Fixed Income

Highlights As investors increasingly look at allocating assets based on environmental, social, and governance (ESG) considerations, these strategies are becoming less niche. We look at different ESG investing strategies, in both equities and bonds, and analyze their historical risk-adjusted returns and performance in bear markets and recessions. We find that ESG indices have at least performed in line with, and often outperformed, aggregate indices, with lower volatility. However, performance varies from region to region and between asset classes. Markets with the worst ESG standards tend to see the biggest improvement in performance when ESG factors are considered Feature Increasing investor interest in environmental, social, and governance (ESG) investing poses a big question for money managers: how does an allocation to ESG investments affect the return and volatility profile of a traditional portfolio? This Special Report addresses the following issues: What are the risk-return characteristics of ESG investments from a top-down perspective? Do ESG investments provide recession/bear market protection? What are the unique challenges that money managers using an ESG strategy need to account for? A Brief Overview Of ESG To begin, we need to define what exactly ESG investing means. We see it as any investment activity that recognizes a certain set of principles to screen for environmental, social, and governance standards. ESG investing, as a term, is relatively new. However, the core concept can be traced back several decades. During the 20th century, ethical investing (EI) emerged, as investors applied faith-based criteria to their investments. From the 1980s, socially responsible investing (SRI) allowed investors to focus on social and environmental goals, in addition to their ethical beliefs. This was mainly due to an increased global awareness of environmentalism that emerged in this period, following events such as the Exxon Valdez oil spill in 1989 and claims of labor-rights abuses in various industries. In the early 2000s, ESG investing arose from investors' increasing awareness of the need to include corporate governance as an additional screening to SRI investing. The inclusion of the governance factor was also due to numerous corporate scandals, such as Enron's bankruptcy in 2001. Simply put, ESG is a broader concept than the previous incarnations of ethical investing. Throughout the early 2000s, various global initiatives started supporting the cause of ESG investing. The United Nations launched the Principles for Responsible Investing (PRI) in 2006 to promote ESG investing among institutional investors.1 Based upon six pillars, the PRI aims to encourage the use of ESG factors by investors in their investment process. Currently, most of the demand for ESG investing comes from larger financial institutions, particularly pension funds, whereas smaller investment institutions and retail investors lag in their interest. The Global Sustainable Investment Alliance (GSIA) has released a global standard classification to distinguish between the different ESG strategies as summarized in Table 1. Negative screening, positive screening, and corporate engagement are the most used strategies, while themed investing and targeted-situation investing have relatively less allocation. Figure 1 illustrates various examples of which types of investments might fall under ESG.2 Table 1Global Standard ESG Classification* ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Figure 1Types Of Investments That Fall Under ESG* ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit The total market size of "sustainable investing" is difficult to quantify, due to the wide range of securities that could fall under this ambiguous label. According to the 2016 Global Sustainable Investment Review, published bi-annually by the GSIA, global ESG assets under management (using a very broad definition of ESG) totaled $22.9 trillion dollars as of 2016, a 25% increase from 2014.3 The development of cleaner energy sources, changing social norms, interest by millennials in environmental and social issues, and regulation are among the drivers of this growth. The increasing number of ETFs and mutual funds that define themselves as "socially conscious", standing at 279 as of Q3 2018, also demonstrates the growing interest in ESG investing.4 Additionally, the number of active managers integrating ESG factors in their investment strategy has grown (Chart 1). Chart 1Growing Interest... ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Increasing investor demand has translated into further transparency from companies. According to the Governance & Accountability Institute, the number of S&P 500 firms that disclose their sustainability, corporate governance and social responsibility performance more than quadrupled between 2011 and 2017 (Chart 2).5 Chart 2...More Transparency ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit However, transparency is not the only barrier to the growth of ESG investing. The term ESG is still utilized and defined in different ways, confusing investors. A joint survey by the UN and the CFA Institute showed that 43% of U.S. equity and fixed income investors cited a lack of historical data, and 41% limited understanding and knowledge of ESG issues as the top barriers to incorporating ESG.6 Additionally, due to the lack of a standardized reporting system, investors cannot properly assess and compare ESG metrics across firms.7 ESG factors tend to be hard to quantify. Inconsistent ESG ratings due to differences in data analysis and reporting contribute to the lack of comparability. Investors should do their own thorough due diligence before investing. Various funds that screen for "socially responsible" criteria do sometimes include controversial stocks. For example, Vanguard's SRI European Stock Fund includes Royal Dutch Shell and British American Tobacco plc amongst its top 10 holdings.8 Risk-Return Characteristics9 To compare returns across regions, we use the MSCI ESG Leaders Index, which MSCI describes as using a best-in-class strategy and excluding companies involved in the alcohol, gambling, tobacco, nuclear power, and weapons businesses. It also minimizes sector-based tracking error by targeting 50% of the market capitalization within each GICS sector.10 MSCI assigns companies an ESG rating ranging from AAA to CCC; companies must maintain a rating above BB to be eligible for inclusion. We use the Bloomberg Barclays MSCI Socially Responsible Indices for our fixed-income comparisons. These indices use a negative screening process to exclude issuers involved in businesses that are in conflict with social and environmental values. Historical data for ESG indices tend to be limited; the earliest data-point for the MSCI ESG Leaders Index is September 2007. We analyze historical metrics for two periods: one starting September 2007, and the other starting July 2009 to show returns after the negative impact of the Global Financial Crisis (GFC). Tables 2 and 3 show that equity investors have enjoyed higher risk-adjusted returns on equity ESG indices thanon standard equity indices. However, this is not the case across all regions. The global ESG equity index outperformed in both periods, with lower volatility (Chart 3). In the U.S. and U.K., ESG indices underperformed their conventional counterparts, but in the euro area, China and Canada they significantly outperformed, while achieving lower volatility (charts for all countries shown in the Appendix). Emerging markets are perhaps the biggest surprise, since here the ESG index outperformed by over 3.5% annually in both periods. However, EM outperformance was mainly driven by China (Chart 4). Table 2Equities: Risk-Return Profile (September 2007 - October 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Table 3Equities: Risk-Return Profile (July 2009 - October 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Chart 3ESG Equities: Global Outperformance ESG Equities: Global Outperformance ESG Equities: Global Outperformance Chart 4China Drove EM Outperformance China Drove EM Outperformance China Drove EM Outperformance A study conducted by MSCI ESG Research showed that stock selection had the biggest contribution to the excess return of the emerging markets ESG equity indices, followed by sector-selection tilts. In fact, stock-selection added value in most regions, except the U.S. The MSCI ESG Leaders Index excludes firms such as Amazon (for its labor practices), Apple (supply-chain issues), and Facebook (privacy and data security) from both the U.S. and the global ESG indices, which resulted in its relative poor performance during the strong technology market of the past few years. Some argue that the regions with the worst ESG standards tend to see the biggest improvement in performance when ESG factors are considered. However, a debate then arises as to whether ESG ratings can be taken at face value, or should simply be an input into a broader analysis.11 One of the most surprising results from Tables 2 and 3 is the finding that the global ESG index has lower volatility, given the more idiosyncratic risk of ESG indices, which have on average only about half the number of constituents of aggregate market indices. The concentration - based on a Herfindahl-Hirschman Index (HHI) - of the top 10 ESG constituents is about four times that of the broad indices. ESG equity indices trade at lower PE multiples than traditional indices. Chart 5 shows that, on average, ESG equities' outperformance has been mainly driven by stronger relative earnings growth rather than relative multiple expansion. Earnings contributed 48% to total return growth for the ACWI ESG index, compared to 41% for its counterpart. PE expansion contributed 21% of the ESG index's total return, compared to over 30% for the ACWI index. Chart 5Drivers Of Return Drivers Of Return Drivers Of Return The conclusions are not very different for fixed income (Table 4). There is little difference between returns for corporate SRI bonds and investment grade bonds. Despite the slight sector tilts towards financials and banks in SRI Bond Indices, the indices have largely tracked each other (Chart 6). Table 4Bonds: Risk-Return Profile (July 2009 - October 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Chart 6ESG Bonds: No Difference In Performance ESG Bonds: No Difference In Performance ESG Bonds: No Difference In Performance Only a limited amount of research has been conducted into the importance of ESG factors for credit portfolios, but several papers concluded that ESG scores do not significantly impact performance, though there was some evidence that bonds of companies with higher ESG scores actually trade at wider spreads.12 Recession/Bear Market Protection Despite the efforts of ESG providers to limit sector-based tracking error, ESG equity indices still tend to have sector tilts due to over- and under-weighting firms based on their ESG scores. Sectors such as Information Technology, Financials, Communication Services, and Healthcare usually are favored relative to Materials, Industrials, and Energy. However, the magnitude of these tilts differs from region to region, and understanding the scope of these tilts is important when considering an ESG allocation. For example, the Chinese MSCI ESG Leaders Index is heavily skewed towards Communication Services (one stock, Tencent, in particular). Simply put, the sector composition/index construction of ESG indices alters their cyclicality and, therefore, performance. To understand this, it is important to observe this behavior over as many cycles as possible. To analyze this, we looked at the U.S. MSCI KLD 400 Index, one of the oldest ESG indices, with data starting in 1990. In 2001-2002 (the aftermath of the tech bubble), the KLD 400 underperformed the S&P 500 due to the former's larger exposure to tech. On the other hand, during the 2007-2008 GFC, the KLD 400 had a smaller drawdown than the S&P 500 (Chart 7). Chart 7Sector Tilts Matter Sector Tilts Matter Sector Tilts Matter Additionally, Table 5 shows that an ESG allocation has tended to at least perform in line with equities overall, if not slightly outperform them, during bear markets. The MSCI KLD 400 outperformed the S&P 500 by an annualized average of 1% in the past five bear markets.13 Table 5Bear Market Protection? ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit We performed a risk-return analysis of a portfolio consisting of 60% conventional equities and 40% investment-grade bonds, compared to similarly weighted ESG-focused equity and fixed income indices. The results for the three regions for the period July 2009 and October 2018 are shown in Chart 8. Chart 8Portfolio Performance (Jul 2009 - Oct 2018) ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit The global and the euro area multi-asset ESG portfolios outperformed the conventional portfolios by 2 and 10 bps a year respectively while achieving slightly lower volatility. The U.S. ESG portfolio, on the other hand, slightly underperformed due to the underperformance of the ESG equity index in a strong tech market of the past nine years. Conclusion From the above analysis, we would draw the following conclusions: There is little evidence that ESG investing detracts from performance. In fact, there is some evidence that it can provide some outperformance and bear-market protection depending on the ESG index composition. Consideration of ESG factors in taking investment decisions needs to go beyond simply looking at ESG scores. Incorporating ESG analysis will increasingly become a core step in assessing risk for both equity and fixed-income investors. Index methodology and construction, as well as sector composition, play a big role in evaluating expected performance. ESG indices are growing. As of end of 2017, there were 42 ESG-focused equity indices by the major three providers as shown in Appendix Table 1. We expect to see more as ESG becomes increasingly acknowledged. Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1 Please see https://www.unpri.org/pri/about-the-pri 2 Please see https://www.ussif.org/files/Publications/Retail_Investor_Guide.pdf 3 Please see http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf 4 Please see Charles Schwab, Socially Conscious Funds List https://www.schwab.com/public/file/P-9561751/. Based on data from Morningstar, Inc. 5 Please see https://www.ga-institute.com/press-releases/article/flash-report-85-of-sp-500-indexR-companies-publish-sustainability-reports-in-2017.html 6 Please see ESG Integration In The Americas: Markets, Practices, And Data https://www.unpri.org/download?ac=5397 7 Please see CFA Financial Analysts Journal, Third Quarter 2018, Volume 74, Issue 3 https://www.cfapubs.org/doi/pdf/10.2469/faj.v74.n3.full 8 Please see https://global.vanguard.com/portal/site/loadPDF?country=ch&docId=14053 9 It is important to note that, in this report, we make no assumptions regarding the methodology or ESG ranking scores of the indices discussed, but rather take them as given by their providers (MSCI and Bloomberg Barclays). 10 Please see https://www.msci.com/eqb/methodology/meth_docs/MSCI_ESG_Leaders_Indexes_Methodology_June_2017.pdf 11 Please see http://www.whebgroup.com/what-do-esg-ratings-actually-tell-us/#_edn4 12 Please see https://static.macquarie.com/dafiles/Internet/mgl/global/shared/sf/images/corporate/asset-management/investment-management/understanding-esg-in-credit-portfolios.pdf?v=3 13 Bear markets defined as a drawdown of 15% lasting more than three months. Appendix Appendix Table 1ESG Equity Indices ESG Investing: No Harm, Some Benefit ESG Investing: No Harm, Some Benefit Appendix Chart 1ESG Equities: U.S. ESG Equities: U.S. ESG Equities: U.S. Appendix Chart 2ESG Equities: Euro Area ESG Equities: Euro Area ESG Equities: Euro Area Appendix Chart 3ESG Equities: Emerging Markets ESG Equities: Emerging Markets ESG Equities: Emerging Markets Appendix Chart 4ESG Equities: Canada ESG Equities: Canada ESG Equities: Canada Appendix Chart 5ESG Equities: U.K. ESG Equities: U.K. ESG Equities: U.K. Appendix Chart 6ESG Bonds: U.S. ESG Bonds: U.S. ESG Bonds: U.S. Appendix Chart 7ESG Bonds: Euro Area ESG Bonds: Euro Area ESG Bonds: Euro Area

Highlights Global Yields: Global bond yields appear to be settling into a new trading range, with the downside limited by tight labor markets but the upside capped by slowing global growth momentum. 2014/15 Redux?: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Feature Dear Client, There will be no Global Fixed Income Strategy report published next Tuesday, November 27th. Instead, you will be receiving a Special Report this Thursday, November 22nd. The report - authored by BCA's Chief Emerging Markets strategist, Arthur Budaghyan - will discuss the outlook for Emerging Market hard currency debt. Best regards, Rob Robis Chief Strategist On the surface, it appears that uncertainty is increasing in global fixed income markets. Government bond yields have dipped over the past couple of weeks, most notably in the U.S. where the benchmark 10-year Treasury yield is back down to 3.05% as we go to press. Corporate credit spreads have also been drifting wider, especially in the U.S. where there is growing concern that economic momentum has peaked, at least temporarily. The problem for bond markets is that while global growth momentum has clearly slowed, it has not been by enough to alleviate inflation pressures coming from tight labor markets. This story is clearly most visible in the U.S., but also in the majority of major developed market economies. Central bankers are sticking to their guns and focusing on their belief in the Phillips Curve model to forecast inflation. Until there are signs that more turbulent financial markets are feeding into actual weaker economic growth, bond yields will not be able to fall by enough to help bail out flailing equities and corporate credit. There are now 83% of OECD countries with an unemployment rate below the estimated full employment NAIRU. As expected with such a backdrop, our Central Bank Monitors are calling for tighter monetary policy across the developed economies. This is also showing up in an unusual divergence between rising global real bond yields and falling global leading economic indicators (Chart of the Week). Chart of the WeekYields Are Less Responsive To Slowing Growth Yields Are Less Responsive To Slowing Growth Yields Are Less Responsive To Slowing Growth By most conventional measures, monetary policy settings are not restrictive across the major economies. Actual policy interest rates remain below conventional measures of equilibrium like a Taylor Rule, while government bond yields - adjusted for inflation expectations - are less than trend real GDP growth (Chart 2). Those gaps are smallest in the U.S., where the Fed has been raising interest rates for the past three years, but remain wide in other countries. Chart 2Global Interest Rates Are Still Below Equilibrium Levels The Bond Market Is Not Your Friend The Bond Market Is Not Your Friend If global growth is merely shifting from above-trend (falling unemployment) to trend (stable unemployment), then central bankers will not be able to move back to a more dovish posture that could trigger a major fall in bond yields. Trading ranges are more likely to result in such an environment, where yields struggle to break higher because of shaky risk assets but cannot break lower because of low unemployment. We are likely in one of those ranges now, measured by a 3-3.25% range on the 10-year U.S. Treasury. Without a friendly boost from falling bond yields, we continue to recommend a cautious stance on global spread product, while maintaining an overall below-benchmark stance on global duration exposure. Will It Be 2014/15 All Over Again? Watch The USD & China Two months ago, we published a comparison of the current macro backdrop to that of the 2014/15 period.1 Back then, the Fed was forced to alter its plans to deliver a series of rate hikes after the end of its quantitative easing program, thanks to a sharply rising U.S. dollar that triggered major financial market selloffs and, eventually, slower U.S. growth. We concluded that such an outcome could occur again in the next few months, but it would take a much larger tightening of financial conditions to get the Fed to stand down this time given tighter U.S. labor markets and stronger U.S. inflation pressures. The way we presented that comparison between today and four years ago was though "cycle-on-cycle" charts, showing financial and economic data today overlapped with data from that 2014/15 period. The two episodes were indexed to the trough in the U.S. dollar in May 2014 and February 2018. This week, we update a few of those charts, but also add a few new indicators to assess if there has been enough financial and economic damage to trigger a shift to a more dovish Fed. U.S. Economy: The domestic U.S. economy appears healthier today versus the 2014/15 period, judging by the more robust readings from the NFIB Small Business Optimism index and the high level of job openings from the JOLTS data (Chart 3). Yet there are similarities seen in the latest decline in the Conference Board survey of U.S. CEO confidence, and the sharp fall in the ISM Manufacturing New Orders index. We suspect that this divergence in business optimism reflects U.S.-China trade tensions, which should have a greater impact on larger corporations that sell globally compared to smaller companies with a more domestic customer base. Chart 3U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Growth Today Vs. 2014/15: Stronger Domestic Economy U.S. Inflation: U.S. core CPI inflation is much faster now than at the similar point in the 2014/15 cycle, as is the growth in Average Hourly Earnings (Chart 4). This is due to the much lower unemployment rate today in the U.S., which is putting more upward pressure on domestically-generated prices and wages. Yet while the ISM Prices Paid index is also at a higher level today than 2014/15, the upward momentum has peaked and the latest decline in commodity prices is following an ominously similar path to four years ago (bottom panel). Chart 4U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation U.S. Inflation Today Vs. 2014/15: Faster Core/Wage Inflation Emerging Markets (EM): EM economic growth has been decelerating at a similar pace to 2014/15, with the aggregate EM (ex-China) PMI produced by our EM strategists now sitting right at the boom/bust 50 line (Chart 5). China's economic growth appears to be holding up better today when looking at the more elevated Li Keqiang index. A possible reason for that is the much larger and faster easing of Chinese monetary conditions today compared to 2014/15, thanks to the sharp weakening of the yuan. Chart 5EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) EM Growth Today Vs. 2014/15: China Drag Is Smaller (For Now) Global Financial Markets: Here, the current cycle is sticking very close to the 2014/15 script when looking at the rising U.S. trade-weighted dollar, widening spreads for U.S. investment grade (IG) corporate bonds and EM USD-denominated sovereign debt, and the tightening of U.S. financial conditions (Chart 6). Although it should be noted that the trade-weighted dollar would have to rise another 10% from current levels, and U.S. IG spreads would have to widen another 60bps, to generate similar moves compared to 2014/15. Chart 6Financial Markets Today Vs. 2014/15: Following A Similar Script Financial Markets Today Vs. 2014/15: Following A Similar Script Financial Markets Today Vs. 2014/15: Following A Similar Script U.S. Treasury Yields: Nominal U.S. Treasury yields are at much higher levels today than four years ago, an obvious consequence of the Fed's tightening cycle and more elevated U.S. inflation expectations (Chart 7). Yet the amount of tightening discounted over the next 12-months in the U.S. Overnight Index Swap (OIS) is similar to 2014/15, as is our estimate of the market-implied level of the terminal real fed funds rate (around 0.5%).2 One major difference: there is a large net short position in the Treasury market today, while positioning was fairly neutral during 2014/15 (bottom panel). Chart 7U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing U.S. Treasuries Today Vs. 2014/15: Higher Yields But Similar Fed Pricing Summing it all up, the broader range of evidence we present here confirms our conclusion from two months ago. There needs to be a much larger tightening of U.S. financial conditions before the Fed can signal a pause on its planned rate hikes, because of a much healthier domestic U.S. economy and a more entrenched acceleration of inflation (especially wage growth). If China's economy can continue to outperform the 2014/15 path - still a big "if" given U.S.-China trade uncertainties and with Chinese policymakers less willing to reflate the domestic credit bubble to boost growth - then the odds of U.S. growth converging down to non-U.S. growth will be reduced. We will continue to monitor these charts and relationships in future Weekly Reports but, for now, we see nothing yet to change our bearish views on U.S. Treasuries and our cautious view on U.S. corporate credit. Bottom Line: The domestic U.S. economy is much stronger today compared to the 2014/15 period when slowing global growth and a rapidly rising U.S. dollar prompted selloffs in global credit markets and, eventually, a dovish shift by the Fed. U.S. financial conditions need to tighten more before the Fed can signal a pause. New Zealand Update: Fade The Recent Bump In Yields We have been structurally positive on New Zealand (NZ) government bonds for some time, dating back to mid-2017. Our view was based on an assessment that the Reserve Bank of New Zealand (RBNZ) would be unable to make any upward change in policy rates due to sub-par economic growth and inflation that would struggle to meet the RBNZ's target of 2% (the midpoint of the 1-3% target band). So far, that scenario has fully played out, and NZ government bonds have significantly outperformed their global peers as a result (Chart 8). Chart 8Sticking With Our Successful Long NZ Trades Sticking With Our Successful Long NZ Trades Sticking With Our Successful Long NZ Trades Our preferred trades, which are part of our Tactical Overlay shown on page 14, have been yield spread trades for NZ government bonds versus U.S. and German equivalents.3 Specifically, we have been recommending long positions in 5-year NZ bonds vs. 5-year U.S. Treasuries and 5-year German government debt. The trades have performed well, but have given back some of the gains in recent weeks. This has mostly come via a surge in NZ yields (+29bps higher since the recent low on September 7th) that has driven yield spreads wider versus the U.S. and Germany (+23bps and +34bps, respectively, since September 7th). These increases are likely to prove unsustainable, given the sluggish momentum in NZ growth and inflation. The latest read on year-over-year real GDP growth came in at below-potential pace of 2.8% in the 2nd quarter of 2018. The manufacturing and services purchasing managers' indices (PMIs) have both fallen sharply throughout 2018, although the latest data points suggest some stabilization above the 50 level on the PMIs (Chart 9). Similar trends can be seen in the RBNZ surveys of business confidence and capacity utilization, which both remain near the post-2008 lows but may also be stabilizing. Chart 9Sub-Par Growth In New Zealand Sub-Par Growth In New Zealand Sub-Par Growth In New Zealand In the November Monetary Policy Statement (MPS) that was released after the RBNZ meeting earlier this month, a cautious view on growth was outlined.4 The pickup in Q2 GDP growth was dismissed as driven by temporary factors, and policymakers expressed concern that deteriorating business confidence could be signaling a more prolonged period of slowing domestic demand. The central bank did also highlight growth risks coming from slowing exports if U.S.-China trade tensions intensify. It is difficult to find an obvious trigger for faster NZ growth at the moment. Both consumer spending and residential investment were fueled by rising immigration and population growth from 2013 to 2017, but those trends have since begun to reverse. The RBNZ projects net monthly immigration to NZ to slow to levels last seen in 2014 and in line with the current growth rate of consumer spending around 3% (Chart 10). Business investment growth has already stalled (middle panel), while the RBNZ'S Business Outlook surveys indicate a negative outlook for export growth (bottom panel). Chart 10Where Will NZ Growth Come From? Where Will NZ Growth Come From? Where Will NZ Growth Come From? Against this sluggish growth backdrop, the RBNZ must continue to run an accommodative monetary policy to support growth. This can be done given the persistent undershooting of NZ inflation versus the RBNZ target. Headline CPI inflation did accelerate to 1.9% in Q3, but core inflation at 1.2% continued to languish near the bottom end of the RBNZ target range. The gap between the two inflation measures can be attributed to previous increases in global energy prices, which caused a blip up in the tradeables portion of the NZ CPI (Chart 11). Yet the recent decline in oil prices, combined with a bounce in the NZ dollar, suggests that the bump in tradeables inflation is likely to reverse in Q4 (middle panel). Non-tradeables inflation, which is driven by domestic factors such as wage growth, has remained stable at just over 2%, even with the NZ unemployment rate at a 10-year low of 4.5% that is below the OECD's NAIRU estimate. Chart 11Stubbornly Low NZ Inflation Stubbornly Low NZ Inflation Stubbornly Low NZ Inflation With an obvious trigger from higher inflation, the RBNZ will be forced to maintain a highly accommodative policy stance. This is especially true given the RBNZ's mandate, which now includes maximizing sustainable employment alongside keeping inflation between 1-3%. We think that means the RBNZ is more likely to tolerate a move to the upper end of that inflation band if the growth outlook was less certain, as is currently the case. Our RBNZ Monitor sits close to the zero line, indicating no pressure to either hike or cut interest rates. In the November MPS, the RBNZ stuck to its forecast that the Official Cash Rate (OCR) would remain unchanged at 1.75% until mid-2020, consistent with the signal from our RBNZ Monitor. The market is differing on this, with the NZ OIS curve currently discounting almost one full 25bp rate hike by the end of 2019, and a faster pace of hikes after that (Chart 12). Chart 12Market-Priced RBNZ Hikes Will Not Happen Market-Priced RBNZ Hikes Will Not Happen Market-Priced RBNZ Hikes Will Not Happen We continue to recommending fading any pricing of RBNZ rate hikes over the next 6-12 months. Given our still bearish views on U.S. Treasuries, we are maintaining our recommended long NZ 5-year/short U.S. 5-year position (on a currency-hedged basis into U.S. dollars). We have been running our long NZ/short Germany position on an UN-hedged basis - atypical for the Global Fixed Income Strategy service, where our views are almost always currency-hedged into U.S. dollars - since the trade's inception last year, based on a currency view that was more bearish on the euro than the New Zealand dollar. The NZD/EUR cross instead fell substantially, which more than fully eroded the gains on the bond side of the trade until the recent 7.5% pop in that exchange rate. After that move, the return on our unhedged trade is nearly back to flat. We are using that as an opportunity to switch our NZ/Germany trade to a more typical currency-hedged basis, moving the exposure into euros from New Zealand dollars. Bottom Line: The RBNZ will continue to maintain a dovish policy stance over at least the next year, amid softening economic growth and underwhelming domestic inflation. Stay long 5-year New Zealand government bonds versus both U.S. Treasuries (hedged into USD) and German sovereign debt (hedged into EUR). Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "EM Contagion? Or Just QT On The Q.T.?", dated September 11th 2018, available at gfis.bcarsearch.com. 2 This is calculated by subtracting the 5-year U.S. CPI swap rate, 5-years forward, from the 5-year U.S. OIS rate, 5-years forward. 3 We freely admit that a position held for over one full year should not be described as "tactical", as the name of our overlay portfolio suggests. Yet we have seen no reason to close these trades early given our market views on NZ. 4 The full Monetary Policy Statement can be found here: https://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Monetary%20policy%20statements/2018/mpsnov2018.pdf Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Bond Market Is Not Your Friend The Bond Market Is Not Your Friend Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. With only 54 bps of rate hikes priced into the curve for the next 12 months, investors should maintain below-benchmark portfolio duration. Credit Spreads: A likely deceleration in U.S. economic growth during the next few quarters is a near-term risk for credit spreads, while waning demand for C&I loans could signal that the market's default outlook is too benign. We see a high risk of spread widening during the next few months, and would advocate only a neutral allocation to spread product on a 6-12 month horizon. TIPS: Breakeven inflation rates remain low because investors are much less fearful of high inflation than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly shift to price more two-way risk into the inflation market. Remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. Feature More Pain Required Fed Chairman Jerome Powell spoke at the Dallas Fed last week, amidst some expectation that he might try to assuage financial market concerns about the pace of monetary tightening. Instead, the Chairman struck a balanced tone that the market took as slightly dovish. A rate hike next month remains fully discounted, but investors are now split on whether the Fed will move again in March (Chart 1). The April 2019 fed funds futures contract implies a funds rate of 2.525% by next April, just barely above the lower-end of the 2.5% - 2.75% target band consistent with two more rate hikes. Chart 1Markets Doubt The Gradual Pace Of Hikes Markets Doubt The Gradual Pace Of Hikes Markets Doubt The Gradual Pace Of Hikes Chairman Powell's remarks did not alter our view of the Fed's reaction function, which we expect will result in continued quarterly rate hikes until a preponderance of evidence is consistent with a significant slow-down in U.S. economic activity. As we discussed in last week's report, it is highly likely that the combination of a waning fiscal impulse and a stronger U.S. dollar will cause U.S. growth to slow during the next few quarters.1 What remains uncertain is whether the slow-down will be severe enough for the Fed to pause its +25 bps per quarter tightening cycle. With only 54 bps of rate hikes priced into the yield curve for the next 12 months, we are inclined to maintain below-benchmark portfolio duration on a 6-12 month investment horizon. However, we do not anticipate a significant move higher in yields during the next few months. We also think credit spreads can widen further in the near-term as growth slows, and we recommend only a neutral allocation to spread product versus Treasuries on a 6-12 month horizon, given the less attractive risk/reward trade-off in corporate credit. Another reason to get defensive on credit spreads before increasing portfolio duration is that further spread widening and tighter financial conditions are likely a necessary pre-condition for the Fed to slow its pace of rate hikes. Chairman Powell noted last week that financial conditions are an important input to the Fed's assessment of future economic growth, and also stressed that the Fed takes a broad view of financial conditions - encompassing not just the stock market but also the level of rates, credit spreads and other factors. With that in mind, we observe that there has been very little tightening in broad indexes of financial conditions during the past few months. In fact, the Chicago Fed's National Financial Conditions Index shows that financial conditions remain far more accommodative than when the Fed started hiking rates in December 2015 (Chart 2). Chart 2More Pain Needed For The Fed To Pause More Pain Needed For The Fed To Pause More Pain Needed For The Fed To Pause We conclude that much more financial market pain will be required before the Fed takes a dovish turn. As such, we are inclined to get more defensive with respect to credit, but to remain bearish on rates for now. Last week's release of the Fed's Senior Loan Officer Survey provided one more negative datapoint for corporate credit. While banks continue to ease standards on commercial & industrial loans, respondents reported that demand for such loans waned during the past three months (Chart 3). If the demand slow-down continues, then lending standards will eventually start to tighten and we will see more corporate defaults. For now, the slow-down in loan demand is a tentative signal that could be reversed next quarter, but it bears close monitoring as a potential warning that we are moving into the late stages of the credit cycle. Stay tuned. Chart 3Tighter Lending Standards Ahead? Tighter Lending Standards Ahead? Tighter Lending Standards Ahead? Bottom Line: U.S. economic growth will decelerate from a high level during the next few quarters, but the Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. Investors should get more defensive on credit spreads, but maintain below-benchmark duration. Stick With TIPS We have been recommending overweight positions in TIPS versus nominal Treasuries for some time, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. This range is consistent with prior periods when core inflation was well-anchored around the Fed's target.2 This recommendation suffered a set-back last week when long-maturity breakevens finally capitulated to the trend in other financial market indicators that have been pointing to weakness in global demand for several months (Chart 4). In fact, for most of this year falling commodity prices and a strengthening dollar have been signaling that global demand is on the decline. But until last week, TIPS breakevens had mostly bucked the trend. Chart 4Held Down By Global Demand Held Down By Global Demand Held Down By Global Demand The reason is that long-maturity TIPS breakeven inflation rates remain under the influence of two competing forces. Signals of waning global demand on the one hand, and rapidly rising U.S. inflation on the other. Last December, the 12-month rate of change in core PCE inflation stood at 1.64%. As of September it stands at 1.97%, within a hair of the Fed's 2% target. Likewise, year-over-year core CPI inflation has increased from 1.76% as of last December to 2.15% as of October. Survey measures of realized and expected price changes have similarly strengthened (Chart 5). Chart 5Pulled Up By U.S. Inflation Pulled Up By U.S. Inflation Pulled Up By U.S. Inflation The combination of strong U.S. inflation and waning global growth has left long-dated breakevens relatively trendless for most of the year. And although we think year-over-year U.S. core inflation will flatten-off during the next few months (see Box), we would remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. BOX Core Inflation: Grappling With Base Effects Year-over-year core CPI inflation was 2.15% in October, down slightly from 2.17% in September. Meanwhile, our Base Effects Indicator ticked up from 3 to 4 but it remains below the critical 5.5 level (Chart 6). Chart 6Expect Year-Over-Year Core CPI To Flatten-Off Expect Year-Over-Year Core CPI To Flatten-Off Expect Year-Over-Year Core CPI To Flatten-Off In our Weekly Report from September 4, 2018, we showed that when our Base Effects Indicator - an indicator derived from near-term rates of change in core CPI - is below 5.5, 12-month core inflation is much more likely to fall than rise during the next six months. While pipeline inflation measures and the tightness of the labor market both suggest that the uptrend in core inflation will remain intact, we expect that year-over-year core inflation will flatten-off during the next six months, at levels close to the Fed's target. Our view is that as long as inflation remains sufficiently close to the Fed's target, over time, investors will start to price two-way risk back into the inflation market. It simply takes time for expectations to fully adapt to the new economic reality. Expectations Are Slow To Adapt To illustrate why we remain optimistic that TIPS breakevens have further upside, we created what we call our Adaptive Expectations Model of the 10-year breakeven rate (Chart 7). The model combines both forward-looking and backward-looking measures of inflation, and is premised on the idea that investors are slow to fully adapt their expectations to a changing environment. Chart 7Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model For example, even though core inflation is now close to the Fed's target on a 12-month rate of change basis, investors remain scarred by the past decade when it was stubbornly low. The long period of low inflation makes it much more difficult for investors to believe that the regime is finally shifting. Our Adaptive Expectations Model includes three variables: The 120-month rate of change in core CPI inflation (annualized) The 12-month rate of change in headline CPI inflation The New York Fed's Underlying Inflation Gauge (full data set measure) The 120-month rate of change is included to capture the impact from investors' long memories when it comes to inflation. The 12-month rate of change is included to capture the more recent trend in prices and the New York Fed's Underlying Inflation Gauge is included to provide a forward-looking measure of inflationary pressures in the economy. Notice in Table 1 that the 120-month rate of change in core CPI carries much greater importance in our model than the other two variables. Table 1Adaptive Expectations Model Regression Output (2003 To Present) Adaptive Expectations In The TIPS Market Adaptive Expectations In The TIPS Market Turning back to Chart 7, we see that the current 10-year TIPS breakeven inflation rate is more or less in line with our model's fair value. We also see that two of the model's three variables (12-month headline CPI and the Underlying Inflation Gauge) have returned to pre-crisis levels. It is only the 120-month rate of change in core CPI that is preventing breakevens from reaching our target range. In other words, even though inflation is more or less back to target levels, investors still doubt whether we have transitioned out of the prior low-inflation regime. The Fear Of High Inflation Is Missing Digging further into the data, we see that the real difference between today and the pre-crisis period is that investors are now much less worried about significantly higher inflation. A break-down of individual responses from the Survey of Professional Forecasters shows that, as in 2004, most forecasters think inflation will average between 2.01% and 2.5% during the next 10 years. But today, only 7% of forecasters think inflation will average above 2.51%. In 2004, 32% of forecasters thought inflation would average above 2.51% over the next 10 years (Chart 8). Chart 8High Inflation Is Less Of A Worry Adaptive Expectations In The TIPS Market Adaptive Expectations In The TIPS Market This assessment of likely inflation outcomes is backed-up by the economic data. The St. Louis Fed's Price Pressures Measure is a macro model designed to output the probability that inflation falls into different ranges over the next year.3 Here again, we see that the probability of inflation being between 1.5% and 2.5% is similar to its pre-crisis level, but the probability of inflation exceeding 2.5% is much lower (Chart 9). Chart 9Price Pressures Price Pressures Price Pressures Even looking at only the post-crisis period shows that it is the upper-tail of the inflation expectations distribution that is lagging. The Fed's Survey of Primary Dealers has been asking respondents to place probabilities on different long-run inflation outcomes since 2011. Chart 10 shows how the most recent responses - from September - compare to the post-2011 range. It shows that respondents are more certain than at any time since 2011 that inflation will be between 2.01% and 2.5% on average during the next 10 years, but are also more doubtful that inflation will be 2.51% or higher. Chart 10Primary Dealer Inflation Expectations Adaptive Expectations In The TIPS Market Adaptive Expectations In The TIPS Market Bottom Line: Even though 12-month inflation has more or less returned to the Fed's target, long-maturity TIPS breakeven inflation rates remain below levels that have been historically consistent with that target. Breakevens remain low because investors are much less fearful of elevated inflation (> 2.5%) than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly adapt to the new regime. Remain overweight TIPS versus nominal Treasuries on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, "The Sweet Spot On The Yield Curve", dated November 13, 2018, available at usbs.bcaresearch.com 2 For details on how we arrive at that range please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/   Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration: The waning impact from fiscal stimulus and the drag from weak foreign economic activity will cause U.S. growth to slow as we enter 2019. But with market-implied rate hike expectations still depressed, we are inclined to maintain below-benchmark portfolio duration. Yield Curve: Over the course of the year the sweet spot on the Treasury curve has shifted from the 5-year/7-year maturity point to the 2-year. The 2-year note offers the best combination of risk and reward of any point on the Treasury curve. This is true in both absolute and duration-neutral terms. Spread Product: Investors looking for attractive alternatives to Treasury debt at the short-end of the curve should consider Agency CMBS and Local Authority debt. Those sectors offer attractive spread pick-up and low risk of capital loss. Feature So far this year the Bloomberg Barclays Treasury index has returned -2.2% in absolute terms and -3.7% versus cash (Chart 1). If the year ended today, it would go into the books as the worst year for excess Treasury returns since 2009. Chart 1A Year To Forget A Year To Forget A Year To Forget Taking stock of this poor bond market performance makes us wonder what might prompt a reversal of fortunes. Our golden rule of bond investing tells us that if the economic outlook worsens enough for the market to discount a slower pace of Fed rate hikes, then bond market performance will improve.1 But with the market priced for only 63 bps of rate hikes during the next 12 months, we are reluctant to make that bet today. That being said, it also seems likely that U.S. GDP growth will slow as we head into the New Year. At the very least, the intensity of the bond market sell-off should diminish as well. Peak Growth There are two reasons why we think U.S. growth will soften during the next few quarters. The first is that global economic growth (excluding the U.S.) has already slowed. In past reports we demonstrated that weak foreign economic growth tends to pull down the U.S., rather than strong U.S. growth pulling up the rest of the world.2 While recent U.S. data show only tentative signs of contagion from the rest of the world, we also see no evidence of moderation in the global growth slowdown.3 The Global Manufacturing PMI fell to 52.1 in October, a far cry from its early-2018 peak above 54 (Chart 2). The percentage of countries with PMIs above the 50 boom/bust line also fell to 74% in October, down from its 2018 high of 95%. Chart 2The Global Growth Slowdown Continues... The Global Growth Slowdown Continues... The Global Growth Slowdown Continues... Considering the major economic blocs, the global growth slowdown continues to be driven by Europe and China (Chart 3). The Eurozone aggregate PMI remains above 50, but is falling rapidly. Meanwhile, the Chinese PMI is threatening to break below 50, and will probably do so during the next few months. The full slate of U.S. import tariffs have still not been implemented, and in the background, leading indicators of Chinese economic activity remain soft (Chart 4). Chart 3...Driven By Europe And China ...Driven By Europe And China ...Driven By Europe And China Chart 4Chinese Economy Keeps Slowing Chinese Economy Keeps Slowing Chinese Economy Keeps Slowing The second reason why U.S. growth is likely to slow during the next few quarters is the waning impact from fiscal stimulus. With the Democrats taking control of the House following last week's midterm elections, any hopes for another round of tax cuts should be quickly dashed. There is probably room for compromise between the two parties on infrastructure spending, but it will take some time (possibly the better part of two years) for them to reach an agreement. Meanwhile, the IMF estimates that fiscal policy will shift from adding 1% to GDP growth in 2018 to only 0.4% next year (Chart 5). Chart 5Less Boost From Fiscal In 2019 Less Boost From Fiscal In 2019 Less Boost From Fiscal In 2019 Bottom Line: The waning impact from fiscal stimulus and the drag from weak foreign economic activity will cause U.S. growth to slow as we enter 2019, but at this point it is not clear whether growth will slow sufficiently for the Fed to deviate from its +25 bps per quarter rate hike pace. With the market only priced for 63 bps of rate hikes during the next year, below-benchmark portfolio duration remains warranted. We prefer to position for slowing U.S. growth by taking less credit risk, maintaining only a neutral allocation to spread product with an up-in-quality bias. The Increasing Attractiveness Of Shorter Maturities Chart 1 shows a fairly consistent bearish trend in the bond market: at no point in 2018 were Treasury index returns in the black. But this doesn't mean that nothing has changed in the Treasury market this year, far from it. In fact, this year's bear-flattening of the yield curve has shifted the sweet spot for Treasury investors from the 5-year/7-year maturity point to the 2-year maturity point (Chart 6). This is true both in absolute and duration-neutral terms. Chart 6Par Coupon Treasury Curve The Sweet Spot On The Yield Curve The Sweet Spot On The Yield Curve Absolute Returns As can be seen in Chart 6, at the beginning of the year the steepest part of the Treasury curve ended at around the 5-year/7-year maturity point. Today, the curve flattens off considerably after the 2-year maturity point. This change in shape has important implications for the amount of return investors can earn from rolling down the yield curve. Table 1 shows expected 12-month returns for 2-year, 5-year and 10-year Treasury notes in three different scenarios. A scenario where the yield curve is unchanged during the next year, one where all yields rise by the average of historical 12-month yield increases, and one where all yields decrease by the average of historical 12-month yield declines. Table 1Bullish And Bearish Scenarios At Different Points Of The Curve The Sweet Spot On The Yield Curve The Sweet Spot On The Yield Curve In the unchanged yield curve scenario, expected returns are equal to "carry" which is simply the sum of the coupon income from the note (yield pick-up) and the capital gains earned from rolling down the curve (roll-down). It is in the roll-down component where the changing shape of the yield curve is most apparent. At the beginning of the year, an investor in the 5-year Treasury note could expect to earn 40 basis points of roll-down on a 12-month investment horizon, whereas an investor in the 2-year note would only earn 13 bps. But today, there is 21 bps of roll-down embedded in the 2-year note and only 6 bps in the 5-year. The end result is that we would actually expect the 2-year note to outperform the 5-year note in an unchanged yield curve environment, and only deliver 15 bps less return than the 10-year note. Charts 7A and 7B show that this sort of attractiveness in the 2-year note is quite rare. The 2-year does not usually offer more carry than the 5-year or 10-year, and periods when it does tend to coincide with an inverted yield curve. Since an inverted yield curve is a reliable predictor of recession, it usually makes sense to extend duration and favor long maturity Treasuries in those environments. This is because yields are likely to fall as the Fed cuts rates to fight the recession. But in the current environment, if recession is avoided during the next 12 months - as is our expectation - and Treasury yields continue to drift higher, a strategy of favoring the 2-year note will pay off handsomely. Chart 7AMore Carry In The 2-Year Note I More Carry In The 2-Year Note I More Carry In The 2-Year Note I Chart 7BMore Carry In The 2-Year Note II More Carry In The 2-Year Note II More Carry In The 2-Year Note II This is further elucidated by the bull and bear cases shown in Table 1. In the bearish scenario where each point on the yield curve rises by its historical 12-month average (the average is calculated only for periods when yields actually increased), the 2-year note still has a positive expected return. More importantly, the 2-year note offers an expected return that is 215 bps greater than the expected return from the 5-year note. At the beginning of the year, the 2-year note only offered 161 bps more expected return than the 5-year note in the bearish bond scenario. Similarly, in the bullish bond scenario, the 2-year note is only expected to lag the 5-year note by 228 bps. At the beginning of the year, the 2-year would have been expected to lag the 5-year by 297 bps in the bullish bond scenario. In other words, from an absolute return perspective the 2-year Treasury note is the most attractive part of the yield curve. The 2-year will outperform other maturities by more than usual in a rising yield scenario and underperform by less than usual in a falling yield scenario. This alluring combination of risk and reward looks even more enticing when coupled with our preference for keeping portfolio duration low. In Duration-Neutral Terms We do not typically look at expected total returns for specific maturity points. Rather, we prefer to separate the portfolio duration call from the yield curve positioning call. In other words, we communicate our view on the level of rates through our portfolio duration recommendation and then consider which parts of the yield curve look most attractive in duration-neutral terms. To do this, we look at butterfly spreads. Chart 8 shows that the 2/5/10 butterfly spread - the spread between the 5-year bullet and a duration-matched 2/10 barbell - has turned negative. This is unusual outside of environments where the 2/10 slope is inverted. In fact, our fair value model for the 2/5/10 butterfly spread is based on the slope of the 2/10 Treasury curve and it currently flags the 5-year bullet as expensive (Chart 8, bottom panel).4 Chart 8The 5-Year Bullet Is Expensive... The 5-Year Bullet Is Expensive... The 5-Year Bullet Is Expensive... In contrast, the 2-year bullet is the cheapest it has been since 2005 relative to the 1/5 barbell (Chart 9). This means that the 1/5 slope would have to flatten dramatically for returns in the 1/5 barbell to overcome the carry advantage in the 2-year note. For this reason we closed our prior yield curve position - long the 7-year bullet and short the 1/20 barbell - in last week's report, and entered a position long the 2-year bullet and short the 1/5 barbell. Chart 9...But The 2-Year Bullet Is Cheap ...But The 2-Year Bullet Is Cheap ...But The 2-Year Bullet Is Cheap Bottom Line: Over the course of the year the sweet spot on the Treasury curve has shifted from the 5-year/7-year maturity point to the 2-year. The 2-year note offers the best combination of risk and reward of any point on the Treasury curve. This is true in both absolute and duration-neutral terms. Short Maturity Spread Product Given that the sweet spot on the yield curve has shifted from the 5-year/7-year maturity point to the 2-year maturity point, we thought we should also examine which spread products offer attractive opportunities to earn extra compensation at the short-end of the curve, as an alternative to simply buying the 2-year Treasury note. Table 2 shows the spread per unit of duration offered by different high-quality (Aaa/Aa rated), low maturity (1-3 year) spread products. We exclude non-Agency CMBS and Agency MBS because the spread volatility in those sectors makes them riskier than their credit ratings imply. Table 21-3 Year Maturity Aaa/Aa-Rated Spread Products The Sweet Spot On The Yield Curve The Sweet Spot On The Yield Curve Auto loan ABS and Aa-rated corporate bonds offer the most spread pick-up per unit of duration, but we see some potential for spread widening in both sectors. Corporate spreads could widen as profit growth falls below the rate of debt growth during the next few quarters and consumer ABS spreads might also have upside. The consumer credit delinquency rate is rising, and banks are tightening standards lending standards (Chart 10). Chart 10Some Upside In Consumer ABS Spreads The Sweet Spot On The Yield Curve The Sweet Spot On The Yield Curve Agency CMBS and Foreign Agencies both offer 17 bps of spread per unit of duration. Of those two sectors we prefer Agency CMBS, which look very attractive on our Bond Map.5 Foreign Agencies also look attractive on our Map, but could struggle as the U.S. dollar appreciates making dollar debt more difficult for foreign borrowers to service. Of all the sectors listed in Table 2, the 15 bps spread per unit of duration offered by Local Authority debt looks most alluring. Largely composed of taxable municipal issues, Local Authority debt is insulated from weakness abroad and still offers a reasonably attractive spread pick-up. Bottom Line: Investors looking for attractive alternatives to Treasury debt at the short-end of the curve should consider Agency CMBS and Local Authority debt. Those sectors offer attractive spread pick-up and low risk of capital loss. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 3 While U.S. data remain very strong, the low contribution of nonresidential investment spending to overall GDP growth in Q3 could be a sign of contagion from the rest of the world. For further details please see U.S. Bond Strategy Weekly Report, "What Kind Of Correction Is This?", dated October 30, 2018, available at usbs.bcaresearch.com 4 For further details on our butterfly spread models, please see U.S. Bond Strategy Special Report, "Bullets, Barbells And Butterflies", dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Toxic Combination", dated November 6, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Falling Oil Prices & Bond Yields: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. ECB Corporate Bond Purchases: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days in this cycle for European corporate credit are behind us, as the ECB will not treat its corporate bond purchases any differently than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade & high-yield. Feature Are Falling Oil Prices Telling Us Something About Global Growth? Thus far in November, global financial markets have reversed some of the steep losses incurred during the "Red October" correction. This has occurred for U.S. equities (the S&P 500 fell -8% last month but has risen +4% so far this month), U.S. corporate bonds (high-yield spreads widened +71bps last month and have tightened -19bps this month) and emerging market hard currency debt (USD-denominated sovereign spreads widened +27bps last month and have tightened -9bps this month). One market that has not rebounded, however, is oil. The benchmark Brent oil price fell -11% in October, but has fallen another -7% in November. This has been enough to nearly wipe out the entire +20% run-up seen in August and September. Global government bond yields have been very sensitive to swings in oil markets in recent years. Such a large decline in the oil price as has been seen of late would typically result in sharp drop in government bond yields, driven by falling inflation expectations. That correlation has been holding up in the major economies outside the U.S., where nominal yields and inflation expectations are lower than the levels seen before the October peak in oil prices. Nominal U.S. Treasury yields, by contrast, remain resilient, despite the fall in TIPS breakevens (Chart of the Week). This is because real Treasury yields have been climbing higher as investors acquiesce to the steady hawkish message from the Fed by making upward revisions to the expected path of U.S. policy rates. Chart of the WeekShifting Correlations Shifting Correlations Shifting Correlations The biggest impediment holding back a full recovery of the October losses for global risk assets is uncertainty over the global growth outlook. While the U.S. economy continues to churn along at an above-trend pace, there are signs that tighter monetary policy is starting to have an impact. Both housing and capital spending have cooled, although not yet by enough to pose a terminal threat to the current long business cycle expansion. The outlook for growth outside the U.S. is far more muddled, adding to investor confusion. China has seen a clear growth deceleration throughout 2018, but the recent reads from imports and the Li Keqiang index suggest that growth may be stabilizing or even modestly re-accelerating (Chart 2). Our China strategists are not convinced that this is anything more than a ramping up of imports and production in advance of the full imposition of U.S. trade tariffs, especially with Chinese policymakers reluctant to deploy significant fiscal or monetary stimulus to boost growth. Chart 2Mixed Messages On Growth Mixed Messages On Growth Mixed Messages On Growth A similar mixed read is evident in overall global trade data. World import growth has also slowed throughout 2018, but has shown some stabilization of late (second panel). A similar pattern can be seen in capital goods imports within the major developed economies. Our global leading economic indicator (LEI) continues to contract, but the pace of the decline has been moderating and our global LEI diffusion index - which measures the number of countries with a rising LEI versus those with a falling LEI - may be bottoming out (third panel). There are also large, and growing, divergences within the major developed economies. The manufacturing purchasing managers' indices (PMIs) for the euro area and the U.K. have been falling steadily since the start of the year, but the PMIs have recently ticked up in the U.S. and Japan (Chart 3). A similar pattern can be seen in the OECD LEIs, which have retreated from the latest cyclical peaks by far more in the U.K. (-1.6%) and euro area (-1.2%) than in the U.S. (-0.3%) and Japan (-0.6%). Chart 3Diverging Growth, Diverging Bond Yields Diverging Growth, Diverging Bond Yields Diverging Growth, Diverging Bond Yields With such mixed messages from the macro data, investors understandably lack conviction. The backdrop does not look soft enough yet to threaten global profit growth and justify sharply lower equity prices and wider corporate bond spreads. Yet the growth divergences between the U.S. and the rest of the world are intensifying, creating a backdrop of rising U.S. real interest rates and a stronger U.S. dollar. That combination is typically toxic for emerging markets, but the impact of that would be muted this time if China were to indeed see a genuine growth reacceleration. This macro backdrop lines up with our current major fixed income investment recommendations. We suggest only a neutral allocation to global corporate bonds given the uncertainty over growth, but favoring the U.S. over Europe and emerging markets given the clearer evidence of a strong U.S. economy. At the same time, we continue to recommend below-benchmark overall portfolio duration exposure, but with regional allocations favoring countries where central banks will have difficulty raising interest rates (Japan, Australia, core Europe, the U.K.) versus nations where policymakers are likely to tighten monetary policy (U.S., Canada). However, the latest dip in oil should not be ignored. A more sustained breakdown of oil prices could force us to downgrade corporate bonds and raise duration exposure - if it were a sign that global growth was slowing and inflation expectations had peaked. The current pullback in oil has occurred alongside a decelerating trend in global economic data surprises, after speculators had ramped up long positions in oil and prices were stretched relative to the 200-day moving average (Chart 4). This suggests that the latest move has been corrective, and not a change in trend, although the burden of proof now falls on the evolution of global growth, both in absolute terms and relative to investor expectations. Chart 4Oil Correction Or Growth Scare? Oil Correction Or Growth Scare? Oil Correction Or Growth Scare? Bottom Line: Murky trends in global growth data, at a time of tight labor markets and gently rising inflation, are preventing a full recovery of risk assets after the October correction. A new concern is the falling price of oil, although this looks more corrective than a true change in trend. For now, maintain a cautious stance within global fixed income portfolios - neutral on corporate credit, below-benchmark on duration exposure. European Corporates Are About To Lose A Major Buyer Last week, we published a Special Report discussing the ECB's options at next month's critical monetary policy meeting.1 One of our conclusions was that the central bank will deliver on its commitment to end the new purchases phase of its Asset Purchase Program (APP) at year-end. The bulk of the assets in the APP are government bonds, but the ECB has also been buying corporate debt in the APP since June 2016. The ECB is set to end those purchases at the end of December, to the likely detriment of euro area corporate bond returns. The Corporate Sector Purchase Program (CSPP), as it is formally known, has been a targeted tool used by the ECB to ease financial conditions for euro area companies. This has occurred through three main channels: tighter corporate bond spreads, greater access for companies to issue debt in the corporate primary market, and increased bank lending to non-financial corporations. The CSPP was intended to complement the ECB's other monetary stimulus measures, like negative interest rates and the buying of government debt. The first CSPP purchases were made on June 8, 2016. The euro area corporate bond market responded as expected, with investment grade spreads tightening from 128bps to 86bps by the end of 2017. There were spillovers into high-yield bonds, as well, with spreads falling -129bps over the same period (Chart 5). Since then, however, spreads have steadily widened and European corporates have underperformed their U.S. equivalents. This suggests that some of the relative performance of euro area credit may have simply reflected the relative strength of the euro area economy compared to the U.S. The greater acceleration of euro area growth in 2017 helped euro area corporates outperform U.S. equivalents, while the opposite has held true in 2018. Chart 5ECB Buying Does Not Control European Credit Spreads ECB Buying Does Not Control European Credit Spreads ECB Buying Does Not Control European Credit Spreads The CSPP has operated with a defined set of rules governing the purchases. Bank debt was excluded, as were bonds rated below investment grade. Only debt issued by corporations established in the euro area were eligible for the CSPP, although bonds from euro-based companies with parents who were not based in the euro area were also eligible. The latest update on the holdings data from the ECB shows that there are just under 1,200 bonds in the CSPP portfolio. Yet despite the ECB's best efforts to maintain some degree of portfolio diversification, the impact of the CSPP on euro area corporate bond markets was fairly consistent across countries and sectors (Chart 6). Italy is the notable diverging country this year, as the rising risk premiums on all Italian financial assets have pushed corporate bond yields and spreads well above the levels seen in core Europe, even with the ECB owning some Italian names in the CSPP. Chart 6Spread Convergence During CSPP Spread Convergence During CSPP Spread Convergence During CSPP There was also convergence of yields and spreads among credit tiers during the first eighteen months of the CSPP, with valuations on BBB-rated debt falling towards the levels on AA-rated and A-rated bonds (Chart 7). That convergence has gone into reverse in 2018, with BBB-rated spreads widening by +55bps year-to-date (this compares to a smaller +25bps increase in U.S. BBB-rated corporate spreads). A surge in the available supply of BBB-rated euro area bonds is a likely factor in that spread widening, as evidenced by the sharp rise in the market capitalization of the BBB segment of the Bloomberg Barclays euro area corporate bond index (top panel). Chart 7A Worsening Supply/Demand Balance For European BBBs? A Worsening Supply/Demand Balance For European BBBs? A Worsening Supply/Demand Balance For European BBBs? More broadly, the CSPP has helped the ECB's goal of boosting the ability of European companies to issue debt in primary bond markets. Traditionally, European firms have used bank loans as their main source of borrowed funds, with only the largest firms being able to issue debt in credit markets. That has changed during the CSPP era. According to data from the ECB, gross debt issuance by euro area non-financial companies (NFCs) has risen by €104bn since the start of the CSPP, taking issuance back to levels not seen since 2014 (Chart 8). The bulk of the issuance has been in shorter-maturity bonds, but there has been a notable increase in the issuance of longer-dated debt since the CSPP began. Chart 8Bank Funding Versus Bond Funding Bank Funding Versus Bond Funding Bank Funding Versus Bond Funding The ECB's role as a marginal buyer of bonds in the primary, or newly-issued, market has helped boost that gross issuance figure. The share of bonds that the ECB owns in the CSPP that was issued in the primary market has gone from 6% soon after the CSPP started to the current 18% (Chart 9). The growth in euro area non-financial corporate debt went from 6% to over 10% during the peak of the CSPP buying between mid-2016 and end-2017, but has since decelerated to 7%. At the same time, the annual growth in loans to NFCs, which was essentially zero during the first eighteen months of the CSPP, has accelerated to 2% over the course of 2018. Chart 9More Bank Loans, Less Debt Issuance More Bank Loans, Less Debt Issuance More Bank Loans, Less Debt Issuance In other words, euro area companies had been substituting bank financing for bond financing in the CSPP "era", but have since shifted back towards bank loans in 2018. That shift in financing was most notable among CSPP-eligible companies, particularly those smaller firms that had not be able to issue debt in the primary market pre-CSPP, according to an ECB analysis conducted earlier this year.2 From the point of view of the investible euro area corporate bond market, however, even larger companies that have done that shift in bank financing to bond financing have seen no noticeable increase in aggregate corporate leverage. In Chart 10, we show our bottom-up version of our Corporate Health Monitor (CHM) for the euro area. This indicator is designed to measure the aggregate financial health of euro area companies using financial ratios incorporating actual data from individual companies. We separated out the list of companies used in that CHM that are currently held in the CSPP portfolio and created a "CSPP-only" version of the CHM (the blue lines in all panels). All issuers that were eligible for inclusion in the CSPP, but whose bonds were not actually purchased by the ECB, are used to create a "non-CSPP" CHM (the black dotted lines). Chart 10No Fundamental Changes From CSPP No Fundamental Changes From CSPP No Fundamental Changes From CSPP As can be seen in the chart, there is no material difference in any of the ratios for bonds within or outside the CSPP. The one notable exception is short-term liquidity, where the ratios were much lower for names purchased by the ECB than for those that were not. This lends credence to the idea that the CSPP most helped firms that were more liquidity-constrained, likely smaller companies. The biggest change in any of the ratios has been in interest coverage, but that has been for both CSPP and non-CSPP issuers, suggesting a common factor outside of ECB buying - zero/negative ECB policy rates, ECB purchases of government bonds that helped reduce all European borrowing rates - has been the main driver of lowering interest costs. Looking ahead, the ECB is likely to stop the net new purchases of its CSPP program when it does the same for the full APP next month. All of which is occurring for the same reason - the euro area economy is deemed by the central bank to no longer need the support of large-scale asset purchases given a full employment labor market and gently rising inflation. As we discussed in our Special Report last week, the ECB has other options available to them if there is a reduction in euro area banks' capacity or willingness to lend, such as introducing a new Targeted Long-Term Refinancing Operation (TLTRO). Continuing with unconventional measures involving direct ECB involvement in financial markets, like buying corporate debt, is no longer necessary. Our euro area CHM suggests that there are no major problems with European corporate health that require a wider credit risk premium. We still have our reservations, however, about recommending significant euro area corporate bond exposure while the ECB is set to end its asset purchase program. New buyers will certainly come in to replace the lost demand from the elimination of CSPP purchases, but private investors will likely require higher yields and spreads than the central bank - especially if the current period of slowing euro area growth were to continue. Bottom Line: The ECB is set to end the new buying phase of its Asset Purchase Program next month. This suggests that the best days for European corporate debt for the current cycle are behind us, as the ECB will not treat its corporate bond purchases any different than its government bond purchases. Both are going to stop. Remain underweight euro area corporate debt, both investment grade and high-yield. Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/Foreign Exchange Strategy Special Report, "Evaluating The ECB's Options In December", dated November 6th 2018, available at gfis.bcareserach.com and fes.bcaresearch.com. 2 The ECB report on its CSPP program was published in the March 2018 edition of the ECB Economic Bulletin, which can be found here. https://www.ecb.europa.eu/pub/economic-bulletin/html/eb201804.en.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stubbornly Resilient Bond Yields Stubbornly Resilient Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Equities had a wild ride in October, ... : The S&P 500 has bounced smartly off of its October 29th lows, but the decline that preceded the bounce was unusually severe. ... that unsettled a lot of investors, and made us reconsider our constructive take on risk assets: To judge by the November 5th Barron's, and some client conversations, several technically-minded investors are unconvinced by the bounce. Nothing has changed with our equity downgrade checklist, however, ... : The fundamental picture hasn't changed at all - neither corporate revenues nor margins appear to be in any immediate difficulty; though we still expect inflation to surprise to the upside, the latest data will not push the Fed to speed up its gradual rate-hike pace; and the combination of blockbuster third-quarter earnings and October's selloff made valuations more reasonable. ... so we see no reason to downgrade equities now, though we do have the admonition of a Wall Street legend ringing in our ears: If the fundamental backdrop remained unchanged, we would be inclined to upgrade equities if the S&P 500 got back to the 2,600-2,640 range, even though we are operating with a heightened sense of vigilance befitting the lateness of the hour. Feature It has been just four weeks since we rolled out our equity downgrade checklist. We would not ordinarily devote an entire Weekly Report to reviewing all of its components, but the last four weeks have hardly been ordinary. The swiftness of the decline, and the apparent lateness of the cycle, have unsettled investors enough to make several of them reconsider just how long they want to stay at the bull-market party. At times when market action provokes emotional gut checks, it is essential for investors to have a process to fall back on. Process provides a rational, objective haven from noise and emotion, and should help foster better decision-making. Our commitment to process underpins our fondness for checklists. They will never be comprehensive - as usual, we have our minds on other important inputs - but they help to ground our thinking, and we're happy to have them when markets make wild swings. Has The Recession Timetable Speeded Up? We are not interested in recessions for their own sake - we'll let the NBER's Business Cycle Dating Committee tell us when recessions begin and end, several months after the fact - but they're poison for risk assets. Any asset allocator who can recognize them in a timely fashion has a leg up on outperforming the competition. We therefore have been repeatedly monitoring the individual components of our recession indicator (Table 1). They do not betray any more concern than they did four weeks ago. Table 1Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist The yield curve is clearly flattening, just as one would expect as the Fed gets further into a rate-hiking campaign, but it is still a comfortable distance from inverting (Chart 1). We think yields at the long end have a way to go before they stop rising, so we expect the fed funds rate will have to get well into the 3's before the 3-month bill rate can overtake the 10-year Treasury yield. The Conference Board's Leading Economic Indicator is still expanding at a robust clip (Chart 2). Finally, we estimate the fed funds rate is about a year away from exceeding the equilibrium rate, thus signaling that policy has turned restrictive. Chart 1The Yield Curve Is Flattening, But It's Not About To Invert ... The Yield Curve Is Flattening, But It's Not About To Invert ... The Yield Curve Is Flattening, But It's Not About To Invert ... Chart 2... And Leading Economic Indicators Are Still Surging ... And Leading Economic Indicators Are Still Surging ... And Leading Economic Indicators Are Still Surging The unemployment rate continues to fall. Reversing the trend so that the three-month moving average could back up by the third of a percentage point that has unfailingly accompanied recessions (Chart 3) would require net monthly payroll additions to crater. Assuming annual population growth of 1%, and a constant labor force participation rate, net monthly job gains would have to fall to 100,000 for the three-month moving average to back up to 4% in 2020; if the pace of gains merely held at 120,000, the unemployment recession signal wouldn't be issued until 2021 (Chart 4). We applied the same conditions to the Atlanta Fed's online unemployment calculator to see what it would take for the unemployment rate to cross into the danger zone in 2019 (Table 2). Since the seven-year trend of 200,000 monthly net payroll additions would have to reverse on a dime for unemployment to issue a near-term warning, we do not foresee checking this box anytime soon. Chart 3Investors Should Beware An Uptick In The Unemployment Rate ... Investors Should Beware An Uptick In The Unemployment Rate ... Investors Should Beware An Uptick In The Unemployment Rate ... Chart 4... But None Is Forthcoming ... ... But None Is Forthcoming ... ... But None Is Forthcoming ... Table 2... Unless Hiring Falls Off A Cliff Checking In On Our Equity Downgrade Checklist Checking In On Our Equity Downgrade Checklist Are Corporate Earnings Coming Under Pressure? As we mentioned last week, we view the labor market as tight and getting tighter. We thereby expect that wages are on their way to rising enough to crimp corporate margins, albeit slowly. The composite employment cost index has been in an uptrend since 2016, but it ticked lower last month, and remains well below its cyclical highs ahead of the last two recessions (Chart 5). Chart 5Snails, Godot, Molasses And Wages Snails, Godot, Molasses And Wages Snails, Godot, Molasses And Wages October's global upheaval was good for the safe-haven dollar, which surged to a new year-to-date high (Chart 6). The DXY dollar index is now within 3% of the 100 level that would lead us to check the dollar strength box. Even though we're not checking the box yet, the dollar's 10% advance since mid-February will exert a modest drag on S&P 500 earnings for the next few quarters. Triple-B corporate yields have ticked a little higher since we rolled out the checklist, extending their six-year highs (Chart 7), though we still view them as manageable. Chart 6A Gentle Headwind (For Now) A Gentle Headwind (For Now) A Gentle Headwind (For Now) Chart 7Higher Yields Aren't Biting Yet Higher Yields Aren't Biting Yet Higher Yields Aren't Biting Yet A rising savings rate would cancel out some of the top-line benefits from employment gains. It fell pretty sharply in the third quarter, however, amplifying the self-reinforcing effect of new hiring. It's at the bottom of the range that's prevailed since 2014 (Chart 8), but could go still lower if consumption tracks the robust consumer confidence readings, as it consistently has in the past. Chart 8Consumers Are Well-Fortified Consumers Are Well-Fortified Consumers Are Well-Fortified EM economies have become considerably more indebted since the crisis, as developed-world savings sought an outlet; corporate profits are falling; and a stronger dollar makes it harder for EM borrowers to service their USD-denominated debt. A credit crisis (or multiple credit crises) could slow global activity enough to pressure multinationals' earnings, even if the U.S. economy is mostly insulated from EM wobbles. EM equities have gotten a respite since global equities put in their year-to-date lows, and Chinese stimulus could extend EM economies a lifeline, though BCA expects that Beijing will disappoint investors hoping for a meaningful boost. We remain bearish on emerging markets as a firm, but EM distress is not anywhere near acute enough to justify ticking the box. Is Inflation Starting To Make The Fed Uneasy? There are two channels by which inflation could pose a problem for equities. The first is the Fed: if it is discomfited by what it sees in realized inflation, or perceives that inflation expectations could become unanchored, it is likely to move forcefully to quash upward pressure on prices. A forceful pace is considerably faster than a gradual pace, and would bring forward a monetary policy inflection. If policy flips from accommodative to restrictive sooner than we expect, the window for risk-asset outperformance will shrink. With all of its talk about symmetric inflation targets, the FOMC has made it clear that it will not make any attempt to defend its 2% core PCE inflation target. It is comfortable with an overshoot, and has indeed openly wished for one for much of the post-crisis era. There are limits to its indulgence, however, and we suspect that the Fed would not be comfortable if core PCE inflation were to make a new 20-year high above 2.5%. With that red line far off (Chart 9), inflation is not yet likely to encourage the Fed to quicken the pace at which it removes accommodation. Chart 9Turtles, Sloths And Inflation Turtles, Sloths And Inflation Turtles, Sloths And Inflation Inflation expectations aren't yet pressing the Fed to speed things up, either. Long-maturity TIPS break-evens have retreated slightly since mid-October, and have yet to enter the range consistent with the 2% inflation target (Chart 10). The media and the broad mass of investors don't bother with symmetric targets, or implied break-evens; they take their cues from consumer prices. A multiple haircut driven by popular inflation fears is the second channel by which inflation could halt the equity advance, but CPI remains well below the mid-3% levels that would provoke concern (Chart 11). Chart 10Stubbornly Well-Anchored Stubbornly Well-Anchored Stubbornly Well-Anchored Chart 11No Reason To Trim Multiples Yet No Reason To Trim Multiples Yet No Reason To Trim Multiples Yet So What's To Worry About? Irrational exuberance is always a concern after an extended period of gains, but there's no sign of it in broad market measures right now. Blockbuster earnings gains have pulled the S&P 500's forward P/E multiple back down to the 15s from its January peak above 18. Secondary measures like price-to-sales, price-to-book, and price-to-cash-flow are well below extreme levels in the aggregate. If the S&P 500 is going to get silly, it will have to surge first. That said, the latter stages of bull markets and expansions can be perilous, and we are on high alert. We continue to actively seek out any evidence that challenges our broadly constructive take on risk assets and the U.S. economy. Though we have yet to find anything compelling, an admonition from legendary technical analyst and strategist Bob Farrell has lodged in our mind. Rule number nine of Farrell's ten market rules to remember states, "When all the experts and forecasts agree - something else is going to happen." It's much more fun to bring novel views and analysis to our clients, but we don't get overly concerned about agreeing with investor consensus. It's inevitable that a lot of people will agree in the middle of extended cycles; we simply strive to be among the first to recognize the major macro inflection points and determine the optimal asset-allocation framework to benefit from them. We get a little antsy, though, when everyone knows that something is either certain to happen, or cannot happen by any stretch of the imagination. The near-unanimity with which the investment community believes that a recession cannot begin in 2019 is increasingly eating at us. We have been checking and re-checking the data, and checking and re-checking our colleagues' various models, in search of trouble, but to no avail. Even though recessions begin at economic peaks, and the economy nearly always appears to be in fine fettle when the downturn asserts itself, the sizable fiscal thrust on tap for 2019 seems to obviate the possibility of a contraction. When discussing potential risks in face-to-face meetings with clients this week, we most often cited trade tensions, as any material rollback of globalization would erode corporate profit margins and would strike at global trade, on which much of the rest of world's economies rely. A dramatic worsening of the trade picture is not our base case, but we do expect upside surprises in inflation, and an attendant upside surprise in the terminal fed funds rate. We have been considering that view mainly from the perspective of fixed-income positioning: underweight Treasuries and maintain below-benchmark duration. We also have been assuming that the FOMC would lift the fed funds rate to 3.5% at the end of 2019 via four quarter-point rate hikes, and possibly take it all the way to 4% in the first half of 2020. If it were to speed up its pace, and take the fed funds rate to 3.5% by the middle of next year, and 4% by the end, we believe financial conditions would tighten enough to choke off the expansion. Monetary policy impacts the economy with a lag, so a recession may still not begin until 2020 in that scenario, but we'd bet that an equity bear market would begin in 2019. Investment Implications Balanced investors should maintain at least an equal weight position in equities. Although our checklist is a downgrade checklist, we're alert to opportunities to upgrade as well as downgrade. As we first wrote one week before the October selloff ended, we would look to overweight equities if the S&P 500 were to dip back into the 2,600-2,640 range (Chart 12). If U.S. equities wobble again in line with our Global Investment Strategy team's MacroQuant model's near-term discomfort, investors may get another opportunity before the year is out. Chart 12Only One Chance To Upgrade So Far, But There May Be More Only One Chance To Upgrade So Far, But There May Be More Only One Chance To Upgrade So Far, But There May Be More Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com