Fixed Income

Highlights There is little risk that inflation will heat up over the next several months, … : Weak growth is more of a threat to the global economy than inflation. … which means the Fed won’t be in any hurry to take away this year’s rate cuts, … : We expect the Fed to leave the target fed funds rate alone for nearly all of 2020. … giving the economy plenty of opportunity to overheat: If trade tensions move to the back burner, and global manufacturing activity revives, the “insurance” rate cuts executed by the Fed and other central banks may turn out to have been unnecessary. The investment punch line is that accommodative monetary policy is likely to push asset prices and Treasury yields higher: Our revised Rates View Checklist supports going back to a below-benchmark duration stance over the tactical timeframe, in line with our cyclical view. Feature BCA researchers’ latest monthly view meeting opened with a discussion of whether inflation or deflation is the bigger risk to financial markets. Should investors be more concerned about signs of overheating or stalling growth? With inflation unable to get traction in any of the major economies, we all agreed that growth is the more critical unknown. An investor who gets the growth call right has the best chance of getting broad asset class positioning right, along with country, sector, duration, credit and currency tilts. While we continue to believe that there are more inflation pressures beneath the surface of the US economy than most investors realize, they are highly unlikely to manifest themselves any time soon. At today’s low-single-digit levels, inflation’s investment import is limited to its impact on monetary policy. Inflation expectations remain far below the levels that are consistent with the Fed’s inflation target (Chart 1), and the Fed is likely to keep policy easy until they adjust higher. Though it is uncertain just what levels of realized inflation, or inflation expectations, would trigger the Fed’s reaction function, we are confident that inflation will not be an issue in the coming year. Chart 1No Pressure To Remove Accommodation No Pressure To Remove Accommodation No Pressure To Remove Accommodation Chart 2Global Revival Ahead? Global Revival Ahead? Global Revival Ahead? We expect that global growth will surprise to the upside, pulling bond yields and risk asset prices higher. BCA’s global LEI bottomed earlier this year, and the diffusion index that leads directional moves in the LEI has turned sharply higher (Chart 2). The improvement is consistent with the easing in global financial conditions and the tentative détente in the trade war. Although we will not count on a completed “Phase I” agreement until it is signed, financial markets’ allergic reaction to trade tensions seems to have encouraged the White House to back off lest it undermine its re-election prospects. Interest Rates – Looking Back Figure 1Rates View Checklist Refreshing Our Rates View Refreshing Our Rates View We rolled out our Rates View Checklist a little over a year ago to systematize our interest rate analysis and to clarify the rationale underpinning our views1 (Figure 1). Detailing the key series we monitor to anticipate the future direction of rates helps clients think along with us while giving them the chance to adapt the framework for their own purposes. As we were starting from a position of recommending below-benchmark duration, the checklist was aimed at identifying and tracking the factors that could encourage us to become more constructive about Treasury bonds. We never did warm to duration on a cyclical basis, though we did turn tactically neutral in mid-August. Part of the reason was that we did not give enough weight to events outside of the US. Highly-rated, developed-market sovereign bonds are substitutes for one another, and there is a limit to how much currency-adjusted yields can deviate across countries. Very low to negative yields in the UK, France, Germany and Switzerland have exerted a magnetic pull on Treasury yields (Chart 3), and the different sovereigns should move in tandem going forward, with currency-hedged yields observing a tight range. Chart 3Birds Of A Feather Birds Of A Feather Birds Of A Feather The short end of the yield curve exerts considerable influence on rates across all maturities. Our US bond strategists’ golden rule of bond investing homes in on the deviation between actual and expected moves in the fed funds rate as the key determinant of duration positioning outcomes. Following their lead, our checklist is oriented around anticipating the Fed’s reaction to important incoming data. It seems to have done its job over the last year, highlighting the factors that drove the Fed to switch from dialing back accommodation to dialing it up. Although we never checked more than four of the eleven boxes in the checklist – Inverted Yield Curve, Sluggish Rise in Realized Inflation, Sluggish Rise in Inflation Breakevens and International Duress – those four boxes were enough to inspire the Fed’s dovish pivot. That pivot has so far encompassed three quarter-point rate cuts, pruning back the funds rate to 1.75% from 2.5%. It turns out that the key items in the checklist were the orientation of the yield curve; sluggish inflation expectations that the Fed worried could become “unanchored on the downside;” and the shadow of trade tensions that seem to have induced a global manufacturing recession, even if they have yet to infect the DM economies’ larger services sector. They tipped the scales for Fed policy and we will be especially alert to them going forward. Interest Rates – Looking Ahead Figure 2Revised Rates View Checklist Refreshing Our Rates View Refreshing Our Rates View While our interpretation of the checklist left something to be desired, we are convinced that the checklist approach is sound. We return to its framework for insight into the current rates outlook, after making a few tweaks to shore it up (Figure 2). Starting with Fed perceptions, there is still some daylight between our fed funds rate expectations and the market’s, as we think the Fed is done cutting, while the money market assigns a high probability to the possibility of one more cut (Chart 4). The combination of rate cuts and the rally in 10-year Treasury yields got the yield curve back to its typical upward-sloping orientation in October (Chart 5), so we can now uncheck the inverted curve box. We see the five-month inversion as a reason to be more vigilant, but given the unusually negative term premium, we are not treating it as a hard-and-fast sign of looming weakness. The money market has priced out all but one more rate cut, and the yield curve is no longer inverted, suggesting that recession fears are abating. Chart 4Looking For One More Cut Looking For One More Cut Looking For One More Cut Chart 5The Curve Is No Longer Inverted The Curve Is No Longer Inverted The Curve Is No Longer Inverted Chart 6Inflation Is Muted, ... Inflation Is Muted, ... Inflation Is Muted, ... We continue to check both of the sluggish inflation boxes. Realized inflation measures, headline and core, have slumped (Chart 6), and below-target inflation expectations remain a hot-button concern, judging by Fed speakers’ repeated references to them. The Fed has strapped itself to the mast with all its talk about inflation expectations, and it will not begin removing accommodation until inflation expectations revive. We cannot directly observe the output gap, but nearly 3% growth in 2018, and a rip-roaring labor market, offer solid evidence that it has closed and we leave its box unchecked. Labor market indicators unanimously point to the conclusion that monetary accommodation is not necessary. The unemployment rate is a full percentage point below the Fed’s and the CBO’s estimates of NAIRU. Ancillary indicators like the broader definition of unemployment including discouraged workers and involuntary part-time workers (Chart 7, top panel), and the openings (Chart 7, middle panel) and quits rates (Chart 7, bottom panel) from the JOLTS survey, testify to an extremely tight labor market. We expect that the pause in wage acceleration will prove temporary (Chart 8). Chart 7... Despite A Red-Hot Labor Market ... Despite A Red-Hot Labor Market ... Despite A Red-Hot Labor Market Chart 8Wage Gains Will Pick Up Again Wage Gains Will Pick Up Again Wage Gains Will Pick Up Again Chart 9No Overheating In The Real Economy No Overheating In The Real Economy No Overheating In The Real Economy With cyclical spending well short of past business cycle peaks (Chart 9), the real economy isn’t exerting any pressure on the Fed to intervene to choke off the expansion. (Although a modest pace of Fed hikes would support below-benchmark duration positioning, aggressive tightening to cut off overheating leads to recessions, and would favor long-maturity Treasuries.) We have removed the financial sector imbalances box because there has been no apparent follow through from Governor Brainard’s speech last September, which appeared to set the stage for tightening on the basis of frothy credit conditions. We maintain the international duress box, which is meant to alert us to an overseas crisis or near-crisis that could spark a flight to quality that depresses Treasury yields and/or inspires the Fed to pursue easier policy in an attempt to stave off contagion risks. Green shoots in manufact-uring, here and abroad, support the idea that growth outside the U.S. could be poised to accelerate. Chart 10Global Manufacturing Is Coming Back ... chart 10 Global Manufacturing Is Coming Back ... Global Manufacturing Is Coming Back ... Chart 11... And US Manufacturing May Have Bottomed ... And US Manufacturing May Have Bottomed ... And US Manufacturing May Have Bottomed We add “Flagging Global Growth” to address the global growth blind spot that undermined our call last year. Our US Bond Strategy colleagues find that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials Index are the global growth measures that exert the strongest influence on Treasury yields. The Global Manufacturing PMI has risen off its lows over the last three months and is within striking distance of getting back above the 50 contraction/expansion line, led by the US2 and China (Chart 10). The outlook for the US ISM Manufacturing PMI looks good on several counts. First, the comparatively modest manufacturing sector tends to move with the much larger services sector, and the sharp bounce in the Services PMI bodes well for the Manufacturing PMI (Chart 11, top panel). Within the manufacturing survey, New Export Orders’ leap back over 50 suggests that the global economy may have already seen the worst of the manufacturing weakness that has swept the rest of the world (Chart 11, bottom panel). The jury is still out on the CRB Raw Industrials-to-gold ratio (Chart 12, top panel), as industrial commodity prices have yet to show any spunk (Chart 12, bottom panel).   Chart 12Commodities Have Yet To Turn Commodities Have Yet To Turn Commodities Have Yet To Turn Chart 13A Weaker Dollar Would Support Higher Rates A Weaker Dollar Would Support Higher Rates A Weaker Dollar Would Support Higher Rates With our trio of indicators mixed-to-positive on balance, we leave the global growth box unchecked. We have also added a dollar box to monitor when Treasury yields are drifting out of alignment with other sovereign yields. If the dollar and Treasury yields rise together, we would view the rise in yields as suspect and at risk of being reversed.3 There doesn’t appear to be any decoupling pressure now, as Treasury yields have risen while the dollar has bumped around in a narrow range (Chart 13, top panel), and bullish sentiment toward the dollar has cooled off, pointing the way to a currency-approved path to higher yields (Chart 13, bottom panel). Bottom Line: We check only two of the boxes in our revised rates checklist (Figure 2), supporting a below-benchmark duration stance. Investment Implications Like all investors, we hate to get anything wrong. We were wrong on rates, though, failing to see the potential for the 10-year Treasury yield to fall to 1.5%. The duration miss undermined results within the fixed income sleeve of our recommendations, as we didn’t take it off until the 10-year Treasury yield had fallen to 1.74% .4 We have modified our rates checklist to force ourselves to be more aware of the world beyond the US, but the available data still support below-benchmark duration positioning, and we now recommend going back to it over the tactical (0-3-month) timeframe. The date when monetary policy turns restrictive has been pushed out, and so have the dates when the bull markets in risk assets will end. We note that our overall asset allocation calls have performed well. Since we upgraded equities in our first 2019 report,5 the S&P 500 Total Return Index has gained 24% while our Treasury underweight, as proxied by the Bloomberg Barclays US Treasury Total Return Index, is up 7% (Chart 14, top panel). Since we upgraded spread product in late January,6 the Bloomberg Barclays US Corporate Investment Grade and High Yield Total Return Indexes are up 12% and 8%, respectively, versus the Treasury Index’s 7% (Chart 14, bottom panel). Chart 14Underweighting Treasuries Has Been The Way To Go Underweighting Treasuries Has Been The Way To Go Underweighting Treasuries Has Been The Way To Go The run-up to the Fed’s series of mid-cycle rate cuts doomed our duration call, but it has fortified the case for overweighting equities and spread product. We still expect the expansion, the equity bull market, and spread product’s long period of generating excess returns to die at the hands of the Fed. Now that the date when monetary policy settings become restrictive has been indefinitely delayed, the end-dates of the equity and credit bull markets have as well. We continue to recommend overweighting equities and spread product, and underweighting Treasuries.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 17, 2018 US Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com. 2 The Global PMI is compiled from Markit’s individual country PMIs, so the chart shows the Markit US PMI instead of the more familiar ISM measure. 3 It the dollar were to rise significantly while Treasury yields rose faster than other DM sovereign yields, currency-adjusted Treasury yields would decouple from peer yields and arbitrage activity would likely bring them back down. 4 Please see the August 12, 2019 US Investment Strategy Weekly Report, “When The Facts Change,” available at usis.bcaresearch.com. 5 Please see the January 7, 2019 US Investment Strategy Weekly Report, “What Now?” available at usis.bcaresearch.com. 6 Please see the January 28, 2019 US Investment Strategy Weekly Report, “Double Breaker,” available at usis.bcaresearch.com.

Highlights Investors’ perception of “fallen angels” – bonds downgraded from investment grade to high yield – is mostly negative, especially since many believe we are near the end of the economic and credit cycle. In this report, we show that fallen angels can provide investors with an opportunity to invest in relatively high-quality bonds at attractive valuations – bonds which on average outperform other corporate bonds. We find that a good entry-point into fallen angels is usually a week after the bonds are downgraded, after which selling pressures begin to fade. However, investors need to be aware that fallen angels are accompanied by some, less obvious, risks, particularly longer duration and sector skewness. Introduction Chart 1Baa-Rated Bonds Are Now 50% Of The IG Universe Baa-Rated Bonds Are Now 50% Of The IG Universe Baa-Rated Bonds Are Now 50% Of The IG Universe Elevated levels of US corporate debt, as well as declining credit quality in the investment-grade space, have raised investor worries that a large portion of bonds will be downgraded in the next recession and default cycle. The lowest tranche of investment-grade debt, Baa-rated, now constitutes over 50% of the investment-grade index (Chart 1). However, investors tend to dismiss the opportunities that this tranche of debt can provide when downgraded from investment grade to high yield – known as “fallen angels”. The change in the ownership structure of corporate bonds has contributed to the performance of fallen angels. Increasing demand for corporate-bond funds – both mutual funds and ETFs – has displaced direct ownership of corporate bonds by households and financial institutions over the past few years (Chart 2, panels 1 & 2). Chart 2Corporate Bond Ownership Corporate Bond Ownership Corporate Bond Ownership Active fund managers, constrained by their rules to hold only bonds with a certain (usually non-speculative grade) rating, are often forced to sell their holdings ahead of a potential downgrade. In addition, passive funds exacerbate the selling pressure, since they are forced to sell a bond in the event of a downgrade. Insurance companies and pensions funds, the biggest holders of corporate bonds, have increased their allocation to corporate bonds in the search for income in an environment of low yields. Estimates suggest that life insurance companies’ holdings of Baa-rated bonds comprise 34% of their total portfolios.1 However, high-yield bonds represented less than 5% as of the end of 2016.2 There is no regulation prohibiting them from owning sub-investment-grade bonds, but they face higher capital costs when they do. This could also fuel fire sales during the next downgrade cycle. Fallen angels therefore often enter the high-yield index at a much cheaper valuation than bonds that were originally issued as high yield. In fact, during the past two downgrade cycles, in 2007-2008 and 2015-2016, the average spread of fallen angels over an adjusted high-yield index (weighted so that it has the same credit rating as fallen angels) widened by 560 and 130 basis points, respectively (Chart 3). While this seems negative at a first glance, it also leaves more room for spread compression, once market conditions improve, for investors who correctly time their entry into this market. As the bottom panel of Chart 3 shows, investors almost always receive a higher yield for holding fallen angels compared to a similarly rated high-yield basket. Chart 3Fallen Angels Have Mostly Traded At A Discount... Fallen Angels Have Mostly Traded At A Discount... Fallen Angels Have Mostly Traded At A Discount... Chart 4...Despite Their Better Performance ...Despite Their Better Performance ...Despite Their Better Performance In this Special Report, we explain what fallen angels are, analyze their historical risk-return characteristics, and compare them to other major asset classes, particularly high-yield corporate bonds in general. We show that, once downgraded, fallen angels – due to oversold pressures – tend to outperform other asset classes as well as similarly-credit-rated high-yield bonds (Chart 4). We also assess their performance during periods of financial-market stress. Finally, we discuss the risks associated with owning fallen angels, and highlight the vehicles investors can use to access this asset class. What Are Fallen Angels? Fallen angels refer to bonds that have been downgraded from investment grade to junk (or speculative grade). Whereas different commercial indices can have slightly different classifications for the term (discussed below in the Historical Risk And Return section), the generic definition includes bonds previously classified as investment grade but later downgraded to high yield. These transitions can occur from and to any credit rating within both universes. However, the majority of downgrades occur between the lowest tranche of investment-grade bonds, rated Baa, and the highest tranche of high-yield bonds rated Ba (Chart 5). Generally, fallen angels have provided inves­tors with an opportunity to buy higher qual­ity, cheaper, and better performing corpo­rate bonds than those originally issued as high yield. Generally, fallen angels have provided investors with an opportunity to buy higher quality, cheaper, and better performing corporate bonds than those originally issued as high yield. So how do fallen angels differ? Higher quality: Over 73% of bonds within the fallen angels ETF fall into the Ba bucket – the highest tranche in the speculative space — versus 45% within the broader high-yield ETF (Chart 6). Chart 5The Downgrade Transition Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 6Fallen Angels Have Better Credit Quality Than High Yield Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Cheaper: In anticipation of a downgrade, selling pressure from fund managers intensifies, causing prices of “potential” fallen angels to drop prior to their downgrade date. However, our US Bond Strategists report academic findings that show forced fire sales of fallen angels are usually short-lived.3 They conclude that, once Baa-rated securities are downgraded, there is no mechanism to force downward pressure on the price to continue. Chart 7Selling Pressures Intensify Even After The Bonds Are Downgraded Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Academic research corroborates this view: fallen angels exhibit ‘V-shaped’ price action,4 where their prices start falling ahead of a potential downgrade. This is the result of the reaction of active fund managers as discussed earlier. This trend persists for a short while even after the bonds are downgraded, as passive funds – index mutual funds and ETFs – offload the bonds. Selling pressures come to a halt shortly after the downgrade date (on average around seven trading days). This represents an entry-point for investors to add fallen angels to their portfolios. These conclusions are also supported by the price trajectory of a sample5 of fallen angels we tested (Chart 7). Note, however, that the trajectory shown in our results suggests that the attractiveness of fallen angels disappears quite quickly, since prices plateau about three to four months after the downgrade. Chart 8Fallen Angels Peform Better Than Similar High- Yield Bonds Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Better performance: The fallen angels index has outperformed a similarly credit-rated duration-matched high-yield basket in eight out of the 15 years since the index’s inception. In particular, fallen angels have tended to outperform in years when the Federal Reserve was on hold or cutting interest rates, due to their longer average duration of 5.5 years versus 2.9 years for high-yield bonds – as discussed below in the Risks section (Chart 8). Generally, fallen angels are concentrated in sectors that were subject to a recent shock. This was the case in the Telecommunications sector in 2001, the Financials sector in 2007-2008, and the Energy sector in 2014-2015. How Many Fallen Angels Will There Be In The Next Downturn? Over the past three decades, US Baa-rated debt – the lowest tranche in investment grade – has doubled from only 20% of total corporate debt to 40%. This coincided with an increase in nonfinancial corporate debt from 55% of GDP in the mid-1990s to nearly 75% by the end of 2018. Low interest rates over the past 10 years incentivized firms to take advantage of cheaper financing for capital expenditure, equity buybacks, M&A, and more (Chart 9). To a degree, this corporate behavior was rational since businesses understood that their optimal capital structure in a world of low interest rates required them to take on more debt. Simply put, firms found that targeting a Baa rating was more desirable. While rising leverage and weaker corporate health are concerns, we do not see these as imminent risks until the next recession and downgrade cycle hit – which we do not see happening in the next 12 months. For now, there is no worrying trend in downgrades. In fact, there are more “rising stars” – corporate bonds previously classified as high yield that have been upgraded to investment grade – than fallen angels (Chart 10). Nevertheless, it is important for investors to gauge the extent of potential downgrades during the next recession. Chart 9Debt Issuance: A Smart Corporate Decision Debt Issuance: A Smart Corporate Decision Debt Issuance: A Smart Corporate Decision Chart 10Rising Stars Versus Fallen Angels Rising Stars Versus Fallen Angels Rising Stars Versus Fallen Angels Several research papers use historical probabilities and downgrade rates to estimate a range for potential fallen angels. Given that investment-grade bonds currently amount to $5.3 trillion, and that the average peak in the one-year rate of investment-grade bond downgrades over the past four decades was 7.1%, that would imply the amount of new fallen angels in the next recession to be $376 billion. That is three times bigger than the current value of fallen angels, and represents nearly 30% of the entire junk-bond universe.6  Historical Risk And Return Chart 11Fallen Angels Provide Alpha Fallen Angels Provide Alpha Fallen Angels Provide Alpha To assess the performance of fallen angels versus other high-yield bonds, we adjust the indices to which we compare the fallen angels index in two ways. First, we remove the fallen angels from the overall high-yield index. However, that on its own would fail to consider the different credit qualities of the two indices – shown in Chart 6. It would also make it difficult to account for differences in duration. We therefore create a high-yield duration-matched basket with similar credit ratings to the fallen angels index in order to account for this. Fallen angels significantly outperformed both indices (Chart 11). In doing so, we were also able to distinguish between the extra performance due to duration– the gap between the jade and indigo lines – and the alpha created by fallen angels – the gap between the dark green and the jade lines. For the purpose of this report, we use the Bloomberg Barclays US High Yield Fallen Angel 3% Capped Bond Index, which is designed to track USD-denominated fallen angels. The index, based on the market value of the underlying bonds, includes securities that have a current high-yield rating, while having been assigned an investment-grade index rating at some point since issuance. The index relies on the average of three credit-rating agencies, Fitch, Moody’s, and S&P, to qualify bonds for inclusion. It is worth noting that there are other indices that track fallen angels, with different methodologies. For example, the FTSE Time-Weighted US Fallen Angel Index implements a time-weighted metric, assigning a larger weight to recently downgraded securities. It also adds a maximum inclusion period of 60 months. Since the index’s inception, fallen angels have outperformed other fixed-income assets on both an absolute and risk-adjusted return basis (Table 1). In absolute terms, fallen angels had the highest return of all the assets we compared them with. However, that came with an annualized volatility of 1.5 percentage points higher than the similarly rated high-yield basket – albeit not when compared to its duration-matched counterpart. Another explanation is that the extra volatility is a function of the swift fall and recovery in prices, as well as on going turbulence in the impacted sectors. Table 1Historical Risk-Return Characteristics Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Financial Market Stress Having established that fallen angels on average outperform other types of bonds, we now address the question: how do they perform during recessions and other periods of financial market stress? Given the index’s relatively short history, the only recession we are able to cover is the Global Financial Crisis (GFC) of 2007-2009. Nevertheless, we also look at other market crises dating back to 2005. During the GFC, fallen angels fell, similarly to their high-yield peers. However, coming out of the recession, fallen angels’ performance diverged from similarly rated high-yield bonds as well as from Treasurys and investment-grade bonds. Fallen angels have outperformed other similarly rated high-yield bonds after every market stress period over the past 14 years, except the Q4 2018 equity selloff caused by trade tensions (Chart 12). Fallen angels – even when credit and dura­tion are accounted for – have outperformed following periods of broad credit distress. They also seem to outperform during peri­ods of sector-specific distress. Fallen angels – even when credit and duration are accounted for – have outperformed following periods of broad credit distress. They also seem to outperform following periods of sector-specific distress. Chart 12Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Fallen Angels Outperform In Periods Of Credit- And Sector-Specific Distress Chart 13The Energy Sector: A Perfect Example The Energy Sector: A Perfect Example The Energy Sector: A Perfect Example This was evident in 2015-2017, when Brent crude oil fell from $120 to nearly $40, causing spreads of energy-rated junk bonds to widen dramatically. There was also a rise in corporate downgrades, particularly within the Energy sector. However, as the oil market stabilized and the Energy sector recovered, Energy corporate spreads quickly tightened and fallen angels outperformed a similarly credit-rated high-yield index. In the second half of 2016, the Energy sector comprised 28% of the fallen angels ETF, compared to 13% and 10% of the high-yield and investment grade ETFs respectively (Chart 13).7 Risks The arguments above should make fallen angels of interest to any investor. However, there are also risks, in particular the following: Sector skew: We have shown that fallen angels can be concentrated in sectors going through distress – the oil market in 2014-2015 being a perfect example. It is important to be aware of the sector skew of fallen angels compared to the high-yield and investment-grade bond universes. As of October 2019, the fallen angels universe was skewed towards the Energy, Technology, and the Industrials sectors compared to both high-yield and investment-grade bonds. It was notably underweight Consumer Non-cyclicals (Chart 14). Fallen angels also have a skew towards Banks – 12% as opposed to 2% in the high-yield universe. This might represent an opportunity rather than a risk. It could allow investors to exploit sectoral differences in the credit market. Longer Duration: Fallen angels also present greater duration risk. Given that they were once investment grade, they have a longer maturity of 9.8 years on average, versus 7.1 years for the credit-weighted high-yield basket. That would partially explain why fallen angels’ duration did not decline as much this year when long-term bond yields fell over 100 bps. We expect higher long-term interest rates over the next 12 months, which might hurt the performance of fallen angels (Chart 15). Chart 14Sector Skew: Risk And Opportunity Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 15Fallen Angels: Characteristics Fallen Angels: Characteristics Fallen Angels: Characteristics Idiosyncratic Risks: The most obvious risk would be that the firm is incapable of fixing its balance sheet, and ultimately becomes subject to further downgrades. Catching Fallen Angels Investors now have access to vehicles that track fallen angels, though these ETFs are still new and rather small. ANGL and FALN were launched in 2012 and 2016 and track the BofA Merrill Lynch and Bloomberg Barclays fallen angles indices respectively (Table 2). Table 2ETFs Tracking Fallen Angels Even Fallen Angels Have A Place In Heaven Even Fallen Angels Have A Place In Heaven Chart 16Catching Fallen Angels Catching Fallen Angels Catching Fallen Angels Chart 16 shows the tracking error and tracking difference between the fallen angels index and the FALN ETF. The tracking error for FALN has been higher than the ETF tracking the overall high-yield index (HYG), but the tracking difference has been less volatile. Conclusion        Fallen angels allow investors to buy certain high-yield bonds at an attractive valuation for a period of time. Fallen angels have historically provided a pick-up in risk-adjusted performance over overall high-yield bonds, even when adjusting for quality differences. They have also outperformed investment-grade bonds on a risk-adjusted basis, as well as other asset classes. Investors need to time their entry-point into fallen angels. The ideal timing is usually about a week after the bond is downgraded. The sector weighting of the fallen-angels index tends to be related to a recent market or sector shock. Sector skew and long duration remain the principal risks that investors should be wary of.   Amr Hanafy Research Associate AmrH@bcaresearch.com   Footnotes 1    Please see Financial Times "Search for yield draws US life insurers to risky places", available at https://www.ft.com/ 2   Please see National Association Of Insurance Commissioners, Capital Markets Special Report Index, “U.S. Insurers’ High-Yield Bond Exposure On The Rise”, December 21st 2017. 3   Please see US Bond Strategy Special Report titled “The Risk From US Corporate Debt Part 2: Fund Flows, BBBs, And Leveraged Loans", available at usbs.bcaresearch.com 4   Please see Prof. Andrew Clare, Prof. Stephen Thomas, Dr Nick Motson “Fallen Angels: The investment opportunity”, dated September 2016, Cass Business School. 5   We looked at the 12-month price trajectory (six months before and after the downgrade date) of 60 corporate bonds in the FALN ETF. 6   Please see Moody’s Investors Service, Fallen angels: High-yield market buffers potential transitions amid wider risks, May 13, 2019. 7   We used the iShares Fallen Angels USD Bond ETF (FALN) as a proxy for fallen angels, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) as a proxy for high-yield bonds, and the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) as a proxy for investment-grade bonds.

Highlights Prevailing winds are still blowing in favor of the US dollar. Continue shorting a basket of EM currencies versus the greenback. Deflationary forces are gaining momentum in EM/China while inflationary pressures are accumulating in the US economy. The dollar will appreciate further, distributing inflationary pressures away from the US and into EM/China. Feature Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered. Last week the EM index closed a hair short of this level. Our strategy remains intact: We continue to recommend caution and defensive positioning for EM investors, but will recommend playing the rally if the index breaks above this level. The fact that industrial metals and oil prices have failed to rally substantially even though the S&P 500 is making new highs gives us comfort that the Chinese industrial cycle is not experiencing a revival. Our buy stop on the MSCI EM equity index at 1075 has not yet been triggered.  Absent a sustained recovery in the Chinese capital spending and rising commodities prices, EM equities and currencies will not be able to maintain their rebound. Chart I-1 illustrates that the total return on EM ex-China currencies (including the carry) correlates strongly with industrial metals prices. Similarly, EM share prices move in tandem with global materials stocks (Chart I-2). Chart I-1EM Currencies Correlate Strongly With Industrial Metals Prices bca.ems_wr_2019_11_14_s1_c1 bca.ems_wr_2019_11_14_s1_c1 Chart I-2EM Share Prices Move In Tandem With Global Materials Stocks EM Share Prices Move In Tandem With Global Materials Stocks EM Share Prices Move In Tandem With Global Materials Stocks   The basis for these relationships is as follows: The majority of EM economies, and hence their share prices and exchange rates, are leveraged to China’s business cycle. The latter also drives industrial commodities prices, as the mainland accounts for 50% of global metals consumption. We elaborated on these relationships in our recent report titled EM: Perceptions Versus Reality. In this report, we examine the dichotomy between inflation in EM and US and discuss the macro rebalancing required and the implications for financial markets. Inflation: A Dichotomy Between EM… Low and rapidly falling inflation accompanying extremely weak real growth constitute the current hazards to EM economies and their financial markets: Headline and core inflation in EM ex-China, Korea and Taiwan1 – the universe pertinent for EM bond portfolios – are low and falling, justifying lower interest rates (Chart I-3). Consistently, aggregate nominal GDP growth in these economies is hovering close to its 2015 low (Chart I-4). Chart I-3EM: Inflation Is Low And Falling EM: Inflation Is Low And Falling EM: Inflation Is Low And Falling Chart I-4EM: Nominal GDP Is Subdued And Decelerating EM: Nominal GDP Is Subdued And Decelerating EM: Nominal GDP Is Subdued And Decelerating Chart I-5EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing EM Ex-China, Korea And Taiwan: Money And Loan Growth Are Slowing In China, core consumer price inflation is at 1.5% and falling, and producer prices are declining. Even though many EM central banks have been cutting rates, narrow and broad money as well as bank loan growth are either weak or decelerating (Chart I-5). In brief, policy easing in these economies hasn’t yet revived money and credit growth. The reason why low nominal interest rates have not yet led to a recovery in money/credit is because real (inflation-adjusted) borrowing costs remain elevated. In addition, poor banking system health stemming from lingering non-performing loans – a legacy of the credit boom early this decade – has also hindered credit origination. Corroborating the fact that borrowing costs are high in real (inflation-adjusted) terms, interest rate and credit-sensitive sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. In particular, high-frequency data such as capital goods imports and car sales are shrinking (Chart I-6). Residential property markets are very sluggish in the majority of developing economies (Chart I-7). Chart I-6EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking EM Ex-China, Korea And Taiwan: Credit-Sensitive Spending Is Shrinking Chart I-7Property Prices In Local Currency Terms Property Prices In Local Currency Terms Property Prices In Local Currency Terms Chart I-8Chinese Imports For Domestic Consumption And EM Exports Chinese Imports For Domestic Consumption And EM Exports Chinese Imports For Domestic Consumption And EM Exports Finally, the combined exports of EM ex-China, Korea and Taiwan – which are correlated with mainland imports for domestic consumption – are shrinking (Chart I-8). Without a revival in Chinese domestic demand in general, and commodities in particular, EM exports will continue to languish. Bottom Line: Risks stemming from low and falling inflation in EM are rising. While central banks are cutting rates, they are behind the curve. For now, investors should not expect an imminent domestic demand recovery based on EM central bank interest rate cuts. …And The US In contrast to EM, investors and financial markets are complacent about inflation risks in the US. This is not to say that there is a risk of runaway inflation in the US. Our point is as follows: If US growth slows further, US inflation will subside. However, if US growth accelerates, consumer price inflation will surprise to the upside. Sectors such as capital spending, real estate and discretionary consumer spending are all extremely weak. US core consumer price inflation has been trending upwards in the past several years, consistent with a positive and widening output gap (Chart I-9, top panel). The average of six core consumer price inflation measures – core CPI, core PCE, trimmed mean CPI, trimmed PCE, market-based core PCE, and median CPI – is slightly above 2% and looks to be headed higher (Chart I-9, bottom panel). US unit labor costs are rising faster than the corporate price deflator (Chart I-10, top panel). A tight labor market will translate to robust wage growth.  Chart I-9Barring Slowdown, US Core Inflation Will Rise Further Barring Slowdown, US Core Inflation Will Rise Further Barring Slowdown, US Core Inflation Will Rise Further Chart I-10Beware Of A US Profit Margin Squeeze Beware Of A US Profit Margin Squeeze Beware Of A US Profit Margin Squeeze   With corporate profit margins already shrinking (Chart I-10, bottom panel) and consumer spending robust, companies will try to pass on higher costs to consumers. Hence, barring a slowdown in US consumer spending, consumer price inflation will likely rise. If global growth recovers, the dollar will sell off and US manufacturing will revive. Provided these two factors have been counteracting inflationary pressures in the US, their reversal will allow inflation to rise. Bottom Line: Underlying core inflation in the US has been drifting higher. Unless growth slows, inflation will surprise to the upside. Macro Rebalancing: In The Dollar’s Favor Bond yields and exchange rates often act as shock absorbers and re-balancing mechanisms for the global economy. The agility and corresponding adjustments of these financial variables assure a more stable real global economy. Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. A strong greenback will redistribute inflationary pressures away from the US and into EM. An analogy for this adjustment process is the role of wind in rebalancing air pressure around the globe. When air pressure in location A is higher than in location B, the air moves from location A to location B, causing wind. This allows for a rebalancing of air pressure around the earth. US core consumer price inflation has been trending upwards in the past several years. When air pressure differences are substantial, winds become forceful – potentially to the point of causing damage. In a nutshell, this adjustment could come at the cost of strong winds, or even a storm. Global currency markets play a similar role to wind. A strong greenback will help cap US inflation by dampening activity and employment in America’s manufacturing sector. Slumping manufacturing will moderate activity in the service sector, as well as slowdown aggregate income and spending growth.  In turn, weakening currencies will help reflate EM economies by mitigating the negative impact of lower exports in general and commodities prices in particular. EM economies need an external boost, especially now when their banking systems are in hibernation mode and China is not boosting its demand to the same extent it did during downturns since 2008. A caveat is in order here: In the case of many EMs, currency deprecation will initially hurt growth. The reason is that companies and banks in many EMs still hold large amounts of US dollar debt (Chart I-11). As the dollar appreciates, the cost of foreign debt servicing will escalate, prompting them to reduce corporate spending and bank lending. Hence, wind could turn into a storm. All in all, we continue to bet on EM currency depreciation, regardless of the direction of US bond yields. The basis is as follows: Contrary to widespread consensus, EM exchange rates correlate more strongly with commodities prices – please refer to Chart I-1 on page 1 – than US bond yields as shown in Chart I-12. Chart I-11EM External Debt Is A Risk If EM Currencies Depreciate EM External Debt Is A Risk If EM Currencies Depreciate EM External Debt Is A Risk If EM Currencies Depreciate Chart I-12EM Currencies And US Bond Yields: No Stable Relationship bca.ems_wr_2019_11_14_s1_c12 bca.ems_wr_2019_11_14_s1_c12   Emerging Asian currencies correlate with their export prices and the global trade cycle. Neither global trade activity nor Asian export prices are recovering (Chart I-13). Therefore, the recent bounce in EM currencies is not sustainable.   Given the current inflationary pressures in the US amid deflationary forces in EM, one of the ways in which this adjustment process will manifest itself is in the form of US dollar appreciation versus EM currencies. Could it be that US inflationary pressures are dampened by deflationary tendencies originating from EM/China, producing a benign (goldilocks) scenario for financial markets? It is possible but not likely in the case of EM financial markets. Exchange rates hold the key to all EM asset classes. If the US dollar continues drifting higher – which is our bet – it will stifle the performance of EM equity, local bonds and credit markets (Chart I-14). Chart I-13Asian Export Prices And Container Freight Herald Weaker Regional Currencies Asian Export Prices And Container Freight Herald Weaker Regional Currencies Asian Export Prices And Container Freight Herald Weaker Regional Currencies Chart I-14Trade-Weighted Dollar And EM Share Prices Are Still Correlated Trade-Weighted Dollar And EM Share Prices Are Still Correlated Trade-Weighted Dollar And EM Share Prices Are Still Correlated   Further, Box I-1 on page 10 discusses the 2008 clash between inflationary forces in EM and deflation in the US. Bottom Line: We continue to recommend playing the following EM currencies on the short side versus the dollar: ZAR, CLP, COP, IDR, KRW and PHP. We are also short CNY versus the dollar. For allocations within EM equity, domestic bonds and sovereign credit, please refer to our investment recommendations on pages 16-17. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Box 1 Inflationary + Deflationary Forces = Goldilocks? Will inflationary pressures in the US be offset by disinflation in EM, resulting in a goldilocks outcome globally? A goldilocks period is one in which strong growth is accompanied by moderate inflation. It is possible, but in the global macro world inflation + deflation does not always equal goldilocks. In other words in global macro, (1-1) does not always equal zero. For instance, an inflation dichotomy was present in the first half of 2008. Back then, the US economy was already in recession, with acute deflationary pressures stemming from the deflating housing and credit bubbles. In turn, EM growth was still rampant and inflationary pressures were acute. In fact, in the period between March and mid-July of 2008, US and global bond yields were climbing on the back of rising worries about inflation. In retrospect, such an inflation dichotomy between the US and EM did not result in a goldilocks environment, but occurred on the precipice of the largest deflationary black hole in the post-war period. In the second half of 2008, US deflation overwhelmed EM inflation, generating a major deflationary tsunami worldwide. Russia: Long Domestic Bonds / Short Oil Chart II-1Undershooting CB's 4% Inflation Target Undershooting CB's 4% Inflation Target Undershooting CB's 4% Inflation Target Russia’s growth is already very sluggish. Lower oil prices2 entail both weaker growth and ruble weakness. The primary risk in Russia is low and falling inflation rather than rising inflation. Therefore, unlike in previous downturns, the central bank will be able to engage in counter-cyclical monetary policy, namely continue cutting interest rates. This makes a long position in local currency bonds a “no-brainer”.  The only risk to owning Russian domestic bonds is the ruble depreciation due to falling oil prices and a risk-off phase in EM exchange rate markets. To hedge against these risks, we recommend the following trade: long Russian domestic bonds / short oil. The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. As a result, local bonds on a total- return basis in US dollar terms will outperform oil. The basis to expect a further meaningful drop in interest rates in Russia is as follows: Inflation Is Low And Falling: Various measures of inflation suggest that disinflation is broad based (Chart II-1). As a result, inflation will continue falling towards the central bank’s inflation target of 4%. Crucially, wage growth is decelerating both in nominal and real terms (Chart II-2). Monetary Policy Is Still Restrictive: Even though the central bank has cut rates by 125bps over the past 6 months, monetary policy remains behind the dis-inflation curve. Both policy and lending rates remain too high, especially relative to the low nominal growth environment (Chart II-3). Real borrowing costs stand at 9% for consumer and 4.5% for corporate loans (Chart II-4). The macro backdrop in Russia justifies considerably lower interest rates and we believe the central bank will deliver further rate cuts despite moderate currency depreciation. Chart II-2Russia: Sluggish Wage Growth Russia: Sluggish Wage Growth Russia: Sluggish Wage Growth Chart II-3Russia: Tight Monetary Policy Russia: Tight Monetary Policy Russia: Tight Monetary Policy   Notably, weakening credit impulses for both business and consumer segments suggest that domestic demand will disappoint (Chart II-5). Chart II-4Russia: High Real Lending Rate Across Sectors Russia: High Real Lending Rate Across Sectors Russia: High Real Lending Rate Across Sectors Chart II-5Weakening Credit Impulses = Lower Demand And Investment Weakening Credit Impulses = Lower Demand And Investment Weakening Credit Impulses = Lower Demand And Investment   Since October 1, the CBR has taken measures to curb consumer borrowing from banking and non-banks credit institutions. These new guidelines limit the latter’s lending to consumers with high debt loads. In short, much lower nominal and real interest rates will be required to reinvigorate domestic demand. Fiscal Policy Is Tight: The government has overplayed its hand in running very tight fiscal policy. The government primary budget surplus now stands at 3.8% of GDP. Government spending growth both in real and nominal terms remains very weak (Chart II-6). The National Project initiative has not yet been sufficient to expand government expenditures. In fact, a recent report from the Audit Chamber suggests that total spending under this National Project program for 2019 will be below government targets of 3% of GDP per year. Finally, the authorities committed a policy mistake at the beginning of year by hiking the VAT tax which has hurt consumption. Russian local currency bond yields are set to fall, even as oil prices decline over the coming months. A Healthy Balance Of Payment (BoP) Position: Total external debt and debt servicing are extremely low by emerging markets standards. Russia has the lowest external debt amongst its EM counterparts. Likewise, Russia’s international investment portfolio liabilities – foreigners’ ownership of equities and bonds – remain one of the lowest amongst EM (Chart II-7). Chart II-6A Lot Of Room To Boost Government Spending A Lot Of Room To Boost Government Spending A Lot Of Room To Boost Government Spending Chart II-7Foreigners' Holding Of Russian Financial Assets Are Low Foreigners' Holding Of Russian Financial Assets Are Low Foreigners' Holding Of Russian Financial Assets Are Low   Investment Recommendations Chart II-8Local Bonds Are Decoupling From Oil Local Bonds Are Decoupling From Oil Local Bonds Are Decoupling From Oil Russian local currency bond yields are set to fall, even as oil prices decline over the coming months (Chart II-8). In light of this, we recommend the following pair trade: long local currency bonds / short oil. Dedicated EM fixed-income portfolios should continue to overweight Russian sovereign and corporate credit, as well as local currency government bonds relative to their respective EM benchmarks. Tight fiscal and monetary policies favor creditors. We have been bullish on Russian markets for some time arguing that they will behave as a low-beta play in EM selloff as discussed in our previous report. This view remains intact. Dedicated EM equity portfolios should continue overweighting Russian stocks, a recommendation made in October 2018. Given the ruble will likely depreciate gradually rather than plunge amid falling oil prices, the authorities will continue cutting rates and provide fiscal stimulus. That will benefit Russia versus many other EM countries. Finally, we remain long the RUB versus the Colombian Peso, a trade instituted on May 31, 2018. Andrija Vesic Research Analyst andrijav@bcaresearch.com   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    We exclude