Gov Sovereigns/Treasurys

Highlights Duration: The upturn in bond yields is not yet confirmed by our preferred global growth indicators. We anticipate that a reduction in trade uncertainty during the next few months will cause our indicators to rebound. But until then, investors should view the bond sell-off as tenuous. Yield Curve: Expect modest 2/10 steepening during the next few months, as the Fed keeps rates low even as economic growth improves. Steepening will show up in real yields, not in the TIPS breakeven inflation curve. The 2/10 slope will stay in a range between 0 bps and 50 bps for the next 6-12 months. Yield Curve Strategy: The 5-year Treasury note looks expensive compared to the rest of the yield curve, and historical correlations suggest it will rise the most if the Fed delivers fewer rate cuts than are currently expected. We recommend that investors short the 5-year bullet versus a duration-matched 2/30 barbell. Await Confirmation Bond yields look like they might be bottoming. The 2-year and 10-year Treasury yields are up 10 bps and 31 bps, respectively, since the 2/10 slope briefly inverted in late August (Chart 1). We are cautiously optimistic that the growth revival getting priced into Treasury yields will materialize. However, it’s vital to note that the yield rebound is not yet confirmed by the economic data. Even timely global growth indicators like the CRB Raw Industrials index remain downbeat (Chart 1, bottom panel). If global growth measures don’t bottom soon, then Treasury yields are certain to fall back. Chart 1Yields Are Ahead Of The Data Yields Are Ahead Of The Data Yields Are Ahead Of The Data We do expect the economic data to follow bond yields higher. We noted in last week’s report that the weakness in US economic data is concentrated in survey measures (aka “soft” data), while measures of actual economic activity (aka “hard data”) are holding up well.1    For example: The ISM Manufacturing survey is below its 2016 trough, but the year-over-year growth rate in industrial production is well above 2016 levels (Chart 2, top panel). Capacity utilization also remains elevated (Chart 2, bottom panel). New orders for core capital goods are holding firm, even with CEO confidence at its lowest since 2009 (Chart 2, panel 2). Employment growth remains strong, despite the employment component of the ISM Non-Manufacturing survey being just above the 50 boom/bust line (Chart 2, panel 3). Chart 2Will "Soft" Data Rebound? Will "Soft" Data Rebound? Will "Soft" Data Rebound? Our interpretation of the divergence is that uncertainty about the US/China trade war is weighing on sentiment and holding survey measures down. If that uncertainty is removed, survey measures will quickly rebound and converge with the “hard” data. On that front, we think it’s very likely that trade uncertainty diminishes during the next few months. The US and China have already agreed to an informal “phase one deal” that will require China to buy $40-$50 billion of US agricultural goods while the US delays the October 15 tariff hike. Odds are that President Trump will also delay the planned December 15 tariff hike and probably roll back some existing tariffs.2 The reason is that while Trump’s overall approval rating has been consistently low; until recently, he had been receiving high marks for his handling of the economy (Chart 3). But his economic approval rating took a tumble this summer and, as we head toward the 2020 election, he desperately needs an economic boost and/or policy victory to push up his numbers. We already see some tentative signs of a rebound in the regional Fed manufacturing surveys. A tactical retreat on trade should improve sentiment and cause survey data to move higher, alongside bond yields. And in fact, we already see some tentative signs of a rebound in the regional Fed manufacturing surveys (Chart 4). October figures are out for the New York, Philadelphia, Richmond, Kansas City and Dallas surveys, and they have all diverged positively from the national ISM. Chart 3It's Trump's Economy It's Trump's Economy It's Trump's Economy Chart 4Some Optimism From Regional Surveys Some Optimism From Regional Surveys Some Optimism From Regional Surveys Bottom Line: The upturn in bond yields is not yet confirmed by our preferred global growth indicators. We anticipate that a reduction in trade uncertainty during the next few months will cause our indicators to rebound. But until then, investors should view the bond sell-off as tenuous. Yield Curve: Macro Drivers We noted in the first section that the 2/10 Treasury slope has steepened sharply since it briefly broke below zero in late August. In this section, we consider whether this 2/10 steepening might continue. To do this we run through the main macro drivers of the yield curve. The Fed Funds Rate Traditionally, there is a very tight correlation between the fed funds rate and the slope of the curve (Chart 5). Fed tightening puts upward pressure on the curve’s front-end relative to the back-end, leading to a bear-flattening. Conversely, Fed easing drags the front-end down relative to the long-end, leading to bull-steepening. Chart 5The Fed's Yield Curve Control The Fed's Yield Curve Control The Fed's Yield Curve Control The traditional pattern broke down between 2009 and 2015 when the fed funds rate was pinned at zero. This period saw many episodes of bear-steepening and bull-flattening. But since the funds rate has been off zero, the traditional correlation has begun to re-assert itself. Our base case outlook calls for one more 25 bps rate cut tomorrow, followed by an extended on-hold period. This scenario might be expected to impart some mild steepening pressure to the curve, except for the fact that the front-end is already priced for 53 bps of easing during the next 12 months, significantly more than we expect. Our base case outlook calls for one more 25 bps rate cut tomorrow, followed by an extended on-hold period. If our base case scenario is incorrect, and growth continues to deteriorate, forcing the Fed to cut rates all the way back to zero. Then we would expect some initial bull-steepening, followed by bull-flattening as the funds rate approaches the zero bound. Wage Growth Wage growth is another excellent yield curve indicator, mainly because it helps determine the direction of the fed funds rate. Stronger wage growth causes the Fed to tighten and the curve to flatten. On the flipside, wage growth is a less effective indicator during Fed easing cycles, when it tends to lag changes in the funds rate (Chart 6). In fact, while wage growth is tightly correlated with the 2/10 slope, it lags changes in the slope by about 12 months (Chart 6, panel 2). Chart 6Wages Lead Tightening, But Lag Easing Wages Lead Tightening, But Lag Easing Wages Lead Tightening, But Lag Easing The upshot is that if the economy heads toward recession, then wage growth will not be a timely indicator of Fed rate cuts. However, if recession is avoided and wages continue to accelerate (Chart 6, bottom 2 panels), strong wage growth will limit how accommodative the Fed can be as it seeks to re-anchor inflation expectations. As such, persistently strong wage growth will limit the amount of curve steepening that can occur. Inflation Expectations The Fed’s need to re-anchor inflation expectations in a range consistent with its target is the main reason to forecast curve steepening. At present, the 10-year TIPS breakeven inflation rate is a mere 1.66%, well below the 2.3%-2.5% range that the Fed would consider “well anchored”. One might conclude that if the Fed succeeds in driving this rate higher, it will impart significant steepening pressure to the curve. However, we must also note that the 2-year TIPS breakeven inflation rate is even lower than the 10-year rate (Chart 7). Given our view that long-dated inflation expectations adapt only slowly to the actual inflation data, we would expect both the 2-year and 10-year breakevens to rise in tandem, exerting some modest flattening pressure on the curve.3 Chart 7Any Steepening Will Come From Real Yields Any Steepening Will Come From Real Yields Any Steepening Will Come From Real Yields Ironically, if the Fed is successful in re-anchoring long-dated inflation expectations, we expect it will cause the yield curve to steepen, but through its impact on real yields. At present, the 2-year and 10-year real yields are 0.37% and 0.14%, respectively. The act of holding rates steady for long enough to re-anchor inflation expectations will exert downward pressure on the 2-year real yield, while the 10-year real yield will rise in response to an improved growth outlook. The Fed’s goal of re-anchoring inflation expectations will likely lead to some curve steepening, but through the real component of yields, not the inflation component. The Neutral Rate The neutral rate – the fed funds rate that is neither inflationary nor deflationary – is a major wild card when it comes to the yield curve. Right now, the median Fed estimate calls for a neutral rate of 2.5%, while the market is pricing-in an even lower rate of 2%, at least according to the 5-year/5-year forward Treasury yield (Chart 8). Neutral rate estimates have been revised lower during the past few years, exerting significant flattening pressure on the yield curve. In theory, if we reach an inflection point where neutral rate estimates are revised higher, it would lead to substantial curve steepening. One thing to watch to help predict movement in neutral rate estimates is the gold price.4 Gold performs well when the market perceives monetary policy as increasingly accommodative, either because the Fed is cutting rates or because the assumed neutral rate is rising. The 2013 drop in gold foreshadowed downward revisions to the Fed’s neutral rate estimate (Chart 8, bottom panel). A further increase in gold, especially once the Fed stops cutting rates, would send a strong signal that current neutral rate estimates are too low. Monetary policy arguably exerts its greatest economic impact through the housing market. Investors can also watch the housing market for clues about the neutral rate. Monetary policy arguably exerts its greatest economic impact through the housing market. If housing activity starts to wane, it can be a strong signal that interest rates are too high. Last year, housing activity started to flag once the mortgage rate moved above 4% (Chart 9). If 4% proves to be the ceiling on mortgage rates, it would mean that the Fed’s current neutral rate estimate is roughly correct. However, home prices have moderated since last year, and new construction has started to focus more on the low-end of the market, where supply remains scarce.5 This shift in focus from homebuilders has caused the price of new homes to fall considerably (Chart 9, bottom panel), a supply side re-adjustment that could make the housing market more resilient in the face of higher rates. Chart 8Tracking The Neutral Rate: Gold Tracking The Neutral Rate: Gold Tracking The Neutral Rate: Gold Chart 9Tracking The Neutral Rate: Housing Tracking The Neutral Rate: Housing Tracking The Neutral Rate: Housing An upward re-assessment of the neutral rate would impart steepening pressure to the yield curve, but only if it occurs quickly, before the Fed has time to deliver offsetting rate hikes. However, we think it’s more likely that any increase in neutral rate estimates will occur gradually, alongside Fed tightening. In that case, a roughly parallel upward shift in the yield curve would be the most likely outcome. Verdict Considering all of the above factors, we would look for some modest 2/10 curve steepening during the next few months. The steepening will be driven by the Fed’s desire to re-anchor long-dated inflation expectations, a desire that will result in them keeping rates steady (apart from one more cut tomorrow), even as economic growth improves. As noted above, this steepening will show up in real yields, not in the TIPS breakeven inflation curve. That being said, strong wage growth and overly dovish market rate cut expectations will ensure that any steepening is well contained. We expect the 2/10 slope to stay in a range between 0 bps and 50 bps for the next 6-12 months. Yield Curve Strategy Chart 10Treasury Yield Curve Position For Modest Curve Steepening Position For Modest Curve Steepening When thinking about how to position a Treasury portfolio for our expected yield curve outcome, we first look at the value proposition offered by different Treasury maturities. Chart 10 shows the Treasury yield curve, and also each maturity’s 12-month rolling yield. The rolling yield is simply the combination of each maturity’s 12-month yield income and the price impact of rolling down the curve. It can be thought of as the return you would earn holding each bond for 12 months in an unchanged yield curve environment. The first thing that sticks out in Chart 10 is that the 5-year note offers poor value. We also note that the curve steepens sharply beyond the 5-year maturity point, so maturities greater than 5 years benefit a lot from rolldown. The simple intuition from Chart 10 is confirmed by our butterfly spread models.6  Chart 11shows that the 5-year bullet looks very expensive relative to a duration-matched barbell portfolio consisting of the 2-year and 10-year notes. In fact, with only a few exceptions, bullets are expensive relative to barbells across the entire Treasury curve (see Appendix). Chart 11Bullets Are Very Expensive Bullets Are Very Expensive Bullets Are Very Expensive All else equal, bullets tend to outperform barbells when the yield curve steepens. However, given current valuations, it would take a lot of steepening for bullets to outperform barbells during the next few months. Chart 12Yield Curve Correlations Yield Curve Correlations Yield Curve Correlations Further, Chart 12 shows that the front-end of the yield curve – out to about the 5-year/7-year point – tends to steepen when our 12-month discounter rises, while the long-end of the curve – beyond the 7-year point – tends to flatten. Given that our 12-month discounter is currently -53 bps, meaning that the market is priced for 53 bps of rate cuts during the next year, we expect it will rise during the next few months. This should exert the most upward pressure on the 5-year/7-year part of the curve. We have been recommending that investors play the curve by going long a 2/30 barbell and shorting the 7-year bullet. But given the significant rolldown advantage in the 7-year compared to the 5-year, we amend that recommendation this week. We now recommend that investors short the 5-year bullet and go long a duration-matched barbell consisting of the 2-year and 30-year maturities. Bottom Line: The 5-year Treasury note looks expensive compared to the rest of the yield curve, and historical correlations suggest it will rise the most if the Fed delivers fewer rate cuts than are currently expected. We recommend that investors short the 5-year bullet versus a duration-matched 2/30 barbell. Appendix Table 1Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of October 25, 2019) Position For Modest Curve Steepening Position For Modest Curve Steepening Table 2Butterfly Strategy Valuation: Standardized Residuals (As of October 25, 2019) Position For Modest Curve Steepening Position For Modest Curve Steepening Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 2 For further details on BCA’s outlook for US/China trade negotiations please see Geopolitical Strategy Weekly Report, “How Much To Buy An American President?”, dated October 25, 2019, available at gps.bcaresearch.com 3 For further details on how inflation expectations adapt to the actual inflation data please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Signal From Gold?”, dated May 1, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 For details on our butterfly spread models please see U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Analysis on Chile is available below. EM local bond yields have decoupled from their traditional macro drivers. This could be a sign that EM domestic bonds are entering a New Normal. We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as their currencies depreciate. Only time will tell whether the recent decoupling between EM local bond yields and their currencies is due to investor complacency or represents a sustainable paradigm shift. We are instituting a buy stop on the MSCI EM equity index at 1075. If and when the EM stock index in dollar terms breaks decisively above this level, we will become cyclically bullish and recommend playing the rally. Feature EM local currency bond yields have fallen below their 2013 lows (Chart I-1) – levels not reached since before the Federal Reserve-induced “Taper Tantrum” in the spring of 2013, when EM domestic bond yields spiked and currencies plunged. Crucially, in a major departure from their historical relationship, the aggregate EM GBI index of local bond yields has decoupled from EM currencies (Chart I-1), commodities prices, EM U.S dollar-denominated sovereign bond yields and the global business cycle (Chart I-2). Chart I-1EM Local Bond Yields Have Decoupled From EM Currencies EM Local Bond Yields Have Decoupled From EM Currencies EM Local Bond Yields Have Decoupled From EM Currencies Chart I-2EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers EM Domestic Bond Yields Have Diverged From Their Traditional Macro Drivers   Will this decoupling persist, or will the past relationship be re-established? In other words, have EM local currency bonds entered a New Normal – a paradigm where their yields behave like DM yields – falling during deflationary periods and rising during business cycle recoveries? What We Got Right And Wrong We had not been anticipating such a large drop in EM domestic bond yields this year. Our analysis has been based on the following pillars: That the global trade and manufacturing recession would persist until late 2019, and that such an outcome would herald lower commodities prices and weaker EM currencies. Falling resource prices and EM currency deprecation, consistent with the history shown in Chart I-1 and I-2, would lead to a foreign investor exodus from EM local bonds, reinforcing currency depreciation and somewhat higher yields.   Our theme that the global trade and manufacturing recession has been driven by weak domestic demand in China and the rest of the EM has played out quite well; commodities prices have been weak and EM currencies have depreciated. In addition, the broad trade-weighted dollar has been strong and DM bond yields have plunged in the past 12 months, in line with our theme of a global growth slump. In a major departure from their historical relationship, the aggregate EM GBI index of local bond yields has decoupled from EM currencies commodities prices, EM U.S dollar-denominated sovereign bond yields and the global business cycle. Nevertheless, our view of a selloff in EM domestic bonds has not panned out. In other words, our spot-on macro analysis has not translated into a successful investment call on the direction of EM local yields. The reason has been a change in the relationship between EM bond yields and their typical global macro drivers, specifically EM currencies. A potential counter-argument could be that falling DM bond yields have pushed EM local yields lower. However, contrary to the widespread consensus view, both EM local bond yields and currencies have illustrated a relatively weak correlation with U.S. bond yields (Chart I-3). All in all, even though our macro view has been on the ball, we have been flat-footed by the shifting relationship between EM domestic bond yields and their traditional macro drivers as illustrated in Chart I-1 and I-2.  Finally, even though EM bond yields have plunged, their total returns in U.S. dollar terms have not been spectacular (Chart I-4, top panel). Crucially, the EM GBI total return index in dollar terms has not outperformed that of duration-matched U.S. Treasurys (Chart I-4, bottom panel). Chart I-3No Stable Correlation Between EM Markets And U.S. Bond Yields No Stable Correlation Between EM Markets And U.S. Bond Yields No Stable Correlation Between EM Markets And U.S. Bond Yields Chart I-4EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys EM Local Bonds Have Rallied But Have Not Outperformed U.S. Treasurys   Our macro views and themes have been positive for DM bonds. Fixed-income investors who favored U.S. Treasurys over EM local bonds have not underperformed by much in the past 12 months and have actually dramatically outperformed in 2018. Complacency Or A New Normal? There are two possible scenarios for EM domestic bonds going forward: Bullish Scenario: EM Local Bonds Have Entered A New Normal We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as EM currencies depreciate. This implies the past relationships between EM domestic yields on the one hand, and EM currencies and global macro variables on the other hand have permanently reversed. If EM domestic bonds have entered a New Normal, central banks in high-yielding EMs should cut interest rates during global growth slowdowns even if their exchange rate depreciates. Besides, their local bond yields should move lower despite currency weakness. If these two conditions are satisfied, one can argue that a major regime shift in EM interest rates has taken place. Ongoing rate cuts by a few of EM central banks - despite lingering weakness in their currencies - could be an indication that we are entering such a regime shift (Chart I-5). We refer to a New Normal for EM local bonds when their yields drop during a global growth slowdown even as EM currencies depreciate. We are open to accept this idea of a New Normal. Central banks in any economy where growth is slowing and inflation is low or falling should reduce interest rates even if their exchange rate depreciates. This will be a positive development for these countries, as it will make their monetary policy counter-cyclical - as it should be. One pre-condition for EM domestic bonds entering a New Normal is for the share of foreign investors holding of local currency bonds to decline. It is occurring at the margin in some countries. In Turkey, South Africa, Malaysia and Poland, the share of foreign investors in domestic bonds has fallen (Chart I-6). Yet, this phenomenon is not occurring in Indonesia, Russia, Colombia and Mexico. Chart I-5Rare Examples Of Rate Cuts Amid Currency Weakness Rare Examples Of Rate Cuts Amid Currency Weakness Rare Examples Of Rate Cuts Amid Currency Weakness Chart I-6Falling Share Of Foreign Investors Falling Share Of Foreign Investors Falling Share Of Foreign Investors   Negative Scenario: Investor Complacency Ends Chart I-7EM Currencies Correlate With Global Business Cycle And Commodities Prices bca.ems_wr_2019_10_24_s1_c7 bca.ems_wr_2019_10_24_s1_c7 Another potential explanation for the resilience of EM domestic yields to local currency depreciation is investor complacency: extremely low and negative bond yields in DM is inducing an unrelenting search for yields. As a result, investors are looking through EM currency depreciation, hoping it will be fleeting. Conditional on our view that EM currencies remain at risk of further depreciation panning out, EM local bonds are unlikely to avoid foreign outflows and higher yields under this scenario. This is especially true for the EM countries with high foreign ownership of local bonds. In theory, various macro forces such as expectations of domestic monetary policy, fiscal policy, inflation prospects, domestic business cycles, individual countries’ exchange rates as well as global interest rates should influence EM local bond yields. In reality, however, EM local yields have historically risen during periods of global business cycle downturns and falling commodities prices. The channel was via EM currencies, which depreciated during these periods (Chart I-7). Thereby, the primary driver for local bond yields has historically been swings in domestic exchange rates. In turn, the basis for this high sensitivity of EM domestic bond yields to their exchange rates has been due to the large share of foreign ownership. Table I-1 illustrates that the share of local currency government bonds held by foreign investors is high in the majority of EM countries. The exceptions are China, India, Korea, the Philippines and Chile. The data for Brazil are suspect. It is difficult to believe that foreigners own a mere 12% and declining share of Brazilian local currency bonds. Another potential explanation for the resilience of EM domestic yields to local currency depreciation is investor complacency: extremely low and negative bond yields in DM is inducing an unrelenting search for yields. As a result, investors are looking through EM currency depreciation, hoping it will be fleeting. What is critical, is that international investors care about the returns on their investments in U.S. dollars, euros or Japanese yen. Hence, they are very sensitive to exchange rates. Historically, foreign investors flee EM local bond markets when EM currencies depreciate, and vice versa. Chart I-8 illustrates the wide gap between total returns on EM domestic bonds in local currency and U.S. dollar terms. Table I-1Share Of Domestic Bonds Held By Foreign Investors EM Local Bonds: A New Normal? EM Local Bonds: A New Normal? Chart I-8EM Currencies Are Key To EM Local Bonds Volatility EM Currencies Are Key To EM Local Bonds Volatility EM Currencies Are Key To EM Local Bonds Volatility   In short, most investment return volatility in EM local bonds can be attributed to exchange rates – i.e., investments in EM local bonds have in practical terms constituted a bet on their exchange rates. If EM currencies experience another downleg, foreign investors’ patience might run out, causing a spike in EM local yields. Bottom Line: It is still early to conclude if a New Normal in EM domestic bonds has already taken hold. Only time will tell whether the recent decoupling between EM local bond yields and their currencies is due to an unrelenting search for yield or represents a paradigm shift. Reasons Why Local EM Yields Could Rise There are two macro risks to EM local bonds: 1.  A deepening/persisting growth slump in China Deteriorating Chinese domestic growth or a weaker RMB remain the key risks to the rest of the world. In brief, odds are high that China will continue exporting deflation to the rest of the world. Shrinking Chinese imports imply that the rest of the world’s export revenues emanating from their shipments to China are contracting (Chart I-9). A negative growth shock in EM economies that are exposed to China heralds both weaker currencies and lower interest rates. Given that high-yielding EM local bonds yields have risen historically during negative growth shocks, we are reluctant to chase these EM yields lower. This has been, and remains, our main thesis for high-yielding EM bond markets. 2.  Rising inflation in the U.S. Despite commentators’ preoccupation with global deflation and recession, U.S. core inflation is moving up. The equal-weighted average of various core measures presently stands at 2.2% and is drifting higher (Chart I-10). Chart I-9Chinese Imports Are Shrinking Chinese Imports Are Shrinking Chinese Imports Are Shrinking Chart I-10U.S. Core Inflation Is Above 2% And Rising U.S. Core Inflation Is Above 2% And Rising U.S. Core Inflation Is Above 2% And Rising   Besides, BCA Research’s U.S. wage tracker and unit labor costs have been accelerating (Chart I-11). The tight labor market in the U.S. suggest that risks to wages and unit labor costs and, ultimately, inflation are skewed to the upside. Chart I-11U.S. Wages And Unit Labor Costs Are Accelerating U.S. Wages And Unit Labor Costs Are Accelerating U.S. Wages And Unit Labor Costs Are Accelerating Unless U.S. growth slows much further, America’s fixed-income markets will at some point wake up to the reality of rising inflation. This will produce a shift up in the entire yield curve. Such a spike in U.S. Treasury yields will lead to a period of dollar strength and a selloff in overbought EM local bonds. Bottom Line: EM local bonds are discounting a goldilocks scenario. The two most likely risks that investors should monitor are a deepening growth slump in China and upside surprises in U.S. consumer price inflation.  Investment Strategy: Instituting A Buy Stop on EM Equities Given our negative stance on EM exchange rates, we have been receiving rates in EM countries where interest rates historically dropped amid currency deprecation. These include Korea, Chile and Mexico (the latter due to the value in local rates). For a dedicated EM local bond portfolio, our recommended overweights have been: Mexico, Russia, Central Europe, Chile, Korea and Thailand. Our underweights have been South Africa, Turkey, Indonesia, the Philippines and Argentina. Clients can always find our country allocation and trades for the EM local bond universe at the end of our weekly reports - please refer to page 14 - or on our website.  Also, gauging the direction of EM local bond yields is critical not only to fixed-income portfolio managers but to equity managers as well. Chart I-12 illustrates that EM equities rally when their domestic bond yields are falling. The failure of EM share prices to rally in recent months amid plunging EM local bond yields has been due to shrinking corporate profits. We are instituting a buy stop on the MSCI EM equity index at 1075. Any pick-up in EM domestic bond yields without recovery in EM corporate earnings will cause a major drop in EM equities. As to our EM equity strategy, our negative view is currently being challenged by the reaction of global share prices to negative profits and growth data releases. Despite very weak global trade and manufacturing data as well as downbeat profits from cyclical sectors, U.S. high-beta stocks and global cyclicals – an equal-weighted average of global industrials, materials and semiconductor stocks - have held up well (Chart I-13). Chart I-12EM Stocks Struggled Despite Falling Local Yields EM Stocks Struggled Despite Falling Local Yields EM Stocks Struggled Despite Falling Local Yields Chart I-13Global Cyclicals And U.S. High-Beta Stocks Are Holding Up Global Cyclicals And U.S. High-Beta Stocks Are Holding Up Global Cyclicals And U.S. High-Beta Stocks Are Holding Up   This could reflect investor complacency or it could be that the equity market is sensing an imminent recovery in global growth that we do not see in data. In particular, DM equities are at a critical juncture – not only the S&P 500 but also euro area stock prices are flirting with their previous highs (Chart I-14). Chart I-14Euro Area Stocks Are At Their Major Resistance Euro Area Stocks Are At Their Major Resistance Euro Area Stocks Are At Their Major Resistance If they relapse from here, it will signify a bear market. On the other hand, if these equity markets break out, it would suggest that a major upleg is in the making. Even though EM share prices are well below their previous highs, they are also at a make or break juncture. Therefore, we are instituting a buy stop on the MSCI EM equity index at 1075 (Chart I-15). If and when the EM stock index in dollar terms breaks decisively above this level, we will become cyclically bullish and recommend playing the rally. Chart I-15We Are Instituting A Buy Stop at 1075 on MSCI EM Index We Are Instituting A Buy Stop at 1075 on MSCI EM Index We Are Instituting A Buy Stop at 1075 on MSCI EM Index   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chile: Structural Equity De-Rating The latest violent protests in Chile have raised doubts about its socio-political and economic stability. As a result, Chilean share prices could be facing both absolute and relative (versus other EM bourses) de-ratings. We are downgrading this bourse from overweight to neutral within an EM equity portfolio, reiterating our short position in the peso versus the dollar, and continue to bet on lower rates and falling inflation cyclically, as discussed in great length in our recent report. Chilean stocks have always been among the most expensive within the EM universe due to the nation’s economic and socio-political stability. The violent protests now warrant a structural de-rating of equity valuations (Chart II-1). Chart II-1Chilean Share Prices: A Long-Term Perspective Chilean Share Prices: A Long-Term Perspective Chilean Share Prices: A Long-Term Perspective First, the government will be forced to adopt much more populist policies, such as the recently announced raise in minimum wages, pension payments and healthcare benefits. Unit labor costs for businesses are set to rise substantially, eating into corporate profit margins. Second, in line with more populist policies, larger budget deficits and structurally higher inflation will cause the long-end of the yield curve to rise. Higher interest rates will put downward pressure on equity multiples. Finally, equity investors will require a higher risk premium to invest in this bourse. Chile’s equity valuation premium versus EM overall will shrink. Bottom Line: The central bank will have to cut rates by a larger margin: continue receiving 3-year swap rates. A recession is unavoidable as business confidence will plunge and derail hiring and investments. Inflation will fall much further cyclically: bet on lower inflation by going long 3-year local currency bonds and shorting their inflation-linked counterparts. Continue shorting the peso versus the U.S. dollar. Downgrade the allocation to Chilean stocks from overweight to neutral within an EM equity portfolio. Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights On a tactical horizon, underweight bonds versus cash, especially those bonds with deeply negative yields… …and underweight bonds versus equities. On a strategic horizon, remain overweight a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos, at either 10-year or 30-year bond maturities. Investors could also play the component pairs: overweight U.S. T-bonds versus German bunds; and overweight Italian BTPs versus Spanish Bonos. New recommendation: switch Japanese yen long exposure into Swedish krona long exposure. Fractal trade: long SEK/JPY. Feature Chart of the WeekSwiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Swiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Swiss Bond Yields Have Found It Difficult To Go Down, But Easy To Go Up! Anybody who has dared to bet that JGB yields would rise has ended up being carried out of their job, feet first. Shorting Japanese government bonds (JGBs) is known as the widow maker trade. Over the past 20 years, any investment manager who has dared to bet that JGB yields would rise – whether starting from 2 percent, 1 percent, or even 0.5 percent – has ended up being carried out of their job in a box, feet first. Today, the Bank of Japan’s policy of ‘yield curve control’ means that JGB yields are constrained within a tight range around zero, limiting their immediate scope to break higher. The European equivalent of the widow maker trade has been to short Swiss government bonds. Just as with JGB’s during the past two decades, anybody who has dared to bet that Swiss government bond yields would rise – whether starting from 2 percent, 1 percent, or 0.5 percent – has been proved fatally wrong (Chart I-2). Chart I-2Widow Makers: Shorting Japanese And Swiss Bonds Widow Makers: Shorting Japanese And Swiss Bonds Widow Makers: Shorting Japanese And Swiss Bonds That is, until this year, when Swiss government bond yields reached -1 percent. The Lower Bound To Bond Yields Is Around -1 Percent According to several senior central bankers who have spoken to us, the practical lower bound to the policy interest rate is -1 percent, because “-1 percent counterbalances the storage cost of holding physical cash and/or other stores of value”. They argue that if bank deposit rates were to fall much below -1 percent, it would be logical for bank depositors to flee wholesale into physical cash, and such a deposit flight would destroy the banking system.1 Still, couldn’t central banks just abolish physical cash, forcing us all into ‘digital cash’ with unlimited negative interest rates? No, because that would just push us into other stores of value: for example, gold, or the rapidly growing ‘decentralised’ cryptocurrency asset-class. The common counterargument is that cryptocurrencies’ volatility makes them a poor store of value. But that is also true for gold: during a few months in 2013, gold lost one third of its value (Chart I-3). Yet who has ever argued that gold cannot be a store of value just because its price is volatile! Chart I-3Gold Is A Store Of Value ##br## Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility Gold Is A Store Of Value Despite Its Volatility The practical lower bound to the policy interest rate is around -1 percent because the central bank policy rate establishes the banking system’s funding rate – for example, the Eonia rate in the euro area (Chart I-4). If the funding rate fell well below the rate that the banks were paying on deposits, the banking system would come under severe strain and ultimately go bust. The lower bound of the policy rate also sets the lower bound of the bond yield, because a bond yield is just the expected average policy rate over the bond’s lifetime. Chart I-4The Policy Interest Rate Establishes The Banking System's Funding Rate The Policy Interest Rate Establishes The Banking System's Funding Rate The Policy Interest Rate Establishes The Banking System's Funding Rate There is one important exception. If bond investors price in the possibility of being repaid in a different and more valuable currency, the bond yield will carry a further redenomination discount as an offset for the potential currency gain. This is relevant to euro area bonds because there remains the remote possibility of euro disintegration. Bonds which would expect to see a currency redenomination gain – notably, German bunds – therefore carry an additional discount on their yields. But for bonds where no currency redenomination is possible, the practical lower bound to bond yields is around -1 percent. Overweight High Yielding Bonds Versus Low Yielding Bonds To state the obvious, the closer that a bond yield gets to the -1 percent lower bound, the more limited becomes the possibility for a further yield decline (capital gain), while the possibility for a yield increase (capital loss) stays unlimited. This unattractive lack of upside combined with plenty of potential downside is called negative skew or negative asymmetry. It follows that, close to the lower bound of yields, the cyclicality or ‘beta’ of bond prices also becomes asymmetric. In risk-off phases, the bond prices cannot rally; while in risk-on phases, bond prices can plummet. Making such bonds a ‘lose-lose’ proposition. Case in point: Swiss bond yields have found it difficult to go down this year, but very easy to go up (Chart of the Week). Because their yields were already so close to -1 percent, Swiss bond yields could not decline much during the bond market’s recent strong rally – meaning, Swiss bond prices were very low beta on the way up. But in the recent reversal, Swiss bond yields have risen much more than others – meaning, Swiss bond prices are high beta on the way down (Chart I-5).   Chart I-5Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Swiss Bond Prices Are Low Beta Going Up, But High Beta Going Down Does this mean the widow maker trade can finally work? Yes, but only on a tactical horizon. For the full rationale, which we will not repeat here, please see Growth To Rebound In The Fourth Quarter, But Fade In 2020. However in summary, expect bond yields to edge modestly higher, and especially those yields that are deeply in negative territory. Also on a tactical horizon, prefer equities over bonds.  On a longer term horizon, a much safer way to play the asymmetric beta is to short low yielding bonds in relative terms. In other words, overweight high yielding bonds versus low yielding bonds.2 Close to the lower bound of yields, the cyclicality or ‘beta’ of bond prices becomes asymmetric. Our strategic recommendation is to overweight a 50:50 combination of U.S. T-bonds and Italian BTPs versus a 50:50 combination of German Bunds and Spanish Bonos, at either 10-year or 30-year bond maturities. Since initiation five months ago, the recommendation at the 30-year maturity is already up by almost 7 percent. Nevertheless, it has a lot further to go (Chart I-6). Investors could also play the component pairs: overweight U.S. T-bonds versus German bunds; and overweight Italian BTPs versus Spanish Bonos (Chart I-7 and Chart I-8), but the combined two bonds versus two bonds recommendation has better return to risk characteristics. Chart I-6Expect High Yielding Bonds To Outperform Low Yielding Bonds Expect High Yielding Bonds To Outperform Low Yielding Bonds Expect High Yielding Bonds To Outperform Low Yielding Bonds Chart I-7Expect Yield Spread Convergence At 10-Year Maturities... Expect Yield Spread COnvergence At 10-Year Maturities... Expect Yield Spread COnvergence At 10-Year Maturities... Chart I-8...And At 30-Year ##br##Maturities ...And At 30-Year Maturities ...And At 30-Year Maturities Switch Into The Swedish Krona   Bond yield spreads are also an important driver of currency moves. The currency corollary of overweighting high yielding versus low yielding bonds is to tilt towards low yielding currencies, because these are the currencies that have the most scope for substantial upside. Our favourite low yielding currency has been the Japanese yen, and this has worked very well. Since early 2018, the yen has been the strongest major currency, and is up 16 percent versus the euro. But our favourite currency is now changing to the Swedish krona, for three reasons: The SEK is depressed from a valuation perspective. For example, it is the only major currencies that is weaker than the GBP compared to before the Brexit vote in 2016 (Chart I-9). Chart I-9The Swedish Krona Has Underperformed The Pound Despite Brexit The Swedish Krona Has Underperformed The Pound Despite Brexit The Swedish Krona Has Underperformed The Pound Despite Brexit Unlike other major central banks, the Riksbank is seeking to normalise the policy rate upwards. The SEK is technically oversold on its 130-day fractal dimension, signalling over-pessimism in the price (Chart I-10), while the JPY is showing the opposite tendency. Chart I-10The Swedish Krona Is Due A Countertrend Move The Swedish Krona Is Due A Countertrend Move The Swedish Krona Is Due A Countertrend Move Bottom Line: switch Japanese yen long exposure into Swedish krona long exposure. Fractal Trading System* (Chart 1-11) As just discussed, this week's recommended trade is long SEK/JPY. Set the profit target at 1.5 percent with a symmetrical stop-loss. In other trades, long NZD/JPY has started off very well and long Spain versus Belgium achieved its 3.5 percent profit target, at which it was closed, leaving five 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-11 NZD VS. JPY NZD VS. JPY The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European  Investment Strategist dhaval@bcaresearch.com Footnotes 1 The cost of holding physical cash is the cost of its safe storage. 2 Please see the European Investment Strategy Weekly Report ‘Growth To Rebound In The Fourth Quarter, But Fade In 2020’, October 3, 2019 available at eis.bcaresearch.com. Fractal Trading Model Cyclical Recommendations Structural Recommendations Fractal Trades The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? The ‘Widow Maker’ Trade: Can It Finally Work? 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 Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Pricing Out Some Expected Rate Cuts ... Pricing Out Some Expected Rate Cuts ... Chart 4… Across All Developed Markets ... Across All Developed Markets ... Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Global Growth Bottoming Out Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cracks Are Forming In The Bond-Bullish Narrative Cracks Are Forming In The Bond-Bullish Narrative Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The investors we met last week were ready to hear some good news: The constructive story we told across three days of client meetings is more sanguine than the consensus view, but clients were open to considering it. Global economic weakness and the elevated risk of a U.S. recession were primary concerns, … : As our Global Investment Strategy colleagues have suggested, it will take some time for investors to be convinced that global manufacturing really has seen the bottom and that the U.S. isn’t flirting with a recession. … followed by trade tensions and corporate indebtedness, … : Our small sample suggests that investors may have become de-sensitized to the daily ebb and flow of the U.S.-China conflict, though we continue to believe it looms large in the minds of corporate managements. … but nothing matches the anxiety provoked by Elizabeth Warren’s ascent: Every client asked about the potential consequences of a Warren White House. Feature We spent most of last week meeting with a subset of wealth management and family office clients. They are more focused on absolute returns than relative returns, but their primary concerns are nearly identical to their relative-return peers’. Our meetings touched on a broad constellation of questions about the fate of the expansion, the equity bull market, global growth and the U.S.-China trade negotiations. Clients also asked about the credit outlook and if inflation should be on their radar, but the topic that they raised with the most fervor, in every single one of our meetings, was the prospect of a Warren or Sanders presidency. Q: What is the bond market telling us? We think of the bond market as having two distinct components, rates (Treasuries) and credit (spread product). We have gotten used to regular retracements in the 10-year Treasury yield since it bottomed in July 2016, but watching it melt from 3.25% last November to 1.5% this August has challenged our constructive take on the U.S. economy. Falling yields are not necessarily signaling imminent economic trouble, however, so we continue to hold the view that a recession won’t occur before late 2021 or early 2022. We see this year’s falling Treasury yields as a coincident reflection of decelerating growth, not a harbinger of a recession. On a purely domestic basis, the principal driver of the decline in yields has been the shift in monetary policy expectations. The Fed’s dovish pivot did not occur in a vacuum, of course. Clear signs of decelerating growth set the stage for easier policy, both here and abroad. Whether or not the Fed was always calling the tune, all three step-function declines in 12-month forward fed funds rate expectations occurred as it was guiding markets to expect easier policy: ahead of the March FOMC meeting, when Fed speakers began warning of the danger of inflation expectations becoming unanchored on the downside; in May, when they were busily preparing the ground for a rate cut; and after the July meeting raised the prospect that the July cut would not be a one-off event (Chart 1). Chart 1The Fed's Dovish Pivot, ... The Fed's Dovish Pivot, ... The Fed's Dovish Pivot, ... Sovereign rates are not entirely determined domestically, and much of the softness in Treasury yields reflects the softness in yields in the rest of the world. So far this year, 10-year sovereign yields have moved in lockstep on either side of the Atlantic (Chart 2), preserving no-arbitrage conditions in currency-hedged Treasuries, gilts and bunds. Crude prices are another global variable, and their decline has weighed on inflation break-even rates (Chart 3), dampening the inflation compensation demanded by Treasury buyers. From a rates perspective, we think the bond market is telling us that global growth has slowed, central banks have taken monetary accommodation up a notch, and oil prices have slid. That’s not exactly an ideal growth backdrop, but it hardly spells the end of the expansion. Chart 2... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower ... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower ... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower The credit market concurs. It doesn’t betray a whit of concern that the expansion is in trouble. Spreads quickly unwound last year’s fourth-quarter spike, and have since hung around their post-crisis lows (Chart 4). Non-financial corporations have become more indebted throughout the expansion, but servicing the debt is not at all onerous with yields at rock-bottom levels (Chart 5). Our U.S. Bond Strategy service’s proprietary corporate health monitor is signaling that corporate balance sheets have weakened (Chart 6, third panel), but the other elements required for a meaningful widening of spreads – a completed monetary tightening cycle1 (Chart 6, second panel), and a tightening of lending standards (Chart 6, bottom panel) – are not yet in place. Chart 3Falling Oil Prices Have Smothered Inflation Worries Falling Oil Prices Have Smothered Inflation Worries Falling Oil Prices Have Smothered Inflation Worries Chart 4Spreads Are Tight, ... Spreads Are Tight, ... Spreads Are Tight, ...   Chart 5... And Debt Service Is Easy ... And Debt Service Is Easy ... And Debt Service Is Easy Q: Isn’t it time to reduce credit exposures? Tight spreads may be a contrarian warning sign. Though it is sensible to shift some of a company’s financing burden to debt when it is so much cheaper than equity, combining a larger debt burden with degraded covenant protections is a concern. Low interest rates will keep debt service costs from chafing, and help keep defaults in check for now, but the bond market is increasingly vulnerable. Chart 6Spread Widening Conditions Aren't Yet In Place Spread Widening Conditions Aren't Yet In Place Spread Widening Conditions Aren't Yet In Place Chart 7Income Investors Need Not Apply Income Investors Need Not Apply Income Investors Need Not Apply Despite that vulnerability, when the next default cycle arrives, it will not have anywhere near the impact of the housing bust because it will deal no more than a glancing blow to the banks. Single-family homes collateralize the American banking system; corporate bonds are held by a diffuse assortment of unlevered players. It stinks for any unlevered investor when it loses money, but it doesn’t cause much of a ripple in the overall economy. Today’s buildup in corporate borrowing is not analogous to 2006-7’s residential mortgage Superfund site, and suggestions to the contrary are ill-founded. Elevated corporate leverage is a vulnerability, but it is not enough for an investor to identify a vulnerability; s/he also has to identify the catalyst that will cause it to snap. Nonfinancial corporate debt levels are a fissure that has been made longer by debauched covenants. Markets won’t suffer until the fissure lengthens and widens enough to turn into a crack that no investor can ignore. It is our view that easy monetary conditions will keep the fissure out of sight and out of mind for several months at least. Defaults only occur when a borrower is unable to refinance its maturing obligations. As long as there is at least one lender willing to extend new credit at manageable terms, the borrower won’t go bust. The current monetary policy backdrop, featuring zero/negative interest rate policy in much of the major economies, all but ensures a steady supply of willing lenders. Life insurers, pension funds and endowments with a need for income to offset fixed liabilities have been forced out the risk curve to source income sufficient to meet them (Chart 7). The net result has been to provide even wobbly credits offering an incremental 50 or 75 basis points with a line of would-be lenders out the door and around the corner. The global manufacturing sector has already succumbed to recession, but stout performance in the service sector has allowed developed economies to keep expanding. The weakest credits will not find lifelines, but plenty of dubious ones will. The current ultra-loose monetary policy environment is simply not a backdrop in which defaults pick up in earnest. Until central banks get a little less prodigal, the marginal lender won’t become more selective, the plates will keep spinning, and spread product will continue to generate excess returns over cash and Treasuries. Q: Things look worse outside the U.S. What’s your global growth outlook? Chart 8Manufacturing May Be Bottoming, ... Manufacturing May Be Bottoming, ... Manufacturing May Be Bottoming, ... The global manufacturing sector is in recession, but the overall global economy is not (Chart 8). A manufacturing recession does not necessarily lead to a full-blown recession, and the ongoing expansion in developed economies’ much larger service sector provides a formidable bulwark against manufacturing’s struggles (Chart 9). While it is too early to conclude if or when global activity will accelerate, our global leading economic indicator, and the diffusion index that leads it, suggest that it is in the process of bottoming (Chart 10). Chart 9... And Services May Have Stopped Decelerating ... ... And Services May Have Stopped Decelerating ... ... And Services May Have Stopped Decelerating ... Chart 10... If Leading Indicators Have Found A Footing ... If Leading Indicators Have Found A Footing ... If Leading Indicators Have Found A Footing Chart 11From Headwind To Tailwind From Headwind To Tailwind From Headwind To Tailwind Our China Investment Strategy team sees scope for Chinese growth to gather some steam in the first quarter of 2020, when local governments will be freed from the budget constraints imposed by Beijing through the end of this year. In the meantime, September money and credit growth topped expectations, and policymakers have been undertaking modest stimulus measures like trimming bank reserve requirement ratios. Changes in Chinese credit growth lead changes in global growth (Chart 11), via China’s credit-reliant import channel. Its imports are Europe’s, Japan’s, Asian EMs’, and Australia’s, Brazil’s and Chile’s exports. As their exports rise, so too does their aggregate demand, giving rise to a self-reinforcing virtuous circle. Q: What would President Warren mean for markets? Investors’ concerns about a Warren presidency are surely justified; Senator Warren has openly, and often gleefully, expressed hostility for banks, defense contractors, drug companies, oil companies engaged in fracking, and big tech. That’s quite a list, and it accounts for a considerable share of S&P 500 market capitalization. It is fair to say that a Warren administration would be unfriendly to equity investors, but there are several points to keep in mind before liquidating one’s portfolio and fleeing the country. It’s too early to award her the Democratic nomination. In October 2007, the smart money was certain that Hillary Clinton had already locked up a berth in the finals against the eventual Republican nominee. Very few Americans could have named the freshman senator from Illinois, known for little more than a well-received speech at the 2004 convention, but he became President Obama. A lot could still happen between now and the Iowa caucuses on February 3rd. Unseating an incumbent president is a tall order. As long as the economy does not enter a recession between now and next November, and the administration can achieve a policy victory without suffering a high-profile policy failure, our Geopolitical Strategy colleagues argue that Trump should be the presumed winner of the 2020 election. Their presumption applies no matter who captures the Democratic nomination, even as the U.S. electorate is shifting to the left over time (Chart 12). Transforming Washington is easier said than done. The framers designed the federal government to be fairly resistant to sweeping change. The Electoral College tamps down popular passions in the presidential election, and Congress and the courts limit the power of the executive branch. Administrations with majorities in the House and Senate routinely find themselves with less freedom than they would like, especially after they exhaust political capital achieving one major legislative initiative (as with the Obama Administration and the Affordable Care Act). Even if the Democrats ride President Warren’s coattails to control over Capitol Hill next November, legislators from conservative or swing districts and states will balk at her entire suite of proposals. Chart 12Democratic Voters Are Leaning More Left Questions From The Road Questions From The Road Investment Implications Our sunnier view of the global economic outlook translates into more constructive equity allocations across global regions and blocs. The BCA house view recommends equal weight allocations to Emerging Markets and the Eurozone within global equity portfolios across tactical (0-3-month) and cyclical (3-12-month) timeframes. We expect to upgrade EM and Eurozone equities to overweight, and downgrade U.S. equities from overweight, across those timeframes once global growth begins to accelerate. We would also favor higher-beta currencies versus the dollar, and limit or avoid exposure to lower-beta currencies like the yen or the Swiss franc, if the data are poised to validate our base-case growth scenario. BCA’s recommendations have become especially data dependent because global investors seem to be firmly ensconced in “show-me” mode. It has been our sense as a firm, supported by the impression we got from last week’s meetings, that investors are reluctant to give growth prospects, and risk assets, the benefit of the doubt. Ground down by trade-related tweets, and skeptical that the latest wave of extraordinary monetary policy measures will have a perceptible impact on growth or inflation, they want to see definitive evidence of a turn before they’ll adjust their portfolio positioning to accommodate it. The wariness is also a reflection of the conflicting signals issued late in the business cycle and the elevated levels of geopolitical uncertainty. If the global economy turns as we think it soon will, global investors should be prepared to add cyclical exposures to their portfolios, even if Elizabeth Warren solidifies her current status as the front-runner for the Democratic nomination. That sense of wariness keeps us recommending benchmark duration exposure in fixed income portfolios over the 0-to-3-month tactical timeframe, though we have little appetite for interest-rate exposure looking out beyond the near term, and are below-benchmark duration over the 3-to-12-month cyclical and greater-than-12-month strategic timeframes. We still like spread product over the full 12-month horizon, as we expect stronger growth will make viable U.S. corporations better credits and that ZIRP/NIRP will continue to protect some of the rest. We endorse the house view that relative U.S. equity returns may slow, but global growth should give a boost to absolute equity returns, and we continue to recommend that investors remain at least equal weight equities in balanced portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 We are in accord with Chair Powell’s stated view that the rate cuts are mid-cycle cuts, not the beginning of a new easing cycle.

Highlights Duration & Fed: Our late-1990s & 2015/16 roadmap for the economy still holds, but risks are mounting. Despite the risks, we expect that trade tensions will calm enough for the economic data to improve during the next few months. The result will be one more Fed rate cut this month, followed by an extended on-hold period. Investors should keep portfolio duration low in that environment. Junk Quality Spreads: This year’s divergence between the Caa/Ba quality spread and the high-yield index spread is highly unusual, but has more to do with movements in Treasury yields and changing index duration than with broader concerns about corporate credit quality. Investment Grade Risk & Reward: We present a novel approach for assessing the risk/reward trade-off among investment grade corporate bond sectors. We note that Saudi Arabian and Mexican Sovereign bonds, Foreign Agency bonds and Conventional 30-year Agency MBS look particularly attractive in risk-adjusted terms. Feature Contagion? This publication has repeatedly pointed to the late-1990s and the 2015/16 periods as appropriate comparables for today’s global growth slowdown. That is, we expect that the current spate of weakness will stay confined within the manufacturing sector and will not spread into the broader economy, leading the U.S. into recession. This call is important from an investment perspective because it implies that the Fed is not currently engaged in an easing cycle that will bring the funds rate back to zero. Rather, we anticipate only three rate cuts this year (we’ve already seen two), followed by the eventual resumption of hikes. Bond yields will not make new lows in that environment. Chart 1Manufacturing Weakness Spreading? Manufacturing Weakness Spreading? Manufacturing Weakness Spreading? Chart 2"Hard" Data Still Firm "Hard" Data Still Firm "Hard" Data Still Firm But some data received this month challenge our economic narrative. Specifically, September’s drop in the ISM Non-Manufacturing PMI from 56.4 to 52.6 and the year-over-year decline in the Conference Board’s survey of consumer confidence (Chart 1). Both are sending tentative signals that economic weakness might be spreading from the manufacturing sector into the broader U.S. economy. The Fed is worried about the same thing, as evidenced by this passage from the September FOMC minutes: One risk that the economy faced was that the softness recorded of late in firms’ capital formation, manufacturing, and exporting activities might spread to their hiring decisions, with adverse implications for household income and spending. Participants observed that such an eventuality was not embedded in their baseline outlook; however, a couple of them indicated that this was partly because they assumed that an appropriate adjustment to the policy rate path would help forestall that eventuality. This passage makes two important points. First, it stresses the risk of contagion from manufacturing into services and consumer spending as a precondition for recession. This risk has clearly increased, but we are not yet ready to abandon our base case outlook. For one thing, Chart 1 shows that the ISM Non-Manufacturing survey printed at 51.8 for one month in 2016, before rebounding sharply. Second, the “hard” economic data paint a much rosier picture that the “soft” survey data (Chart 2). Industrial production has already bounced off its lows and, unlike the ISM Manufacturing PMI, has not yet approached 2015/16 levels. Similarly, new orders for capital goods are much stronger than during the 2015/16 period. As for consumer spending, it continues to grow at a rapid pace despite the drop in confidence. Chart 3Expect One Rate Cut In October Expect One Rate Cut In October Expect One Rate Cut In October The most logical explanation for the divergence between “hard” and “soft” data is that business and consumer sentiment are being pulled down by concerns about the ongoing trade war. Our sense is that some positive news on that front is now required to bring the survey data back into line with the “hard” numbers. On that note, we anticipate that the looming 2020 election will provide enough incentive for President Trump to reach some sort of détente with China. In fact, as we go to press, optimism about a potential trade deal has pushed the 10-year Treasury yield up above 1.70%. If this optimism is not vindicated, then weak survey data will eventually drag the “hard” data lower. The economy is at a critical and highly uncertain juncture. Amidst so much uncertainty, and with so much hinging on near-term political decisions, how should we expect the Fed to respond? The above passage from the September FOMC minutes gives us a strong clue. It illustrates that the Fed believes that sufficiently accommodative monetary policy will help mitigate the risk of contagion from manufacturing into services and consumer spending. In other words, the Fed must help weather the current storm by ensuring that financial conditions remain supportive. This means refraining from delivering hawkish surprises to market expectations.1 The Fed believes that sufficiently accommodative monetary policy will help mitigate the risk of contagion from manufacturing into services and consumer spending. With that in mind, we note that the market has mostly priced-in an October rate cut (Chart 3), and we expect the Fed to deliver on that expectation. Assuming an October cut, the market is only pricing-in a 28% chance of another cut in December. Overall, the market is priced for 59 basis points of rate cuts during the next 12 months. We anticipate a 25 bps cut this month, followed by an improvement in the economic data that will make further cuts unnecessary. Bottom Line: Our late-1990s & 2015/16 roadmap for the economy still holds, but risks are mounting. Despite the risks, we expect that trade tensions will calm enough for the economic data to improve during the next few months. The result will be one more Fed rate cut this month, followed by an extended on-hold period. Investors should keep portfolio duration low in that environment. High-Yield Quality Spreads: Less Than Meets The Eye Corporate bonds have generally performed quite well this year, but oddly, the lowest tier of junk has not kept pace (Chart 4). Investment grade excess returns have followed a typical risk-on pattern. That is, the lowest rated / riskiest credit tiers have performed best in a bull market. However, in the high-yield space, Caa-rated debt has bucked the trend and actually underperformed the duration-matched Treasury index by 33 bps. Chart 4Caa-Rated Junk Is Not Keeping Pace Caa-Rated Junk Is Not Keeping Pace Caa-Rated Junk Is Not Keeping Pace Is this a potentially worrying sign for corporate spreads more generally? To consider the question, we looked at the historical relationships between quality spreads – the spread differential between low-rated and high-rated credit tiers – and the overall index spreads for both investment grade and high-yield. We found a strong positive correlation in both cases, but no leading or lagging properties. That is, quality spreads tend to follow the same trend as the overall index spread, but do not flag signs of trouble before the overall index. Nonetheless, the current divergence between the Caa/Ba quality spread and the high-yield index spread is highly unusual (Chart 5). Our sense, however, is that the divergence has less to do with concerns about credit quality and more to do with this year’s large moves in Treasury yields and changes to bond index duration. Chart 5De-Coupling In Quality Spreads... De-Coupling In Quality Spreads... De-Coupling In Quality Spreads... Chart 6...Is Due To Duration ...Is Due To Duration ...Is Due To Duration   Specifically, we note that this year’s large decline in Treasury yields has caused junk index duration to plunge, but the drop has been greater for the Ba credit tier than the Caa credit tier (Chart 6). Ba index duration has fallen by 0.8 this year (from 4.4 to 3.5), while Caa index duration has fallen by 0.6 (3.4 to 2.8). The result is that if we control for changes in duration by looking at a 12-month breakeven spread instead of the average index option-adjusted spread (OAS), we see that the quality spread widening is roughly consistent with the overall index (Chart 6, panel 3).2 In other words, the steep drop in Treasury yields has not led to the same reduction in risk in the Caa credit tier as it has in the other junk credit tiers. Caa spreads have widened on a relative basis, as a result. This year’s large decline in Treasury yields has caused junk index duration to plunge. It’s also interesting to note that the opposite dynamic is afoot within the investment grade corporate space. The Baa/Aa quality spread is more or less consistent with the overall index spread in OAS terms (Chart 5, top panel), but the quality spread widening is exacerbated when the impact of changing duration is considered (Chart 6, panels 1 & 2). That is, index duration has lengthened by more for the upper credit tiers than it has for the Baa credit tier. This makes Baa corporates look particularly attractive in risk-adjusted terms, as we have noted in prior research.3 From a big picture perspective, it is unusual for Treasury yields to fall so much without a concurrent widening in credit risk premiums. Eventually, this anomaly will be resolved by either: Higher Treasury yields in the event that recession is avoided, or Wider credit spreads in the event of a contraction in U.S. economic activity But in the meantime, negatively convex sectors such as high-yield corporates and Agency MBS look particularly attractive on a risk-adjusted basis. These sectors have benefited from the drop in Treasury yields by seeing their durations fall. They should perform well as long as the current environment of low Treasury yields and stable credit spreads persists. We take a more detailed look at the prospects for risk-adjusted performance within the different investment grade bond sectors in the next section. Risk And Reward In Investment Grade Bond Sectors As mentioned above, in this week’s report we present a novel approach for considering the risk/reward trade-off between different investment grade sectors of the U.S. bond market. We consider 23 sectors in total: 4 corporate credit tiers Conventional 30-year Agency MBS and Agency CMBS Aaa-rated non-Agency CMBS, credit card ABS and auto loan ABS Domestic and Foreign Agency bonds Supranationals Local Authority bonds (mostly taxable munis and USD-denominated Canadian provincial debt) USD-denominated Sovereign bonds for 10 different emerging markets Reward First, we consider the reward side of the equation. We do not impose any macro view, but instead, use the average index OAS as the best estimate for each sector’s 12-month expected excess returns relative to a duration-matched position in Treasuries. Chart 7 shows the expected excess returns for each sector. Right away, the attractiveness of Mexican sovereign debt is apparent. Mexico carries an A rating, but offers a greater spread than the Baa corporate index. Chart 7Expected Returns A Perspective On Risk And Reward A Perspective On Risk And Reward Risk We decided to assess risk using a breakeven spread framework. We calculate a 12-month breakeven spread for each sector. This spread represents the basis point spread widening required for each sector to break even with a duration-matched position in Treasury securities on a 12-month horizon. We calculate the breakeven spread using the following equation: 0 = OAS – D(B) + 0.5*CVXs*(dYs)2 - 0.5*CVXT*(dYT)2 Where: OAS = the sector’s option-adjusted spread D = the sector’s duration B = the breakeven spread CVXs = the sector’s convexity CVXT = the convexity of a duration-matched Treasury security dYs = trailing 1-year volatility of the sector’s yield dYT = trailing 1-year volatility of the duration-matched Treasury yield Chart 8 shows each sector’s 12-month breakeven spread, and it illustrates that the breakeven spread is a sub-optimal measure of risk. In theory, the highest breakeven spreads should be the least likely to see losses, but this is obviously not the case. Baa-rated South African Sovereign debt carries the largest breakeven spread, but it should be among the riskiest of the sectors. Chart 812-Month Breakeven Spreads A Perspective On Risk And Reward A Perspective On Risk And Reward The missing piece of the puzzle is spread volatility. South African sovereign spreads need to widen by 39 bps before losses are incurred, while Aaa-rated credit card ABS spreads only need to widen by 13 bps. However, if spread volatility is much higher for South African sovereigns than for credit card ABS, then the sovereign sector still might be more likely to see losses. To control for this difference we calculate the standard deviation of annual spread changes for each sector, starting from May 2014 when all sectors have available data. We then divide each sector’s breakeven spread by the result. This calculation gives us a volatility-adjusted 12-month breakeven spread. In other words, it is the number of standard deviations of spread widening required for each sector to see losses on a 12-month horizon (Chart 9). Chart 912-Month Volatility-Adjusted Breakeven Spreads A Perspective On Risk And Reward A Perspective On Risk And Reward Risk & Reward We bring risk and reward together in Charts 10-12. Chart 10 shows expected returns on the y-axis and the vol-adjusted 12-month breakeven spread on the x-axis. Sectors plotting near the top-right of the chart give the best returns and lowest risk of losses, while sectors plotting near the bottom-left provide low expected returns and high risk of losses. Immediately, Saudi Arabian sovereigns and Foreign Agency debt stand out as offering high expected returns for their risk levels. Note that South African sovereigns plot off the charts, toward the top-left of Charts 10-12, as indicated by the arrows. Chart 10Expected Returns Vs. Risk Of Negative Excess Returns A Perspective On Risk And Reward A Perspective On Risk And Reward Chart 11Expected Returns Vs. Risk Of Losing 100 BPs A Perspective On Risk And Reward A Perspective On Risk And Reward Chart 12Expected Returns Vs. Risk Of Losing 200 BPs A Perspective On Risk And Reward A Perspective On Risk And Reward In Charts 11 and 12 we make one further refinement to our risk measure. In these charts, instead of calculating 12-month breakeven spreads, we calculate the spread change necessary for each sector to underperform Treasuries by 100 bps and 200 bps, respectively. Saudi Arabian sovereigns and Foreign Agency debt stand out as offering high expected returns for their risk levels. This adjustment arguably gives a more useful perspective on risk. For example, because spreads are quite narrow in the Supranational and Domestic Agency sectors, the risk of negative returns versus Treasuries is quite elevated. However, these sectors also carry high credit ratings and low spread volatility, making it exceedingly unlikely that they would deliver losses of 100 bps or more. Considering Charts 11 and 12, we look for sectors that clearly dominate other ones, i.e. plotting both higher and further to the right. Once again, Foreign Agencies and Saudi Arabian sovereigns both look very appealing. Mexican sovereign debt also offers very high expected return, and less risk that the Baa corporate sector. We would also like to point out the attractiveness of Agency MBS. As we noted in a recent report, Agency MBS offer considerably less risk than high-rated corporate debt, and similar expected returns. Note that this analysis doesn’t impose any macroeconomic view, and our sense is that the macro back-drop is more favorable for MBS spreads than for corporates.4 All in all, we reiterate our recommendation to favor Agency MBS over Aaa-, Aa- and A-rated corporate bonds. We will continue to refine this approach to measuring the risk/reward trade-off in the coming weeks, including incorporating high-yield debt into our analysis. Stay tuned. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 For further discussion on this topic please see U.S. Bond Strategy Weekly Report, “Act As Appropriate”, dated August 27, 2019, available at usbs.bcaresearch.com 2 The 12-month breakeven spread is the spread widening required on a 12-month horizon to break even with a duration-matched position in Treasury securities. It can be approximated by dividing the option-adjusted spread by duration, as is done in Chart 6. 3 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights In this Weekly Report, we present our semi-annual chartbook of the BCA Central Bank Monitors. All of the Monitors are now below the zero line, indicating a growing need to ease global monetary policy (Chart of the Week). Central bankers have already gone down that path in several countries over the past few months (the U.S., the euro area, Australia and New Zealand), helping sustain the powerful 2019 rally in global bond markets. Feature With the global manufacturing & trade downturn now threatening to spill over into domestic demand in the major developed markets, policymakers will need to stay dovish to stave off recession. This will keep global bond yields at depressed levels in the near term, at least until widely-followed data like manufacturing PMIs stabilize and/or there is positive news on U.S.-China trade negotiations. Chart of the WeekStrong Pressures To Ease Global Monetary Policy Strong Pressures To Ease Global Monetary Policy Strong Pressures To Ease Global Monetary Policy Yields already discount a lot of bad economic news, however, and there is a ray of hope visible in the bottoming out of our global leading economic indicator. A sustainable bottom in global bond yields, though, will require some change in the current downward growth or inflation momentum highlighted in our Central Bank Monitors. Yields already discount a lot of bad economic news, however, and there is a ray of hope visible in the bottoming out of our global leading economic indicator. A sustainable bottom in global bond yields, though, will require some change in the current downward growth or inflation momentum highlighted in our Central Bank Monitors.  An Overview Of The BCA Central Bank Monitors* Chart 2Low Bond Yields Are Consistent With Our CB Monitors Low Bond Yields Are Consistent With Our CB Monitors Low Bond Yields Are Consistent With Our CB Monitors The BCA Central Bank Monitors are composite indicators designed to measure the cyclical growth and inflation pressures that can influence future monetary policy decisions. The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, exchange rates, etc). The data series are standardized and combined to form the Monitors. Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the Developed Markets (Chart 2). All of the Monitors are currently pointing in a bond-bullish direction, making them less useful as a country allocation tool within global bond portfolios. With easing pressures most intense in the euro area, given that the ECB Monitor has the lowest reading, our recommended overweight stance on core euro area government bonds (hedged into U.S. dollars) remains well supported. In each BCA Central Bank Monitor Chartbook, we include a new chart for each country that we have not shown previously. In this edition, we show the components of the Monitors, grouped into those focusing on economic growth and inflation, plotted against our central bank discounters that indicate the amount of rate cuts/hikes priced into global Overnight Index Swap (OIS) curves. Fed Monitor: Signaling A Need For More Cuts Our Fed Monitor has fallen below the zero line (Chart 3A), indicating that the Fed’s summer rate cuts were justified with more easing still required. The Monitor, however, has not yet fallen to levels seen during U.S. recessions and is more consistent with the below-trend growth periods in 2016 and the late-1990s. The views of the FOMC on U.S. monetary policy are more deeply divided now than has been seen in many years. The doves can point to slumping global growth, persistent trade uncertainty, contracting capital spending and falling inflation expectations as reasons to continue cutting rates. The hawks can look at continued labor market tightness, elevated asset prices and realized inflation rates holding near the Fed’s 2% inflation target (Chart 3B) as reasons to keep monetary policy steady. That mixed picture can be seen in the components of our Fed Monitor, with the growth components showing the biggest pressure for more rate cuts compared to more stable readings from the inflation and financial components (Chart 3C). Chart 3AU.S.: Fed Monitor U.S.: Fed Monitor U.S.: Fed Monitor Chart 3BU.S. Realized Inflation Holding Firm U.S. Realized Inflation Holding Firm U.S. Realized Inflation Holding Firm Chart 3CGreatest Pressure For Fed Rate Cuts From Growth Components Of Our Fed Monitor Greatest Pressure For Fed Rate Cuts From Growth Components Of Our Fed Monitor Greatest Pressure For Fed Rate Cuts From Growth Components Of Our Fed Monitor The U.S. Treasury market may have gotten ahead of itself after the latest decline in yields, which looks stretched versus the Fed Monitor. The U.S. Treasury market may have gotten ahead of itself after the latest decline in yields, which looks stretched versus the Fed Monitor (Chart 3D). We still expect the Fed to deliver just one more rate cut at the FOMC meeting at the end of October, as the “hard” U.S. data is outpeforming the “soft” data like the weak ISM surveys. That leaves Treasury yields vulnerable to some rebound if global growth stabilizes, although that is conditional on no new breakdown of the U.S.-China trade negotiations – a factor that continues to weigh on U.S. business confidence. Chart 3DTreasury Yields More Than Fully Discount Fed Easing Pressures Treasury Yields More Than Fully Discount Fed Easing Pressures Treasury Yields More Than Fully Discount Fed Easing Pressures BoE Monitor: Easier Policy Needed Our Bank of England (BoE) Monitor, which was in the “tighter money required” zone from 2016-18, has been below the zero line since April of this year (Chart 4A). The market agrees with the message from the Monitor and is now pricing in -12bps of rate cuts over the next twelve months. The relentless uncertainty surrounding Brexit has triggered sharp downgrades of growth expectations and weakened business confidence, which the BoE is now factoring into its own projections. In the August Inflation Report, the BoE lowered its 2020 inflation forecast to below 2% - no surprise given the sharp fall in realized inflation that has already occurred even as economic growth has still not yet fallen substantially below trend (Chart 4B). Chart 4AU.K.: BoE Monitor U.K.: BoE Monitor U.K.: BoE Monitor Chart 4BFalling U.K. Inflation Opens The Door To A BoE Ease Falling U.K. Inflation Opens The Door To A BoE Ease Falling U.K. Inflation Opens The Door To A BoE Ease Still, weakening growth components have been the main driver of the BoE Monitor into rate cut territory (Chart 4C). While a strong jobs market is helping support consumer spending, the Brexit turmoil is having a lasting impact on future growth. Since the 2016 Brexit referendum, business confidence and real business investment have collapsed which, in turn, has hurt productivity growth, as we discussed in a Special Report last month.1 Chart 4CBrexit Uncertainty + Slumping Growth = Pressure For BoE Rate Cuts Brexit Uncertainty + Slumping Growth = Pressure For BoE Rate Cuts Brexit Uncertainty + Slumping Growth = Pressure For BoE Rate Cuts The uncertainty around Brexit dominates the economic outlook and any future BoE decisions. Our Geopolitical Strategy service anticipates that Brexit will be delayed beyond October 31st. As a result, uncertainty will continue to weigh on Gilt yields, even though yields have already fallen in line with our BoE Monitor (Chart 4D). We continue to recommend an overweight stance on U.K. Gilts. Chart 4DGilt Yields Have Fallen In Line With Our BoE Monitor Gilt Yields Have Fallen In Line With Our BoE Monitor Gilt Yields Have Fallen In Line With Our BoE Monitor ECB Monitor: Intense Pressure For Easier Monetary Policy Our European Central Bank (ECB) Monitor is now well below the zero line, signaling a strong need for easier monetary policy (Chart 5A). The global manufacturing downturn has hit the export-dependent economies of the euro area hard, with Germany now likely in a technical recession. Our European Central Bank (ECB) Monitor is now well below the zero line, signaling a strong need for easier monetary policy. Despite the weaker growth momentum, there remains far less spare capacity in the euro area economy than at any time since before the 2009 global recession (Chart 5B). This is keeping realized inflation in positive territory, in contrast to what was seen during the previous downturn in 2015-16. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BEuro Area Inflation Is Subdued, Despite Tight Labor Markets Euro Area Inflation Is Subdued, Despite Tight Labor Markets Euro Area Inflation Is Subdued, Despite Tight Labor Markets The ECB has already responded to the weakening growth & inflation pressures, introducing a new TLTRO program back in March and then cutting the overnight deposit rate and restarting its Asset Purchase Program in September. The latest policy moves were reported to be more contentious, with the “hard money” northern euro area countries opposed to restarting bond purchases. The new incoming ECB President, Christine Lagarde, will likely have her hands full trying to gain consensus on any further easing measures from here, even as both the growth and inflation components of our ECB Monitor indicate that more stimulus is needed (Chart 5C). Chart 5CA Consistent Message On The Need For Future ECB Easing From Growth & Inflation A Consistent Message On The Need For Future ECB Easing From Growth & Inflation A Consistent Message On The Need For Future ECB Easing From Growth & Inflation The big decline in euro area bond yields, which has pushed large swaths of sovereign yields into negative territory, does not look particularly stretched relative to the plunge in the ECB Monitor (Chart 5D). Without signs that the global manufacturing downturn is ending, however, euro area yields will stay mired at current deeply depressed levels. We recommend a moderate overweight on core European government bonds, on a currency-hedged basis into U.S. dollars. Chart 5DBund Rally Looks In Line With The ECB Monitor Bund Rally Looks In Line With The ECB Monitor Bund Rally Looks In Line With The ECB Monitor BoJ Monitor: A Rate Cut On The Horizon? Our Bank of Japan (BoJ) Monitor has drifted slightly below the zero line into “rate cut required” territory (Chart 6A). Over the past few years, the BoJ’s monetary policy has remained unchanged for the most part and its messaging has grown less dovish, citing an expanding economy. However, recent Japanese economic data shows widespread deterioration in growth momentum, as the nation has been hit hard by the global manufacturing and trade recession. Yet even with weaker growth, Japan’s unemployment rate keeps hitting all-time lows. This has not helped boost inflation much, though, with Japan’s CPI inflation still struggling to reach even the 1% level (Chart 6B). Still, the latest leg lower in our BoJ Monitor has been driven by the growth, rather than inflation, components (Chart 6C). Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BNo Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation No Spare Capacity In Japan, But Still No Inflation Weakening confidence has resulted in significant declines in both consumer spending and business investment. Due to the struggling domestic economy, it was expected that the Abe government would postpone the scheduled consumption tax hike, but it was finally initiated on October 1st. The timing could not be worse given the ongoing contraction in global manufacturing and trade activity that has clearly spilled over into Japan’s export and industrially-focused economy. Chart 6CThe Slumping Japanese Economy Could Use Some More BoJ Assistance The Slumping Japanese Economy Could Use Some More BoJ Assistance The Slumping Japanese Economy Could Use Some More BoJ Assistance The BoJ will likely try and deliver some sort of easing in the next few months, but its options are limited after years of already hyper-easy policy. A modest rate cut is likely all that will be delivered, on top of a continuation of the Yield Curve Control policy. That will be enough to keep JGB yields at depressed levels (Chart 6D), even if global yields were to begin climbing. Chart 6DJGB Yields Look Fairly Valued Vs The BoJ Monitor JGB Yields Look Fairly Valued Vs The BoJ Monitor JGB Yields Look Fairly Valued Vs The BoJ Monitor BoC Monitor: Rate Cuts Needed, But Will The BoC Deliver? The Bank of Canada (BoC) Monitor has been below zero since April of this year, indicating a need for easier monetary policy (Chart 7A). Although the BoC has maintained its policy rate at 1.75%, dovish Fed policy and softening domestic economic growth are making it harder for the BoC to continue sitting on its hands Although the Canadian labor market remains solid, household consumption has continued to weaken alongside falling consumer confidence. However, the inflation rate for both headline and core CPI measures is still hovering near the mid-point of BoC 1-3% target range (Chart 7B). Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BRising Inflation Making The BoC’s Job Harder Rising Inflation Making The BoC's Job Harder Rising Inflation Making The BoC's Job Harder At the moment, our BoC Monitor is more influenced by weaker growth components than stabilizing inflation components (Chart 7C). Similar mixed messages are also evident in other data. According to the latest BoC Business Outlook Survey, the overall outlook has edged up to the historical average,2 but real capex growth remains in negative territory and manufacturing new orders are still falling. In contrast, the Canadian labor market remains tight and both wage and price inflation are holding firm. Chart 7CBoC Growth & Inflation Components Signaling Moderate Pressure To Ease BoC Growth & Inflation Components Signaling Moderate Pressure To Rise BoC Growth & Inflation Components Signaling Moderate Pressure To Rise Canadian government bonds have rallied strongly this year, but the yield momentum has appeared to overshoot the decline in our BoC Monitor (Chart 7D). The Canadian OIS curve is discounting -27bps of rate cuts over the next twelve months, but the BoC is not signaling that they will ease. We upgraded our recommended stance on Canadian government bonds to neutral back in May, and we see no need to alter that view without further evidence of more deterioration in Canadian growth or inflation data.3 Chart 7DCanadian Bond Rally Looks A Bit Stretched Canadian Bond Rally Looks A Bit Stretched Canadian Bond Rally Looks A Bit Stretched RBA Monitor: Expect Another Cut The Reserve Bank of Australia (RBA) Monitor has been below the zero line since September 2018, indicating a need for easier monetary policy (Chart 8A). The RBA has already delivered on that signal this year, cutting the Cash Rate twice to an all-time low of 0.75%. Markets are still expecting more, with the Australian OIS curve discounting another -29bps of cuts over the next year, although most of those cuts are expected to occur within the next six months. The signal from our RBA Monitor suggests that Australian bond yields should remain under downward pressure, although the yield momentum has been excessive relative to the fall in the Monitor. Both headline and core CPI inflation remain below the RBA’s 2-3% target range (Chart 8B), and the central bank continues to lower its inflation forecasts, suggesting an entrenched dovish bias. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BNo Inflation For The RBA To Worry About No Inflation For The RBA To Worry About No Inflation For The RBA To Worry About The latest downturn in our RBA Monitor is related to declines in both the inflation and growth components (Chart 8C). The weakness in the growth components is led by falling exports to Asia, in addition to the sharp drop in house prices in the major cities. The fall in the inflation components reflects both weak inflation expectations and spare capacity in labor markets. Chart 8CA Loud & Clear Message On The Need For RBA Easing A Loud & Clear Message On The Need For RBA Easing A Loud & Clear Message On The Need For RBA Easing The signal from our RBA Monitor suggests that Australian bond yields should remain under downward pressure, although the yield momentum has been excessive relative to the fall in the Monitor (Chart 8D). Australia’s economy will not begin to outperform again, however, until China’s current growth slump starts to bottom out, which is unlikely to occur until the first quarter of 2020 at the earliest. Thus, we expect the RBA to deliver another rate cut before the end of the year, justifying a continued overweight stance on Australian government bonds. Chart 8DA Lot Of Bad News Discounted In Australian Bond Yields A Lot Of Bad News Discounted In Australian Bond Yields A Lot Of Bad News Discounted In Australian Bond Yields RBNZ Monitor: More Easing To Come Our Reserve Bank of New Zealand (RBNZ) monitor remains well below zero, indicating that easier monetary policy is still required (Chart 9A). The central bank has already delivered two rate cuts this year: a -25bps cut in May and, more importantly, a shock rate cut of -50bps in August. Forward guidance remains dovish, with RBNZ Governor Adrian Orr signaling more easing is likely and even hinting at negative rates in the future. This rhetoric is reflected in the NZ OIS curve, which is pricing in a further -42bps of easing over the next twelve months. High inflation is not a constraint for the RBNZ. Both headline and core measures of inflation are currently at 1.7% (Chart 9B). As the RBNZ targets a 1-3% range over the medium term, the prospect of overshooting the 2% longer-term target will not restrict policymakers from acting as appropriate to boost growth. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Creeping Higher NZ Inflation Creeping Higher NZ Inflation Creeping Higher Most of the pressure to ease has come from the continued deterioration in the growth component of our RBNZ Monitor (Chart 9C), reflecting weakness in manufacturing and consumption. The manufacturing PMI is currently in contractionary territory at 48.4, having fallen almost five points since February of this year. Annual growth in retail sales has been slowing for the past two years while consumer confidence is at 7-year lows. Chart 9CWeak Growth Is The Reason RBNZ Rate Cuts Are Needed Weak Growth Is The Reason RBNZ Rate Cuts Are Needed Weak Growth Is The Reason RBNZ Rate Cuts Are Needed We feel confident in reiterating our bullish recommendation on NZ government bonds versus U.S. and German sovereign debt. The RBNZ Monitor suggests that policy will stay dovish for some time, while NZ yields still offer a relatively attractive yield, unlike deeply overbought Treasuries and Bunds (Chart 9D). Chart 9DStill A Bullish Case For New Zealand Government Bonds Still A Bullish Case For New Zealand Government Bonds Still A Bullish Case For New Zealand Government Bonds Riksbank Monitor: Watching And Waiting Our Riksbank Monitor remains very slightly below zero and the market is currently priced for -4bps of rate cuts over the next year (Chart 10A). The Riksbank has decided to hold the Repo Rate constant at -0.25% while forecasting a hike towards the end of this year or the beginning of 2020. Given the policy environment, rate cuts remain unlikely. At most, the Riksbank can further delay rate hikes if the data continues to disappoint. The Riksbank noted in its September Monetary Policy Report that the unexpectedly weak development of the labor market indicates that resource utilization will normalize sooner than expected. This is reflected in Chart 10B, where the unemployment gap is now negative. Meanwhile, inflation readings are giving a mixed signal for the central bank. While the headline CPI measure has declined precipitously year-to-date, owing to the dramatic fall in oil prices, core inflation has continued to climb steadily. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BMixed Messages From Swedish Inflation Mixed Messages From Swedish Inflation Mixed Messages From Swedish Inflation As a result, the inflation components of our Riksbank monitor - driven by a spike in the Citigroup Inflation Surprise Index, wage growth hooking upward and inflation expectations holding firm around 2% - are signaling the need for tighter monetary policy (Chart 10C). However, the growth components – led by weak exports, employment, and manufacturing data - are exerting pressure in the opposite direction. This is evident in the Swedish Manufacturing PMI, which tumbled from 51.8 to 46.3 in September, deep into contractionary territory. Chart 10CThere Is A Reason Why The Riksbank Has Been On Hold There Is A Reason Why The Riksbank Has Been On Hold There Is A Reason Why The Riksbank Has Been On Hold Keeping in mind the inflation constraint, it remains unlikely that the Riksbank will cut rates unless the economic data disappoints more significantly to the downside. This should help put a floor under Swedish bond yields in the near term (Chart 10D). Chart 10DSwedish Yields Have Fallen Too Far, Too Fast Swedish Yields Have Fallen Too Far, Too Fast Swedish Yields Have Fallen Too Far, Too Fast Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com   Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes * NOTE: All information in this report reflects our knowledge of global events as of Thursday, October 10. 1 Please see BCA Global Fixed Income Strategy Special Report “United Kingdom: Cyclical Slowdown Or Structural Malaise?” dated September 20, 2019, available at gfis.bcaresearch.com. 2https://www.bankofcanada.ca/2019/06/business-outlook-survey-summer-2019/ 3 Please see BCA Global Fixed Income Weekly Report, “Reconcilable Differences” dated May 8, 2019, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index BCA Central Bank Monitor Chartbook: Intensifying Pressure To Ease BCA Central Bank Monitor Chartbook: Intensifying Pressure To Ease Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Q3/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark by -30bps during the third quarter of the year. Winners & Losers: The biggest underperformance came from underweight positions in U.S. Treasuries (-28bps) and Italian government bonds (-18bps) as yields plunged, dwarfing gains from overweights in corporate bonds in the U.S. (+11bps) and euro area (+4bps). Scenario Analysis For The Next Six Months: We are maintaining our current positioning, staying below-benchmark on duration while overweighting U.S. and euro area corporates vs. government debt. In our base case scenario, global growth will begin to stabilize but the Fed will deliver one more “insurance” rate cut by year-end, leading to corporate bond outperformance. Feature Global bond markets have enjoyed a powerful bull run throughout 2019, as yields have plummeted alongside weakening global growth and growing political uncertainty. Those two forces came to a head in the third quarter of the year, with U.S.-China trade tensions ratcheting up another notch after the imposition of higher U.S. tariffs in early August and global manufacturing PMI data moving into contraction territory – especially in the U.S. The result was a significant fall in government bond yields as markets discounted both lower inflation expectations and more aggressive monetary easing from global central banks, led by the Fed and ECB. The benchmark 10-year U.S. Treasury yield and 10-year German Bund yield plunged -40bps and -25bps, respectively, during the July-September period. Yet at the same time, global credit markets remained surprisingly stable, as the option-adjusted spread on the Bloomberg Barclays Global Corporates index was unchanged over the same three months. In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful third quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2019 Model Portfolio Performance Breakdown: Good News On Credit Trumped By Bad News On Duration Chart of the WeekDuration Losses Dwarf Credit Gains In Q3/19 Duration Losses Dwarf Credit Gains In Q3/19 Duration Losses Dwarf Credit Gains In Q3/19 The total return for the GFIS model portfolio (hedged into U.S. dollars) in the third quarter was 2.0%, lagging the custom benchmark index by -30 bps (Chart of the Week).1 This brings the cumulative year-to-date total return of the portfolio to +7.8%, which has underperformed the benchmark by a disappointing –67bps. The Q3 drag on relative returns came entirely from the government bond side of the portfolio; specifically, the underweight allocation to U.S. Treasuries and Italian government bonds (Table 1). Those allocations reflected our views on overall portfolio duration (below benchmark) and a relative value consideration within European spread product (preferring corporates to Italy). Both those recommendations went against us as global bond yields dropped during Q3, with Italian yields collapsing (the benchmark 10-year yield was down –126bps) as investors chased any positive yield denominated in euros after the ECB signaled a new round of policy easing. The total return for the GFIS model portfolio (hedged into U.S. dollars) in the third quarter was 2.0%, lagging the custom benchmark index by -30 bps  Table 1GFIS Model Bond Portfolio Q3/2019 Overall Return Attribution Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Providing some partial offset to the U.S. and Italy allocations were gains from overweight positions in government bonds in the U.K., Australia and Japan. More importantly, our overweights in corporate debt in the U.S. and euro area made a strong positive contribution to the performance of the portfolio. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The most significant movers were: Chart 2GFIS Model Bond Portfolio Q3/2019 Government Bond Performance Attribution Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Chart 3GFIS Model Bond Portfolio Q3/2019 Spread Product Performance Attribution By Sector Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Biggest outperformers Overweight U.S. high-yield Ba-rated (+4bps) Overweight U.S. high-yield B-rated (+3bps) Overweight U.S. investment grade industrials (+3bps) Overweight Japanese government bonds with maturity of 5-7 years (+2bps) Overweight euro area corporates, both investment grade (+2bps) and high-yield (+2bps) Biggest underperformers Underweight U.S. government bonds with maturity beyond 10+ years (-15bps) Underweight Italy government bonds with maturity beyond 10+ years (-10bps) Underweight U.S. government bonds with maturity of 7-10 years (-5bps) Underweight Japanese government bonds with maturity beyond 10+ years (-4bps) Underweight U.S. government bonds with maturity of 3-5 years (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q3/2019 (red for underweight, blue for overweight, gray for neutral).2 Ideally, we would look to see more blue bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The Model Bond Portfolio In Q3/2019 Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence One thing that stands out from Chart 4 is that every fixed income sector generated a positive return, except for EM USD-denominated corporates. This is a fascinating outcome given the sharp falls in risk-free government bond yields which typically would correlate to a selloff in risk assets and widening of credit spreads. The soothing balm of looser global monetary policy seems to have offset the impact of elevated uncertainty on trade and future economic growth, allowing both bond yields and credit spreads to stay low. The soothing balm of looser global monetary policy seems to have offset the impact of elevated uncertainty on trade and future economic growth, allowing both bond yields and credit spreads to stay low.  We maintained an overweight stance on global spread product throughout Q3, as we felt that the monetary policy effect would continue to overwhelm uncertainty. We did, however, make some tactical adjustments to our duration stance after the U.S. raised tariffs on Chinese imports, upgrading to neutral on August 6th.3 We had felt that higher tariffs were a sign that a potential end to the U.S.-China trade conflict was now even less likely, which raised the odds of a potential risk-off financial market event that would temporarily push bond yields lower. We shifted back to a below-benchmark duration stance on September 17th, given signs of de-escalation in the trade dispute and, more importantly, some improvement evident in global leading economic indicators.4 Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index during the third quarter of the year, with the drag on performance from an underweight stance on U.S. Treasuries and Italian BTPs overwhelming the gains from corporate credit overweights in the U.S. and euro area. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will continue to be driven by two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt versus government bonds. Chart 5Overall Portfolio Allocation: Overweight Credit Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence In terms of the specific high-level weightings in the model portfolio, we currently have a moderate overweight, equal to eight percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on future global growth. Early leading economic indicators are starting to bottom out and global central bankers are maintaining a dovish policy bias despite low unemployment rates – both factors that will continue to benefit growth-sensitive assets like corporate debt. Early leading economic indicators are starting to bottom out and global central bankers are maintaining a dovish policy bias despite low unemployment rates – both factors that will continue to benefit growth-sensitive assets like corporate debt. We are maintaining our below-benchmark duration tilt at 0.6 years short of the custom benchmark (Chart 6). We recognize, however, that the underperformance from duration in the model portfolio will not begin to be clawed back until there are signs of a bottoming in widely-followed cyclical economic indicators like the U.S. ISM index and the German ZEW. We think that will happen given the uptick in our global leading economic indicator (LEI), but that may take a few more months to develop based on the usual lead time from the LEI to the survey data like the ISM. The hook up in the global LEI does still gives us more confidence that the big decline in global bond yields seen this year is over, especially if a potential truce in the U.S.-China trade war is soon reached, as our political strategists believe to be increasingly likely. Chart 6Overall Portfolio Duration: Moderately Below Benchmark Overall Portfolio Duration: Moderately Below Benchmark Overall Portfolio Duration: Moderately Below Benchmark Turning to country allocation, we are sticking with overweights in countries where central banks are likely to be more dovish than the Fed over the next 6-12 months (Germany, France, the U.K., Japan, and Australia). We are staying underweight the U.S. where inflation expectations appear too low and Fed rate cut expectations look too extreme. The Italy underweight has become a trickier call. We have long viewed Italian debt as a growth-sensitive credit instrument rather than the yield-driven rates vehicle it became in Q3 as markets priced in fresh monetary easing measures from the ECB (including restarting government purchases). We will revisit our Italy views in an upcoming report but, until then, we will continue to view Italian BTPs within the context of our European spread product allocation. Thus, we are maintaining an overweight on euro area corporate debt (by 1% each in investment grade and high-yield) while having an equal-sized underweight (-2%) in Italian government bonds. Our combined positioning generates a portfolio that has “positive carry”, with a yield of 3.1% (hedged into U.S. dollars) that is +25bps over that of the custom benchmark index (Chart 7). That same portfolio, however, generates an estimated tracking error (excess volatility of the portfolio versus its benchmark) of 55bps - well below our self-imposed 100bps ceiling and still within the 40-60bps range we have targeted since the start of 2019 (Chart 8). Chart 7Portfolio Yield: Positive Carry From Credit Portfolio Yield: Positive Carry From Credit Portfolio Yield: Positive Carry From Credit Chart 8Portfolio Risk Budget Usage: Cautious Portfolio Risk Budget Usage: Cautious Portfolio Risk Budget Usage: Cautious Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.5 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Table 2BEstimated Government Bond Yield Betas To U.S. Treasuries Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, all revolve around our expectation that the most important drivers of future market returns will continue to be the momentum of global growth and the path of U.S. monetary policy. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are shown visually in Chart 9. Table 3AScenario Analysis For The GFIS Model Bond Portfolio For The Next Six Months Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Table 3BU.S. Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Chart 9Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Base Case (Global Growth Bottoms): The Fed delivers one more -25bp rate cut by the end of 2019, the U.S. dollar weakens by -3%, oil prices rise by +10%, the VIX hovers around 15, and there is a bear-steepening of the UST curve. This is a scenario where the U.S. economy ends up avoiding recession and grows at roughly a trend-like pace. The Fed, however, still delivers one more “insurance” rate cut to mitigate the risk of low inflation expectations becoming more entrenched. Global growth is expected to bottom out as heralded by the global leading indicators. A truce (but not a full deal) is expected on the U.S.-China trade front, helping to moderately soften the U.S. dollar through reduced risk aversion. The model bond portfolio is expected to beat the benchmark index by +91bps in this case. Global Growth Strongly Rebounds: The Fed stays on hold, the U.S. dollar weakens by -5%, oil prices rise by +20%, the VIX declines to 12, there is a modest bear-steepening of the UST curve. In this tail-risk scenario, global growth starts to reaccelerate in lagged response to the global monetary easing seen this year, combined with some fiscal stimulus in major countries (China, the U.S., perhaps even Germany). The U.S. dollar weakens as global capital flows shift to markets which are more sensitive to global growth. The model bond portfolio is expected to beat the benchmark index by +106bps in this case. U.S. Downturn Intensifies: The Fed cuts rates by -75bps, the U.S. dollar is flat, oil prices fall by -15%, the VIX rises to 30; there is a bull-steepening of the UST curve. Under this tail-risk scenario, the current slowing of U.S. growth momentum gains speed, pushing the economy towards recession. The Fed cuts rates aggressively in response, helping weaken the U.S. dollar, but not before global risk assets sell off sharply to discount a worldwide recession. The model portfolio will underperform the benchmark by -38bps in this scenario. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. The underweight duration position, however, will also eventually begin to pay off if the message from the budding improvement in global leading economic indicators turns out to be correct. A collapse of the U.S.-China trade negotiations is the biggest threat to our base case, which would make the “U.S. Downturn Intensifies” scenario a more likely outcome. Bottom Line: We are maintaining our current positioning, staying below-benchmark on duration while overweighting U.S. and euro area corporates governments. In our base case scenario, global growth will begin to stabilize but the Fed will deliver one more “insurance” rate cut by year-end, leading to spread product outperformance.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Note that sectors where we made changes to our recommended weightings during Q3/2019 will have multiple colors in the respective bars in Chart 4. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “The World Is Not Ending: Return To Below-Benchmark Portfolio Duration”, dated September 17, 2019, available at gfis.bcaresearch.com. 5 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Q3/2019 GFIS Model Bond Portfolio Performance Review: More Duration/Credit Divergence Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Contagion? Contagion? Contagion? Until last week, global growth weakness had been wholly confined to the manufacturing sector. But the drop to 52.6 in September’s Non-Manufacturing PMI (from 56.4 in August) raises the specter of contagion from manufacturing into the broader U.S. economy. A further drop would be consistent with an economy headed toward recession, and run contrary to the 2015/16 roadmap that has been our base case (Chart 1). We think it is still premature to abandon the 2015/16 episode as an appropriate comparable for the current period. For one thing, the hard economic data paint a rosier picture than the PMI surveys. Industrial production and core durable goods new orders are up 2.5% and 2.3% (annualized), respectively, during the past 3 months. These data have helped drive the economic surprise index above zero, an event that usually coincides with rising yields (bottom panel). The divergence between soft and hard data makes it clear that trade uncertainties are so far having a greater impact on business sentiment than on actual production, but history tells us that these divergences don’t last long. Some positive news on the trade front will be required during the next few months to raise business sentiment and push bond yields higher. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 42 basis points in September, before giving back 37 bps in the first week of October. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions, and (iii) valuation. At present, the chief conundrum for investors is that while corporate balance sheet health is weak, the monetary environment is extraordinarily accommodative.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still very low, the Fed can maintain its “easy money” policy for some time yet. This will ensure that interest coverage stays solid and that bank lending standards continue to ease (bottom panel). This is an environment where corporate bond spreads should tighten. How low can spreads go? Our assessment of reasonable spread targets for the current environment suggests that Aaa, Aa and A-rated spreads are already fully valued, while Baa-rated spreads are 13 bps cheap (panels 2 & 3).2 We recommend focusing investment grade corporate bond exposure on the Baa credit tier, and subbing some Agency MBS into your portfolio in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Crunch Time Crunch Time Table 3BCorporate Sector Risk Vs. Reward* Crunch Time Crunch Time High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in September, before giving back 117 bps in the first week of October. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 171 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, before giving back 25 bps in the first week of October. MBS have underperformed Treasuries by 31 bps, year-to-date. The conventional 30-year zero volatility spread held flat at 82 bps in September, as a 3 bps increase in expected prepayment losses (option cost) was offset by a 3 bps tightening in the option-adjusted spread (OAS). In last week’s report, we recommended favoring Agency MBS over Aaa, Aa and A-rated corporate bonds.6 We have three main reasons for this recommendation. First, expected compensation is competitive. The conventional 30-year MBS OAS is now 57 bps. This is above the pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. Aaa, Aa and A-rated corporate bond spreads also all look expensive relative to our targets. Second, risk-adjusted compensation heavily favors MBS. The 12-month breakeven spread for a conventional 30-year MBS is 21 bps. This compares to 6 bps, 8 bps and 12 bps for Aaa, Aa and A-rated corporates, respectively. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgage. This burnout will keep refi activity low, and MBS spreads tight (panel 2), going forward. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +163 bps. September returns were concentrated in the Foreign Agency sub-sector. These securities outperformed the Treasury benchmark by 55 bps on the month, bringing year-to-date excess returns up to +197 bps. Sovereign bonds underperformed duration-equivalent Treasuries by 6 bps in September, dragging year-to-date excess returns down to +436 bps. Local Authority and Domestic Agency debt underperformed by 1 bp and 2 bps on the month, respectively. Meanwhile, Supranationals bested the Treasury benchmark by a single basis point. Sovereign debt remains very expensive relative to equivalently-rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would also perform well in such an environment. Given the much more attractive starting point for U.S. corporate bond spreads, we find it difficult to recommend sovereign debt as an alternative. While sovereign debt in general looks expensive. USD-denominated Mexican sovereign bonds continue to look attractive relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 10 basis points in September, dragging year-to-date excess returns down to -57 bps (before adjusting for the tax advantage). We recommended upgrading municipal bonds from neutral to overweight in last week’s report.7  We based the decision on the increasing attractiveness of yield ratios, despite an underlying credit environment that remains supportive for munis. Municipal bond yields failed to keep pace with falling Treasury yields in recent months, and now look quite attractive as a result (Chart 6). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 4% in September and is now back above 90%. This is well above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. In fact, Aaa M/T yield ratios for every maturity are now above average pre-crisis levels. Though yield ratios still look best at the long-end of the Aaa curve (panel 2), we now recommend owning munis in place of Treasuries across the entire maturity spectrum. Fundamentally, state & local government balance sheets remain solid. We showed in last week’s report that our Municipal Health Monitor is in “improving health” territory, and noted that state & local government interest coverage is positive (bottom panel). Both of those trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in September, and then bull-steepened sharply last week. All in all, the 2/10 Treasury slope is +12 bps, 12 bps steeper than it was at the end of August. The 5/30 slope is +67 bps, 10 bps steeper than at the end of August. Our fair value models (see Appendix B) continue to show that bullets are expensive relative to barbells across the entire Treasury curve. In particular, 5-year and 7-year maturities look very expensive compared to the short and long ends of the curve. Notice that the 2/5/10 butterfly spread, the spread between the 5-year bullet and a duration-matched 2/10 barbell, remains negative despite the recent 2/10 steepening (Chart 7). We have shown in prior research that the 5-year and 7-year maturities are the most highly correlated with our 12-month Fed Funds Discounter. Our discounter is currently at -74 bps, meaning that the market is priced for nearly three more Fed rate cuts during the next 12 months (top panel). We expect fewer cuts than that, and as such, think the Discounter is more likely to rise. 5-year and 7-year maturities would underperform the rest of the curve in that scenario. We also continue to hold our short position in the February 2020 fed funds futures contract. That contract is currently priced for 2 more rate cuts during the next 3 FOMC meetings. That outcome is possible, but our base case economic outlook is more consistent with 1 further cut, likely occurring this month. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 38 basis points in September, dragging year-to-date excess returns down to -142 bps. The 10-year TIPS breakeven inflation rate fell 3 bps in September, and then another 2 bps last week. It currently sits at 1.51%, well below levels consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low, nowhere near the 2.3% - 2.5% range that is consistent with the Fed’s target. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.8 That being said, the 10-year TIPS breakeven inflation rate is currently 43 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and we maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in September, dragging year-to-date excess returns down to +72 bps. The index option-adjusted spread for Aaa-rated ABS widened 2 bps on the month. It currently sits at 36 bps, very close to its minimum pre-crisis level (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries on a 12-month horizon. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in September, bringing year-to-date excess returns up to +227 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS held flat on the month, before widening 4 bps last week. It currently sits at 75 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 2 basis points in September, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread held flat on the month, before widening by 5 bps last week. It currently sits at 61 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 74 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Crunch Time Crunch Time Crunch Time Crunch Time Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of October 4, 2019) Crunch Time Crunch Time Table 5Butterfly Strategy Valuation: Standardized Residuals (As of October 4, 2019) Crunch Time Crunch Time Table 6 Crunch Time Crunch Time Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12Excess Return Bond Map (As Of October 4, 2019) Crunch Time Crunch Time Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights MARKET FORECASTS Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Investment Strategy: Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. We think both preconditions will be realized. Until then, risk assets could come under pressure. Global Asset Allocation: Investors should overweight stocks relative to bonds over a 12-month horizon, but maintain higher-than-normal cash positions in the near term as a hedge against downside risks. Equities: EM and European stocks will outperform once global growth bottoms out. Cyclical sectors, including financials, will also start to outperform defensives when the growth cycle turns. Bonds: Central banks will remain dovish, but yields will nevertheless rise modestly on the back of stronger global growth. Favor high-yield corporate credit over government bonds. Currencies: As a countercyclical currency, the U.S. dollar should peak later this year. Commodities: Oil and industrial metals prices will move higher. Gold prices have entered a holding pattern, but should shine again late next year or in 2021 when inflation finally breaks out. Feature Dear Client, In lieu of this report, I hosted a webcast on Monday, October 7th at 10:00 AM EDT, where I discussed the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist   I. Global Macro Outlook A Testing Phase For The Global Economy The global economy has reached a critical juncture. Growth has been slowing since early 2018, reaching what many would regard as “stall speed.” This is the point where economic weakness begins to feed on itself, potentially triggering a recession. Will the growth slowdown worsen? Our guess is that it won’t. Global financial conditions have eased significantly over the past four months, thanks in part to the dovish pivot by most central banks. Looser financial conditions usually bode well for global growth (Chart 1). Our global leading indicator has hooked up, mainly due to a marginal improvement in emerging markets’ data (Chart 2). Chart 1Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Chart 2Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows     An important question is whether the weakness in the manufacturing sector will spread to the much larger services sector. There is some evidence that this is happening, with yesterday’s weaker-than-expected ISM non-manufacturing release being the latest example. Nevertheless, the deceleration in service sector activity has been limited so far (Chart 3). Even in Germany, with its large manufacturing base, the service sector PMI remains in expansionary territory. This is a key difference with the 2001/02 and 2008/09 periods, when service sector activity collapsed in lockstep with manufacturing activity. Chart 3AThe Service Sector Has Softened Less Than Manufacturing (I) The Service Sector Has Softened Less Than Manufacturing (I) The Service Sector Has Softened Less Than Manufacturing (I) Chart 3BThe Service Sector Has Softened Less Than Manufacturing (II) The Service Sector Has Softened Less Than Manufacturing (II) The Service Sector Has Softened Less Than Manufacturing (II) The Drive-By Slowdown If one were to ask most investors the reasons behind the manufacturing slowdown, they would probably cite the trade war or the Chinese deleveraging campaign. These are both valid reasons, but there is a less well-known culprit: autos. According to WardsAuto, global auto sales fell by over 5% in the first half of the year, by far the biggest decline since the Great Recession (Chart 4). Production dropped by even more. Chart 4Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Chart 5U.S. Auto Demand Is Recovering U.S. Auto Demand Is Recovering U.S. Auto Demand Is Recovering   The weakness in the global auto sector reflects a variety of factors. New stringent emission requirements, expiring tax breaks, lagged effects from tighter auto loan lending standards, and trade tensions have all played a role. In addition, the decline in gasoline prices in 2015/16 probably brought forward some automobile purchases. This suggests that the 2015/16 global manufacturing downturn may have helped sow the seeds for the current one. The fact that automobile output is falling faster than sales is encouraging because it means that excess inventories are being worked off. U.S. auto loan lending standards have started to normalize, with banks reporting stronger demand for auto loans in the latest Senior Loan Officer Survey (Chart 5). In China, auto sales have troughed after having declined by as much as 14% earlier this year (Chart 6). The Chinese automobile ownership rate is a fifth of what it is in the U.S., a quarter of what it is in Japan, and a third of what it is in Korea (Chart 7). Given the low starting point, Chinese auto sales are likely to resume their secular uptrend. Chart 6Auto Sector In China Is Finding A Floor Auto Sector In China Is Finding A Floor Auto Sector In China Is Finding A Floor Chart 7China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright   The Trade War: Tracking Towards A Détente? Chart 8A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Manufacturing cycles typically last about three years – 18 months of slowing growth followed by 18 months of rising growth (Chart 8). To the extent that the global manufacturing PMI peaked in the first half of 2018, we should be nearing the end of the current downturn. Of course, much depends on policy developments. As we go to press, high-level negotiations between the U.S. and China have resumed. While it is impossible to predict the outcome of these talks, it does appear that both sides have an incentive to de-escalate the trade conflict. President Trump gets much better marks from voters on his management of the economy than on anything else, including his handling of trade negotiations with China (Chart 9). A protracted trade war would hurt U.S. growth, while weakening the stock market. Both would undermine Trump’s re-election prospects. Chart 9Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 10Who Will Win The 2020 Democratic Nomination? Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market China also wants to bolster growth. As difficult as it has been for the Chinese leadership to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would especially be the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more pliant to deal with on trade matters. Does the Chinese government really want to negotiate over environmental standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 10)? The Democrats’ initiative to impeach President Trump make a trade resolution somewhat more likely. First, it brings attention to Joe Biden’s (and his son’s) own dubious dealings in Ukraine, thus delivering a blow to China’s preferred U.S. presidential candidate. Second, it makes Trump more inclined to want to put the China spat behind him in order to focus his energies on domestic matters. More Chinese Stimulus? Strategically, China has a strong incentive to stimulate its economy in order to prop up growth and gain greater leverage in the trade negotiations. The Chinese credit impulse bottomed in late 2018. The impulse leads Chinese nominal manufacturing output and most other activity indicators by about nine months (Chart 11). So far, the magnitude of China’s credit/fiscal easing has come nowhere close to matching the stimulus that was unleashed on the economy both in 2015/16 and 2008/09. This is partly because the authorities are more worried about excessive debt levels today than they were back then, but it is also because the economy is in better shape. The shock from the trade war has not been nearly as bad as the Great Recession – recall that Chinese exports to the U.S. are only 2.7% of GDP in value-added terms. Unlike in 2015/16, when China lost over $1 trillion in external reserves, capital outflows have remained muted this time around (Chart 12). Chart 11Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chart 12China: No Major Capital Outflows China: No Major Capital Outflows China: No Major Capital Outflows Better-than-expected Chinese PMI data released earlier this week offers a glimmer of hope. Nevertheless, in light of the disappointing August activity numbers, China is likely to increase the pace of stimulus in the coming months. The authorities have already reduced bank reserve requirements. We expect them to cut policy rates further in the coming months. They will also front-load local government bond issuance, which should help boost infrastructure spending. European Growth Should Improve A pickup in global growth will help Europe later this year. Germany, with its trade-dependent economy, will benefit the most. Chart 13Spreads Have Come In Across Southern Europe Spreads Have Come In Across Southern Europe Spreads Have Come In Across Southern Europe Chart 14Faster Money Growth Bodes Well For GDP Growth In The Euro Area Faster Money Growth Bodes Well For GDP Growth In The Euro Area Faster Money Growth Bodes Well For GDP Growth In The Euro Area Falling sovereign spreads should also support Southern Europe (Chart 13). The Italian 10-year spread with German bunds has narrowed by almost a full percentage point since mid-August, taking the Italian 10-year yield down to 0.83%. Greek 10-year bonds are now yielding less than U.S. Treasurys (the Greek manufacturing PMI is currently the strongest in the world). With the ECB back in the market buying sovereign and corporate debt, borrowing rates should remain low. Euro area money growth, which leads GDP growth, has already picked up (Chart 14). Bank lending to the private sector should continue to accelerate. A modest serving of fiscal stimulus will also help. The European Commission estimates that the fiscal thrust in the euro area will increase by 0.5% of GDP in 2019 (Chart 15). Assuming, conservatively, a fiscal multiplier of one, this would boost euro area growth by half a percentage point. Owing to lags between changes in fiscal policy and their impact on the real economy, most of the gains to GDP growth will occur over the remainder of this year and in 2020. Chart 15Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Chart 17Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Chart 16U.K.: Brexit Uncertainty Is Weighing On Growth U.K.: Brexit Uncertainty Is Weighing On Growth U.K.: Brexit Uncertainty Is Weighing On Growth In the U.K., Brexit uncertainty continues to weigh on growth. U.K. business investment has been especially hard hit (Chart 16). Prime Minister Boris Johnson remains insistent that he will take the U.K. out of the EU with or without a deal at the end of October. We would downplay his bluster. The Supreme Court has already denied his attempt to shutter parliament. The public is having second thoughts about the desirability of Brexit (Chart 17). While we do not have a strong view on the exact plot twists in the Brexit saga, we maintain that the odds of a no-deal Brexit are low. This is good news for U.K. growth and the pound. Japan: Own Goal Recent Japanese data releases have not been encouraging: Machine tool orders declined by 37% year-over-year in August. Exports contracted by over 8%, with imports recording a drop of 12%. The September PMI print exposed further deterioration in manufacturing, with the index falling to 48.9 from 49.3 in August. In addition, industrial production contracted by more than expected in August, falling by 1% month-over-month, and close to 5% year-over-year. The ongoing uncertainty surrounding the U.S.-China trade negotiations, as well as Japan’s own tensions with neighboring South Korea, have also weighed on the Japanese economy. Japanese industrial activity will improve later this year as global growth rebounds. But the government has not helped growth prospects by raising the consumption tax on October 1st. While various offsets will blunt the full effect of the tax hike, it still amounts to unwarranted tightening in fiscal policy. Nominal GDP has barely increased since the early 1990s. What Japan needs are policies that boost nominal income. Such reflationary policies may be the only way to stabilize debt-to-GDP without pushing the economy back into a deflationary spiral.1  The U.S.: Hanging Tough Chart 18U.S. Has A Smaller Share Of Manufacturing Than Most Other Developed Economies Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market The U.S. economy has fared relatively well during the latest global economic downturn, partly because manufacturing represents a smaller share of GDP than in most other economies (Chart 18). According to the Atlanta Fed GDPNow model, real GDP is on track to rise at a trend-like pace of 1.8% in the third quarter (Chart 19). Personal consumption is set to increase by 2.5%, after having grown by 4.6% in the second quarter. Consumer spending should stay robust, supported by rising wage growth. The personal savings rate also remains elevated, which should help cushion households from any adverse shocks (Chart 20).   Chart 19U.S. Growth Has Softened, But Is Still Close To Trend Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Residential investment finally looks as though it is turning the corner. Housing starts, building permits, and home sales have all picked up. Given the tight relationship between mortgage rates and homebuilding, construction activity should accelerate over the next few quarters (Chart 21). Low inventory and vacancy rates, rising household formation, and reasonable affordability all bode well for the housing market (Chart 22). Chart 20The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Chart 21U.S. Housing Will Rebound U.S. Housing Will Rebound U.S. Housing Will Rebound Chart 22U.S. Housing: On A Solid Foundation U.S. Housing: On A Solid Foundation U.S. Housing: On A Solid Foundation Chart 23U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels In contrast to residential investment, business capex continues to be weighed down by the manufacturing recession, a strong dollar, and trade policy uncertainty. Core durable goods orders declined in August. Capex intention surveys have also weakened, although they remain well above recessionary levels (Chart 23). The ISM manufacturing index hit its lowest level since July 2009 in September. The internals of the report were not quite as bad as the headline. The new orders-to-inventories component, which leads the ISM by two months, moved back into positive territory. The weak ISM print also stands in contrast to the more upbeat Markit U.S. manufacturing PMI, which rose to its highest level since April. Statistically, the Markit PMI does a better job of tracking official measures of U.S. manufacturing output, factory orders, and employment than the ISM. Taking everything together, the U.S. economy is likely to see modestly stronger growth later this year, as the global manufacturing recession comes to an end, while strong consumer spending and an improving housing market bolster domestic demand. II. Financial Markets Global Asset Allocation Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. As such, investors should maintain larger-than-normal cash positions for the time being to guard against downside risks. Chart 24Stocks Will Outperform Bonds If Growth Recovers Stocks Will Outperform Bonds If Growth Recovers Stocks Will Outperform Bonds If Growth Recovers Fortunately, any pullback in risk asset prices is likely to be temporary. If trade tensions subside and global growth rebounds later this year, as we expect, stocks and spread product should handily outperform government bonds over a 12-month horizon (Chart 24). Admittedly, there are plenty of things that could upend this sanguine 12-month recommendation: Global growth could continue to deteriorate; the trade war could intensify; supply-side shocks could cause oil prices to spike up again; the U.K. could end up leaving the EU in a “hard Brexit” scenario; and last but not least, Elizabeth Warren or some other far-left candidate could end up becoming the next U.S. president. The key question for investors today is whether these risks have been fully discounted in financial markets. We think they have. Chart 25 shows our estimates for the global equity risk premium (ERP), calculated as the difference between the earnings yield and the real bond yield. Our calculations suggest that stocks still look quite cheap compared to bonds. Chart 25AEquity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Chart 25BEquity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) One might protest that the ERP is high only because today’s ultra-low bond yields are reflecting very poor growth prospects. There is some truth to that claim, but not as much as one might think. While trend GDP growth has fallen in the U.S. over the past decade, bond yields have declined by even more. The gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is close to two percentage points, the highest since 1979 (Chart 26). Chart 26Bond Yields Have Fallen More Than Trend Nominal GDP Growth Bond Yields Have Fallen More Than Trend Nominal GDP Growth Bond Yields Have Fallen More Than Trend Nominal GDP Growth At the global level, trend GDP growth has barely changed since 1980, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 27). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure of economic momentum. Gauging Future Equity Returns A high ERP simply says that equities are attractive relative to bonds. To gauge the prospective return to stocks in absolute terms, one should look at the absolute level of valuations. Chart 27The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM chart 27 The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Chart 28S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector As we argued in a recent report entitled “TINA To The Rescue?,”2 the earnings yield can be used as a proxy for the expected real total return on equities. Empirically, the evidence seems to bear this out: Since 1950, the earnings yield on U.S. equities has averaged 6.7%, compared to a real total return of 7.2%. Today, the trailing and forward PE ratio for U.S. stocks stand at 21.1 and 17.4, respectively. Using a simple average of the two as a guide for future returns, U.S. stocks should deliver a long-term real total return of 5.2%. While this is below its historic average, it is still a fairly decent return. One might complain that this calculation overstates prospective equity returns because the U.S. earnings yield is temporarily inflated by abnormally high profit margins. The problem with this argument is that virtually all of the increase in S&P 500 margins has occurred in just one sector: technology. Outside of the tech sector, S&P 500 margins are not far from their historic average (Chart 28). If high IT margins reflect structural changes in the global economy – such as the emergence of “winner take all” companies that benefit from powerful network effects and monopolistic pricing power – they could remain elevated for the foreseeable future.   Regional And Sector Equity Allocation The earnings yield is roughly two percentage points higher outside the U.S., suggesting that non-U.S. stocks will best their U.S. peers over the long haul. In the developed market space, Germany, Spain, and the U.K. appear especially cheap. In the EM realm, China, Korea, and Russia stand out as being very attractively priced (Chart 29). At the sector level, cyclical stocks look more appealing than defensives (Chart 30). Chart 29U.S. Stocks Appear Expensive Compared To Their Peers Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 31Economic Growth Drives Stocks Over A 12-Month Horizon Economic Growth Drives Stocks Over A 12-Month Horizon Economic Growth Drives Stocks Over A 12-Month Horizon Chart 30Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Chart 32EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves Valuations are useful mainly as a guide to long-term returns. Over a horizon of say, 12 months, cyclical factors – i.e., what happens to growth, interest rates, and exchange rates – matter more (Chart 31). Fortunately, our cyclical views generally line up with our valuation assessment. Stronger global growth, a weaker dollar, and rising commodity prices should benefit cyclical stocks relative to defensives. To the extent that EM and European stock markets have more of a cyclical sector skew than U.S. stocks, the former should end up outperforming (Chart 32). We would put financials on our list of sectors to upgrade by year end once global growth begins to reaccelerate. Falling bond yields have hurt bank profits (Chart 33). The drag on net interest margins should recede as yields start rising. European banks, which currently trade at only 7.6 times forward earnings, 0.6 times book value, and sport a hefty dividend yield of 6.3%, could fare particularly well (Chart 34). Chart 33AHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Chart 33BHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) As Chart 35 illustrates, a bet on financials is similar to a bet on value stocks. Growth has trounced value over the past 12 years, but a bit of respite for value is in order over the next 12-to-18 months. Chart 34European Banks Are Attractive European Banks Are Attractive European Banks Are Attractive Chart 35Is Value Turning The Corner? Is Value Turning The Corner? Is Value Turning The Corner?   Fixed Income Chart 36AYields Should Rise On Stronger Growth (I) Yields Should Rise On Stronger Growth (I) Yields Should Rise On Stronger Growth (I) Dovish central banks and, for the time being, still-subdued inflation will help keep government bond yields in check over the next 12 months. Nevertheless, yields will still rise from currently depressed levels on the back of stronger global growth (Chart 36).     Chart 36BYields Should Rise On Stronger Growth (II) Yields Should Rise On Stronger Growth (II) Yields Should Rise On Stronger Growth (II) Bond yields tend to rise or fall depending on whether central banks adjust rates by more or less than is anticipated (Chart 37). Investors currently expect the Fed to cut rates by another 80 basis points over the next 12 months. While we think the Fed will bring down rates by 25 basis points on October 30th, we do not anticipate any further cuts beyond then. The cumulative 75 basis points in cuts during this easing cycle will be equivalent to the amount of easing delivered during the two mid-cycle slowdowns in the 1990s (1995/96 and 1998). All told, the U.S. 10-year Treasury yield is likely to move back into the low 2% range by the middle of 2020. Chart 37AStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Chart 36BStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Chart 38U.S. Government Bond Yields Are More Procyclical Than Yields Abroad U.S. Government Bond Yields Are More Procyclical Than Yields Abroad U.S. Government Bond Yields Are More Procyclical Than Yields Abroad Unlike U.S. equities, which tend to have a low beta compared to stocks abroad, U.S. bonds possess a high beta. This means that U.S. Treasury yields usually rise more than yields abroad when global bond yields, in aggregate, are increasing, and fall more than yields abroad when global bond yields are decreasing (Chart 38).  Moreover, U.S. Treasurys currently yield less than other bond markets once currency-hedging costs are taken into account (Table 1). If U.S. yields were to rise more than those abroad over the next 12-to-18 months, this would further detract from Treasury returns. As a result, investors should underweight Treasurys within a global government bond portfolio. Stronger global growth should keep corporate credit spreads at bay. Lending standards for U.S. commercial and industrial loans have moved back into easing territory, which is usually bullish for corporate credit (Chart 39). According to our U.S. bond strategists, high-yield corporate spreads, and to a lesser extent, Baa-rated investment-grade spreads, are still wider than is justified by the economic fundamentals (Chart 40).3 Better-rated investment-grade bonds, in contrast, offer less relative value. Table 1Bond Markets Across The Developed World Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 39Easier Lending Standards Bode Well For Corporate Credit Easier Lending Standards Bode Well For Corporate Credit Easier Lending Standards Bode Well For Corporate Credit Chart 40U.S. Corporates: Focus On Baa And High-Yield Credit U.S. Corporates: Focus On Baa And High-Yield Credit U.S. Corporates: Focus On Baa And High-Yield Credit     Looking beyond the next 18 months, there is a high probability that inflation will start to move materially higher. The unemployment rate across the G7 has fallen to a multi-decade low (Chart 41). The share of developed economies that have reached full employment has hit a new cycle high (Chart 42). For all the talk about how the Phillips curve is dead, wage growth has remained tightly correlated with labor market slack (Chart 43). Chart 41Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Chart 42Developed Markets: Full Employment Reaching New Cycle Highs Developed Markets: Full Employment Reaching New Cycle Highs Developed Markets: Full Employment Reaching New Cycle Highs Chart 43The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well As wages continue to rise, prices will start to move up, potentially setting off a wage-price spiral. The Fed, and eventually other central banks, will have to start raising rates at that point. Once interest rates move into restrictive territory, equities will fall and credit spreads will widen. A global recession could ensue in 2022. Currencies And Commodities Chart 44The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The U.S. dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). We do not have a strong near-term view on the direction of the dollar at the moment, but expect the greenback to begin to weaken by year end as global growth starts to rebound. EUR/USD should increase to around 1.13 by mid-2020. GBP/USD will rise to 1.29. USD/CNY will move back to 7. USD/JPY is likely to be flat, reflecting the yen’s defensive nature and the drag on Japanese growth from the consumption tax hike. The trade-weighted dollar will continue to depreciate until late-2021, after which time a more aggressive Fed and a slowdown in global growth will cause the dollar to rally anew. During the period in which the dollar is weakening, commodity prices will move higher (Chart 45). Chart 45Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities BCA’s commodity strategists are particularly bullish on oil over a 12-month horizon (Chart 46). They see Brent crude prices rising to $70/bbl by the end of this year and averaging $74/bbl in 2020 based on the expectation that stronger global growth and production discipline will drive down oil inventory levels. OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is currently below its historic average (Chart 47). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 48). Chart 46Supply Deficit To Continue Supply Deficit To Continue Supply Deficit To Continue Chart 47Limited Availability Of Spare Capacity To Offset Outages Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 48Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Higher oil prices should benefit currencies such as the Canadian dollar, Norwegian krone, Russian ruble and Colombian peso. Finally, a few words on gold. We closed our long gold trade on August 29th for a 20-week gain of 20.5%. We still see gold as an excellent long-term hedge against higher inflation. In the near term, however, rising bond yields may take the wind out of gold’s sails, even if a weaker dollar does help bullion at the margin. We will reinitiate our long gold position towards the end of next year or in 2021 once inflation begins to break out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Are High Debt Levels Deflationary Or Inflationary?” dated February 15, 2019. 2Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed,” dated September 17, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Tactical Trades Strategic Recommendations Closed Trades