Fixed Income

Highlights Monetary Policy: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Duration: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Feature Fed Chairman Jerome Powell used his highly anticipated Jackson Hole address to reinforce the theme that has quickly become the hallmark of his tenure.1 Much like at the June FOMC press conference, the Chairman stressed the importance of incorporating uncertainty into the decision-making process.2 Specifically, the uncertainty surrounding real-time estimates of important macroeconomic variables such as the natural rate of unemployment (NAIRU) and the neutral (or equilibrium) fed funds rate. Chart 1The Fed's "Gradual" Rate Hike Cycle The Fed's "Gradual" Rate Hike Cycle The Fed's "Gradual" Rate Hike Cycle Uncertainty Surrounding NAIRU Considering the uncertainty surrounding NAIRU, the Chairman pointed to two specific time periods. The first being the "Great Inflation" of the 1960s and 1970s. In the late 1960s, real-time NAIRU estimates suggested that the unemployment rate was only slightly below its natural level, meaning that inflationary pressures were thought to be relatively muted (Chart 2). That expectation led policymakers to maintain an accommodative monetary policy that fueled the inflation of the 1970s. In Powell's view, the policy error was placing too much faith in real-time estimates of NAIRU, which with hindsight have been heavily revised (Chart 2, bottom panel). Chart 2Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers Real-Time NAIRU Estimates Are Often A Poor Guidepost For Policymakers The second period Powell discusses is the late 1990s. This period is the opposite of the 1960s in the sense that real-time NAIRU estimates were eventually revised lower (Chart 2). At the time, labor markets were thought to be very tight. But former Fed Chairman Alan Greenspan downplayed real-time NAIRU estimates and kept monetary policy easier for longer than many would have liked. Powell argues that subsequent downward NAIRU revisions vindicated that decision. At present, the unemployment rate of 3.9% is considerably below the Fed's most recent median NAIRU estimate of 4.5% (Chart 3). Complete faith in that NAIRU estimate would suggest that the Fed should be aggressively tightening policy. But as in the 1990s, it is possible that current NAIRU estimates will eventually need to be revised down. Despite seemingly tight labor markets, year-over-year core PCE inflation has still not returned to the Fed's 2% target. This makes future downward NAIRU revisions currently appear more likely than future upward revisions. Chart 3Current Estimates Point To A Very Tight Labor Market Current Estimates Point To A Very Tight Labor Market Current Estimates Point To A Very Tight Labor Market Powell argues that the Fed's "gradual" tightening path - raising the fed funds rate 25 bps per quarter - is a way of splitting the difference. The process of lifting rates acknowledges the current NAIRU estimate, while the relatively slow pace hedges the risk that it turns out to be too high. Uncertainty Surrounding The Neutral Rate Chart 4Growth At Odds With The Yield Curve Growth At Odds With The Yield Curve Growth At Odds With The Yield Curve Other than NAIRU, policymakers must also deal with the concept of the neutral (or equilibrium) fed funds rate. This is the interest rate that will keep the economy growing at its potential, leading to neither inflationary nor deflationary pressures. At the moment, most FOMC participants think the longer-run neutral rate is somewhere between 2.75% and 3% (in nominal terms). If this is correct, it means that the Fed's current 25 bps per quarter rate hike pace will cause the funds rate to reach neutral by the middle of next year. This is illustrated by the shaded grey boxes in Chart 1. If we assume complete confidence in the current estimate of the neutral rate, it is obvious that unless inflation significantly overshoots the 2% target, the Fed should halt its tightening cycle next year when the funds rate hits neutral. In fact, some FOMC members are advocating for at least a pause. Dallas Fed President Robert Kaplan recently said that when the fed funds rate reaches the current estimate of neutral: I would be inclined to step back and assess the outlook for the economy and look at a range of other factors - including the levels and shape of the Treasury yield curve - before deciding what further actions, if any, might be appropriate.3 However, the importance Powell places on uncertainty makes us think that any such pause would be very brief, if it occurs at all. In a recent report we showed that while the slope of the yield curve is consistent with a monetary policy that is already close to neutral, economic indicators do not corroborate this message (Chart 4).4 Bottom Line: Investors should not place much importance on current estimates of NAIRU or the neutral fed funds rate. The Fed will continue to lift rates at a pace of 25 bps per quarter until the economic recovery is threatened, revising NAIRU and neutral rate estimates as necessary. Heading For A Slowdown? The catalyst that could actually derail the Fed's rate hike cycle would be a meaningful slowdown in U.S. economic growth. In this regard, we observed in a recent report that current weakness outside of the U.S. is likely to spill over.5 Since 1993, every time the Global (ex. U.S.) Leading Economic Indicator (LEI) has fallen below zero, the U.S. LEI has eventually followed (Chart 5). Is there any reason to believe that this time might be different? One reason for optimism is that the Eurozone has been the main driver of the year-to-date slowdown in the Global Manufacturing PMI (Chart 6). This is encouraging because while Eurozone growth has certainly slowed, the PMI remains at a high level, well above the 50 boom/bust line. Further, recent data have shown some stabilization. The PMI is falling less rapidly than earlier in the year and broad money growth has picked up (Chart 7, top panel). However, weakness in China and emerging markets could easily swamp any positive impulse out of Europe. Though indicators of current economic activity in China appear in good shape, leading indicators and the imposition of tariffs point to weakness ahead (Chart 7, panel 2). Chinese policymakers have taken some steps to ease monetary conditions (Chart 7, bottom panel), but it remains unclear whether that will be sufficient to maintain current growth rates. Chart 5Global Growth Could Bring Down The U.S. Global Growth Could Bring Down The U.S. Global Growth Could Bring Down The U.S. Chart 6Weakness Due To Eurozone Weakness Due To Eurozone Weakness Due To Eurozone Chart 7The Biggest Risk Is From China The Biggest Risk Is From China The Biggest Risk Is From China Our assessment is that it is highly likely that weak global growth will eventually filter into the States. This will cause the Fed to pause its 25 bps per quarter tightening cycle at some point next year. However, applying Chairman Powell's uncertainty doctrine to our investment strategy, we must weigh this risk against what the market is already discounting. Chart 1 shows that the fed funds futures market is priced for a funds rate of 2.33% by the end of this year and 2.68% by the end of 2019. This means that the market is priced for only a single 25 bps rate hike in 2019, rather than the four we would expect in an environment of no economic hiccups. According to our golden rule of bond investing, we should be reluctant to adopt an above-benchmark portfolio duration stance unless we are confident that Fed rate hikes will come in below expectations over our investment horizon.6 Given that a significant growth slowdown would be required for the Fed to deliver only one hike in 2019, we think below-benchmark portfolio duration is still justified on a 6-12 month horizon. Bottom Line: The spillover from weak global growth into the U.S. will probably cause the Fed to pause its gradual rate hike cycle at some point next year. But with the market priced for only one rate hike in all of 2019, this risk is already in the price. Maintain below-benchmark portfolio duration on a 6-12 month investment horizon. Inflation Update An additional reason why any pause in the Fed's rate hike cycle could prove fleeting is that core inflation is very close to returning to the Fed's 2% target. Trailing 12-month core PCE inflation clocked in at 1.98% in July, while trailing 12-month trimmed mean PCE inflation was 1.99%. Rising inflation is likely the reason that long-dated TIPS breakeven inflation rates have remained stable in recent weeks, even as high-frequency global growth indicators have turned down (Chart 8). Looking ahead, the economic backdrop suggests that monthly inflation prints will continue to be strong. Our Pipeline Inflation Indicator remains elevated, despite the recent decline in commodity prices, and our PCE diffusion index shows that recent price increases have been broadly based (Chart 9). Chart 8Closing In On Target Closing In On Target Closing In On Target Chart 9Macro Environment Is Inflationary Macro Environment Is Inflationary Macro Environment Is Inflationary However, unless month-over-month inflation prints strengthen considerably, we should expect smaller increases in the year-over-year inflation rate going forward, as base effects provide less of a tailwind. To assess how much base effects influence year-over-year inflation rates we created our Core PCE Base Effects Indicator. We constructed the indicator using core PCE growth rates over horizons ranging from 1 to 11 months. We compare each growth rate to the growth rate over the next longest interval and increase the indicator's value by 1 each time a shorter-interval growth rate exceeds a longer-interval growth rate. In other words, we compare the 1-month growth rate in core PCE to the 2-month growth rate. If the 1-month growth rate is above the 2-month growth rate, we add 1 to our indicator. We then compare the 2-month growth rate to the 3-month growth rate, and so on. This gives us an indicator that ranges between 0 and 11. Chart 10 shows that when our Base Effects Indicator is elevated it usually means that year-over-year core PCE inflation will rise during the next six months, and vice-versa. We also observe that the cut-off point between positive and negative base effects is between 5 and 6. That is, when our indicator is at 6 or above, base effects bias the year-over-year core PCE inflation rate higher. Base effects tend to drag year-over-year inflation lower when our Indicator gives a reading of 5 or below. Chart 11 demonstrates the impact of base effects in more detail. The chart presents the median, first quartile and third quartile of 6-month changes in year-over-year core PCE inflation for each possible reading from our indicator. The median inflation change is positive for readings of 6 and above, and negative for readings of 5 and below. Chart 10Base Effects Now Less Of A Tailwind Base Effects Now Less Of A Tailwind Base Effects Now Less Of A Tailwind Chart 11The BCA Base Effects Indicator Tested (1960 - Present) The Powell Doctrine Emerges The Powell Doctrine Emerges In recent months, the reading from our Base Effects Indicator had been at 8, suggesting a very strong tailwind pushing the year-over-year growth rate in core PCE higher. But following last week's July PCE release our indicator fell to 6, suggesting only a mild positive impact from base effects going forward. Bottom Line: Recent rapid increases in year-over-year core inflation will moderate in the coming months, as base effects provide less of a tailwind. But the economic back-drop remains highly inflationary and we expect inflation's uptrend will continue. Investors should maintain an overweight allocation to TIPS versus nominal Treasuries, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 2 Please see U.S. Bond Strategy Weekly Report, "Rigidly Defined Areas Of Doubt And Uncertainty", dated June 19, 2018, available at usbs.bcaresearch.com 3 https://www.bloomberg.com/news/articles/2018-08-21/fed-s-kaplan-inclined-to-reassess-rates-amid-yield-curve-angst 4 Please see U.S. Bond Strategy Weekly Report, "Tracking The Two-Stage Treasury Bear", dated August 14, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "An Oasis Of Prosperity?", dated August 21, 2018, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature Desynchronization To Continue This year has been characterized by strong growth and asset performance in the U.S., and weakness everywhere else. While U.S. stocks are up by 10% year-to-date, those in the rest of the world have fallen by 3% in dollar terms (Chart 1). GDP growth in Q2 was 4.2% QoQ annualized in the U.S., compared to 1.6% in the euro area and 1.9% in Japan. Leading economic indicators point to this continuing and, therefore, to the U.S. dollar strengthening further (Chart 2). This has already put significant pressure on emerging markets, where equities have fallen by 7% this year in USD terms. Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update Chart 1U.S. Has Outperformed U.S. Has Outperformed U.S. Has Outperformed Chart 2...And Leading Indicators Suggest This Will Continue ...And Leading Indicators Suggest This Will Continue ...And Leading Indicators Suggest This Will Continue There are many reasons why the desynchronization is likely to continue: U.S. growth continues to be boosted by tax cuts and increased fiscal spending which, according to IMF estimates, will add 0.7% to GDP growth this year and 0.8% next. The peak impact from the stimulus will not come until around Q1 next year. Further protectionist tariff increases. Despite August's tentative agreement between the U.S. and Mexico, the Trump administration still plans to implement 10-25% tariffs on $200 billion of Chinese imports, and also possibly 25% tariffs on auto imports, in September. This will - initially at least - be more negative for global exporters, such as China, the euro area and Japan, than for the U.S. China is unlikely to implement the sort of massive stimulus that it carried out in 2009 and 2015.1 It has recently cut interest rates and brought forward fiscal spending to cushion downside risk. But, given the Xi administration's focus on deleveraging and structural reform, we do not expect to see a substantial increase in credit creation (Chart 3). This indicates that emerging markets, and capital goods and commodities exporters, will continue to struggle. European banks will stay under pressure because of the problems in Italy (which will fight this fall with the European Commission over its fiscal stimulus plans) and Turkey. Euro zone equity relative performance is heavily influenced by the performance of financials, even though the sector is only 18% of market cap (Chart 4). The euro zone and Japan are also far more sensitive to a slowdown in EM growth: exports to EM are 8.4% and 6.4% of GDP in the euro zone and Japan respectively, but only 3.6% in the U.S. Chart 3China Unlikely To Repeat 2009 and 2015 China Unlikely To Repeat 2009 and 2015 China Unlikely To Repeat 2009 and 2015 Chart 4Banks Drive European Equity Performance Banks Drive European Equity Performance Banks Drive European Equity Performance Eventually, however, strong growth in the U.S. will become a headwind for U.S. assets too. Already, there are some signs of wage growth ticking up (Chart 5), suggesting that the labor market is finally becoming tight. Fed chair Jerome Powell, in his speech at Jackson Hole last month, reiterated that a "gradual process of normalization [of monetary policy] remains appropriate", suggesting that the Fed will continue to hike by 25 basis points a quarter. But the futures market is pricing in only 75 basis points in hikes over the next two years (Chart 6). And, if core PCE inflation were to rise above the Fed's forecast of 2.1% (it is currently 2.0%), the Fed would need to accelerate the pace of tightening. This all points to further dollar strength which will hurt emerging markets, given the consistent inverse correlation between U.S. financial conditions and EM asset performance (Chart 7). Chart 5Is Wage Growth Finally Accelerating? Is Wage Growth Finally Accelerating? Is Wage Growth Finally Accelerating? Chart 6Markets Pricing In Only Three More Fed Hikes Markets Pricing In Only Three More Fed Hikes Markets Pricing In Only Three More Fed Hikes Chart 7Tightening Financial Conditions Are Bad For EM Tightening Financial Conditions Are Bad For EM Tightening Financial Conditions Are Bad For EM We continue for now, therefore, to remain overweight U.S. equities in USD terms within a global multi-asset portfolio, despite their strong performance this year. We are neutral on equities overall and expect to move to negative perhaps early next year, when we will see some of the classic warning signs of recession (inverted yield curve, rise in credit spreads, peak in profit margins) starting to flash. Profit expectations are one key to the timing of this. Analysts forecast 22% YoY EPS growth for S&P 500 companies in Q3 and 21% in Q4, slowing to 10% in 2019. Those are strong numbers. But if companies are unable to beat these forecasts, what would be the catalyst for stocks to continue to rise? Moreover, analysts' expectations for long-term earnings growth are more optimistic currently than any time since 2000 (Chart 8). It would not take much of a downside earnings surprise - perhaps caused by the strength of the dollar, or regulatory change for internet companies - to disappoint the market. Equities: Our strongest conviction call remains an underweight on emerging markets. Emerging markets are entering what is likely to be a prolonged period of deleveraging, given their elevated levels of debt relative to GDP and exports (Chart 9). That makes them very vulnerable to the stronger U.S. dollar and higher interest rates that we expect. While EM equities have already fallen significantly, they are not yet cheap and investors have mostly not capitulated: outflows from EM funds have been small relative to inflows in previous years (Chart 10). Among developed markets, we keep our overweight on the U.S.: not only does its lower beta mean it should outperform in the event of a sell-off, but if markets were to see a last-year-of-the-bull-market "melt-up" (similar to 1999), this would likely be led by tech and internet stocks, where the U.S. is overweight. Chart 8Analysts Too Optimistic About Long-Term Earnings Growth Analysts Too Optimistic About Long-Term Earnings Growth Analysts Too Optimistic About Long-Term Earnings Growth Chart 9Long Period Of Deleveraging Ahead For EM Long Period Of Deleveraging Ahead For EM Long Period Of Deleveraging Ahead For EM Chart 10No Signs Of Capitulation In EM Yet No Signs Of Capitulation In EM Yet No Signs Of Capitulation In EM Yet Fixed Income: Higher inflation, and more Fed tightening than the market is pricing in, suggest that long-term rates have further to rise. Fed rate surprises have historically been a good indicator of the return from U.S. Treasury bonds (Chart 11). We expect to see the 10-year yield reach 3.3-3.5% by early next year. We therefore remain underweight duration, and prefer TIPS over nominal bonds. We recently lowered our weighting in corporate credit to neutral (within the underweight fixed-income category). Junk bonds have continued to perform well, thanks to their 250 basis point default-adjusted spread over Treasuries. But spreads typically start to widen one to two quarters before equities peak, so we think caution is already warranted, particularly in the light of the higher leverage, longer duration, and falling average credit rating which currently characterize the U.S. corporate credit market. Currencies: As described above, mainly because of divergent growth and monetary policy, we expect the U.S. dollar to strengthen further, but more against emerging market currencies than against the yen or euro. Short-term, however, the dollar may have overshot and speculative positions are significantly dollar-long (Chart 12), so a temporary pullback would not be surprising. Chart 11More Fed Hikes Means Higher Long-Term Rates More Fed Hikes Means Higher Long-Term Rates More Fed Hikes Means Higher Long-Term Rates Chart 12Are Investors Too Dollar Bullish? Monthly Portfolio Update Monthly Portfolio Update Chart 13Dollar And China Hurting Commodities Dollar And China Hurting Commodities Dollar And China Hurting Commodities Commodities: Industrial metals prices have declined sharply over the past few months, on the back of the stronger dollar and slowdown in China (Chart 13). We expect this to continue. Gold, we have long argued, has a place in a portfolio as an inflation hedge. But it is also negatively impacted by rises in the dollar and real interest rates, and these are likely to continue to be a drag on performance. The oil price is currently being driven by supply dynamics: How much more oil will Saudi Arabia produce? Will the E.U. and Japan follow the U.S. in imposing sanctions on Iran? Will Venezuelan production fall further? These will make the crude oil price more volatile, but our energy strategists see Brent softening a little to average $70 in H2 this year, but with potential upside surprises taking it up to an average of $80 in 2019. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 For details on why we think massive stimulus is unlikely, please see BCA Geopolitical Strategy Special Reports, "China: How Stimulating Is The Stimulus?" Parts One and Two, dated 8 August 2018 and 15 August 2018, available at gps.bcaresearch.com GAA Asset Allocation

Highlights The global 6-month credit impulse is likely to turn up in the fourth quarter. This warrants profit-taking in some pro-defensive equity sector, regional, and country allocation... ...for example, in the 35 percent outperformance of European healthcare versus banks in just seven months. But do not become aggressively pro-cyclical until the 10-year yield on the Italian BTP (now at 3.2) moves closer to 3... ...and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) also moves closer to 3. Chart Of The WeekThe Cycle Is About To Turn The Cycle Is About To Turn The Cycle Is About To Turn Feature One of the most common questions we get is, when will the cycle turn? And our response is always, which cycle? The cycle that most people focus on is the so-called business cycle, which describes multi-year economic expansions punctuated by recessions. However, the business cycle - to the extent that it is a cycle - is very irregular. Its upswings and downswings vary greatly in length (Chart I-2). This irregularity is one reason why economists are useless at calling the turns. Nevertheless, investors still obsess with calling the business cycle because they think this is the only cycle that drives the financial markets. Chart I-2The Business Cycle Is Very Irregular The Business Cycle Is Very Irregular The Business Cycle Is Very Irregular We disagree. Nature bestows us with a multitude of cycles with different periodicities: the daily tides, the monthly phases of the moon, the annual seasons, and the multi-year climate cycles. So it would be unnatural, and somewhat arrogant, to assume the economy and financial markets possess only one cycle. In fact, just as in nature, the economy and financial markets experience a multitude of cycles with different periodicities. There Is Not One Cycle In The Economy, There Are Many If you plotted yearly changes in temperature, you would get a flat line and you would think there were no seasons! The point being that you cannot see a yearly cycle if you look at yearly changes. To see the cyclicality of the seasons, you must plot 6-month changes in temperature. Likewise, you cannot see the shorter-term cycles in the economy and financial markets using analysis, such as yearly changes, designed to see longer-term cycles. Once you grasp this basic maths, the mini-cycles in the economy and financial markets will stare you in the face (Chart I-3), and a whole new world of investment opportunities will open up. Chart I-3The Mini-Cycle Is Very Regular The Mini-Cycle Is Very Regular The Mini-Cycle Is Very Regular As we advised on January 4: "Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging eight months. As the current mini-upswing started in May 2017 we can infer that it is likely to end at some point in early 2018. So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half, contrary to what the consensus is expecting... Pare back exposure to cyclicals and redeploy to defensives" The advice proved to be very prescient. The global economy did enter a mini-downswing sourced in the emerging markets (Charts I-4 - I-6). Chart I-4The U.S. Mini-Downswing Was Muted... The U.S. Mini-Downswing Was Muted The U.S. Mini-Downswing Was Muted Chart I-5...The Euro Area Mini-Downswing Was Also Muted... ...The Euro Area Mini-Downswing Was Also Muted... ...The Euro Area Mini-Downswing Was Also Muted... Chart I-6...But The China Mini-Downswing Was Severe ...But The China Mini-Downswing Was Severe ...But The China Mini-Downswing Was Severe Nevertheless, the global nature of financial markets meant that the German 10-year bund yield declined by 40 bps, while European healthcare equities outperformed banks by a mouth-watering 35 percent, and materials by 15 percent (Chart I-7 and Chart I-8). Some of these performances are as large as can be gained in a full business cycle begging the question: Why obsess with the impossible-to-predict business cycle when there are equally rich pickings in the easier-to-predict mini-cycle? Chart I-7Banks Vs. Healthcare Tracks The Mini-Cycle Banks Vs. Healthcare Tracks The Mini-Cycle Banks Vs. Healthcare Tracks The Mini-Cycle Chart I-8Materials Vs. Healthcare Tracks The Mini-Cycle Materials Vs. Healthcare Tracks The Mini-Cycle Materials Vs. Healthcare Tracks The Mini-Cycle Furthermore, if you get the equity sector calls right, you will get the equity regional and country calls right too. As cyclicals have underperformed, the less cyclically-exposed S&P500 has been the star performer of the major regional indexes. And cyclical-heavy stock markets like Italy's MIB have strongly underperformed defensive-heavy stock markets like Denmark's OMX (Chart I-9). Chart I-9Italy Vs. Denmark = Banks Vs. Healthcare Italy Vs. Denmark = Banks Vs. Healthcare Italy Vs. Denmark = Banks Vs. Healthcare It follows that the evolution of the global economic mini-cycle is pivotal in every investment decision (Box 1). BOX 1 The Theory Of Economic And Market Mini-Cycles The academic foundation of the global economic mini-cycles is a model called the Cobweb Theorem.1 When bond yields rise, interest rate sensitive sectors in the economy feel a headwind, but with a lag. Similarly, when bond yields decline, interest rate sensitive sectors feel a tailwind, but again with a lag. The lag occurs because credit demand leads credit supply by several months. As credit demand leads credit supply, the turning point in the price of credit (the bond yield) always leads the quantity of credit supplied (the credit impulse). The result is a perpetual mini-cycle oscillation in both economic variables. And because the quantity of credit supplied is a marginal driver of economic activity, this also creates mini-cycles in economic activity. These mini-cycles are remarkably regular with half-cycle lengths averaging around eight months and the regularity creates predictability. Moreover, as most investors are unaware of this predictability, the next turning point is not discounted in financial market prices - providing a compelling investment opportunity for those who do recognise the existence and predictability of these cycles. The Mini-Cycle Will Soon Turn Up The global 6-month credit impulse entered its current mini-downswing in January. Given that mini-downswings tend to last around eight months, we should expect the global economy to exit its mini-downswing in September, the escape valve being the recent decline in bond yields (Chart Of The Week). The caveat is that bond yields were slow to react to the mini-downswing and the decline in 10-year yields, averaging around 40 bps from the peak, has been pretty shallow. It follows that the next mini-upswing could be delayed to October/November, and be somewhat muted. Nevertheless, the surprise could be that global growth will stabilise in the fourth quarter of 2018, contrary to what the consensus is expecting. And this would suggest taking some of the most mouth-watering profits in pro-defensive equity sector, regional, and country allocation - for example, in the 35 percent outperformance of European healthcare versus banks (Chart I-10). Chart I-10Banks Have Severely Underperformed Healthcare Banks Have Severely Underperformed Healthcare Banks Have Severely Underperformed Healthcare Would we go a step further and become pro-cyclical? Not yet. One reason is that there is a limit to how far bond yields can rise before destabilising the very rich valuations of all risk-assets. This is captured in our 'rule of 4' which says that when the sum of the 10-year yields on the U.S. T-bond, German bund, and Japanese government bond (JGB) exceeds 4 - which broadly equates to the global 10-year yield exceeding 2 percent - it is time to go underweight equities. With the sum now equal to 3.4, yields can rise by only 25-30 bps before hurting risk-assets. Another reason for circumspection is that the investment landscape is still scattered with a large number of landmines, one of which has its own rule of 4. The Other 'Rule Of 4': The Italian 10-Year Bond Yield When Italian bond prices decline, it erodes the value of Italian banks' €350 billion portfolio of BTPs and weakens the banks' balance sheets. Investors start to get nervous about a bank's solvency when equity capital no longer covers net non-performing loans (NPLs). On this basis, the largest Italian banks now have €160 billion of equity capital against €130 billion of net NPLs, implying excess capital of €30 billion (Chart I-11). It follows that the markets would start to worry about Italian banks' mark-to-market solvency if their bond valuations sustained a drop of around a tenth from the recent peak. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-12).2 Chart I-11Italian Banks' Equity Capital Exceeds Net NPLs By 30 Bn Euro Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn Chart I-12Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Italian Banks' Solvency Would Be In Question If The 10-Year Yield Breached 4% Today the 10-year BTP yield stands just shy of 3.2 percent, but it is about to enter a testing period. The Italian government must agree its 2019 budget by September and present a draft to the European Commission by mid-October. The budget must tread a fine line. Cutting the structural deficit to appease the Commission would diminish the credibility of the populist government. It would also be terrible economics, making it harder for Italy to escape its decade-long stagnation.3 On the other hand, locking horns with Brussels and aggressively increasing the structural deficit might panic the bond market. The optimal outcome would be to leave the structural deficit broadly where it is now. To sum up, the global 6-month credit impulse is likely to turn up in the fourth quarter, warranting some profit-taking in pro-defensive positions. But we do not advise aggressive pro-cyclical sector, regional, and country allocation until the 10-year yield on the Italian BTP (now at 3.2) - and the sum of the 10-year yields on the U.S. T-bond, German bund and JGB (now at 3.4) - both move closer to 3. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Please see the European Investment Strategy Special Report 'The Cobweb Theory And Market Cycles' published on January 11 2018 and available at eis.bcaresearch.com. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 Please see the European Investment Strategy Special Report 'Monetarists Vs Keynesians: The 21st Century Battle' July 12 2018 available at eis.bcaresearch.com. Fractal trading Model* In support of the preceding fundamental analysis, the outperformance of healthcare versus banks is technically extended. Its 130-day fractal dimension is at the lower bound which has reliably signalled previous trend exhaustions. On this basis we would position for a 10% reversal with a symmetrical stop-loss. In other trades, long PLN/USD reached the end of its 65-day holding period comfortably in profit, and is now closed. This leaves six open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Long Global Basic Resources, Short Global Chemicals Long Global Basic Resources, Short Global Chemicals * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights The Golden Rule: During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? In this report we demonstrate that an investor who can correctly answer that question will very likely make the right bond market call. We call this framework for market analysis the golden rule of bond investing. Exceptions: We identify a few periods when applying the golden rule correctly would not have led to the right market call. Such periods are rare, but they tend to occur when the market "fights the Fed". One such episode occurred as recently as 2017. Total Return Forecasts: We use the golden rule framework to generate total return forecasts for Treasury indexes of all different maturities and many different spread product indexes. Feature Dear Client, This week, we are sending you a Special Report written by Ryan Swift, Chief Strategist of our sister publication, U.S. Bond Strategy. The report introduces an intriguing framework that directly links market expectations of changes in short-term interest rates to bond market returns for both U.S. Treasuries and U.S. spread product. We will extend the analysis to non-U.S. bond markets in a future Special Report to be published in late September. I trust you will find this report to be interesting and insightful. Best Regards, Rob Robis It's easy to get lost in the sea of financial market news. Last week alone saw the suggestion of additional tariffs, weak housing data, strong consumer data, falling commodity prices and steep Chinese currency depreciation. It's not always obvious what's important for bond markets and what isn't. While there is no miracle solution to this problem, we propose one helpful question that investors should always ask themselves to help discern the signal from the noise. During the next 12 months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? If you are able to answer that question correctly you will make the correct bond market call most of the time, and any new piece of information should be judged on how it impacts your answer. In fact, the framework of viewing everything through the lens of answering the above question works so well that we call it the golden rule of bond investing. In this Special Report we illustrate the empirical success of the golden rule. We also draw on historical evidence to consider periods when the rule failed. Finally, we translate the golden rule into a method for forecasting total returns, and we generate total return forecasts for many different bond indexes, encompassing both Treasuries and spread product. Testing The Golden Rule's Performance Chart 1 shows how well the golden rule has worked during the past 28 years. The top panel shows the 12-month fed funds rate surprise - the difference between the expected change in the fed funds rate that was priced into the market at the beginning of the 12-month investment horizon and the change in the fed funds rate that was ultimately delivered. A reading above zero indicates that the market expected a larger increase (or smaller decrease) than actually occurred, a reading below zero indicates that the market expected a smaller increase (or larger decrease) than actually occurred. The bottom panel shows 12-month excess returns from the Bloomberg Barclays Treasury Master Index relative to a position in cash. Chart 1The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record If the golden rule works, then dovish fed funds rate surprises (positive values in Chart 1, shown shaded) will coincide with positive Treasury excess returns, and vice-versa. Chart 1 shows that this has indeed generally been the case. Digging a little deeper, we find a strong positive relationship between 12-month Treasury excess returns and the 12-month fed funds rate surprise (Chart 2) and a similarly strong relationship using Treasury index price return instead of the excess return versus cash (Chart 3). Dovish fed funds rate surprises coincide with positive 12-month Treasury excess returns 87% of the time for an average excess return of +3.9%. They also coincide with positive Treasury price returns 76% of the time for an average price return of +2.1%. Hawkish surprises coincide with negative 12-month Treasury excess returns 61% of the time for an average excess return of -0.3%. They also coincide with negative Treasury price returns 72% of the time for an average price return of -1.9% (Table 1). Chart 2Treasury Index Excess Return &##BR##Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 3Treasury Index Price Return &##BR##Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Table 112-Month Treasury Index Returns And Fed Funds Rate Surprises (1990 - Present) The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Total Treasury returns also factor in coupon income, and are therefore often positive even when the price return is negative. Still, Table 1 shows that Treasury index total returns average +7.1% in periods with a dovish fed funds rate surprise and only +3.4% in periods with a hawkish surprise. Further, 65% of negative total return periods occurred when there was a hawkish fed funds rate surprise. Of course, the golden rule is no panacea. The results presented above are impressive, but they assume that investors are able to correctly predict whether the market is over- or under-pricing the Fed. Making that determination remains a tall order. The key insight to be gleaned from the golden rule is that if a piece of information does not alter your opinion about the future path of the fed funds rate relative to expectations, then it should probably be ignored. The golden rule is certainly not the "be all and end all", but it is a very useful first step. Learning From Failures While Table 1 shows that correctly determining the 12-month fed funds rate surprise allows us to make the correct bond market call most of the time, it also shows that it doesn't always work. To understand why the golden rule might fail, it is useful to think about why it works in the first place. To do this, let's first consider that any Treasury yield can be thought of as consisting of three components: Treasury Yield = Fed Funds Rate + Expectations For Future Change In The Fed Funds Rate + Term Premium Based on this formula, it is obvious that if rate expectations and the term premium are held constant, a higher fed funds rate translates directly into a higher Treasury yield, and vice-versa. This is one reason why the fed funds rate surprise correlates with Treasury returns. The second reason that the fed funds rate surprise correlates with Treasury returns is that the expectations component of the above formula also tracks the fed funds rate surprise. In other words, investors are more likely to revise their rate expectations higher when the Fed is already in the process of delivering hawkish surprises. They are also more likely to revise their rate expectations lower when the Fed is delivering dovish surprises. This dynamic is illustrated in Chart 4. The top panel shows the correlation between the 12-month fed funds rate surprise and changes in rate expectations as measured by our 12-month fed funds discounter. The two lines are mostly positively correlated, though they do occasionally diverge. The largest divergences appear near inflection points in monetary policy - e.g. when the Fed switches from hiking rates to cutting. Such inflection points are often prompted by economic recession. Chart 4When The Golden Rule Doesn't Work When The Golden Rule Doesn't Work When The Golden Rule Doesn't Work The bottom panel of Chart 4 shows the much tighter correlation between the 12-month fed funds rate surprise and the change in the average yield on the Treasury Master index. These two lines also occasionally diverge, but only during periods when rate expectations move strongly in the opposite direction of what is suggested by the rate hike surprise. Crucially, the abnormal change in rate expectations has to be so large that it more than offsets the impact from the change in the fed funds rate itself. Such periods are rare, though we did experience one as recently as last year. The 2017 Episode Treasury returns in 2017 provide a textbook example of one of the rare periods when the golden rule failed. The Treasury Master Index returned +1.5% in excess of cash, even though the Fed lifted rates 25 bps more than the market expected at the beginning of the year. The reason for the divergence is that even though the Fed was in the process of lifting rates by more than what the market anticipated, the market continued to doubt the Fed's resolve and revised its expectations lower. At the beginning of 2017 the market was priced for 51 bps of rate hikes for the year. Then, just as the Fed started to lift rates more quickly than that expectation would suggest, core inflation plunged (Chart 5). The market started to price-in that the Fed would react to falling inflation by turning more dovish, but as it revised its expectations lower the Fed continued to hike. Chart 5The 2017 Example The 2017 Example The 2017 Example The end result is that the impact of the downward revision to rate hike expectations more than offset the upward pressure on yields from Fed rate hikes, and the Treasury index outperformed cash for the year. Forecasting Total Returns One final application of the golden rule is that it can be used as a framework for generating total return forecasts for different bond indexes. To illustrate how this is achieved we will walk through how we calculate such a forecast for the Treasury Master Index. Chart 6Market Has Underestimated##BR##The Fed In Recent Years Market Has Underestimated The Fed In Recent Years Market Has Underestimated The Fed In Recent Years First, we note that the current reading from our 12-month fed funds discounter is 79 bps. This means that the market expects 79 bps of Fed rate hikes during the next 12 months. If we assume that the Fed will lift rates by 100 bps during the next 12 months, then we have a hawkish fed funds rate surprise of 21 bps. As an aside, Chart 6 shows that we have consistently witnessed hawkish fed funds rate surprises since mid-2017, and our 12-month discounter has increased, as is typically the case. But this also means that the bar for further hawkish rate surprises is now much higher. We already demonstrated the strong correlation between the 12-month fed funds rate surprise and the 12-month change in the average yield from the Treasury index (see Chart 4). This allows us to translate our assumed fed funds rate surprise into an expected change in the index yield. In this case, that expected change in yield is +19 bps. With an expected yield change in hand, it is relatively simple to calculate an expected total return using the index's yield, duration and convexity: Expected Total Return = Yield - (Duration*Expected Change In Yield) + 0.5*Convexity*E(DY2) E(DY2) = 1-year trailing estimate of yield volatility In our scenario where we assume the Fed lifts rates by 100 bps during the next 12 months, the above formula spits out an expected total return of +1.59% for the Treasury Master Index. Table 2 shows total return forecasts using this same method but with many different rate hike assumptions. For example, if we assume only 50 bps of Fed rate hikes during the next 12 months we get an expected Treasury Index total return of +3.36%. Table 2Treasury Index Total Return Forecasts The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Table 2 also displays total return forecasts for different maturity buckets within the Treasury Master index. These forecasts are all generated using the same method, but we correlate the 12-month fed funds rate surprise with different Treasury yields in each case. One caveat here is that the correlation between the fed funds rate surprise and the change in Treasury yield declines as we move into longer maturities (Appendix A). This is because long-dated yields are less directly connected to near-term changes in the fed funds rate. As such, there is more uncertainty surrounding the total return forecasts for long maturity sectors. Spread Product Total Return Forecasts With one additional assumption we can also apply our return forecasting method to different spread product indexes. That additional assumption is for the expected change in the average index spread. Using Table 3, you can simply pick a column based on the number of Fed rate hikes you expect during the next 12 months and pick a row based on whether you think spreads will remain flat, widen or tighten. Table 3Spread Product Total Return Forecasts The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing For example, if the Fed lifts rates by 100 bps during the next 12 months and investment grade corporate bond spreads stay flat, we would expect investment grade corporate bond index total returns of +2.79%. For each sector, the spread widening scenario assumes that the average index spread widens to its highest level since the beginning of 2016 and the spread tightening scenario assumes the average index spread tightens to its lowest level since the beginning of 2016. All the spread scenarios are depicted graphically in Appendix B. For the High-Yield sector we make the additional adjustment of subtracting expected 12-month default losses from the average index yield. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Appendix A Chart 7Change In 1-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 8Change In 2-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 9Change In 3-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 10Change In 5-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 11Change In 7-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 12Change In 10-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Chart 13Change In 30-Year Yield Vs.##BR##12-Month Fed Funds Rate Surprise The Golden Rule Of Bond Investing The Golden Rule Of Bond Investing Appendix B Chart 14Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Corporate Bond Spread Scenarios Chart 15Government-Related Spread Scenarios Government-Related Spread Scenarios Government-Related Spread Scenarios Chart 16Structured Product Spread Scenarios Structured Product Spread Scenarios Structured Product Spread Scenarios

Highlights Chart 1Corporate Health: Improving Everywhere, ##br##Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Corporate Health: Improving Everywhere, Down In The U.S. Dollar bull markets are often accompanied by positive returns for the S&P 500. While a strong dollar hurts the earnings outlook for the S&P 500, it supports an expansion of multiples by putting downward pressure on rates and elongating the U.S. business cycle. The dollar and stocks are most positively correlated when the U.S. yield curve slope is between zero and 50-basis points, and flattening. Today's environment fits this bill. BCA is neutral on U.S. in a balanced portfolio. While the USD's strength should be associated with rising U.S. equity prices, the quality of U.S. stock returns is deteriorating. This warrants a certain degree of de-risking relative to our former overweight stance. Feature For the past two weeks, we have warned investors that the dollar rally was over-extended, and that a correction was likely to ensue. However, we also argued that this correction was likely to prove a countertrend move, and that the dollar was likely to end the year at higher levels. BCA has a neutral stance on equities on both a cyclical and tactical horizon. BCA is also neutral on U.S. equities within a global equity portfolio. For investors, it becomes important to understand whether a stronger dollar constitutes an additional downside risk for stocks. This is especially relevant in the U.S., where equity valuations are comparatively elevated, and where corporate health is deteriorating relative to the rest of the world (Chart 1). In this report, we built on the research of our colleague Anastasios Avgeriou, who spearheads BCA's U.S. Equity Sector Strategy service, who has shown that the dollar and the S&P often do rise in unison.1 Ultimately, while the dollar can have an impact on the relative performance of the U.S., it is generally not a strong determinant of the trend in the S&P 500. Strong Dollar And The S&P: Good Friends Indeed A picture is worth a thousand words. As Chart 2 illustrates, a strong dollar has never really been enough to slay a bull run in the S&P 500. Between late 1978 and early 1985, the real trade-weighted dollar rallied by 45%, yet the S&P 500 was able to advance by 102%. Between 1995 and 2002, the real trade-weighted dollar increased by 33% but rallied by nearly 92%. If one were to confine their observations to 1995 to August 2000 window, the dollar would have been up 16.5% and the S&P an outstanding 223%. Finally, from its most recent cyclical bottom in 2011 to the end of 2016, the trade-weighted dollar rallied by 22%, but the S&P 500 managed to rise by another impressive 68%. It is true that the magnitude of the strength of U.S. equities in the face of a strong dollar has decreased over time. This essentially reflects the fact that in the early 1980s, 20% of S&P 500 revenues were garnered outside the U.S. versus roughly 40% today, which in turn has increased the drag on earnings created by a stronger dollar. This problem is illustrated by the negative relationship present between the dollar and U.S. earnings revisions (Chart 3). Chart 2Strong Dollar, No Problem Strong Dollar, No Problem Strong Dollar, No Problem Chart 3Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Dollar Is Dangerous For The Earnings Outlook Yet, despite this negative link between earnings revisions and the dollar, the S&P can still rise when the dollar increases. What explains this seeming paradox? The answer is almost tautological: It is multiples. A strong dollar tends to be associated with a rising P/E ratio. This is because a strong dollar has a dampening impact on inflation. As a result, when the dollar rises, the Federal Reserve can keep interest rates lower than would otherwise be the case, fomenting periods of declining bond yields (Chart 4). Thanks to lower bond yields, not only do multiples get a boost, but additionally the domestically driven U.S. economic cycle also gets elongated. This further helps stocks in the process. Another more international dimension helps explain the positive correlation between stocks and the dollar. The dollar tends to experience its strongest rallies when U.S. growth is superior to that of the rest of the G-10. As Chart 5 illustrates, the bulk of the early 1980s dollar rally, of the late 1990s rally, and of the 2011 to early 2017 rally materialized when U.S. economic activity was outperforming. In all these instances, the relative strength of the U.S. economy attracted funds from abroad. This also meant that foreign funds flowing into the U.S. economy bolstered liquidity in the U.S. economy. Not only did this liquidity support economic activity, thereby counterbalancing the drag created by a stronger dollar, these funds also found their way into asset markets, generating higher multiples in the U.S. in the process. Chart 4Strong Dollar Hurts Yields Strong Dollar Hurts Yields Strong Dollar Hurts Yields Chart 5Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Growth Differentials Matter For The Dollar Bottom Line: A strong dollar in and of itself has never been enough to derail a bull market in the S&P 500. While a strong dollar creates a hurdle for foreign earnings accruing to U.S. firms, higher multiples often compensate for this negative. Essentially, a higher dollar causes downside to bond yields, warranting lower hurdle rates and higher valuations. Moreover, a stronger dollar diminishes inflationary pressures in the U.S., warranting easier Fed policy than would otherwise be the case. Since the U.S. economy is domestically driven, this elongates the business cycle, helping stocks in the process. Correlation And The Yield Curve Slope While a strong dollar does not seem to be a death threat for the equity market, are there environments when the dollar and the S&P 500 are more correlated than others? Table 1Dollar Versus S&P 500 Correlation: ##br##A Function Of The Yield Curve The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar The answer to this question is yes. As Table 1 illustrates, the correlation between the dollar and the S&P 500 fluctuates significantly based on both the slope of the yield curve and whether the yield curve is flattening or not. Interestingly, when the yield curve is steep (defined as greater than a 50-basis-point spread between 10-year and 2-year Treasury yields), the dollar and U.S. stock prices tend to move in opposite directions. However, when the yield curve is flatter but before it has yet to invert (a yield curve slope of between zero and 50 basis points), the correlation between the dollar and the S&P 500 changes: it becomes positive. In fact, the time at which the correlation between stocks and the dollar is the highest is when the yield curve slope is in that zone and is also flattening. This is surprising, but at the same time it makes sense. We know that when the yield curve is flat but not inverted, the stock market tends to still rally (Chart 6). However, this flattening yield curve indicates that monetary conditions are not as accommodative as they once were. Interestingly, while the dollar performs poorly in the early innings of a monetary tightening campaign, it performs much better when monetary conditions are not so easy anymore that they juice up global growth, but they are not yet tight enough to cause an imminent recession in the U.S.2 This corresponds to a an environment with a flatter yield curve that has yet to invert, such as the one in place today. In light of these observations, the close correlation between the S&P 500 and the dollar in this environment should not be very surprising. Chart 6Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Flat And Flattening: No Problem For Stocks Bottom Line: The dollar and the stock market are not always positively correlated. However, when the U.S. yield curve slope stands between zero and 50 basis points and is flattening, the positive correlation between the S&P 500 and the dollar is at its strongest. This defines today's environment. Investment Implications BCA thinks the U.S. dollar has ample downside on a long-term basis. After all, the U.S. dollar trades at a significant premium to its PPP fair value, and this kind of overvaluation historically indicates significant downside for the greenback on a multi-year time horizon (Chart 7). Moreover, the Trump administration's fiscal policy is likely to result in a widening of both the fiscal and current account deficits. While a twin deficit rarely impacts the dollar negatively, so long as U.S. real rates rise relative to the rest of the world, it nonetheless often ends up being a harbinger of long-term weakness in the greenback.3 It is hard to make any inference for the S&P 500 based on a bearish long-term dollar view as historically, during a structural dollar bear market, the relationship between the greenback and the S&P has been rather ambiguous. However, BCA also thinks the 2018 dollar rally is not over. As Chart 8 shows, when U.S. rates are in the top of the distribution of interest rates among G-10 economies, the dollar tends to perform well. The U.S.'s status as the global high-yielder is currently unchallenged. This suggests the dollar has a natural advantage over other currencies through the remainder of the year. Chart 7Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Long-Term Downside For The Dollar... Chart 8...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over ...But 2018 Rally Is Not Over Moreover, as the U.S. economy is less exposed to the global industrial cycle than the rest of the world is, the U.S. dollar will benefit from the softening global economic environment. This is even truer, given that the U.S. economy was already set to outperform other G-10 economies even before the soft patch in global trade began. As a result, long-term flows into the U.S. are strong, which is generating a basic balance-of-payments surplus (Chart 9). American investors are not blind to this reality; the higher expected rate of returns on U.S. projects along with U.S. corporations bringing earnings back home to take advantage of the Trump tax cuts is generating outsized repatriation flows into the country, historically a good correlate of a strong dollar (Chart 10). This phenomenon is likely to remain alive through the remainder of the year. Chart 9Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Money Is Making Its Way Into The U.S. Chart 10Americans Like Their Dollar Americans Like Their Dollar Americans Like Their Dollar Since the U.S. yield curve slope currently stands between zero and 50 basis points while it is flattening in response to the Fed's interest rate hikes, we are in the part of the cycle where the dollar and stocks are positively correlated, and where they in fact often rise together. This suggests the S&P 500 has more upside ahead for the rest of the year as well. It is important to note that the tech sector is now the most at risk from the dollar strength as it has the largest percentage of foreign sales (Chart 11). However, BCA is neutral on stocks on a cyclical horizon. This is not because stocks will not be able to eke out some positive returns; it is because we are acutely aware that we stand close to the end of the bull market. Moreover, the end of an equity bull market is often marked by a pick-up in volatility. Accordingly, risk-adjusted returns for U.S. equities are declining. Hence, while an underweight stance on stocks is not yet warranted, a neutral stance is appropriate as we believe that it is better to be early and leave some money on the table than to be late.4 There remains a big risk that could cause the dollar to rally and stocks to fall, despite where we stand in the cycle: trade disputes. As Chart 12 illustrates, since May, tariff announcements and protectionist pronouncements have buoyed the dollar. However, the same announcements ultimately represent a real risk to profits as they create a real danger for global supply chains and imply higher cost of goods sold by U.S. corporations. Investors should monitor these risks closely. Chart 11S&P 500: Aggregate Sector International Revenue Exposure (%) The S&P Doesn't Abhor A Strong Dollar The S&P Doesn't Abhor A Strong Dollar Chart 12While Tariffs Can Help The Dollar, ##br##They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks While Tariffs Can Help The Dollar, They Will Not Help Stocks Bottom Line: BCA anticipates the dollar to be able to rise over the course of the next six to nine months, as U.S. rates are in favor of the greenback and domestic growth outperformance will continue to favor inflows into the U.S. This bullish view on the U.S. dollar currently does not constitute a reason to downgrade stocks to underweight. In fact, at this stage of the cycle, U.S. stocks and the dollar tend to rise in unison. However, since the quality of the equity gains is likely to deteriorate as equity volatility is on an uptrend, BCA prefers to maintain a neutral cyclical stance on equities within a balanced portfolio rather than an overweight stance. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see U.S. Equity Sector Strategy Insight Report, titled "Can the S&P 500 Continue Rising Alongside the U.S. Dollar?", dated October 13, 2016, available at uses.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "This Time Is NOT Different," dated May 25 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Twin Deficits: Bearish Or Not, The Fed Holds The Trump Card," dated February 23 2018, available at fes.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report, titled "U.S. Fiscal Policy: An Unprecedented Macro Experiment," dated June 28, 2018 available at bcaresearch.com.

Highlights EM, The USD & Bond Yields: The turbulence in Turkey and other emerging markets has likely not been enough to move the Fed off its planned 25bp/quarter trajectory. It will take a larger and faster U.S. dollar appreciation, and more serious U.S. market declines, before the Fed backs down and bond yields fall more decisively. Stay below-benchmark on overall portfolio duration exposure, but only neutral on spread product exposure. Australia: Australian economic growth momentum is choppy and inflation is struggling to accelerate amidst ample excess capacity in labor markets. Stay overweight Australian government bonds, but temper return expectations after the big outperformance year-to-date. Feature It's All About The Dollar Chart of the WeekBad Things Happen More Often With A Rising USD Bad Things Happen More Often With A Rising USD Bad Things Happen More Often With A Rising USD The turmoil in Turkey and collapse of the lira has been the latest bout of financial market turbulence seen in 2018. From the VIX shock in early February, to the Italy yield spike in May, to the bear market in Chinese equities, there have been big market meltdowns that seem to come out of nowhere. Yet these are not isolated events. The slowing pace of bond buying by the European Central Bank and the Bank of Japan, in addition to the Fed unwinding its huge balance sheet, have left the global financial system with diminished liquidity. More importantly, the Fed's tightening cycle has turned the U.S. dollar from a weak currency in 2017 to a strong currency in 2018 (Chart of the Week). Yes, U.S.-China trade tensions have compounded matters by raising uncertainties about global growth, but tightening monetary policies and more growth uncertainties have been the true cause of this year's market shocks. Turkey and Italy were questionable credits in 2017, but investors did not care when the dollar was soft and global growth was accelerating. Looking ahead, the key variable to watch will be the U.S. dollar. Many of BCA's strategists have made comparisons between the backdrop today and the late 1990s period that resulted in the 1998 Asian Crisis.1 Those comparisons are valid, given the high level of dollar debt in the emerging markets at a time of Fed tightening and a rising U.S. dollar (Chart 2). A key difference is that, in that late 1990s episode, the Fed was keeping U.S. monetary policy very tight as evidenced by the inverted U.S. Treasury yield curve and a fed funds rate that was well in excess of inflation (and well above what we now know to be the neutral r-star rate). The dollar surged during that period because global growth differentials strongly favored the U.S. Today, the Fed has not yet pushed the funds rate into restrictive territory and the dollar is still well below the peak seen in the late 1990s. With the Fed still not signaling any adjustment to its rate hike plans based on the latest bout of EM turmoil, there is scope for the dollar to continue appreciating over the next 6-12 months. The critical factor that could change this dynamic, however, is the pace of dollar appreciation. The U.S. trade-weighted dollar is now only 5% above the levels of a year ago. Looking back at the 2014/15 surge in the dollar, the peak annual pace of dollar appreciation reached 15% in mid-2015 (Chart 3). That move was big enough, and fast enough, to trigger a sharp U.S. economic growth slowdown, a contraction in U.S. corporate profit growth and a large fall in U.S. inflation (admittedly, helped by collapsing oil prices). It would take a 10% appreciation from current levels (think EUR/USD at 1.04) over the next four months to generate an equivalent pace of dollar appreciation (the black dotted line in all panels). So far, the EM turmoil and dollar strength have not resulted in much turbulence in U.S. financial markets (Chart 4). Corporate credit spreads have stayed well behaved, while U.S. equities are only modestly off the recent highs. Only U.S. Treasury yields have dipped lower from recent highs, even though yields are still contained within the range of the past few months. This is in sharp contrast to the 2015 episode, when U.S. financial markets eventually succumbed to the pressure of the strong dollar and EM selloff - but not without decisive evidence of slowing U.S. growth (top panel). Only then did the Fed finally capitulate and announce a pause after lifting rates just once at the end of 2015, sending Treasury yields sharply lower. Chart 2It's Not 1998##BR##...Yet It's Not 1998...Yet It's Not 1998...Yet Chart 3The Pace Of USD Appreciation##BR##Matters A Lot The Pace Of USD Appreciation Matters A Lot The Pace Of USD Appreciation Matters A Lot Chart 42015 Redux? Watch##BR##U.S. Growth & Earnings 2015 Redux? Watch U.S. Growth & Earnings 2015 Redux? Watch U.S. Growth & Earnings Until there is evidence that the U.S. economy is losing momentum, and that the stronger U.S. dollar and emerging market volatility are a root cause of slowing growth, global bond yields are unlikely to fall much lower on a sustainable basis. The next few readings on the ISM indices, employment growth and small business confidence, along with the third quarter earnings reports starting in October, will be critical in determining if the U.S. economy is falling victim to the "EM Flu". It will likely take more dollar strength before that happens, however. In the meantime, we continue to recommend a below-benchmark overall duration stance, with only a neutral allocation to global corporate bonds versus government debt. We still favor U.S. corporate debt over non-U.S. equivalents until there is evidence of slowing U.S. growth. Bottom Line: The turbulence in Turkey and other emerging markets has likely not been enough to move the Fed off its planned 25bp/quarter trajectory. It will take a larger and faster U.S. dollar appreciation, and more serious U.S. market declines, before the Fed backs down and bond yields fall more decisively. Stay below-benchmark on overall portfolio duration exposure, but only neutral on spread product exposure. Australia: Still Too Much Uncertainty For Rate Hikes One of our highest conviction calls since the start of 2018 has been to stay overweight Australian government bonds. The logic behind the view was simple; it would be very difficult for the Reserve Bank of Australia (RBA) to deliver even a single rate hike over the course of the year. A combination of a fragile consumer, persistent slack in labor markets and softening Chinese demand for Australian exports would all conspire to restrain Australian inflation and keep the RBA on the sidelines. So far, our view has largely come to fruition, to the benefit of Australian government bond performance. Chart 5Massive Australian Bond Outperformance vs USTs Massive Australian Bond Outperformance vs USTs Massive Australian Bond Outperformance vs USTs The RBA has held the benchmark Cash Rate at the same 1.5% level that has prevailed since August 2016. This has helped the Bloomberg Barclays Australia Treasury index deliver a local currency total return of 2.68% year-to-date. The performance has been even more impressive hedged into U.S. dollars, with an excess return over U.S. Treasuries of 3.95% - surpassing the overall Global (ex U.S.) Treasury index excess return by 85bps. The benchmark 10-year Australian yield has fallen 10bps since the end of 2017, in sharp contrast to the 46bps increase in the 10-year U.S. Treasury yield, with the spread between the two bonds now in negative territory for the first time since 1998 (Chart 5). Obviously, the potential for further outperformance of Australian bonds is diminished after such an impressive run. The Australian Overnight Index Swap (OIS) curve is now only discounting a mere 15bps of rate hikes over the next twelve months, and a move to outright rate cuts will be difficult with the economy still growing above trend and inflation now back to the low end of the RBA's 2-3% target range. Headline unemployment is now down to 5.4%, the lowest level since 2012 and within hailing distance of the 5% level that the RBA believes to be full employment. Yet there are now enough uncertainties regarding the Australian economic outlook to suggest that Australian government bonds should continue to outperform developed market peers over the next 6-12 months. The Biggest Uncertainties: Consumer Spending, Housing & Banks Consumer spending - 60% of Australian GDP, the largest component - has struggled to gain much positive momentum in recent years. Since the end of 2013, the year-over-year growth rate of real consumption has ranged between 2.2% and 3.1%. The lack of spending power has been the biggest problem, with real wage growth averaging a mere 0.2% over the past five years and hours worked remaining stagnant (Chart 6). Anemic income growth means that the household saving rate had to fall from 8% to 2% just to maintain an uninspiring 2.5% average pace of real consumer spending. Both real wage growth and average weekly hours worked have decelerated since the start of 2017, with the former now only at 0.1% and the latter at an all-time low. This has compounded the biggest structural risk to the Australian consumer - high debt. Household debt is now up to a record 190% of disposable income, the fourth highest figure among OECD countries after having shot up thirty percentage points since the end of 2012 (bottom panel). The ability to carry that huge debt load is helped by low interest rates that have helped keep debt service ratios in line with long-run averages. More recently, house prices have been coming off the boil (Chart 7). National house prices were down 2.5% in July on a year-over-year basis, led by declines in the major markets of Sydney (down 5.5% from the July 2017 peak) and Melbourne (down 3% from the November 2017 peak). In the RBA's latest Statement on Monetary Policy released earlier this month, it was noted that even such a modest decline in housing values after years of substantial price gains could have an outsized impact on overall consumption if focused on the more highly indebted or credit-constrained households.2 Yet a cooling of overheated housing values is, as RBA Governor Philip Lowe noted in a speech last week, a "welcome development" after years of unsustainable price gains that greatly diminished housing affordability.3 Homebuyer sentiment and growth in housing approvals have already ticked up in response to the slowing pace of house price appreciation, although both remain well below levels seen during the boom years. One wild card that could short-circuit any rebound in house prices is the availability of credit from Australian banks. The entire Australian banking industry has come under harsh criticism from the findings of the government's Royal Commission on Misconduct in the Banking, Superannuation and Financial Services Industry.4 The Commission was established at the end of 2017, after years of public pressure regarding the questionable business practices of Australian financial firms. Evidence of bribery, forged documents, extending loans to those that could not afford it and even charging fees to dead clients has already come to light. With financial firms on the defensive, there is a risk that banks will raise lending standards for new loans going forward. Australian bank equities have already been underperforming and credit growth is slowing (Chart 8). The bigger concern is the sharp decline in bank deposit growth, which is now contracting modestly on a year-over-year basis. Already, Australian banks are facing some higher funding costs through rising money market rates. Much of that spike seen earlier in 2018 could be attributed to rise in the U.S. bank funding costs, but there is now a notable divergence between LIBOR-OIS spreads in Australia and the U.S., which may be a sign of uniquely Australian funding pressures. Chart 6Poor Fundamentals For##BR##The Australian Consumer Poor Fundamentals For The Australian Consumer Poor Fundamentals For The Australian Consumer Chart 7Weaker Prices =##BR##Stronger Housing Demand? Weaker Prices = Stronger Housing Demand? Weaker Prices = Stronger Housing Demand? Chart 8An Australian Credit##BR##Crunch Unfolding? An Australian Credit Crunch Unfolding? An Australian Credit Crunch Unfolding? The RBA has noted that the absolute levels of bank funding costs (bank debt spreads, deposit rates wholesale lending rates) remain low by historical standards, and that overall financial conditions remain supportive for Australian economic growth. Yet the marginal changes in funding dynamics, combined with the pressure on banks to be more prudent in extending loans, raise downside risks to Australian growth from future credit availability. Other Uncertainties: Capital Spending, Exports & Commodity Prices Australian businesses have ramped up capital spending over the past year, with the annual growth rate of machinery and equipment investment now at the fastest pace since 2012 (Chart 9). An improvement in Australian commodity prices and the overall terms of trade has helped boost corporate profits, helping to fund investment spending. Importantly, the recent pickup in commodity prices has been more broad-based than the iron ore boom in 2010/11, with prices of non-ferrous metals rising even with iron ore prices languishing. Looking ahead, there are increasing risks to the capital spending upturn from growing uncertainties surrounding the outlook for Chinese economic growth, and global trade activity more generally. The NAB business confidence survey, which leads capital spending intentions, has been falling over the past several months (bottom panel). This comes after a significant slowing of Australian export growth, the manufacturing PMI and capacity utilization (Chart 10). Much of that is due to diminished demand from China, which remains Australia's largest export market. Chart 9Capex Upturn At Risk From Global Trade Tensions Capex Upturn At Risk From Global Trade Tensions Capex Upturn At Risk From Global Trade Tensions Chart 10China Is A Big Source Of Uncertainty In Australia China Is A Big Source Of Uncertainty In Australia China Is A Big Source Of Uncertainty In Australia China is now undertaking some fresh economic stimulus in response to the growing trade war with the U.S. and the imposition of tariffs. Our colleagues at BCA's China Investment Strategy and Geopolitical Strategy recently penned a Special Report discussing the potential for China's stimulus measures to halt the Chinese growth deceleration seen so far in 2018.5 Their conclusion was that the overall size of the stimulus would be significant, with the surge in fiscal spending potentially equaling the 3% GDP boost seen in 2015/16. This would help support Australia export demand, on the margin, and could potentially boost the prices of Australia's key industrial commodities. However, the overall impact will be less than was seen in 2016/17 given that there will be some offsetting drag from the imposition of tariffs by China and the U.S. The Most Important Uncertainty: How Much Spare Capacity? Chart 11Still Lots Of Slack In The Australian Economy Still Lots Of Slack In The Australian Economy Still Lots Of Slack In The Australian Economy Given all these potential headwinds to Australian growth, the RBA has stated that they are in no hurry to raise interest rates, particularly without any serious threat of an acceleration in inflation. Headline Australian CPI inflation rose to 2.1% in the second quarter of 2018, while core inflation drifted down to 1.8%. Both measures have struggled to breach the lower bound of the RBA's 2-3% target range in recent years (Chart 11). The biggest reason for this is the continued existence of spare capacity in the economy. The IMF estimates that Australia will have a negative output gap of nearly -1% in 2018, unlike most other developed economies where the gap has been closed. Overall wage inflation remains modest, as discussed earlier. While the headline unemployment rate of 5.4% is below the IMF's estimate of the full employment NAIRU of 5.9% (middle panel), the RBA thinks NAIRU is closer to 5%. That implies that there is still slack in the labor market, which is evidenced by the high level of underemployment and the growing share of part-time employment (bottom panel). The RBA anticipates that full employment will not be reached until the end of 2020, even with real GDP growth expected to average 3.25% over the next two years. Both headline and core inflation are projected to rise only to 2.25% by the end of 2020, staying in the lower half of the RBA target band. Unsurprisingly, the RBA has provided guidance stating that it does not expect to raise the Cash Rate before then. Investment Conclusions The Australian OIS curve has now priced out much of the nearly 50bps of rate hikes that were discounted at the start of the year, but there are still 15bps of rate increases expected over the next twelve months. Yet our own Australia Central Bank Monitor has now flipped into negative territory, indicating that fundamental economic and inflation pressures are pointing to the RBA's next move being a rate cut (Chart 12). While that is not our expectation, we think the argument that supported our original investment thesis on Australian government bonds at the beginning of 2018 still holds. Growth uncertainties, ample spare capacity and moderate inflation pressures will ensure that the RBA will struggle to deliver even a single rate hike in 2018 or 2019. Chart 12Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds The main risk to our view would come from a bigger-than-expected stimulus from China and/or a resolution of the U.S.-China trade war. This would boost Australian economic growth and commodity prices and potentially bring forward the timing of the next RBA hike. We continue to recommend an overweight stance on Australian government bonds in global fixed income portfolios. All positions should be run on a currency-hedged basis, as the Australian dollar is likely to remain under downward pressure from less supportive interest rate differentials. For dedicated Australian bond investors, we recommend a neutral duration stance, as we see yields broadly following the path laid out in the forwards. Bottom Line: Australian economic growth momentum is choppy and inflation is struggling to accelerate amidst ample excess capacity in labor markets. Stay overweight Australian government bonds, but temper return expectations after the big outperformance year-to-date. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Foreign Exchange Strategy/Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17th 2018, available at fes.bcaresearch.com and gps.bcaresearch.com. 2 https://www.rba.gov.au/publications/smp/2018/aug/pdf/statement-on-monetary-policy-2018-08.pdf 3 https://www.rba.gov.au/speeches/2018/sp-gov-2018-08-17.html 4 https://financialservices.royalcommission.gov.au/Pages/default.aspx 5 Please see BCA Geopolitical Strategy/China Investment Strategy Special Report, "China: How Stimulating Is The Stimulus?", dated August 8th 2018, available at gps.bcaresearch.com and cis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Turmoil In Emerging Markets: Days Of Future Past Turmoil In Emerging Markets: Days Of Future Past Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, There will be no U.S. Bond Strategy report next week. Our regular publishing schedule will resume on September 4th. Best regards, Ryan Swift Highlights Global Growth Divergences: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. But history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporates: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wages will exacerbate the problem, much like in the late 1990s. Municipal Bonds: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Feature "It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress." - Alan Greenspan, September 19981 Fed Chairman Alan Greenspan uttered the above sentence in early September 1998. Russia had just defaulted on its government debt and a few weeks later the heavily-exposed hedge fund Long-Term Capital Management would require a bail-out, kicking off a period of turmoil in U.S. financial markets. The Federal Reserve responded by cutting interest rates by 75 basis points between September 30th and November 4th, despite a domestic labor market that Chairman Greenspan described as "unusually tight." We recall this tumultuous period because a divergence between strong U.S. and weak non-U.S. growth is once again putting upward pressure on the U.S. dollar, leading to pain in emerging markets. So far it is the Turkish lira bearing the brunt of the sell-off, but the lesson from the late 1990s is that other EMs, and eventually the U.S., are also vulnerable. A joint Special Report, published last week, from our Foreign Exchange Strategy and Geopolitical Strategy services provides a blow-by-blow account of the late 1990s period, with implications for today's currency markets.2 In this week's report, we focus on what divergences between strong U.S. growth and weak non-U.S. growth mean for U.S. bond portfolios. A History Of False Starts The divergence between strong U.S. and weak non-U.S. growth is illustrated in Chart 1. The shaded regions in the chart correspond to periods when the Global (ex. U.S) leading economic indicator (LEI) is contracting while the U.S. LEI continues to rise. There have been 10 such episodes since 1966. In the four instances that occurred prior to 1993, the U.S. economy remained insulated from flagging growth in the rest of the world. That is, the U.S. LEI continued to expand and the Global (ex. U.S.) LEI eventually recovered into positive territory. However, since 1993, every time the Global (ex. U.S) LEI has dipped below zero the U.S. LEI has eventually followed. In other words, prior to 1993 the U.S. economy acted very much like an oasis of prosperity. But global events have become much more important since then. Chairman Greenspan's claim was correct in 1998 and remains relevant today. Case Study: 1997 Two of the post-1993 growth divergence episodes are particularly relevant for bond investors today. The first occurred in 1997 (Chart 2). The Fed tried to kick off a rate hike cycle in March 1997, but the combination of a Fed rate hike and weak foreign growth led to a surge in the dollar. Eventually, the strong dollar dragged our Fed Monitor below zero and the Fed was forced to abandon rate hikes until June 1999. In the interim, the Fed's dovish turn caused the dollar to halt its uptrend (Chart 2, panel 3). Treasury yields collapsed and then recovered (Chart 2, panel 4). Credit spreads moved in line with the exchange rate (Chart 2, bottom panel), widening alongside a stronger dollar in 1997/98, and then leveling off as the Fed eased policy and the dollar moved sideways. The end result of the 1997 episode is that Treasury yields took a round trip, falling as the Fed backed away from its rate hike path, then rising again once rate hikes resumed. Credit spreads, however, never fully recovered their 1997 tights. Case Study: 2015 More recently, growth divergences flared again in 2015 (Chart 3). This time, our Fed Monitor was already recommending rate cuts in late-2015, but the Fed pressed on and delivered the first rate hike of the cycle that December. Once again, the combination of a hawkish Fed and weak foreign growth put upward pressure on the dollar (Chart 3, panel 3), and the Fed was forced to pause its rate hike cycle. Chart 1The Weight Of The World The Weight Of The World The Weight Of The World Chart 2False Start 1997 False Start 1997 False Start 1997 Chart 3False Start 2015 False Start 2015 False Start 2015 Much like in 1997, Treasury yields declined as the Fed went on hold and then started to rise again as rate hikes resumed (Chart 3, panel 4). Also like 1997, credit spreads widened alongside the strengthening dollar, though this time they actually managed to tighten back to new lows when the Fed went on hold and the upward pressure on the dollar abated in 2016/17 (Chart 3, bottom panel). Implications For The Present Day Chart 4Inflation Is Much Closer To Target Inflation Is Much Closer To Target Inflation Is Much Closer To Target What lessons can we take away from these two episodes? The first is that if growth divergences continue to worsen and the dollar continues to appreciate, it will eventually cause our Fed Monitor to dip below zero and the Fed will likely pause its rate hike cycle. Such a dovish pause will lead to a decline in Treasury yields and a flattening-off, or even depreciation, of the dollar. However, we also know from history that any decline in Treasury yields is likely to prove fleeting. Once dovish Fed action takes the shine off the dollar, foreign economic growth will improve and the Fed will soon be able to resume rate hikes. This was the case in both 1997 and 2015. There is even reason to believe that any pause in Fed rate hikes could be particularly short-lived this time around. Inflation is already closing-in on the Fed's target and there is some evidence that long-dated inflation expectations have become stickier. Long-maturity TIPS breakeven inflation rates have not fallen much in recent weeks, even as weakening foreign growth has dragged down commodity prices (Chart 4). As for credit spreads, history shows that they are likely to widen as global growth divergences deepen and the dollar appreciates. Then, any pause in Fed rate hikes will improve credit's outlook for a time. Once again, because relatively strong inflation will limit the length of time that the Fed can pause lifting rates, we think any period of spread tightening that coincides with more dovish Fed policy will be short-lived. We also see similarities with the 1997 episode in terms of the outlook for corporate defaults. Such similarities bode ill for credit spreads, as is discussed in the next section. Bottom Line: The impact of weak foreign growth will eventually be felt in the U.S. and could even result in the Fed pausing its rate hike cycle for a time. However, history tells us that the resulting decline in Treasury yields will not last long. Investors should hedge the risk of weak foreign growth by maintaining only a neutral allocation to spread product, but should maintain below-benchmark portfolio duration. Corporate Defaults: Look To The Late 1990s Considering the two case studies presented above, the reason corporate bonds performed worse in 1997 compared to 2015 is that in 1997 corporate leverage and defaults started to creep higher and did not peak until the 2001 recession. In contrast, corporate leverage flattened-off and defaults fell once the Fed paused its rate hike cycle in 2016 (Chart 5). Chart 5Corporate Defaults: The Late 1990s Roadmap Corporate Defaults: The Late 1990s Roadmap Corporate Defaults: The Late 1990s Roadmap Looking closer, the bottom panel of Chart 5 shows that once profit growth fell below the rate of debt growth in 1997 it continued to trend down. In 2015/16, profit growth was again dragged lower by the strong dollar, but it quickly rebounded once the Fed turned dovish. In our view, if global growth divergences continue to worsen and the dollar continues to strengthen, the next increase in corporate leverage will probably look more like 1997. To see why, we consider the two reasons why profit growth decelerated in 1997. The first is the obvious reason that the strong dollar started to weigh on corporate revenues. The growth in business sales moderated and the PMI dipped below 50 (Chart 6). Today, we have not yet seen enough dollar strength to weigh on business sales or the manufacturing PMI, which is still hovering around 60 (Chart 6, bottom panel). But this will change as the emerging market turmoil spreads and eventually impacts the U.S. business sector. The second reason why the 1997 corporate default episode is the most comparable to the present day is that much like in 1997, but unlike in 2015, the labor market is extremely tight and wages are starting to accelerate (Chart 7). The growth in unit labor costs started to outpace the growth in corporate selling prices in 1997, and this caused our Profit Margin Proxy to fall (Chart 7, panel 2). At present, our Profit Margin Proxy is very close to the zero line, but with a sub-4% unemployment rate further downside is likely. Finally, much like in 1997, small businesses are increasingly citing labor quality as a more important problem than lack of sales (Chart 7, bottom panel). The difference between the rankings of these two problems has done a good job tracking profit growth historically. This indicator is currently at levels that are much more reminiscent of the late 1990s. Chart 6Dollar Strength Drags Down Revenue Dollar Strength Drags Down Revenue Dollar Strength Drags Down Revenue Chart 7Wages Will Weigh On Profits Wages Will Weigh On Profits Wages Will Weigh On Profits Bottom Line: As global growth divergences deepen and the dollar strengthens, corporate profit growth will eventually fade and corporate leverage and defaults will rise. Accelerating wage growth will exacerbate the problem, much like in the late 1990s. Take Shelter In Municipal Bonds Chart 8Munis As A Safe Haven Munis As A Safe Haven Munis As A Safe Haven Another implication of the divergence in growth between the U.S. and the rest of the world is that fixed income sectors that are more exposed to the domestic U.S. economy and less exposed to foreign growth and the exchange rate should fare better. In this regard, municipal bonds are an obvious candidate. While state & local government net borrowing has flattened off at a relatively high level during the past few quarters, state governments have recently re-committed to austerity (Chart 8). Data from the National Association of State Budget Officers show that states enacted a net $9.9 billion increase in revenues in fiscal year 2018, with another $2.8 billion planned for fiscal year 2019. Historically, revenue raises of this magnitude have led to declines in net borrowing, which should ensure that municipal ratings upgrades continue to outpace downgrades for the time being (Chart 8, bottom panel). But there's an even better reason for investors to favor municipal bonds. Quite simply, yields remain attractive compared to the riskier corporate alternatives, particularly at longer maturities. The top section of Table 1 shows relevant statistics for the 5-year, 10-year and 20-year tax-exempt Bloomberg Barclays Municipal bond indexes, along with the closest comparable indexes from the investment grade corporate sector. We observe that a 5-year Aa-rated municipal bond carries a yield of 2.18% versus a yield of 3.26% for a comparable corporate bond index. This implies that an investor with an effective tax rate of 33% should be indifferent between the two bonds. Any investor exposed to an effective tax rate above 33% should favor the municipal bond, even before considering the differences in risk between the two sectors. Moving further out the curve, the breakeven tax rate falls to 24% at the 10-year maturity point and to either 13% or 21% at the 20-year maturity point, depending on whether you use Aa-rated or A-rated corporate debt as the relevant comparable. We also find that High-Yield municipal debt looks attractive compared to the corporate alternative. The Bloomberg Barclays High-Yield Muni Index (excluding Puerto Rico) trades at a breakeven tax rate of 18% relative to a Ba-rated corporate bond, and 33% relative to a B-rated corporate bond. Even the taxable municipal space is attractive. The bottom section of Table 1 shows that the average yield on the 1-5 year taxable municipal bond index is slightly higher than that of the closest comparable corporate bond index. The same goes for the 5-10 year taxable muni index. Table 1A Comparison Of Municipal And Corporate Bond Yields An Oasis Of Prosperity? An Oasis Of Prosperity? Finally, drawing on work we presented in a recent Special Report, we provide total return forecasts for different municipal bond indexes along with the comparable corporate sector indexes (Table 2).3 We show results for three different effective tax rates, depending on how many rate hikes you expect from the Fed during the next 12 months and whether you expect Municipal / Treasury yield ratios to remain flat, widen to their post-2016 highs, or tighten to their post-2016 lows. Table 2Municipal Bonds Total Return Forecasts Vs. Corporate Sector Comparables An Oasis Of Prosperity? An Oasis Of Prosperity? For example, in an environment where the Fed delivers four rate hikes during the next 12 months and Municipal / Treasury yield ratios remain flat, an investor with a 24% effective tax rate can expect a total return of 2.81% from the 10-year Municipal bond index. If we adjust returns using the top marginal tax rate of 37% the expected total return rises to 3.52%. In the same scenario, where corporate spreads also remain flat, investors can expect a total return of 2.86% from a corporate bond with similar duration and credit rating. Bottom Line: Municipal bonds offer attractive yields relative to corporate bonds, especially considering that they are more insulated from weakening foreign growth. Remain overweight municipal bonds. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/speeches/1998/19980904.htm 2 Please see Foreign Exchange Strategy / Geopolitical Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "The Golden Rule Of Bond Investing", dated July 24, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights It has not been a lot of fun being a corporate bond investor in 2018. Global credit markets have struggled to deliver positive returns, amid a news flow that has been overwhelming at times. Geopolitical uncertainty, shifting monetary policy biases, greater inflation pressures, intensifying trade tensions, a rising U.S. dollar, slowing Chinese growth - all have combined to form a backdrop where investors should require wider risk premiums to own risky assets like corporate debt. Yet are wider spreads justified relative to the underlying financial health of companies? Feature Chart 1Global Corporates: Fading Support From##BR##Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Global Corporates: Fading Support From Growth & Monetary Policy Against this backdrop of more uncertainty in credit markets, we are presenting our latest update of the BCA Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 16. The broad conclusion from the latest readings on our CHMs is that global credit quality has been enjoying a cyclical improvement across countries, regions and credit tiers. The U.S. has delivered the biggest improvement in corporate health, compared to the recent past and to bearish investor perceptions as well. Much of that can be attributed to the impact of the Trump corporate tax cuts, though. At the same time, there have even been significant improvements in profitability metrics in regions that have lagged during the current global economic expansion, like Peripheral Europe. We recently downgraded our overall global spread product allocation to neutral.1 This reflected the increased concerns of the BCA Strategists that valuations on global risk assets looked rich compared to growing geopolitical risks (U.S.-China trade tensions, U.S.-Iran military tensions). Yet it also was related to the ongoing development of our biggest investment theme for 2018 - the eventual likely collision between tightening global monetary policy and rich valuations on global risk assets. Looking ahead, the tailwinds that have been supportive for corporate health and the performance of global corporate debt in the past couple of years - a coordinated cyclical upturn driving solid earnings growth, with low inflation allowing monetary policies to stay accommodative - are becoming headwinds (Chart 1). The overall OECD leading economic indicator, which is well correlated to the annual excess returns of global high-yield debt, has peaked. Central banks are either delivering rate hikes, talking about rate hikes, or cutting back on the pace of balance sheet expansion. All of these factors will weigh on corporate bond returns over the next 6-12 months. U.S. Corporate Health Monitors: Improving Thanks To Resilient Growth & Tax Cuts Chart 2Top-Down U.S. CHM:##BR##Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Top-Down U.S. CHM: Boosted By Cyclically Strong Profits Our top-down CHM for the U.S. has been in the "deteriorating health" region for fifteen consecutive quarters dating back to the middle of 2014 (Chart 2). That streak appears set to end soon, as the indicator has been falling since peaking in 2016 and now sits just above the zero line. The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. It is important to note that the top-down CHM uses after-tax earnings measures in several of the ratios the go into the indicator: return on capital, profit margin and debt coverage. All three of those ratios saw significant upticks in the first quarter of 2018, which is the latest available data for the top-down CHM. The Trump tax cuts did take effect at the start of the year, but given the robust results seen in reported second quarter profits reported so far, a bigger impact will likely be visible once we are able to update the CHM for the most recently completed quarter. The ability for U.S. companies to continue expanding margins will be tested in the next 6-12 months. The tight U.S. labor market is pushing up wage growth, which will pressure margins and prompt some firms to try and raise prices to compensate. Firming U.S. inflation is already keeping the Fed on a 25bps-per-quarter pace of rate hikes, and perhaps more if U.S. inflation continues to accelerate without any slowing of U.S. economic growth. If the Fed starts actively targeting a slower pace of U.S. growth to cool off inflation, credit markets will take notice and U.S. corporate debt will underperform. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. There are no imminent domestic pressures on U.S. corporate finances that should require wider credit spreads to compensate for rising default risk. The bottom-up versions of the U.S. CHMs for investment grade (IG) corporates (Chart 3) and high-yield (HY) companies (Chart 4) have also both improved, with the HY indicator now crossing over the zero line into "improving health" territory. This confirms that the signal from our top-down CHM is being reflected in both higher-rated and lower quality companies. Yet the longer-term issues of high leverage and low interest/debt coverage are not going away, suggesting that potential problems are being stored up for the next U.S. economic downturn. What also remains worrying is the fact that IG interest coverage has fallen in recent years, despite high profit margins and historically low corporate borrowing rates. This indicates that the stock of U.S. corporate debt is now so large that the interest expense required to service that debt is eating up a greater share of corporate earnings, even at a time when profit growth is still quite strong. This will raise downgrade risk if corporate borrowing rates were to rise significantly or if U.S. earnings growth slows sharply. We moved our recommended stance on U.S. IG and HY to neutral at the end of June as part of our downgrade of overall global spread product exposure. We may consider a move back to overweight (versus U.S. Treasuries) on any meaningful spread widening given our optimistic view on U.S. economic growth and the positive measure on credit risk signaled by our CHMs. Yet it may be difficult to get such an opportunity. The U.S. is reaching a more challenging point in the monetary policy cycle with the Fed likely to shift to a restrictive stance within the next 6-12 months. At the same time, there are risks to the U.S. economy stemming from the widening U.S.-China trade conflict, a stronger U.S. dollar and, potentially, the growing turmoil in emerging markets. Yet the state of U.S. corporate health has improved substantially, leaving companies less immediately vulnerable to any of those shocks. Given this balance of risks, a neutral stance on U.S. corporates remains appropriate (Chart 5). Chart 3Bottom-Up U.S. Investment Grade CHM:##BR##Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Bottom-Up U.S. Investment Grade CHM: Stable, But Watch Profit Margins Chart 4Bottom-Up U.S. High-Yield CHM:##BR##Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Bottom-Up U.S. High-Yield CHM: Cyclical Improvement Chart 5U.S. Corporates:##BR##Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY U.S. Corporates: Stay Neutral IG & HY Euro Corporate Health Monitors: Strong Economy, Big Improvements Our top-down euro area CHM remains in "improving health" territory, as has been the case for the past decade (Chart 6). The indicator had been worsening towards the zero line during 2016-17, but rebounded in the first quarter of 2018 thanks to a pickup in profit margins and debt coverage. Those positive developments are even more impressive since they occurred during a quarter when there was some cooling from the robust pace of economic growth seen in 2017. Chart 6Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Top-Down Euro Area CHM: Modestly Improving Interest coverage and liquidity remain in structural uptrends, supported by the super-easy monetary policies of the European Central Bank (ECB) that have lowered corporate borrowing costs (negative short-term interest rates, liquidity programs designed to prompt low-cost bank lending, and asset purchase programs that include buying of corporate bonds). Our bottom-up versions of the CHMs for euro area IG (Chart 7) and HY (Chart 8), which are based on individual company earnings data, both confirm the positive message from the top-down CHM. For IG, a noticeable gap has opened up between domestic and foreign issuers in the euro area corporate bond market. Return on capital, operating margins, interest coverage and debt coverage all ticked higher in the first quarter of this year, while leverage slightly declined. Those developments were not repeated among the foreign issuers in our sample. Within the Euro Area, our bottom-up CHMs show that the gap has closed between IG issuers from the core countries versus the periphery, but both remain in the "improving health" zone. (Chart 9). Somewhat surprisingly, the only ratios where there is a material difference are leverage (150% and falling in the periphery, 100% and stable in the core countries) and interest coverage (rising sharply toward 5x in the periphery, stable just above 6x in the core). Despite the improvement in the CHMs, credit spreads for euro area IG and HY have both widened over the course of 2018, while excess returns have been negative year-to-date (Chart 10). Looking ahead, we see the biggest threat for euro area corporate bond performance to come from a shift in ECB policy. We expect the ECB to follow through on its commitment to fully taper net new government bond purchases by the end of 2018, while continuing to reinvest the proceeds of maturing debt in 2019 and beyond. It is less clear what the ECB will do with its corporate bond buying program, and there has been some speculation that the ECB could leave its corporate program untouched while tapering the government purchases. We doubt that the ECB would want to make such a distinction that would artificially suppress corporate borrowing costs relative to government yields. The ECB is more likely to end both programs concurrently at the end of the year, which will remove a major prop under the euro area corporate bond market. This is a main reason why we are currently recommending an underweight stance on euro area corporates versus U.S. corporates. Chart 7Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Bottom-Up Euro Area Investment Grade CHMs: Domestic Issuers Looking Better Chart 8Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Bottom-Up Euro Area High-Yield CHMs: Falling Leverage, Mediocre Profitability Chart 9Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Bottom-Up Euro Area IG CHMs: Periphery Improving vs Core Yet the bigger reason why we prefer corporates from the U.S. over the euro area is that the relative improvement in corporate health has been bigger in the U.S. The gap between our top-down CHMs for the U.S. and Europe has proven to be an excellent directional indicator for the relative performance of U.S. credit vs Europe (Chart 11). That CHM gap continues to favor U.S. credit, which has been outperforming over the past several months (on a common currency basis compared to euro area debt hedged in USD). Chart 10Euro Area Corporates:##BR##Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Euro Area Corporates: Stay Underweight IG & HY Chart 11Relative Top-Down CHMs:##BR##Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe Relative Top-Down CHMs: Continue To Favor U.S. over Europe U.K. Corporate Health Monitor: Deteriorating Amid Rising Domestic Risks The U.K. CHM saw a significant deterioration in the first quarter of 2018, thanks largely to slowing U.K. growth that has impacted all the profit-focused ratios (Chart 12). The CHM is still in the "improving health" zone, but just barely. Seeing the return on capital, profit margin, interest coverage and debt coverage ratios all roll over at historically low levels is a worrying sign for future U.K. credit quality. This is especially true given the extremely stimulative monetary policy run by the Bank of England (BoE) since the 2008 Global Financial Crisis. The only ratio in the U.K. CHM that has seen steady improvement over the past decade is short-term liquidity (bottom panel), which has been boosted by steady increases in working capital. The performance of U.K. credit has benefited from the BoE's additional monetary policy measures taken after the shock Brexit vote in 2016. This involved both interest rate cuts and asset purchases, which included buying of U.K. corporate bonds. The BoE has shifted its policy bias from easing to tightening over the past year, even with sluggish U.K. economic growth and still-unresolved uncertainty about the future U.K. trading relationship with the European Union. This has raised the risks that the BoE could commit a policy error through additional interest rate hikes over the next 6-12 months, especially if policymakers focus more on targeting higher real policy rates as we discussed in a recent Weekly Report.2 U.K. corporates have been a laggard among global credit markets throughout 2018 and especially so in the month of July during a generally positive month for global corporate debt (Chart 13). We see the underperformance continuing in the coming months, as wider spreads will be required given the uncertainties surrounding Brexit, economic growth and BoE monetary policy. Stay underweight U.K. corporate debt within an overall neutral allocation to global spread product. Chart 12U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration U.K. Top-Down CHM: Cyclical Deterioration Chart 13U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight U.K. Corporates: Stay Underweight Japan Corporate Health Monitor: No Problems Here We added Japan to our suite of global CHMs earlier this year.3 Although the Japanese corporate bond market is small (the Bloomberg Barclays Japan Corporates index only has a market capitalization of $116bn), the asset class does provide opportunities for investors to pick up a bit of yield versus zero-yielding Japanese government bonds (JGBs) Japanese corporate health has been excellent for the past decade, with the CHM steadily holding in "improving health" territory (Chart 14). The trends in the Japan CHM ratios since 2008 are quite different than those seen in the CHMs for other countries. Leverage has been steadily falling, return on capital has been steadily rising (and has now converged to the 6% level seen in other countries' CHMs), and the interest coverage multiple of 9.6x is by far the largest in our CHM universe. Default risk is non-existent in Japan. Only pre-tax operating margins for our bottom-up Japan CHM have lagged those in other countries, languishing at 6% for the past three years. Yet Japanese corporate profits are at all-time highs, a logical outcome when companies can borrow at less than 50bps and earn a return on capital of 6%. That wide gap should allow Japanese companies to continue to earn steady, strong profits even with wage inflation finally showing life in Japan alongside a 2.3% unemployment rate. Japanese corporate bond spreads have widened a bit in 2018, but remain far more stable compared to corporates in other developed markets (Chart 15). The lack of spread volatility has allowed Japanese corporates to steadily outperform JGBs since 2011, even as all Japanese bond yields have collapsed. That trend is likely to continue, as the Bank of Japan (BoJ) is still a long way from being able to credibly pull off any upward adjustment of the current 0% BoJ yield target on 10-year JGBs. Chart 14Japan Bottom-Up CHM: Still Healthy,##BR##But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Japan Bottom-Up CHM: Still Healthy, But Has Cyclical Improvement Peaked? Chart 15Japan Corporates:##BR##Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Japan Corporates: Stay Overweight vs JGBs Importantly, the BoJ recently introduced new forward guidance that states there will be no interest rate hikes until at least 2020. This will positively affect Japanese corporate health by keeping borrowing costs extremely low and preventing any unwanted strength in the yen that could damage Japanese competitiveness. There is a risk that increasing global trade tensions could impact the export-heavy Japanese economy and damage corporate profit growth and corporate bond performance. We do not yet see that as a major risk that could derail the Japanese economy and we continue to recommend an overweight stance on Japanese corporate debt vs JGBs. Canada Corporate Health Monitor: Faster Growth Hiding Structural Warts We introduced both top-down and bottom-up CHMs for Canada in our previous CHM Chartbook in April. As was the case then, both CHMs are in "improving health" territory (Chart 16). These CHMs are typically correlated to the price of oil, as befits Canada's status as a major energy exporter. Yet the strong CHMs also reflect the solid pace of overall Canadian economic growth. Looking at the individual components of the Canada CHMs, the leverage ratios for both measures have been steadily rising and currently sit above 100%. The return on capital has been in a structural downtrend, as is the case for most countries in our CHM universe (excluding Japan), but has ticked up alongside faster economic growth over the past couple of years. There was a noticeable drop in the margin ratio for the bottom-up CHM, coming entirely from the HY firms within our sample group of companies. Interest coverage and debt coverage ratios remain depressed, even with some improvement in corporate profits. This is partially due to rising interest rates as the Bank of Canada (BoC) has been tightening monetary policy - a trend that we expect to continue over the next 6-12 months. Canadian corporate bond spreads have widened slightly since the start of 2018, but remain tight relative to a longer-term history (Chart 17). Excess returns over Canadian government bonds have flattened out after enjoying a very solid period of outperformance in 2016-17. Looking ahead, there are balanced risks to the outlook for Canadian corporate debt. Chart 16Canada CHMs: Cyclically Improving,##BR##But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Canada CHMs: Cyclically Improving, But Longer-Term Problems Are Building Chart 17Canadian Corporates:##BR##Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt Canadian Corporates: Stay Neutral Vs Canadian Government Debt We continue to expect the BoC to hike rates because of solid growth and faster inflation in Canada. Yet we do not see the BoC moving rapidly to a restrictive monetary stance that would damage growth expectations and trigger some credit spread widening. At the same time, we also see risks stemming from Canada-U.S. trade disagreements that could hurt Canadian growth and cause investors to demand cheaper valuations for Canadian corporate bonds. Adding it all up, a neutral stance on Canadian corporates versus government debt remains appropriate, largely as a carry trade. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.4 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual "bottom-up" CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. Table 1Definitions Of Ratios That Go Into The CHMs BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News 1 Please see BCA Global Fixed Income Weekly Report, "Time To Take Some Chips Off The Table; Downgrade Global Corporate Bond Exposure To Neutral", dated June 26 2018, available at gfis.bcaresearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "An R-Star Is Born", dated August 7th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Sticking With The Plan", dated March 13th 2018, available at gfis.bcaresearch.com. 4 Please see Section II of The Bank Credit Analyst, "U.S. Corporate Health Gets A Failing Grade", dated February 2016, available at bca.bcaresearch.com. Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors APPENDIX 2: ENERGY SECTOR APPENDIX 2: ENERGY SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: MATERIALS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: COMMUNICATIONS SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER DISCRETIONARY SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: CONSUMER STAPLES SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: HEALTH CARE SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: INDUSTRIALS SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: TECHNOLOGY SECTOR APPENDIX 2: UTILITIES SECTOR APPENDIX 2: UTILITIES SECTOR Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News BCA Corporate Health Monitor Chartbook: There's Good News & There's Bad News Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: The market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace. Maintain below-benchmark portfolio duration. The Neutral Rate: Our indicators of the neutral (or equilibrium) fed funds rate are sending conflicting signals. The economic data suggest that the neutral rate might be above 3%, but this is contradicted by weakness in the price of gold. TIPS: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Remain overweight TIPS versus nominal Treasuries. Feature In February we published a report that outlined how we expect the cyclical bear market in bonds to evolve. Essentially, we view the bear market as consisting of two stages.1 The first stage is characterized by the re-anchoring of inflation expectations and the second stage deals with determining the neutral (or equilibrium) federal funds rate. In this week's report we track how the two-stage Treasury bear market has progressed since February and consider the implications for portfolio strategy. The First Stage Is Nearly Complete Long-maturity TIPS breakeven inflation rates are slightly higher than when we published our February report, but they are still not at levels we would consider "well anchored". We showed in our February report that prior periods when core inflation was close to the Fed's 2% target coincided with both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates in a range between 2.3% and 2.5%. At present, the 10-year TIPS breakeven inflation rate is 2.10% and the 5-year/5-year forward is 2.19%. As long as TIPS breakeven inflation rates remain below the 2.3% - 2.5% target range, nominal Treasury yields have further cyclical upside due to the re-anchoring of inflation expectations. This re-anchoring will play out as the core inflation data are released and investors come to realize that inflation is no longer consistently undershooting the Fed's target. When that re-anchoring occurs and both the 10-year and 5-year/5-year forward breakevens cross above 2.3%, the first stage of the bond bear market will be complete. One recent development is that TIPS breakevens have risen even as commodity prices have declined (Chart 1). In fact, while breakevens are somewhat higher than when we published our February report, commodity prices - as measured by the CRB Raw Industrials index - are lower. While this shift in correlation is so far only tentative, it could signal that TIPS investors are increasingly influenced by the actual core inflation data and not swings in the global growth outlook. We would not be surprised to see this correlation continue to weaken going forward, especially considering that core inflation looks more and more consistent with the Fed's 2% target. Core CPI for July came in at 2.33% on both a trailing 12-month and 3-month basis, annualized (Chart 2). This is more or less consistent with the pre-crisis period when the Fed's preferred PCE inflation measure was close to the 2% target. Alternative measures of CPI send a similar message (Chart 2, panel 2) and our diffusion index shows that more individual items have accelerated in price than have decelerated in each of the past three months (Chart 2, bottom panel). Taken together, the signals point to further near-term price acceleration. Chart 1Inflation Date Sinking In Inflation Date Sinking In Inflation Date Sinking In Chart 2Inflation Picking Up Steam Inflation Picking Up Steam Inflation Picking Up Steam Digging deeper, we see that the outlook for higher inflation pervades each of the main components of core CPI (Chart 3). The reading from our shelter inflation model has stabilized, core goods inflation continues to track non-oil import prices higher, and the rebound in core services inflation is consistent with rising wage growth. Eventually, we would expect the strengthening dollar to exert a drag on import prices (Chart 4), but it will be some time before this is reflected in the CPI data. Another important development is that, after appearing to have turned a corner in 2016, the residential vacancy rate has dipped back down (Chart 4, bottom panel). Such a low vacancy rate will continue to support strong shelter inflation. Chart 3The Components Of Core CPI The Components Of Core CPI The Components Of Core CPI Chart 4A Headwind And A Tailwind For Inflation Headwing & Tailwind For Inflation Headwing & Tailwind For Inflation Bottom Line: Long-dated TIPS breakeven inflation rates remain slightly below target levels, but appear to be increasingly taking their cues from the realized inflation data rather than swings in global growth and commodity prices. Nominal Treasury yields have further upside at least until both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates reach a range between 2.3% and 2.5%. We also continue to recommend an overweight position in TIPS relative to nominal Treasury securities. We will remove this recommendation when breakeven rates reach our target range and stage one of the bond bear market is complete. Stage 2 Update: Conflicting Evidence On The Neutral Rate Once inflation expectations are well-anchored at levels consistent with the Fed's target, the cyclical bond bear market will transition into its second stage. How much further Treasury yields rise during this stage will depend on how high the Fed is able to lift interest rates before the economy starts to slow. In other words, the cyclical peak in Treasury yields will be determined by the neutral (or equilibrium) fed funds rate - the level of interest rates where monetary policy is neither accommodative nor restrictive, and which is also consistent with stable inflation near the Fed's 2% target. Unfortunately, the neutral rate can only be known with certainty in hindsight. But in a recent report we presented three factors that investors can track in real time that have forewarned of the shift from accommodative to restrictive monetary policy in the past.2 We review the recent trends in each of these signals below. Signal 1: Nominal GDP Growth Vs The Fed Funds Rate Chart 5The Message From Nominal GDP Growth The Message From Nominal GDP Growth The Message From Nominal GDP Growth A fed funds rate that is above the year-over-year growth rate in nominal GDP is typically a signal (though often a lagging one) that monetary policy has turned restrictive (Chart 5). An intuition that is confirmed by the fact that the spread between nominal GDP growth and the fed funds rate correlates positively with the slope of the yield curve. But while the flattening yield curve has caused some to worry that the Fed is tightening too quickly, the message from nominal GDP growth is that monetary policy is actually becoming more accommodative (Chart 5, bottom panel). If the Fed continues to lift rates at its current pace of 25 basis points per quarter, the fed funds rate will be between 3.25% and 3.5% by the end of 2019. Nominal GDP would have to decelerate fairly substantially from its current 5.4% growth rate to signal restrictive monetary policy by then. Signal 2: Cyclical Spending Another indicator that has historically coincided with restrictive monetary policy and the cyclical peak in bond yields is when growth in the most interest-rate sensitive sectors of the economy (aka the cyclical sectors) slows as a proportion of overall growth (Chart 6). This is especially true for consumer spending on durable goods. Not only is it well below pre-crisis levels as a percent of GDP, but recent data revisions revealed that the personal savings rate is much higher than previously thought. The savings rate looks especially elevated relative to household wealth, which leaves room for spending to accelerate as it falls to more normal levels (Chart 7). Extremely high consumer confidence supports the view that the savings rate will decline (Chart 7, panel 2), and despite recent increases in interest rates and the price of gasoline, consumer spending on essentials is not yet excessive relative to income (Chart 7, bottom panel). Chart 6Signal 2: Cyclical Spending Signal 2: Cyclical Spending Signal 2: Cyclical Spending Chart 7The Outlook For Consumer Spending The Outlook For Consumer Spending The Outlook For Consumer Spending Cyclical spending - which includes consumer spending on durable goods, residential investment and nonresidential investment in equipment & software - is currently rising only slowly as a proportion of GDP, but it remains well below average historical levels. This suggests that further catch-up is likely. Much like consumer spending, residential investment also has a lot of room to play catch-up relative to pre-crisis levels (Chart 6, panel 3). However, growth in residential investment has waned in recent months (Chart 8). The slowdown is likely the result of the housing market coming to grips with higher mortgage rates. But while higher rates have definitely impaired affordability, housing remains quite cheap compared to history (Chart 8, panel 2). A further support for housing is that homebuilders are extraordinarily confident in the outlook (Chart 8, panel 3). This is for good reason. The outstanding housing supply is historically low and continues to contract relative to demand as increases in building permits fail to keep pace with household formation (Chart 8, bottom panel). Unlike consumer spending on durables and residential investment, nonresidential investment in equipment & software is roughly consistent with its average historical level as a proportion of GDP (Chart 6, bottom panel). But so far leading indicators are not pointing to a slowdown. On the contrary, surveys of new orders, capital expenditure plans and CEO confidence suggest that investment growth will stay strong for the next few quarters (Chart 9). At some point, given its higher level relative to GDP, investment could be the cyclical sector that first shows some evidence of weakness. But so far this is not the case. Chart 8The Outlook For Residential Investment The Outlook For Residential Investment The Outlook For Residential Investment Chart 9The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment The Outlook For Non-Residential Investment Signal 3: Gold Chart 10Signal 3: Gold Signal 3: Gold Signal 3: Gold The final signal of restrictive monetary policy we consider is the price of gold. The widely accepted perception of gold as a long-run store of value makes it the ideal "anti-central bank" asset. In other words, gold tends to perform well when monetary policy is perceived to be turning more accommodative relative to its neutral level, and it tends to sell off when policy is perceived to be turning restrictive. Gold is also a useful addition to our suite of indicators because it is a price that is set in financial markets. Compared to our other two indicators which are based on economic data, financial market indicators can provide more of a leading signal. The trade-off, however, is that false signals are far more frequent. Most interestingly, we observe that fluctuations in the price of gold have preceded revisions to the Fed's estimate of the neutral fed funds rate in the post-crisis period (Chart 10). This seems entirely logical. The falling gold price in 2014/15 suggested that the market viewed Fed policy as becoming increasingly restrictive, but market expectations for the near-term path of rate hikes were roughly flat during this period (Chart 10, bottom panel). The only explanation is that investors were revising down their estimates of the neutral fed funds rate during this time, resulting in a de-facto policy tightening. Similarly, around the same time that gold put in a bottom in early 2016, neutral rate estimates from both investors and the Fed started to level-off around the 3% level, where they remain today. Going forward, the implication is that if gold were to break out of its trading range to the upside, it would send a strong signal that the Fed is perceived to be falling behind the curve. Such a price movement would make upward revisions to the neutral fed funds rate, and a higher cyclical peak in Treasury yields, more likely. Conversely, if gold continues its recent slide, it could signal that policy is turning restrictive more quickly than many expect. Bottom Line: Trends in our neutral rate indicators since February are sending conflicting signals. The economic data - nominal GDP growth and cyclical spending - have improved and suggest that we should think about a neutral fed funds rate above the current market consensus of 3%. On the other hand, the weakness in the price of gold suggests that investors view monetary policy as becoming increasingly restrictive. Investment Strategy How best to square these conflicting signals when formulating a portfolio strategy? For the time being we strongly advise investors to maintain below-benchmark duration on a cyclical (6-12 month) horizon. For one thing, the bond bear market remains in its first stage and the market is still not fully convinced that inflation will re-anchor itself around the Fed's 2% target. This alone argues for maintaining below-benchmark duration and an overweight allocation to TIPS versus nominal Treasuries, at least until long-dated TIPS breakevens reach our target range. Beyond that, while the true neutral fed funds rate remains uncertain, the market is only priced for a fed funds rate of 2.83% by the end of 2019. This is well below the range of 3.25% to 3.5% that will prevail if the Fed sticks to its current 25 basis points per quarter rate hike pace, and is consistent with a neutral rate that is well below 3% (Chart 11). Chart 11The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace The Market Not Buying Into The Fed's Current Rate Hike Pace In other words, current market pricing tilts the risk/reward trade-off firmly in favor of below-benchmark duration, but we will keep a close eye on our neutral rate signals in the coming quarters to see if a more consistent message emerges. Stay tuned. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "A Signal From Gold?", dated May 1, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification