Valuations

Key Portfolio Highlights The S&P 500 has started 2019 with a bang as dovish cooing from the Fed has proven a tonic for equities. While we have not entirely retraced the path to the early-autumn highs, our strategy of staying cyclically exposed, based on our view of an absence of a recession in 2019, has proven a profitable one as investor capitulation reached extreme levels (Charts 1 & 2). Chart 1Capitulation Capitulation Capitulation Chart 2Selling Is Exhausted Selling Is Exhausted Selling Is Exhausted Importantly, risk premia have been deflating as the end-of-year spike in volatility has subsided and junk spreads have narrowed from the fear-induced heights in December (Chart 3). Chart 3Risk Premia Renormalization Risk Premia Renormalization Risk Premia Renormalization Nevertheless, in order for the reflex rebound since the late-December lows to morph into a durable rally, the macro/policy backdrop has to turn from a headwind to a tailwind. We are closely monitoring three potential positive catalysts: A definitively more dovish Fed, which would help restrain the greenback A continuation of the earnings juggernaut A positive U.S./China trade resolution With respect to the first of these, the S&P 500 convulsed following the December 19 Fed meeting and suffered a cathartic 450 point peak-to-trough fall two months ago. The Fed likely made a policy error, and Fed Chair Powell’s resolve is getting tested as has happened with every Chair since Volcker (Charts 4 & 5). Chart 4Powell's Resolve Getting Tested Powell's Resolve Getting Tested Powell's Resolve Getting Tested Chart 5Fed Policy Mistake Fed Policy Mistake Fed Policy Mistake The rising odds of a pause in the Fed tightening cycle, at least for the first half of the year, will likely serve as a welcome respite for equities. Our second catalyst has been gaining steam through the Q4 earnings season which has seen continuation of the double-digit earnings growth of the prior three quarters. Our earnings model points to a moderation of earnings growth in the year to come, in line with sell-side expectations (Chart 6). Our 2019 year-end target remains 3,000 for the SPX, based on $181 2020 EPS and a 16.5x multiple.1 This represents a 6% EPS CAGR, assuming 2018 EPS ends near $162. Chart 6EPS Growth > 0 EPS Growth > 0 EPS Growth > 0 Chart 7 In Chart 7, we show that financials, health care and industrials are responsible for 61% of the SPX’s expected profit growth in 2019 while technology’s contribution has fallen to a mere 7.2%. While the risk of disappointment encompases financials, health care and industrials, there are high odds that tech surprises to the upside as it has borne the brunt of recent negative earnings revisions (Charts 8 & 9). Chart 8Earnings Revisions... Earnings Revisions... Earnings Revisions... Chart 9...Really Weigh On Tech ...Really Weigh On Tech ...Really Weigh On Tech Lastly, the negativity surrounding the slowdown in China is likely fully reflected in the market (Chart 10), implying an opportunity for a break out should a positive resolution to the U.S./China trade spat be delivered. China’s reflation efforts suggests that the Chinese authorities remain committed to injecting liquidity into their economy (Chart 11). Chart 10China Slowdown Baked In The Cake China Slowdown Baked In The Cake China Slowdown Baked In The Cake Chart 11Reflating Away Reflating Away Reflating Away Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (Chart 12). All of these underlie our style preferences for cyclicals over defensives2 and international large caps over domestically-geared small caps. Chart 12Heed The PBoC Message Heed The PBoC Message Heed The PBoC Message Chris Bowes, Associate Editor chrisb@bcaresearch.com S&P Financials (Overweight) The divergence between the directions for our CMI and valuation indicator (VI) for S&P financials has reached stunning levels, with the former accelerating into pre-GFC territory and the latter falling to two standard deviations below fair value. Our technical indicator (TI) is sending a relatively neutral message, though this does not diminish the most bullish signal in our cyclical indicator’s history (Chart 13). Chart 13S&P Financials (Overweight) S&P Financials (Overweight) S&P Financials (Overweight) The ongoing strength of the U.S. economy is the driver of such a positive indicator, particularly with respect to the key S&P banks sub index. Our total loans & leases growth model and BCA’s C&I loan growth model (second & bottom panels, Chart 14) are in positive territory. The latter is significant given that C&I loans are the single biggest credit category in bank loan books. Importantly, C&I loans have gone vertical recently topping the 10.5% growth mark despite softening capex intentions and CEO confidence. Further, multi-decade highs in consumer confidence are offsetting the Fed’s tightening cycle and suggest that consumer loans, another key lending category, will also gain traction (third panel, Chart 14). In the context of the generationally high employment rate, the implied lower defaults should drive amplified profit improvement from this credit growth. We reiterate our overweight recommendation. Chart 14Loan Growth Drives Profits Loan Growth Drives Profits Loan Growth Drives Profits S&P Industrials (Overweight) The still-solid domestic footing has maintained our industrials CMI close to its cyclical highs, which are also some of the most bullish in the history of the indicator. However, stock prices have not responded accordingly and our VI has descended mildly from neutral to undervalued. Our TI sends a much more definitive message and stands at a full standard deviation into oversold territory (Chart 15). Chart 1515. S&P Industrials (Overweight) 15. S&P Industrials (Overweight) 15. S&P Industrials (Overweight) While their cyclical peers S&P financials are almost exclusively a domestic play, S&P industrials have been weighed down by trade flare ups for most of the past year (bottom panel, Chart 16). Accordingly, much of the benefit of positive domestic capex indicators and the more tangible capital goods orders maintaining a supportive trajectory has failed to show up in relative EPS growth (second & third panels, Chart 16), though the latter has recently hooked much higher. Chart 16Industrial Earnings Growth Has Recovered Industrial Earnings Growth Has Recovered Industrial Earnings Growth Has Recovered S&P Materials (Overweight) Our materials CMI has made a turn, rising off its lowest level in 20 years. This has coincided with our VI bouncing off its cyclical low, though it remains in undervalued territory. The signal is shared by our TI which has only recently recovered from a full standard deviation into the oversold zone, a level that has historically presaged S&P materials rallies (Chart 17). Chart 17S&P Materials (Overweight) S&P Materials (Overweight) S&P Materials (Overweight) When we upgraded the S&P materials sector to overweight earlier this year, we noted that China macro dominates the direction of U.S. materials stocks. On the monetary front, the Chinese monetary easing cycle continues unabated and the near 150bps year-over-year drop in the 10-year Chinese Treasury yield will soon start to bear fruit (yield change shown inverted and advanced, bottom panel, Chart 18). The renminbi also moves in lockstep with relative share prices. The apparent de-escalation in the U.S./China trade tensions has boosted the CNY/USD and is signaling that a playable reflation trade is in the offing in the S&P materials sector (top panel, Chart 18). Chart 18Chinese Data Drives Materials Performance Chinese Data Drives Materials Performance Chinese Data Drives Materials Performance S&P Energy (Overweight) Our energy CMI has moved horizontally for the past six quarters, though this followed a snap-back recovery from the extremely depressed levels of 2016 and 2017. Meanwhile both our VI and TI have descended steeply into buying territory with the former approaching two standard deviations below fair value (Chart 19). Chart 19S&P Energy (Overweight) S&P Energy (Overweight) S&P Energy (Overweight) As with the CMI, the relative share price ratio for the S&P energy index has moved laterally since our mid-summer 2017 upgrade to overweight. Interestingly, the integrated oil & gas energy subindex neither kept up with the steep oil price advance until the end of September, nor with the recent drubbing in crude oil prices (top panel, Chart 20). Put differently, oil majors never discounted sustainably higher oil prices, and are also refraining from extrapolating recent oil prices weakness far into the future. Chart 2020. The Stage Is Set For A Recovery In Crude Prices 20. The Stage Is Set For A Recovery In Crude Prices 20. The Stage Is Set For A Recovery In Crude Prices Nevertheless, the roughly 30% per annum growth in U.S. crude oil production is unsustainable and, were production to remain near all-time highs and move sideways in 2019, then the growth rate would fall back to the zero line. Such a paring back in the growth rate would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, bottom panel, Chart 20). This echoes BCA’s Commodity & Energy Strategy service, which continues to forecast higher oil prices into 2019, a forecast which should set the stage for a sustainable rebound next year in S&P energy profits, the opposite of what analysts currently expect (Chart 7). S&P Consumer Staples (Overweight) An improving macro environment is reflected in our consumer staples CMI that has vaulted higher in recent months. However, the strong recent relative outperformance has also shown up in our VI which, though still in undervalued territory, has recovered significantly. Our TI has fully recovered and now sends a neutral message (Chart 21). Chart 21S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) S&P Consumer Staples (Overweight) The surging S&P household products sector has been carrying the S&P consumer staples index on its back as solid pricing efforts have been dragging results and forward guidance higher. While household product sales have been enjoying a multi-year growth phase (second panel, Chart 22), it has largely been driven by volumes. However, the recent resurgence in pricing power (third panel, Chart 22) has given volume gains an added kick, pushing sales further. Meanwhile, exports have continued their two-year ascent despite the tough currency environment and the upshot is that relative EPS growth will likely remain upbeat (bottom panel, Chart 22). In light of challenged EM consumer spending growth, this signal is very encouraging. Chart 22Household Products Is Carrying Staples Household Products Is Carrying Staples Household Products Is Carrying Staples S&P Health Care (Neutral) Our health care CMI has been treading water recently. Further, a recovery in pharma stocks has taken our VI from undervalued to a neutral position, while our TI sends a distinctly bearish message as health care stocks have been overbought (Chart 23). Chart 23S&P Health Care (Neutral) S&P Health Care (Neutral) S&P Health Care (Neutral) Healthcare stocks have outperformed in the back half of 2018. Recently a merger mania that has swept through the pharma and biotech spaces has underpinned relative share prices. The last three months have seen an explosion of deals, including the largest biopharma deal ever (Bristol-Myers Squibb buying Celgene for approximately $90 billion) with other global deals falling not too far behind (Takeda buying Shire for $62 billion mid-last year). Such exuberance has clearly confirmed that merger premia are alive and well in the S&P pharma index. It is not merely rising premia that have taken pharma higher either. Pricing power has entered the early innings of a recovery (top panel, Chart 24) while the key export channel points to increasingly bright days ahead (second panel, Chart 24). However, the rise of regulatory pressure from the Trump administration may cause better pricing to prove fleeting. Chart 24Merger Mania In Pharma Merger Mania In Pharma Merger Mania In Pharma Further, pharma’s consolidation phase has come at a cost to sector leverage ratios that have dramatically expanded (bottom panel, Chart 24). Such profligacy may come to haunt the sector should the pricing power recovery falter. S&P Technology (Neutral) Our technology CMI has been moving laterally for the better part of the last three years, though the S&P technology index has ignored the macro headwinds and soared higher over that time. Our VI remains on the overvalued side of neutral, despite the recent tech selloff while our TI has been retrenching into oversold territory (Chart 25). Chart 25S&P Technology (Neutral) S&P Technology (Neutral) S&P Technology (Neutral) Until the end of last year, we maintained a barbell portfolio within the sector by recommending an overweight position in the late-cyclical and capex-driven technology hardware, storage & peripherals and software indexes while recommending an underweight position in the early-cyclical semi and semi equipment indexes. However, we recently upgraded the niche semi equipment to overweight for three reasons. First, trade policy uncertainty has dealt a blow to this tech subindex. Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Second, emerging market financial indicators are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (second panel, Chart 26). Third, long term semi equipment EPS growth estimates have recently collapsed to a level far below the broad market, indicating that the sell side has thrown in the towel on this niche sector (third panel, Chart 26). Chart 26A Bottom In Semi Equipment A Bottom In Semi Equipment A Bottom In Semi Equipment Overall, and despite our more bullish view on semi equipment, we continue to recommend a neutral weighting in S&P technology. S&P Utilities (Underweight) Our utilities CMI has recovered recently, bouncing off its 25-year low, driven by the modest easing in interest rates, (Chart 27). This has also manifested in a recovery in the S&P utilities index as this fixed income proxy has reacted to the recent fall in Treasury yields (change in yields shown inverted, top panel, Chart 28) and jump in natural gas prices. Further, utilities are typically seen as a domestic defensive play and the recent trade troubles have made utilities soar in a flight to safety. Chart 27S&P Utilities (Underweight) S&P Utilities (Underweight) S&P Utilities (Underweight) We think the tailwinds lifting utilities are transitory and likely to shift to headwinds. First, one of our key themes for the back half of the year is rising interest rates; a move higher in yields will have a predictably negative impact on these high-dividend paying equities. Second, a flight to safety looks fleeting; the ISM manufacturing new orders index usually moves inversely in lock step with utilities and the most recent message is negative for the S&P utilities index (ISM manufacturing new orders index shown inverted, second panel, Chart 28). Meanwhile, S&P utilities earnings estimates have continued to trail the broad market, having taken a significant step down this year (third panel, Chart 28). Chart 28Rising Rates In Late-2019 Will Be A Headwind For Utilities Rising Rates In Late-2019 Will Be A Headwind For Utilities Rising Rates In Late-2019 Will Be A Headwind For Utilities Our VI and TI share this bearish message as the VI is deeply overvalued and the TI is in overbought territory (Chart 27). S&P Real Estate (Underweight) Our real estate CMI has recently started to turn up, though this is off the near decade-low set last year and remains deeply depressed relative to history (Chart 29). This is principally the result of the backup in interest rates since late last year and the lift they have given to the sector, which has been a relative outperformer over the past six months (top panel, Chart 30). Much like the S&P utilities sector in the previous section, and in the context of BCA’s higher interest rate view, we continue to avoid this sector. Chart 29S&P Real Estate (Underweight) S&P Real Estate (Underweight) S&P Real Estate (Underweight) Along with the modest reprieve in borrowing rates, multi family construction continues unabated (second panel, Chart 30), likely driven by all-time highs in CRE prices (third panel, Chart 30). In the absence of an outright contraction in construction, recent weakening in occupancy (bottom panel, Chart 30) will likely prove deflationary to rents, and thus profit prospects. Chart 30Falling Occupancy Will Hurt REIT Profits Falling Occupancy Will Hurt REIT Profits Falling Occupancy Will Hurt REIT Profits Our VI suggests that REITs are modestly overvalued, though the recent outperformance has driven our TI to an overbought condition (Chart 29). S&P Consumer Discretionary (Underweight) Our consumer discretionary CMI has ticked up recently, pushed higher by resiliency in consumer data. However, the S&P consumer discretionary index has clearly responded, pushing against 40-year highs relative to the S&P 500 and taking our VI to two standard deviations above fair value (Chart 31). Much of this should be attributed to Amazon (roughly 30% of the S&P consumer discretionary index) and their exceptional 12% outperformance relative to the broad market over the past year. Chart 31S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) S&P Consumer Discretionary (Underweight) While we have an underweight recommendation on the S&P consumer discretionary index, we have varying intra-segment preferences, highlighted by the recent inception of a pair trade going long homebuilders and short home improvement retailers (HIR). Housing starts and building permits are extremely sensitive to interest rates, depend on first time home buyers and move in lockstep with the homeownership rate. Currently, interest rates are easing, the homeownership rate is coming out of its GFC funk and first time home buyers are slated to make a comeback this spring selling season. This is a boon for homebuilders at the expense of HIR (top & middle panels, Chart 32). Further, the price of lumber is a key determinant of relative profitability: lumber represents an input cost to homebuilders whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it. The recent drubbing in lumber prices should ease margin pressures on homebuilders but eat into HIR profits (momentum in lumber prices shown inverted and advanced in bottom panel, Chart 32). Chart 32Long Homebuilders / Short Home Improvement Retailers Long Homebuilders / Short Home Improvement Retailers Long Homebuilders / Short Home Improvement Retailers S&P Communication Services (Underweight) As the newly-minted communication services has little more than four months of existence, we do not have adequate history to create a cyclical macro indicator. However, we have created Chart 33 with a number of valuation indicators, though we caution that they too are less reliable than the other indicators presented in the preceding pages, owing to a dearth of history. Chart 33S&P Communication Services (Underweight) S&P Communication Services (Underweight) S&P Communication Services (Underweight) Rather, we refer readers to our still-fresh initiation of coverage on the sector3 and look forward to being able to deliver something more substantive in the future. Size Indicator (Favor Large Vs. Small Caps) Our size CMI has been hovering near the boom/bust line, as it has for most of the last two years (Chart 34). Despite the neutral CMI reading, we downgraded small caps in the middle of last year,4 and moved to a large cap preference, based on the diverging (and unsustainable) debt levels of small caps vs. their large cap peers (bottom panel, Chart 35). This size bias remains a high conviction call for 2019. Chart 34Favor Large Vs. Small Caps Favor Large Vs. Small Caps Favor Large Vs. Small Caps Macro data too has turned against small caps. Recent NFIB surveys have shown that small business optimism has continued to fall through the end of the year, albeit from a very high level (top panel, Chart 35). This has coincided with the continued slide of small cap stocks relative to their large cap peers. Chart 35Small Caps Have A Big Balance Sheet Problem Small Caps Have A Big Balance Sheet Problem Small Caps Have A Big Balance Sheet Problem Further, the percentage of small businesses with planned labor compensation increases continues to set new all-time highs and deviates substantially from the national trend (second panel, Chart 35). This divergence becomes more worrying when plotted against those same firms increasing prices (third panel, Chart 35), which has trailed for some time and recently flattened. The inference is that margin pressure is intensifying and likely to continue for the foreseeable future. In the context of the absence of small cap balance sheet discipline during the past five years, ongoing large cap outperformance seems ever more likely. Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “ Catharsis,” dated January 14, 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. 3      Please see BCA U.S. Equity Strategy Daily Insight, “New Lines Of Communication,” dated October 1, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Daily Insight, “Small Caps Have A Big Balance Sheet Problem,” dated May 10, 2018, available at uses.bcaresearch.com.

Highlights We always strive to develop new analytical methods to complement our focus on judging currencies based on global liquidity conditions and the business cycle. This week, we introduce a ranking method based strictly on domestic factors: We call it the Aggregate Domestic Attractiveness Ranking. Using this method alone, the USD, the NZD, the AUD, and the NOK are the most attractive currencies over the coming three months, while the JPY, the GBP, the EUR and the CHF are the least attractive ones. If we further filter the results using a valuation gauge, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY and the GBP are the least attractive ones. Ultimately, the message is clear: if the dollar corrects, domestic factors suggest it will be shallow. However, buying pro-cyclical commodity currencies at the expense of countercyclical ones makes sense no matter what. Feature This publication places significant emphasis on understanding where we stand in the global liquidity and business cycle in order to make forecasts for G-10 currencies. However, we also like to refer to other methods to add supplementary dimensions to our judgment calls. In this optic, we have focused on factor-based analyses such as understanding momentum, carry and valuation considerations. This week, we take another approach: We build a ranking methodology using domestic economic variables only, intentionally excluding global business cycle factors. Essentially, we want to create an additional filter to be used independently of our main method. This way, we can develop a true complement to our philosophy rooted in understanding the global business cycle. With this approach, we rank currencies in terms of domestic growth, slack, inflation, financial conditions, central bank monitors, and real rates. We look at the level of these variables as well as how they have evolved over the past 12 months. After ranking each currency for each criterion, we compute an aggregate attractiveness ranking incorporating all the information. We then compare the attractiveness of each currency to their premiums/discounts to our Intermediate-Term Timing Models. Based on this methodology, the USD, the NOK and the CAD are the most attractive currencies over the coming three months, while the CHF, the JPY, and the GBP are the least attractive ones. Building A Domestic Attractiveness Ranking Domestic Growth Chart I-1 Chart I-2 The first dimension tries to capture the strength and direction of domestic growth. We begin by looking at the annual growth rate of industrial production excluding construction, as well as how this growth rate has evolved over the past 12 months. Here, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. As Chart I-1 illustrates, Sweden is performing particularly well on this dimension, while the euro area, Switzerland, the U.K, and Japan are not. The U.S. stands toward the middle of the pack. When aggregating this dimension on both the first and second derivative of industrial production, Sweden ranks first, followed by the U.S. and Norway (Chart I-2). The U.K. and the euro area rank at the bottom. Chart I-3 Chart I-4 When trying to gauge the impact of domestic growth on each currency’s attractiveness, we also look at the forward-looking OECD leading economic indicator (LEI). As with industrial production, the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This changes the ranking. New Zealand exhibits the highest annual growth rate, followed by the U.S. Meanwhile, when looking at how the annual rate of change has evolved over the past 12 months, Australia shows the least deterioration, and the euro area the most (Chart I-3). Putting these two facets of the LEI together, Australia currently ranks first, followed by the U.S. and New Zealand. Switzerland and the U.K perform the most poorly (Chart I-4). Slack Chart I-5 Chart I-6 Then, we focus on slack, observing the dynamics in the unemployment gap, calculated using the OECD estimates of the non-accelerating inflation rate of unemployment (NAIRU). Here, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. Switzerland enjoys both a very negative and rapidly falling unemployment gap (Chart I-5). The U.K. also exhibits a clear absence of slack, but in response to the woes surrounding Brexit, this tightness is decreasing. Interestingly, the euro area looks good. Despite its high unemployment rate of 7.9%, the unemployment gap is negative, a reflection of its high NAIRU. Combining the amount of slack with the change in slack, Switzerland, New Zealand and the euro area display the best rankings, while the U.S. and Sweden exhibit the worst (Chart I-6). The poor rankings for both the U.S. and Sweden reflect that there is little room for improvement in these countries. Inflation Chart I-7 Chart I-8 When ranking currencies on the inflation dimension, we look at core inflation and wages. We assume that rising inflationary pressures are a plus, as they indicate the need for tighter policy. We begin with core inflation itself; the currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Canada and the U.S. both sport higher core inflation than the rest of the sample, as well positive inflationary momentum (Chart I-7). Switzerland displays both a very low level of inflation as well as declining momentum. U.K. inflation displays the least amount of momentum. On the core CPI ranking, the Canadian dollar ranks first, followed by the USD. Unsurprisingly, Japan and Switzerland rank at the bottom of the heap (Chart I-8). Chart I-9 Chart I-10   We also use wages to track inflationary conditions as G-10 central banks have put a lot of emphasis on labor costs. Similar to core inflation, we measure each country’s level of wage growth as well as its wage-growth momentum. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. This time, the U.S. and the U.K. display both the highest annual growth rate of wages as well as the fastest increase in wage inflation (Chart I-9). Meanwhile, Norwegian wage growth is very poor, but improving. The U.S. and the U.K. rank first on this dimension, while Switzerland and Canada rank last, the latter is impacted by its very sharp deceleration in wage growth (Chart I-10). Financial Conditions Chart I-11 Chart I-12 The Financial Conditions Index (FCI) has ample explanatory power when it comes to forecasting a country’s future growth and inflation prospects. This property has made the FCI a key variable tracked by G-10 central banks. Here we plot the level of the FCI relative to the annual change in FCI. A low and easing FCI boosts a nation’s growth prospects, while a high and tightening FCI hurts the outlook. Consequently, the currencies of countries at the top right of the chart are least attractive, while those at the bottom left are most attractive. While Switzerland has the highest level of FCI – courtesy of an overvalued exchange rate – the U.S. has experienced the greatest tightening in financial conditions (Chart I-11). Combining the level and change in FCI, we find that New Zealand currently possess the most pro-growth conditions, followed by both Sweden and Norway. On the other end of the spectrum, Japan and the U.S. suffer from the most deleterious financial backdrop (Chart I-12). Central Bank Monitors Chart I-13   Chart I-14 We often use the Central Bank Monitors devised by our Global Fixed Income Strategy sister publication as a gauge to evaluate the most probable next moves by central banks. It therefore makes great sense to use this tool in the current exercise. The only problem is that we currently do not have a Central Bank Monitor for Switzerland, Sweden and Norway. Nonetheless, using this variable to create a dimension, we compare where each available Central Bank Monitor stands with its evolution over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. Currently, Canada and the U.S. show a clear need for tighter policy, without a pronounced fall in their respective Central Bank Monitors (Chart I-13). However, while the U.K. could stand higher rates right now, the British Central Bank Monitor is quickly falling, suggesting the window of opportunity for the Bank of England is dissipating fast. The euro area and Australia do not seem to justify higher rates right now. On this metric, Canada and the U.S. stand at one and two, while Australia and the euro area offer the least attractive conditions for their currencies (Chart I-14). Real Interest Rates Chart I-15 Chart I-16   The Uncovered Interest Rate Parity (UIP) hypothesis has been one the workhorses of modern finance in terms of forecasting exchange rates. To conduct this type of exercise, our previous work has often relied on a combination of short- and long-term real rates, a formulation with a good empirical track record.1 Accordingly, in the current exercise, we use this same combination of short- and long-term real rates to evaluate the attractiveness of G-10 currencies. This dimension is created by comparing the level of real rates to the change in real rates over the past 12 months. The currencies of countries at the top right of the chart are most attractive, while those at the bottom left are least attractive. The U.S. dollar is buoyed by elevated and rising real rates, while the pound is hampered by low and falling real rates (Chart I-15). This results in the dollar ranking first on this dimension, and the pound ranking last (Chart I-16). Interestingly, the yen ranks second because depressed inflation expectations result in higher-than-average and rising real rates. Aggregate Domestic Attractiveness Ranking and Investment Conclusions Chart I-17 Chart I-18   Once we have ranked each currency on each dimension, we can compute the Aggregate Domestic Attractiveness Ranking as a simple average of the ranking of the eight different dimensions. Based on this method, domestic fundamentals suggest that the USD, the NZD, the NOK and the AUD are the most attractive currencies over the next three months or so, while the JPY, the GBP, the EUR and the CHF are the least attractive ones (Chart I-17). Interestingly, this confirms our current tactical recommendation espoused over recent weeks to favor pro-cyclical currencies at the expense of defensive currencies. However, it goes against our view that the U.S. dollar is likely to correct further over the same time frame. This difference reflects the fact that unlike our regular analysis, the Aggregate Domestic Attractiveness Ranking does not take into account the global business cycle, momentum and sentiment. We can refine this approach further and incorporate valuation considerations. We often rely on our Intermediate-Term Timing Model to gauge if a currency is cheap or not. Chart I-18 compares the Aggregate Domestic Attractiveness Ranking of G-10 currencies to their deviation from their ITTM. Countries at the bottom left offer the most attractive currencies, while those at the upper right are the least attractive currencies. This chart further emphasizes the attractiveness of the dollar: not only do domestic factors support the greenback, so do its short-term valuations. The CAD, the NOK and the SEK also shine using this method, while the less pro-cyclical EUR, CHF and JPY suffer. The pound too seems to posses some short-term downside. Ultimately, this tells us that if the global environment is indeed unfavorable to the U.S. dollar right now, we cannot ignore the strength of U.S. domestic factors. Consequently, we refrain from aggressively selling the USD during the tactical anticipated correction. Instead, if the global environment favors the pro-cyclical commodity currencies on a three-month basis, it is optimal to buy them on their crosses, especially against the CHF and JPY. Meanwhile, the pound has very little going for it, and selling it against the SEK or the NOK could still deliver ample gains.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1  Please see Foreign Exchange Strategy Special Report, "In Search Of A Timing Model" dated July 22, 2016, available at fes.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. has been mixed: January U.S. consumer confidence index surprised to the downside, coming in at 120.2.  U.S. unemployment rate in January increased to 4.0%, from a previous 3.9% reading; however, this data point was likely distorted by the government shutdown Non-farm payrolls in January surprised to the upside, coming in at 304k. The DXY index rebounded by 0.9% this week. Tactically, we remain bearish on the dollar, as we believe that the current easing in financial conditions will help global growth temporarily surprise dismal investor expectations. Nevertheless, we remain cyclical dollar bulls, as the Fed will ultimately hike more than what is currently priced this year, and as China’s current reflation campaign is about mitigating the downside to growth, not generating a new upswing in indebtedness and capex. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 The recent data in euro area has been negative: The Q4 euro area GDP on a year-over-year basis fell to 1.2%, in line with expectations. Euro area headline inflation in January on a year-over-year basis decreased to 1.4%, from the previous 1.6% in December 2018, core inflation rose to 1.1%. January Markit euro area composite PMI fell to 51.0. Euro area retail sales in December fell to 0.8% on a year-over-year basis, from the previous 1.8%. In response to this poor economic performance, EUR/USD has fallen by 0.8% this week. We remain cyclically bearish on the euro, as we believe that the Fed will hike more than anticipated this cycle and that Europe is more negatively impacted by China’s woes than the U.S. is. Hence, slowing global growth will force the ECB to stay dovish much longer than expected. Moreover, our Intermediate Term Timing Model, is showing that the euro is once again trading at a premium to short term fundamentals. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 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 has been mixed: Annual inflation increased to 0.4% from previous 0.3%, core inflation increased to 0.7% from 0.6%, and inflation ex fresh food increased to 1.1% from 0.9%. December retail trade weakened to 1.3% from the previous 1.4%. Japanese unemployment rate in December has fallen to 2.4%. January consumer confidence index fell to 41.9, underperforming the expectations. USD/JPY has risen by 0.3% this week. We remain bearish on the yen on a tactical basis. The recent FOMC meeting kept the U.S. key interest rate unchanged, so did many other central banks. The resulting ease in global financial conditions could be a headwind for safe havens, like the yen. Moreover, U.S. yields are likely to rise even after the easing in financial conditions is passed, as BCA anticipates the Fed to resume hiking in the second half of 2019. This will create additional downside for the yen. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 The recent data in Britain has been negative: Markit U.K. composite PMI has surprised to the downside, falling to 50.3 in January; service PMI dropped to 50.1 while construction PMI fell to 50.6.  Halifax house prices yearly growth, surprised to the downside, coming in at 0.8%. Finally, Markit Services PMI also underperform, coming in at 50.1. The Bank of England rate decided to keep rates on hold at 0.75%. GBP/USD has lost 0.8% this week. On a long-term basis, we remain bullish on cable, as valuation for the pound are attractive. However, we believe that the current stalemate in Westminster, coupled with the hard-nose approach of Brussels has slightly increase the probability of a No-deal Brexit. This political uncertainty implies that short-term risk-adjusted returns remains low. Report Links: Deadlock In Westminster - January 18, 019 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 has been negative: Building permits in December has surprised to the downside, coming in at -8.4% on a month-over-month basis.  December retail sales has slowed down, coming in at -0.4%. Finally, in December, with exports contracted at a -2% pace, and imports, at -6% pace. The RBA decided to leave the cash rate unchanged at 1.5%. While it was at first stable, AUD/USD ultimately has fallen by 2% this week. Overall, we remain bearish on the AUD in the long run. The unhealthy Australian housing market coupled with very elevated debt loads, could drag residential construction and household consumption down. Moreover, the uncompetitive Australian economy could fall into a potential liquidity trap as the credit conditions tighten further. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 The recent data in New Zealand has been negative: The participation rate underperformed expectations, coming in at 70.9%. Moreover, employment growth also surprised to the downside, coming in at 0.1%. Finally, the unemployment rate surprised negatively, coming in at 4.3%. NZD/USD has fallen by 2.3% this week. Overall, we remain bullish on the NZD against the AUD, given that credit excesses are less acute in New Zealand than in Australia. Moreover, New Zealand is much less exposed to the Chinese industrial cycle than Australia. This means that is China moving away from its current investment-led growth model will likely negatively impact AUD/NZD. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 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 The recent data in Canada has been negative: GDP has fallen to 1.7% on a year-over-year basis from the previous 2.2%. The December industrial production growth came in at -0.7% month-on-month, a negative surprise. Canadian manufacturing PMI in January decreased to 53. On the back of these poor data and weaker oil prices, USD/CAD rose by 1.6% this week, more than undoing last week’s fall. We expect the CAD to outperform other commodity currencies like the AUD and the NZD, oil prices are likely to outperform base metals on a cyclical basis. Moreover, the Canadian economy is more levered to the U.S. than other commodity driven economies. Thus, our constructive view on the U.S. implies a positive view on the CAD on a relative basis. Report Links: CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 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 has been mixed: Real retail sales yearly growth improved this month, coming in at -0.3% versus -0.6% last month. However, the SVME Purchasing Manager’s Index underperformed expectations, coming in at 54.3. EUR/CHF has fell 0.2% this week. Despite this setback, we remain bullish on EUR/CHF. Last year’s EUR/CHF weakness tightened Swiss financial conditions significantly and lowered inflationary pressures. Given that the Swiss National Bank does not want a repeat of the deflationary spiral of 2015, we believe that it will continue with its ultra-dovish monetary policy and increase its interventionism in the FX market, in order to weaken the franc, and bring back inflation to Switzerland. Moreover, on a tactical basis, the ease in financial conditions should hurt safe havens like the franc. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 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 has been negative: The December retail sales missed the consensus estimates, coming in at -1.80%. December credit indicator decreased to 5.4%. Registered unemployment rate in January has increased to 2.6%, surprising to the downside. USD/NOK has risen by 1.8% this week. We are positive on USD/NOK on a cyclical timeframe. Although we are bullish on oil prices, USD/NOK is more responsive to real rate differentials. This means, that a hikes later this year by the Fed will widen differentials between these two countries and provide a tailwind for this cross. Nevertheless, the positive performance of oil prices should help the NOK outperform non-commodity currencies like the AUD. We also expect NOK/SEK to appreciate and EUR/NOK to depreciate. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 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 has been negative: Consumer confidence surprised to the downside, coming in at 92. Moreover, retail sales yearly growth also underperformed expectations, coming in at 5.6%. Finally, manufacturing PMI came in line with expectations at 51.5. USD/SEK has risen by 2.2% this week. Overall, we remain long term bullish on the krona against the euro, given that Swedish monetary policy is much too easy for the current inflationary environment, a situation that will have to be rectified. However, given our positive view on the U.S. dollar on a cyclical basis, we are cyclically bullish on USD/SEK, since krona is the G-10 currency most sensitive to dollar moves. Report Links: Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Chart 1Look For Rate Hikes In H2 2019 Look For Rate Hikes In H2 2019 Look For Rate Hikes In H2 2019 First things first: The Fed’s rate hike cycle is not over. Last week’s FOMC statement told us that the Fed will be “patient” and Chairman Powell cited slower global growth and tighter financial conditions as reasons to keep the funds rate steady. However, both of those reasons could soon evaporate. With the market now priced for 8 bps of rate cuts during the next 12 months and the dollar off its highs, there is scope for financial conditions to ease and global growth to improve in the first half of the year. According to our Fed Monitor, only tight financial conditions warrant a pause in rate hikes (Chart 1). The economic growth and inflation components of our Monitor (not shown) continue to recommend a tighter policy stance. The message is that if risk assets rally during the next six months causing financial conditions to ease, then all else equal, the Fed will have the green light to re-start rate hikes in the second half of the year. Investors should maintain below-benchmark duration in U.S. bond portfolios. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 183 basis points in January. The index option-adjusted spread tightened 25 bps on the month and currently sits at 127 bps. We upgraded our recommended allocation to corporate bonds three weeks ago because spreads had become too wide given the current phase of the credit cycle.1 Presently, we observe that the 12-month breakeven spread for Baa-rated corporate bonds has been tighter 43% of the time since 1989 (Chart 2). In the phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps, corporate breakeven spreads are typically in the lower third of their distributions.2 Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Baa-rated bonds currently offer better value than higher-rated credits. The 12-month breakeven spread for A-rated debt has been tighter 29% of the time since 1989 (panel 2). Aa and Aaa-rated credits clock in at 25% and 4%, respectively. With the Fed in a holding pattern, we are comfortable taking credit risk for the next six months and recommend that investors move down in quality to capture the extra return. The Fed’s Q4 Senior Loan Officer Survey, released yesterday, showed that a net 3% of banks reported tightening lending standards on C&I loans. Tighter lending standards correlate with higher defaults and wider spreads, so this tentative development bears close monitoring going forward. Chart   Chart High-Yield: Overweight High-yield outperformed the duration-equivalent Treasury index by 408 basis points in January. The index option-adjusted spread tightened 103 bps, and currently sits at 416 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 224 bps, slightly below the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 224 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 Moody’s revised its baseline 12-month default rate forecast higher last month, from 2.6% to 3.4%, and as was discussed in last week’s report, the revised forecast looks reasonable given our economic outlook.3 Specifically, our measure of nonfinancial corporate sector gross leverage – calculated as total debt over pre-tax profits – is roughly consistent with a 4% default rate. This leverage measure improved rapidly during the past year, but should start to stabilize during the next few quarters as profit growth decelerates. All in all, baseline default rate expectations have moved higher in recent months, but junk spreads still offer adequate compensation for that risk. In fact, if we assume excess compensation equal to the historical average, then junk spreads embed an expected default rate of 3% (panel 4), not far from the Moody’s base case. While junk spreads offer adequate compensation given our 12-month default outlook, the near-term outlook for excess returns is somewhat brighter as the Fed’s dovish turn should lead to spread compression during the next few months. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The conventional 30-year zero-volatility spread tightened 3 bps on the month, driven by a 3 bps decline in the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The drop in the 30-year mortgage rate to 4.46%, from 4.94% in November, led to a sharp spike in mortgage refinancings. However, refi activity remains very low relative to history (Chart 4). With the longer-run uptrend in mortgage rates still intact, the recent spike in refinancings is bound to reverse in the coming months. This will keep MBS spreads capped near historically low levels. Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Outside of refi activity, MBS spreads are also influenced by changes in mortgage lending standards. The Federal Reserve’s Senior Loan Officer Survey showed no change in residential mortgage lending standards in Q4 2018 (bottom panel), while reported mortgage demand took a significant dip. Periods of tightening lending standards tend to coincide with MBS spread widening, but faced with weaker demand banks are much more likely to ease standards going forward. This is particularly true because very little progress has been made easing lending standards since the financial crisis. The median FICO score for new mortgages peaked at 781 in Q1 2011, but had only fallen to 758 as of Q3 2018. With relatively little risk of spread widening we are comfortable with a neutral allocation to Agency MBS, though tight spreads make the sector less appealing than corporate bonds from a return perspective. Later in the cycle, when the risk of corporate spread widening is more pronounced, MBS will likely warrant an upgrade. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 53 basis points in January. Sovereign debt led the way, outperforming the Treasury benchmark by 221 bps. Foreign Agencies outperformed by 65 bps, Local Authorities outperformed by 32 bps, and Supranationals outperformed by 3 bps. Domestic Agency bonds were the sole laggard, underperforming Treasuries by 3 bps on the month. The Fed’s pause and the accompanying weakness in the dollar spurred last month’s outperformance of USD-denominated Sovereign debt. But given the current attractiveness of U.S. corporate credit, we are not eager to chase the outperformance in Sovereigns. The option-adjusted spread advantage in Baa-rated U.S. corporate credit relative to the Sovereign index is as wide as it was in mid-2016 (Chart 5), a period when corporate bonds outperformed Sovereigns by a significant margin. Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview At the country level, our analysis of USD-denominated Emerging Market Sovereign spreads shows that only Argentina, Mexico, Saudi Arabia, Qatar, UAE and Poland offer excess spread compared to equivalently-rated U.S. corporates.4 We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 7 basis points in January (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 2% in January, and currently sits at 84% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% 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 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 -14 bps. In contrast, municipal bonds have delivered annualized excess returns of +47 bps (before adjusting for the tax advantage).5  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. Long maturity municipal debt continues to offer a substantial yield advantage relative to the short-end of the curve. For example, a muni investor needs an effective tax rate of 35% to equalize the after-tax yields between a 5-year Aa-rated municipal bond and the equivalent-duration U.S. credit index. For a 20-year muni the same breakeven tax rate is between 10% and 17%. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields declined in January, with the 5-year and 7-year maturities falling more than the short and long ends of the curve. The 2/10 slope flattened 3 bps on the month, from 21 bps to 18 bps. The 5/30 slope steepened 5 bps on the month, from 51 bps to 56 bps. In a recent report we looked at the correlations between different yield curve slopes and our 12-month Fed Funds Discounter.6 We found that the 5-year and 7-year maturities are most sensitive to changes in the discounter, while the short and long ends of the curve tend to be more stable. In other words, a decline in our 12-month discounter, like the one seen during the past two months (Chart 7), will tend to flatten the curve out to the 5-year/7-year maturity point and steepen the curve beyond that point. An increase in the discounter has the opposite effect. Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview We expect the market to price some Fed rate hikes back into the curve as financial conditions ease during the next few months. Based on that view, we recommend adopting a yield curve strategy that benefits from a rise in our 12-month discounter. A position short the 7-year bullet and long a duration-matched 2/30 barbell provides the appropriate exposure and is attractively valued by our yield curve models (panel 4).7 TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 84 basis points in January. The 10-year TIPS breakeven inflation rate rose 14 bps on the month, and currently sits at 1.88%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps, and currently sits at 2.04%. 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. The 10-year TIPS breakeven inflation rate also remains below the fair value reading from our Adaptive Expectations Model (Chart 8).8 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value reading will trend steadily higher as long as core CPI inflation remains above 1.83%. The 1.83% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in our model.   Chart 8Inflation Compensation Inflation Compensation Inflation Compensation On that note, core CPI has increased at an annual rate of 2.48% during the past 3 months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 4), 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 Asset-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 8 bps on the month, and currently sits at 40 bps, 6 bps above its pre-crisis low. The Excess Return Bond Map in Appendix C shows that consumer ABS offer greater expected return than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The Fed's Senior Loan Officer Survey for Q4 2018 showed that banks tightened lending standards slightly for both credit cards and auto loans. This is consistent with a continued gradual uptrend in consumer credit delinquencies (Chart 9). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Rising household interest expense further confirms that the consumer credit delinquency rate is biased higher, albeit from a low starting point (panel 4). All in all, ABS still offer a reasonable risk/reward trade-off but could warrant a downgrade in the coming quarters as credit quality worsens. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 67 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 11 bps on the month and currently sits at 105 bps. 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 (Chart 10). This is a typical negative environment for CMBS spreads. Decelerating CRE prices are also a cause for concern (panel 3). Investors should maintain an underweight allocation to non-Agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The index option-adjusted spread tightened 4 bps on the month and currently sits at 57 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. Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for 8 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. 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 yield curve. The models are explained in detail in the following two Special Reports: 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 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of January 31, 2019) On Pause But Not Forgotten On Pause But Not Forgotten   Table 5Butterfly Strategy Valuation: Standardized Residuals (As of January 31, 2019) On Pause But Not Forgotten On Pause But Not Forgotten   Table 6Discounted Slope Change During Next 6 Months (BPs) On Pause But Not Forgotten On Pause But Not Forgotten 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, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 2 For further details on how we divide the credit cycle based on the slope of the yield curve 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, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearh 6 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 7 The output from all of our yield curve models is shown in Appendix B of this report. 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Portfolio Strategy Chinese reflation, the ongoing global capex upcycle, and the Fed induced cap on the greenback with the knock-on effect of higher commodity prices, all signal that it still pays to overweight S&P cyclicals at the expense of S&P defensives.  Sustained EM stock outperformance, a soft U.S. dollar, improving semi equipment operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside.   Recent Changes There are no changes in the portfolio this week. Feature The SPX consolidated the 350 point advance since the Christmas Eve trough last week, setting the stage for a durable advance in the coming months. The Fed stood pat last Wednesday, and signaled a much more dovish policy stance going forward. Chairman Powell was clearly humbled by last December’s convulsing equity market and abrupt tightening in financial conditions. On that front, in the latest FOMC statement the explicit mention of patience is significant: “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. A definitively more dovish Fed, which will help restrain the greenback, remains one of the three key catalysts for a durable equity market advance as we have highlighted in recent research.1 Encouragingly, our proprietary Equity Capitulation Indicator (ECI) has bottomed at two standard deviations below the historical mean (Chart 1). Over the past two decades, such a depressed level in our ECI has marked previous equity market troughs including the early-2016, 2011, 2002 and 1998 iterations. Only the GFC episode was lower, falling to three standard deviations below the mean. Clearly the late-December selling frenzy registers as another investor capitulation point and, if history at least rhymes, more gains are in store for the broad equity market. Chart 1Capitulation Capitulation Capitulation Chart 2 shows some other measures of breadth that corroborate our ECI’s message: investors hit the panic button and exited equities in droves in Q4. The upshot is that with selling exhausted, stocks can now stage a durable recovery as long as profits continue to expand. As a reminder, the continuation of the earnings juggernaut is the second key catalyst we identified two weeks ago.2 Midway through earnings season, SPX EPS have held up well with growth approaching 16%. For calendar 2019 we expect mid-single digit EPS growth in line with the signal from our macro driven S&P 500 EPS growth model (please refer to Chart 4 from the mid-January Weekly Publication).3 Chart 2Selling Is Exhausted Selling Is Exhausted Selling Is Exhausted A positive resolution to the U.S./China trade spat is the third catalyst we highlighted recently in order for equities to break out to fresh all-time highs.4 Related to this, China’s reflation efforts are equally important. On that front, news of quasi QE from the PBOC suggests that the Chinese authorities remain committed to injecting liquidity into their economy.5 Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (second panel, Chart 3). Chart 3Heed The PBoC Message Heed The PBoC Message Heed The PBoC Message Beyond the PBOC balance sheet expansion, the Chinese six-month credit impulse is also in a sling shot recovery. This Chinese credit backdrop is enticing and moves more or less in tandem with the SPX six-month impulse (top panel, Chart 4). Chart 4Reflating Away Reflating Away Reflating Away Two forces explain these relationships. First, China’s rise to become the second largest economy in the world along with its insatiable appetite for commodities and durable goods. Second, 40% of S&P 500 sales are international and an increasing share now originates in emerging markets in general and in China in particular. Keep in mind that the S&P cyclicals/defensives ratio is not only a high beta play on the SPX itself (top panel, Chart 3), but also an S&P global versus domestic gauge. Thus, both of these Chinese indicators also enjoy a positive correlation with the cyclicals vs. defensives tilt (bottom panels, Charts 3 & 4). With that in mind, this week we are drilling deeper into why we continue to prefer S&P cyclicals over S&P defensives and also highlight a highly cyclical index we went overweight in mid-December that has gone parabolic. Double Down On Cyclicals Vs. Defensives Early-October 2017 marks the initiation of our cyclical vs. defensive preference. Initially, this tilt jumped and peaked in mid-2018 returning 18% since inception. Since then, it has given up all of those gains and then some before troughing with the market on Christmas Eve, suffering a 6% drop since inception. Currently, the ratio has moved full circle and is back to where it was when we first recommended this portfolio bent (Chart 5). Chart 5Full Circle Full Circle Full Circle Should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop? The short answer is yes. Charts 3 & 4 show that China’s reflation efforts and the fate of the S&P cyclicals/defensives ratio are closely correlated. In addition to the PBOC’s expanding balance sheet and rising Chinese credit impulse, Chinese monetary easing also benefits S&P cyclicals at the expense of S&P defensives. The Chinese reserve requirement ratio (RRR) has plummeted to the lowest point since the GFC and Chinese interest rates are also plumbing multi-year lows (RRR shown inverted, top panel, Chart 6). Chart 6China Flashing Green China Flashing Green China Flashing Green Tack on a resurgent currency with the CNY briefly breaking 6.70 with the U.S. dollar, and factors are falling into place for a playable rally in the cyclicals/defensive ratio. Likely, the Chinese are trying to appease President Trump by underpinning the yuan, but the Fed’s recent more dovish stance on interest rate hikes is also pushing the greenback lower. Taken together, this is a boon for the commodity exposed U.S. cyclicals that also garner a significant share of their sales from abroad (bottom panel, Chart 6). Commodity prices troughed last September, staying true to their leading properties and have been in recovery mode ever since (top panel, Chart 7). Now that the Fed has capped the U.S. dollar, more gains are in store for commodities and that is a boon for commodity producers’ top line growth prospects. Chart 7Capex Remains Healthy Capex Remains Healthy Capex Remains Healthy The demand backdrop is also enticing at the current stage of the business cycle, not only domestically, but also in China. Capital outlays remain upbeat and despite some recent turbulence, U.S. capex intentions are near multi-year highs (third panel, Chart 7). In China, recent piece meal fiscal easing announcements are far from negligible; already infrastructure spending has jumped after contracting late last year (second panel, Chart 7). Were these announcements to get supplemented by a bigger and more comprehensive package, then commodity-levered equities will excel further. A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel, Chart 8). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel, Chart 8). Chart 8B/S Improvement Continues B/S Improvement Continues B/S Improvement Continues Sell-side analysts have not yet taken notice of the macro tide that is turning in favor of cyclicals over defensives. Relative forward profit growth has collapsed to nil and net EPS revisions are at previous nadirs (fourth & fifth panels, Chart 9). Chart 9Oversold And Unloved Oversold And Unloved Oversold And Unloved In sum, if our thesis pans out that China will continue to reflate, global capex will remain vibrant, the greenback will drift lower (U.S. dollar shown inverted, top panel, Chart 9) courtesy of a dovish Fed that will push the broad commodity complex higher, then a significant valuation rerating looms for the cyclicals/defensives tilt (second panel, Chart 9). Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives. We also reiterate our recent long S&P materials/short S&P utilities pair trade.6 Semi Equipment: Buy Into Strength In mid-December we boosted the S&P semi equipment index to overweight from underweight and since then this niche chip subindex has outperformed the broad market by 17%.7 Semi equipment stocks are high beta (bottom panel, Chart 10) and, while we are recommending to buy into strength, from a portfolio risk management perspective, today we are also setting a trailing stop at the 10% return mark in order to protect profits in this tactical (three-to-six month time horizon) position. Chart 10Buy Into Strength... Buy Into Strength... Buy Into Strength... These high-octane highly-cyclical tech stocks move in lockstep with other volatile asset classes. Rebounding emerging market (EM) stocks and FX confirm the S&P semi equipment breakout, and signal additional gains in the coming months (Chart 11). Not only do they share the high-beta status, but also semi equipment stocks garner 90% of their sales outside U.S. shores and 21% of total revenues come from China (please refer to Table 3 in our December 17, 2018 Weekly Report). Thus, the tight inverse correlation with the greenback and positive correlation with the outperforming EM stocks comes as no surprise (Chart 11). Chart 11...But Expect Heightened Vol ...But Expect Heightened Vol ...But Expect Heightened Vol Importantly, Taiwan and Korea are chip manufacturing hubs and semi equipment stocks are levered plays on the macro backdrops of these two economies. Recent data suggests that a turn is in the making in two key indicators in these countries, respectively. Taiwanese tech capex has likely troughed at a depressed level (middle panel. Chart 12), and Korean electronic components manufacturing capacity is now contracting for the first time since late-1997 (bottom panel, Chart 12). The latter is significant as this abrupt and sizable reining in of productive capacity will soon help arrest the fall in chip prices, which serves as an excellent pricing power proxy for the semi equipment industry. Chart 12Green Shoots Green Shoots Green Shoots Historically, relative forward profit growth and DRAM price momentum are joined at the hip. Therefore, were DRAM prices to exit deflation on the back of constrained Korean capacity, that would be a boon for relative profit prospects (second panel, Chart 13). Chart 13Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Analysts Have Thrown In The Towel Despite these marginal positive developments, sell-side analysts’ pessimism reigns supreme. Industry revenue and profit growth expectations trail the broad market by a wide margin and net EPS revisions remain as bad as they get. The upshot is that these lowered profit and sales growth bars will be easy to surpass in 2019 (Chart 13). With regard to technicals and valuations, oversold conditions bounced, as we posited in mid-December using history as a guide, but still remain depressed (middle panel, Chart 14). Valuations are compelling with the S&P semi equipment forward P/E trading at a roughly 40% discount to the overall market (fourth panel, Chart 13). Chart 14Technicals Remain Depressed Technicals Remain Depressed Technicals Remain Depressed Finally, earnings season has revealed that the bifurcated semiconductor market has staying power with semi equipment stocks (we are overweight) outperforming their ailing semi producer brethren (we remain underweight). Netting it out, sustained EM stock outperformance, a soft U.S. dollar, improving industry operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside. Bottom Line: Maintain the overweight stance in the S&P semi equipment index for a while longer, but set a trailing stop at the 10% relative return mark in order to protect profits in this tactical (three-to-six month time horizon) position. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX, KLAC.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2      Ibid. 3      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 5      Please see Bloomberg Article, “PBOC Sets Up Swap Tool to Aid Bank Capital via Perpetual Bonds” dated January 24, 2019, available at www.bloomberg.com. 6      Please see BCA U.S. Equity Strategy Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 7      Please see BCA U.S. Equity Strategy Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD... Financial Conditions Point To A Tactical Rebound In The AUD And The CAD... Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation ...So Does Chinese Reflation ...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Chart 3 Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Canadians And Australians Make Americans Look Frugal (1) Canadians And Australians Make Americans Look Frugal (1) Chart 4BCanadians And Australians Make Americans Look Frugal Canadians And Australians Make Americans Look Frugal (2) Canadians And Australians Make Americans Look Frugal (2) Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) A Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Canadian And Australian Banks Remain Profitable... Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise ...As Long As NPLs Do Not Rise ...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far Canada And Australia Have Avoided A Liquidity Trap... So Far Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households Higher U.S. Rates Threaten Canadian And Australian Households Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year. Chart 10   Chart 11Budding U.S. Inflationary Pressures Budding U.S. Inflationary Pressures Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Upside For U.S. Productivity Equals Upside For U.S. Rates Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Canada And Australia Are Uncompetitive Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Changing Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Canadian Financial Assets Are Cheaper Than Australian Ones... Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space ...But Australia Has More Fiscal Space ...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Duration: The U.S. economic data show few signs of restrictive monetary policy, despite the fact that the market is now priced for an end to the Fed’s rate hike cycle. Investors should position for further rate hikes this year. Practically, this means keeping portfolio duration low and avoiding the 5-year/7-year part of the Treasury curve. Corporate Spreads: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield bonds offer adequate compensation for default losses, in line with the historical average. Corporate Defaults: A simple model using gross nonfinancial corporate leverage pegs fair value for the 12-month speculative grade default rate at 4.1%. This fair value estimate should decline slightly in the months ahead, as long as pre-tax profit growth stays above 7%, the approximate rate of debt growth. Feature Fed rate hikes have been completely priced out of the curve. As of last Friday’s close, the overnight index swap market was priced for 2 basis points of rate hikes during the next 12 months and 9 bps of cuts during the next 24 months (Chart 1). The sharp drop in rate hike expectations is an overreaction, and investors should position for a near-term rise in rate expectations. The Fed’s rate hike cycle still has room to run before interest rates peak. Chart 1Market Says "No More Hikes" Market Says "No More Hikes" Market Says "No More Hikes" In this week’s report we survey the recent economic data, searching for any signal that interest rates are high enough to choke off the recovery. We conclude that monetary conditions remain accommodative, and that the Fed’s rate hike cycle will re-start in the second half of this year. Searching For Signs Of Tight Money Policymakers frequently talk about the concept of the neutral (or equilibrium) fed funds rate. In essence, the neutral rate is the interest rate that is consistent with trend economic growth and stable inflation. If the fed funds rate is set above neutral, then we should expect growth to slow and inflation to fall. Conversely, if the fed funds rate is set below neutral, we should expect growth to accelerate and inflation to rise. The slope of the yield curve can help distill this concept for bond investors. An inverted yield curve signals that the market is priced for interest rate cuts in the future. This is what we would expect to see in an environment where the fed funds rate is above neutral and monetary conditions are restrictive. Conversely, a very steep yield curve means that investors expect rate hikes in the future. This is usually consistent with accommodative monetary policy and an interest rate well below neutral. We find the neutral rate to be a useful concept, though like Fed Chairman Powell we think it is unwise to place too much stock in point estimates of its level.1 Such estimates are very difficult to make in real time, and tend to be heavily revised with hindsight.2 For investors, a wiser strategy is to look for signs in the economic data that interest rates are too high, and to use those signs to decide when interest rates have peaked for the cycle. We review a few of those potential signs below. Nominal GDP Growth One simple signal of restrictive monetary policy is when interest rates rise above the year-over-year growth rate in nominal GDP. In the last cycle, Treasury returns versus cash didn’t move materially higher until after year-over-year nominal GDP growth was below both the 10-year Treasury yield and the 3-month T-bill rate (Chart 2). At present, year-over-year nominal GDP growth is running at 5.5%. Though it is very likely to slow during the next few quarters, it still has a long way to go before it falls below 2.76%, the current 10-year Treasury yield. Chart 2GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative GDP Growth Suggests That Monetary Policy Remains Accommodative Verdict: An assessment of nominal GDP growth shows that monetary policy remains accommodative. The Housing Market Given that the mortgage market provides the most direct link between interest rates and real economic activity, it makes sense that signs of tight money might show up first in the housing data. Empirical investigation backs up this claim. As was observed by Edward Leamer in his 2007 paper, of the ten post-WWII U.S. recessions, eight were preceded by a significant slowdown in residential investment.3 Our own reading of the data is consistent with this message. Downtrends in the 12-month moving averages of both single-family housing starts and new home sales preceded inflection points higher in excess Treasury returns in each of the past two cycles (Chart 3). Chart 3No Signal From Housing No Signal From Housing No Signal From Housing While these housing metrics certainly deteriorated during the past nine months, it appears that the worst is now behind us. The recent moderation in mortgage rates has already led to a significant bounce in mortgage purchase applications and a pop in homebuilder confidence (Chart 4). This will translate into increased housing starts and new home sales during the next few months. Chart 4Housing Rebound Underway Housing Rebound Underway Housing Rebound Underway Verdict: The housing data are most likely consistent with still-accommodative monetary policy. However, if single-family housing starts and new home sales do not respond as expected to the recent drop in the mortgage rate, then we will be forced to re-visit this view. The Labor Market Of all the available labor market statistics, initial unemployment claims tend to be the most leading and have historically provided the best signal of tight monetary conditions. In each of the past two cycles a significant increase in jobless claims has coincided with the inflection point higher in Treasury excess returns (Chart 5). While there was some concern toward the end of last year that claims were trending up, this has now been dashed and claims actually fell below 200k last week. Notice in Chart 5 that the 13-week change in claims remains negative. In prior cycles it rose above zero around the same time that Treasury returns started to improve.. Chart 5No Signal From Labor Market No Signal From Labor Market No Signal From Labor Market Verdict: The labor market data remain consistent with accommodative monetary policy. Bottom Line: It seems very likely that U.S. monetary policy remains accommodative. Nominal GDP growth and the labor market both strongly support this claim. The housing data have been weaker, but are already showing signs of rebounding. The implication for bond investors is that the Fed is not done lifting interest rates, even though the market is priced for exactly that outcome. Investors should maintain below-benchmark portfolio duration on the view that rate hikes will re-start in the second half of this year. The 5-year/7-year part of the Treasury curve is especially vulnerable to an increase in rate hike expectations. Investors should avoid this part of the curve, focusing on the very long and short maturities.4 The Weakness Is Global The analysis in the above section begs the question: If the economic data do not suggest that monetary policy is restrictive, then why is the market priced for an end to the Fed’s rate hike cycle? The answer is that everything is not rosy in the economic outlook. Specifically, we have already seen a significant slowdown in non-U.S. economic growth that weighed significantly on financial markets near the end of last year and is starting to impact the most externally-exposed segments of the U.S. economy. Chart 6 shows that a slowdown in the Global ex. U.S. Leading Economic Indicator (LEI) is now dragging the U.S. LEI down with it. Chart 6Global Weakness Infects U.S. Global Weakness Infects U.S. Global Weakness Infects U.S. Not surprisingly, the components of the U.S. LEI that have weakened are those related to financial markets and the corporate sector. Given that corporate profits are determined globally, a slowdown in global growth often shows up first in downward revisions to investors’ corporate profit expectations. This weighs on equity prices and causes business owners to re-assess their future investment plans. Consistent with this narrative, we have seen significant downward moves in ISM New Orders and NFIB Capital Spending Plans, shown averaged together in the top panel of Chart 7. Capital spending plans as reported in regional Fed surveys have also moderated (Chart 7, panel 2), and CEO confidence has plunged (Chart 7, bottom panel). All of these indicators suggest that weaker global growth will weigh on the nonresidential investment component of U.S. GDP during the next few quarters. Chart 7Weaker Nonresidential Investment... Weaker Nonresidential Investment... Weaker Nonresidential Investment... But while corporate investment is poised to weaken, the U.S. consumer is in rude health (Chart 8). Core retail sales are growing strongly, though the most recent data only extend through November. For more timely data we can look at the Johnson Redbook measure of same-store sales which has accelerated into the New Year (Chart 8, top panel). The University of Michigan survey of consumers shows that expectations dipped last month (Chart 8, panel 2), but also that consumers still view current conditions as extremely positive (Chart 8, bottom panel). Chart 8...And Resilient Consumer Spending ...And Resilient Consumer Spending ...And Resilient Consumer Spending The overall picture is reminiscent of 2015/16. The U.S. consumer and labor market are in good shape, but slowing foreign growth and a strong U.S. dollar are weighing on the corporate profit outlook and U.S. corporate investment spending. As in 2016, the solution is for the Fed to temporarily pause its rate hike cycle. This will allow the dollar’s uptrend to moderate and will take some pressure off the corporate profit and investment outlooks. With a Fed pause discounted in the market, the conditions are already in place for renewed optimism on the corporate sector. It is for this reason that we upgraded our recommended allocation to corporate bonds two weeks ago.5 We expect this optimism will cause financial conditions to ease during the next few months, allowing the Fed to resume its rate hike cycle in the second half of this year. Corporate Bond Valuation Update As mentioned above, we increased our recommended exposure to corporate credit (both investment grade and junk) two weeks ago, partly due to valuations that had become too attractive to pass up. The Breakeven Spread One of our preferred valuation techniques is to look at 12-month breakeven spreads for each corporate credit tier as a percentile rank versus history.6 We like this method for three reasons: First, focusing on each individual credit tier controls for the fact that the average credit rating of bond indexes can change over time. Second, using the breakeven spread instead of the average index option-adjusted spread allows us to control for the changing average duration of the bond indexes. Finally, we find that the percentile rank is often a better representation of credit spreads than the spread itself. This is because credit spreads often tighten to very low levels and then remain tight for an extended period of time. By showing us the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. At present, Baa-rated debt and all junk credit tiers have 12-month breakeven spreads at or above their historical medians. Aa and A rated bonds have breakeven spreads that rank near the 40th percentile, and Aaa-rated debt remains expensive with a 12-month breakeven spread below the 10th percentile since 1989. To appreciate how cheap these spreads are, especially for Baa-rated and junk credits, consider that the current 12-month breakeven spread for a Baa-rated corporate bond is 24 bps (Chart 9). In our analysis of the different phases of the economic cycle, we determined that in an environment where the slope of the 3/10 Treasury curve is between 0 bps and 50 bps (it is 18 bps today), the 12-month Baa-rated breakeven spread averages 18 bps.7 Chart 9Attractive Baa Valuation Attractive Baa Valuation Attractive Baa Valuation Given current index duration, if the 12-month Baa-rated breakeven spread returned to the 18 bps level that is typical for this stage of the cycle, it would imply a tightening in the option-adjusted spread from 169 bps to 129 bps – a 40 bps tightening! Default-Adjusted Spread Another valuation measure to consider is our high-yield default-adjusted spread. This is the excess spread available in the high-yield index after subtracting expected default losses. To determine expected default losses we use Moody’s baseline forecast for the 12-month default rate and our own forecast for the 12-month recovery rate. At present, this gives us a default-adjusted spread of 237 bps, right in line with the historical average (Chart 10). In other words, if default losses during the next 12 months match those embedded in our calculation, then investors should expect an excess return that is in line with the historical average, assuming also no capital gains/losses from spread tightening/widening. Chart 10In Line With Historical Average In Line With Historical Average In Line With Historical Average But how likely is it that default losses fall in line with that expectation? In its last Monthly Default Report, Moody’s revised its baseline 12-month default rate forecast up to 3.4%, from 2.6% previously. The new 3.4% forecast seems reasonable to us. A simple model of the 12-month trailing default rate based only on our measure of gross leverage for the nonfinancial corporate sector puts fair value for the 12-month default rate at 4.1% (Chart 11). Our measure of gross leverage is simply total debt divided by pre-tax profits. This measure fell during the past year because pre-tax profits grew by 17% and total debt grew by only 7%. Chart 11Default Expectations Default Expectations Default Expectations Going forward, profit growth will almost certainly moderate during the next 12 months, driven by the combination of weaker global growth and rising wage pressures. However, it needs to fall a long way, to below 7%, before our measure of leverage starts to rise. In other words, a further slight decline in our measure of gross leverage is a reasonable expectation at the current juncture, which would bring the fair value from our simple default rate model close to the current Moody’s projection. All in all, our default-adjusted spread tells us that high-yield bonds offer historically average compensation given reasonable default expectations. Bottom Line: Corporate breakeven spreads are too wide for this phase of the cycle, especially for the Baa and junk credit tiers. Our default-adjusted spread shows that high-yield valuation is in line with the historical average, given a reasonable expectation for default losses. Overall, we conclude that corporate spreads are attractive at current levels and we recommend an overweight allocation to both investment grade and high-yield corporate debt in a U.S. bond portfolio.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Powell Doctrine Emerges”, dated September 4, 2018, available at usbs.bcaresearch.com 2 Chairman Powell cites a few examples of this in his Jackson Hole address from last fall. https://www.federalreserve.gov/newsevents/speech/powell20180824a.htm 3 http://www.nber.org/papers/w13428  4 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 6 The 12-month breakeven spread is the spread widening required on a 12-month investment horizon for a corporate bond to break even with a duration-matched position in Treasury securities. It can be quickly approximated by dividing the bond’s option-adjusted spread by its duration. 7 For a more complete analysis of the economic cycle based on the slope of the yield curve 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 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy We highlight our top seven reasons of why it pays to initiate a long materials/short utilities pair trade this week. Enticing long-term residential real estate prospects, a vibrant labor market, the recent improvement in house affordability, encouraging industry operating metrics and rock bottom valuations, all signal that a durable advance looms for the S&P homebuilding index. Recent Changes Initiate a long S&P Materials/short S&P Utilities pair trade today on a tactical (3-6 month) horizon.   Table 1 Trader's Paradise Trader's Paradise Feature The S&P 500 pierced through the 50-day moving average last week and managed to hold the line above this key technical level. Stocks are still absorbing the December shock, and our sense is that it may take a while before the SPX clears 2,800 where it faced stiff resistance all last year (Chart 1). This is a ripe trading environment. Chart 12,800 Is Stiff Resistance 2,800 Is Stiff Resistance 2,800 Is Stiff Resistance However, in order for a breakout to materialize, we reiterate the three potential positive catalysts we identified last week: A continuation of the earnings juggernaut A positive U.S./China trade resolution A definitively more dovish Fed, which would help restrain the greenback On the earnings front, Charts 2 & 3 update our GICS1 sector EPS growth models with one caveat: due to a lack of data we continue to show telecom services instead of communications services. While most sectors are projected to decelerate following 2018’s fiscal easing-related profit growth boost, the energy sector is the one that clearly stands out. Chart 2Sector EPS Growth... Sector EPS Growth... Sector EPS Growth... Chart 3...Models Update ...Models Update ...Models Update Last week we highlighted that sell-side analysts are anticipating energy profits to contract in 2019;1 this is in line with our S&P energy EPS growth model that continues to point toward EPS contraction (third panel, Chart 2). Nevertheless, we expect upward surprises in this deep cyclical sector given BCA’s Commodity & Energy Strategy service bullish oil forecast for the year. With regard to the three profit heavyweight sectors, tech, financials and health care, our EPS growth models are more or less in line with the street’s estimates (please refer to Table 2 in last week’s Weekly Report). Tech profits in particular are kissing off the zero growth line according to our regression model (top panel, Chart 3), and we continue to recommend a barbell positioning approach, overweighting the S&P software (high-conviction) and tech hardware, storage & peripherals indexes at the expense of the S&P semiconductors index. As a reminder we are neutral the broad S&P tech sector. Beyond profit growth, looking at our S&P 500 GICS1 sector Valuation Indicator (VI) and Technical Indicator (TI) provides a more complete sector positioning picture. Chart 4 is a valuation versus technical map of the 11 sectors, using our proprietary VI and TI as inputs. The map plots the VI on the y-axis and the TI on the x-axis. Both indicators depict Z-scores (please look forward to our upcoming Cyclical Indicator Update report that will highlight long-term GICS1 sector time series of our VI and TI). Chart 4 The S&P utilities sector is the most stretched and simultaneously very expensive sector. Real estate is just behind utilities and we continue to dislike both of these niche interest rate-sensitive sectors. The S&P consumer discretionary sector also makes it in this top right quadrant and is the most expensive GICS1 sector; we remain underweight this early cyclical sector. On the flip side, energy, materials and financials populate the bottom left quadrant; as a reminder we are overweight all three sectors. The S&P energy sector is the most undervalued and unloved of all GICS1 sectors. Netting it all out, we continue to prefer deep cyclical to defensive sectors as we still see the most opportunity in this tilt on all three fronts: earnings, valuations and technicals. Importantly, most of the bad/negative China slowdown news is likely reflected in the downtrodden cyclical/defensive ratio and a slingshot recovery is looming (China slowdown story count shown inverted, bottom panel, Chart 5). Chart 5China Slowdown Baked In The Cake China Slowdown Baked In The Cake China Slowdown Baked In The Cake In that light, this week we are initiating a new cyclical/defensive pair trade that is primed to generate alpha, and also update a niche early cyclical group. Buy Materials/Sell Utilities A playable market-neutral opportunity has resurfaced to buy materials at the expense of utilities stocks. Below we outline our top seven reasons why investors should put on this pair trade on a tactical (3-6 month) horizon. Chart 6The Dollar's Trough The Dollar's Trough The Dollar's Trough While global growth is decelerating, this news is last year’s story, especially now that even the IMF came out and downgraded global output growth. This is contrarily positive as cyclical stocks have more than discounted a softer growth outlook. If anything, the surprise this year would be for global growth to pick up momentum on the back of a positive U.S./China trade dispute resolution. The top panel of Chart 6 shows our Global Trade Activity Indicator (GTAI) that is making an effort to trough. Historically, the GTAI has been an excellent leading indicator of the long materials/short utilities price ratio and the current message is that the latter has bottomed. As the Fed is backing off aggressively raising interest rates this year and this has dealt a modest blow to the U.S. dollar. As a reminder, a depreciating greenback is conducive to rising global growth and vice versa. Were the U.S. dollar to complete its reverse head and shoulders technical formation courtesy of a more dovish Fed, this will prove a boon for relative share prices (middle panel, Chart 6). Related to the softening currency is a pickup in commodity price inflation. In fact, already metal prices are outpacing natural gas prices. The latter is the marginal price setter for utilities. This relative pricing power gauge is signaling that the worst is behind this pair trade ratio and a relative profit-led advance is in the offing (bottom panel, Chart 6). While the China slowdown narrative is well telegraphed to the markets (Chart 5), there is increasing pressure on the Chinese to either strike a deal with the U.S. and resolve the trade tussle or put together a comprehensive fiscal package alongside the already easing monetary backdrop in order to aid their decelerating economy. Importantly, the V-shaped recovery in the Li Keqiang index is signaling that the opening of the monetary taps and up-to-now piecemeal fiscal easing are starting to pay dividends. The upshot is that materials have the upper hand versus utilities (Li Keqiang index shown advanced, Chart 7). Chart 7...Chinese Reflation... ...Chinese Reflation... ...Chinese Reflation... Domestic conditions are also fertile ground for the relative share price ratio. While the ISM manufacturing survey took a beating last month, the latest release of the Philly Fed manufacturing business outlook ticked higher (both current activity and six-month forecast), reversing last month’s downbeat sentiment reading (Chart 8). BCA’s view remains that there will be no recession in 2019, which underpins materials at the expense of utilities. Chart 8...No U.S. Recession... ...No U.S. Recession... ...No U.S. Recession... High-frequency financial market indicators also suggest that the path of least resistance is higher for this cyclicals vs. defensives share price ratio. Inflation expectations have rebounded following an over 50bps collapse late last year, and financial conditions have also started to ease, partially reversing December’s spike (Chart 9). At the margin, materials are an inflation beneficiary/hedge and also investors shed defensive utilities stocks when financial conditions start to ease (junk bond spread shown inverted, bottom panel, Chart 9). Finally, our EPS growth models do an excellent job in capturing all these relative macro drivers and underscore that a reversal in bombed out technicals and depressed valuations looms (Chart 10).​​​​​​ Chart 9...Financial Market Indicators... ...Financial Market Indicators... ...Financial Market Indicators... Chart 10...And Compelling Valuations & Technicals Say Buy Materials/Sell Utilities ...And Compelling Valuations & Technicals Say Buy Materials/Sell Utilities ...And Compelling Valuations & Technicals Say Buy Materials/Sell Utilities In sum, a softer U.S. dollar, positive global/China growth surprises, commodity price inflation, an easing in financial conditions and no 2019 U.S. recession, all suggest that a relative earnings led advance will unlock excellent relative value and push the materials/utilities ratio higher in the coming months. Bottom Line: Initiate a new long S&P materials/short S&P utilities pair trade today on a tactical (3-6 month) horizon. Will Homebuilders Go Through The Roof? While we were admittedly a bit early in buying homebuilders in late-September, relative share prices have come full circle and are in the black since inception.2 We maintain our overweight stance in this niche consumer discretionary sub index and reiterate our long S&P homebuilding/short S&P home improvement retail pair trade that we initiated last week.3 Domestic long-term housing prospects remain compelling, especially given that the GFC wrung out all the residential real estate excesses. Currently, household formation is still running higher than housing starts and building permits (top panel, Chart 11). Similarly the homeownership ratio remains low by historical standards (it has yet to return to the long-term mean, not shown) and suggests that there is pent up housing demand. Chart 11Robust Long-term Housing Fundamentals Robust Long-term Housing Fundamentals Robust Long-term Housing Fundamentals Further, housing valuations are not pricey as both the price-to-rent and price-to-income ratios are a far cry from the 2005/06 peak (bottom panel, Chart 11). BCA’s view remains that wages will continue to rise this year and the economy will avoid recession. Historically, a vibrant labor market and residential construction are joined at the hip (unemployment rate and unemployment insurance claims shown inverted, Chart 12). Chart 12Labor Market And Residential Construction Move In Lockstep Labor Market And Residential Construction Move In Lockstep Labor Market And Residential Construction Move In Lockstep Tack on the recent fall in the 30-year fixed mortgage rate courtesy of a marginally more dovish Fed, and first-time home buyers will return this spring selling season (second panel, Chart 11). Already there is tentative evidence that potential home-owners have rushed to take advantage of the near 50bps drop in interest rates since the early November peak. The Mortgage Bankers Association's (MBA) mortgage applications purchase survey hit a multi-year high this month and signals that the there is a long runway ahead for the S&P homebuilding share price ratio (bottom panel, Chart 13). Chart 13Buyers Are Coming Back Buyers Are Coming Back Buyers Are Coming Back On the homebuilding operating front there are also some encouraging signs. Lumber prices, are down $300/tbf since mid-summer. This wholesale lumber liquidation phase provides profit margin relief to homebuilders given that framing lumber is a key input cost to housing construction (second panel, Chart 14). Chart 14Firming Operating Metrics Firming Operating Metrics Firming Operating Metrics Importantly, bankers are still willing extenders of residential real estate credit according to the latest Fed Senior Loan Officer survey. Indeed, mortgage credit is expanding at a healthy clip and there are high odds that this recent pick up in mortgage loan origination will remain upbeat owing to the decrease in the price of credit (third & bottom panels, Chart 14). Finally, sell-side analysts’ exuberance on homebuilding profits has returned to earth and now industry long-term profit growth is trailing the overall market. This significantly lowered profit hurdle coupled with depressed relative valuations suggest that investors seeking early cyclical equity exposure can still park capital in homebuilding stocks (Chart 15). Chart 15Homebuilders Are Still Cheap Homebuilders Are Still Cheap Homebuilders Are Still Cheap Adding it all up, enticing long-term residential real estate prospects, a vibrant labor market, the recent improvement in house affordability, encouraging industry operating metrics and rock bottom valuations, all signal that a durable advance looms for the S&P homebuilding index. Bottom Line: Maintain the overweight stance in the S&P homebuilding index. The ticker symbols for the stocks in this index are: BLBG: S5HOME – PHM, LEN, DHI. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Indurated” dated September 24, 2018, 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