economies of China, Korea and Taiwan because they are different in their economic structure and inflation dynamics compared with majority of EMs. 2   BCA’s Emerging Markets Strategy team expects lower oil prices consistent with its thesis of EM slowdown. This is different from BCA’s house view that is bullish on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The attractiveness of European stocks is relative to European bonds rather than relative to non-European stocks. Despite vastly different stock market valuations in Germany, Japan, and the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent per annum. Overweight the DAX versus German long-dated bunds. Equities would lose their attractiveness if the global 10-year bond yield were to rise through 2.5 percent, because the required excess return from equities would viciously normalise. Tactically overweight EM versus DM. Fractal trade: short GBP/NOK, as the recent rally in the pound appears technically extended. Feature Chart of the WeekOverweight Europe Vs. World = Overweight Consumer Staples Vs. Technology Overweight Europe Vs. World = Overweight Consumer Staples Vs. Technology Overweight Europe Vs. World = Overweight Consumer Staples Vs. Technology   Stock markets recently broke to new highs, begging the perennial question: how attractive are equities at current valuations? To answer, we need to assess the prospective return that is now ‘baked in the equity valuation cake’. But which valuation metric gives the most credible assessment of prospective returns? Equity valuations based on assets are problematic – because nowadays, assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to value. Equity valuations based on earnings are problematic. Equity valuations based on earnings (profits) are also problematic – because they take no account of structurally high profit margins (Chart I-2). The problem is that earnings will face a headwind when profit margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this does not correct for the structural rise in profit margins. Chart I-2Structurally High Profit Margins Flatter Earnings Structurally High Profit Margins Flatter Equity Earnings Structurally High Profit Margins Flatter Earnings Structurally High Profit Margins Flatter Equity Earnings Structurally High Profit Margins Flatter Earnings Hence, the most credible assessment comes from price to sales – because sales are quantifiable, unambiguous, and undistorted by profit margins. Significantly, while price to earnings missed the high valuation of world equities in 1990 (Japanese bubble) and 2007 (credit bubble), price to sales did not (Chart I-3 and Chart I-4). Chart I-3Price To Earnings Missed The Japanese Bubble And The Credit Bubble... Price To Earnings Missed The Japanese Bubble And The Credit Bubble... Price To Earnings Missed The Japanese Bubble And The Credit Bubble... Chart I-4...But Price To Sales ##br##Didn't ...But Price To Sales Didn't ...But Price To Sales Didn't Are Stocks Attractive? Based on the credible assessment from price to sales, today’s prospective 10-year annualised return from world equities is around 5 percent (Chart I-5). This is not that different to the 4 percent prospective return at the peak of the credit bubble in 2007.1 Which raises an obvious question. Back in 2007, a secular growth boom provided the excuse for the rich absolute valuation, but today, if anything, investors fear a ‘secular stagnation’. What can excuse today’s rich absolute valuation? Chart I-5The Prospective Return From World Equities Is 5 Percent The Prospective Return From World Equities Is 5 Percent The Prospective Return From World Equities Is 5 Percent The answer is ultra-low bond yields. In 2007, the global 10-year bond yield stood at 5 percent; today, it stands well below 2 percent (Chart I-6). A lower prospective return on bonds means a lower prospective return on competing long-duration assets, like equities. Chart I-6The Global 10-Year Bond Yield Has Plunged To Below 2 Percent The Global 10-Year Bond Yield Has Plunged To Below 2 Percent The Global 10-Year Bond Yield Has Plunged To Below 2 Percent Moreover, as bond yields approach their lower bound, the riskiness of bonds rises because they take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered this year, prices do not rise much in a rally, but they do plunge in a sell-off. This higher riskiness of bonds justifies an abnormally low (or zero) ‘risk premium’ on competing long-duration assets, like equities. The 5 percent prospective return makes equities look attractive relative to bonds.  The upshot is that the 5 percent prospective return from equities is low in absolute terms. But in a world of ultra-low numbers – for both bond yields and equity risk premiums – the 5 percent prospective return makes equities look attractive relative to bonds. At the peak of the credit bubble in 2007, equities were offering a lower prospective return than the 5 percent available from bonds. But today’s equity risk premium over bonds is generous. The caveat is that this would change if the global 10-year bond yield were to rise through 2.5 percent because the required risk premium on equities would viciously normalise. Are European Stocks Attractive? Turning to the relative attractiveness of major stock markets, it is tempting to think that the markets trading on the best head-to-head valuation comparisons are the most attractive. For example, Germany and Japan, both trading on a price to sales multiple of 0.9, appear compelling buys compared to the US, trading on a multiple of 2.1 (Chart I-7). But such a knee-jerk conclusion is wrong, for two reasons. Chart I-7Germany And Japan Trade On Much Lower Multiples Than The US Germany And Japan Trade On Much Lower Multiples Than The US Germany And Japan Trade On Much Lower Multiples Than The US First, stock markets have very different sector compositions. Two sectors with vastly different structural growth prospects – say, technology and banks – must necessarily trade on vastly different valuations. So the sector with the lower valuation is not necessarily the better-valued sector. By extension, the stock market with the lower valuation because of its ‘sector fingerprint’ is not necessarily the better-valued stock market. Second, major stock markets are dominated by multinational companies with mixed currency sales and profits, while the stock price is quoted in the domestic currency. Hence, if the market expects the mixed currency profits to depreciate in domestic currency terms, the stock will trade at a discount. Put another way, if the domestic currency is cheap the stock market will appear cheap. The best way to see this is to look at the two valuations of dual-listed multinationals like the UK/US cruise operator Carnival. In London, the stock trades on a price to forward earnings at 9.7; in New York it trades at 10.3. But it would be absurd to suggest that Carnival is cheaper in London than in New York! The discrepancy is simply because the market expects the pound to appreciate versus the dollar.  A head-to-head comparison of stock market valuations is misleading. Allowing for the distortions from sector skews and currency adjustments, the best way to assess an equity region’s attractiveness is to quantify the prospective return implied by its valuation versus its own history. The method is to regress historic starting price to sales with the (historic) prospective 10-year returns that followed. Then apply this relationship to the current price to sales to predict the (current) prospective 10-year return. The results are amazing. Despite the vastly different price to sales multiple of 0.9 in Germany and Japan, and 2.1 in the US, the implied prospective 10-year annualised returns are almost identical – at around 5 percent from each of the three stock markets (Chart I-8-Chart I-10). Chart I-8Expect Near-Identical Returns From The US... Expect Near-Identical Returns From The US... Expect Near-Identical Returns From The US... Chart I-9…Germany… ...Germany... ...Germany... Chart I-10...And Japan ...And Japan ...And Japan Still, there is one significant difference: the 10-year bond yield is much lower in Germany and Japan than in the US, equating to a much more attractive equity risk premium of over 5 percent in Germany and Japan. So to answer this week’s title, yes, European stocks are attractive. But the attractiveness is not relative to non-European stocks, the attractiveness of European stocks is relative to European bonds. Bottom Line: maintain a structural overweight to the DAX versus German long-dated bunds. Europe’s ‘Sector Fingerprint’ Is No Longer Pro-Cyclical Over the short term, stock market relative performance is just the result of global sector relative performance combined with the unique sector fingerprint of each stock market. It follows that regional and country equity allocation must always start with a sector view combined with an awareness of the sector fingerprint of the major bourses (Table 1-1). Table I-1EM, DM, And Europe Have Unique ‘Sector Fingerprints’ Are European Stocks Attractive? Are European Stocks Attractive? In this regard, there is an important change. Market action plus index composition changes are making the European index less cyclical. Specifically, the European index is no longer over-weighted to Financials relative to the world index. Instead, the European sector fingerprint is now: ‘Overweight Consumer Staples, Underweight Technology’ (Chart of the Week). With the overweight skew being to defensive staples and the underweight skew to partly-cyclical tech, the cyclicality of the European index has become ambiguous. By contrast, emerging market (EM) equities remain ultra-cyclical with a sector fingerprint that is: ‘Overweight Banks, Underweight Healthcare’ (Chart I-11). Suffice to say, this is ultra-cyclical because the 10 percent overweight is to an unambiguously cyclical sector, while the symmetrical 10 percent underweight is to an unambiguously defensive sector. Chart I-11Overweight EM Vs. DM = Overweight Banks Vs. Healthcare Overweight EM Vs. DM = Overweight Banks Vs. Healthcare Overweight EM Vs. DM = Overweight Banks Vs. Healthcare The upshot is that a pro-cyclical sector tilt no longer implies an overweight to European equities versus other regions, but it does strongly imply an overweight to EM equities. This is our recommended stance, albeit only on a tactical horizon until our leading indicators show that the current growth rebound can be sustained well into 2020. Stay tuned. Fractal Trading System* The broken 65-day fractal structure of GBP/NOK suggests that its recent rally is susceptible to a countertrend sell-off, albeit UK election campaign developments are likely to be the near-term sentiment drivers. Go short GBP/NOK, setting a profit target at 2.5 percent with a symmetrical stop-loss. In other trades, short Italian 10-year BTP achieved its 3 percent profit target and is now closed, while long gold / short nickel is very close to its 11 percent profit target. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. NOK/GBP NOK/GBP The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1  Total (capital plus income) nominal annualised returns Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Are European Stocks Attractive? Are European Stocks Attractive? Are European Stocks Attractive? Are European Stocks Attractive? Are European Stocks Attractive? Are European Stocks Attractive? Are European Stocks Attractive? Are European Stocks Attractive? Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Duration: A survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Credit Cycle: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. IG Valuation: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk. Feature Chart 1Recession Risk Getting Priced Out Recession Risk Getting Priced Out Recession Risk Getting Priced Out The bond sell-off continued last week, driven by positive developments in US/China trade negotiations and tentative signs of stabilization in some global growth indicators. The renewed sense of economic optimism has reduced the recessionary risk priced into bond markets. The 2/10 Treasury slope has steepened 30 bps since it briefly inverted in late August. During that same period, the 2-year Treasury yield is up 15 bps, the 10-year yield is up 45 bps and the Bloomberg Barclays Treasury index has underperformed a position in cash by 2.7% (Chart 1). These recent developments raise two important questions. First, should investors chase or fade the back-up in Treasury yields? And second, if the sell-off does continue, how high can yields go? To answer these questions we turn to the five macro factors that drive trends in US bond yields. These factors were outlined in our “Bond Kitchen” report from last April, and are listed right here:1 Global growth Policy uncertainty The US dollar The output gap Sentiment Back In The Kitchen Global Growth Chart 2CRB Index Needs To Rebound CRB Index Needs To Rebound CRB Index Needs To Rebound Three global growth indicators are particularly relevant for US Treasury yields. They are the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index. The latter is especially useful because it updates on a daily basis. Considering the CRB index, we notice that, while it is no longer in a steep downtrend, it has also not rebounded alongside the jump in bond yields (Chart 2). This should give us pause. Continued low readings from the CRB index make it more likely that bond yields will fall back in the coming weeks. We should also note that the ratio between the CRB index and Gold is more highly correlated with the 10-year Treasury yield than the CRB index itself.2 This ratio has bounced off its lows (Chart 2, top panel), but only because Gold has come under downward pressure. With the Fed committed to maintaining an accommodative policy stance until inflation expectations are re-anchored, we expect the Gold price to remain well bid. This means that raw industrials prices must rebound to keep the ratio trending higher. The CRB/Gold ratio has bounced off its lows, but only because Gold has come under downward pressure. More encouraging than the CRB index is the Global Manufacturing PMI, which has moved off its lows during the past three months (Chart 3). The increase has been partially driven by stronger US readings (Chart 3, panel 2), but principally by a significant jump in China’s PMI (Chart 3, bottom panel). Chart 3China Pulling The Global Manufacturing PMI Higher China Pulling The Global Manufacturing PMI Higher China Pulling The Global Manufacturing PMI Higher Somewhat stronger China PMI readings should be expected, given the rebound in our China Investment Strategy’s Li Keqiang Leading Indicator – a composite measure of monetary conditions, money and credit growth (Chart 4).3 We should also expect further modest policy stimulus from China, as long as the labor market remains under pressure (Chart 4, bottom panel). Turning to the US, we have seen three very positive developments in the economic data during the past month. First, the ISM Services PMI jumped from 52.6 to 54.7 in October (Chart 5). A drop in this index to 50 or below would be consistent with a US recession, while the combination of a strong service sector and a depressed manufacturing sector is consistent with our baseline 2015/16 roadmap. This roadmap leads to an eventual rebound in the manufacturing index. Second, the ISM Manufacturing PMI rose a tad in October, but the New Export Orders component jumped significantly from 41 to 50.4 (Chart 5, panel 2). Since the global slowdown began as a non-US phenomenon, a rebound in this export component sends a strong signal that we are at an inflection point. Finally, consumer confidence rose in October following a sharp decline in September. A year-over-year decline in the consumer confidence index is a reasonably strong recession signal, but recent data suggest that this signal is fading (Chart 5, bottom panel). Chart 4Modest Stimulus In China Modest Stimulus In China Modest Stimulus In China Chart 5Three Positive Developments Three Positive Developments Three Positive Developments All in all, the global growth data have turned more positive during the past month. US indicators, in particular, are no longer sending strong recessionary signals. A rebound in the CRB Raw Industrials index would give us more confidence in the durability of the recent rise in Treasury yields. Policy Uncertainty Uncertainty about the US/China trade conflict has eased considerably during the past few weeks, as the two sides appear to be working toward a “phase 1” deal that would prevent the imposition of new tariffs and roll back some that are already in place. Heightened uncertainty about the trade war played a large role in dragging bond yields lower in 2019. This becomes apparent when you notice that survey and sentiment (aka “soft”) data about the economic outlook have been significantly worse than the actual “hard” data on US economic activity.4 It is clear that negative sentiment about the trade war has held survey data and bond yields down, even as underlying US economic activity has been solid. Less bullish dollar sentiment supports a continued uptrend in Treasury yields.  We see a continued easing of trade tensions as we head into the first half of next year. President Trump has an incentive to support the economy in an election year, given the historical record of incumbent presidents being re-elected when the economy is strong. However, if this strategy doesn’t work and Trump finds himself behind in the polls by the end of next summer, then he could decide that ramping up the trade war again is the best course of action. In other words, another spike in policy uncertainty in the second half of 2020 is possible if President Trump is trailing in the polls. The US Dollar Chart 6Dollar Sentiment Points To Higher Yields Dollar Sentiment Points To Higher Yields Dollar Sentiment Points To Higher Yields The US dollar is important for the path of US Treasury yields because it signals whether US yields are decoupling from yields in the rest of the world. In other words, if the dollar appreciates significantly alongside rising Treasury yields, then we should view those yields as increasingly out of step with the rest of the world, and thus more likely to fall back down. So far, the dollar has been relatively flat as yields have risen and bullish sentiment toward the US dollar has declined significantly (Chart 6). Less bullish dollar sentiment supports a continued uptrend in Treasury yields. But if yields do in fact continue to rise, it will be important to watch the dollar’s reaction. The Output Gap Chart 7Wage Gains Hurting Margins, Not Raising Prices Wage Gains Hurting Margins, Not Raising Prices Wage Gains Hurting Margins, Not Raising Prices Some sense of the output gap is important for forecasting bond yields. This is because the same amount of global growth will lead to more inflationary pressure and higher bond yields when the output gap is small than when it is large. The fact that the output gap is smaller now than it was in 2016 is probably the reason why the 10-year Treasury yield bottomed 10 bps above its 2016 trough this year, and why the average Treasury index yield bottomed 47 bps above its 2016 trough. We have found wage growth to be an excellent indicator of the output gap, and noted in a recent report that wage growth should continue to accelerate.5 In this vein, another crucial variable to monitor is labor compensation as a percent of national income (Chart 7). The rise in this series indicates that wage gains during the past few years have come at the expense of corporate profit margins, and have not been passed through to higher consumer prices. If this series proves to have a lot more cyclical upside, then it could be some time before wage acceleration translates to higher inflation. Sentiment Chart 8Surprise Index Says Sentiment Is Neutral Surprise Index Says Sentiment Is Neutral Surprise Index Says Sentiment Is Neutral The final factor we consider when forecasting US Treasury yields is sentiment. We have found that the Economic Surprise Index is the single best measure of aggregate market sentiment. That is, when the Surprise index reaches a positive or negative extreme, it usually means that sentiment is too positive or too negative, and will mean-revert in the months ahead. Also, we have observed a strong correlation between the Surprise index and changes in Treasury yields (Chart 8). At present, the Surprise index is roughly neutral, and therefore does not send a strong signal about where sentiment might push bond yields during the next few months. Investment Conclusions To summarize, the outlook from our five macro factors suggests that Treasury yields will rise further in the coming months. Global growth indicators are showing tentative signs of bottoming, and should rise to levels more consistent with the “hard” economic data as policy uncertainty continues to wane. The fact that the US economic data look less recessionary than they did one month ago makes us more confident that our global indicators will rebound. Chart 9A Clear Path To 2.5% A Clear Path To 2.5% A Clear Path To 2.5% We would become concerned about a renewed downtick in yields if the CRB Raw Industrials index fails to rebound, or if the dollar strengthens significantly in the coming weeks. At the beginning of this report, we asked how high Treasury yields can go if the global growth rebound proves durable. To answer that question we refer to current estimates of the long-run neutral fed funds rate. The FOMC’s median estimate of the long-run neutral fed funds rate is 2.5% and the median estimate from the New York Fed’s Survey of Market Participants is 2.48%, with an interquartile range of 2.25% - 2.5%. If recessionary fears move to the back burner, it would be logical for long-dated yields to converge toward those levels. That is in fact what happened in recent years, with the 5-year/5-year forward Treasury yield peaking several times at levels close to the Fed’s median neutral rate estimate (Chart 9). With this in mind, we see a clear path to 2.5% on the 5-year/5-year forward Treasury yield, with the 10-year yield reaching similar levels since the 5/10 Treasury slope is likely to remain flat (Chart 9, bottom panel). For yields to eventually move above 2.5%, the market would have to re-consider its outlook for the long-run neutral fed funds rate. We discussed what factors to monitor in this regard in a recent report.6 Bottom Line: Treasury yields have moved significantly higher in recent weeks, but a survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Checking In On The Credit Cycle In previous reports, we mentioned that three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health Monetary conditions Valuation We last presented a detailed examination of these factors in a report from mid-September, concluding that accommodative monetary conditions will support corporate bond excess returns, despite deteriorating balance sheet health.7 Three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health, monetary conditions,and valuation. But since then, C&I lending standards – an important indicator of monetary conditions – moved into “net tightening” territory for the third quarter of 2019 (Chart 10). Tightening C&I lending standards, if they persist, would put significant upward pressure on corporate defaults and credit spreads. Chart 10Credit Cycle Checklist: Monetary Conditions Credit Cycle Checklist: Monetary Conditions Credit Cycle Checklist: Monetary Conditions While the recent move in lending standards is concerning, we expect it to reverse in the near future. The yield curve, another indicator of monetary conditions, has steepened in recent months, suggesting that conditions are becoming more accommodative. Also, loan officers reported that the terms on C&I loans continued to ease in Q3, even as overall standards tightened (Chart 10, panel 3). Most importantly, inflation expectations remain extremely low (Chart 10, bottom panel). This gives the Fed every incentive to maintain accommodative monetary conditions. This should give lenders the confidence to ease lending standards, leading to tight credit spreads and a low corporate default rate. Bottom Line: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. Downgrade Investment Grade Corporates To Neutral Last week, we downgraded our recommended allocation to investment grade corporate bonds from overweight to neutral.8 We maintain a positive view of the credit cycle, and expect that corporate bonds will continue to outperform Treasuries. However, investment grade corporate spreads no longer provide adequate compensation for their level of risk. We maintain an overweight allocation to high-yield corporates, where spreads remain attractive. Chart 11 shows that investment grade corporate spreads have tightened somewhat in recent months, but that they remain well above the tights seen in early 2018. However, the chart also shows that average index duration has increased considerably this year. All else equal, higher index duration justifies a wider spread. In contrast, notice that high-yield index duration fell this year (Chart 11, bottom panel). This is because high-yield bonds usually carry embedded call options, making them negatively convex. All else equal, lower index duration makes the spread offered by the high-yield index more attractive. Because changes in spread and duration are both important, we prefer to use the 12-month breakeven spread as our main valuation tool. This measure is the spread widening required on a 12-month investment horizon to underperform a duration-matched position in Treasuries. It can be approximated by dividing the option-adjusted spread by duration. Chart 12 shows investment grade 12-month breakeven spreads as a percentile rank since 1995. The overall message is that spreads have rarely been lower. Chart 11Higher Durations Makes IG Spreads Look Too Tight Higher Durations Makes IG Spreads Look Too Tight Higher Durations Makes IG Spreads Look Too Tight Chart 12Investment Grade Corporate Spreads Have Rarely Been Lower Investment Grade Corporate Spreads Have Rarely Been Lower Investment Grade Corporate Spreads Have Rarely Been Lower Finally, we can also recognize that spreads tend to be tight in the middle and late stages of the credit cycle. In the current environment, that means we should expect spreads to be near the bottom of their historical ranges. To control for this fact, we re-calculate our breakeven spread percentile ranks using only mid-cycle periods when the slope of the yield curve is between 0 bps and 50 bps. We can then back-out spread targets for each credit tier based on the median 12-month breakeven spreads seen in similar macro environments. Chart 13 shows that spreads for all investment grade credit tiers have moved below our targets. High-yield spreads are not shown, but they remain well above target levels.9 Chart 13Spreads For All IG Credit Tiers Are Below Target Spreads For All IG Credit Tiers Are Below Target Spreads For All IG Credit Tiers Are Below Target In place of investment grade corporates, which have become expensive, we recommend upgrading Agency MBS. MBS now offer expected returns that are comparable with corporate bonds rated A or higher, with considerably less risk.10 Bottom Line: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 For details on why the ratio between the CRB Raw Industrials index and Gold tracks the 10-year Treasury yield please see US Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com 3 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 4 For more details on the divergence between “soft” and “hard” data please see US Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Portfolio Allocation Summary, “The Fed Will Stay Supportive”, dated November 5, 2019, available at usbs.bcaresearch.com 9 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 10 For more details on the positive outlook for MBS please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The mood among investors is shifting from the recessionary gloom of this past summer. Equities worldwide are rallying, buoyed by a combination of dovish monetary policies, tentative signs of bottoming global growth and expectations of some sort of trade détente between the US and China. The latter is fueling more bullish sentiment towards equities in regions most exposed to global trade and manufacturing like Emerging Markets (EM) and Europe. Feature Chart 1Global Corporates: 2016 Revisited? Global Corporates: 2016 Revisited? Global Corporates: 2016 Revisited? Credit investors, in an unusual twist, have been far more optimistic than their equity brethren. Corporate bonds have delivered solid performance in 2019, with the Bloomberg Barclays Global Corporates total return index up +9.5% year-to-date. This is a surprising development, as global growth concerns triggered a major decline in developed market government bond yields but no widening of credit risk premia (Chart 1). With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The overriding message from the latest read of our CHMs is that the manufacturing-led slowing of global growth this year has not resulted in much deterioration in overall corporate creditworthiness. There are fascinating cross-currents within the data, however. On a regional basis, the CHMs in the euro area, the UK and Canada are in better shape than in the US and Japan. The most interesting differences are across credit quality, with our “bottom-up” high-yield (HY) CHMs looking better than the investment grade (IG) equivalents in both the US and euro area, mostly due to greater relative increases in IG leverage. Our current global corporate bond investment recommendations broadly follow the trends signaled by our CHMs: an aggregate overweight stance versus global government debt, but with a “reverse quality bias” favoring HY over IG in the US and Europe. With government bond yields now on the rise across the developed markets – and with credit spreads fairly tight across the majority of countries - the period of hyper-charged absolute corporate bond returns is over. Expect more carry-like excess returns over sovereigns during the next 6-12 months. US Corporate Health Monitors: Steady Deterioration, Mostly Within Investment Grade Our top-down US CHM is sending a negative message on credit quality, staying in the “deteriorating health” zone since 2015 (Chart 2). The structural declines in the profitability ratios (return on capital and operating margin), debt coverage and, more recently, short-term liquidity are the main causes of that deterioration in US corporate health. Not all the news is negative, however. While operating margins have clearly peaked, they remain at a very high level. The top-down interest coverage ratio is also improving, thanks to low corporate borrowing rates. That is a welcome development that will help extend the US credit cycle by keeping downgrade/default risk, and the credit spreads required to compensate for it, subdued. When looking at our bottom-up US CHMs, the story becomes more nuanced. The bottom-up US high-yield CHM is signaling a surprisingly positive story, spending the past two years in “improving health” territory. The bottom-up US IG CHM remains above the zero line, as has been the case since 2012 (Chart 3). The multi-year increase in the debt-to-equity ratio, and declines in return on capital and interest coverage over the same period, are the main reasons why US IG corporate health has worsened, even as profit margins have stayed high. Chart 2Top-Down US CHM: Steadily Worsening Top-Down US CHM: Steadily Worsening Top-Down US CHM: Steadily Worsening Chart 3Bottom-Up US IG CHM: Some Areas Of Concern Bottom-Up US IG CHM: Some Areas Of Concern Bottom-Up US IG CHM: Some Areas Of Concern The bottom-up US HY CHM is signaling a more positive story, spending the past two years in “improving health” territory (Chart 4), led by stable balance sheet leverage and improvements in operating margins and return on capital. The absolute levels of interest and debt coverage ratios for US HY remain low – a potential future risk for US HY when the US economy goes into its next prolonged downturn. One common signal from all our US CHMs, both top-down and bottom-up, is that short-term liquidity ratios have declined. Those moves are driven by increases in the denominator of the ratios (the market value of assets for the top-down CHM, and the value of current liabilities in the bottom-up CHMs), rather than declines in working capital or cash on corporate balance sheets – trends that would typically precede periods of corporate distress. Just last week, we downgraded US IG to neutral, while maintaining an overweight tilt on US HY.1 The rationale for the move was based on value, as spreads for all US IG credit tiers had tightened to our spread targets, which is not yet the case for HY. The message from our bottom-up US CHMs supports that recommendation. The combination of improving global growth and a Fed that will stay dovish until US inflation has sustainably moved higher paints a favorable backdrop for the relative performance of all US corporate debt versus Treasuries. However, given our expectation that US bond yields will continue to move higher over the next 6-12 months, the lower interest rate duration of US HY relative to IG also supports favoring the former over the latter (Chart 5). Chart 4Bottom-Up US HY CHM: Looking Better Than IG (!) Bottom-Up U.S. HY CHM: Looking Better Than IG (!) Bottom-Up U.S. HY CHM: Looking Better Than IG (!) Chart 5US Corporates: Stay Overweight HY & Neutral IG U.S. Corporates: Stay Overweight HY & Neutral IG U.S. Corporates: Stay Overweight HY & Neutral IG Euro Corporate Health Monitors: Some Cyclical Weakness Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area IG, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating health” territory (Chart 6). Leverage has gone up for all issuers, with debt/equity ratios now above 100%, but the pace of increase has been faster for domestic issuers. Return on capital and profit margins for domestic issuers have declined since the start of 2018 alongside the prolonged slowing of euro area economic growth. For domestic euro area IG issuers, interest coverage has been steadily climbing since 2015 when the ECB went to negative rates and, more importantly, started its Asset Purchase Program that included corporate debt. Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area HY, the signal from the bottom-up CHM is more positive for both domestic and foreign issuers (Chart 7), with both CHMs sitting just in the “improving health” zone. Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers than foreign issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, with both above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. We have maintained a moderate overweight stance on euro area corporates, both for IG and HY, since the summer of this year (Chart 9). This view was based on expectations that the European Central Bank (ECB) would ease monetary policy, not on a forecast that euro area growth would revive organically. That outcome came to fruition when the ECB cut rates in September and restarted asset purchases earlier this month. The ECB’s moves create a more supportive monetary backdrop (along with an undervalued euro) that will help keep euro area credit spreads tight – a trend that is reinforced by decent corporate health. Chart 8Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Chart 9Euro Area Corporates: Stay Overweight IG & HY Euro Area Corporates: Stay Overweight IG & HY Euro Area Corporates: Stay Overweight IG & HY Chart 10Relative Bottom-Up CHMs: Turning In Favor Of The US? Relative Bottom-Up CHMs: Turning In Favor Of The US? Relative Bottom-Up CHMs: Turning In Favor Of The US? We see no reason to alter our recommendations on euro area credit, based on our forecast of better global growth, with no change to the ECB’s ultra-accommodative monetary stance, in 2020. However, a stronger growth backdrop could benefit euro area HY performance more than IG, based on the comparatively healthier signal from the bottom-up euro area HY CHM. The gap between the combined IG/HY bottom-up CHMs for the US and euro area aligns with credit spread differentials between euro area and US issuers (Chart 10).2 latest trends show a narrowing of the gap between the US and euro area CHMs, suggesting relative corporate health favors US names (middle panel). At the same time, the stronger performance of the US economy, which is much less levered to global trade and manufacturing compared to Europe, continues to support US corporate performance versus euro area equivalents (bottom panel). UK Corporate Health Monitor: Some Improvement, Even With Brexit Uncertainty Despite the persistent uncertainty over the UK-EU Brexit negotiations that has weighed on UK economic confidence, our top-down UK CHM remains in the "improving health" zone (Chart 11). All of the individual components are contributing to the strength of the CHM, which even improved from those healthy levels in Q2/2019 (the most recent data available). A sustained easing of UK financial conditions – easy monetary policy alongside a deeply undervalued currency – have helped boost interest/debt coverage ratios by keeping UK corporate borrowing costs low. Top-down operating margins for UK non-financial firms have surprisingly increased and now sit just under 25%. Short-term liquidity remains solid with leverage holding at non-problematic levels. As we discussed in a recent Special Report, the UK economy has been holding up fairly well despite the political uncertainty that has driven a prolonged slowdown in productivity growth through weak business investment.3 The UK consumer has continued to spend, however, seemingly desensitized to the political drama, and the labor market has remained tight enough to support a decent pace of household income growth. Despite the persistent uncertainty over the UK-EU Brexit negotiations, our top-down UK CHM remains in the "improving health" zone. The near term performance of the UK's economy is highly dependent on the final result of Brexit negotiations. If a negotiated Brexit occurs, UK corporates can start to ramp up the capital spending that has been delayed due to the political uncertainty, which will eventually lead to an improvement in UK productivity growth and overall corporate performance. A strengthening pound and rising government bond yields, driven by markets unwinding Brexit risk premia, will mitigate some of that growth thrust, but the net effect will still boost the relative performance of UK corporate debt versus Gilts. There are still near-term political risks stemming from the UK parliamentary election next month, with the deadline for a UK-EU Brexit deal delayed until after the election. Thus, we continue to maintain only a neutral stance on UK IG corporates in our model bond portfolio, despite our overall bias to be overweight global corporate debt versus government bonds. We will reconsider that stance after we have more clarity on the final resolution of the Brexit uncertainty. At a minimum, however, we expect UK corporates to continue to deliver solid excess returns versus UK Gilts (Chart 12). Chart 11UK Top-Down CHM: Solid Improvement, Despite Brexit U.K. Top-Down CHM: Solid Improvement, Despite Brexit U.K. Top-Down CHM: Solid Improvement, Despite Brexit Chart 12UK Corporates: Stay Neutral U.K. Corporates: Stay Neutral U.K. Corporates: Stay Neutral Japan Corporate Health Monitor: A Further Cyclical Deterioration Our bottom-up Japan CHM remains in the "deteriorating health" zone, as has been the case since the start of 2018 (Chart 13).4 The message from the individual CHM components, however, is that this is a cyclical, not structural, deterioration in Japanese corporate credit quality, and from a very healthy starting point. Leverage, defined here as the ratio of total debt to the book value of equity, is slightly above 100%, well below the 100-140% range seen between 2006 and 2015. A similar trend exists for return on capital, which has dipped below 5% but remains high relative to its history (although very low by global standards). Operating margins, debt coverage and short-term liquidity are down from recent peaks but all remain well above the lows of the decade since the 2008 financial crisis. Interest coverage has suffered a more meaningful deterioration relative to its history. However, this is more a cyclical issue related to falling profits (the numerator of the ratio) rather than rising interest costs (the denominator), with the latter remaining subdued thanks to the Bank of Japan’s hyper-easy monetary policy. For the former, the cyclical momentum in Japan’s economy is not improving, despite some recent evidence that global growth may be stabilizing. According to the latest Tankan survey, Japanese manufacturers – who saw profits fall -31% on a year-over-year basis in Q2/2019 - reported a worse business outlook than previously expected, both for large and small firms. This is not surprising, as Japan’s economy remains highly levered to global growth and export demand, in general, and China, in particular. Yet the less trade-sensitive services sector has also weakened – forecasts of the Tankan non-manufacturing index have already rolled over and the services PMI dropped to 49.7 in October. Japan’s corporate spread has widened slightly (+10bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets. This is sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns (on a duration-matched basis) versus Japanese Government Bonds (JGBs); yields on the latter will remain anchored near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM.  Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Japan Corporates: Stay Overweight Vs JGBs For Carry Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitors: Continuous Improvement Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving” zone as of the latest data available from Q2/2019 (Chart 15). The cyclical components (return on capital and operating margins) have gradually improved over the past three years, but remain relatively weak compared to history. Leverage is rising (now above 120% in our bottom-up CHM), but interest/debt coverage ratios remain steady and, in the case of the bottom-up CHM, have outright improved over the past year. We reviewed the Canadian economy last week5 and concluded that a Bank of Canada interest rate cut was unlikely because of signs of improving domestic growth momentum at a time when core inflation was at the midpoint of the BoC’s 1-3% target range. Overall, Canadian growth has been resilient in the face of the 2019 global manufacturing downturn, and should re-accelerate in the next year led by a firm consumer with rebounding housing and business investment. This should help boost the cyclical components of our Canada CHMs, especially if some improvement in global growth helps lift demand for Canadian commodity exports. We also introduced a framework to analyze Canadian corporate bonds in a Special Report published in late August.6 We concluded that Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability were longer-term concerns. We also noted that the higher credit quality of Canadian corporates, where only 40% of the investment grade index is rated BBB, made them more potentially appealing on a creditworthiness basis relative to the lower quality markets in the US (50% BBB share) and euro area (52%). We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have held in a well-established range of 100-200bps since the 2009 recession (Chart 16), even during periods when our CHMs were indicating worsening corporate health. Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Canada CHMs: Still Healthy, Despite Slower Growth Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More Top-down CHMs are now available for the US, euro area, the UK and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.7 The financial data of a broad set of individual US and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcareseach.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from US companies that issue in the euro area market that are part of our US CHMs. 3 Please see BCA Research Global Fixed Income Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated September 20, 2019, available at gfis.bcaresearch.com. 4 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Special Report, “The Great White North: A Framework For Analyzing Canadian Corporate Bonds”, dated August 28, 2019, available at gfis.bcaresearch.com. 7 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Appendix 2: US Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR   APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR   The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More BCA Corporate Health Monitor Chartbook: Mixed Signals, But Growth Matters More Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Chart I-1Lebanese Bond Yields Have Surged To Precarious Levels Lebanese Bond Yields Have Surged To Precarious Levels Lebanese Bond Yields Have Surged To Precarious Levels In a May 2018 Special Report, we warned that a devaluation and government default were only a matter of time in Lebanon. The country's sovereign US dollar bond yields have now reached a whopping 21% and local currency interest rates stand at 18% (Chart I-1). On the black market, the Lebanese pound is already trading 12% below its official rate. A public run on banks and bank deposit moratorium, as well as public debt default and a massive currency devaluation are now unavoidable. A Classic Case Of EM Bank Run And Currency Devaluation… The current state of Lebanon’s balance of  payments (BoP) is disastrous: The current account (CA) deficit has oscillated between 10% and 20% of GDP in the past 10 years (Chart I-2). This wide CA deficit has been funded by speculative portfolio flows into local currency government bonds, sovereign bonds and bank deposits. However, since the middle of 2018 these inflows have dried up. In turn, to defend the currency peg to the US dollar and avoid a currency depreciation in the face of the BoP deficit, the Central Bank of Lebanon (BDL) has been depleting its foreign exchange (fx) reserves, i.e., the central bank has been financing the BoP deficit (Chart I-3). Chart I-2Lebanon's Chronic Current Account Deficit Lebanon's Chronic Current Account Deficit Lebanon's Chronic Current Account Deficit   Chart I-3Lebanon: The BoP Has Been Deteriorating Substantially Lebanon: The BoP Has Been Deteriorating Substantially Lebanon: The BoP Has Been Deteriorating Substantially   BDL’s gross fx reserves – including gold – have dropped from $48 billion in 2018 to its current level of $43 billion. We estimate that BDL’s net foreign exchange reserves excluding commercial banks’ US dollar deposits at BDL are at just $26 billion. This amount is insufficient in light of the panic-induced outflows the country and the banking system are experiencing.1  As a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon. Chart I-4Depositors’ Are Heading For The Exit Depositors' Are Heading For The Exit Depositors' Are Heading For The Exit Worryingly, as a result of the two-week long bank shutdown amid massive protests, confidence in the banking system is quickly collapsing and capital is leaving Lebanon.2   Moreover, after opening their doors, Lebanese commercial banks are now imposing unofficial capital controls – they are paying US dollar deposits in local currency only and are no longer providing dollar-denominated credit lines to businesses and importers. This will only intensify the panic among depositors. Chart I-4 illustrates that local currency deposits have already been declining while US dollar deposits have been slowing, and will likely begin contracting soon. In short, capital outflows will intensify in the coming weeks as people and businesses quickly realize that banks cannot meet their demand for deposits. Critically, we suspect Lebanese commercial banks are short on US dollars to meet people’s demand for the hard currency. Commercial banks’ net foreign currency assets stand at negative $70 billion or 127% of GDP. They hold, roughly, somewhere around $20 billion worth of US dollars in the form of liquid and readily available deposits (in banks abroad and deposits in the central bank) versus $124 billion worth of dollar deposits. Over the years, Lebanese commercial banks have been an attractive place for investors and residents to park their US dollars given the high interest rate paid by the banks. In turn, Lebanese commercial banks have been converting these US dollar deposits into local currency in order to buy government bonds. With domestic bonds yielding well above the rates on US dollar deposits - and given the exchange rate peg to the dollar - commercial banks have been de facto playing the carry trade. In addition, commercial banks also lent some of these dollars directly to the private sector. With the economy collapsing and the widening dollar shortage, banks will not be able to either collect their dollar loans or purchase dollars in the market.   Without new dollar funding – which is very likely to persist – banks will fail to meet the demand for dollars. As a result, a bank run is imminent. At this point, the sole option is for the central bank to keep pushing local interest rates higher to discourage capital flight and a run on the banks. Yet, at 18% and surging, interest rates will suffocate the Lebanese economy and the property market. This will dampen sentiment further and cause a bank run. Bottom Line: A bank run is brewing and bank moratorium as well as currency devaluation are inevitable. …As Well As Public Debt Default Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Chart I-5Public Debt Dynamics Are Toxic Public Debt Dynamics Are Toxic Public Debt Dynamics Are Toxic Lebanese commercial banks are not only being squeezed by capital outflows and deposit withdrawals, they are also about to face a public debt default. Commercial banks own 37% of outstanding government debt. This will come on top of skyrocketing private-sector non-performing loans and will push banks into outright bankruptcy. Lebanon’s fiscal and public debt dynamics have reached untenable levels. The fiscal deficit stands at 10% of GDP and total public debt stands at 150% of GDP (Chart I-5). Surging government borrowing costs will push interest payments as a share of government aggregate expenditures to extremely high levels. These are unsustainable fiscal and debt arithmetics (Chart I-6). Meanwhile, government revenues will decline as growth falters (Chart I-6, bottom panel). The pillars of the Lebanese economy – private credit growth and construction activity – have been already collapsing (Chart I-7). Chart I-6Surging Interest Rates Will Make Public Debt Servicing Impossible Surging Interest Rates Will Make Public Debt Servicing Impossible Surging Interest Rates Will Make Public Debt Servicing Impossible Chart I-7Lebanon: Domestic Economy Has Been Collapsing Lebanon: Domestic Economy Has Been Collapsing Lebanon: Domestic Economy Has Been Collapsing Bottom Line: The Lebanese government will be forced to default on both local currency and dollar debt. This will be the final nail in the coffin of the Lebanese banking system.    Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes 1    BDL does not publish its holding of net foreign exchange reserves. However, other estimates of BDL’s net fx reserves  are even lower. Please refer to the following paper: Financial Crisis In Lebanon, by Toufic Gaspard and the following article: Lebanon Warned on Default and Recession as Its Reserves Decline. 2   Banks shut down allegedly as a result of the ongoing civil disobedience that was sparked by the government’s reckless decision to tax WhatsApp's call service. The protests quickly escalated to a country-wide uprising, causing the government to resign on October 29.