.2 Equity bear markets reliably coincide with recessions, however, and over the last 50 years, they have begun an average of six months before their onset (Chart 2). An investor who recognizes that a recession is at hand has a good chance of outperforming his/her competitors as long as s/he aggressively adjusts portfolio allocations in line with that recognition. Chart 2Bear Markets Rarely Occur Outside Of Recessions, ... Bear Markets Rarely Occur Outside Of Recessions, ... Bear Markets Rarely Occur Outside Of Recessions, ... Our key view, then, is that the start of the next recession is at least 18 to 24 months away. Tight monetary policy is a necessary, albeit not sufficient, condition for a recession (Chart 3), and we consider the Fed’s current monetary policy settings to be easy, especially after this year’s three rate cuts. A recession can’t begin until the Fed reverses those three cuts and, per our estimate of the equilibrium rate, tacks on at least three additional hikes. Tightening along those lines is decidedly not on the Fed’s 2020 agenda. Chart 3... And Recessions Only Occur When Monetary Conditions Are Tight ... And Recessions Only Occur When Monetary Conditions Are Tight ... And Recessions Only Occur When Monetary Conditions Are Tight Our recession judgment compels us to be overweight equities. Even if the next recession begins exactly halfway through 2021, history suggests that 2020 returns will be robust. Over the last 50 years, the S&P 500 has peaked an average of six months before the start of a recession, and returns heading into the peak have been quite strong, especially in the last four expansions (Table 1). Those results are consistent with bull markets’ tendency to sprint to the finish line (Chart 4). Table 1Stocks Don't Quit Until A Recession Is Near 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Chart 4Bull Markets End In Stampedes 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet The Fed Funds Rate Cycle We estimate that the equilibrium fed funds rate is currently around 3¼%, and project it will approach 3½% by the end of next year. If we are correct that the Fed’s main policy aim is to prod inflation expectations higher, it follows that it will remain on hold at 1.75% well into 2020. A desire to avoid even the appearance of meddling in the election may well keep the FOMC sidelined until its November and December meetings. The implication is that monetary policy will have no chance to cross into restrictive territory before the first half of 2021. The bottom line for investors is that the day when the economy and markets will have to confront tight monetary conditions has been indefinitely postponed. The Fed has effectively deferred the inflections in the business cycle and the equity market to some point beyond 2020. A longer stretch of accommodation would also continue to fuel the equity bull market, as Phases I and IV of the fed funds rate cycle, in which the fed funds rate is below our estimate of equilibrium (Chart 5), have been equities’ historical sweet spot. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 2), while Treasuries have shined when it’s tight (Table 3). Chart 5The Fed Funds Rate Cycle 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Table 2Equities Love Easy Policy, … 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Table 3… When They Leave Treasuries Far Behind 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet The Credit Cycle Our 30,000-foot view of the credit cycle is based on the banking mantra that bad loans are made in good times. When an expansion has been going on for a while, loan officers focus more on maintaining market share than lending standards, while managers of credit funds attract more assets, pushing them to find a home for their new inflows. Banks and bond managers are thereby pro-cyclical at the margin, keeping the good times going by lending to increasingly marginal borrowers and/or relaxing the terms on which they will lend. (They’re conversely stingy when real-time conditions are bad.) Lenders’ lagging/coincident focus keeps lending standards and borrower performance closely aligned in real time (Chart 6). Chart 6Standards Are Coincident In Real Time, ... Standards Are Coincident In Real Time, ... Standards Are Coincident In Real Time, ... Standards are a contrarian indicator over longer periods, though, because shoddily underwritten loans eventually show their true colors. We find a solid fit between corporate bond default rates and lending standards in the preceding 20 quarters (Chart 7). Lending standards tightened slightly in 2015, but were still quite easy in an absolute sense. A majority of banks tightened standards in 2016 amidst the oil rout, which could point to marginally better 2020-21 performance, but post-2010 standards have hardly been stringent. Chart 7... And Leading Over Five-Year Periods ... And Leading Over Five-Year Periods ... And Leading Over Five-Year Periods The stock of outstanding loans and bonds is therefore vulnerable. The relaxation of corporate bond covenants so soon after the financial crisis has not escaped the notice of bearish investors and reporters. It is not enough for an investor to identify a vulnerability, however; s/he also has to identify the catalyst that is going to cause a rupture. The challenge is that ultra-accommodative monetary policy delays the formation of negative catalysts. To the utter torment of an observer with an attraction to the Austrian School of Economics’ survival-of-the-fittest ethic, it is not at all easy to default in a ZIRP/NIRP world. The stock of $12 trillion of bonds with negative nominal yields (down from August’s $17 trillion peak) has ginned up a fervent search for yield among large institutional investor constituencies that have to meet a fixed distribution schedule, like life insurers and pension funds. These income-starved investors help explain why nearly any borrower, no matter how sketchy, can draw a crowd of would-be lenders simply by offering an incremental 50 or 75 basis points of yield. Borrowers default when no one is willing to roll over their maturing obligations; they get even more leveraged when lenders are climbing over each other to lend to them. It is also hard to default when central banks are deliberately pursuing reflation. Inflation makes debt service easier, and central banks are all-in for reflation as a means to bolster inflation expectations, defend against further trade tensions, and to ensure currency strength doesn’t undermine exports. The credit cycle is well advanced, and the Austrians may be at least partially vindicated when the ensuing selloff is worse than it would otherwise have been for having been delayed, but it looks to us like it has more room to run. The rapture remains out of reach for Austrian School devotees, who slot between Tantalus and New York Knicks fans on the cosmic persecution scale. Bonds We remain bearish on Treasuries and reiterate our below-benchmark duration recommendation, though we recognize that the 10-year Treasury yield is unlikely to rise beyond the 2.25-2.5% range in the next year. There’s only one more rate cut to price out of the OIS curve, and neither inflation expectations nor the term premium will return to normal levels quickly. The intermediate- and long-term outlook for the Federal budget is grim, given the size of the deficit while unemployment is at a 50-year low (Chart 8), but Dick Cheney will maintain the upper hand over deficit hawks for 2020 and several years beyond. We do think investors are complacent about inflation’s eventual return, though, and continue to advocate for TIPS over nominal Treasuries. It is tough to default in a ZIRP/NIRP world, when several institutional investor constituencies have a voracious appetite for yield. Chart 8The Budget Outlook Is Grim The Budget Outlook Is Grim The Budget Outlook Is Grim Chart 9IG Spreads Are Wafer Thin IG Spreads Are Wafer Thin IG Spreads Are Wafer Thin Our benign near-term view of the credit cycle makes us comfortable continuing to overweight spread product, subject to our US Bond Strategy colleagues’ preferences. They are only neutral on investment-grade corporates, given their scant duration-adjusted spread over Treasuries (Chart 9). They recommend overweighting high-yield corporate bonds instead, given that high-yield spreads still offer ample positive carry. They also recommend agency mortgage-backed securities as a high-quality alternative to investment-grade corporates, noting that their low duration (three years versus nearly eight for corporates) offers better protection against rising rates. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive until early to mid-2021 at the earliest, the bull market should be able to continue through all of 2020. We do not foresee a return to double-digit earnings growth, but the upward turn in leading indicators across a wide swath of countries outside of the US suggests that a revival in the rest of the world could help S&P 500 constituents grow earnings by mid-single digits, via a pickup in non-US demand and some softening in the dollar. Net share retirements could even nudge earnings growth into the high single digits. If earnings multiples hold up (they’ve expanded at a 5.5% annual rate in Phase IV of the fed funds rate cycle, and don’t typically contract until Phase II), S&P 500 total returns could reach the high single digits, easily putting them ahead of prospective Treasury returns. Multiple expansion isn’t required to support an overweight equities recommendation, but we would not be at all surprised if it occurred. Bull markets often get silly as they sprint to the finish line, and it would be unusual if some froth didn’t bubble up before this bull market, the longest of the postwar era, calls it quits. The Dollar We expect the dollar to weaken against other major currencies in 2020. As the rest of the world finds its footing and begins to accelerate, the growth differential between the US and other major economies will narrow. The dollar will attract less safe-haven flows as the rest of the world’s major economies escape stall speed. Though we expect the countercyclical dollar will rally again when the next recession hits, weakening in 2020 is consistent with our constructive global growth view. Putting It All Together We are sanguine about the US economy, which continued to trundle along at a trend pace in 2019 despite a series of headwinds. It withstood 4Q18’s sharp equity selloff and bond-spread blowout that tightened financial conditions and made corporate and investor confidence wobble. It withstood the 35-day federal government shutdown that lasted nearly all of January. It kept marching forward despite the trade war with China, and it overcame, at least for now, the angst over the inverted yield curve. If the economy continued to expand at roughly its trend pace despite those obstacles, it may not really have needed 25-basis-point rate cuts in July, September and October. The thread connecting our macro views and investment recommendations is the idea that monetary policy settings are highly accommodative and are likely to stay that way until the 2020 election. We expect that risk assets will outperform against an accommodating monetary backdrop. The naysayers are as likely to be confounded by central banks in 2020 as they have been throughout the entire ZIRP/NIRP era. The scolds scouring the data to try to find signs of excesses, and the Chicken Littles who have been frightened by clickbait headlines and strategists deliberately pursuing pessimistic outlier strategies, get one thing right. The market selloffs when the equity and credit bull markets end will be worse than they would have been if the Fed and other central banks were not deliberately attempting to reflate their economies. But their timing is likely to be as bad now as it has been all throughout 2019 (and for the entire post-crisis period for card-carrying, sandwich-board-wearing Austrians). You can’t fight the Fed, much less the ECB, the Bank of Japan, the Bank of England, the Swiss National Bank, the Reserve Banks of Australia and New Zealand, and a broad swath of all of the rest of the world’s central banks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the December 2019 Bank Credit Analyst, “Outlook 2020: Heading Into The End Game,” available at www.bcaresearch.com. 2 The NBER’s Business Cycle Dating Committee announced in December 2008 that the last recession began in December 2007. It announced in September 2010 that it had ended in June 2009.

Highlights We are upgrading Pakistani equities to overweight within an EM equity portfolio. Fixed-income investors should consider purchasing 5-year local currency government bonds. The balance-of-payments adjustment is probably over. Hence, the currency will be stable, allowing inflation and interest rates to drop. Feature The country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Chart I-1Pakistani Stocks: The Worst Is Over Pakistani Stocks: The Worst Is Over Pakistani Stocks: The Worst Is Over We downgraded Pakistani equities in March 2017  and put this bourse on our upgrade watch list this past May (Chart I-1). In the past two years, the country has been going through a severe balance-of-payments crisis and a correspondingly painful adjustment. In recent months, the country’s macro dynamics have shown signs of stabilization. This has begun benefiting share prices in both absolute terms and relative to the EM equity benchmark. Today we are upgrading Pakistani stocks to overweight within an EM equity portfolio and recommend buying 5-year local currency government bonds. The worst is over for the economy and its financial markets for the following reasons. First, the country’s balance-of-payments position will improve. In real effective exchange rate (REER) terms, the Pakistani rupee has depreciated 15% over the past two years (Chart I-2). This will boost exports and cap imports, narrowing both trade and current account deficits further (Chart I-3).   Chart I-2Considerable Depreciation In Pakistani Rupee… Considerable Depreciation In Pakistani Rupee... Considerable Depreciation In Pakistani Rupee... Chart I-3…Will Boost Exports And Cap Imports ...Will Boost Exports And Cap Imports ...Will Boost Exports And Cap Imports We expect exports to grow 5-10% next year. The country’s competitiveness has improved considerably, with its top commodities exports all having shown impressive growth in volume terms, despite weakening global growth (Chart I-4). Besides, in order to boost exports, the government has reduced the cost of raw materials and semi-finished products used in exportable products by exempting them from all customs duties in fiscal 2020 (July 2019 – June 2020). The government has also promised to provide sales tax refunds to the export sector. Chart I-4Increasing Competitiveness In Pakistan Exports Increasing Competitiveness In Pakistan Exports Increasing Competitiveness In Pakistan Exports In addition, falling oil prices will help reduce the country’s import bill. Remittance inflows – currently equaling 9% of GDP – have become an extremely important source of financing for Pakistan’s trade deficit. In the past 12 months, remittances sent from overseas have risen to US$22 billion, and have covered most of the US$28 billion trade deficit.   Financial inflows are also likely to increase in 2020 and will be sufficient to finance the current account deficit. The IMF will disburse roughly US$2 billion to Pakistan. Other multilateral/bilateral lending/grants and planned issuance of Sukuk or Euro bonds will provide the government with much-needed foreign funding.  As the economy recovers, net foreign direct inflows are also likely to increase. Net foreign direct investment received by Pakistan has grown 24% year-on-year in the past six months, with 56% of the increase coming from China. Overall, the improvement in Pakistan’s balance-of-payments position will continue, resulting in a refill of the country’s foreign currency reserves. Odds are that the central bank will purchase foreign currency from the government as the latter gets foreign funding. This will provide the government with local currency to spend. At the same time, the central bank’s purchases of these foreign exchange inflows will boost the local currency money supply – a positive development for the economy and stock market. Chart I-5 shows that the Pakistani stock market closely correlates with swings in the nation’s narrow money growth. The Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Chart I-5Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Pakistan: Ameliorating Balance-Of-Payments Position Will Benefit Stock Prices Chart I-6Pakistan: Improving Fiscal Balance Pakistan: Improving Fiscal Balance Pakistan: Improving Fiscal Balance Second, Pakistan’s fiscal balance also shows signs of improvement. Pakistan and the IMF have agreed to set the target for the overall budget and primary deficits at 7.2% of GDP and 0.6% of GDP, respectively, for the current fiscal year (Chart I-6). This will be a considerable improvement from the 8.9% of GDP and 3.3% of GDP, respectively, last fiscal year. In early November, the IMF praised Pakistan for having successfully managed to post a primary budget surplus of 0.9% of GDP during the first quarter (July 1, 2019 – September 30, 2019) of its current fiscal year. The authorities are determined to maintain strict fiscal discipline. The country’s tax-to-GDP ratio is at about 12%, one of the lowest in the world, so there is room to expand the tax base. Third, the Pakistani central bank will soon start a rate-cutting cycle as the exchange rate stabilizes. This is a typical recovery process following a balance-of-payments crisis and substantial currency devaluation. Both headline and core inflation seem to have peaked (Chart I-7). Headline inflation fell to 11% in October, which already lies within the central bank’s target range of 11-12% for the current fiscal year. The policy rate is currently 225 basis points higher than headline inflation. As inflation drops and the currency finds support, interest rates will be reduced to facilitate the economic recovery. In addition, there has been much less public debt monetization by the central bank. After borrowing Rs3.16 trillion from the central bank in the previous fiscal year, the federal government has curtailed such borrowing to only Rs122 billion in the first three months of this fiscal year. Diminishing debt monetization will also help ease domestic inflation. Chart I-7Inflation Has Peaked Inflation Has Peaked Inflation Has Peaked Chart I-8Manufacturing Activity Is Likely To Recover Soon Manufacturing Activity Is Likely To Recover Soon Manufacturing Activity Is Likely To Recover Soon Fourth, manufacturing activity in Pakistan has plunged to extremely low levels, comparable to the 2008 Great Recession (Chart I-8). With a more stabilized local currency, easing domestic inflation and interest rate reductions, Pakistan’s economic activity is set to recover soon from a very low base.  Finally, Phase II of the China-Pakistan Economic Corridor (CPEC) is set to begin this month. Under Phase II of the CPEC, five special economic zones will be established with Chinese industrial relocation. Phase II will also bring forward dividends from Phase I projects. The nation’s infrastructure facilities built by China over the past several years have enhanced the productive capacity of the Pakistani economy. The significant increase in electricity supply and improved railway/highway transportation will promote higher productivity/efficiency gains. Bottom Line: We are upgrading Pakistani equities to overweight within the emerging markets space. Both absolute and relative valuations of Pakistani stocks appear attractive (Charts I-9 and I-10). Chart I-9Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Pakistani Stocks: Valuations Are Attractive In Absolute Terms... Chart I-10…And Relative To EM Equities ...And Relative To EM Equities ...And Relative To EM Equities Meanwhile, we recommend going long Pakistani 5-year local currency government bonds currently yielding 11.5%, as we expect interest rates to drop quite a bit (Chart I-11).  Chart I-11Go Long Pakistani 5-Year Local Currency Government Bonds Go Long Pakistani 5-Year Local Currency Government Bonds Go Long Pakistani 5-Year Local Currency Government Bonds   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations