Japan

Highlights Monetary policy remains accommodative in Japan, but will tighten on a relative basis if the Bank Of Japan (BoJ) stands pat. The BoJ’s margin of error is non-trivial, since a small external shock could well tip the economy back into deflation. Historically, the BoJ has needed an external shock to act, suggesting the path towards additional stimulus could be lined with a stronger yen. Our bias is that USD/JPY could weaken to 104 in the next three to six months, especially if market volatility spikes further. We are carefully monitoring any shift in the yen’s behavior, in particular its role as a counter-cyclical currency. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. Feature The powerful bounce in global markets since the December lows is sitting at a critical juncture. With the S&P 500 at its 200-day moving average, crude oil and Treasury yields plunging and the dollar taking a bid, it may only require a small shift in market prices to change sentiment sharply. The yen has strengthened in sympathy with these moves, but the balance of evidence suggests the possibility of a much bigger adjustment. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. BoJ: Out Of Policy Bullets For most of the 1990s, Japan was in a deflationary bust. In hindsight, the reason was simple: The structural growth rate of the economy was well below interest rates, which meant paying down debt was preferable to investing. Tight money also led to a structurally strong currency, reinforcing the negative feedback loop (Chart I-1). Chart I-1The Story Of Japan In One Chart Much farther down the road, the three arrows of ‘Abenomics’ arrived, ushering in a paradigm shift. Since 2012, Japan has enjoyed one of its longest economic expansions in recent history, having fine-tuned monetary policy each time private sector GDP growth has fallen close to interest rates. The result has been remarkable. The unemployment rate is close to a 26-year low, and the Nikkei index has tripled. But if the economy once again flirts with deflation, additional monetary policy options may be hard to come by, since there have been diminishing economic returns to additional stimulus. Chart I-2Stealth Tapering By ##br##The BoJ Chart I-32 Percent Inflation Equal Mission Impossible? The end of the Heisei era1 has brought forward the urgency of the above quandary. At its latest monetary policy meeting, the BoJ strengthened forward guidance, expanded collateral requirements for the provision of credit, and stated that it will continue to “conduct purchases of JGBs in a flexible manner so that their amount outstanding will increase at an annual pace of about 80 trillion yen.”2 But with the BoJ owning 46% of outstanding JGBs, about 75% of ETFs, and almost 5% of JREITs, this will be a tall order. The supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. Total annual asset purchases by the BoJ are currently running at about ¥27 trillion, while JGBs purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and is unlikely to change anytime soon. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at its current pace, then the rate of expansion in its balance sheet will severely slow, and could trigger a knee-jerk rally in the yen (Chart I-2). The BoJ targets an inflation rate of 2%, but it is an open question as to whether it can actually achieve this. It pays attention to three main variables when looking at inflation: Core CPI, the GDP deflator, and the output gap. All indicators are pointing in the right direction, but the recent slowdown in the global economy could reverse this trend. It is always important to remember that the overarching theme for prices in Japan is a falling (and aging) population leading to deficient demand (Chart I-3). More importantly, almost 40% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for prices within the BoJ’s control, an aging demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years the government has been a thorn in the side of telecom companies, pushing them to keep cutting prices, given domestic pressures from its voting base. Transportation and telecommunications make up 17% of the core consumption basket in Japan, a non-negligible weight. This is and will remain a powerful drag on CPI (Chart I-4), making it difficult for the BoJ to re-anchor inflation expectations upward. On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathemas for Japanese net interest margins and share prices (Chart I-5). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. Chart I-4The Japanese Prefer Falling Prices Chart I-5Negative Rates Are Anathema To Banks Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it might first require a riot point. Go short USD/JPY. High Hurdle For Delaying Consumption Tax Since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a disastrous outcome. More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Foreign and domestic machinery orders are slowing, employment growth has halved from 2% to 1%, and wages are inflecting lower (Chart I-6). This is especially worrisome since the labor market has been the poster child of the Japanese recovery.3 The consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Why go ahead with the consumption tax then? The answer lies in the concept of Ricardian equivalence.4 Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has remained tepid. By the same token, the savings ratio for workers has surged (Chart I-7). If consumers are caught in a Ricardian equivalence negative feedback loop, exiting deflation becomes a pipe dream. Chart I-6A Bad Omen Increased social security spending: This will be particularly geared towards child education. For example, preschool and tertiary education will be made free of charge. Promoting cashless transactions: Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. This incentive should help lift the velocity of money. Chart I-7Strong Labor Market, Weak Consumption Construction spending: This will offset the natural disasters that afflicted Japan last year. Construction orders in Japan accelerated at a 66% pace in March. The Abe government’s strategy has so far been to offset the consumption tax hike with increased domestic spending. The thinking is that once in a liquidity trap, the fiscal multiplier tends to be much larger. Some of these outlays include: Chart I-8Japan Needs More Fiscal Stimulus The new immigration law will also help. Foreign workers were responsible for 30% of all new jobs filled in Japan in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will be beneficial for consumption. To be sure, this may not be enough. The IMF still projects the fiscal drag in Japan to be 0.1% of GDP in 2019 and 0.6% in 2020 (Chart I-8). This puts the onus back on the BoJ to ease financial conditions. A combination of easier fiscal and monetary policy will be a headwind for the yen. This could happen if the U.S./China trade war escalates, and twists the arm of the finance ministry. But the hurdle is high for the government to roll back the consumption tax, given significant spending offsets. The Yen As A Safe Haven Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence (Chart I-9). This is because with a net international investment position of almost 60% of GDP and net income receipts of almost 4% of GDP, volatility in markets tend to lead to powerful repatriation flows back to Japan. Real interest rates also tend to be higher in Japan in recessions as already-low inflation expectations fall further. Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence. Some have suggested that the BoJ’s asset purchases are pushing investors out of Japan and weakening the safe-haven status of the yen. While plausible, our view is that other factors have been at play. First, tax changes led to repatriation of capital back to the U.S. in 2018. This unduly pressured foreign direct investment in Japan as well as other safe-haven countries like Switzerland. Second, Japan, by virtue of its current account surplus, runs a capital account deficit. This means that portfolio outflows are the norm. This is how it has managed to build the biggest net international investment position in the world. Only in times of severe flight to safety are those investments liquidated and brought home. More importantly, the time may now be very ripe for yen long positions, given rising suspicion towards the currency as a haven. To see why, one only has to return to late 2016. Back then, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the BoJ. Despite that backdrop, the yen strengthened by almost 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. With U.S. interest rates having risen significantly versus almost all G10 countries in recent years, including Japan’s, the dollar has become a carry currency. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and these trades get unwound, this will be a powerful undercurrent for the yen (Chart I-10). Chart I-9The Yen Remains A Safe Haven Chart I-10The Yen Has Financed Carry Trades Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. What If Global Growth Picks Up? The eventual bottom in global growth is a key risk to our scenario. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds, but it will be important to monitor if this correlation shifts during the next equity market rally. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Our contention is that the yen will surely weaken at the crosses, but could strengthen versus the dollar. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Meanwhile, large net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-12). Chart I-11Japan: Better Governance, Higher ROIC Chart I-12Short USD/JPY: A Contrarian Bet Bottom Line: Short USD/JPY trades have entered into an envious “heads I win, tails I do not lose too much” position. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up later this year, the yen could weaken on its crosses but may actually strengthen versus the dollar. Housekeeping We are closing our short EUR/CZK position with a 4.7% profit. Interest rate differentials between the Czech Republic and the euro area have widened significantly, at a time when growth and labor market tightness could be fraying at the edges. Meanwhile, possible weakness in the dollar will be a risk to this position.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period corresponding to the reign of Japanese Emperor Akihito from 1989 until 2019. 2 Please see “Minutes of the Monetary Policy Meeting,” Bank of Japan, dated May 8, 2019, p.27. 3 Sample changes last year make it more difficult to have an apples-to-apples comparison for wages. 4 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data in the U.S. have been negative: Total durable goods orders decreased by 2.1% in April. On the housing front, FHFA house price growth fell to 0.1% month-on-month in March. MBA Mortgage applications fell by 3.3% in May. Conference Board consumer confidence index improved to 134.1 in May. Dallas Fed Manufacturing activity index fell to -5.3 in May. Annualized GDP came in at 3.1% quarter-on-quarter in Q1, revised from the previous 3.2% but higher than the consensus of 3%. Q1 headline and core PCE both fell to 0.4% and 1% quarter-on-quarter respectively. DXY index increased by 0.6% this week. In the long-term, we maintain a pro-cyclical stance, and continue to believe that the path of least resistance for the dollar in down. In the short-term however, there is more room for the trade-weighted dollar to rise before eventually reversing, amid global data weakness and political uncertainties. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro EUR Technicals 1 EUR Technicals 2 Recent data in the euro area have shown improvement: Private loans increased by 3.4% year-on-year in April. Money supply (M3) increased by 4.7% year-on-year in April. Business climate indicator fell to 0.3 in May. Despite the weak business climate indicator, soft data in the euro area have generally improved in May: economic confidence rose to 104; industrial confidence increased to -2.9; services confidence climbed to 12.2. Lastly, the consumer confidence increased to -6.5. EUR/USD fell by 0.7% this week. During this weekend’s European Parliament election, the European People’s Party (EPP) won with 24% of the seats. However, 43 seats were lost compared with their last election result. The S&D party also lost 34 seats, together ending the 40-year majority of the center-right and center-left coalitions. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen JPY Technicals 1 JPY Technicals 2 Recent data in Japan have been negative: All industry activity index fell by 0.4% month-on-month in March. The leading index and coincident index both fell to 95.9 and 99.4 respectively in March. PPI services fell to 0.9% year-on-year in April, below the expected 1.1%. Labor market  and CPI data will be released after we go to press today. USD/JPY rose by 0.3% this week. BoJ Governor Haruhiko Kuroda has given two speeches this week, warning about the high degree of uncertainty, and potential downside risks worldwide. On the positive side, Kuroda thinks that EM capital outflows are less at risk than during recent financial crises, given a better framework for risk management. In the meantime, uncertainties remain regarding the U.S.-Japan trade disputes, especially vis-à-vis Japanese auto exports. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound GBP Technicals 1 GBP Technicals 2 Recent data in the U.K. continue to outperform: Total retail sales increased by 5.2% year-on-year in April, surprising to the upside. BBA mortgage a pprovals increased to 43 thousand in April. GBP/USD fell by 0.8% this week. The uncertainties of Brexit increased with the resignation of Prime Minister Theresa May last Friday. With a Brexit decision not due until October 31, 2019, the U.K. has participated in the recent EU election. The newly formed Brexit Party led by Nigel Farage, won with more than 31% of the votes. This reflects a growing dissatisfaction with traditional parties within U.K. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar AUD Technicals 1 AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 118.6 this week. HIA new home sales fell by 11.8% month-on-month in April. Moreover, building permits decreased by 24.2% year-on-year. Private capital expenditure in Q1 fell by 1.7% quarter-on-quarter. Building approvals fell by 4.7% month-on-month in April. AUD/USD fell by 0.2% this week. As we argued in last week’s report, we favor the Aussie dollar from a contrarian point of view. Despite the negative data points on the surface, the recent election result and dovish shift by RBA all support the Australian economy in the long-term. Moreover, the robust job market, rising terms of trade, and Chinese stimulus will likely put a floor under AUD/USD. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ activity outlook increased by 8.5% in May, well above consensus. Building permits fell by 7.9% month-on-month in April. ANZ business confidence remained low at -32 in May. NZD/USD fell by 0.6% this week. The Financial Stability Report, released by RBNZ this week, highlighted the worrisome debt levels, particularly in the household and dairy sectors. Ongoing efforts are necessary to bolster system soundness and efficiency, according to RBNZ governor Adrian Orr. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar CAD Technicals 1 CAD Technicals 2 Recent data in Canada have been positive: Bloomberg Nanos confidence index improved to 55.7, from the previous 55.1. Current account deficit increased to C$17.35 billion from C$16.62 billion, but it is lower than the expected C$ 18 billion. USD/CAD increased by 0.4% this week. On Wednesday, the Bank of Canada (BoC) held interest rates steady at 1.75%, as widely expected. Despite the recent trade uncertainties, the BoC views the slowdown in late 2018 and early 2019 as temporary, and expects growth to pick up again in the second quarter this year, supported by recovering oil prices, stabilizing housing sector, robust job market and easy financial conditions. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data in Switzerland have been mixed: Q1 GDP came in higher-than-expected at 1.7% year-on-year, from the previous reading of 1.5%. Trade surplus reduced to 2.3 million CHF in April, mostly due to the decrease in exports. KOF leading indicator fell to 94.4 in May. ZEW expectations fell in May to -14.3. USD/CHF appreciated by 0.7% this week. We favor the Swiss franc as a safe haven when market volatility rises. In the longer term, the high domestic savings rate, rising productivity, and current account surplus should all underpin the franc. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone NOK Technicals 1 NOK Technicals 2 There is little data from Norway this week: Retail sales increased by 1.6% year-on-year in April. Credit expanded by 5.7% year-on-year in April USD/NOK increased by 0.9% this week. Our Commodity & Energy Strategy team believe that the energy market is underpricing the U.S. - Iran war risk, and overestimating the short-term effects of the trade war. In the long run, the Chinese stimulus, dollar weakness, and supply uncertainties should lift oil prices, which will support the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data in Sweden have been mostly negative: Producer price inflation fell to 4.9% year-on-year in April from 6.3% in March. Consumer confidence fell to 91 in May. Moreover, manufacturing confidence fell to 103.7 in May. Trade surplus fell from 6.4 billion to 1.4 billion SEK in April. Q1 GDP came in at 2.1% year-on-year, outperforming expectations but lower than the previous 2.4%. USD/SEK has been flat this week. Swedish exports, a reliable barometer for global business confidence, fell from 133.4 billion SEK to 128 billion SEK in April, which is a total decrease of 5.4 billion SEK in exports, implying that the global growth remains in a volatile bottoming process. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The view that the world will sink into a deflationary “ice age” hinges on the assumption that policymakers will make a colossal mistake by failing to do what is in their own best interest. Contrary to popular belief, governments always have a tool to increase inflation, even when an economy has fallen into a liquidity trap: It’s called sustained fiscal stimulus. Japan could have avoided its deflationary epoch if the authorities had eased fiscal policy more aggressively. Ironically, bigger budget deficits probably would have caused the government debt-to-GDP ratio to rise less than it did. The U.S. and China are unlikely to repeat Japan’s mistake. Actually, looking ahead, Japan may not repeat Japan’s mistake. The euro area is a tougher call given the region’s political and institutional constraints; but even there, a reflationary outcome is more likely than not. An intensification of the trade war will cause government bond yields to fall a bit further in the near term. However, yields are likely to be higher one year from now. Global equities will follow the same path as bond yields: Down in the near term, but up over a 12-month horizon. Feature I feel more confident than ever that the next phase of the Ice Age will soon be upon us. Much of the thesis has come from learning the hard deflationary lessons from Japan. Most commenters now accept the Japanification of mainland Europe has occurred, but they just cannot conceive that the same thing might happen with the US. My biggest conviction call is that US 10y bond yields will converge with Japanese and German yields in the next recession at around minus 1% (and US 30y yields will fall to zero or below) and that markets will panic as outright deflation takes an icy grip. -  Albert Edwards, Société Générale (May 2019) Fire Or Ice? If you were to ask most central bankers today whether it is better to err on the side of too much or too little inflation, chances are they would say the former. Their rationale would surely be as follows: If inflation rises to uncomfortably high levels, they can simply raise interest rates in order to cool the economy. In contrast, if inflation gets too low, and interest rates are already close to zero, monetary policy loses potency. It is better to have more control over the economy than less. This reasoning is correct on its own terms, but if one stands back and thinks about it, it is rather perverse to argue that deflation, which generally stems from a lack of aggregate demand, should be more difficult to overcome than inflation, which is usually the result of too much demand. After all, people like to spend money. Getting someone to work and produce should, in principle, be more difficult than getting them to consume. Inflation should be a bigger problem than deflation. So why do so many economists think otherwise? The Paradox Of Thrift There actually is a very good reason for this bias, one which John Maynard Keynes articulated more than 80 years ago. Keynes observed that when unemployment is rising, people are likely to try to save more due to fear of losing their jobs. Since one person’s spending is another’s income, this could create a vicious cycle where falling spending leads to lower aggregate income, and so on. Unfortunately, it is hard to save if you do not have a job. Thus, the decision by all individuals to save more could result, ironically, in a decline in aggregate savings.1 Keynes called this the paradox of thrift. At the heart of the paradox of thrift lies a deep-seated coordination problem. During an economic downturn, everyone would be better off if everyone else spent more money. However, since the spending of any one person only has a negligible effect on aggregate demand, no one has an incentive to spend more than is absolutely necessary. Keynes’ seminal insight was that a government could overcome this coordination problem by acting as a spender of last resort. Keynes argued that if the private sector decides to save more, the public sector should save less by running a bigger budget deficit. The result would be the preservation of full employment. Debt And Deliverance A common objection to the idea that governments should run bigger budget deficits to compensate for inadequate private-sector demand is that this will cause public-sector debt levels to swell to the point that a fiscal crisis becomes inevitable. The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. For countries such as Italy, this is a legitimate concern. If a country does not have a central bank that can serve as a buyer of last resort of government debt, it can end up facing a pernicious feedback loop where rising bond yields increase the likelihood of default, leading to even higher bond yields. These countries can, and often do, face speculative attacks on their bond markets (Chart 1). For countries that issue debt in their own currencies, this concern does not exist. This is because their governments can print money to pay for goods and services. Since the cost to the government of printing a $100 bill is negligible, the government can always conjure up demand out of thin air. Of course, there is a risk that the government will manufacture too much demand and inflation will rise. But if the goal is to prevent deflation, this is a feature not a bug. Once demand increases enough, the government can just pull the plug on further fiscal stimulus, and everyone can live happily ever after. Japan’s Experience Chart 2The 1990s Japanese Example Didn’t Japan try this approach and fail? No. Japan suffered the mother of all financial shocks in the early 1990s when the real estate and stock market bubbles simultaneously burst. This happened just as the working-age population was peaking, which made businesses even less eager to expand domestic capacity. The result of all this was a massive increase in excess private-sector savings. The government did loosen fiscal policy, but not by enough. Consequently, deflation eventually set in. As inflation expectations fell, real rates rose (Chart 2). Rising real rates put upward pressure on the yen and increased the government’s real debt financing costs. To make matters worse, falling prices made it more difficult for private-sector borrowers to pay back their loans. This further depressed spending. Ironically, had the Japanese government eased fiscal policy more aggressively to begin with, it probably would have been able to trim deficits later on. Nominal GDP would have also increased more briskly. As a consequence, the government debt-to-GDP ratio would have ended up rising less than it did. Today, Japan remains mired in a deflationary mindset. Twenty-year CPI swaps, a proxy for long-term inflation expectations, are trading at 0.3%, nowhere close to the Bank of Japan’s 2% target. Interest rates are stuck near zero, reflecting the fact that the economy continues to suffer from excess savings. Japan Needs Fiscal Stimulus, Not Austerity The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. Given Japan’s pathetically low fertility rate, a sensible strategy would be to offer subsidized housing and baby bonuses to any couple that has three or more children. It is impossible to know how big a budget deficit will be required to reset inflation expectations to a higher level. If people believe that the government is serious about easing fiscal policy by enough to get inflation up to target, real rates will collapse, the yen will fall, and private demand will rise. In the end, the government may not need to raise the budget deficit that much. Even if the Japanese government did have to increase the budget deficit substantially, this would not endanger the economy. As long as the interest rate at which the government borrows is below the growth rate of the economy, any budget deficit, no matter how large, will produce a stable debt-to-GDP ratio in the long run (Chart 3).2 Since there would be no need to ease fiscal policy by so much that the Bank of Japan is forced to lift interest rates above the economy’s growth rate, there is little risk that the debt-to-GDP ratio will end up on an unsustainable trajectory. Chart 4Japanese Excess Savings Are Starting To Recede Will the Japanese government heed this advice? While Q1 GDP growth surprised on the upside, this was mainly because of a strong contribution from net exports and inventories. Final domestic demand remains underwhelming. Stronger global growth will help Japan later this year, but we think there is still a 50/50 chance the planned VAT hike will be postponed. Looking ahead, the exodus of Japanese workers from the labor market into retirement will reduce private-sector savings. The household savings rate has already fallen from nearly 20% in the early 1980s to around 4% in recent years. The ratio of job openings-to-applicants has risen to a 45-year high (Chart 4). Falling private-sector savings will raise the neutral rate of interest, thus giving the BoJ more traction over monetary policy. Japan’s deflationary ice age may be coming to an end. Stimulus With Chinese Characteristics Like Japan, China has struggled to consume enough of what it produces. In the days when China had a massive current account surplus, it could export that excess savings abroad. It cannot do that anymore, so the government has consciously chosen to spur fixed-investment spending in order to prop up employment. Since a lot of investment is financed through credit, debt levels have risen (Chart 5). Much of China’s debt-financed investment spending has been undertaken by local governments and state-owned enterprises. This has made credit and fiscal policy virtually indistinguishable. While the general government fiscal deficit stands at a moderate 4.1% of GDP, the augmented deficit, which includes a variety of off-balance sheet expenditures, has swollen to 10.7% of GDP, up more than six percentage points since 2010 (Chart 6). Chart 5China: From Exporting Savings To Investing Domestically And Building Up Debt As we discussed a few weeks ago in a report entitled “Chinese Debt: A Contrarian View”, there is little preventing the Chinese government from further ramping up credit/fiscal stimulus.3 The fact that the trade negotiations are on the ropes only strengthens the case for additional easing. The government knows full well that it will gain negotiating leverage over the U.S. if the Chinese economy is humming along despite higher tariffs on Chinese imports. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Europe: Turning Japanese? Judging from the fact that German bund yields have fallen to Japanese levels, one might conclude that the Japanification of Europe is complete. There is, however, at least one key macro difference between the two regions: While long-term inflation expectations in the euro area have declined, they are still well above Japanese levels (Chart 7). As a result, real yields are quite a bit lower in core Europe, which gives countries such as Germany and France some cushion of support. Chart 7Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower In Germany Than Japan Chart 8Italian Bond Yields Are Still Worryingly High Bond yields remain elevated in Italy, though still below the levels seen last October, and far below their peak during the euro crisis in 2011 (Chart 8). Short of the creation of a pan-euro area fiscal union, Italy’s best hope is that Germany takes steps to reflate its own economy. The conventional wisdom is that the German psyche, ever focused on fiscal discipline, would never permit that to happen. This view, however, forgets that Germany had no trouble violating the Maastricht Treaty’s deficit cap of 3% of GDP in the early 2000s. Germany today sees little need to significantly loosen fiscal policy because years of wage repression, and more recently, a weak euro, have caused its current account surplus to swell to 9% of GDP. However, the country’s ability to push out its excess production to the rest of the world may become more limited in the future. The gap in unit labor costs between Germany and other euro area members has narrowed steadily in recent years. This development has coincided with a decline in Germany’s trade surplus with the rest of the euro area (Chart 9). If the common currency starts to appreciate and wage growth in Germany continues to outpace the rest of the region, the German government may have no choice but to loosen the fiscal screws. Chart 9Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Chart 10U.S.: Federal Discretionary Spending Has Been Gaining Steam   U.S.: Ice Age Vs. Green New Deal While Trump’s tax cuts have gotten a lot of attention, an equally important development in recent years has been the rapid acceleration in federal government spending. From a contraction of 7% in 2013, real discretionary outlays are set to grow by 3% in 2019 (Chart 10). There is little reason to think that the U.S. budget deficit will shrink anytime soon. Taxes may go back up if the Democrats take control of the White House and sweep Congress next year. However, even in that scenario, any increase in tax rates is likely to be neutralized by higher social welfare spending – yes, including partial implementation of the green new deal. Meanwhile, government outlays on Social Security and health care programs such as Medicaid are on track to rise by 5.4% of GDP over the next thirty years (Chart 11). So far, an overstimulated U.S. economy has not produced much in the way of inflation. But with the unemployment rate down to a 49-year low, that could change over the next few years. Recent communications from FOMC members suggest a growing tolerance for a modest inflation overshoot of the 2% target. An outright increase in the Fed’s inflation target is unlikely in the near term, but could become a viable option if realized inflation moves above the Fed’s current comfort zone of 2%-to-2.5% for long enough. If that were to happen, raising the inflation target could turn out to be politically more expedient than engineering a deep recession in an effort to bring inflation back down. It will also help alleviate the rising real debt burden that will ensue from high deficits. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. The Fed is already facing political pressure from the Trump administration to keep rates low. Politics in the U.S. and in many other countries is moving in a more populist direction. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Historically, there is a clear inverse correlation between central bank independence and inflation (Chart 12). Investment Conclusions On the question of whether we are heading for a deflationary ice age or a period of inflationary global warming, we would put higher odds on the latter. Many of the structural factors that have produced lower inflation over the last few decades are in retreat. Globalization has stalled, and may even reverse course if the trade war intensifies (Chart 13). The ratio of workers-to-consumers globally is starting to shrink as the post-war generation leaves the labor force (Chart 14). Central bank autonomy is under attack, while fiscal policy is turning more expansionary. Chart 13The Age Of Globalization Is Over Chart 14The Worker-To-Consumer Ratio Has Peaked Globally To believe that politicians will not dial up fiscal stimulus in the face of a chronic shortfall of aggregate demand is to believe that they will act incompetently. Not incompetent in the low-IQ sort of way. Incompetent in the sense that they will act against their own self-interest. Voters want more employment. In the age of populism, it seems unlikely that politicians with ready access to the printing press will fail to deliver what the people want. We declared “The End Of The 35-Year Bond Bull Market” on July 5, 2016. As luck would have it, this was the very same day that the U.S. 10-year Treasury yield hit an all-time low of 1.37%. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. Right now, we are witnessing a countertrend rally in bond prices. Yields could fall a bit further in the coming weeks if the trade war heats up. However, yields will be higher in 12 months’ time, provided that China and the U.S. begrudgingly reach a trade truce and global growth reaccelerates, as we expect. Global equities are likely to follow the same pattern as bond yields. Trade tensions could push stocks down about 5% from current levels (we are presently positioned for this by being tactically short the S&P 500 against an underlying structural overweight position). However, equities will move to fresh highs over a 12-month horizon as global growth picks up. The recent stock market correction caused our long European bank trade to be stopped out for a loss of 7%. We will re-enter the trade once we conclude that global equities have found a bottom. The dollar will probably strengthen a bit more in the near term, but as a countercyclical currency, the greenback will weaken in the second half of this year. This will provide a good opportunity to go overweight EM and European stocks in common-currency terms.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Another way to see this point is to recall that business spending normally declines when the economy weakens. Investment spending tends to move in lockstep with national savings (indeed, at the global level, the two must be exactly equal to each other). Thus, if consumer spending falls in response to the decision by households to try to save more, and this leads to lower investment, it will also lead to lower aggregate savings. 2      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 3      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights Global financial markets are currently dealing with a fresh round of uncertainty related to U.S.-China trade tensions. Yet while equities and government bond yields have fallen in response to the U.S. imposition of tariffs and escalation of the trade war with China, corporate bond markets in the developed economies have been relatively well-behaved (so far). Credit spreads have only widened modestly, which perhaps should not be surprising given central bankers’ increasingly dovish bias combined with early signs of a cyclical global growth rebound (Chart 1). Feature Chart 1Global Corporates: Shifting To A Friendlier Growth Backdrop? With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) that are designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The main conclusion from the latest readings on our CHMs is that slower economic growth over the past year has resulted in some erosion of overall global credit quality. The deterioration was most pronounced in the more economically fragile regions that have suffered the deepest pullbacks in growth: Europe and Japan. The CHMs are currently giving an overall “neutral” signal in the U.S., although there are some worrying trends developing within the sub-components like interest coverage and short-term liquidity. Meanwhile, the CHMs in the U.K. and Canada are showing modest cyclical deterioration from very strong levels. Broadly speaking, the CHMs support our main global corporate bond market investment recommendations: a tactical aggregate overweight versus global government bonds, with a regional bias favoring the U.S. over Europe, and a quality bias tilted towards U.S. high-yield (HY) over investment grade (IG). Renewed U.S.-China trade hostilities represent a threat to that pro-cyclical fixed income asset allocation, although we expect more aggressive responses from policymakers on both sides (more fiscal and monetary stimulus in China, a more dovish bias from the Fed) to offset any tariff-induced weakness in growth. U.S. Corporate Health Monitors: Cyclically OK, But Longer-Term Problems Are Brewing Our top-down U.S. CHM is sending a neutral message on credit quality, sitting right on the threshold separating “deteriorating health” from “improving health” (Chart 2). The indicator, however, has been trending in a direction showing improving credit metrics over the past year. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle.  The resilience of the U.S. economy, combined with the positive impact on U.S. profitability from the Trump corporate tax cuts, has put U.S. companies in a cyclically healthier position, even with relatively high leverage. The ratios directly related to corporate profits that go into the top-down CHM – return on capital, profit margins and interest coverage – have all gone up over the past year, generating the bulk of the directional improvement in the top-down CHM. From a fundamental perspective, the top-down U.S. CHM suggests that the U.S. credit cycle is being extended by the stubborn endurance of the U.S. business cycle. In other words, there are no immediate domestic pressures on U.S. corporate finances that should require significantly wider credit spreads to compensate for rising downgrade/default risk. That does not mean that all the news is good, however. The short-term liquidity ratio has fallen sharply and is now at levels last seen in the years leading up to the 2008 Financial Crisis. Similar deteriorations can be seen in the short-term liquidity ratios within the bottom-up versions of our U.S. CHMs for IG corporates (Chart 3) and HY companies (Chart 4). Coming at a time when interest coverage ratios have been steadily declining for IG, and are already at low levels for HY, declining short-term liquidity would leave U.S. corporates highly vulnerable during the next economic downturn. Chart 2Top-Down U.S. CHM: A Neutral Reading Chart 3Bottom-Up U.S. IG CHM: Modest Deterioration With Worrying Trends We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates. For now, however, the message from our bottom-up U.S. CHMs is the same as that from our top-down U.S. CHM, with all hovering near the zero line suggesting no major deterioration in overall credit quality. We see no reason yet to exit our tactical overweight stance on U.S. IG and HY corporates versus both U.S. Treasuries and non-U.S. corporates (Chart 5). Our favored indicators continue to point to a rebound in global growth in the latter half of 2019, and the Fed currently has no desire to push the funds rate into restrictive territory, so the risk/reward over the next six months still favors staying overweight U.S. corporates. The medium-term outlook, however, is far more challenging given the growing body of evidence pointing to the advanced age of the U.S. credit cycle, such as falling interest coverage and liquidity. Chart 4Bottom-Up U.S. HY CHM: A Cyclical Improvement, Nothing More Chart 5U.S. Corporates: Stay Tactically Overweight IG & HY One final point – in Appendix 2 starting on page 17, we present bottom-up CHMs for the main industry sector groupings of companies that go into our overall U.S. IG CHM. Most of the sector CHMs are hovering near the zero line, but two industry groupings stand out as having a rising CHM that is now well within “deteriorating health” territory – Consumer Staples and Utilities. Euro Corporate Health Monitors: Worsened By Weaker Growth The message from our bottom-up CHMs for the euro area shows that there was some damage done to credit quality from last year’s growth slump, evidenced by lower profit margins and interest coverage ratios. Although overall credit quality remains fairly neutral (i.e. the CHMs remain near the zero line). For euro area IG, the gap between domestic and foreign issuers in the euro area corporate bond market continues to widen, with the former now slightly in the “deteriorating health” zone (Chart 6). Profit margins have fallen far more sharply for domestic issuers, reflecting the very rapid slowing of euro area growth over the latter half of 2019. Interest coverage for domestic issuers is also lower than for foreign issuers, while short-term liquidity ratios have weakened for both over the past year. For euro area HY, the signal from the bottom-up CHM is more consistently positive between domestic and foreign issuers (Chart 7). Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weaker Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthier Through Lower Leverage Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, and are now hovering just above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. Despite the lack of a major overall negative signal from the euro area CHMs, we are only maintaining a neutral allocation to euro area corporates, even within our current overweight stance on overall global corporates (Chart 9). The spread tightening already seen in euro area credit is too extreme relative to the still sluggish pace of economic growth in the region. This will inhibit the ability for spreads to tighten further in the event of a pickup in growth, while also leaving spreads vulnerable to widening pressures if euro area growth continues to languish. Chart 8Bottom-Up Euro Area Regional IG CHMs: Trending In The Wrong Direction Chart 9Euro Area Corporates: Stay Tactically Neutral IG & HY Chart 10Relative Bottom-Up CHMs: Continue To Favor U.S. Over Europe In addition, we are sticking with our preference to favor U.S. corporates – both IG and HY – over euro area equivalents for two important reasons: stronger U.S. growth and better U.S. corporate health. The gap between the combined IG/HY bottom-up CHMs for the U.S. and euro area has been strongly correlated to the difference in credit spreads between euro area and U.S. issuers (Chart 10).1 The latest trends show a narrowing of the gap between the U.S. and euro area CHMs, suggesting relative corporate health favors U.S. names (middle panel). At the same time, the relatively stronger performance of the U.S. economy continues to support U.S. corporate performance versus euro area equivalents (bottom panel). U.K. Corporate Health Monitor: Brexit Uncertainty Is Not Helping Our top-down U.K. CHM remains in the “improving health” zone, although the indicator has been drifting towards “deteriorating health” over the past two years. Almost all of the components of the U.K. CHM have contributed to this worsening trend (Chart 11), with only short-term liquidity remaining in a powerful multi-year uptrend. Most worryingly, the interest and debt coverage ratios remain historically depressed, even as the Bank of England has keep interest rates at extraordinarily low levels for the past several years. The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits.   The cyclical deterioration in the U.K. CHM components can be traced to the sluggish performance of the U.K. economy and corporate profits. The persistent uncertainty from Brexit has weighed on business confidence and investment spending by U.K. firms, keeping growth at a below-trend pace. While the immediate deadline of “Brexit Day” came and went back in March, there is still a high degree of uncertainty over the U.K.’s future economic relationship with the European Union. With Prime Minister Theresa May now set to step down, an election will extend the period of politically-driven uncertainty in the U.K. We have maintained a moderate underweight recommendation on U.K. corporates in our model bond portfolio over the past year, despite the lack of an obvious negative signal from our U.K. CHM. Spread widening in 2018 has been followed by spread tightening in 2019 (Chart 12), but the latter has been driven by the global rally in risk assets rather than diminished perceptions of U.K. political risk. Chart 11U.K. Top-Down CHM: Modest Pullback From Healthy Levels Chart 12U.K. Corporates: Stay Modestly Underweight Although there has been some improvement in U.K. economic data of late, leading economic indicators continue to trend lower. In addition, the Bank of England continues to hint that any positive resolution to the Brexit uncertainty could result in a tightening of monetary policy (although that is less of a threat given the synchronized dovish turn by global central bankers over the past few months). Given all the uncertainties, the risk/reward balance continues to favor a modest underweight in U.K. corporates, particularly at current tight spread levels to Gilts. Japan Corporate Health Monitor: A Modest Cyclical Deterioration Our bottom-up Japan CHM has shown a worsening trend over the past year and now sits in the “deteriorating health” zone (Chart 13).2 Interestingly, all of the individual components have contributed to that move in the CHM, and not just the cyclical components (profit margins, return on capital, interest coverage) that reflect the recent slowing of economic growth in Japan. Leverage has increased (albeit from very low levels), while short-term liquidity has also weakened (albeit from very high levels). Strictly looking at the overall level of all the Japan CHM components, the message does not signal a major deterioration in Japanese corporate credit quality. Leverage, defined here as the ratio of total debt to the book value of equity, is still below 100%, well below the 100-140% range seen between 2006 and 2015. The same story applies to the return on capital, which at 5% is still high versus Japan’s history (although very low by global standards). Interest coverage and short-term liquidity both remain high relative to the past decade. The absolute level of Japanese corporate health remains solid, but there has been marginal deterioration from weaker economic growth. On that front, the cyclical momentum in Japan’s economy is not improving. According to the latest Tankan survey, Japanese firms reported that their business outlook was worse than previously expected. Declining confidence has damaged capital spending, as shown by the falling growth of domestic machinery and machine tool orders. Japan’s economy remains highly levered to global growth and export demand and their economy has taken a hit from the slower pace of global trade over the past year. Wage growth has also weakened after finally seeing some positive momentum in 2018, which is weighing on consumer confidence and spending. Japan’s corporate spread has widened slightly (+5bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets (the Bloomberg Barclays Global Corporates index spread has tightened by -33bps year-to-date). This is a sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns versus Japanese Government Bonds (JGBs) with yields held near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM. Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitor: Still In Decent Shape Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving health” area over the past few years (Chart 15). The marginal moves have shown some modest deterioration in the cyclically-sensitive components (most notably, return on capital and profit margins for the top-down Canadian CHM). This should not be surprising given how rapidly Canadian economic growth slowed in the final quarter of 2018. There has also been some deterioration in the non-cyclical components. Leverage is high and rising, while the absolute levels of return on capital and debt/interest coverage are historically low. This may be building up risks for the next major Canadian economic downturn, but for now, Canadian companies look in decent shape. With so much of Canada’s economy (and its financial markets) geared to the performance of the energy sector, the recent recovery in global oil prices is a significant boost for the overall Canadian corporate market. Our commodity strategists see additional upside in oil prices over the next six months, which will further underpin the health of Canadian oil companies – and should also help support Canadian corporate bond performance. The Bank of Canada is now taking an extended pause from its rate-hiking cycle, with policy rates well below the central bank’s own estimate of neutral (2.25-3.25%). Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt We continue recommending an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have been in a very stable range since the 2009 recession (Chart 16), ranging between 100-200bps even during periods when our CHMs were indicating worsening corporate health. To break out of that range to the upside, we would need to see a prolonged deterioration of Canadian economic growth or sharp monetary tightening from the Bank of Canada – neither outcome is likely over the next 6-12 months.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com   Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the U.S., euro area, the U.K. and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.3 The financial data of a broad set of individual U.S. and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix 2: U.S. Bottom-Up CHMs For Selected Sectors       Footnotes 1 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from U.S. companies that issue in the euro area market that are part of our U.S. CHMs. 2 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 3 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns