Fixed Income

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

Highlights Corporate Default Rate: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. Corporate Bond Valuation: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy: Corporate spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth. However, tighter Fed policy and a higher-than-expected corporate default rate could pressure spreads wider in the second half of 2019. We will be quick to back off our overweight corporate bond stance when our near-term spread targets are met. Feature Investors should remain overweight corporate bonds within U.S. fixed income portfolios, but be conscious that the window for outperformance may close quickly. While the Fed’s dovish turn and signs of global growth stabilization will allow spreads to tighten during the next few months, corporate default risk is rising in the background. This week’s report focuses on corporate default risk. We assess where the default rate is headed during the next 12 months and discuss the implications for investment strategy. Default Rate Near A Bottom Chart 1 shows that the trailing 12-month speculative grade default rate has been steadily falling since early 2017. However, it also shows that the fair value reading from our macro-driven default rate model has not fallen as much. The actual trailing 12-month default rate came in at 2.7% in February, the fair value reading from our model stands at a loftier 3.6%. Chart 1Corporate Default Rate Near A Bottom? Corporate Default Rate Near A Bottom? Corporate Default Rate Near A Bottom? Our default rate model is based on two factors, Commercial & Industrial bank lending standards and gross corporate leverage. The latter is defined as total nonfinancial corporate debt divided by pre-tax profits. With that in mind, our model provides a framework for assessing where the default rate is headed under different scenarios for corporate profit and debt growth. We consider each of these two factors in turn. Corporate Profit Growth Will Moderate Nonfinancial corporate pre-tax profits grew an astonishing 17% during the four quarters ending in Q3 2018, but all leading indicators point to deceleration in Q4 2018 and beyond. On the revenue side of the ledger, leading indicators are in universal agreement that growth is poised to slow (Chart 2): Chart 2Corporate Revenues Will Soften Corporate Revenues Will Soften Corporate Revenues Will Soften The ISM Manufacturing index has fallen to 54.2 from a recent peak above 60. The year-over-year growth rate in total business sales came in at 2% in December, down from a recent peak of 8.4%. The year-over-year growth rate in industrial production fell to 3.5% in February, from a September peak of 5.7%. The year-over-year growth rate in the U.S. Leading Economic Indicator is down to 3.2% as of January, from a September peak of 6.8%. Clearly, the global growth slowdown has migrated to the U.S. and the impact is being seen in the leading U.S. economic data. Some slowdown in corporate revenue growth is all but assured. All leading indicators point to deceleration in corporate profit growth in Q4 2018 and beyond. Corporate profit growth and investment spending are tightly linked in the sense that firms are more likely to take on new projects when they feel better about their future cash flow prospects. The upshot is that we can infer trends in corporate profits by looking at data on investment spending and firms’ investment plans. That data paint a similar picture of widespread deceleration (Chart 3): Chart 3Investment Indicators Investment Indicators Investment Indicators The year-over-year growth rate in core durable goods orders is down to 4% from a recent peak close to 9%. An average of firms’ capital spending plans as reported in regional Fed surveys remains elevated, but has declined markedly in recent months. Small business capital spending plans, as reported to the NFIB, have fallen sharply during the past few months. Periods of tightening lending standards coincide with decelerating corporate debt. Wage growth is another important driver of corporate profits. In particular, we can get a read on profit growth by looking at the difference between corporate selling prices and unit labor costs, aka our Profit Margin Proxy (Chart 4). Our Profit Margin Proxy remains at a high level because growth in unit labor costs has been tepid. Even though top-line wage growth has improved, this has been matched by an acceleration in productivity growth (Chart 4, bottom panel). The latter has kept unit labor costs low, even as nominal wages have risen. Chart 4Wage Growth A Drag On Profits Wage Growth A Drag On Profits Wage Growth A Drag On Profits Extremely tight labor markets will lead to a continued acceleration in wage growth during the next few quarters.1 Meanwhile, the prospect for continued rapid productivity growth is much more uncertain. It seems reasonable to expect that corporate profits will come under some downward pressure from rising unit labor costs during 2019. Finally, we can get a sense of the corporate profit outlook by looking at equity analyst net earnings revisions (Chart 5). Analyst earnings per share (EPS) upgrades outpaced downgrades for most of 2018, but that trend reversed sharply near the end of last year. Analysts are once again lowering EPS forecasts more often than they are raising them. Chart 5More EPS Downgrades Than Updgrades More EPS Downgrades Than Updgrades More EPS Downgrades Than Updgrades Debt Growth Should Also Slow Fortunately, some of the balance sheet impact from decelerating profits will likely be offset by slower debt growth during the next few quarters. Corporate debt growth has been robust and fairly stable since 2012, but C&I lending standards tightened slightly in the fourth quarter of last year. Typically, periods of tightening lending standards coincide with decelerating corporate debt (Chart 6). Chart 6Tighter Lending Standards Implies Slower Debt Growth Tighter Lending Standards Implies Slower Debt Growth Tighter Lending Standards Implies Slower Debt Growth Anecdotally, several high profile firms have recently taken steps to curtail debt growth. Most notably, General Electric just announced a major asset divestment to pay down debt, and the stock market rewarded them for doing so. If our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. More broadly, we observe that firms with low debt/asset ratios have been outperforming firms with high debt/asset ratios, a dynamic that tends to occur when lending standards are tightening and corporate debt growth is falling (Chart 7). Chart 7Low Leverage Firms Are Outperforming Low Leverage Firms Are Outperforming Low Leverage Firms Are Outperforming For a sense of scale, nonfinancial corporate debt grew 6.5% in the four quarters ending Q4 2018 and has averaged 6.3% since 2012. Some mild deceleration from these growth rates is likely during the next few quarters. Putting It All Together Table 1 shows that trailing 12-month profit growth of 17% and debt growth of 6.5% led to gross corporate leverage of 6.95, which translates to a fair value default rate of 3.6%. Table 1 also shows where the fair value default rate will head during the next 12 months based on different scenarios for profit and debt growth. Table 1Default Rate Scenarios Assessing Corporate Default Risk Assessing Corporate Default Risk For example, if profits grow by 5% and debt growth is between 0% and 8%, then the fair value default rate will be between 3.5% and 4.1% one year from now. This seems like a reasonable scenario based on our macro forecast. A scenario that would result in a default rate that is much higher than the current Moody’s baseline forecast of 1.7%. And One More Thing Though they are not included in our model, job cut announcements are a fairly reliable coincident indicator of corporate defaults. Recently, job cut announcements have clearly bottomed even as the default rate has continued to fall (Chart 8). This is a clear warning sign that the default rate might head higher in the coming months. Chart 8Warning Sign From Job Cuts Warning Sign From Job Cuts Warning Sign From Job Cuts Bottom Line: The trailing 12-month corporate default rate is too low according to our macro model. Further, the likely trajectories for corporate profit and debt growth suggest that the default rate is more likely to rise than fall during the next 12 months. We expect the corporate default rate to be above 3% during the next 12 months, higher than the Moody’s baseline forecast of 1.7%. It increasingly looks like the second half of 2019 will be more challenging for corporate credit. Are Investors Adequately Compensated For Default Risk? Forecasting the default rate is important, but it is only one side of the coin when it comes to corporate bond investing. The other relevant question is whether current spreads offer adequate compensation for expected defaults. At present, the average option-adjusted spread (OAS) on the Bloomberg Barclays High-Yield index is 388 bps. If we assume that defaults occur in line with the Moody’s baseline forecast during the next 12 months, then we would expect default losses of approximately 90 bps (assuming a 49% recovery rate).2 That translates to an excess junk spread of 298 bps, well above the historical average realized excess spread of 250 bps. In other words, investors should expect better than average excess junk returns if the Moody’s baseline default rate forecast turns out to be correct. However, our analysis suggests that the default will be significantly higher during the next 12 months. If we assume a 3.5% default rate, more in line with our macro forecast, and a slightly lower recovery rate of 45%, then the excess spread available in the high-yield index falls to 198 bps. This number is still positive, so unless there is significant spread widening investors should still earn a positive excess return versus Treasuries, but it is considerably below average historical levels. Another factor to consider is the historical correlation between junk spreads and the Moody’s baseline default rate forecast. We find that the average high-yield OAS has the strongest positive correlation with the 9-month forward Moody’s baseline default rate expectation (Chart 9). In other words, if our default rate forecast turns out to be correct and the Moody’s forecast is eventually revised higher, it will likely coincide with some junk spread widening. Chart 9Default Rate Revisions Will Lead To Wider Spreads Default Rate Revisions Will Lead To Wider Spreads Default Rate Revisions Will Lead To Wider Spreads Bottom Line: Corporate bond investors are still adequately compensated for default risk, even under our more pessimistic scenario. However, some junk spread widening later this year is possible if market default rate expectations converge with our more pessimistic forecast. Investment Strategy While this report has focused on detecting early warning signs of default risk, that is not the only thing that matters for corporate spreads. We continue to believe that spreads have room to tighten in the near-term, due to accommodative Fed policy and a budding improvement in global growth.3 The purpose of this report is to stress that our current overweight stance on corporate bonds is unlikely to last through to the end of the year. First, if spreads tighten during the next few months leading to an easing in overall financial conditions, then the Fed will probably turn more hawkish in the second half of 2019 and monetary policy will shift from being a tailwind for corporate credit to a headwind. This shift could occur at around the same time that corporate defaults start to exceed current expectations. As a matter of strategy, we have published spread targets for each corporate credit tier based on average spread levels seen during similar stages of past economic cycles (Charts 10A & 10B).4 We will be quick to move off our overweight stance once these spread targets are achieved. Note that Aaa spreads are already below target. We recommend that investors avoid Aaa-rated corporate bonds. Chart 10AInvestment Grade Spread Targets Investment Grade Spread Targets Investment Grade Spread Targets Chart 10BHigh-Yield Spread Targets High-Yield Spread Targets High-Yield Spread Targets While the current environment remains positive, it increasingly looks like the second half of 2019 will be more challenging for corporate credit. Stay tuned. Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further details on the amount of labor market slack in the economy please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 2 We forecast the recovery rate based on its inverse historical relationship with the default rate. A higher default rate implies a lower recovery rate, and vice-versa. 3 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com 4 For more details on our spread targets please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com

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

Highlights Duration: With rate hikes more likely than cuts over the next 12 months, it makes sense to maintain below-benchmark duration in U.S. bond portfolios. However, timing the next up-move in Treasury yields is difficult. We recommend that investors initiate positive carry yield curve trades to boost returns while we wait for Treasury yields to bottom alongside the CRB/Gold ratio. Corporates: The Fed’s pause is leading to improvement in our global growth indicators. The end result is a window where corporate spreads will tighten during the next few months. Remain overweight corporate bonds, but be prepared to downgrade when spreads reach our targets. CMBS: We upgrade our allocation to non-agency CMBS from underweight to neutral, due to elevated spreads relative to other Aaa-rated sectors. While spreads are currently attractive, the macro back-drop is also fairly bleak. If spreads tighten to more reasonable levels or CMBS delinquencies start to rise we will be quick to downgrade. Feature Green Shoots For Global Growth Since 1994 the Global (ex. U.S.) Leading Economic Indicator (LEI) has contracted relative to its 12-month trend six times. In all six episodes it eventually dragged the U.S. LEI down with it (Chart 1). As we predicted last August, the U.S. economy cannot remain an oasis of prosperity when the rest of the world is in turmoil.1 However, to focus on the weakening U.S. data right now is to miss the bigger picture. Chart 1U.S. Follows The Rest Of The World U.S. Follows The Rest Of The World U.S. Follows The Rest Of The World Corporate bond spreads already reacted to the global slowdown by widening near the end of last year. Then, the Federal Reserve reacted to tighter financial conditions by signaling a pause in its rate hike cycle. We took that opportunity to turn more bullish on spread product, and now, there are budding signs of improvement in the global growth outlook. While the Global LEI (including the U.S.) remains in a downtrend, our Global LEI Diffusion Index is well off its lows (Chart 2). Historically, the Diffusion Index has a good track record leading changes in the overall indicator. Chart 2Global LEI Diffusion Index Is Back Above 50% Global LEI Diffusion Index Is Back Above 50% Global LEI Diffusion Index Is Back Above 50% Similarly, the timeliest indicators of global growth that called the early-2016 peak in credit spreads are starting to improve (Chart 3). The CRB Raw Industrials index is breaking out, the BCA Market-Based China Growth Indicator has recovered and Global Industrial Mining Stock prices are heading up. Chart 3Global Growth Checklist Global Growth Checklist Global Growth Checklist All told, it appears that the Fed’s pause and related dollar weakness, along with less restrictive fiscal and monetary policies in China, are starting to pay dividends.2 The end result is a window where leading global growth indicators will improve and financial conditions will ease. We recommend that investors maintain an overweight allocation to corporate bonds during this supportive window, though we also note that the continued rapid pace of corporate re-leveraging is a cause for concern. We will be quick to downgrade our recommended allocation to corporate bonds when our near-term spread targets are hit. Our spread target for Aa-rated corporates is 57 bps, the current spread level is 61 bps. Our spread target for A-rated corporates is 85 bps, the current spread level is 92 bps. Our spread target for Baa-rated corporates is 128 bps, the current spread level is 159 bps. Our spread target for Ba-rated corporates is 188 bps, the current spread level is 243 bps. Our spread target for B-rated corporates is 297 bps, the current spread level is 400 bps. Our spread target for Caa-rated corporates is 573 bps, the current spread level is 827 bps. We recommend avoiding Aaa-rated corporate bonds, which already look expensive. We explore the universe of Aaa-rated spread product in more detail below. Implications For Treasury Yields The Fed’s pause and the nascent improvement in global growth are both obvious positives for corporate spreads. The impact on Treasury yields is somewhat less obvious. We contend that once financial conditions ease sufficiently, the market will start to price-in further Fed rate hikes and this will pressure Treasury yields higher at both the short and long ends of the curve. The ratio between the CRB Raw Industrials index and the gold price can help clarify this concept. Chart 4 shows that the 10-year Treasury yield tends to rise when the CRB index outpaces gold, and vice-versa. The rationale for this correlation is that the CRB index is a proxy for global growth and gold is a proxy for the stance of monetary policy. Chart 4Timing The Next Treasury Sell-Off Timing The Next Treasury Sell-Off Timing The Next Treasury Sell-Off A rising gold price suggests that monetary policy is becoming increasingly accommodative. This eventually leads to an improvement in global growth and a rising CRB index. But Treasury yields do not rise alongside the CRB index. They only increase once the improvement in global growth is sufficient for the market to discount a tighter monetary policy. That moment occurs when the CRB index rises more quickly than the gold price. The bottom line is that with rate hikes more likely that cuts over the next 12 months it makes sense to maintain below-benchmark duration in U.S. bond portfolios. However, timing the next up-move in Treasury yields is difficult. We recommend that investors initiate positive carry yield curve trades to boost returns while we wait for Treasury yields to bottom alongside the CRB/Gold ratio.3 Checking In On The Labor Market Based on the number of emails we’ve received on the topic, the last two U.S. employment reports have stoked some confusion among investors. This is not surprising given the volatility in the headline numbers: Nonfarm payrolls increased +311k in January and only +20k in February. The U3 unemployment rate jumped to 4% in January, then fell back to 3.8% in February. The U6 unemployment rate jumped to 8.1% in January, then fell back to 7.3% in February. Much of the volatility is likely explained by data collection issues related to the partial government shutdown, which makes it useful to look through the noise and focus on a few important trends. Trend #1: Slow Growth In Q1 The employment data clearly point to a U.S. growth slowdown in the first quarter of 2019. Real GDP growth can be proxied by looking at the sum of the growth rate in aggregate hours worked and the growth rate in labor force productivity (Chart 5). The recent steep decline in hours worked suggests that first quarter growth is going to be weak. Chart 5Employment Data Point To Slow Growth In Q1 Employment Data Point To Slow Growth In Q1 Employment Data Point To Slow Growth In Q1 But as was noted in the first section of this report, weak Q1 GDP is the result of the global growth slowdown dragging the U.S. lower. Crucially, the market has already discounted this eventuality and the budding improvement in leading global growth indicators suggests that the U.S. slowdown will prove temporary. Trend #2: No More Slack A broad set of indicators now all point to the fact that the U.S. economy is at full employment (Chart 6). The implication is that we should expect wage growth to accelerate and payroll growth to decelerate as we move deeper into the cycle. Chart 6At Full Employment At Full Employment At Full Employment Some investors may retain the belief that a rising labor force participation rate will keep wage growth capped, but even here the prospects are dim. The participation rate for people of prime working age (25-54) has risen rapidly during the past few years, but that has only led to a small bounce in overall participation (Chart 7). This is because the aging of the population has pushed more and more people out of that prime working age demographic bucket. Chart 7Labor Force Participation Labor Force Participation Labor Force Participation The dashed line in the top panel of Chart 7 shows where the labor force participation rate would be, based on current demographics, if the participation rate for each narrow age cohort reverted to its July 2007 level. The message is that the scope for a further increase in labor force participation is limited. Trend #3: No Recession Risk Yet The full employment state of accelerating wage growth and decelerating employment growth can last for some time before a recession hits. In our research we have noted that, from a financial markets perspective, one of the best leading indicators is the change in initial jobless claims. Typically, a bottom in initial jobless claims coincides with an inflection point in Treasury excess returns (Chart 8). Chart 8Jobless Claims Have Called Troughs In Treasury Returns Jobless Claims Have Called Troughs In Treasury Returns Jobless Claims Have Called Troughs In Treasury Returns Initial jobless claims have risen somewhat during the past few weeks, and while this trend is worth monitoring, it is premature to flag it as a concern. The 4-week moving average in claims has already fallen back to 226k from a recent high of 236k, and next week an elevated print of 239k will roll out of the 4-week average. Any initial claims print below 239k next week will cause the 4-week average to decline further. Bottom Line: The U.S. labor market has reached full employment. Going forward we should expect a continued acceleration in wage growth and deceleration in payroll growth. This situation can persist without causing a recession until initial jobless claims start to head higher. We see no evidence of this as of yet. Aaa-Rated Spread Products In this week’s report we consider the risk/reward trade-off on offer from the major Aaa-rated spread products. Specifically, we consider corporate bonds, agency and non-agency CMBS, conventional 30-year residential MBS and consumer ABS (both credit cards and auto loans). Focusing purely on expected returns, we find that non-agency CMBS offer the highest option-adjusted spread of 73 bps. This is followed by 65 bps from corporates, 50 bps from Agency CMBS, 41 bps from MBS, 35 bps from auto ABS and 31 bps from credit card ABS. But this is just one side of the equation. Chart 9 shows each sector’s spread relative to the likelihood that it will experience losses versus Treasuries. To measure the risk of losses we use our measure of Months-To-Breakeven. This is defined as the number of months of average spread widening that each sector requires before it starts to lose money relative to a duration-matched position in Treasury securities. Essentially, the Months-To-Breakeven measure is each sector’s 12-month breakeven spread adjusted by its spread volatility since 2014. We only calculate spread volatility since 2014 because that it is when data for Agency CMBS start. Chart 9 Chart 9 shows that while Aaa corporate bonds offer elevated expected returns compared to the other sectors, they also offer a commensurate increase in risk. Similarly, consumer ABS offer lower expected returns than the other sectors but with considerably less risk. According to Chart 9, the only sector that offers an attractive risk/reward trade-off is non-agency CMBS. This warrants further investigation. Looking at spreads throughout history, we see that non-agency CMBS spreads also look relatively attractive. While Aaa-rated consumer ABS spreads are near all-time lows, non-agency CMBS spreads are still not quite one standard deviation below the pre-crisis mean (Chart 10). Chart 10CMBS Spreads Have Room To Narrow CMBS Spreads Have Room To Narrow CMBS Spreads Have Room To Narrow We noted in last week’s report that consumer ABS look even worse when we incorporate the macro environment.4 All-time tight ABS spreads currently coincide with tightening consumer lending standards and a rising consumer credit delinquency rate. This is why we downgraded consumer ABS from neutral to underweight last week. The macro environment for CMBS is also fairly bleak (Chart 11). Commercial real estate lending standards are tightening, loan demand is waning and prices are decelerating. The one saving grace is that, so far, this has not translated into a rising CMBS delinquency rate (Chart 11, bottom panel). It is probably only a matter of time before CMBS delinquencies start to trend higher, but with spreads so attractive relative to the investment alternatives, the sector warrants better than an underweight allocation. Chart 11Delinquencies Biased Higher? Delinquencies Biased Higher? Delinquencies Biased Higher? Bottom Line: We upgrade our allocation to non-agency CMBS from underweight to neutral. Spreads are currently attractive relative to other Aaa-rated sectors, but we will keep a close eye on the evolving macro backdrop. If spreads tighten to more reasonable levels or if CMBS delinquencies start to rise, we will be quick to downgrade.   Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity”, dated August 21, 2018, available at usbs.bcaresearch.com 2 For further details on recent shifts in Chinese policy please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com 3 For more details on the attractiveness of positive carry yield curve trades please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification