Valuations

Feature It no longer pays to be underweight the BCA aerospace index considering the long profit growth runway and potential trade easing catalysts. Accordingly, we are moving to a benchmark allocation in this sector. There are two pillars supporting the BCA aerospace index and its relative performance: global trade sentiment and execution-driven profit performance. Despite a tangible easing in trade tensions between the U.S. and China, the global trade environment remains uncertain in the near term as economic weakness has permeated beyond U.S. shores and new trade issues seem likely to pop up (including potential tariffs on EU- or Japan-produced autos) to replace those being resolved. Aerospace profits are soaring to new heights and have been underpinning an aerospace bull market in 2019; a robust order environment suggests this may continue. However, a debt-fueled change in corporate capitalization and stratospheric valuations should keep investor expectations grounded. The Canary In The Coal Mine  The ebb and flow of the trade dispute with China has been reflected partially in the relative performance of industrials1 in general (top panel, Chart 1), aerospace in particular (middle panel, Chart 1) and Boeing specifically (bottom panel, Chart 1). This is due in large part to Boeing taking on the mantle of a global trade bellwether and also dominating our index. Chart 1Aerospace Is Leading The Way Aerospace Is Leading The Way Aerospace Is Leading The Way Considering the global nature of the firm, this role seems appropriate. Chart 2 shows the company’s order backlog by region; the domestic market represents only 25% of the next several years of production while all of the DM represents only 40%. The bulk of Boeing’s production backlog, and hence future revenues, are derived from the EM. Boeing is also particularly unique in that it has virtually no currency exposure as its products are invariably priced in U.S. dollars, as is the case with the bulk of U.S. aerospace firms. Chart 2 Examining relative performance with global leading indicators provides some insight. The global manufacturing PMI shares an exceptionally tight directional relationship with aerospace’s relative performance (second panel, Chart 3). Though the current message is negative, BCA’s Global Leading Economic Indicator (GLEI) diffusion index has already started to recover (bottom panel, Chart 3), signaling that global growth is likely putting in a bottom and aerospace outperformance may resume anew. Chart 3Global Indicators Lead Relative Performance Global Indicators Lead Relative Performance Global Indicators Lead Relative Performance Nevertheless, from a sentiment perspective, aerospace investors are focused squarely on weakness in the Chinese economy. On this front, we think there are three reasons to be modestly hopeful. First, negativity has been prominent in the media narrative (second panel, Chart 4) but this seems now fully priced in to the market. Second, China’s efforts to reflate the economy and the resulting rising odds of a soft landing is a boon to U.S. aerospace stocks (third panel, Chart 4). Lastly, as we have highlighted repeatedly in previous research, resolution of the trade spat between the U.S. and China would provide a significant catalyst for U.S. equities with particular emphasis on the trade-geared aerospace stocks. Chart 4Aerospace Is An EM Bellwether Aerospace Is An EM Bellwether Aerospace Is An EM Bellwether Net, though we remain optimistic for global trade, aerospace’s role as the wind vane for how trade winds are blowing should add both a greater degree of volatility and unpredictability to the index. Earnings Are Increasing Thrust In Aerospace  Despite the above section, the reason why aerospace stocks went vertical at the end of January of this year was not easing trade relations. Rather, it was Boeing’s release of blowout earnings which was followed by earnings beats across the sector. Industry sales have pushed into double-digit growth territory (second panel, Chart 5) while margins are reaching into the stratosphere, hitting record levels (third panel, Chart 5). Chart 5Aerospace Margins At Record Highs Aerospace Margins At Record Highs Aerospace Margins At Record Highs We think the reason why earnings are so elevated has much to do with the age of the order book. In Chart 6, we show Boeing’s order backlog and the years of production in backlog. Following a meltdown in 2008, Boeing’s backlog consistently represented between six and eight years of production. The implication is that the portion of the backlog currently being delivered was booked in the 2012 to 2014 period (circled in Chart 6) which happened to be the best order growth period in Boeing’s history and, in the context of this exceptionally powerful demand, likely built in particularly wide margins. This is compounded to the upside by being that much further along the production curve, particularly for some airliner programs that were troubled at the time, notably the 787 program. Chart 6 Nevertheless, it stands to reason that the bookings added to backlog in the difficult period during and immediately post the GFC and the resulting weak margin performance of 2016-2017 has largely been worked through. Investors should now focus on the current margin profile as being the new status quo and current bookings as an indication of future earnings growth. Can Orders Sustain This Trajectory?  New orders in aerospace are driven, as with all capex decisions, by growth and margin considerations. With respect to the latter, the obvious driver is jet fuel prices which are usually the largest cost line item in an airline’s P&L. In 2010, jet fuel prices spiked and stayed elevated for the next five years (jet fuel prices shown advanced by nine months, top panel, Chart 7). Global airlines responded by splurging on new orders to replace older, less efficient aircraft with more modern and highly efficient types. Chart 7Fare Growth & Input Costs Drive Orders Fare Growth & Input Costs Drive Orders Fare Growth & Input Costs Drive Orders Though jet fuel prices are off the heights that spurred the extraordinary order growth in the early part of this decade, they are also above the lows of the energy price crash in 2015. If BCA’s bullish oil view comes to fruition, order flow should continue to be well supported by the refleeting theme. At the same time as fuel prices were spiking in 2010, DM consumer confidence was climbing out from beneath the recession (G7 consumer confidence shown advanced by one year, bottom panel Chart 7), giving airlines the demand push to add capacity to global fleets. The rapid increase in aerospace orders has been revealing itself in global airline capacity growth, which has been increasing by mid-single digits for the past six years (top panel, Chart 8). Interestingly, global load factors (the ratio of revenue-paying passengers to available seats, the airline industry measure of capacity utilization) have been rising despite this increase in capacity, implying global demand has been outstripping supply growth. Chart 8 This data is echoed in the core domestic market where the load factor has plateaued at a record high level, approximating the global average (bottom panel, Chart 9), while capacity has grown mostly uninterrupted since the GFC. Chart 9Few Barriers To Domestic Capacity Expansion Few Barriers To Domestic Capacity Expansion Few Barriers To Domestic Capacity Expansion In sum, we expect upbeat aerospace orders on the back of firming passenger demand driving capacity growth combined with the pursuit of ever more efficient aircraft to drive profits. However, given the long lead times, order growth should be used only as a guide; profit growth has driven relative performance (bottom panel, Chart 10) to a much greater degree than order growth (middle panel, Chart 10). Chart 10Earnings Drive Performance Over Orders Earnings Drive Performance Over Orders Earnings Drive Performance Over Orders Changing Financial Structure And Costly Equities Notwithstanding the rapid increase in sales and, hence, production in the aerospace sector, capex has been in decline for the last couple of years (second panel, Chart 11). However, industry debt levels have been rapidly increasing (third panel, Chart 11), begging the question: where has the industry been deploying capital? Chart 11Debts Levels Are Rising... Debts Levels Are Rising... Debts Levels Are Rising... The answer is in share buybacks. Our share count proxy (middle panel, Chart 12) shows that industry share counts have been roughly halved over the past decade, which partially underlies the outperformance of sector equities. In late-2018, Boeing announced a new $20 billion stock buyback plan, representing roughly 10% of its market capitalization, implying share buybacks in the aerospace sector are not fading anytime soon. Chart 12...As Share Counts Are Shrinking ...As Share Counts Are Shrinking ...As Share Counts Are Shrinking At the same time, profit growth has not kept pace with the ramp up in leverage and leverage ratios have worsened to their highest point since the aviation crises of the early-2000’s (bottom panel, Chart 12). While still reasonable relative to the broad market, net debt / EBITDA has reached a level where further deterioration would likely add an incremental risk premium to aerospace stocks, denting valuations. With that in mind, valuations bear close examination. The exceptionally robust stock price run over the past two years and ballooning balance sheets has resulted in sector enterprise values skyrocketing (second panel, Chart 13). Relative to sector EBITDA, equities in the aerospace sector are as expensive as they have ever been (bottom panel, Chart 13). Chart 13Sky-High Valuations... Sky-High Valuations... Sky-High Valuations... This message is echoed by our valuation and technical indicators (Chart 14) which indicate that aerospace stocks are at least one standard deviation overvalued and overbought, respectively. Chart 14...Across Multiple Measures ...Across Multiple Measures ...Across Multiple Measures A Word On Defense Few of the stocks in our aerospace index are pure-play commercial aerospace investments. Rather, most of the companies rely, to a certain extent, on defense revenues either as a primary supplier of defense goods or as a part of defense production supply chains. Boeing, for example, averaged more than 20% of its revenues in the last three fiscal years from its defense segment. United Technologies, the next largest constituent firm, will likely generate an even greater proportion of its revenues from defense once its spinoff of its commercial & industrial businesses are complete, though at 14% of sales last year, defense is clearly a significant driver. Late last year we reiterated our secular overweight in the BCA defense index2 and we take this opportunity to do it again. We believe defense remains on a structural growth trajectory, driven by rising competition between the world's great nations, the decline of globalization and the resumption of a global arms race. Domestic defense spending has been rocketing higher since the Trump administration took the reins (second and third panels, Chart 15). Further, the non-partisan Congressional Budget Office projects this rapid buildup in defense spending to continue apace for the foreseeable future (bottom panel, Chart 15). With little political will to pare this growth from either side of the aisle, we see no reason to expect these estimates to falter. As such, our positive view on defense equities stands in support of our more sanguine view of their aerospace peers. Chart 15Defense Spending Is Accelerating Defense Spending Is Accelerating Defense Spending Is Accelerating A Long Runway For Aerospace But Risks Are Elevated Overall, aerospace sales and earnings growth look assured for a reasonable forecast horizon, considering the upbeat commercial aerospace demand over the past five years as well as the current robust order environment. Add to this the powerful catalyst that relief in trade wars represent, at least from a sentiment perspective, and aerospace equities are on a solid footing. Nevertheless, that same trade sentiment pendulum swings both ways and we believe elevated trade tensions will increase volatility and decrease predictability. Further, aerospace firms have been blowing out their balance sheets to retire debt and currently enjoy record valuations. Net, we think it no longer pays to be underweight the BCA aerospace index and we are moving to a benchmark allocation. The ticker symbols for the stocks in the BCA aerospace index are: BA, UTX, HON, TXT.   Chris Bowes, Associate Editor chrisb@bcaresearch.com Footnotes 1 Please see BCA U.S. Equity Strategy Weekly Report, “Reflationary Or Recessionary?,” dated February 25, 2018, available at uses.bcaresearch.com. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Icarus Moment?,” dated October 22, 2018, available at uses.bcaresearch.com.

Highlights The deceleration in global growth that began in 2018 is entering a transition phase. The bottoming out process could prove to be volatile, warning against betting the farm too early on pro-cyclical currencies. Tactical short USD bets should initially be played via the euro1 and Swedish krona. The poor Canadian GDP report last week could be a harbinger for more data disappointments down the road. Meanwhile, the dovish shift by the ECB could paradoxically be bullish for the euro beyond the near term. Go short USD/SEK and buy EUR/CAD for a trade. Feature A currency exchange rate is simply a measure of relative prices between two countries. As such, the starting point for any currency forecast should be how those values are likely to evolve over time. For much of 2018, U.S. growth benefited from the impact of the Trump tax cuts, a boost to government spending agreed in January of that year, and the lagged effect of an easing in financial conditions from December 2016 to January 2018. Outside the U.S., what appeared to be idiosyncratic growth hiccups in both Europe and Japan finally morphed into full-blown slowdowns. Slower Chinese credit growth and the U.S.-China trade war were the ultimate straws that broke the camel’s back, deeply hurting global growth (Chart I-1). Consequently, the greenback surged. Chart I-1The Global Growth Slowdown Persists The Global Growth Slowdown Persists The Global Growth Slowdown Persists Fading U.S. Dollar Tailwinds At first glance, the picture remains largely similar today, with global growth still slowing and U.S. growth still outperforming. However, a key difference from last year is that U.S. growth leadership is set to give way to the rest of the world. The U.S. ISM manufacturing PMI peaked last August and has been steadily rolling over relative to its trading partners. The U.S. economic surprise index tells a similar story, with last month’s disappointing retail sales numbers nudging the series firmly below zero. Relative leading economic indices also suggest that U.S. growth momentum has slowed relative to the rest of the world. Historically, the relative growth differential between the U.S. and elsewhere has had a pretty good track record of dictating trends in the dollar (Chart I-2). Chart I-2U.S. Growth Leadership Might Soon End U.S. Growth Leadership Might Soon End U.S. Growth Leadership Might Soon End Whether or not these trends persist beyond the first quarter will depend on the sustainability of China’s recent stimulus efforts. On the positive side, typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices have perked up in response to a nascent upturn in the credit impulse. On the other hand, policy shifts affect the economy with a lag, suggesting it is too early to tell whether the latest credit injection has been sufficient to turn around the Chinese economy, let alone the rest of the world. What is clear is that the bottoming processes tend to be volatile and protracted, suggesting it is still too early to bet the farm on pro-cyclical currencies. In the interim, investors could track the following indicators to help time a definitive turning point: Whether or not easing liquidity conditions will lead to higher growth is often captured by the CRB Raw Industrial index-to-gold, copper-to-gold, and oil-to-gold ratios. It is encouraging that these also tend to move in lockstep with the U.S. bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-3). The next confirmation will come with a clear break-out in these ratios. Chart I-3Reflation Indicators Are Perking Up Reflation Indicators Are Perking Up Reflation Indicators Are Perking Up Chinese M2 relative to GDP has bottomed. Historically, this ratio has lit a fire under cyclical stocks and, by extension, pro-cyclical currencies (Chart I-4). The growth rate is still at zero, meaning excess liquidity is not accelerating on a year-over-year basis. Meanwhile, our Emerging Markets team argues that broad credit growth is still decelerating.2 A break above the zero line, probably in the second half of this year, could be a catalyst to shift fully to a pro-cyclical currency stance. Chart I-4Chinese Excess Liquidity Improving Chinese Excess Liquidity Improving Chinese Excess Liquidity Improving On a similar note, currencies in emerging Asia that sit closer to the epicenter of stimulus appear to have bottomed. If those in Latin America can follow suit, it would indicate that policy stimulus is sufficient, and the transmission mechanism is working (Chart I-5). Chart I-5EM Currencies Are Trying To Bottom EM Currencies Are Trying To Bottom EM Currencies Are Trying To Bottom Finally, China-sensitive industrial commodities, especially metals and building materials, appear to have troughed and are perking up nicely. There was a supply-related issue with the Vale dam bursting in Brazil and a subsequent surge in iron-ore prices, but it is now clear that the entire industrial commodity complex has stopped falling (Chart I-6). Chart I-6Chinese Industrial Commodities Are Rallying Chinese Industrial Commodities Are Rallying Chinese Industrial Commodities Are Rallying Be Selective On USD Shorts Our strategy is to be selective as U.S. dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the euro and the Swedish krona. Last week, we highlighted the fact that investors are currently too pessimistic on Europe’s growth prospects. More importantly, most of the factors that toppled European growth domestically – the implementation of new auto-emission standards in Germany, the rising cost of capital in Italy via exploding bond yields, and the populist Gilets Jaunes protests in France – are mostly behind us. Fiscal policy is also set to be loosened this year, and last year’s weakness in the euro will contribute to easier financial conditions. The improvement in European investor sentiment relative to current conditions could be a harbinger of positive euro area data surprises ahead (Chart I-7). Chart I-7Euro Zone Data Might Surprise To The Upside Euro Zone Data Might Surprise To The Upside Euro Zone Data Might Surprise To The Upside The European Central Bank left rates unchanged at yesterday’s policy meeting but the decision for a new Targeted Long Term Refinancing Operation (TLTRO III – or in other words, cheap loans), could be paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that this is bearish for the currency. Our Global Fixed Income team nailed the move by the ECB in this week’s report.3 European banks have been in the firing line of sluggish growth, negative interest rates, and increased regulatory scrutiny. In the case of Italy, an NPL ratio 9.4% is nearly triple that of the euro area. And with circa 10% of total bank lending in Spain and Italy funded by TLTROs, re-funding by the ECB is exactly what the doctor ordered. In the case of the Sweden, the undervaluation of the krona has begun to mitigate the effects of negative interest rates – mainly a buildup of household leverage and an exodus of foreign direct investment. The GDP report last week was well above expectations, with year-on-year growth of 2.4%. Encouragingly, this was driven by net exports rather than consumption. The Swedish manufacturing PMI release for February was also very encouraging. Orders jumped from 50.4 to 54.0 while export orders jumped from 51.5 to 53.4. The growth in wages is beginning to catch up to new borrowings, meaning domestic consumption could be increasingly financed through income. This will alleviate the need for the Riksbank to maintain an ultra-accommodative policy. On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is facing strong resistance at the triple top established from the 2009 highs around 9.45 (Chart I-8). Aggressive investors should begin accumulating short positions, while being cognizant of the negative carry. Chart I-8The Swedish Krona Looks Like A Buy The Swedish Krona Looks Like A Buy The Swedish Krona Looks Like A Buy Bottom Line: Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio. Ever since the global financial crisis, gold has stood as a viable threat to dollar liabilities, capturing the ebb and flow of investor confidence in the greenback tick-for-tick (Chart I-9). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, USD short positions should be played via the euro and Swedish krona.   Chart I-9Pay Close Attention To The Gold-To-Bond Ratio Pay Close Attention To The Gold-To-Bond Ratio Pay Close Attention To The Gold-To-Bond Ratio Buy EUR/CAD For A Trade Last week saw an extremely disappointing GDP report out of Canada, which prompted the Bank of Canada to keep interest rates on hold this week, followed by quite dovish commentary. In a 90-degree maneuver from its January policy statement that rates will need to rise over time, BoC Governor Stephen Poloz said the path for future increases had become “highly uncertain.”   Like many central banks around the world, the BoC has been blindsided by the depth of the negative growth impulse outside its borders, which has begun to seep into the domestic economy. The economy grew at an annualized pace of 0.4% in the fourth quarter, the lowest in over two years. Capital expenditures collapsed at a rate of 2.7%, marking the third consecutive quarter of declines. The forward OIS curve is pricing in no rate hikes for Canada this year, meaning sentiment on the loonie is already depressed. However, our contention is that even if growth bottoms by the second half of this year, the Canadian dollar will offer little value to play this cyclical rebound. Our recommendation is to play the loonie’s downside via the euro. First, valuations and balance-of-payment dynamics favor the euro versus the CAD on a long-term basis. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada (Chart I-10). European rates are further below equilibrium, and the ECB’s dovish shift will help lift the growth potential of the euro area. Meanwhile, the Canadian neutral rate will be heavily weighed down by the large stock of debt in the Canadian private sector, exacerbated by overvaluation in the housing market. This means that expectations in the 2-year forward market are likely to favor the euro versus the CAD. Chart I-10Buy EUR/CAD For A Trade Buy EUR/CAD For A Trade Buy EUR/CAD For A Trade The biggest risk to this view is the price of oil. The EUR/CAD exchange rate is not as negatively correlated with oil as the USD/CAD, but nonetheless the CAD benefits more from rising oil prices than the euro does. BCA’s bullish oil view is a risk over the next six months. On the downside, the EUR/CAD could potentially test the bottom of the upward trending channel that has existed since 2012. This would put EUR/CAD in the vicinity of 1.45 (currently trading at 1.5049). However, initial upside resistance rests at the triple top a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside EUR/CAD Technicals: Limited Downside EUR/CAD Technicals: Limited Downside Meanwhile, economically, Canada is benefiting less from oil prices today than it has in the past. First, the Canadian oil benchmark trades at a large discount to Brent, and second, Canada is having trouble shipping its own oil at a moderate cost due to lack of pipeline capacity.4  Bottom Line: Investors should buy the EUR/CAD for a trade. The Canadian dollar is likely to outperform its antipodean counterparts, but faces limited upside versus the U.S. dollar. There are better opportunities to play USD downside, namely via the Swedish krona and the euro. Stand Aside On The Australian Dollar For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities is rapidly morphing into a housing crash (Chart I-12). Chart I-12Australia: Anatomy Of A Hard Landing Australia: Anatomy Of A Hard Landing Australia: Anatomy Of A Hard Landing In addition, the upcoming general election could exacerbate the risks to the country’s banks and the housing market.5 The center-left Labour Party, which has moved further to the left in this electoral cycle, has promised several regulatory changes. First, the Labour government would want to get rid of “negative gearing,” the practice of using investment properties that are generating losses to offset one’s income tax bill. Second, the capital gains tax exemption from selling properties will be reduced from 50% to 25%. Third, the Labour government would end the policy of reimbursing investors for the corporate tax paid by the company. This would end the incentive for retirees to own high dividend yielding equities, such as those of Australian banks. This week, the Reserve Bank of Australia kept rates on hold and acknowledged risks to the housing market, but bank stocks suggest they remain well behind the curve (Chart I-13). The futures market is already pricing in 23 basis points of rate cuts by the end of the year, and the contention of our fixed income team is that more might be needed down the road. First, all the preconditions for a rate hike – underemployment below 8%, a rebound in Chinese economic activity and core CPI in the range of 2-3% – have not been met. The reality is that core CPI has lagged the target range since late-2015, and now faces downside risks. Chart I-13Australian Bank Stocks Are Pricing In A Curve Inversion Australian Bank Stocks Are Pricing In A Curve Inversion Australian Bank Stocks Are Pricing In A Curve Inversion That said, a lot of the bad news already appears priced into the Australian dollar, which is down 14% from its 2018 peak, and 37% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth, or simply the forces of mean reversion (Chart I-14). Chart I-14Stand Aside On The Australian Dollar For Now Stand Aside On The Australian Dollar For Now Stand Aside On The Australian Dollar For Now Bottom Line: Sentiment on the Aussie dollar is already bearish, warning against putting on fresh shorts. Our short AUD positions, expressed via the NZD and the CAD, are currently 6.74% and 1.99% in the money, respectively. Investors should hold onto these positions, but tighten stops to protect profits.   Chester Ntonifor,  Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report titled “A Contrarian Bet On The Euro,” dated March 1, 2019 available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report titled “EM: A Sustainable Rally Or False Start?,” dated March 7, 2019 available at ems.bcaresearch.com 3 Please see Global Fixed Income Strategy Special Report, titled “The ECB’s Next Move: Taking Out Some Insurance,” dated March 5, 2019, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Price Diffs: Global Convergence,” dated March 7, 2019, available at ces.bcaresearch.com 5 Please see Geopolitical Strategy Special Report, titled “A Year Of Change In Australia?,” dated December 5, 2018, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mixed: Annualized Q4 GDP growth came in line with expectations at 2.6%, but both the Atlanta and New York Fed models suggest sub 1% growth in Q1 this year. ISM manufacturing PMI missed expectations, falling to 54.2, while the non-manufacturing PMI increased to 59.7. Q4 unit labor costs increased to 2%, surprising to the upside. The DXY index has gained 1.17% this week. Upside on the dollar will be based on Fed’s capacity to continue tightening monetary policy later this year. However, there are increasing signs pointing to a weakening in leadership of U.S. growth this cycle, which could be a headwind for the counter-cyclical dollar. 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 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area show some specter of stabilization: Yearly consumer price inflation increased to 1.5%, in line with expectations. Q4 GDP growth on a year-on-year basis fell to 1.1%, marginally in line. Encouragingly, the Markit composite PMI increased to 51.9. The manufacturing PMI came in at 49.3, while services PMI came in at 52.8.  Finally, retail sales grew higher than expected, with a reading of 2.2%. EUR/USD has fallen by 1.3% this week. The ECB kept interest rates on hold with a dovish tilt. Paradoxically, this could be bullish for the euro, if it allows growth to definitively bottom. Easing financial conditions in the euro area are reflationary and risks to the periphery have been curtailed. Report Links: A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Yearly inflation surprised to the upside, coming in at 0.6%. The core inflation excluding fresh food also came in higher than expected at 1.1%. January unemployment rate missed expectations, climbing to 2.5%; while the jobs-to-applicants ratio stayed at 1.63. Nikkei manufacturing PMI surprised to the upside, coming in at 48.9. USD/JPY has risen by 0.4% this week. While we are positive on the safe-haven yen on a structural basis, we struggle to see any near-term upside amid significant Japanese stock and bond outflows. We will be discussing the outlook for the yen in an upcoming report. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been improving: February consumer confidence came in at -13, slightly higher than expectations. Markit manufacturing PMI came in at 52, in line with expectations; while the services PMI surprised to the upside, coming in at 51.3. The Halifax house price index surprised to the upside, rising 5.9% mom in February. GBP/USD has fallen by 1.2% this week. During the speech on March 5, the Bank of England governor Mark Carney highlighted the market underestimates the potential for interest rate hikes. Overall, we remain bullish on the pound in the long-term, but volatility is set to rise in the near term as we approach the Brexit March 29 deadline. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been dismal: The RBA commodity price index advanced by 9.1% year-on-year in February, but this was supply related. Building permits continue to contract at 29% year-on-year. Finally, the annualized Q4 GDP growth fell to 0.2%, more than 50% below expectations. AUD/USD fell by 1.2% this week. The RBA kept the interest rate unchanged at 1.5%. Governor Philip Lowe acknowledged the downside risks to the housing market and overall economy, and warned about the “significant uncertainties around the forecast.” That said, AUD/USD has fallen by a 13% since the January 2018 highs, warning against establishing fresh shorts at this juncture. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Seasonally adjusted building permits increased 16.5% month-on-month in January, a huge jump. However, the ANZ activity business confidence dropped to -30.9. Most importantly, terms of trade fell to -3% in the fourth quarter, underperforming expectations. NZD/USD depreciated by 0.9% this week. The key for the Kiwi will be a pickup in agricultural commodity prices, which remain in a definitive bear market. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been disappointing: Q4 current account balance has deteriorated, coming in at C$ -15.48 billion. Moreover, annualized Q4 GDP growth missed analysts’ forecast, coming in at 0.4%. Finally, the Markit manufacturing PMI weakened to 52.6 in February. USD/CAD has gained 2.1% this week. The BoC kept interest rates on hold at 1.75% given that domestic economic conditions have now coupled to the downside with a bleak external picture. The caveat for the Canadian dollar is that rising oil prices could provide some support. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: Annualized Q4 GDP growth missed analysts’ expectations by 50%, coming in at 0.2%.  In addition, the retail sales contracted 0.4% year-on-year. Lastly, CPI was in line at 0.6%, but this is a far cry from the March 2018 peak. EUR/CHF has been flat this week. Overall, we are bullish EUR/CHF on a cyclical basis. Stabilization in global growth will make safe-haven currencies like the franc less attractive. In addition, the foreign direct investment and portfolio investment outflows from Switzerland should put more downward pressure on the franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: Monthly unemployment rate fell to 2.5%, in line with expectations. However, the Q4 current account balance fell to 46.8 billion from 91.36 billion in Q3. The manufacturing PMI has been stable for a few months now, coming in at 56.3 for the month of February. USD/NOK increased by 2.2% this week. We are optimistic on the NOK on a structural basis, given the positive outlook for oil prices. Moreover, the NOK is undervalued and trading at a large discount to its long-term fair value. 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 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Retail sales was in line with expectations at 0.8% month-on-month. However, annualized Q4 GDP growth was double expectations at 1.2%. The February manufacturing PMI also came in higher at 52.5. In addition, industrial production yearly growth came in higher at 3.4%. Lastly, the Q4 current account balance increased to 39.6 billion. USD/SEK increased by 2% this week. The SEK is still trading at a large discount to its long-term fair value. We remain bearish on USD/SEK on a structural basis as we see many signs pointing to a recovery in the Swedish economy, which is a tailwind for the Swedish krona.   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 Chart 1Track The CRB/Gold Ratio Track The CRB/Gold Ratio Track The CRB/Gold Ratio Earlier this year the Fed signaled a dovish policy shift in response to slowing global growth and tighter financial conditions. In large part due to the Fed’s move, financial conditions are now easing and the CRB Raw Industrials index – a timely proxy for global growth – is starting to perk up. But when will this improvement translate to higher Treasury yields? The CRB/gold ratio offers some clues. Gold moves higher when monetary policy eases. Then with a lag, that easier policy spurs stronger global growth and a rising CRB index. Eventually, that stronger growth puts rate hikes back on the table. A more hawkish Fed limits the upside in gold and sends Treasury yields higher. In fact, we find that the 10-year Treasury yield only starts to rise when the CRB index outpaces the gold price (Chart 1). The recent jump in the CRB index is a positive sign, but we shouldn’t expect Treasury yields to rise until the CRB/gold ratio heads higher. In the meantime, investors should maintain below-benchmark portfolio duration and initiate positive-carry yield curve trades (see page 10) to boost returns while we wait for the next upward adjustment in yields. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 59 basis points in February, bringing year-to-date excess returns up to +243 bps. The Federal Reserve’s pause opens a window for corporate spreads to tighten during the next few months. We recommend overweight positions in corporate bonds for now, but will be quick to reduce exposure once spreads reach our near-term targets (Chart 2). Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview In last week’s report we published option-adjusted spread targets for each corporate credit tier.1 The targets are based on the median 12-month breakeven spreads during prior periods when the slope of the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.2 Currently, the Aa-rated spread of 59 bps is 3 bps above our target (panel 2). The A-rated spread of 91 bps is 6 bps above our target (panel 3). The Baa-rated spread of 156 bps is 28 bps above our target (panel 4). The Aaa-rated spread is already below our target. We advise investors to avoid the Aaa-rated credit tier. With profit growth poised to moderate during the next few quarters, it is unlikely that gross corporate leverage will continue to decline at its current pace (bottom panel). As such, we will be quick to reduce corporate bond exposure when spreads reach our targets. Renewed Fed hawkishness will be another headwind for corporate bonds in the second half of the year. Chart Chart High-Yield: Overweight High-Yield outperformed the duration-equivalent Treasury index by 175 basis points in February, bringing year-to-date excess returns up to +590 bps. In last week’s report we published near-term spread targets for each high-yield credit tier.3 The targets are based on the median 12-month breakeven spreads seen during periods when the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.4 At present, the Ba-rated option-adjusted spread is 224 bps, 37 bps above our target. The B-rated spread is 376 bps, 81 bps above our target. The Caa-rated spread is 780 bps, 208 bps above our target. Our default-adjusted spread is an alternative measure of high-yield valuation. It represents the excess spread available in the High-Yield index after accounting for expected default losses. It is currently 243 bps, very close to the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast during the next 12 months, high-yield bonds will return 243 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview The Moody’s baseline forecast calls for a default rate of 2.4% during the next 12 months. This appears a touch too optimistic, as our own macro model is calling for a default rate closer to 3.5%.5 In either case, junk bonds currently offer adequate compensation for default risk. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in February, bringing year-to-date excess returns up to +39 bps. The conventional 30-year zero-volatility spread tightened 2 bps on the month, driven by a 5 bps decline in the compensation for prepayment risk (option cost). The fall in option cost was partially offset by a 3 bps widening in the option-adjusted spread (OAS). The recent drop in the 30-year mortgage rate led to a jump in mortgage refinancings from historically low levels, putting some temporary upward pressure on MBS spreads (Chart 4). However, the relatively tepid pace of new issuance during the past few years means that the existing MBS stock is not very exposed to refinancing risk, even if mortgage rates fall further. All in all, we view agency MBS as one of the safest spread products in the current macro environment. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview The problem with MBS is that valuation remains unattractive. The index option-adjusted spread for conventional 30-year MBS is well below its average pre-crisis level (panel 3) and the sector offers less compensation than normal compared to corporate bonds (panel 4). We continue to recommend a neutral allocation to agency MBS. An upgrade will only be appropriate when value in the corporate sector is no longer attractive relative to expected default risk. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 38 basis points in February, bringing year-to-date excess returns up to +92 bps. Sovereign debt outperformed duration-equivalent Treasuries by 97 bps on the month, bringing year-to-date excess returns up to +320 bps. Local Authorities outperformed the Treasury benchmark by 54 bps in February, bringing year-to-date excess returns up to +86 bps. Foreign Agencies outperformed by 44 bps in February, bringing year-to-date excess returns up to +109 bps, while Domestic Agencies outperformed by 12 bps on the month, bringing year-to-date excess returns up to +9 bps. Supranationals outperformed by 10 bps in February, bringing year-to-date excess returns up to +13 bps. The USD-denominated sovereign debt of most countries continues to look expensive relative to equivalently-rated U.S. corporate credit. However, in a recent report we highlighted that Mexican sovereign debt is an exception (Chart 5).6 Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview Not only is Mexican sovereign debt cheap relative to U.S. corporate credit, but our Emerging Markets Strategy service highlights that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs.7 This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite real interest rates being much higher in Mexico than in the U.S. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 85 basis points in February, bringing year-to-date excess returns up to +92 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 5% in February, and currently sits at 81% (Chart 6). This is more than one standard deviation below its post-crisis mean and right at the average level that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview In other words, municipal bonds on average are no longer cheap. Rather, they appear fairly valued compared to similar prior macro environments. But a pure focus on the average yield ratio across the curve hides an important distinction. The yield ratio for short maturities (2-year and 5-year) is very low relative to history, while the yield ratio for long maturities (10-year, 20-year and 30-year) remains quite cheap (panel 2). Investors should continue to focus on long-maturity municipal debt to add yield to U.S. bond portfolios. In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of +3 bps. In contrast, municipal bonds have delivered annualized excess returns of +64 bps (before adjusting for the tax advantage).8 Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields rose in February, led by the long-end of the curve. The 2/10 Treasury slope steepened 3 bps on the month and currently sits at 21 bps. The 5/30 slope steepened 1 bp on the month and currently sits at 57 bps. Our 12-month fed funds discounter remains below zero, meaning that the market is priced for rate cuts during the next year (Chart 7). We continue to view rate hikes as more likely than cuts on this time horizon, and therefore recommend yield curve trades that will profit from a move higher in our discounter. In prior research we found that the 5-year and 7-year Treasury maturities are most sensitive to changes in our discounter, so any trade where you sell the 5-year or 7-year bullet and buy a duration-matched barbell consisting of the long and short ends of the curve will provide the appropriate exposure.9 Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview An added benefit of implementing a barbell over bullet strategy in the current environment is that barbells currently offer higher yields than bullets, meaning that you earn positive carry as you wait for the market to price rate hikes back into the curve (bottom 2 panels).10 Not surprisingly, barbell strategies also look attractively valued on our yield curve models, the output of which is found in Appendix B. TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 36 basis points in February, bringing year-to-date excess returns up to +120 bps. The 10-year TIPS breakeven inflation rate rose 11 bps on the month and currently sits at 1.96%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps on the month and currently sits at 2.07%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. After last month’s increase, the 10-year TIPS breakeven inflation rate is currently very close to the fair value reading from our Adaptive Expectations model (Chart 8).11 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ inflation expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value will trend steadily higher as long as core CPI inflation remains above 1.84%. The 1.84% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in the model. Chart 8Inflation Compensation Inflation Compensation Inflation Compensation On that note, core CPI has increased at an annual rate of 2.58% during the past four months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 3), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Cut To Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in February, bringing year-to-date excess returns up to +38 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 8 bps on the month and currently sits at 31 bps, 3 bps below its pre-crisis low (Chart 9). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Our excess return Bond Map, shown in Appendix C on page 18, shows that Aaa-rated ABS offer a relatively poor risk/reward trade-off compared to other U.S. bond sectors. Aaa-rated auto loan ABS in particular offer greater risk and lower potential return than the Aggregate Plus index (the Bloomberg Barclays Aggregate index plus high-yield).  Tight spreads look even more unattractive when you consider that the delinquency rate for consumer credit is rising, and according to the uptrend in household interest expense, will continue to march higher in the coming quarters (panel 4). Lending standards are also tightening for both credit cards and auto loans, a dynamic that often coincides with a rising delinquency rate and wider ABS spreads (bottom panel). Given the recent spread tightening, we advise investors to reduce consumer ABS exposure in U.S. bond portfolios. Other sectors, such as Agency CMBS, offer a more attractive risk/reward trade-off within high-rated spread product. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in February, bringing year-to-date excess returns up to +142 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 13 bps on the month and currently sits at 93 bps, below the average pre-crisis level but somewhat higher than the recent tights (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (bottom 2 panels). This, coupled with decelerating CRE prices paints a relatively negative picture for non-agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Teasury index by 49 basis points in February, bringing year-to-date excess returns up to +77 bps. The index option-adjusted spread tightened 8 bps on the month and currently sits at 48 bps. The excess return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. 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. At present, the market is priced for 2 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the change in the fed funds rate. 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. 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 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +55 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 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of February 28, 2019) The Sequence Of Reflation The Sequence Of Reflation Table 5Butterfly Strategy Valuation: Standardized Residuals (As of February 28, 2019) The Sequence Of Reflation The Sequence Of Reflation Table 6Discounted Slope Change During Next 6 Months (BPs) The Sequence Of Reflation The Sequence Of Reflation 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, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com 8 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 9  Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018 available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights It was easy to upgrade equities to overweight at the beginning of the year, … : The fourth-quarter selloff had reduced the S&P 500’s forward four-quarter multiple to 13.6 at its trough, and we never shared the market’s fear that the Fed was one false move from triggering a recession. … but what should someone who sat out January’s and February’s moves do?: Is it worth buying stocks now, after they’ve risen 10% since our upgrade, and 18% since the Christmas Eve bottom? Wait, in our opinion, but it’s not an easy answer: We find it hard to believe that the S&P 500 is going to go straight back to its late-September highs, reversing the fourth-quarter swoon in a mirror-image first-quarter blast. Our best guess is that the bull market is not yet over, but we think its upside is limited: It’s hard to see a bear market materializing in the absence of a recession, and the Fed’s pause has likely pushed the next one out to the second half of 2020 at the earliest. The potential gains are not unlimited, however, and an inflation-wary Fed will eventually cut off the bull’s oxygen. Feature Take two dozen opinionated people with backgrounds in markets and economics and scatter them around a boardroom table. Introduce the day’s key global economic data releases, market activity, corporate news, and geopolitical developments as potential discussion topics. Have the moderator remain alert for points of contention and seek to intensify them at every opportunity. Add four or five months of the worst winter weather North America’s got to offer, this side of Winnipeg and International Falls, Minnesota, and stir. If only economists were more telegenic, or Canadians could credibly be as unpleasant as their neighbors to the south, that might be the elevator pitch for a can’t-miss reality show. Instead, it’s the recipe for BCA’s daily morning meetings, and not one of its hard-working participants is likely to be able to use it as a step on the path to celebrity riches. It is a path to getting better at analysis and reasoning, however, and an ideal forum for stress-testing economic or market hypotheses. It can also furnish research ideas, as it did for us last week. “Let’s say you have a client who missed the equity run-up in January and February. What would you recommend s/he do now?” one of our colleagues called out to us late in Tuesday’s session. Someone else jumped in before we could reply, the thread was lost, and the meeting broke up so everyone could get back to their own research priorities. Had we gotten to reply, we would have recommended that the client wait for a better entry point, and this week’s report is devoted to explaining why, in the simplest back-of-the-envelope terms. How Much Can S&P 500 Earnings Grow? When analyzing equities, we like to decompose them into their component parts: forward earnings and the multiple investors are willing to pay for them. In the hall of mirrors as described in Keynes’ newspaper-beauty-contest metaphor,1 what matters for our purposes in projecting S&P 500 earnings is less what will happen, or what our own earnings models might project will happen, than what the analyst consensus thinks will happen. The consensus estimate of calendar 2019 S&P 500 earnings per share (EPS) is currently $168.37, a modest 4% increase over calendar 2018 EPS. This is a conservative estimate, relative to history, given that S&P 500 operating EPS have grown at an average rate of 8% over the last 40 years (Chart 1). Chart 1Outside Of Recessions, Earnings Typically Grow Outside Of Recessions, Earnings Typically Grow Outside Of Recessions, Earnings Typically Grow It is also conservative given the pattern earnings estimates have followed across the five bull markets that have occurred in the 40 years since estimates began to be compiled. We have previously observed that equity bull markets tend to sprint to the finish line. On average, they begin by being blasted out of a cannon, sharply cool off in the second quintile, and build back up in the third and fourth quintiles, before retrenching ahead of a latter-stages surge (Chart 2). Chart 2 The earnings estimate pattern is jumpier. Forward estimates stumble out of the first-decile gate before rising at a double-digit rate over the rest of the first half, then slow sharply to the first decile’s pace in preparation for posting their most potent growth in the final decile (Chart 3). Disaggregating the individual bull markets’ performance shows that the overall last-decile performance is not the product of a couple of outlier readings. In all but the December ’87 – July ’90 bull market that ended with flatlining estimates, estimated forward four-quarter earnings growth in the final decile of the bull market comfortably exceeded mean growth across the full bull market (Chart 4). Chart 3 Chart 4Optimistic At The Very End Optimistic At The Very End Optimistic At The Very End Analysts’ 2019 estimates additionally look low because median corporate revenue growth ought to converge with nominal GDP growth over time. With 40 basis points of fiscal stimulus slated to be deployed in 2019, we expect the U.S. will have no trouble growing above its 2 – 2.25% trend. Assuming GDP growth at the top of that range, no change in profit margins, share buybacks to reduce outstanding share count by 2%, and 2% inflation, the S&P 500 should be able to grow EPS by 6.25%. The 2.25% difference between the consensus estimate and the back-of-the-envelope projection aligns with corporations’ desire to manage analyst expectations. If the S&P 500 can grow earnings at a rate of 6.25% this year, calendar 2019 EPS would come in at $172.13. The default estimate for the following year would be the mean of historical EPS gains, or about 9%. Applying a 2% lower-the-bar haircut, corporate management teams might guide to 7% growth in 2020. Grossing up our estimated calendar 2019 earnings by 7% yields projected calendar 2020 earnings of $184.17 (Table 1). Table 1Estimating Consensus Expectations For Calendar 2020 S&P 500 EPS How Much Do U.S. Equities Have Left? How Much Do U.S. Equities Have Left? What Multiple Might Investors Pay? Estimating a plausible forward multiple is more of a challenge than coming up with a reasonable consensus S&P 500 EPS estimate. Multiples, like all market prices, are dictated in large part by emotion, which often defies prediction. We can make some inferences from the 40-year history of forward multiples nonetheless. That history suggests that the current 16.5 multiple is elevated, but not worryingly so, as it is only a little more than half of a standard deviation above the mean (Chart 5). Chart 5Elevated, But Not Stretched Elevated, But Not Stretched Elevated, But Not Stretched Multiple movements have followed a pattern across the last five bull markets, but their moves are much more volatile than moves in forward estimates, which never decline in a bull market. Broadly, multiples explode higher at the start, plateau, and then retrace some of their initial gains (Chart 6). Their growth pattern inflects higher in the second half before peaking near the end of the bull market and rolling over into the finish. The broad pattern applies to all of the bull markets except the October ’02 – October ’07 bull, in which the multiple peaked in the third decile before sinking for much of the rest of the way. Chart 6Multiples Usually Follow A Well-Defined Pattern Multiples Usually Follow A Well-Defined Pattern Multiples Usually Follow A Well-Defined Pattern Aggregating the multiple moves by decile shows the pattern with more clarity (Chart 7). A burst of re-rating in the first decile signals the beginning of the bull market. The multiple goes on to retrench through the fourth decile and then expands at a double-digit annualized rate until it runs out of steam at the beginning of the final decile. The empirical takeaway is that investors shouldn’t look for much in the way of multiple expansion over the rest of the bull market, and we therefore apply a 16.5 multiple to our $184.17 estimate of forward four-quarter earnings a year from now, yielding an S&P 500 target of 3,040. Chart 7 Mapping A Course Using forward four-quarter earnings four quarters out to develop our price target shows that we do not expect the S&P 500 to surpass its late September highs anytime soon. We have marveled at the way the index has moved straight up since its Christmas Eve bottom, and have been waiting for it to reveal the top of a tradeable range. We thought 2,640, which had marked a triple-bottom in October and November’s turbulence, might present some resistance, and then perhaps 2,700, but the S&P went through both levels like a warm knife through butter (Chart 8). This week’s action suggests that 2,800 – which was a significant level throughout much of 2018 – just might mark the top for a little while. Chart 8Trying To Find The Top Of The Range Trying To Find The Top Of The Range Trying To Find The Top Of The Range Our recommendation to an investor who spent January and February underweight equities is therefore to wait. It’s also our recommendation to anyone seeking to add more exposure. As for investors seeking to reduce exposure, the action Friday as we were going to press seemed to suggest that the current levels around 2,800 are a good place to lighten up on equity holdings. If we’re wrong, an investor could buy out-of-the-money calls, which are not too onerously expensive now that the VIX is back below 15, though we almost always think the insurance offered by options is cost prohibitive for investors who are judged on a relative-return basis. Closing Thoughts We are devoted followers of long-term-oriented investors with long-term records of success who are willing to share aspects of their approach in print or in public appearances. We avidly read Warren Buffett’s annual letter to Berkshire Hathaway shareholders this week, and were delighted to discover a transcript of Charlie Munger’s Q-and-A session with shareholders at the privately-held Daily Journal Corporation’s annual meeting. Howard Marks has been a particular favorite of ours over the years, and this exercise provided confirmation of his view that bull markets end when conditions appear to be at their very best. In line with the Buffett view that investors should be fearful when others are greedy, Marks has argued that bull markets are done in by too much optimism. The tendency for earnings estimates to grow at their most rapid pace in the final stages of a bull market supports Marks’ position. It seems improbable on its face that corporate earnings would make their biggest move at the end of the cycle (Chart 3). The fact that the growth in actual operating earnings tends to peak well before the end of the business cycle (Chart 1) suggests that analysts – and the corporate management teams whose guidance provides the starting point for their earnings models – get lulled to complacency by the successes in the rear-view mirror. In that sense, it may be good for equities that expectations are so beaten down now. Perhaps this bull market will not end until managers, analysts and investors get at least a little bit euphoric.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 In his General Theory of Employment, Interest and Money, Keynes compared financial markets to a newspaper contest in which every contestant chooses the six most attractive people from a set of one hundred head shots. The winner is the contestant whose choices best align with the most attractive photos as selected by all of the entrants. Sophisticated contestants don’t bother with the faces they consider to be the most attractive, but with the faces that best align with conventional notions of attractiveness. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects average opinion to be.”

Highlights Investors are currently too pessimistic on Europe’s growth prospects. In fact, European growth will soon bottom. European growth and inflation are also set to improve relative to the U.S. This should give investors an opportunity to reassess the long-term outlook for European Central Bank policy relative to the Fed. Global growth dynamics are also moving in an increasingly dollar-bearish direction, which should create a tailwind for the euro. Based on the pricing of European assets relative to the U.S., there is scope to see more capital flows into the euro area, implying that more euro buying is forthcoming. The entire European currency complex is a buy relative to the dollar; while the NOK, the SEK, and even the GBP could outperform the euro, the CHF will underperform. EUR/JPY also has upside. Feature The case to sell the euro is easy to make. European growth has been very poor: PMIs, industrial production and even German exports are all pointing to a contraction in output; and economic surprises are testing levels recorded during the euro area crisis. Most importantly, this economic retrenchment is particularly sharp when compared to the U.S., which suggests that real interest rate differentials should continue to hurt EUR/USD (Chart 1). Chart 1Selling The Euro Seems So Easy... Selling The Euro Seems So Easy... Selling The Euro Seems So Easy... The problem with this narrative is that investors are already well aware of Europe’s woes. Could Europe instead recover and the euro rebound against the dollar? After all, in the past, when investor pessimism towards Europe experienced as pronounced a dip as the one just witnessed, EUR/USD invariably rebounded soon after (Chart 2). Chart 2...But Maybe We Should Look The Other Way ...But Maybe We Should Look The Other Way ...But Maybe We Should Look The Other Way In this piece, we explore what could go right for the euro, and argue that the euro is indeed attractive at current levels. European Growth Has Hit A Nadir It is safe to say that the euro area is in a funk today: European real GDP growth dipped to a 1.1% annual rate in the fourth quarter of 2018, while industrial production has plunged by 3.9% on a year-on-year basis. But the markets warned us this would happen: The euro has fallen 9% from its February 2018 top, German bund yields are again flirting with the 0.1% level and European banks plunged by more than 40% between January and December last year. Going forward, for European yields to remain as depressed as they are, for the euro to fall again by a similar margin, or for domestic plays to suffer large declines, European growth will have to slow even further. We are not expecting such a scenario. Instead, we expect European growth to recover significantly this year. First, when it comes to Germany, the locomotive of Europe, the shock from the implementation of the new WLTP auto emission standards is passing: Automobile production is stabilizing, capex is accelerating and inventories have been pared down. Moreover, the slowdown in foreign demand has already percolated through the domestic economy, as domestic manufacturing orders are already experiencing one of their sharpest declines since the Great Financial Crisis (Chart 3, top panel). Chart 3European Growth Is Set To Rebound European Growth Is Set To Rebound European Growth Is Set To Rebound Another source of optimism comes from the credit market. As the middle panel of Chart 3 illustrates, the European 12-month credit impulse has begun to bottom. This points to stronger euro area-wide domestic demand. Moreover, the Chinese credit and fiscal impulse is also bottoming, suggesting the drag from foreign demand could be dissipating (Chart 3, bottom panel). When looking at other specific trouble spots, Italy first springs to mind. In our view, the most recent deceleration in Italy was mainly a consequence of the tightening in financial conditions that resulted from the surge in Italian yields following the budget standoff between Rome and Brussels. However, the Lega Nord / Five Star Movement coalition has folded and is more or less acquiescing to the EU’s demands. Moreover, the rising probability that the European Central Bank will continue to provide long-term liquidity to the eurozone banking system via some form of new LTRO should diminish the funding risk to the Italian banking system, and thus, the risks to Rome’s fiscal sustainability. This implies that the decline in Italian borrowing costs could deepen (Chart 4), further easing Italian financial conditions and improving the growth outlook in the euro area’s third-largest economy. Chart 4Easing Financial Conditions In Italy Easing Financial Conditions In Italy Easing Financial Conditions In Italy France, too, has had its fair share of problems, though it is interesting that its industrial sector is not suffering as much as Germany’s, as highlighted by a French manufacturing PMI above the 50 boom/bust line. Instead, the French service sector is the one contracting (Chart 5). This bifurcation is likely to be a byproduct of the gilets jaunes protests that have lasted since November 2018 and affected retail trade. However, the intensity of the protests is declining and the French population is getting used to this. As a result, we are seeing a rebound in French household confidence, which implies that consumption, the main engine of French growth, is likely to perk up. Chart 5Fade The Gilets Jaunes, Paris In Spring Is Beautiful Fade The Gilets Jaunes, Paris In Spring Is Beautiful Fade The Gilets Jaunes, Paris In Spring Is Beautiful Finally, euro area fiscal policy is set to be loosened this year, with the fiscal thrust moving from 0.05% of GDP to 0.4% of GDP (Chart 6). The response of French President Emmanuel Macron to the gilets jaunes protests could even make the fiscal policy support slightly bigger this year. Chart 6Positive Fiscal Thrust In 2019 Positive Fiscal Thrust In 2019 Positive Fiscal Thrust In 2019 Ultimately, this combination of factors suggests that the large dip in European industrial production is likely to prove transitory, and that European activity will revert back toward the levels implied by the Belgian Business Confidence Index, which has historically been a good leading indicator of European growth (Chart 7). Chart 7European IP To Follow Brussels' Mood European IP To Follow Brussels' Mood European IP To Follow Brussels' Mood Bottom Line: The deterioration in European growth has captured the imagination of investors. However, the performance of European assets last year forewarned that growth would decelerate meaningfully. What matters now is how growth will evolve. Developments from Germany, France, Italy, the credit channel and the fiscal front all suggest that European activity will perk up soon. It’s All Relative While getting a sense of European growth is important when making a call on EUR/USD, economic trends must also be considered relative to the U.S. Surprisingly, despite notorious European growth underperformance, rays of hope are emerging. A major structural negative for EUR/USD has abated: The European debt crisis is behind us, and the aggregate European banking sector has been getting healthier, albeit slowly. This means that the euro area credit growth is not declining anymore against that of the U.S. This is a very long-term force that dictates multi-year cycles in the EUR/USD. As Chart 8 shows, it will be difficult for EUR/USD to move below 1.10 so long as the broad trend in the relative credit growth does not weaken anew. Chart 8Credit Dynamics Suggest That The Worst Is Over For EUR/USD Credit Dynamics Suggest That The Worst Is Over For EUR/USD Credit Dynamics Suggest That The Worst Is Over For EUR/USD More immediately, the euro area leading economic indicator relative to the U.S. is forming a bottom (Chart 9). Since the U.S. is not benefiting from as large a fiscal boost as in 2018, and financial as well as monetary conditions have tightened there relative to Europe, this suggests the improvement in the euro area relative LEI could continue this year. Chart 9Bottoming European LEI Versus U.S. Bottoming European LEI Versus U.S. Bottoming European LEI Versus U.S. Relative labor market slack is also evolving in a euro-friendly fashion. From 2013 to 2018, the euro area suffered from greater labor market slack than the U.S., courtesy of a double-dip recession and generally more-moribund growth. However, thanks to a 4.2-percentage-point fall in the European unemployment rate since 2013 to 7.9%, the euro area unemployment gap has not only closed, it is also below that of the U.S. Historically, when the U.S. unemployment gap leapfrogs that of Europe, EUR/USD tends to appreciate (Chart 10). Chart 10Less Slack Leads To A Stronger EUR/USD Less Slack Leads To A Stronger EUR/USD Less Slack Leads To A Stronger EUR/USD Relative slack does not only have value in itself, it also matters for relative inflation trends, which have been a crucial determinant of EUR/USD. As Chart 11 illustrates, EUR/USD tends to follow how euro area core CPI evolves relative to the U.S. After sharply falling last year, European relative core inflation is trying to rebound, which at a minimum suggests that EUR/USD has limited downside. Moreover, EUR/USD has correlated positively with German market-based inflation expectations (Chart 11, bottom panel). This suggests that actual relative inflation as well as euro area inflation expectations play a key role in determining perceptions among investors of how ECB policy will evolve relative to the Federal Reserve. Chart 11EUR/USD Trades Off Of Inflation Dynamics EUR/USD Trades Off Of Inflation Dynamics EUR/USD Trades Off Of Inflation Dynamics The recent euro decline has matched the decline in inflation expectations. However, inflation expectations have been much weaker than implied by the level of wage growth in Europe (Chart 12). This suggests that European inflation breakevens have scope to improve, a positive for the euro. Moreover, European wage growth is not only picking up steam in isolation, it is also rising relative to the U.S., which highlights that European inflation should not just stabilize vis-à-vis the U.S., but also accelerate. Chart 12European Wages Point To Rising Inflation Expectations European Wages Point To Rising Inflation Expectations European Wages Point To Rising Inflation Expectations This case is made even more saliently by looking at relative financial conditions. Due to the tightening in U.S. financial conditions compared to the euro area, European headline and core inflation is set to accelerate relative to the U.S. (Chart 13). Again, this reinforces the case that maybe the euro has upside this year. Chart 13Relative Euro Area Inflation Will Rise Thanks To Easier FCI Relative Euro Area Inflation Will Rise Thanks To Easier FCI Relative Euro Area Inflation Will Rise Thanks To Easier FCI Ultimately, for the euro to rise, investors will have to begin pricing in some switch in policy spreads between the ECB and the Fed. In the past, we showed that short-term policy expectations are important, but long-term ones can be even more relevant, especially when a central bank is well along the path of lifting rates, as the Fed is, while the other remains at maximum accommodation, like the ECB is today.1  Currently, investors expect euro area short rates to be only 0.5% 5-years from now (Chart 14, top panel). The spread between the eurozone and U.S. 5-year forward 1-month OIS rates remains near all-time lows, which explains the weakness in the euro. Now that European policy is much more accommodative than the U.S.’s, there’s scope for investors to upgrade the path of long-term euro area rates relative to the U.S. This would be bullish for the euro (Chart 14, bottom panel). Recovering relative credit flows and improving relative slack and inflation dynamics could catalyze this change. Chart 14The ECB Is Never Raising Rates The ECB Is Never Raising Rates The ECB Is Never Raising Rates Bottom Line: To make the euro an attractive buy, European growth and inflation conditions cannot just increase, they need to improve relative to the U.S. Since long-term interest rate expectations are very depressed in Europe relative to the U.S., a small improvement in the relative growth profile could be enough to catalyze a repricing of the ECB vis-à-vis the Fed, creating a powerful tailwind behind the euro. Nothing Happens In A Vacuum Ultimately, exchange rates, like other prices in the economy, do not only respond to domestic determinants but are also influenced by much larger, global forces. This is because those global trends percolate through domestic economies, resulting in changing relative expected returns that drive money across borders, leading to currency movements. In the case of the euro, global growth matters a lot, because European growth is much more sensitive to global economic fluctuations than U.S. growth is. This is particularly true if shocks emanate from emerging markets (Chart 15). Today, global cyclical variables are increasingly pointing toward an end to the global growth slowdown. A stabilization and reacceleration in global activity would support the euro. Chart 15 First, Chinese monetary conditions have begun to ease, which historically tends to be linked with improvements in European growth relative to the U.S. (Chart 16). Questions remain surrounding this point: How durable will the rebound in Chinese credit be? By how much will Chinese policymakers nurture this bounce? And will this jump be large enough to lift economic activity in the Middle Kingdom? Nonetheless, a reflationary wind from China has begun to blow, and since investors have already discounted much bad news out of Europe, only small improvements could turn the euro around.   Chart 16If China Is Really Stimulating, Europe Will Rip A Greater Dividend If China Is Really Stimulating, Europe Will Rip A Greater Dividend If China Is Really Stimulating, Europe Will Rip A Greater Dividend Second, as Chart 17 shows, our Nowcast for global industrial activity has decisively stepped down. Yet, the countercyclical dollar has been flat since October 2018. Historically, the performance of EM carry trades funded in yen tends to lead global growth. Currently the performance of these strategies is stabilizing. If EM carry trades funded in yen can rally further, this will spell trouble for the greenback, helping the euro – the anti-dollar – in the process. Chart 17An Early Positive For Global Growth An Early Positive For Global Growth An Early Positive For Global Growth Third, EUR/USD tends to correlate with the relative performance of global cyclical equities (Chart 18). The stabilization in these sectors since 2015 suggests it will be difficult for the euro to fall further from current levels. In fact, if EM carry trades can rebound more, cyclicals have additional scope to outperform, and the euro could rally. Chart 18Cyclical Stocks Pointing To No Real Downside In EUR/USD Cyclical Stocks Pointing To No Real Downside In EUR/USD Cyclical Stocks Pointing To No Real Downside In EUR/USD Fourth, the prospects for the semiconductor sector are improving. Demand for semis is highly pro-cyclical, and the U.S. Chip Stock Timing Model developed by our U.S. Equity Strategy service colleagues is currently sending a bullish signal.2 Since such developments link to improving global growth prospects, they are also associated with a stronger EUR/USD (Chart 19). This is also consistent with a generally weaker dollar and stronger Asian currencies. Chart 19The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar Finally, the breakout in copper prices, the stabilization in the CRB Raw Industrials Index and the rally in gold prices all support an improving global growth outlook that could lift EUR/USD. Bottom Line: Various indicators, such as Chinese monetary conditions, EM carry trades, semiconductor demand determinants and commodity prices are suggesting that global growth may soon bottom. Such a development should hurt the countercyclical dollar, amounting to a macro tailwind for EUR/USD. The Bad News Is Priced In Ultimately, the capacity of EUR/USD to rally rests on how much investors upgrade their outlook for Europe. It is therefore crucial to get a sense of exactly how uninspiring Europe currently is to global market participants. There is no better gauge of relative economic pessimism than the price of euro area financial assets relative to U.S. ones. Essentially, money talks. On this front, markets already seem to have internalized the known bad news from Europe, and there is scope for a contrarian rally in the euro, especially if, as we expect, European economic activity improves. First, on a 12-month forward P/E ratio basis, euro area equities are trading at the kind of deep discount to U.S. stocks normally symptomatic of a trough in relative sentiment toward Europe. Such a discount is often followed by a rally in EUR/USD (Chart 20). Chart 20Stock Valuations: Investors Do Not Like Europe Stock Valuations: Investors Do Not Like Europe Stock Valuations: Investors Do Not Like Europe Second, retailers’ equities can often give a more focused assessment of how investors perceive the comparative outlook for domestic demand between two nations. Currently, euro area retailers trade at a 16-year low versus their U.S. counterparts (Chart 21). Investors are therefore much more ebullient about the prospects for U.S. domestic demand than in Europe. Interestingly, the euro’s gyrations since 2016 have tracked the direction of the relative performance of retailers but have diverged in terms of levels. This suggests some underlying support for the currency. Chart 21Can European Domestic Demand Really Validate Such Pessimistic Expectations? Can European Domestic Demand Really Validate Such Pessimistic Expectations? Can European Domestic Demand Really Validate Such Pessimistic Expectations? Third, the relative stock-to-bond ratio also often provides a good read on investors’ comparative economic euphoria/pessimism towards two nations. In 2018, the annual performance of the euro area stock-to-bond ratio relative to the U.S. collapsed to levels not recorded since the euro area crisis was at its apex (Chart 22). This further confirms that investors were massively depressed on European growth prospects relative to the U.S. While this indicator is rebounding, it is still in negative territory, implying that market participants still have room to upgrade their assessment of the euro area relative to the U.S. Historically, this kind of setup has been associated with a rebound in the EUR/USD. Chart 22The Stock-To-Bond Ratio Points To Some Upside Potential The Stock-To-Bond Ratio Points To Some Upside Potential The Stock-To-Bond Ratio Points To Some Upside Potential Fourth, European net earnings revisions relative to the U.S. have also hit bombed-out levels and are in the process of improving. Since earnings are tightly linked to global growth and reflect the same information that informs capital flows into a country (Chart 23), sell-side analysts becoming more positive on Europe at the margin could indicate that investors are in the process of re-assessing whether to buy European assets. A decision to do so would support EUR/USD. Chart 23When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies Bottom Line: Financial market pricing suggests that investors are displaying deep pessimism toward the euro area’s relative growth prospects. The euro could be a contrarian buy. Most importantly, there are early signs that this growth pricing is starting to move in favor of Europe. If our economic view on Europe and global growth is correct, this trend has further to go, implying that more capital could move into Europe, creating a potent tailwind for EUR/USD. What Else? Three additional factors need to be considered: Currency valuations, balance-of-payment dynamics, and technicals. First, while it is not as cheap as it once was, the real trade-weighted euro is still trading below its historical average (Chart 24). Purchasing-power considerations can rarely be used as a timing tool, but our confidence in the euro’s upside would be greatly dented if the euro were a very expensive currency. It is not even mildly pricey. Chart 24Euro Valuations: No Headwinds There Euro Valuations: No Headwinds There Euro Valuations: No Headwinds There Second, balance-of-payment considerations have become increasingly euro-positive. The euro area runs a current account surplus of 3.3% of GDP, and despite large FDI outflows – a natural consequence of being a savings-rich economy – the basic balance of payments remains in surplus. Moreover, as fixed-income outflows have been dissipating, the aggregate portfolio flows into Europe have also been improving (Chart 25). The end of the ECB’s Asset Purchase Program should solidify this trend. Chart 25The Euro Area Balance Of Payments Is Increasingly Favorable The Euro Area Balance Of Payments Is Increasingly Favorable The Euro Area Balance Of Payments Is Increasingly Favorable Finally, technical oscillators are behaving increasingly well. As Chart 26 shows, not only does our Intermediate-Term Indicator remains oversold, but also, it is has begun to form a positive divergence with the price of EUR/USD. If the economic outlook is becoming more bullish, such a technical setup can often be translated into significant gains. Chart 26EUR/USD: Oversold And A Positive Divergence Is Forming EUR/USD: Oversold And A Positive Divergence Is Forming EUR/USD: Oversold And A Positive Divergence Is Forming Bottom Line: The euro’s valuation is not as attractive as it once was, but it remains cheap. Moreover, the euro area’s balance-of-payment dynamics and the EUR/USD’s technical setup both suggest the timing is increasingly ripe to buy the euro against the dollar. Investment Conclusions A trough in European growth, improving growth and inflation prospects relative to the U.S., green shoots for global growth and deep pessimism toward Europe relative to the U.S. all argue that the timing is right to bet on a euro rebound. At this point, the durability of the euro rebound remains unclear. Investors are under-appreciating the ability of the Fed to raise rates this year, which could help the dollar. On the other hand, they seem even more sanguine toward the ECB ever lifting rates. Ultimately, the capacity of the euro to rebound on a long-term basis against the dollar will be constrained by global growth. This means that China will continue to play a center-stage role for this crucial FX pair. At this point, it is unclear how determined Chinese policymakers are to reflate their economy. Thus, we recommend investors monitor Chinese policy to gauge how long to stay in the euro. For the time being, enough pieces are falling into place to warrant buying EUR/USD for three to six months. However, if the Chinese credit impulse can continue on its recent rebound, the durability of a euro rally could be extended, implying that the euro may be in the process of forming a long-term bottom against the dollar. A strengthening euro should support the entire European currency complex against the dollar. In fact, the NOK, the SEK and the GBP may even outperform the EUR. The NOK is being boosted by rising oil prices, a more hawkish central bank, better valuations and an even healthier balance of payments. The SEK is also supported by a Riksbank that is slightly more hawkish than the ECB, and better valuations; it also benefits from a Swedish economy that is even more pro-cyclical than the euro area’s. The GBP also benefits from a greater valuation discount than the euro, and political developments in the U.K. are beginning to move toward a more clear-cut positive outcome on the Brexit front.3 The countercyclical and expensive CHF will prove the European laggard. Finally, EUR/JPY is also set to continue its rebound that began on January 4th. In fact, it may be one of the best vehicles to express a euro-bullish view because it is less sensitive to what the Fed does than EUR/USD is. Rising bond yields are an unmitigated positive for EUR/JPY, and BCA firmly believes that U.S. Treasury yields have upside, whether or not the Fed goes back to lifting rates. The Fed will mostly impact whether it is the real or inflation component that lifts Treasury yields. Bottom Line: The entire European currency complex is set to rise along with the euro against the greenback. In fact, the NOK, the SEK and the GBP are likely to outperform the euro, while the CHF should underperform. EUR/JPY may in fact offer the best risk-adjusted returns to play a euro rebound. While it is clear that at this moment that buying the euro makes sense, the principal risk lies around how long this rally will last. We are increasingly convinced that the euro has made a low for the cycle and that its long-term outlook is looking increasingly bright.  Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see the EUR/USD: Focus On The Western Shores Of The Atlantic section of the Foreign Exchange Strategy Weekly Report, titled “Canaries In The Coal Mine Alert: EM/JPY Carry Trades”, dated December 1, 2017, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Weekly Report, titled “Reflationary Or Recessionary”, dated February 25, 2019, available at uses.bcaresearch.com 3 Please see European Investment Strategy Weekly Report, titled “Why A Catastrophic No-Deal Might Be Good… For The EU”, dated February 28, 2019, available at eis.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Low Bond Volatility: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan, are likely to stay range bound. USTs vs Bunds/JGBs: Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars. Feature Bond Yields Are In Winter Hibernation Developed market (DM) government bonds, never the most exciting of asset classes to begin with, have become boring of late. While benchmark 10-year yields since the end of January have moved in line with our recommended country allocations - lower in Germany (-7bps), Japan (-3bps), the U.K. (-5bps) and Australia (-11bps) where we are overweight, higher in the U.S. (+5bps), Canada (+2bps) and Italy (+19bps) where we are underweight – government bonds have settled into trading ranges and lack direction. The proximate trigger for the muted yield volatility was the Federal Reserve shifting to a neutral stance on U.S. monetary policy in January. Investors have priced out any possibility of a Fed rate hike over the next year, and now even discount a modest rate cut, according to the U.S. Overnight Index Swap (OIS) curve. Yet while most of the attention for bond investors have been focused on the U.S., there are developments in other major economies that are also depressing yields – namely, weakening economic momentum and sluggish inflation. In particular, the downturn has shown no signs of stabilizing in the eurozone and Japan, with the latest readings on manufacturing PMIs now below the 50 line, signaling a contraction (Chart of the Week). The latest data in both regions still shows that core inflation is nowhere near the inflation targets of the European Central Bank (ECB) and Bank of Japan (BoJ). The story is much different in the U.S, with the manufacturing PMI still well above 50 and core inflation hovering close to the Fed’s 2% inflation target. Yet Treasury yield volatility has collapsed, with the MOVE index of Treasury options prices now back to the lows of this cycle. Chart Of The WeekAre Treasuries Leading Or Following? Are Treasuries Leading Or Following? Are Treasuries Leading Or Following? For the time being, non-U.S. factors are driving the direction of global bond yields. We think that will change later this year, as steady U.S. growth and surprisingly firm U.S. inflation readings will prompt the Fed to begin hiking rates again. Yet until there are signs that non-U.S. growth is stabilizing, the low yields in Europe and Japan will act as an anchor on U.S. Treasury yields, particularly given how wide U.S./non-U.S. yield differentials already reflect faster growth and inflation in the U.S. Decomposing Treasury-Bund & Treasury-JGB Spreads When looking at the pricing of the “Big 3” DM government bond markets – the U.S., Germany and Japan – there are some major differences but also some similarities as well. Even with the benchmark 10-year U.S. Treasury sitting at 2.68% compared to a mere 0.11% and -0.03% on the 10-year German Bund and 10-year Japanese government bond (JGB), respectively. Simply looking at the breakdown of those nominal 10-year yields into the real and inflation expectations components, there is not much of a comparison (Chart 2). The real 10-year Treasury yield is in positive territory at 0.6%, compared to -1.4% and +0.2% for JGBs and German bunds, respectively. Inflation expectations, measured by 10-year CPI swap rates, are 2.1% in the U.S., 1.5% in Germany and 0.2% in Japan. Thus, the current wide 10-year Treasury-Bund spread (just under +260ps) can be broken down into a real yield spread of +200bps and an inflation expectations gap of +60bps. In the case of the 10-year Treasury-JGB spread (just under +270bps), that breaks down into a real yield differential of +80bps and an inflation gap of +190bps. Chart 2Big Differentials Here... Big Differentials Here... Big Differentials Here... So while the Treasury-Bund and Treasury-JGB spreads are of similar magnitude, the valuation components driving the spread are much different. The former is more of a real yield gap, while the latter is more of an inflation expectations gap. That is no surprise given the BoJ’s Yield Curve Control policy that maintains a ceiling on the 10-year JGB yield of between 0.1% and 0.2%, limiting how much real yields can move (there are no BoJ restrictions on the level of CPI swap rates). Yet the U.S.-Japan inflation expectations gap is not too far off the spread between realized headline and core inflation measures in both countries - both are 1.4 percentage points higher in the U.S. as of January. Looking at other valuation metrics, the cross-county differentials are less pronounced (Chart 3). Chart 3...But Less So For Other Yield Measures ...But Less So For Other Yield Measures ...But Less So For Other Yield Measures Yield curves are quite flat, with the 2-year/10-year slope a mere +16bps in the U.S., +14bps in Japan and only +66bps in Germany. Our estimates of the term premia on 10-year government debt are negative for all three markets, most notably in the countries that have seen quantitative easing in recent years (-10bps in the U.S., -90bps in Germany and -60bps in Japan). Perhaps most importantly, our preferred measure of the market pricing of the real terminal policy rate – the 5-year OIS rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is +0.2% in the U.S., -0.5% in Germany and 0.0% in Japan. That means the market is pricing in only a +70bp differential, in real terms, between the neutral policy rates of the Fed and ECB. That gap is only +20bps between market pricing of the neutral real rates for the Fed and BoJ. That narrower gap between the market-implied pricing of the real neutral rate is consistent with the theoretical macroeconomic drivers of real rate differentials, like growth rates of potential GDP and labor productivity. According to OECD estimates, potential GDP growth is 1.8% in the U.S., 1.5% in the overall euro area and 1.2% in Japan (Chart 4). This implies a long-run real yield gap between the U.S. and Germany of +60bps and the U.S. and Japan of +30bps – very close to the market pricing for the real terminal rate differentials.1 When looking at the 5-year annualized growth rates of labor productivity data from the OECD, there is no difference between the three regions with all growing at a mere 0.5% (suggesting that either a faster growth rate of the labor input, or greater productivity of capital, accounts for the higher potential growth rate in the U.S.). Chart 4No Major Differences In Long-Run Real Growth No Major Differences In Long-Run Real Growth No Major Differences In Long-Run Real Growth With the cross-country yield spreads now effectively priced for the long-run real growth differentials between the U.S. and Europe/Japan, this will limit the ability for nominal Treasury-Bund and Treasury-JGB spreads to widen much further. Right now, U.S. inflation expectations are rising faster than those of Europe and Japan, in response to the Fed’s more dovish stance. Yet if those expectations continue to rise, likely in the context of stickier realized U.S. inflation alongside solid U.S. growth, then the Fed will return to a hawkish bias. That ultimately means higher U.S. real yields and, most likely, some pullback in U.S. inflation expectations since the markets would begin to price in the implications of the Fed moving to a restrictive policy stance (including a stronger U.S. dollar that will help dampen U.S. inflation, at the margin). So that means inflation differentials between the U.S. and Germany/Japan can move wider now but will narrow later; and vice versa for real yield differentials (narrower now and wider later). The main investment implication: nominal UST-Bund and UST-JGB spreads are unlikely to move much wider, likely for the remainder of this business cycle/Fed tightening cycle. The main takeaway is that bond yields in core Europe and Japan are effectively anchoring global yields, in general, and U.S. yields, in particular. Treasury yields will not be able to break out of the current narrow trading ranges until there are signs that growth has stabilized in Europe and Japan. Reduced global trade tensions and faster Chinese growth (and import demand) are necessary conditions to reflate the export-heavy economies of Europe and Japan. Yet even if that scenario does unfold in the months ahead (which is BCA’s base case scenario), there is still a case to prefer Bunds and JGBs over U.S. Treasuries on a currency-hedged basis in U.S. dollars. Given the wide short-term interest rate differentials between the U.S. and Europe/Japan, those near-zero 10-year Bund and JGB yields, after hedging into U.S. dollars, are actually higher than 10-year Treasury yields, which benefits the relative hedged performance of the low-yielders versus the U.S. (Chart 5) Chart 5Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Thus, we continue to recommend an overweight stance on core Europe and Japan, versus an underweight tilt on the U.S., in global U.S. dollar-hedged government bond portfolios. Bottom Line: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan are likely to stay range bound. Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com    Footnotes 1      We are using the full euro area data for these economic comparisons, even though we are discussing U.S.-German yield differentials in this report. We think this is reasonable given the status of German government bonds as the benchmark for the euro area, and with the ECB setting its monetary policy for the overall euro area. The differences between the data for Germany and the overall euro area are modest, with German potential GDP and 5-year productivity growth both only 0.3 percentage points higher. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Europe & Japan: The Anchor Weighing On Global Bond Yields Europe & Japan: The Anchor Weighing On Global Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy The ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency financial market data and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector. Leading indicators of chip end-demand are flashing green, at a time when the chip liquidation phase is clearing excess supplies. It no longer pays to be bearish the S&P semiconductors index.             Recent Changes Lift the S&P semiconductors index to neutral today; it is now also on upgrade alert. Table 1 Reflationary Or Recessionary? Reflationary Or Recessionary? Feature The SPX continued to grind higher last week, and is now within reach of the key 2,800 level. We expect stiff resistance to persist at that mark; 2,800 has served as a barrier on several occasions last year as we highlighted in recent research (please refer to Chart 1 from the January 28 Weekly Report).1  Year-to-date, we have identified three pillars that would propel the market higher – a more dovish Fed alongside a softer U.S. dollar, a year-over-year increase in SPX EPS for calendar 2019 and a positive resolution to the U.S./China trade spat. As the S&P 500 has come full circle and returned to the early December level, this slingshot recovery suggests that there is positive progress on all three pillars. However, our sense is that the bond market now has to remain tamed in order to cement these equity market gains and vault to fresh all-time highs, likely in the back half of the year. Chart 1 highlights this goldilocks macro backdrop. Chart 1Staying Divorced For A While Staying Divorced For A While Staying Divorced For A While In other words, as U.S. GDP downshifts from last year’s fiscal easing-induced sugar-high back down to trend growth and most importantly avoids recession, equities should excel. Why? Not only will this entice the Fed to stand pat for longer, but the 10-year Treasury yield will also remain on a lower trajectory than previously anticipated. Crudely put, a neither too-hot nor too-cold economic backdrop will allow equities to reflate away. As such, there are high odds that stocks stay divorced from bond yields for a while longer, and we interpret this bond market backdrop as reflationary rather than recessionary. Meanwhile on the Chinese front, following news of the PBoC’s quasi QE that we highlighted in early February as a positive SPX and cyclicals over defensives catalyst,2 it appears that Chinese authorities could not stomach a below 50 print in the Chinese manufacturing PMI for long and are aggressively opening the fiscal taps anew (Chart 2). Chart 2Chinese reflation... Chinese reflation... Chinese reflation... This enormous lending/fiscal stimulus complements ongoing monetary easing and the recent PBoC’s quasi QE, and should ensure that the Chinese economy at least steadies. The upshot is that global growth should also stabilize and put an end to its yearlong deceleration (Chart 3).        Chart 3... Should Aid Global Growth ... Should Aid Global Growth ... Should Aid Global Growth In addition, as U.S. and Chinese negotiation teams race to the finish line in order to get some sort of a deal done before the March 1st deadline, it is clear that a positive outcome is already discounted by the stock market as the SPX enjoys one of the best starts to the year in recent memory. Once this trade policy uncertainty permanently dies down, then last year’s worst performing sectors that were hit hard by the trade dispute will turn into this year’s stock market champions (Chart 4). Chart 4Trade War Hit Deep Cyclicals The Most Trade War Hit Deep Cyclicals The Most Trade War Hit Deep Cyclicals The Most In that light, we reiterate our cyclical over defensive portfolio bent and this week we highlight that a deep cyclical sector stands to benefit greatly from China’s reflation and the apparent resolution of the U.S./China trade spat; another tech subsector weighed down by the trade tussle is also going to enjoy a reversal of fortune and it no longer pays to be bearish. Don’t Write Off Mighty Industrials Year-to-date, industrials stocks are the best performing GICS1 sector, outperforming the SPX by a massive 650bps (Chart 5). While such a breakneck pace is unsustainable and a short term breather is likely, from a cyclical perspective more gains are in store in this still underowned sector. In this report we highlight the top five reasons it still pays to be overweight this deep cyclical sector. Chart 5 Capex upcycle. The capex upcycle theme remains intact and while there has been some softness recently in the national accounts reported investment outlays, it is highly unlikely that spending plans will grind to a halt similar to the late-2015/early-2016 episode (third panel, Chart 6). Capital goods producers have since replenished their cash coffers and remain committed to develop their capital expenditure projects. Importantly, leading indicators of capex corroborate this backdrop; regional Fed surveys suggest that capital outlays will remain firm for the rest of the year (second panel, Chart 6). Chart 6Capex Upcycle Supports Industrials Capex Upcycle Supports Industrials Capex Upcycle Supports Industrials Resurgent credit growth. Loan growth is on fire in the U.S. and commercial and industrial loan growth is leading the pack, galloping higher and breaching the 10%/annum mark. Bankers are providing the needed fuel to bring to fruition industrials capex plans and, given that historically loan growth and relative profit growth have been positively correlated, the current message is upbeat (Chart 7). Chart 7Loan Growth Fueling The Fire Loan Growth Fueling The Fire Loan Growth Fueling The Fire Chinese easy policy trifecta: credit, fiscal & monetary. Beyond the positive resolution in the U.S./China trade dispute, China has opened up its central bank liquidity tap to complement ongoing easy monetary policy. Tack on the recent monster loan origination and reaccelerating infrastructure spending and factors are falling into place for a pick up in end demand, which is a boon for U.S. capitals goods producers (Chart 8). Chart 8Heed The Chinese Reflation Message... Heed The Chinese Reflation Message... Heed The Chinese Reflation Message... Upbeat signal from high frequency EM related financial market data. Emerging market stocks have been outperforming the MSCI ACW Index since early-October and even in absolute terms have troughed in late-October. The ultimate leading EM indicator, EM FX, put in a bottom in early September, sniffing out some sort of reflationary impulse. Meanwhile, momentum in the CRB raw industrials commodity index has also troughed, confirming the high-frequency EM data points. As a reminder, industrials stocks and the global commodity complex move in lockstep, and we heed the positive message all these financial market indicators are emitting (Chart 9). Chart 9...EM Financial Variables Concur ...EM Financial Variables Concur ...EM Financial Variables Concur Downtrodden sector sentiment and compelling valuations. Despite this year’s rebound in industrial equities, sour investor sentiment appears deeply ingrained. Relative EPS breadth and oversold technical conditions are contrarily positive. Relative valuations are also beaten down and still offer a compelling entry point (Chart 10). Even on a forward P/E basis industrials are trading at a 4% discount to the broad market and below the historical average. Finally, industrials profit and revenue expectations for the coming 12-months are forecast to trail the broad market according to the sell-side community. Were our thesis to pan out, these would represent low hurdles for capital goods producers to surpass. Chart 10Underowned And Unloved Underowned And Unloved Underowned And Unloved Nevertheless, there is a key macro variable, the U.S. dollar, that is a risk to our sanguine S&P industrials sector view. Chart 11 shows that the greenback and industrials sector fortunes are tightly inversely correlated. Not only is an appreciating U.S. dollar deflationary for global commodities that are priced in the reserve currency, but it also weighs on industrials P&Ls via negative translation effects. As a reminder, roughly 40% of industrials sales are international. Chart 11Rising Greenback Is A Risk Rising Greenback Is A Risk Rising Greenback Is A Risk Netting it all out, the ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency EM related financial markets and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector.         Bottom Line: Stay overweight the S&P industrials sector. The Chip Cycle Is Turning It no longer pays to be bearish chip stocks; lift the S&P semiconductors index to neutral from underweight today. There are high odds that the chip cycle will soon take a turn for the better. Global chip sales have been decelerating for 17 months and are now on the cusp of contraction (Chart 12). Over the past two decades, steep contractions have been associated with recession. Given that BCA’s view does not call for recession this year, it is highly unlikely for global semi sales to suffer a major setback. While we do not rule out a brief and shallow dip below zero similar to the 2011/12 and 2015/16 parallels, leading indicators of global semi sales suggest that a trough is near. Chart 12Global Semi Cycle... Global Semi Cycle... Global Semi Cycle... Namely, BCA’s Global Leading Economic Indicator (GLEI) diffusion index is in a V-shaped recovery signaling that global growth is close to a nadir (middle panel, Chart 12). Similarly the U.S. dollar is decelerating which is a boon to global growth and conducive to higher global chip sales (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 12). With regard to U.S. domiciled semi producers, a depreciating currency provides tremendous leverage to profits as foreign sourced revenues are roughly 80% of the total or twice as high compared with the SPX. Table 2, shows the one year trailing internationally- and China-derived revenues of the ten largest firms in the S&P semiconductors index, representing over 95% of the index. On a weighted basis, 80% of sales are sourced from overseas, including 36% of total sales coming from China. Clearly, global growth in general and Chinese growth in particular are key drivers of semi top line growth. Thus, any positive U.S./China trade dispute resolution would provide more relief for the S&P semi index. Table 2Semi Sales Geographical Exposure Reflationary Or Recessionary? Reflationary Or Recessionary? Moreover, electronics activity is an excellent gauge for semi end-demand. The all-important Chinese electronics imports have ticked up recently. In the U.S., consumer outlays on electronics are firing on all cylinders. Taken together, there is tentative evidence that global semi demand will soon bottom (Chart 13). Chart 13...Is Turning ...Is Turning ...Is Turning Importantly, the global semi inventory liquidation is ongoing and this supply backdrop should help balance the market. Already Asian DRAM prices, our pricing power gauge for the semi industry, are contracting, underscoring that the semi market is clearing (second & third panels, Chart 14). Importantly, global semi billings that tend to lead global semi sales by a few months have also ticked higher of late (top panel, Chart 14). Chart 14Improving Supply/Demand Dynamics Improving Supply/Demand Dynamics Improving Supply/Demand Dynamics Unfortunately, none of these positive catalysts are picked up by sell-side analysts. In fact, despite the recent rebound in relative share prices, 12-month forward EPS and revenue expectations remain in free fall. Net EPS revisions are as bad as they get, and have sunk near previous troughs that have coincided with durable relative share price rallies (second panel, Chart 15). Chart 15Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel On the relative technical and valuation fronts, pessimism reigns supreme. Our Technical Indicator hovers near one standard deviation below the historical mean and our Valuation Indicator is probing all-time lows. Interestingly, the S&P semi index sports a higher dividend yield than the SPX currently, underscoring that semi stocks are cheap (Chart 16). Chart 16Compelling Valuations And Technicals Compelling Valuations And Technicals Compelling Valuations And Technicals Our Chip Stock Timing Model (CSTM) does an excellent job in capturing all these moving parts and is currently sending a bullish signal (Chart 17). We heed the signal from our CSTM and are compelled to lift exposure to neutral. Chart 17Prepare To Deploy Capital Prepare To Deploy Capital Prepare To Deploy Capital Bottom Line: Lift the S&P semiconductors index to neutral and it is now also on our upgrade watch list; we are looking for an opportunity to boost to overweight on a pullback, stay tuned. Finally, from a risk management perspective we are enticed to increase our trailing stop to 15% in our tactical overweight in the S&P semi equipment index, in order to protect gains. The ticker symbols for the stocks in the S&P semiconductors index are: BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Don’t Fight The PBoC” dated February 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Please note that analysis on India is published below. Even if the recent upturn in the Chinese credit impulse is sustained, there will likely still be a six- to nine-month lag between the impulse’s trough and the bottom in the mainland’s business cycle. EM corporate earnings cycles typically lag Chinese stimulus efforts by about nine months. Therefore, EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. EM equity valuations are not cheap enough to shield stocks from profit contraction. Feature China’s credit growth was very strong in January. We contend that even if the upturn in the credit impulse proves to be persistent, there will likely be a six- to nine-month lag between its low point and the bottom in the mainland’s business cycle. Chart I-1 demonstrates that the credit impulse leads both nominal manufacturing output growth and the manufacturing PMI’s import subcomponent by roughly nine months. Chinese imports are the most pertinent variable to gauge China’s economic impact on the rest of the world. Chart I-1China: Credit Impulse Leads Business Cycle By Nine Months China: Credit Impulse Leads Business Cycle By Nine Months China: Credit Impulse Leads Business Cycle By Nine Months In the meantime, will financial markets exposed to Chinese growth look through the valley of the ongoing growth deceleration and continue to rally? Or will they experience a major relapse in the coming months? In our opinion, corporate profits will be the key to broader financial market performance. So long as corporate profits do not shrink, investors will likely look beyond weak macro data, and any weakness in stocks will be minor. However, if corporate profits contract in the next nine months, then share prices will plummet anew. EM Profits Are Heading Into Contraction Chart I-2 illustrates that China’s credit impulse leads both EM and Chinese corporate earnings per share (EPS) by at least nine months and that it currently foreshadows EPS contraction in the first three quarters of 2019. Even if the recent upturn in the credit impulse is sustained, EM and Chinese EPS growth will likely bottom only in August – while they are in negative territory. Chart I-2EM EPS Is Beginning To Contract EM EPS Is Beginning To Contract EM EPS Is Beginning To Contract EM corporate earnings growth has already dropped to zero and will turn negative in 2019. Chart I-3A reveals that EPS in U.S. dollar terms are already contracting in six out of 10 sectors – industrials, consumer staples, consumer discretionary, telecom, utilities and health care. Chart I-3AEM EPS By Sector EM EPS By Sector EM EPS By Sector Chart I-3BEM EPS By Sector EM EPS By Sector EM EPS By Sector EPS growth has not yet turned negative for financials, technology, energy and materials (Chart I-3B). Notably, corporate earnings within these four sectors collectively account for 70% of EM total corporate earnings, as shown in Table I-1. Chart I- Over the course of 2019, these sectors’ EPS are also set to shrink: Technology (accounts for 20% of MSCI EM corporate earnings): NAND semiconductor prices have been plunging for some time, and DRAM prices are also beginning to drop (Chart I-4). This reflects broad-based weakness in global trade – global auto sales are shrinking for the first time since the 2008 global financial crisis, global semiconductor sales are relapsing and global mobile phones shipments are falling (Chart I-5). Chart I-4Semiconductor Prices Are Falling Semiconductor Prices Are Falling Semiconductor Prices Are Falling Chart I-5Broad-Based Weakness In Global Trade Broad-Based Weakness In Global Trade Broad-Based Weakness In Global Trade Semiconductors accounted for 77% of Samsung’s operating profits in the first three quarters of 2018, suggesting the potential drop in DRAM prices will be devastating for its profits. Next week we will publish a Special Report on Korea and discuss the outlook for both semiconductors and Korean profits in more detail. In addition, the ongoing contraction in Taiwanese exports of electronics parts confirms downside risks to EM tech earnings (please refer to top panel of Chart I-3B). In brief, the ongoing decline in semiconductor prices will bring about EPS contraction in the EM technology sector. Financials/Banks (financials make up 31% of EM corporate earnings): Banks’ profits often correlate with fluctuations in economic activity, because the latter drive non-performing loan (NPL) cycles (Chart I-6). NPL cycles outside Brazil, Russia and India – where the banking systems have already gone through substantial NPL recognition and provisioning – will deteriorate, and push banks to increase their provisions. The latter will be a major drag on EM banks’ profits. Chart I-6EM Banks EPS And Economic Activity EM Banks EPS And Economic Activity EM Banks EPS And Economic Activity Regarding Chinese banks in particular, if the credit revival in January is sustained, it would strongly suggest that the government is resorting to its old, credit-driven growth playbook. Following 10 years of an enormous credit frenzy and a 20-year capital spending boom, it is currently difficult to find many financially viable projects. Hence, a renewed credit binge will once again be associated with further capital misallocation and more NPLs. Many of these projects will fail to generate sufficient cash flow to service debt. NPLs will thus rise considerably and the need to raise capital will dilute the banks’ existing shareholders. Of course, this will happen with a time lag. Chart I-7 shows that the gap between Chinese banks’ EPS and non-diluted profits has once again widened, and that EPS are beginning to contract. Chart I-7Chinese Banks: Earnings Dilution Chinese Banks: Earnings Dilution Chinese Banks: Earnings Dilution Chinese banks could issue perpetual bonds – discussed in great detail in last week’s report – to recapitalize themselves. Nevertheless, this will be negative for existing shareholders. In a nutshell, despite low multiples, share prices of Chinese banks will drop because more credit expansion amid the lingering credit bubble is negative for existing shareholders. The basis is that it will ultimately lead to their dilution. Chinese banks make up 4.5% of the MSCI’s EM equity market cap and 10% of aggregate EM profits. Hence, their EPS contraction will have a non-trivial impact on overall EM EPS. Resource sectors (energy and materials together make 20% of EM corporate earnings): The ongoing slowdown in China will exert renewed selling pressure in commodities markets. As shown in Chart I-9 on page 8, base metals prices lag the turning points in the Chinese credit impulse by several months and are still at risk of renewed price decline. Hence, profits of firms in the materials sector are at risk. Energy companies’ trailing EPS growth is still positive because the late-2018 carnage in oil prices has not yet filtered through to corporate earnings announcements (Chart I-3B on page 3). More importantly, the recent oil price rebound can be attributed to both Saudi Arabia’s output cuts as well as stronger demand – in the form of a surge in Chinese imports of oil and petroleum products. Chart I-8 illustrates that growth rates of China’s intake of oil and related products approached zero when crude prices were rising but has dramatically accelerated following their plunge. This is consistent with China’s pattern of buying commodities on dips. The point is that the upside in oil prices will be capped by China, which will likely moderate its oil purchases going forward, as crude prices have recently rallied. Chart I-8China And Oil bca.ems_wr_2019_02_21_s1_c8 bca.ems_wr_2019_02_21_s1_c8 Bottom Line: EM profit cycles lag Chinese’s stimulus by about nine months. EM profits will be contracting in the first three quarters of 2019. This will short-circuit the current rebound in EM share prices. China’s Credit Cycles And Financial Markets What has been the relationship between China’s credit cycle and related financial markets over the past 10 years? The time lag between turning points in China’s credit impulse and relevant financial markets can be anywhere from zero to 18 months. Chart I-9 illustrates historical time lags between the Chinese credit impulse on the one hand and EM share prices, base metals prices and the global manufacturing PMI on the other. The time lag has not been consistent over time. Chart I-9Chinese Credit Impulse And Financial Markets: Understanding Time Lags Chinese Credit Impulse And Financial Markets: Understanding Time Lags Chinese Credit Impulse And Financial Markets: Understanding Time Lags In late 2015-early 2016, the rebound in China’s credit impulse led financial markets by six months. At the recent market peak in January 2018, the credit impulse led financial markets and the global manufacturing PMI by about 18 months. In the meantime, in the 2012-13 mini cycle, EM share prices and commodities markets did not rally much, despite the meaningful upturn in China’s credit impulse. Finally, at the 2010-2011 peak, the credit impulse led EM stocks and base metals prices by 12 months. In short, the credit impulse led those financial markets by a few months to as much as a year and a half. Further, not only do time lags to the stimulus vary, but the impact on both economic activity and financial markets varies as well. This is because both economic activity and financial markets are driven by human psychology and behavior; iterations in stimulus, economic activity and financial markets are chaotic and complex in nature and do not follow well-defined patterns. Given the poor state of sentiment among Chinese consumers, business managers and entrepreneurs, more stimulus and more time may be required to turn the mainland’s business cycle this time around. Besides, unlike in previous episodes, there has not been any stimulus for the property market and no tax reductions on auto sales. Finally, although China and the U.S. may strike a deal on trade, it is unlikely to be a comprehensive agreement that is sustainable in the long run. This would be consistent with our Geopolitical Strategy team’s view that China and the U.S. are in a long-term and broad geopolitical confrontation – not a trade war. The trade war and tariffs are just one dimension of this. Hence, Chinese consumers and businesses, as well as the global business community may well look through this potential deal and not significantly alter their cautious behavior, at least for some time. In other words, the genie of geopolitical confrontation is out of the bottle, and the presidents of the U.S. and China are unlikely to succeed in putting it back. Bottom Line: Turning points in China’s credit impulse generally lead financial markets exposed to Chinese growth by several months. Given that the improvement in the credit impulse is both very recent and modest, odds are that China-related plays including EM risk assets will go through a major selloff before putting in a durable bottom.1 EM Equity Valuations In terms of the ability of EM stocks to withstand profit contraction, would cheap valuations not shield share prices from a considerable drop? We do not think EM equities are cheap; their valuations are neutral. Hence, there is no real valuation cushion in EM stocks to help them endure a period of negative EPS growth. We have written frequently about valuations and will touch on the topic only briefly here. Market cap-based multiples indeed appear very low. However, some segments of the EM universe such as Chinese banks and state-owned companies in Russia, Brazil, China and India have had low multiples for years. In other words, they are a value trap and their multiples are low for a reason. We elaborated above why Chinese banks are chronically “cheap”. For many other companies, low multiples are due to structural issues such as the lack of focus on profitability and shareholder value, or the high cyclicality of profits. Many of these stocks have large market caps, which pull down the EM index’s aggregate multiple. To remove market-cap bias, we have calculated 20% trimmed-mean multiples by ranking 50 MSCI EM industry groups (sub-sectors) and cutting off the top and bottom 10%. Then, we calculate the equal-weighted average of the remaining 80% of the sub-sectors. We did this calculation for the following five ratios: trailing P/E, forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend. Then, we combined them into a composite valuation indicator (Chart I-10, top panel). This indicator shows that EM equity valuations are neutral. Chart I-10EM Equity Valuations In Absolute Terms bca.ems_wr_2019_02_21_s1_c10 bca.ems_wr_2019_02_21_s1_c10 In addition, we calculated the median and equal-weighted composite valuation indicators (Chart I-10, middle and bottom panels). They also remove market cap bias and tell the same message: EM stocks are trading close to their fair value. EM equities are also close to their historical average relative to developed markets (DM). Chart I-11 illustrates relative EM versus DM valuation indicators based on 20%-trimmed mean, median and equal-weighted metrics. Chart I-11EM Equity Valuations Versus DM bca.ems_wr_2019_02_21_s1_c11 bca.ems_wr_2019_02_21_s1_c11 In sum, EM valuations are not cheap neither in absolute terms, nor relative to DM. According to both measures, valuations are neutral. Hence, valuations will not prevent share prices from falling as profits begin to contract. This is why we continue to recommend a defensive strategy for absolute-return investors, and we continue to underweight EM versus DM within a global equity portfolio. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Beware Of Rural Growth Lapse Indian share prices are weak and are underperforming the emerging markets benchmark in U.S. dollar terms (Chart II-1, top panel). Small cap stocks are in a full-fledged bear market (Chart II-1, bottom panel). Chart II-1Indian Stocks Are Weak Indian Stocks Are Weak Indian Stocks Are Weak The latest earnings season turned out to be disappointing. Many companies missed their earnings estimates. Chart II-2 shows that net profit margins of listed non-financial companies have turned down and overall EPS growth is weakening. Chart II-2Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Indian Corporate Profits Are Sluggish Disappointing corporate earnings are confirmed by macro data as well. Chart II-3A shows that manufacturing production is decelerating and intermediate goods production is contracting. Further, sales of two-wheelers, three-wheelers, passenger and commercial vehicles, as well as tractors, are either slowing or contracting (Chart II-3B). Chart II-3ACyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating Chart II-3BCyclical Spending Is Decelerating Cyclical Spending Is Decelerating Cyclical Spending Is Decelerating This weakness emanates from rural areas. The basis is that food prices have been falling since the summer of 2018 – and are deflating for the first time since the early 2000s. This is hurting rural incomes. Several indicators confirm considerable weakness in rural income growth and the latter’s underperformance versus urban income and spending: The top panel of Chart II-4 illustrates that our proxy for spending in rural areas relative to urban areas has deteriorated massively along with the decline in Indian food prices. Chart II-4Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One Rural Spending Is Weaker Than Urban One This measure is calculated as revenue growth of four rural-exposed listed companies minus the revenue growth of four urban-exposed listed companies. In both cases, the companies largely operate in the consumer goods space. Credit growth in rural areas has lagged that of urban areas, explaining the underperformance of rural spending (Chart II-4, bottom panel). Corroborating this, stock prices of these urban-exposed companies have outperformed their rural peers substantially (Chart II-5). Chart II-5Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Urban-Exposed Stocks Have Outperformed Rural Ones Such a slump in rural income is posing a challenge to Modi’s re-election in May. His government – which lost three key state elections in late 2018 – is aware of these ominous trends and is acting boldly to revive income growth in rural areas. The government announced an expansionary budget that appeases rural voters. In particular, the budget aims to strengthen farmers’ support schemes, cut taxes for low- and middle-income earners and introduce a pension scheme for social security coverage of unorganized labor. However, there is a significant risk that the authorities’ fiscal and monetary stimulus are too late to lift growth before May’s elections. According to the past relationship between fiscal spending and India’s business cycle, higher government expenditure growth will only begin to have an effect on the economy in the second half of this year – i.e. after the elections are held (Chart II-6). Hence, the BJP could lose its majority, meaning it would either rule in a minority government or be forced to turn over power to the Congress Party and its allies. Chart II-6Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Government Expenditures To Lift Growth In H2 2019 Beyond the elections, food prices might be approaching their lows. Well-below average rain will likely result in weak agricultural production and, hence, higher food prices in the second half of 2019 (Chart II-7). Chart II-7Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Below Trend Monsoon = Food Prices Will Likely Rise Therefore, in the second half of 2019, both fiscal easing and higher food prices will revive rural incomes and spending. In the meantime, monetary easing and credit growth acceleration will support demand in urban areas. Overall, Indian financial markets will likely remain in a risk zone until the elections as economic growth and corporate profits will continue to disappoint. If the opposition Congress Party’s alliance wins the election, Indian stocks and the currency will initially sell off. After this point, Indian assets could offer a buying opportunity because growth will likely revive in the second half of 2019. Bottom Line: For now, we continue to recommend an underweight position in Indian equities relative to the EM equity benchmark. Weakening growth, the very low interest rate differential versus U.S. rates and political uncertainty ahead of the general elections, pose risks of renewed rupee depreciation. A weaker rupee will continue to benefit India’s export-oriented software companies. Therefore, we also reiterate our long Indian software / short EM stocks recommendation. Finally, fixed-income investors should stay with the yield curve steepening trade. The central bank could further cut rates in the near term. However, long-term bond yields will not fall substantially and will likely start drifting higher sooner than later. The widening fiscal deficit, expectations of growth revival in the second half of 2019, and eventually higher food prices and inflation expectations, will all lead to a continuous steepening in the local yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      This is the view of BCA’s Emerging Markets Strategy team and it is different from BCA’s house view on China-related assets and the global business cycle. The primary source of the difference is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Portfolio Strategy The path of least resistance is higher for the broad equity market on the back of a reflationary impulse and a less dogmatic Fed. Now that the SPX forward EPS bar has been lowered to the ground, upward surprises loom, especially if the third catalyst we have been highlighting in recent research materializes: a positive resolution to the U.S./China trade spat. The recent M&A fever, a less dogmatic Fed that has suppressed the 10-year Treasury yield and a pick up in the U.S. credit impulse can serve as catalysts to unlock excellent value in the S&P biotech index. Upgrade to overweight. A profit margin squeeze on the back of soft pharma pricing power, weak operating conditions and a race to buy out biotech stocks to build up drug pipelines warn that the derating phase has just began for the S&P pharma index. Downgrade to underweight. Recent Changes Boost the S&P biotech index to overweight today. Trim the S&P pharma index to underweight today. Table 1 Reflating Away Reflating Away Featured The S&P 500 has been flirting with its 200 day moving average and once it categorically clears this hurdle there are high odds that previous resistance will turn into support. The next important level is 2,800, as we highlighted in recent research, a level where the SPX failed numerous times last year.1 Encouragingly, the character of the market has changed from December’s extreme daily weakness to this year’s significant daily resilience. As we first posited on January 18, while everyone is looking for a retest to re-enter the equity market, we already had the retest in December and are now in a slingshot recovery eerily similar to the 2016 and 1998 episodes.2 Importantly, what has changed since the post-December Fed meeting carnage is that the bond market has completely priced out Fed hikes for 2019 and the 10-year Treasury yield is 15bps lower. Chart 1 highlights this reflationary backdrop for U.S. stocks. Our proprietary Reflation Gauge (RG, comprising oil prices, interest rates and the U.S. dollar) is probing levels last hit in 2012. Historically, our RG and equity momentum have been joined at the hip and the current message is to expect a rebound in the latter. Chart 1Heed The Reflation Message Heed The Reflation Message Heed The Reflation Message The latest ISM manufacturing survey also corroborates the signal from our RG. The jump in the ISM new orders-to-inventories ratio underscores that the rebound in stocks has further to run (bottom panel, Chart 1). Granted, a lot rests on EPS and in order for stocks to propel to fresh all-time highs later this year, as we expect, profits will have to deliver. On that front, despite recent steep downward EPS revisions across the board, we believe the level of quarterly EPS will hit fresh all-time highs in the back half of the year, carrying stocks into uncharted territory (Chart 2). As a reminder, BCA’s view remains that the U.S. will avoid recession in 2019. Chart 2Joined At The Hip Joined At The Hip Joined At The Hip One key profit driver that has put pressure on recent earnings releases and will continue to weigh on internationally-exposed P&Ls is the greenback. With a delayed effect, the first two quarters of this year should bear the brunt of last year’s steep U.S. dollar climb, but that effect will reverse in the back half of 2019. Not only is the greenback inversely correlated with the SPX, but also with the global manufacturing PMI (trade-weighted U.S. dollar shown inverted and advanced, Chart 3). Chart 3Dollar The Reflator... Dollar The Reflator... Dollar The Reflator... Thus, the greenback is a key macro variable that we are closely monitoring. On that front, global U.S. dollar based liquidity is one of the most important determinants/drivers of global growth. The longer U.S. dollar liquidity gets drained, the more downward pressure it will put on SPX momentum and SPX EPS (Chart 4). Once U.S. dollar based liquidity starts to get replenished at the margin, it can serve as a catalyst for a global growth recovery. A Fed tightening cycle pause and recent acknowledgment that the balance sheet asset roll off is important and the Fed stands ready to tweak it, are a net positive for at least a trough in global U.S. dollar liquidity. Chart 4...But Watch Global Dollar Liquidity ...But Watch Global Dollar Liquidity ...But Watch Global Dollar Liquidity Adding it up, the path of least resistance is higher for the broad equity market on the back of a reflationary impulse and a less dogmatic Fed. Now that the SPX forward EPS bar has been lowered to the ground, upward surprises loom, especially if the third catalyst we have been highlighting in recent research materializes: a positive resolution to the U.S./China trade spat.3 This week we make a couple of subsurface changes to a defensive sector; these changes do not alter our recommended benchmark allocation to the overall sector. Biotech’s Gain Is... Biotech stocks have been the center of attention recently as the BMY/CELG deal put the whole sector in play, and today we are boosting exposure to overweight in the S&P biotech index. We doubt the merger mania is over and we continue to believe that more mega deals are in store, either intra or inter-industry, with Big Pharma hungry and in a hurry to replenish their drug pipeline. While this is not the sole reason for an above benchmark allocation, 50-60% M&A deal premia are a boon for investors (Chart 5). Chart 5M&A Frenzy M&A Frenzy M&A Frenzy From a long-term macro perspective biotech stocks have been the primary beneficiaries of the 35-year bond bull market. In other words, the multi-decade grind lower in the U.S. Treasury yield has been synonymous with biotech outperformance (10-year U.S. Treasury yield shown inverted, Chart 6). Chart 6Biotech Equities And Rates Move In Opposite Direction Biotech Equities And Rates Move In Opposite Direction Biotech Equities And Rates Move In Opposite Direction The Fed’s recent monetary policy U-turn is a welcome development and these high growth stocks will benefit from the 55bps fall in the 10-year Treasury yield since the early-November peak. In addition, another macro tailwind is working in the S&P biotech index’s favor. The resurgent U.S. credit impulse is unambiguously bullish for this health care index that excels when margin debt availability is rising and liquidity is plentiful (bottom panel, Chart 7). Chart 7Revving Credit Impulse Says Buy Biotech Stocks Revving Credit Impulse Says Buy Biotech Stocks Revving Credit Impulse Says Buy Biotech Stocks Surprisingly, the sell-side community does not share our enthusiasm on any of these positive catalysts. Relative profit growth is forecast to be nil in the next year. In the coming five years, biotech stocks are expected to trail the overall market’s profit growth by 4%/annum (middle panel, Chart 8). This is extremely pessimistic and a first in the 24-year history of the I/B/E/S data set, and it is contrarily positive. Relative revenue growth forecasts are also grim for the upcoming 12 months and both revenue and profit forecasts present low hurdles to overcome (fourth panel, Chart 8). Chart 8Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel With regard to technicals and valuations, investors are doubtful that biotech stocks can stage a playable turnaround. Cyclical momentum remains moribund, printing below the zero line. Meanwhile, the S&P biotech index trades at a 25% discount to the SPX forward P/E and well below the historical mean (second & bottom panels, Chart 8). Chart 9 shows that biotech stocks are also cheap on a relative dividend yield basis. The S&P biotech index has been so oversold that it now sports a dividend yield higher than the S&P 500. Nevertheless, there is one key risk we are closely monitoring. Biotech initial public offerings are at all-time highs, with private equity and venture capital funds rushing for the exit doors. This is worrisome as it offsets the supply reduction owing to the M&A fever and has historically coincided with biotech relative share price peaks (Chart 10). Chart 9Compelling Relative Value Compelling Relative Value Compelling Relative Value Chart 10Watch This Risk Watch This Risk Watch This Risk Netting it all out, the recent M&A fever, a less dogmatic Fed that has suppressed the 10-year Treasury yield and a pick up in the U.S. credit impulse can serve as catalysts to unlock excellent value in the S&P biotech index. Bottom Line: Boost the S&P biotech index to overweight today. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, AMGN, GILD, BIIB, CELG, VRTX, REGN, ALXN, INCY. …Pharma’s Pain In mid-2017 we went underweight the S&P pharma index and booked healthy gains roughly a year later when we lifted exposure to neutral. Since then, Big Pharma has enjoyed a reprieve on the back of congressional inaction and the fact that the Trump Administration’s drug pricing wrath was less severe than initially feared. However, the time has come to trim the S&P pharma index to underweight. Chart 11 shows that pharmaceutical companies have been nearly uninterruptedly raising prices for the past four decades. Higher selling prices have been synonymous with higher profits and thus higher share prices. Chart 11Margin Trouble Margin Trouble Margin Trouble But, something happened in the new millennium. Relative performance peaked as pharma embarked on a mega M&A boom in the late-1990s with the Pfizer/Warner Lambert deal breaking all-time industry M&A records. Why? Because profit margins crested and have never reclaimed their previous zenith (top and middle panels, Chart 11). Neither have relative share prices. Worryingly, pharma prices have hit a wall during the past four years and can barely keep up with overall inflation, despite still being opaque (bottom panel, Chart 11). As both Democrats and Republicans are united to bring down health care costs in general and drug prices in particular, pharma profits will likely suffer a secular downdraft. The implication is that, as pharma revenues erode they will deal a blow to profits. Consequently, the outlook for relative share prices is dim. Importantly, pharma executives have not been frugal enough to offset the soft pricing power backdrop. Headcount has been expanding consistently since 2012 and a wide gap has opened up relative to industry selling price inflation, akin to the one in the mid-2000s that suppressed relative share prices (Chart 12). Chart 12Pricing Power Pressure Pricing Power Pressure Pricing Power Pressure Similar to the M&A boom of the late-1990s, there has been a global pharma M&A race with multiple deal announcements in the past few months, underscoring that the industry is not standing still. As Big Pharma CEOs compete to outdo their peers and buy drug pipelines mostly in the biotech space (Chart 5), they will continue to degrade the industry balance sheet (third panel, Chart 12). Our strategy is to overweight the hunted (biotech) and avoid the hunters (Big Pharma). On the operating front, a supply check reveals that pharma wholesale and manufacturing inventories are growing, whereas shipments are on the verge of contraction. Pharma industrial production has petered out and industry productivity gains are waning (Chart 13). This deteriorating operating backdrop will weigh on relative profits. Chart 13Deteriorating Operating Metrics... Deteriorating Operating Metrics... Deteriorating Operating Metrics... With regard to the macro front, a vibrant U.S. economy – with the ISM manufacturing survey ticking higher and the labor market firing on all cylinders – suggests that defensive pharma relative profits will resume their downtrend (bottom panel, Chart 13). Tack on the U.S. dollar’s reversal since the November peak and defensive pharma equities will remain under pressure (second panel, Chart 14). Chart 14...But EPS Bar Is On The Floor ...But EPS Bar Is On The Floor ...But EPS Bar Is On The Floor Nevertheless, there are three risks to our negative S&P pharma view. First, the M&A fever dies down and there are no additional purchases of biotech outfits. Second, Congress and the President drag their feet and fail to agree on new hawkish pharma pricing legislation. Finally, sell-side analysts have thrown in the towel and maybe most of the bad news is reflected in bombed out relative profit and sales growth estimates (third & fourth panels, Chart 14). In sum, a profit margin squeeze on the back of soft pharma pricing power, weak operating conditions and a race to buy out biotech stocks to build up drug pipelines warn that the derating phase (bottom panel, Chart 14) has just began for the S&P pharma index. Downgrade to underweight. Bottom Line: Trim the S&P pharma index to underweight. The ticker symbols for the stocks in this index are: BLBG: S5PHAR – JNJ, PFE, MRK, LLY, BMY, ZTS, AGN, MYL, NKTR, PRGO. Health Care Remains In The Neutral Column Despite these two subsurface health care sector moves, our overall exposure to the S&P health care sector remains intact at neutral. Please look forward to reading our upcoming research where we will be updating the S&P managed health care, S&P health care facilities and S&P health care equipment subsectors.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Insight Report, “Don’t Bet On A Retest” dated January 18, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Spread Product Valuation: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Corporate Defaults: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Mexican Sovereign Bonds: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Feature Corporate bonds have been on fire since the start of the year. High-yield excess returns have already made back all of their lost ground from 2018, and investment grade credits are on their way (Chart 1). With the Fed’s rate hike cycle on hold and some signs of credit easing in China, the near-term backdrop is amenable to further spread compression. Especially from current elevated levels. Chart 1Corporate Bonds Having A Good Run In 2019 Corporate Bonds Having A Good Run In 2019 Corporate Bonds Having A Good Run In 2019 On the flipside, some indicators of corporate default risk are starting to deteriorate and we can easily envision a more difficult environment for corporate spreads in the second half of this year. Especially if the Fed re-starts rate hikes, as we expect.1 In this week’s report we illustrate the extent of undervaluation in corporate spreads, and also detail our concerns related to budding default risk. We conclude that investors should maintain an overweight allocation to corporate bonds (both investment grade and high-yield) for now, but be prepared to trim exposure once spreads reach more reasonable levels. Finally, we identify an opportunity in USD-denominated Mexican sovereign bonds. Too Cheap For Phase 2 In our Special Report from mid-December that laid out our key themes for 2019, we described how we split the economic cycle into different phases based on the slope of the yield curve (Chart 2).2 We define the three phases of the cycle as follows: Chart 2Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Expect To Stay In Phase 2 For Most (If Not All) Of 2019 Phase 1: From the end of the prior recession until the 3-year / 10-year Treasury slope flattens to below 50 bps Phase 2: When the 3/10 slope is between 0 bps and 50 bps Phase 3: From when the 3/10 slope inverts until the start of the next recession Dividing the cycle this way reveals a reliable pattern in corporate bond excess returns versus Treasuries. Excess returns tend to be highest in Phase 1. They tend to be quite low but still positive in Phase 2, and they tend not to turn negative until Phase 3. We argued in December that we are currently in Phase 2 and that we will probably stay there for most, if not all, of 2019. The main reason that excess returns are lower in Phase 2 than in Phase 1 is that corporate bond spreads are much tighter in Phase 2. Most of the cyclical spread compression occurs in Phase 1, in the immediate aftermath of the recession. With that in mind, consider the data presented in Chart 3. The chart shows 12-month breakeven spreads for each corporate bond credit tier as a percentile rank relative to history.3 For example, a percentile rank of 50% means that the breakeven spread has been tighter than its current level half of the time throughout history. Chart 3 also divides the historical data into two samples, showing how breakeven spreads rank relative to the entire history of available data, and also how they rank relative to other Phase 2 periods only. Chart 3 When the full historical sample is considered, only the B-rated and Caa-rated credit tiers have breakeven spreads above their historical medians. However, when we focus exclusively on Phase 2 environments we see that spreads for every credit tier other than Aaa look extremely cheap. Essentially, Chart 3 shows that today’s spread levels are more consistent with periods when the economy is either just exiting or entering a recession. Absent that sort of macro environment, there would appear to be an obvious buying opportunity in corporate bonds. Interestingly, other spread products don’t look nearly as cheap as corporate bonds. Chart 4 shows the same data as Chart 3 but for all non-corporate U.S. spread products with available data prior to 2000. It shows that Agency MBS and Consumer ABS spreads are close to median Phase 2 levels. USD-denominated Sovereign debt looks somewhat cheap. Meanwhile, Domestic Agencies and Supranationals both look expensive. What’s clear is that right now corporate credit offers the most attractive opportunity in U.S. fixed income. Chart 4 Bottom Line: Corporate bond spreads don’t look especially cheap relative to average historical levels. But they are far too elevated for the current phase of the economic cycle. Valuations in other spread products are not nearly as attractive. Investors should remain overweight corporate bonds (both investment grade and junk) within U.S. fixed income portfolios. Default Cycle At A Turning Point?  Another valuation tool in our arsenal is the High-Yield default-adjusted spread. This is the excess spread available in the high-yield index after accounting for expected 12-month default losses. It can also be thought of as the 12-month return earned by the High-Yield index in excess of a position in duration-matched Treasuries, assuming that default losses match expectations and that there are no capital gains (losses) from spread tightening (widening). Expected default losses are calculated using the Moody’s baseline default rate forecast and our own forecast of the recovery rate. Combining the Moody’s baseline default rate forecast of 2.4% and our recovery rate forecast of 45% gives expected 12-month default losses of 1.3%. Those expected default losses are then subtracted from the average High-Yield index option-adjusted spread to get a default-adjusted spread of 274 bps. This is slightly above the historical average of 250 bps (Chart 5). In other words, junk investors are currently being compensated at slightly above average levels to bear default risk. Chart 5A Look At The Default-Adjusted Spread A Look At The Default-Adjusted Spread A Look At The Default-Adjusted Spread Another way to conceptualize the default-adjusted spread is to ask what default rate would have to prevail over the next 12 months for junk investors to earn average historical excess compensation. This spread-implied default rate is denoted by the ‘X’ in the second panel of Chart 5. It is currently 2.8%, slightly above Moody’s baseline expectation. Is The Baseline Default Rate Forecast Reasonable? If we view the Moody’s 2.4% default rate forecast as reasonable, then we should conclude that junk bonds are attractively valued. However, some macro indicators suggest that 2.4% might be too optimistic. Chart 6 shows a model of the 12-month trailing speculative grade default rate based on gross leverage, which we define as total debt over pre-tax profits, and C&I lending standards. Chart 6A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate A Simple Model Of The 12-Month Trailing Speculative Grade Default Rate Gross leverage has improved during the past few quarters as profit growth has outpaced corporate debt growth (Chart 6, panel 2). This has acted to push down the fair value reading from our default rate model. On the other hand, commercial & industrial (C&I) lending standards tightened in the fourth quarter of last year (Chart 6, bottom panel). A net tightening in C&I lending standards is consistent with a higher default rate. Overall, the fair value reading from our default rate model is currently 3.5%, above the current 12-month trailing default rate of 2.6%. For the purposes of valuation, where the default rate will be 12 months from now is more important than where it is currently. To get a sense of where the fair value from our model is headed we need forecasts for corporate profit and debt growth. Profit growth will almost certainly moderate from its current lofty levels (Chart 7). Pressures on revenues and expenses both point in that direction. Total business sales and the ISM Manufacturing PMI have both fallen sharply from their recent highs (Chart 7, panel 2), suggesting lower corporate revenue growth going forward. Meanwhile, wages continue to accelerate (Chart 7, bottom panel). Chart 7Forecasting Profit Growth Forecasting Profit Growth Forecasting Profit Growth Using a model based on nominal GDP growth, wage growth, industrial production and the trade-weighted dollar, if we forecast that nominal GDP growth slows to the same rate as wage growth over the next 12 months, then the model predicts that profit growth will fall into the mid-single digits (Chart 7, top panel). This would be more or less consistent with the recent growth rate in corporate debt, meaning that gross leverage would flatten-off and the fair value reading from our default rate model would stabilize near 3.5%. In summary, if profit growth moderates in line with our expectations during the next 12 months, then it is likely that the corporate default rate will be somewhat higher than the current Moody’s forecast of 2.4%, possibly as high as 3.5%. But even a 3.5% default rate would still translate to a default-adjusted junk spread of 211 bps. Positive compensation for default risk, though less than average historical levels. In that case we would still expect solid positive excess returns from junk bonds. However, it will be important to monitor our default-adjusted spread during the next few months. If junk spreads tighten in the near-term, as we anticipate, then the excess compensation for default risk will evaporate quickly. Bottom Line: Slowing corporate profit growth during the next 12 months will cause corporate leverage to flatten-off and will lead to a slightly higher default rate than most baseline forecasts suggest. Junk spreads currently offer adequate compensation for the extra default risk, but that cushion will evaporate quickly if spreads tighten during the next few months. Buy Mexican Bonds While most spread products have benefited from the Fed’s pause, delivering excellent year-to-date returns. We notice that the spreads on Mexico’s USD-denominated sovereign debt have not tightened alongside other comparable credits (Chart 8). This presents an attractive opportunity. Chart 8Mexican Bonds: An Attractive Opportunity Mexican Bonds: An Attractive Opportunity Mexican Bonds: An Attractive Opportunity When we compare 12-month breakeven spreads between the USD-denominated sovereign debt of different emerging market countries versus the spreads on equivalently-rated U.S. corporate bonds, we see that Mexico has now joined Argentina, Saudi Arabia, Qatar, UAE and Poland as the only countries that offer attractive compensation relative to the U.S. corporate sector (Chart 9). Chart 9 Why has this happened? Our Emerging Markets Strategy service postulates that many investors fear that the new political regime will bring fiscal profligacy, but in fact, the AMLO administration is proving to be less populist and more pragmatic than expected.4 The 2019 budget, for example, targets a primary surplus of 1% of GDP, and envisages a decline in nominal expenditures in 29 out of 56 categories. This commitment to sound fiscal policy should benefit Mexican sovereign bond spreads. More fundamentally, our Emerging Markets strategists note that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs. This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite interest rates being much higher in Mexico than in the U.S. The Mexican 10-year real yield is currently 4.1%, well above real GDP growth which was 2.6% during the past four quarters (Chart 10). Contrast that with the U.S., where the 10-year real yield is a meagre 0.8% versus real GDP growth of 3% during the past four quarters. In other words, interest rate differentials favor a stronger peso, which is positive for USD-denominated sovereign spreads. Chart 10Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Good Time To Add USD-Denominated Mexican Bonds To A Portfolio Though the Mexican/U.S. interest rate differential remains wide, it is likely to compress going forward. Elevated Mexican interest rates relative to growth signal that monetary policy is restrictive. A fact that is already evident in decelerating Mexican money supply (Chart 10, bottom panel). Meanwhile, low U.S. real yields relative to GDP suggest that further Fed tightening is necessary before U.S. rates are similarly restrictive. Bottom Line: Mexico’s USD-denominated sovereign debt is attractively priced relative to similarly-rated U.S. corporate credit. U.S. fixed income investors should take the opportunity to add USD-denominated Mexican bonds to their portfolios. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy Weekly Report, “Caught Offside”, dated February 12, 2019, available at usbs.bcaresearch.com 2      Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3      The 12-month breakeven spread is the spread widening required over the next 12 months for the corporate bond to break even with a duration-matched position in Treasury securities. We use the breakeven spread instead of the average index spread because it takes into account the changing duration of the bond indexes. 4      Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification