Gov Sovereigns/Treasurys

Highlights Bond yields have fallen a lot since the beginning of November, … : At the close on November 8th, the 10-year Treasury bond yielded 3.24%. By last Monday, it was yielding just 2.07%. … but the move isn’t terribly anomalous relative to history: In terms of nominal yields, the decline was just over a one-standard-deviation event; per real yields, it amounted to a -0.7 sigma move. The Fed may be preparing for a rate cut, but overweight duration positions will only pay off if several more follow: A one-and-done rate cut would stretch out the expansion and the bull markets in equities and spread product, but Treasuries are priced for an extended rate-cutting cycle. Feature Stocks are said to be the only asset that people want more of when prices rise, and less of when they fall. Lately, bonds have also seemed to have an upward-sloping demand curve, because more and more people have bought them as they’ve gotten more expensive. A BCA client who’s been shaking his head at the action got in touch with us last week to try to make some sense of it all. Experience tells him that big moves like the one that’s been unfolding since last November don’t go on forever. When they stop, mean reversion would suggest that they’re prone to retrace a good bit of territory. He came to us for some historical context to support or contradict his intuition, as summed up in something like the following statement. “Over the past 50 years, the current move equates to an x-standard-deviation event. Following similar instances, rates have risen by x basis points over the next six months, and by y basis points over the next twelve months.” The Empirical Record The sharp decline in the 10-year Treasury yield that began in early November can be viewed as three separate declines (Chart 1). In the first, the 10-year yield fell by 68 basis points (“bps”) over a span of 37 trading days. After retracing a third of the decline over the next 11 sessions, it slid by another 40 bps over 48 days. Following a one-half retracement over the ensuing 13 days, it shed 53 basis points in 32 days, capped off by a 36-bps decline across the final eight sessions (Table 1). Chart 1The Path To 2.07% The Path To 2.07% The Path To 2.07% Table 1A Lower 10-Year Treasury Yield In Three Steps Context Context Using the daily 10-year Treasury yield series beginning in 1962, we compared the individual yield declines for prior 37-, 48- and 32-day periods, as well as for the aggregate 141-day session spanning the entire stretch from the November 8th peak to the June 3rd trough. We also looked at the May 21st to June 3rd crescendo relative to past eight-day segments. The standardized moves range from three-quarters of a standard deviation below the mean for the 48-day middle leg to 1.5 and 1.8 for the 37- and 8-day moves, respectively (Table 2). All in all, the entire move grades out to 1.3 standard deviations below the mean – a somewhat unusual move, but nothing too special. Table 2Standardized Values Of Nominal 10-Year Treasury Yield Declines Context Context The current decline’s relative stature is undermined by the wild volatility of the late ‘70s and early ‘80s, when bond yields and annual inflation reached double-digit levels (Chart 2). To try to place the current episode on a more equal framework, we also calculated standardized moves in real (inflation-adjusted) yields. On a real basis, however, the current moves made even less of a splash. The 8-day decline (z-score = -1.2) was the only component that was more than a standard deviation from the mean, and the overall move amounted to just 0.7 standard deviations below the mean (Chart 3). Chart 2No Historical Anomaly In The Current Market No Historical Anomaly In The Current Market No Historical Anomaly In The Current Market Chart 3Little Impact In Terms Of Real Yields Little Impact In Terms Of Real Yields Little Impact In Terms Of Real Yields We are familiar with the electronic financial media’s increasingly popular convention of stating daily yield moves in proportion to the previous day’s closing yield.1 That convention has the advantage of fitting snugly aside stock price quotes on TV and computer screens, but it is ultimately nonsensical. The proportional change in a bond’s yield relative to its starting yield doesn’t come close to approximating the change in the value of that bond. Comparing proportional changes in bond yields across timeframes would be a way of putting today’s yield moves on a more equal footing with yield moves in the high-inflation, high-coupon era of the late seventies and early eighties, but it conveys no practical information. The margin by which long-maturity Treasuries have outperformed intermediate-maturity Treasuries is unusual, ... Our next steps were instead to compare Treasury total returns and the change in the slope of the yield curve to past flattening and steepening episodes. The moves here were also unavailing over both seven- and one-month periods, as the high-coupon ‘70s and ‘80s still dominated (Chart 4). In terms of the change in the 10-year Treasury yield, both nominal and real; Treasury index total returns; and the slope of the yield curve (3-month rate to 10-year yield), both the aggregate move since last October and its three component moves have amounted to one-standard-deviation events. They would only have had about a one-in-six chance of occurring randomly in a normally distributed population, but they do not represent unsustainable moves that cry out to be reversed. Chart 4Little Impact In Terms Of Treasury Total Returns, ... Little Impact In Terms Of Treasury Total Returns, ... Little Impact In Terms Of Treasury Total Returns, ... Digging a little deeper to consider total returns across different regions of the yield curve, we do find one apparent anomaly at the long end of the curve. The long Treasury index has outperformed the intermediate Treasury index by a two-standard-deviation margin over both a seven-month and a one-month timeframe (Chart 5). On a standalone basis, the long Treasury index has beaten the seven-month mean return by one-and-a-half standard deviations, and the one-month mean return by two standard deviations (Chart 6). The two-standard-deviation results would only be expected to occur one out of forty times, and thereby validate our client’s sense that something has been going on. ... and history suggests they’ll be partially unwound over the next six to twelve months. Chart 5... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... ... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... ... But The Spread Between Long- And Intermediate-Index Returns Is Wide, ... Chart 6... And Long-Maturity Returns Have Been Elevated ... And Long-Maturity Returns Have Been Elevated ... And Long-Maturity Returns Have Been Elevated Moving on to the second part of his inquiry, we reviewed the standalone performance of the long Treasury index, and the relative long-versus-intermediate performance, over subsequent six- and twelve-month periods. We focused our analysis on instances when historical z-scores were greater than or equal to their current levels to try to determine if we should expect current performance to reverse and, if so, how sharply. On a standalone basis, long Treasury index performance has gently reverted to the mean over the subsequent six and twelve months, posting returns over those periods within +/- 0.2 standard deviations of its long-run average (Table 3). Table 3Standardized Values Of Future Long-Maturity Treasury Index Returns Context Context Outlying relative long-versus-intermediate performance like we’ve witnessed over the last seven months has reversed more convincingly. The long Treasury index has underperformed its intermediate-maturity counterpart over six and twelve months when its z-scores were greater than or equal to their current levels over a seven- and one-month basis, falling roughly 0.5 standard deviations below the mean (Table 4). The future does not have to resemble the past, especially over small sample sizes, but relative long-end underperformance would accord with our constructive view of the U.S. economy. It would also be consistent with our anti-duration and pro-inflation biases. Table 4Standardized Values Of Future Difference Between Long- And Intermediate-Maturity Treasury Index Returns Context Context The Fed, Again The consistency of the comments from Fed officials last week would seem to suggest that they are trying to prepare the ground for a rate cut. A cut at next week’s FOMC meeting might be a little too abrupt, but it seems increasingly possible that the committee could guide markets to a cut at the next scheduled meeting at the end of July. Various officials have made it abundantly clear that they view trade tensions as a threat to the economy, and that the bank is prepared to adjust policy, if need be, to sustain the expansion. Uber-dovish St. Louis President Bullard, who said last Monday that, “a downward policy rate adjustment may be warranted soon,” no longer appears to be such an outlier. We do not think a rate cut is necessary, and we would be content to remain on the sidelines if we were on the committee, but our opinion is irrelevant. We endeavor not to be distracted by what we think should happen, devoting our focus instead to determining what’s most likely to happen. To that end, our estimate of the probability that the Fed’s next move might be a cut is rising by the speech/interview. When incorporating that probability into investment strategy, we have been thinking a lot about a question that keeps being raised within BCA: If the Fed cuts rates next week or next month, how will markets respond? Assuming the economic backdrop doesn’t deteriorate, we expect that a rate cut will keep the equity and credit bull markets going. The answer depends heavily on the context in which the Fed cuts, and we assume that if the Fed cuts after the economy has taken a dramatic turn for the worse, risk assets would decline. In that case, markets would presumably read the Fed’s decision as confirmation that things were even worse than they perceived and that a significant bout of risk aversion was right around the corner. On the other hand, if the cut came against a backdrop of decent, if unexciting, economic data, risk assets would likely rally. For an investor who cannot resist injecting his/her opinion into the mix, the market response would be supportive of risk assets if a rate cut was unnecessary, but negative if the economy couldn’t get along without it. Investment Implications We believe that the U.S. economy is doing just fine, thank you, and do not yet see the signs that the expansion requires more monetary accommodation if it is to continue. Assuming that the cast of the incoming data does not change enough to change our view, we would expect that a rate cut would defer the end of the expansion and thereby defer the end of the bull markets in risk assets. We are therefore content to stick with our recommendation that investors should remain at least equal weight equities and spread product. We are still looking for restrictive monetary policy to be the catalyst that ends the expansion, and anything that pushes restrictiveness further into the future ought to keep the market parties going. Our view has aligned with the house view over the last year, but there is no guarantee that it will continue to do so. A growing minority of managing editors has been repeatedly challenging the internal consensus in our daily meetings, and it will be debated vigorously at our monthly view meeting Monday morning in Montreal. It is possible that the house view, and the U.S. Investment Strategy view, could soon become less constructive, though our level of conviction remains fairly high.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 If a bond yielding 3% at Friday’s close ends Monday’s session with a yield of 2.94%, 6 bps lower, its yield is shown as having declined 2% on the day (-.0006/.03 = -2%).

Feature Through the past five years, the global long bond yield has tried to surpass 2.5 percent on three occasions – once in 2015, twice in 2018. But it has failed (Feature Chart). The global long bond yield’s five-year struggle to break through 2.5 percent convinces us that the so-called ‘neutral’ rate of interest is now extremely low, indeed zero in real terms. This is a very high conviction view though, to be clear, not every BCA strategist may necessarily concur. Feature ChartSince 2015, The Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, The Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, The Global Long Bond Yield Has Struggled To Surpass 2.5 Percent The neutral rate of interest is the interest rate at which monetary policy is neither accommodative nor restrictive, the interest rate consistent with the economy maintaining full employment while keeping inflation constant. That much is generally accepted. Here’s where we differ from the conventional thinking: what is setting the neutral rate now is not the economy’s direct sensitivity to the interest rate via rate sensitive sectors such as mortgage lending or home construction: rather, it is the economy’s indirect sensitivity to the interest rate via its impact on equities and other so-called ‘risky’ assets. This Special Report challenges the conventional wisdom on the neutral rate on three specific points: The neutral rate is based on the bond yield, not on the policy interest rate. The neutral rate is global, not European or region specific. The neutral rate is nominal, not real. The Neutral Rate Is Based On The Bond Yield, Not On The Policy Interest Rate Chart I-2 The $400 trillion combined value of equities, corporate bonds, real estate and other risky assets dwarfs the $80 trillion global economy by five to one. These risky assets are long-duration assets, because their cash flows extend into the distant future. Hence, the market calibrates the expected return available on these risky assets from the supposedly less risky return available from long-duration bonds – the bond yield – plus a ‘risk premium’. Now comes the part of the story that is not well understood, even by central bankers, because it derives from recent advances outside their field of expertise. Years of research in behavioural finance conclude that the measure that best encapsulates our perception of an investment’s risk is not its volatility but its negative asymmetry: the potential largest loss as a multiple of the potential largest gain (Chart I-2). The $400 trillion combined value of equities, corporate bonds, real estate and other risky assets dwarfs the $80 trillion global economy by five to one. Crucially, when the bond yield gets low, the proximity of its lower bound dramatically reduces the potential for price gains while leaving open the potential for large losses. This sudden onset of negative asymmetry means that bonds are no longer less risky than equities or other risky assets (Chart I-3). So risky assets no longer need to deliver a higher expected return than bonds (Chart I-4). Chart I-3 Chart I-4 Chart I-5Equities Offer Diversification Benefits Too! Equities Offer Diversification Benefits Too! Equities Offer Diversification Benefits Too! Some people counter that bonds offer investors a diversification benefit and, because of this, investors still need a higher return from equities. This argument is wrong. Just as bonds can protect equity investors, equities can protect bond investors during vicious sell-offs in the bond market – such as after Trump’s shock victory in 2016 (Chart I-5). So we could equally argue that equities require the lower return. In fact, at a low bond yield, with the same negative asymmetry and diversification properties, both equities and bonds must offer the same prospective return.   The upshot is that once the bond yield gets low and stays low, equity (and other risky asset) returns collapse to the feeble return offered by bonds with no additional ‘risk premium’ giving the valuation of $400 trillion of assets an exponential uplift (Chart I-6). The unfortunate corollary is that if the bond yield was no longer low, the valuation of $400 trillion of assets would suffer an exponential decline. And the consequent deterioration in financial conditions would send a chill wind through the global economy. Theoretically and empirically, the hyper-sensitivity of equity valuations to bond yields is greatest when the 10-year bond yield is in the 2-3 percent range. But which 10-year bond yield?1  Chart I-6Equities Are Now Priced To Generate A Feeble Long-Term Return Equities Are Now Priced To Generate A Feeble Long-Term Return Equities Are Now Priced To Generate A Feeble Long-Term Return The Neutral Rate Is Global, Not European Or Region Specific The question: ‘will European equities go up or down?’ is essentially the same as ‘will U.S. equities go up or down?’ or ‘will Chinese equities go up or down?’ albeit the size of the moves can be quite different. The same applies to mainstream bond markets; in directional terms, bonds move together. Chart I-7The Global 10-Year Yield Is The Average Of The Euro Area, U.S., And China The Global 10-Year Yield Is The Average Of The Euro Area, U.S., And China The Global 10-Year Yield Is The Average Of The Euro Area, U.S., And China Given this tight directional integration of global capital markets – and to some extent economies too – asset allocators make the asset class choice between equities and bonds their primary decision, and the regional allocation the subsidiary decision. It follows that the point of hyper-sensitivity of equity valuations, be it in Europe or any other region, is when the global 10-year bond yield is in the 2-3 percent range. What is the global 10-year bond yield? Previously, we defined it in terms of the German bund, U.S. T-bond, and JGB. But we now have an even better definition: it is the simple average of the 10-year yields in the world’s three major economies; the euro area, U.S., and China (Chart I-7).2  Given this yield’s five year struggle to surpass 2.5 percent, we can say that the ‘neutral’ rate, at which tighter financial conditions do not threaten any major economy, might be somewhere below this recent empirical limit, at around 2 percent. The Neutral Rate Is Nominal, Not Real Chart I-8 Investors always think about the negative asymmetry of returns in nominal terms. This is because the losses they fear tend to be too short and too sharp for the real return to be meaningfully different from the nominal return.3 It follows that the aforementioned hyper-sensitivity of equity valuations is when the nominal bond yield is in the 2-3 percent range, resulting in a neutral nominal rate which might be 2 percent (Chart I-8). But if inflation is also running fairly close to 2 percent, as it is in the major economies, the upshot is that the neutral real rate of interest is zero.  What Does All Of This Mean? To sum up, a decade of ultra-loose monetary policy has fostered an addiction to – or at least a dependency on – low bond yields (Chart I-9). But the dependency is not of the rate sensitive sectors in the economy per se, rather it is of the rich valuation of risky assets whose worth dwarfs the global economy by five to one (Chart I-10). Gradually, this dependency should diminish as economic and profit growth improves valuations, but this will take time. Chart I-9A Decade Of Ultra-Loose Monetary Policy... A Decade Of Ultra-Loose Monetary Policy... A Decade Of Ultra-Loose Monetary Policy... Chart I-10...Has Made The Rich Valuation Of Risky Assets Dependent On Low Bond Yields ...Has Made The Rich Valuation Of Risky Assets Dependent On Low Bond Yields ...Has Made The Rich Valuation Of Risky Assets Dependent On Low Bond Yields In the meantime, the integration of global capital markets means that the valuation cue for European – and all regional – stock markets now comes from the global 10-year bond yield. Given its recent decline to slightly below neutral, stock markets are unlikely to free fall. A decade of ultra-loose monetary policy has fostered an addiction to – or at least a dependency on – low bond yields. That said, the aggregate market is likely to be in a sideways structural pattern, as it has been for the past eighteen months, and the big opportunities will continue to come from sector rotation: in the second half of the year switch out of economically sensitives such as industrials, and into defensives such as healthcare. A final point is that any decline in the global bond yield to below neutral will come disproportionately from higher yielding bond markets. This will underpin the lower yielding major currencies such as the euro. But our first choice for the second half of the year remains the Japanese yen. Fractal Trading System* This week, we see an excellent opportunity to short Russia’s recent strong outperformance versus Japan. The recommended trade is short MOEX versus Nikkei225 with a profit target of 5 percent and symmetrical stop-loss. In other trades, short WTI crude versus LMEX achieved its profit target. Against this, short the French OAT reached its stop-loss. This leaves three 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 Russia (MOEX) VS. Japan (NIKKEI225) Russia (MOEX) VS. Japan (NIKKEI225) 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 Consider what happens to valuations when bond yields decline from 4% to 2%. At a 4% bond yield, equities possess significantly more negative asymmetry than 10-year bonds. So investors will demand a comparatively higher return from equities, let’s say 8% a year. Whereas, at a 2% bond yield, equities and 10-year bonds possess the same negative asymmetry. So investors will demand the same return from equities as they can get from bonds, 2% a year. At the lower bond yield, the bond must deliver 2% a year less for ten years compared to previously, meaning its price must rise by 22%. But equities must deliver 6% a year less for ten years, so the equity market must surge by 80%. 2 We define the global 10-year bond yield as the simple average of the three 10-year bond yields in the euro area, U.S., and China, where the 10-year bond yield in the euro area is the issue-weighted average of the euro area’s individual 10-year bond yields. 3 For example, if bonds had a countertrend correction of 10% in a month when the economy was suffering severe deflation of 10% (per annum), it would still equate to a 9% loss in real terms! Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - ##br##Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch -##br## Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - ##br##Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The May official PMI shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. The divergence between H-shares and both A-shares and the domestic fixed-income market suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, April’s activity data provided early evidence that the trajectory of the economy was beginning to turn prior to the breakdown in U.S./China trade talks, in response to a meaningful credit improvement in Q1. The May Caixin manufacturing PMI was stable, but the official PMI fell and the experience of last year clearly shows that manufacturing in China will slow over the coming year unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Assuming that the Trump administration follows through with its threat, investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Within financial markets, the most notable development is the contrast between the relative performance of investable Chinese stocks on the one hand, and domestic equities and the Chinese fixed-income market on the other. The recent performance of investable stocks confirms that they have been driven nearly exclusively by trade war developments for the better part of the past year, whereas the somewhat better relative performance of A-shares and the calm in the government bond, corporate bond, and sovereign CDS markets suggests that China’s domestic financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. We agree that such a response will occur over the coming 6-12 months, and would recommend that investors stay overweight Chinese equities within a global equity portfolio over that time horizon. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock A Strong Response From Policymakers Will Likely Offset The Coming Tariff Shock Both Bloomberg’s and our alternative calculation of the Li Keqiang index (LKI) rose in April, albeit only fractionally in the case of the latter. Still, as we noted in last week’s report,1 the Q1 rebound in credit appears to have halted the decline in investment-relevant Chinese economic activity (Chart 1). This suggests that the trajectory of the economy was beginning to change in April prior to the breakdown in U.S./China trade talks, implying that an aggressively stimulative response from Chinese authorities to counter a full 25% tariff scenario has good odds of succeeding. This supports our cyclically overweight stance towards Chinese stocks. Our leading indicator for the LKI declined slightly in April, but remains in a very modest uptrend. The gap between accelerating credit growth and the sluggishness of our leading indicator is explained by the fact that growth in Chinese M2 and M3 has been slow to rise. A weaker-than-expected recovery in Chinese economic activity is much more likely if money growth remains weak, but we cannot reasonably envision an outcome where credit growth continues to trend higher and growth in the money supply does not meaningfully accelerate. The incoming Chinese housing data continues to provide conflicting signals. The annual change of the PBOC’s pledged supplementary lending injections declined further in April, which since 2015 has done an excellent job explaining weak housing demand. However, both floor space started and sold picked up in April (Chart 2), and house price growth remained steady despite a significant decline in the breadth of house price appreciation across 70 cities. Policymakers are likely to allow aggregate credit growth to accelerate significantly over the coming 6-12 months in order to counter the deflationary impact of a trade war with the U.S., but our sense is that policymakers will then refocus their financial stability efforts on the household sector (i.e. they will work to prevent another significant reacceleration in household debt growth). Given this, we continue to expect that housing demand will remain weak, although we will be closely watching floor space sold over the coming few months. The new export orders component of the official manufacturing PMI is signaling an external outlook that is as negative as the 2015/2016 episode. The May official manufacturing PMI fell back into contractionary territory, led by a very significant decline in the new export orders component (Chart 3). The Caixin manufacturing PMI was stable, but the outlook for manufacturing in China is clearly negative unless the recent doubling of U.S. import tariffs can be reversed and the imposition of the remaining tariffs can be avoided. Investors are likely to see a repeat of last year’s perversely positive effects of tariff frontrunning on the Chinese trade data over the next few months; this should be viewed as confirmation of an impending collapse in trade activity, rather than a sign that the underlying trade situation is improving. Chart 2Surprising Resilience In China's Housing Market (For Now) Surprising Resilience In China's Housing Market (For Now) Surprising Resilience In China's Housing Market (For Now) Chart 3A Clearly Negative Outlook For Manufacturing A Clearly Negative Outlook For Manufacturing A Clearly Negative Outlook For Manufacturing There has been a sharp contrast in the behavior of the Chinese investable and domestic equity markets over the past month, which in our view confirms that the former has been driven nearly exclusively by trade war developments for the better part of the past year. Chart 4 shows that the relative performance of investable stocks (versus global) has nearly fallen back to its late-October low, whereas A-shares technically remain in an uptrend despite having sold off. Some investors have attributed the relative support of A-shares to aggressive buying by the “national team”, state-related financial market participants that the government has relied on since 2015 to manage volatility in the domestic equity market. Chart 4Are A-Shares Acting More Rationally Than The Investable Market? Are A-Shares Acting More Rationally Than The Investable Market? Are A-Shares Acting More Rationally Than The Investable Market? However, it is also possible that the A-share market is acting more rationally than the investable market, by focusing on the possibility of a major reflationary response to the Trump tariffs. This contrast in behavior between the investable and domestic markets was also observed pre- and post-February 15th, when the January credit data was released. Prior to this point, the A-share market was (rightly) not confirming the relative uptrend in investable stocks; following February 15th, A-shares exploded higher in response to tangible evidence that a upcycle in credit had arrived. If it is true that the A-share market is better reflecting the prospect of a reflationary response from Chinese policymakers, the relative performance trend for domestic stocks supports our decision to remain cyclically overweight Chinese stocks versus the global benchmark.   Chinese utilities and consumer staples have outperformed in both the investable and domestic equity markets over the past month, which is not surprising given that these sectors typically outperform during risk-off phases. Within the investable market, the sharp underperformance of the BAT (Baidu, Alibaba, and Tencent) stocks has been the most interesting (Chart 5). To the extent that the selloff in BAT stocks reflects trade war retaliation risk (through, for example, delisting from U.S. exchanges), then the selloff is rational. But the fact that Tencent (which also trades in Hong Kong) has also declined so sharply suggests that investors are blanket selling Chinese technology-related stocks out of concern that the sector will be heavily implicated by punitive action from the Trump administration. The BAT stocks are domestically oriented, meaning that “Huawei risk” appears to be minimal. Chart 5A Potential (Future) Opportunity In The BAT Stocks A Potential (Future) Opportunity In The BAT Stocks A Potential (Future) Opportunity In The BAT Stocks Beyond the near-term risk from deteriorating sentiment, the selloff in BAT stocks may present a cyclical opportunity for investors. Unlike Huawei, whose export-oriented business model relied on the U.S. as part of its supply chain, Alibaba and Tencent are largely domestically-driven businesses whose earnings will depend mostly on the outlook for Chinese consumer spending. We agree that reflationary efforts by Chinese policymakers will attempt to avoid stoking a significant acceleration in residential mortgage credit, but it is difficult to envision a scenario in which China stimulates aggressively and consumer spending growth does not accelerate. As such, investors should closely watch the performance of BAT stocks in response to reflationary announcements and developments on the credit front; we would strongly consider an outright long stance favoring BAT stocks if a technical breakout occurs alongside the release of data that is consistent with a significant improvement in the macro outlook. There has been little movement in the Chinese government bond market over the past month, with the Chinese 10-year government bond yield having fallen merely 10 basis points since late-April. This is in contrast to what has occurred in the U.S., with yields on 10-year Treasurys having come in roughly three times as much over the past month (Chart 6). The relative calm in the Chinese government bond market is echoed by the relative 5-year CDS spread between China and Germany, a component of our BCA Market-Based China Growth Indicator. While the spread has certainly moved higher in response to the breakdown in trade talks and President Trump’s full imposition of tariffs on the second tranche of imports from China, it remains below its 2018 average and well below levels that prevailed in 2015 and 2016 (Chart 7). Similarly, Chinese onshore corporate bond spreads have not reacted negatively to the resumption in the trade war, with the spread on the aggregate ChinaBond Onshore Corporate Bond Index up one basis point over the past month. Taken together with the relative performance of A-shares as well as Charts 6 and 7 we see this as evidence that China’s financial market participants are pricing in some probability of a major reflationary response by Chinese authorities. Chart 6Relative Calm In China's Fixed-Income Market Relative Calm In China's Fixed-Income Market Relative Calm In China's Fixed-Income Market Chart 7China's Sovereign CDS Spread Is Rising, But The Level Remains Low China's Sovereign CDS Spread Is Rising, But The Level Remains Low China's Sovereign CDS Spread Is Rising, But The Level Remains Low A decline in the RMB is necessary to stabilize China’s economy (and is thus reflationary), but global investors will not act like it is until the economy visibly improves. Global financial market commentary on the RMB has been focused almost exclusively over the past month on the USD-CNY exchange rate, but Chart 8 shows that the decline in the currency has been broad-based. The RMB has fallen roughly 1.4% versus the euro over the past month, and over 2% versus an equally-weighted basket of Asian currencies. We highlighted in our May 15 Weekly Report that a 25% increase in tariffs affecting all U.S.-China trade would cause economic conditions in China to deteriorate to 2015/2016-like levels, and that currency depreciation was essential in order to generate a 2015/2016-magnitude policy response.2 However, to the extent that the decline in the RMB will contribute to a period of greater volatility in the global foreign exchange market, China-related assets are not likely to respond positively to this form of stimulus until “hard” activity data clearly shows a meaningful rise. Chart 8The RMB Has Declined Against Everything, Not Just The Dollar The RMB Has Declined Against Everything, Not Just The Dollar The RMB Has Declined Against Everything, Not Just The Dollar   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes   1 Please see China Investment Strategy Weekly Report, “Waiting For The Pain”, dated May 29, 2019, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, “Simple Arithmetic”, dated May 15, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Bond Rally Supports Stocks Bond Rally Supports Stocks Bond Rally Supports Stocks Financial markets are pricing-in an intensifying global growth slowdown, but not all assets are responding equally. U.S. Treasuries have rallied strongly, while equities and credit spreads remain resilient. Case in point, the S&P 500 is only 5.9% off its Q3 highs in absolute terms, but is down 11.3% versus bonds (Chart 1). The markets are pricing-in that the Fed will react to slower growth by cutting rates and that easier Fed policy will keep risk assets supported. But consider what will happen if, at the June FOMC meeting, the Fed doesn’t seem as eager to cut rates as the market would like. The perception of less monetary support could prompt a sharp sell-off in equities and credit spreads. That tightening of financial conditions could then be enough to force the Fed’s hand, ultimately leading to the rate cut that the market has already come to expect. The odds of the above scenario are rising by the day, especially since the President’s decision to expand the trade war to Mexico. We recommend a cautious near-term (0-3 month) stance on credit spreads as a hedge against this mounting risk.  Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 139 basis points in May, dragging year-to-date excess returns down to +221 bps. As we noted in last week’s report, corporate bond spreads have not responded as aggressively as some other assets – commodities and Treasuries – to the escalating trade war and the deteriorating global growth data.1 This leaves the sector vulnerable to a near-term sell-off, especially if the Fed doesn’t validate the market’s dovish expectations at this month’s FOMC meeting. We advise investors to hedge their exposure to credit spreads on a 0-3 month horizon. Beyond that, assuming that the U.S. government’s tariff announcements eventually reach a plateau, the outlook for corporate bond excess returns is positive on a 6-12 month investment horizon. Spreads are comfortably above levels typically seen at this stage of the economic cycle (Chart 2) and, tariffs aside, the U.S. economy is growing at a reasonable clip. As for balance sheets, corporate profit growth contracted in the first quarter, dragging the year-over-year growth rate down to 7%. That is roughly equivalent to the trend rate in corporate debt growth, meaning that if profit growth stabilizes near that level our measure of gross leverage will stay flat (panel 4). We are also keeping a close eye on C&I lending standards. While the most recent data showed an easing in Q1, the continued contraction in loan demand poses a risk (bottom panel). Chart Chart High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 250 basis points in May, dragging year-to-date excess returns down to +443 bps. As with investment grade corporates, the risk of near-term spread widening is high. We noted in last week’s report that excess junk returns versus Treasuries outpaced the CRB Raw Industrials index by 9% during the past 12 months, a historically wide divergence that is bound to fade.2 Looking further out, high-yield bonds still look like a good bet on a 6-12 month investment horizon. Spreads are comfortably above typical levels from past cycles and the excess spread available in the junk index after accounting for expected default losses has risen to 325 bps, well above its historical average (Chart 3). Assuming historically average excess compensation and a 50% recovery rate, current junk spreads discount an expected 12-month default rate of 3.1%. This is well above the Moody’s baseline projection of 1.5% and even above the 2.7% default rate seen during the past 12 months. The spread-implied default rate should be easy to beat, though a persistent increase in job cut announcements could pose a risk (bottom panel). MBS: Neutral Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 40 basis points in May, dragging year-to-date excess returns down to -13 bps. The conventional 30-year zero-volatility spread widened 6 bps on the month, the combination of a 4 bps widening in the option-adjusted spread (OAS) and a 2 bps increase in the compensation for prepayment risk (option cost). At 49 bps, the conventional 30-year OAS now looks elevated compared to recent years, though it remains slightly below its pre-crisis mean (Chart 4). Nonetheless, we see high odds that the MBS/Treasury basis will contract going forward. Falling mortgage rates and an uptick in refinancing activity led to the recent widening in MBS spreads. But with the housing activity data showing signs of improvement, we anticipate that mortgage rates are close to a trough and that refis will soon peak (panel 2). If the “risk off” sentiment in financial markets prevails in the near-term, then MBS will outperform corporate credit. But expected 6-12 month excess returns remain higher for corporate bonds than for MBS. We therefore maintain only a neutral allocation to MBS, despite increasingly attractive valuations. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 45 basis points in May, dragging year-to-date excess returns down to +107 bps. Sovereign debt underperformed duration-equivalent Treasuries by 205 bps on the month, dragging year-to-date excess returns down to +206 bps. Local Authorities outperformed the Treasury benchmark by 11 bps, bringing year-to-date excess returns up to +219 bps. Meanwhile, Foreign Agencies underperformed by 61 bps, dragging year-to-date excess returns down to +130 bps. Domestic Agencies underperformed by 1 bp in May, bringing year-to-date excess returns up to +28 bps. Supranationals outperformed by 4 bps on the month, bringing year-to-date excess returns up to +27 bps. Sovereign debt remains expensive relative to equivalently rated U.S. corporate credit (Chart 5), and the dollar’s relentless march higher presents a further headwind for the sector. We continue to recommend an underweight allocation. Previously, we made an exception for Mexican sovereign bonds, which trade cheap relative to U.S. corporates (bottom panel). However, with the U.S. government now threatening tariffs on imported Mexican goods, the peso will likely see heightened volatility in the coming months. We recommend standing aside on Mexican sovereigns for the time being. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 75 basis points in May, dragging year-to-date excess returns down to +29 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 1% in May, and currently sits at 80% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, but close to the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Long-dated municipal bonds (10-year, 20-year and 30-year) have outperformed short-dated munis (2-year and 5-year) by a wide margin since the beginning of the year, but long-end yield ratios remain relatively attractive. 20-year and 30-year Aaa-rated municipal bonds are particularly alluring. Yield ratios for those bonds remain above their pre-crisis averages, whereas 10-year, 5-year and 2-year Aaa yield ratios are close to one standard deviation below their respective pre-crisis means. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.3 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in May, with yields falling by more than 30 basis points for all maturities beyond 1 year. The 2/10 Treasury slope flattened 5 bps on the month and currently sits at 19 bps. The 5/30 slope was unchanged on the month and currently sits at 65 bps (Chart 7). The belly (5-year/7-year) of the curve looks particularly expensive relative to the wings (see Appendix B) and we continue to recommend a barbell curve positioning: Investors should overweight the long and short ends of the curve and avoid the belly.4 Further, this week we recommend an additional fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract. The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if 3 or more rate cuts occur between now and then. We would expect our spread trade to return +48 bps in a scenario where the Fed keeps rates flat until next March and +23 bps in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. TIPS: Overweight Chart 8Inflation Compensation Inflation Compensation Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 116 basis points in May, dragging year-to-date excess returns down to +39 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.74%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps on the month and currently sits at 1.90%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.5 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 3% (annualized) clip in April, but has only risen 1.6% during the past year. 12-month trimmed mean PCE inflation has been higher, and actually just moved above the Fed’s target following last week’s April data release (Chart 8). In last week’s report we noted that core PCE inflation has a track record of converging toward the trimmed mean.6 As such, we recommend that investors remain overweight TIPS versus nominal Treasuries in U.S. bond portfolios. ABS: Underweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +64 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 5 bps on the month and actually hit a new all-time low of 26 bps in mid-May, before settling at 28 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are also shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. 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 8 basis points in May, bringing year-to-date excess returns up to +195 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 69 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst waning demand (bottom panel) and decelerating prices (panel 3). However, CMBS still offer reasonable compensation for this risk. Especially compared to other similarly-rated fixed income sectors.7 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 6 basis points in May, bringing year-to-date excess returns up to +90 bps. The index option-adjusted spread widened 3 bps on the month and currently sits at 51 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread product. An overweight allocation to this defensive sector remains appropriate. 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 75 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. 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. Image Image 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 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of May 31, 2019) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling 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 5Butterfly Strategy Valuation: Standardized Residuals (As of May 31, 2019) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling 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 +56 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 56 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) When Expectations Are Self-Fulfilling When Expectations Are Self-Fulfilling 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 12 Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 4 We have specifically been recommending a position short the 7-year bullet and long a duration-matched 2/30 barbell. 5 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Inverted Curves & Recessions: While an inverted U.S. Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today compared to past recessions. The Role Of The Term Premium: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. The Stance Of Monetary Policy: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Feature The rush into the safety of government debt accelerated rapidly last week, after another Trump Tariff Tweet targeted Mexican exports to the U.S. Investor confidence, already shaken by the escalation of the U.S.-China trade war, was further eroded by the news that the U.S. was willing to broaden the use of blunt economic tools like tariffs to deal with national security issues like illegal immigration. Global equity and credit markets sold off sharply, adjusting to both higher uncertainty and lower growth expectations. The biggest moves, however, came in the U.S. Treasury market. The 2-year Treasury yield fell -14bps to 1.92% after the Mexico tariff announcement and ended -34bps lower for the entire month of May – the largest monthly decline since November 2008 during the depths of the financial crisis. The 10-year Treasury yield fell -37bps on the month to 2.13%, below the fed funds target range of 2.25-2.5% and 22bps lower than the 3-month U.S. Treasury bill rate. This triggered the dreaded “inversion” signal that has preceded the majority of post-WWII U.S. recessions. The current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Given the well-known predictive properties of an inverted Treasury curve, investors are right to be more nervous about the outlook for U.S. economic growth and the potential for a recession. Multiple Fed rate cuts are now discounted in shorter-maturity Treasury yields. At the same time, the intense flight-to-quality bid for duration exposure has driven the term premium on longer-maturity Treasuries – and all other developed market government bonds – down to unprecedentedly negative territory (Chart of the Week). This can potentially alter the meaning of an inverted yield curve with regards to future economic growth and expected changes in monetary policy. Chart of the WeekUST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? UST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? UST Curve Inversion: A Too-Tight Fed Or A Too-Low Term Premium? In this Weekly Report, we discuss the typical drivers of yield curve inversions and conclude that the current Treasury curve inversion is not signaling an imminent U.S. recession – although it may signal a need for the Fed to ease policy to offset global growth uncertainties and below-target inflation. Could The Treasury Curve Be Wrong This Time? Chart 2This Is A GLOBAL Bond Rally This Is A GLOBAL Bond Rally This Is A GLOBAL Bond Rally The current sharp fall in government bond yields is not only occurring in the U.S. Treasury market. Yields are hitting new cyclical lows in many countries, with the 10-year German Bund yield ending May at an all-time low of -0.2%. Yield curves have bull-flattened during this move, with 10-year yields trading below 3-month Treasury bill rates not only in the U.S., but even in places like Canada and Australia (Chart 2). Global yields have been falling steadily since late in 2018, seemingly with little regard to the performance of risk assets in either direction. This suggests a more fundamental driver – like deteriorating growth expectations or perceptions of overly-tight monetary policy – rather than simple asset allocation decisions by investors. In July 2018, we published a Special Report discussing the drivers of yield curve shape in the major developed markets and the potential economic implications.1 For the U.S., we concluded that when the 10-year U.S. Treasury yield traded below the 3-month U.S. Treasury bill rate for an extended period of time (i.e. more than just a few days), the U.S. subsequently entered recession within twelve months, on average (Table 1). With the 10-year yield now trading below the 3-month rate, the clock may have already started counting down to a recession sometime in the next year. Table 1U.S. Curve Flattening, Inversions & Recessions Since 1960 The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. The New York Fed has a model that determines the probability of a U.S. recession one year ahead based on the slope of the 10-year/3-month Treasury curve.2 The current curve level translates into a 36% probability of a recession one year from now, which is in line with the probabilities seen before the three previous U.S. recessions (Chart 3). Chart 3New York Fed's Yield-Curve Based Recession Probability Model Flashing Red New York Fed's Yield-Curve Based Recession Probability Model Flashing Red New York Fed's Yield-Curve Based Recession Probability Model Flashing Red Abstracting away from the yield curve, however, not all other U.S. economic data is behaving in line with past periods leading up to U.S. recessions. In Chart 4, we show a “cycle-on-cycle” analysis of selected U.S. economic data series, comparing the current backdrop to past U.S. business cycles. For all panels, the solid line represents the current cycle, while the dotted line is the average of the past five U.S. business cycles. The data is lined up such that the vertical line in the chart represents the start date of past U.S. recessions as determined by the National Bureau of Economic Research. Shown this way, we can look how the data is evolving today and see how it compares to the way the data typically moves in the run-up to a recession. Based on the data, we can make the following conclusions: The current weakness in the U.S. manufacturing sector is in line with the start of past recessions, based on the depressed level of the ISM Manufacturing New Orders-to-Inventories ratio. The Conference Board’s U.S. leading economic indicator is usually contracting in the year prior to the onset of recession; today, the year-over-year growth rate is slowing but remains positive at 2.6%. The U.S. consumer is in much better shape today - initial jobless claims are not rising and consumer confidence is not falling, as typically happens in the run-up to an economic downturn. Non-financial corporate profits also typically start to contract about one year before a recession begins; today, profit growth has slowed from the tax cut fueled surge of 2018, but has not yet downshifted into negative territory on a year-over-year basis. We can apply the same cycle-on-cycle analysis to the U.S. Treasury curve to see how today compares to past pre-recessionary periods (Chart 5). Typically, the 2-year Treasury yield falls below the fed funds rate about one full year before the start of a recession, and ends up around 150bps below the funds rate when the downturn actually begins. In the current cycle, the 2-year dipped below the funds rate back in March of this year, and now sits 58bps below the funds rate. Both of those curve relationships, however, are influenced by the changing nature of the Treasury term premium. Chart 4Only A Manufacturing Recession Only A Manufacturing Recession Only A Manufacturing Recession Chart 5Mixed Messages From The Curve Mixed Messages From The Curve Mixed Messages From The Curve The New York Fed produces estimates of the Treasury term premium for all maturities, from one year up to ten years, which allows us to see how the term premium looks different today than prior to past U.S. recessions.3 As can be seen in the bottom two panels of Chart 5, the 10-year term premium has averaged between 100-150bps in the year prior to U.S. recessions, while the 2-year term premium has averaged between 25-50bps over the same period. Today, the term premia for 10-year and 2-year yields are now both deeply negative. This suggests that the current inversion of the 2-year/fed funds curve, and the 10-year/3-month curve, is likely giving too pessimistic a signal about future U.S. growth – a fact corroborated by the cycle-on-cycle analysis of U.S. economic data. Bottom Line: While an inverted Treasury curve has been a reliable early indicator of past U.S. recessions, the current inversion appears “too soon” relative to the evolution of U.S. economic data today versus past recessions. The Message From Depressed Bond Term Premia Today, the estimated term premium for 10-year Treasuries and 2-year Treasuries is -88bps and -70bps, respectively. This means that not only are bond investors willing to accept yields below the expected path of interest rates over the life of a bond (i.e. a negative term premium), they are accepting an even lower term/risk premium for bonds with longer maturities and durations – bonds that are more risky strictly in terms of price volatility. Why would that be? Typically, bond term premia are driven by the following factors: The volatility of inflation The volatility of bond yields and returns The volatility of economic growth Investor risk aversion Proxies for the first three factors are presented in Chart 6, alongside the estimate of the 10-year Treasury term premium dating back to the early 1960s. Broadly speaking, bond term premia have been higher when realized inflation is more volatile (second panel), unemployment is high (third panel) and Treasury yield volatility is elevated. Today, all of those factors are at, or very close to, the lowest levels seen over the past 50 years. No wonder term premia are so depressed. Chart 6Term Premia Are Depressed For Structural Reasons ... Term Premia Are Depressed For Structural Reasons ... Term Premia Are Depressed For Structural Reasons ... Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve.  Investor risk aversion does not exhibit the same type of broad multi-decade trends as growth and inflation, but it is safe to assume that investors become more risk averse when the economic backdrop is more uncertain. Periods of stable growth, categorized by low variability of U.S. nominal GDP growth or a rising trend in the global leading economic indicator, are associated with narrow term premiums and low measures of market-implied bond volatility like the MOVE index of U.S. Treasury option prices (Chart 7). Chart 7... And Cyclical Reasons ... And Cyclical Reasons ... And Cyclical Reasons This result does seem counter-intuitive – more economic uncertainty should make bonds safer, not riskier! The key to remember here is that it is only the term premium component of yields that rises during periods of greater volatility. Actual bond yields fall during those same periods, but because of more fundamental drivers like falling inflation expectations and a lower expected path of interest rates as the Fed eases policy. Today, while there has been some modest pickup in GDP volatility, the overall stability of growth and, more importantly, inflation is consistent with depressed bond term premiums. This is mildly exaggerating the pessimistic growth signal from an inverted Treasury curve. Bottom Line: Term premia on U.S. Treasuries are negative at all maturities, much more so further out the yield curve, thanks to historically low economic and inflation volatility and, of late, greater investor risk aversion. This suggests that the economic signal from an inverted Treasury curve is somewhat distorted by unusually low bond risk premiums. So Is The Fed Actually Running A Tight Monetary Policy? As we discussed in our yield curve Special Report last July, curve inversions typically occur during periods when monetary policy is considered restrictive. For example, every time the real fed funds rate (actual fed funds minus core PCE inflation) has been above the Fed’s estimate of the neutral r* real rate, the 10-year/3-month Treasury curve has inverted (Chart 8). Currently, the real funds rate is essentially equal to the Fed’s latest r* estimate, suggesting that monetary policy is neutral and not restrictive. Chart 8Too Soon For Sustained, Policy-Induced Yield Curve Inversion Too Soon For Sustained, Policy-Induced Yield Curve Inversion Too Soon For Sustained, Policy-Induced Yield Curve Inversion Other measures like the Taylor Rule can also provide an indication of whether monetary policy is too tight relative to real interest rates and measures of economic spare capacity. If policy was too restrictive, with a fed funds rate above the Taylor Rule, this would imply a more “fundamental” Treasury curve inversion. The Atlanta Fed’s interactive Taylor Rule tool provides estimates of a variety of Taylor Rules, using differing measures of the neutral real fed funds rate and measures of spare capacity.4 We show the results of those Taylor Rules in Table 2. Only one of twenty rules shown is currently producing a fed funds rate below the current 2.25-2.5% range, with fifteen rules indicating that a higher funds rate is still required. Table 2Taylor Rule Fed Funds Prescription Heat Map For 2019: Q2 The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Chart 9Our Fed Monitor Is Close To Calling For Rate Cuts Our Fed Monitor Is Close To Calling For Rate Cuts Our Fed Monitor Is Close To Calling For Rate Cuts Yet despite the more traditional indicators suggesting that the current level of the fed funds rate is not too high, that does not mean that there are not potential pressures on the Fed to cut rates. Our own Fed Monitor remains near the zero line, suggesting that no change in the Fed’s stance is warranted (Chart 9). Yet when looking at the individual components of the Fed Monitor, there has been enough softening of U.S. growth and inflation momentum to justify Fed rate cuts. Only the Financial Conditions component is preventing the overall Monitor from moving into the “easier policy required” zone. In other words, if equity and credit markets continue to sell off and the U.S. dollar continues to rally, a Fed rate cut becomes a higher probability outcome. Investment Conclusions Summing it all up, it does not appear that the current inverted Treasury yield curve is signaling a risk of a U.S. recession within the next 6-12 months. A very flat Treasury curve is appropriate with a Fed policy stance that is appropriately neutral. On a cyclical perspective, we still think that a small below-benchmark stance on overall portfolio duration for global bond investors is warranted, along with a modest underweight in U.S. Treasuries in currency-hedged global bond portfolios. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. Those cuts are largely discounted in the current level of yields, though. Our 12-Month Discounter now indicates that -75bps of rate cuts over the next year are priced into the U.S. Overnight Index Swap curve. A good tactical way to play for Fed cuts in 2019 is to implement a fed funds futures calendar spread trade to take advantage of possible near-term Fed actions. Investors should buy the August 2019 contract and sell the February 2020 contract – a position we are adding to our Tactical Overlay (see the table on page 15). The long position in the August contract will turn a profit if the Fed responds to market turmoil and cuts rates at the June or July meetings. Meanwhile, the short position in the February 2020 contract will only lose money if three or more rate cuts occur between now and then. On a more tactical basis, however, there is a growing chance that the Fed delivers an “insurance” rate cut or two before year-end in response to the increasing uncertainties over global growth and intensifying trade wars. We would expect our spread trade to return +45bps (unlevered) in a scenario where the Fed keeps rates flat until next March and +19bps (unlevered) in a scenario where there is one rate cut in June or July and another rate cut between September and January. The only scenarios where the trade loses money involve two or more rate cuts between September and January. Bottom Line: Curve inversions that precede recessions are typically accompanied by tight monetary policy that trigger slowing growth expectations. On that front, the Fed’s current stance is roughly neutral based on measures like r* or the Taylor Rule. That does not, however, preclude the Fed from delivering rate cuts to offset the potential economic shock from escalating U.S. trade protectionism. Go long an August 2019/February 2020 fed funds futures calendar spread trade to profit from near-term “insurance’ Fed rate cuts.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Special Report, “Three Frequently Asked Questions About Global Yield Curves”, dated July 31, 2018, available at gfis.bcaresearch.com and usbs.bcaresearch.com. 2 Details of the NY Fed’s probit model of U.S. recession probability based on the slope of the Treasury curve can be found here: https://www.newyorkfed.org/research/capital_markets/ycfaq.html 3 There are several methodologies used to estimate term premia for government bond yields; the one used by the New York Fed is the Adrian, Crump and Moench (ACM) approach, details of which can be found here: https://www.newyorkfed.org/research/data_indicators/term_premia.html 4 The Atlanta Fed’s interactive Taylor Rule tool can be found here: https://www.frbatlanta.org/cqer/research/taylor-rule.aspx?panel=1 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Risk Aversion Curve Inversion The Risk Aversion Curve Inversion Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? Chart 1Worrying Signs? Worrying Signs? Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast Monthly Portfolio Update: China To The Rescue? Monthly Portfolio Update: China To The Rescue? What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Term Premium Near Record Low Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Investors Very Long Duration Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 16 Chart 17Industrial Metals Driven By China Too Industrial Metals Driven By China Too Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Oil Supply Remains Tight Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation  

Please note that analysis on India is published below. Highlights This report reviews several financial market-based indicators and price signals from various corners of global markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these indicators and price actions is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities, and EM assets are all at risk of plunging. Beware of reigning complacency in EM sovereign and corporate credit markets. Various indicators point to wider EM credit spreads. Feature EM risk assets appear to be on the brink of a breakdown. This week we review various market-based indicators that are telegraphing a relapse in both EM risk assets and commodities. The relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months. As always, we monitor economic data extremely closely. However, one cannot rely solely on economic data to predict directional changes in financial markets. Turning points of economic indicators and data often lag those of financial markets. In fact, one can make reliable economic forecasts based on the performance of financial markets. For example, the relative performance of EM versus global stocks leads turning points in the global manufacturing cycle by about six months (Chart I-1). Chart I-1EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle EM Stocks Signal No Improvement In Global Industrial Cycle Over the years, we have devised and tracked several market-based indicators that have a good track record of identifying trends in EM risk assets. In addition, we constantly monitor price signals from various corners of financial markets that are pertinent to the global business cycle, and hence to EM risk assets. The overwhelming message from these market-based indicators is that the global industrial cycle remains in the doldrums, and a recovery is not imminent. As such, global cyclical segments, commodities and EM are all at risk of plunging. Our Reflation Indicator Our Reflation Indicator is calculated as an equal-weighted average of the London Industrial Metals Price Index (LMEX), platinum prices and U.S. lumber prices. The LMEX index is used as a proxy for Chinese growth, while U.S. lumber prices reflect cyclical growth conditions in the American economy. We use platinum prices as a global reflation proxy; this semi-precious metal is sensitive to the global industrial cycle in addition to benefitting from easy U.S. dollar liquidity. The Reflation Indicator has failed to advance above its long-term moving average and has broken down. Chart I-2Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Our Reflation Indicator Presages No Reflation Chart I-2 illustrates that the Reflation Indicator has failed to advance above its long-term moving average and has broken down. Typically, such a technical profile is worrisome and is often followed by a significant drop. In addition, the Reflation Indicator rolled over at its previous highs last year, another bearish technical signal. Investors should heed signals from this indicator as it correlates well with EM share prices in U.S. dollar terms as well as EM sovereign and corporate credit spreads (Chart I-3). EM credit spreads are shown inverted in the middle and bottom panels. An examination of the individual components of the Reflation Indicator reveals the following: Industrial metals prices in general and copper prices in particular have formed a classic head-and-shoulders pattern (Chart I-4, top panel). As and when the neckline of this pattern is broken, a major downward gap is likely to ensue. Platinum prices have reverted from their key technical resistance levels (Chart I-4, middle panel). This constitutes a bearish technical configuration, and odds are that platinum prices will be in freefall. Finally, lumber prices have failed to punch above their 200-day moving average and have broken below their 3-year moving average (Chart I-4, bottom panel). Chart I-3Reflation Indicator And EM Reflation Indicator And EM Reflation Indicator And EM Chart I-4Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices Beware Of Breakdowns In Commodities Prices These technical signals are in accordance with our qualitative assessment of global growth conditions. The global industrial cycle remains very weak, and a recovery is not yet imminent. Meanwhile, the U.S. is the least exposed to the ongoing global trade recession because manufacturing and exports each represent only about 12% of the U.S. economy. Remarkably, economic weakness in Asian export-dependent economies has so far been driven by retrenching demand in China – not the U.S. As Chart I-5 reveals, aggregate exports to China from Korea, Japan, Taiwan and Singapore were still contracting at a 9% pace in April from a year ago, while their shipments to the U.S. grew at a respectable 7% rate. Chart I-5Asian Exports To China And To U.S Asian Exports To China And To U.S Asian Exports To China And To U.S Chart I-6Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Global Steel And Energy Stocks Are Breaking Down Commodities: Hanging By A Thread? Some commodity-related markets are also exhibiting configurations that are consistent with a breakdown. Specifically: Global steel stocks as well as oil and gas share prices have formed a head-and-shoulders pattern, and are breaking below their necklines (Chart I-6). Such a technical configuration foreshadows major downside. Shares of Glencore – a major player in the commodities space – have dropped below their three-year moving average which has served as a support a couple of times in recent years (Chart I-7). Crucially, this stock has also exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads U.S. manufacturing cycles, and has formed a similar configuration to Glencore’s (Chart I-8). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Chart I-7A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... A Head-And-Shoulders Pattern In Glencore Stock... Chart I-8...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) ...And In Kennametal (High-Beta U.S. Industrial Stock) Finally, three-year forward oil prices are breaking below their three-year moving averages (Chart I-9). A drop below this technical support will probably mark a major downleg in crude prices. Bottom Line: Commodities and related equity sectors appear vulnerable to the downside. Meanwhile, the U.S. dollar is exhibiting a bullish technical pattern and will likely grind higher, as we discussed in last week’s report titled, The RMB: Depreciation Time? (Chart I-10). Chart I-9Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Forward Oil Prices Are Much Weaker Than Spot Chart I-10The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher The U.S. Dollar Is Heading Higher EM Equities: A Make-It-Or-Break-It Moment Chart I-11EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff EM Stock Indexes: Sitting On Edge Of A Cliff The MSCI EM Overall Equity Index is at an important technical support level (Chart I-11, top panel). If this support is violated, a major downleg will likely ensue. In addition to the above indicators, the following observations also suggest that this support level will be broken and that a gap-down phase will transpire. Both the EM small-cap and equal-weighted equity indexes have been unable to advance above their respective three-year moving averages and are now breaking down (Chart I-11, middle and bottom panels). This could be a precursor for the overall EM stock index to tumble through defense lines, and drop well below its December lows. Our Risk-On/Safe-Haven Currency ratio also points to lower EM share prices (Chart I-12). This indicator is constructed using relative total returns of commodity related (cyclical) currencies such as the AUD, NZD, CAD, BRL, CLP and ZAR against safe-haven currencies such as the JPY and CHF. Importantly, as with EM stocks, this market-based indicator has failed to break above highs reached over the past 10 years. This is in spite of negative interest rates in both Japan and Switzerland that have eroded the latter’s total returns in local currency terms. This ratio has also formed a head-and-shoulders pattern, and may be on the edge of breaking below its neckline. A move lower will spell trouble for EM financial markets. EM corporate profits are shrinking in U.S. dollar terms, and the pace of contraction will continue to deepen through the end of the year. The U.S.-China confrontation is not the only reason behind the EM selloff. In fact, the EM equity rebound early this year was not supported by improving profits. Not surprisingly, the EM equity rebound has quickly faded as investor sentiment deteriorated in response to rising trade tensions. Global semiconductor share prices have made a double top and are falling sharply. Importantly, prices for semiconductors (DRAM and NAND) have not recovered since early this year. The ongoing downdraft in the global semiconductor industry will continue to weigh on the emerging Asian Equity Index. Finally, the relative performance of emerging Asian equities versus DM ones has retreated from its major resistance level (Chart I-13). Odds are that it will break below its recent lows. Chart I-12Risk-On/Safe-Haven Currency Ratio And EM Equities bca.ems_wr_2019_05_30_s1_c12 bca.ems_wr_2019_05_30_s1_c12 Chart I-13Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Emerging Asian Stocks Versus Developed Markets Bottom Line: EM share prices are sitting on the edge of a cliff. Further weakness will likely lead to investor capitulation and a major selloff. EM Credit Markets: Reigning Complacency? One asset class in the EM space that has so far held up relatively well is sovereign and especially corporate credit. EM sovereign bonds’ excess returns correlate with EM currencies and industrial metals prices, as shown in Chart I-14. So far, material EM currency depreciation and a drop in industrial metals prices have generated only a mild selloff in EM sovereign credit. Lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Excess returns on EM corporate bonds track the global business cycle closely (Chart I-15). The current divergence between EM corporates’ excess returns and the global manufacturing PMI is unprecedented. Chart I-14EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... EM Sovereign Credit Market Is Complacent... Chart I-15...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market ...As Is EM Corporate Credit Market Our expectation that EM credit spreads will widen is not contingent on a massive default cycle unravelling across the EM credit space. However, lower commodities prices, EM currency depreciation and weaker global growth are all negatives for cash flows of both sovereign and corporate issuers. Chart I-16 illustrates that swings in cash flow from operations (CFO) among EM ex-financials and technology companies correlate with other global business cycle indicators such as Germany’s IFO manufacturing index. Chart I-16EM Corporate Cash Flow Fluctuates With Global Manufacturing Cycle bca.ems_wr_2019_05_30_s1_c16 bca.ems_wr_2019_05_30_s1_c16 Chart I-17EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health EM Corporate Spreads Are Too Narrow Given Their Financial Health The lingering weakness in the global business cycle will likely lead to shrinking CFOs among EM companies, and hence warrants wider corporate credit spreads. Concerning valuations, EM corporate bonds are not cheap at all when their fundamentals are taken into account. Chart I-17 demonstrates two vital debt-servicing ratios for EM ex-financials and technology companies: interest expense-to-CFO and net debt-to-CFO. Both measures have improved only marginally in recent years, yet corporate spreads are not far from their all-time lows (Chart I-17, bottom panel). We are aware that with DM bond yields at very low levels - and in many cases even negative - the appeal of EM credit markets has risen. We are also cognizant that some investors are expecting to hold these bonds to maturity and earn a reasonable yield. Such a strategy has largely paid off in recent years. Nevertheless, if the selloff in EM financial markets escalates – as we expect – EM credit markets will be hit hard as well. To this end, it makes sense to step aside and wait for a better entry point. For dedicated fixed-income portfolios, we continue to recommend underweighting EM sovereign and corporate credit versus U.S. investment-grade credit. Finally, to identify relative value within EM sovereign credit spreads, we plot, each country’s foreign debt obligations as a share of annual exports on the X axis against sovereign spreads on the Y axis (Chart I-18). Chart I-18 This scatter plot reveals that Russia and Mexico offer the best relative value in the EM sovereign space. As such, we are reiterating our high-conviction overweight position in these sovereign credit markets as well as in Hungary, Poland, Chile and Colombia. South Africa and Brazil appear attractive as well, but we are underweight these two sovereign credits. The basis for our pessimistic outlook is due to the unsustainable public debt dynamics in these two countries, as we discussed in our Special Report from April 23. Other underweights within the EM sovereign credit space include Indonesia, the Philippines, Malaysia, Turkey and Argentina.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     India: How Sustainable Is A 2.0 Modi Rally? Prime Minister Narendra Modi, and his party – the Bharatiya Janata Party – have won a strong majority in the Indian general election this month. Indian stocks surged in the past month as evidence was emerging that Modi was in the lead. Chart II-1Facing Resistance? Facing Resistance? Facing Resistance? Yet this Modi 2.0 rally is unlikely to last for too long. First, as EM stocks continue selling off, Indian share prices will not defy gravity and will fall in absolute terms. Interestingly, the Indian stock market has hit its previous highs – levels at which it failed to break above in the past 12 years (Chart II-1, top panel). We expect this resistance line to hold this time around too. Likewise, we are still reluctant to upgrade this bourse on a relative basis as it has reached its previous highs. This level will likely prove to be a hindrance, at least for the time being (Chart II-1, bottom panel). The basis for betting against a break out in Indian equity prices in both absolute terms and relative to the EM benchmark over the next couple of months is because of the following: Domestic Growth Weakness: India’s domestic growth has been decelerating sharply. The top two panels of Chart II-2 illustrate that manufacturing and intermediate goods production as well as capital goods production growth are all either contracting or on the verge of shrinking. Similarly, domestic orders-to-inventories ratio for businesses is pointing to a further growth slump according to a survey conducted by Dun & Bradstreet (Chart II-2, bottom panel). Furthermore, sales growth of all types of vehicles are either contracting or have stalled (Chart II-3). Chart II-2Business Cycle Is Weak Business Cycle Is Weak Business Cycle Is Weak Chart II-3Domestic Demand Is Fragile Domestic Demand Is Fragile Domestic Demand Is Fragile Regarding the financial sector, Indian banks – encouraged by a more permissive and forbearing central bank on the recognition of non-performing loans – have recently lowered provisions to boost their earnings (Chart II-4). Share prices should not normally react to such accounting changes. Banks either do carry these NPLs or do not. Therefore, the stock price of a bank should not fluctuate much if a central bank is forcing it to recognize those NPLs or if the latter is relaxing recognition and provisioning standards. Chart II-4Less Provisions = More Paper Profit Less Provisions = More Paper Profit Less Provisions = More Paper Profit Chart II-5Very Weak Equity Breadth Very Weak Equity Breadth Very Weak Equity Breadth In brief, we are skeptical about the sustainability of the current rally in bank share prices based on the relaxation of some accounting rules. Unfavorable Technicals & Valuations: Technicals for India’s stock market are precarious. Participation in this rally has been very slim. Indian small cap stocks have not rallied much, lagging dramatically behind large-cap stocks (Chart II-5, top panel). Our proxy for market breadth – the ratio of equal-weighted stocks to market-cap weighted stocks – has also been deteriorating and is sending a very bearish signal for the overall stock market (Chart II-5, bottom panel). Finally, the Indian stock market is overbought and vulnerable to a general selloff in EM stocks. Namely, foreign investors have rushed into Indian equities as of late. This raises the risk of a pullout as foreign investors become disappointed by India’s dismal corporate earnings and outflows from EM funds leads them to pare their holdings. As for valuations, the Indian stock market is still quite expensive both in absolute and relative terms. Oil Prices: Although oil prices will likely drop,1 Indian stocks could still underperform the EM equity benchmark in the near term. Chart II-6India Versus EM & Oil Prices India Versus EM & Oil Prices India Versus EM & Oil Prices The rationale for this is that Indian equities have brushed off the rise in oil prices since the beginning of the year and outperformed the majority of other EM bourses (Chart II-6). By extension, Indian equities could ignore lower oil prices for a while and underperform the EM benchmark in the near term. Beyond near term underperformance, however, India will likely resume its outperformance. First, sustainably lower oil prices will begin to help the Indian stock market later this year. Second, the growth impact of ongoing fiscal and monetary easing will become visible toward the end of this year. Meanwhile, food prices are starting to pickup and this will support rural income and spending. Finally, the Indian economy is much less vulnerable to a slowdown in global trade because Indian exports make only 13% of the country's GDP. Bottom Line: We are maintaining our underweight stance in Indian equities for tactical considerations, but are putting this bourse on an upgrade watch-list. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com     Footnotes   1 The view on commodities of BCA’s Emerging Markets Strategy service is different from BCA’s house view due to the difference on the view on the global business cycle and Chinese demand. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights U.S. inflation is on a structural uptrend. Monetary and fiscal policy, populism, and demographics will tend to push inflation higher over the coming decade. How can investors protect portfolios against inflation risk? We look at periods of rising inflation to determine which assets were the best inflation hedge. We find that the level of inflation is very important in determining which assets work best. When inflation is rising and high, or very high, the best inflation hedges at the asset class level are commodities and U.S. TIPS. When inflation is very high, gold is the best commodity to hold and defensive sectors will minimize losses in an equity portfolio. However, hedges have a cost. Allocating a large percentage of a portfolio to inflation hedges will be a drag on returns. Investors should opt for a low allocation to hedges now, and increase to a medium level when inflation rises further. Feature Some 38 years have passed since the last time the U.S. suffered from double-digit inflation. The Federal Reserve reform of 1979, championed by Paul Volcker, changed the way the Fed approached monetary policy by putting a focus on controlling money growth.1 The reform gave way to almost four decades of relatively controlled inflation, which persists today. But times are changing. While most of today’s investors have never experienced anything other than periods of tame inflation, BCA expects that rising inflation will be a major driving force of asset returns over the coming decade.2 The main reasons behind this view are the following: 1. A rethink in the monetary policy framework: At its most recent meeting, the FOMC openly discussed the idea of a price-level target, implying that it would be open to the economy running hot to compensate for the past 10 years of below-target inflation (Chart II-1.1A, top panel). Chart II-1.1AStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Chart II-1.1BStructural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I) Structural Forces Point To Higher Inflation In The Coming Decade (I)   2. Procyclical fiscal policy: The U.S. is conducting expansionary fiscal policy while the economy is at near-full employment (Chart II-1.1A, middle panel). The last time this happened in the U.S., during the 1960s, high inflation followed, as the fiscal boost made the economy run substantially above capacity. 3. Waning Fed independence: President Trump has openly questioned the hiking campaign undertaken by the Fed. Moreover, he has tried to nominate Fed governors with dovish tendencies. Historically around the world, a lack of central bank independence has often led to higher inflation rates (Chart II-1.1A, bottom panel). 4. Peak in globalization: Globalization accelerated significantly in the 1990s and 2000s, flooding the global economy with cheap labor (Chart II-1.1B, top panel). However, we believe that globalization has peaked. Instead, populism and protectionism will be the dominant paradigms for years to come, reducing the cheap pool of workers and goods previously available. 5. Demographics: The population in the U.S. is set to age in coming years (Chart II-1.1B, middle panel). As the percentage of U.S. retirees increases, the number of spenders relative to savers will begin to rise (Chart II-1.1B, bottom panel). Higher spending and lower savings in the economy should create upward pressure on inflation. If our view is correct, how should investors allocate their money? We attempt to answer this question by evaluating the performance of five major asset classes during periods when inflation was rising. Furthermore, we look into sub-asset class performance to determine how investors should position themselves within each asset class to take advantage of an inflationary environment. In our asset-class analysis, we use a data sample starting in 1973 and we limit ourselves to five publicly traded assets that have adequate history: global equities, U.S. Treasuries, U.S. real estate (REITs), U.S. inflation-linked bonds,3 and commodities. We compare asset classes according to their Sharpe ratios: average annualized excess returns divided by annualized volatilities.4  BCA expects that rising inflation will be a major driving force of asset returns over the coming decade. In our sub-asset class analysis, we analyze global equity sectors, international vs U.S. equities, and individual commodities. In some of the sections in our sub-asset class analysis, our sample is slightly reduced due to lack of historical data. Moreover, since in some instances all sectors have negative returns, we compare sub-asset classes according to their excess returns only. We base our analysis on the U.S. Consumer Price Index, given that most of the assets in our sample are U.S. based. We opt for this measure because it tends to track the living expenses for most U.S. citizens and it is the preferred measure to index defined-benefit payments. Finally, we decompose the periods of rising inflation into four quartiles in order to examine whether the level of inflation has any impact on the performance of each asset. Chart II-1.2 and Table II-1.1 show the different ranges we use for our analysis as well as a description of the typical economic and monetary policy environments in each of them. Chart II-1 Chart II- Summary Of Results Table II-1.2 shows the summary of our results. For a detailed explanation on how each asset class and sub-asset class behaves as inflation rises, please see the Asset Class section and the Sub-Asset Class section below. Chart II- Which assets perform best when inflation is rising? Rising inflation affects assets very differently, and is especially dependent on how high inflation is. Global equities performed positively when inflation was rising and low or mild, but they were one of the worst-performing assets when inflation was rising and high or very high. Importantly, equities underperformed U.S. Treasuries in periods of both high and very high inflation. Commodities and U.S. TIPS were the best performers when inflation was high or very high. U.S. REITs were not a good inflation hedge. Which global equity sectors perform best when inflation is rising? Energy and materials outperformed when inflation was high. Every single sector had negative excess returns when inflation was very high, but defensive sectors such as utilities, healthcare, and telecommunications5 minimized losses. Which commodities perform best when inflation is rising? With the exception of energy, most commodities had subpar excess returns when inflation was in the first two quartiles. Industrial metals outperformed when inflation was high. Gold and silver outperformed when inflation was very high. Additionally, gold had consistent returns and low volatility. What is the cost of inflation hedging? Chart II-1 To answer this question, we construct four portfolios with different levels of inflation hedging: 1. Benchmark (no inflation hedging): 60% equities/40% bonds. 2. Low Inflation Hedging: 50% equities/40% bonds/5% TIPS/5% commodities 3. Medium Inflation Hedging: 40% equities/30% bonds/15% TIPS/15 % commodities 4. Pure Inflation Hedging: 50% TIPS/50% commodities. While increased inflation hedging provides better performance when inflation is high and rising, these hedges are costly to hold when inflation is at lower ranges or when it is falling (Chart II-1.3, panels 1 & 2). However, adding moderate inflation hedging (low or medium) to a portfolio achieved the right balance between cost and protection, and ultimately improved risk-adjusted returns over the whole sample (Chart II-1.3, panel 3). What about absolute returns? The benchmark outperformed over the whole sample. However, the low and medium inflation hedging did not lag far behind, while avoiding the big drawdowns of high inflation periods (Chart II-1.3, panel 4). Investment Implications High inflation may return to the U.S. over the next decade. Therefore, inflation hedging should be a key consideration when constructing a portfolio. Based on our results, our recommendations are the following: 1. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. 2.  However, these hedges are costly to hold as they will create a drag on returns in periods when inflation is not high or very high. Therefore, a low allocation to inflation hedges is warranted now. 3.   Inflation will probably start to pick up in the 2020s. A medium allocation to inflation hedges will then be appropriate. 4.   When inflation is high (3.3%-4.9%), investors should overweight energy and materials in their equity portfolios. Likewise, they should overweight industrial metals and energy within a commodity portfolio. 5.   When inflation is very high (4.9% or more), investors should overweight defensive sectors in their equity portfolio to minimize losses. Moreover, investors should overweight gold within a commodity portfolio. At the asset-class level, investors should allocate to commodities and U.S. TIPS to hedge inflation. Asset Classes Global Equities Chart II-2 The relationship between equity returns and rising inflation depends on how high inflation is, with outstanding performance when inflation is rising but low or mild, and poor performance as it gets higher (Chart II-2.1, top panel). This relationship can be explained by the interaction between interest rates, inflation, earnings, and valuations: Earnings growth was usually slightly negative when inflation was recovering from low levels. However, given that interest rates were very low in this environment and growth expectations were high, multiple expansion boosted equity returns (Chart II-2.1, bottom panel). When inflation was mild, the Fed typically started to raise rates, resulting in a declining multiple. However, equities had the best performance in this range thanks to very high earnings growth – a result of the economy growing strongly due to a healthy level of inflation. When inflation climbed into the high or very high range, earnings growth was usually positive but beginning to slow, as high inflation weighed on growth. Meanwhile the multiple started to decline rapidly due to rising interest rates and declining growth expectations. With the exception of the mild inflation range, the return profile of equities during inflationary periods was similar to its normal profile: negative skew and excess kurtosis (Table II-2.1). However, the consistency of returns decreased at higher levels of inflation, with only 45% of months with positive returns when inflation was rising and in its highest quartile. Chart II- U.S. Treasuries Chart II-2 U.S. Treasuries reacted in a similar fashion to equities when inflation was rising (Chart II-2.2). However, while Treasuries underperformed equities when inflation was low or mild, they actually outperformed equities when inflation was high or very high. This was in part due to the fact that at higher inflation ranges, U.S. Treasuries offer a higher coupon return when rates are high, at least partially counteracting losses from falling prices. The steady stream of cash flows from the coupons helped Treasuries achieve positive returns roughly two-thirds of the time at the highest levels of inflation (Table II-2.2). However, this consistency in returns came at a cost: very high inflation resulted in negative skew and high excess kurtosis. Therefore, while Treasuries provided frequent positive returns when inflation was very high, they were prone to violent selloffs. Chart II- U.S. REITs Chart II-2 While REITs had high risk-adjusted returns when inflation was rising but mild, much like equities they had subpar performance in every other quartile and particularly poor performance when inflation was high or very high (Chart II-2.3). These results confirm our previous research showing that REITs performance is very similar to that of equities.6 The return consistency for REITs was generally poor in inflationary periods, with the second-lowest percentage of positive return of any asset class (Table II-2.3). Moreover, REIT returns had excess kurtosis and negative skew throughout all inflation quartiles. Chart II- Commodity Futures Chart II-2 Commodities performed positively in every quartile, and did particularly well when inflation was mild (Chart II-2.4, top panel). However, total return and price return were very different due to the behavior of the roll and collateral return: Total risk-adjusted returns were lower than spot risk-adjusted returns when inflation was low and rising. This happened because during these periods, commodity supply was high relative to demand, as the economy was recovering from a deflationary shock. Thus, there was an incentive for producers to conserve inventories, making the futures curve upward-sloping (contango). Thus, roll return was negative (Chart II-2.4, bottom panel). When inflation was in the upper two quartiles, total risk-adjusted returns were much higher than risk-adjusted spot returns. This was because high inflation was the product of supply shocks. These supply shocks resulted in a downward-sloping futures curve (backwardation), which, in turn, resulted in a positive roll return. Additionally, high rates during these regimes contributed to a high collateral return. Commodities provided good return consistency during inflationary periods, with roughly 60% of positive return months in the upper two inflation quartiles (Table II-2.4). The skew of returns was neutral or positive in the top two quartiles. This means that although volatility was high for commodities, extreme return movements were normally positive. Chart II- U.S. Inflation-Protected Bonds Chart II-2 While inflation-protected bonds provided meager returns when inflation was rising but in the mild range, they provided excellent performance at the highest levels of inflation (Chart II-2.5). Moreover, this high Sharpe ratio was not just simply the result of low volatility, since U.S. TIPS had excess returns of 4.6% when inflation was high and 5.7% when inflation was very high.7 The return profile of inflation-protected bonds during inflationary periods was also attractive in our testing period. Average skew was positive, while kurtosis was relatively low (Table II-2.5). The percentage of positive months across all quartiles was also the highest of all asset classes, with a particularly high share of positive returns in the periods of highest inflation. Chart II- Sub-Asset Classes Global Equity Sectors Chart II-3 For the sector analysis, we looked at information technology, financials, energy, materials, utilities, healthcare, and telecommunications. We excluded industrials, consumer discretionary, and consumer staples given that they do not have adequate back data. Once again, we separate rising inflation periods into four quartiles, arriving at the following results: When inflation was low, information technology had the best excess returns while utilities had the worst (Chart II-3.1, panel 1). This matches our observations at the asset class level, as IT is highly responsive to changes in the valuation multiple. When inflation was mild, energy had the best performance, followed by information technology (Chart II-3.1, panel 2). Meanwhile, financials had the worst performance, as rates were normally rising in these periods. When inflation was high, sectors highly correlated with commodity prices such as energy and materials outperformed. Meanwhile, IT was the worst performer (Chart II-3.1, panel 3). When inflation was very high, every sector had negative excess returns. Overall, investing in energy minimized losses (Chart II-3.1, panel 4). However, this performance was in part attributable to the oil spikes of the 1970s. Alternatively, defensive sectors such as utilities, telecommunications, and healthcare also minimized losses. International vs U.S. Equities Chart II-3 How do equities outside of the U.S. behave when inflation is rising? While the high share of U.S. equities in the global index causes U.S. equities to be the main driver of global stock prices, is it possible to improve returns in inflationary environments by overweighting international equities? The answer once again depends on the level of inflation. When inflation was rising but low, U.S. stocks outperformed global ex-U.S. equities in both common currency and local currency terms (Chart II-3.2, panel 1). This was in part due to the inherent tech bias in U.S. stocks. Additionally, the low level of inflation was often accompanied by slowing global growth in our sample, helping the U.S. dollar. When inflation was mild, U.S. stocks once again outperformed international stocks in both local and common currency terms, though to a lesser degree (Chart II-3.2, panel 2). The dollar was roughly flat in this environment. U.S. stocks started to have negative excess returns when inflation was high (Chart II-3.2, panel 3). On the other hand international equities had positive excess returns in dollar terms, partly because of their energy and material bias and partly because the dollar was generally weak in this period. U.S. equities outperformed global ex-U.S. equities by a small margin when inflation was very high, given that defensive sectors such as telecommunication were over-represented in the U.S. index (Chart II-3.2, panel 4). The dollar was roughly flat in this period. Individual Commodities Chart II-3 Our analysis above confirmed that commodities were one of the best assets to hold when inflation was rising. However, which commodity performed best?8 Total return for every commodity was lower than spot return when inflation was low (Chart II-3.3, panel 1). This was due to the upward-sloping term structure of the futures curve (contango), resulting in a negative roll yield. In this range, energy had the best performance, followed by industrial metals. Precious metals had negative excess returns. When inflation was mild, energy had the best performance of any commodity by far (Chart II-3.3, panel 2). Precious and industrial metals had low but positive excess returns in this period. When inflation was high, industrial metals had the highest excess returns, followed by energy (Chart II-3.3, panel 3). We omit energy for the last quartile since there is not enough data available. Overall, when inflation was very high, both gold and silver had the highest excess returns (Chart II-3.3, panel 4). However, gold’s return volatility was much lower, while it also had positive returns 64% of the time compared to 52% for silver. Other Assets U.S. Direct Real Estate Our asset-class analysis confirmed that public real estate (REITs) as an asset class offered poor risk-adjusted returns during inflationary periods. But how did direct real estate perform? We analyzed direct real estate separately from all other assets because of a couple of issues: Our return dataset is available only on a quarterly basis, versus a monthly basis for the rest of the assets in our sample. Even when annualized, volatility is not directly comparable when using data with different frequencies. The NCREIF Real Estate Index that we used is a broad aggregate, which is not investable. Individual property prices might differ from this aggregate. Finally, real estate returns are measured on an appraisal basis. Appraisal-based indices are not reflective of real transactions. Moreover, prices tend to be sticky. To attenuate this issue we unsmoothed the capital returns by removing return autocorrelation. Overall, the Sharpe ratio of direct real estate was solid throughout the first three quartiles of rising inflation (Chart II-4.1, top panel). There is not enough data available for the fourth quartile. However, judging by the performance of U.S. housing in the 1970s from OECD, risk-adjusted returns when inflation was very high was likely positive (Chart II-4.1, bottom panel). Chart II-4 Chart II-4   Cash Cash (investing in a 3-month U.S. Treasury bill) outperformed inflation over our sample (Chart II-4.2, top panel). Moreover, cash provided positive real returns when inflation was mild, or high, or when it was decreasing (Chart II-4.2, bottom panel). However, cash was not a good inflation hedge at the highest inflation quartile, with an average annualized real loss of almost 2%. Juan Manuel Correa Ossa Senior Analyst Global Asset Allocation Footnotes 1       Please see Carl E. Walsh, “October 6, 1979,” FRSBF Economic Letter, 2004:35, (December 3, 2004). 2       Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could it Happen Again? (Part 1), ” dated August 10, 2018, and “1970s-Style Inflation: Could it Happen Again? (Part 2),” dated August 24, 2018, available at gis.bcaresearch.com. 3       We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 4       Excess returns are defined as asset return relative to a 3-month Treasury bill. 5       Sector classification does not take into account GICS changes prior to December 2018.  6       Please see Global Asset Allocation Strategy Special Report "REITS Vs Direct: How To Get Exposure To Real Estate," dated September 15, 2016, available at gaa.bcaresearch.com. 7       It is important to note that the synthetic TIPS series does not completely match actual TIPS series for the periods where they overlap. Specifically, volatility is significantly higher in the synthetic series. Thus, results should be taken as approximations. 8       We decompose the returns into the same 4 quartiles to answer this question. However, due to lower data availability, we start our sample in 1978 instead of 1973. Moreover, our sample for energy is smaller beginning in 1983. This mainly reduces the amount of data available at the upper quartile.