Valuations

Highlights Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2018. We will resume our regular publishing schedule on January 2, 2019 with a Special Report on urbanization/industrialization. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Jonathan LaBerge, CFA, Vice President Special Reports   The evidence over the past year raises the odds that China’s economy has entered a multi-year period of frequent mini-cycles. A mini-cycle world would be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. There is no magic wand to quickly transform China into a services-oriented economy, and it is not clear that the gains in tertiary sector GDP since 2010 are sustainable. A slow transition would raise deep questions about China’s growth model over the coming 2-3 years, and would create a major dilemma for policymakers. Chinese stocks are considerably cheaper than they were a year ago, yet they may be cheap for a reason (even over the very long term). On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral barring even lower prices or tangible evidence of successful structural reforms. Feature Following the publication of our special year end Outlook report for 2019,1 BCA's China Investment Strategy service recently expanded on our global view by outlining our three key themes for China over the coming year.2 As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their longer-term implications. Mini-Cycles, And The Policy Trade-Off Between Growth And Leveraging Over the past year we have described the progression of Chinese growth as part of an economic “mini-cycle”, one that actually began in early-2014 (we have focused on the expansion period of the cycle that started in mid-2015). While this is the first clear mini-cycle in China after a prolonged period of slowing activity that followed the enormous stimulus of 2008/2009, many investors and market participants have speculated about whether these types of events will become more prevalent in the future. In a March 2017 BCA Special Report,3 my colleague Arthur Budaghyan speculated about the potential for such cycles within the context of a falling primary growth trend. Arthur’s argument was that cyclical growth could hold up in China over the coming few years only if the government allows credit growth to continue booming, but that this would entail creeping socialism/statism that would cripple the country’s productivity and thus its potential growth. In fact, the experience of the past three years suggests that mini-cycles may occur over the coming few years even if policymakers do try to prevent a falling primary growth trend. Chart 1 shows that the slowdown in domestic demand that investors only began to price in the middle of this year has clearly been caused by a slowing in money & credit growth (as represented by our leading indicator), which in turn strongly appears to have occurred because of monetary tightening that began at the end of 2016 (panel 2). This tightening has been closely linked to the government’s attempt to de-risk the financial sector. Chart 1Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown Tighter Monetary Policy Caused The Recent Mini-Cycle Slowdown In addition, we presented evidence in our August 29 Special Report suggesting that Chinese state-owned enterprises (SOEs) now have a negative net return on borrowed funds (Chart 2), underscoring that Chinese authorities now face a policy trade-off between growth and leveraging.4 The inference is that investors can expect more of these episodes so long as policymakers stay committed to reforming the financial sector, a policy that appears to remain a strong priority of the Xi government. Chart 2SOEs Now Have A Negative Net Return On Borrowed Funds SOEs Now Have A Negative Net Return On Borrowed Funds SOEs Now Have A Negative Net Return On Borrowed Funds Chart 3 presents three stylized scenarios as a possible multi-year roadmap for investors faced with a “mini-cycle world”. Scenario 1 represents the pessimistic case articulated by Arthur, a set of frequent cycles occurring against the backdrop of a falling primary (or potential growth) trend. Scenarios 2 and 3 represent possible outcomes emerging from successful structural reform: in scenario 2 the downtrend in potential growth is arrested and the primary growth trend becomes flat, whereas scenario 3 depicts the optimistic case, where reform initiatives unleash productivity gains that result in a net increase in potential growth. In both scenarios 2 and 3, the frequency of economic cycles is reduced to be more akin to that of typical business cycles in the developed world, ending the more rapid mini-cycle phase that preceded the success of the reforms. Chart 3A Potential Roadmap For Investors Living In A "Mini-Cycle World" A Potential Roadmap For Investors Living In A "Mini-Cycle World" A Potential Roadmap For Investors Living In A "Mini-Cycle World" For an investor primarily concerned with cyclical asset allocation, one response to Chart 3 might be that any of the scenarios are acceptable because there is money to be made in each case by shifting one’s investment stance in advance of key inflection points. However, as Arthur alluded to in last year’s report, the cycles depicted in Chart 3 are highly stylized and will not repeat themselves over regular, predictable intervals. In addition, even in scenarios 2 and 3, the higher frequency of oscillations depicted in the chart prior to the positive impact of structural reforms means that a mini-cycle world will be a difficult one for investors to navigate, particularly if the boom and bust phases are asymmetrical in length or magnitude. From a longer-term perspective, Chart 3 clearly outlines two key questions that investors should be asking themselves about China if we truly have entered a multi-year period of frequent mini-cycles: Is there tangible evidence of a falling primary growth trend in China, and can this be detected ex-ante rather than ex-post? What are the markers for successful structural reform, and how can progress be tracked in real-time? These are of course difficult questions to answer, and our thoughts are likely to evolve as more evidence presents itself. However, for now, we note the following: Chart 4 presents some evidence of declining potential growth in China, or more precisely a decline in the natural rate of interest. The chart shows that the rise in the weighted average lending rate since late-2016 was relatively minor compared with levels that have prevailed over the past decade, and yet it is clear that it succeeded in materially slowing the investment-driven sectors of China’s economy. Chart 4There Is Some Evidence That China's Natural Rate Of Interest Has Declined There Is Some Evidence That China's Natural Rate Of Interest Has Declined There Is Some Evidence That China's Natural Rate Of Interest Has Declined We also presented some evidence in our November 21 Weekly Report showing that China’s monetary policy transmission mechanism is impaired.5 Chart 5 shows that the recent decline in interbank repo rates implies that average lending rates are set to decline materially over the coming months; measuring the strength of the reaction in the old economy to this decline will provide investors with another crucial observation about the responsiveness of the economy to interest rates. Chart 5More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge More Information On The Responsiveness Of The Economy To Interest Rates Will Soon Emerge Concerning potential signposts of successful structural reform, signs that the government is about to undertake a big-bang cleanup and reorganization of China’s SOEs, one that involves the large-scale transfer of bad SOE debts to the public sector, would obviously be the primary event for investors to watch for. We assume that this will not occur over the coming few years barring a major crisis. At the firm level, non-trivial deleveraging, privatization/incorporation, material capital injection/withdrawal, material divestment of non-core fixed assets and (to a lesser degree) reduction in the wage bill relative to the industry have all shown themselves to be significantly related to the odds of a “zombie” firm returning to a healthy financial state.6 Even quiet signs that SOEs may be going through this process would be a positive indication of the potential for reform. At the macro level, our signposts of successful structural reform would be indications that SOE return on assets is set to rise back above borrowing costs (because of a material rise in the former, not a significant decline in the latter), tangible evidence of passive deleveraging (debt to nominal GDP falling because of a sustained rise in the latter), and a structural rise in the presence of private firms in China’s economy. Chart 6 shows that, at least in the case of the latter, progress appears elusive. Chart 6The Size Of The Private Sector In China Is Now Moving In The Wrong Direction The Size Of The Private Sector In China Is Now Moving In The Wrong Direction The Size Of The Private Sector In China Is Now Moving In The Wrong Direction Over the shorter-term, global investors are strongly focused on whether we are about to enter another mini-cycle upswing, a view that we have recently argued against. We presented our base case view for 2019 in our December 5 Weekly Report2, which is that growth will modestly firm in the second half of 2019 and will provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. But we underscore that the character of the improvement is likely to be materially different than what occurred in 2016, implying that investors betting on substantial returns from China-related financial assets next year are likely to be disappointed. Transitioning To A Services-Oriented Economy: There Is No Magic Wand Part of the structural reform agenda articulated by Xi Jinping involves transitioning China's economy towards the tertiary sector (services). Services activity, in general, tends to have higher added value than manufacturing, construction, and raw material extraction, and it is hoped that a more services-oriented economy will increase China’s per capita GDP and help the country escape the middle-income trap. Chinese policymakers have been very clear about their intention to promote this shift and have emphasized their need to do so quickly, but have not been very clear about how they plan to do so. Admittedly, there is some evidence to suggest that this trend has already begun: Chart 7 shows that tertiary industry GDP has risen as a share of overall GDP by about 7.5 percentage points since 2010, tertiary industry electricity consumption as a share of total is rising steadily, and the market capitalization of information and communication technology-related sectors has risen in China’s domestic and investable equity market (sharply in the case of the latter).7 Chart 7Some Signs Of A Move Towards Services... Some Signs Of A Move Towards Services... Some Signs Of A Move Towards Services... However, BCA’s China Investment Strategy service has been and remains quite skeptical about the likely pace of this transition, which raises deep questions about China’s growth model over the coming 2-3 years: Chart 8 breaks down the increase in tertiary industry GDP as a share of total from 2010 – 2017 into individual sectors.8 The chart shows that finance-related sectors (financial intermediation, leasing & business services, and real estate) accounted for nearly half of the increase in services GDP over the period. It seems difficult to expect that this trend will continue in an environment where the government is trying to contain financial sector risk. Chart 8 Chart 8 shows that tech-related sectors accounted for the second largest increase in tertiary industry GDP over the period, which is not surprising given the data shown in panel 3 of Chart 7. However, there are three problems with assuming that China’s tech sector will expand at a very rapid pace from current levels. First, Chart 9 makes it clear that the incubation period for China’s largest two technology companies by market capitalization was quite long. Alibaba and Tencent were both formed nearly 20 years ago, and only recently gained significant traction. Second, neither of these firms appears to have succeeded because of Chinese industrial policy, underscoring the importance of dynamic, competitive, private markets in driving innovation. Third, other successful examples of “breakthrough” state support for industries show that the process is not a rapid one. In the U.S. between 1978 and 1992, the U.S. Department of Energy invested in the Eastern Gas Shale Program, which contributed somewhat to the development of fracking technology used in shale oil & gas production today. Chart 10 shows how long it took for this program to bear fruit: gas production began to trend higher 12 years after the end of the program, whereas it took nearly two decades for oil production to begin to move higher. And even in this case, the role of private industry in commercializing the technology was overwhelmingly dominant. Chart 9The Incubation Period Of China's Major Tech Success Stories Was Quite Long The Incubation Period Of China's Major Tech Success Stories Was Quite Long The Incubation Period Of China's Major Tech Success Stories Was Quite Long Chart 10The Dividends From State-Assisted R&D Can Take A Long Time To Occur The Dividends From State-Assisted R&D Can Take A Long Time To Occur The Dividends From State-Assisted R&D Can Take A Long Time To Occur It is encouraging to see that education spending in China has increased as a share of GDP over the past several years, as services activity typically requires a highly educated workforce as an input. But China’s post-secondary educational attainment (defined here as the share of 25-34 year olds with tertiary education) appears to be too low to make a meaningful leap over the next 2-3 years (Chart 11). We acknowledge that China’s educational achievement ranks quite highly relative to the world, and this speaks to the high quality of skilled labor in China. However, for now, China’s attainment rate appears to be too low for the country to rapidly shift to services. Chart 11 Finally, Chart 12 shows that while tertiary industry electricity consumption is rising as a share of total, it remains small compared with secondary industry consumption. This underscores that China’s shift to a truly-services oriented economy is something that will take a considerable amount of time. What does a slow transition from secondary to tertiary industry mean for investors? To us, it either raises the risk that: Chart 12A Long Way To Go A Long Way To Go A Long Way To Go policymakers will have to rely on China’s old growth model for longer than they intend, or that Chinese growth will slow considerably more over the coming few years than investors currently expect. In the first case, policymakers may be on a collision course with the reality of poor financial health among SOEs, which as we noted earlier already have a negative net return from leveraging. In the second case, the threat is clear: China’s contribution to global growth could decline sharply, with potentially severe consequences for China-related financial assets. Cheap(er) Chinese Stocks: A Great Long-Term Buying Opportunity? We have received several questions from clients over the past few months asking whether they have been presented with a great long-term buying opportunity for Chinese stocks, even if cyclical economic conditions are set to weaken from current levels. Chart 13In The U.S., Valuation Predicts Long-Term Returns Quite Successfully In The U.S., Valuation Predicts Long-Term Returns Quite Successfully In The U.S., Valuation Predicts Long-Term Returns Quite Successfully This is a valid line of inquiry. Over a 6-12 month time horizon, valuation rarely drives asset returns, and we recently argued against the view that valuation could act as an overwhelming rally catalyst for Chinese stocks in 2019. However, we agree that valuation should be increasingly considered as one’s time horizon expands. Chart 13 shows that valuation has been a powerful predictor of 10-year future performance for the U.S. equity market, and Chart 14 shows that the forward P/E ratio for both domestic and investable Chinese stocks has certainly improved over the past several months. In relative terms, Chinese stocks are not as cheap as they have ever been, but haven’t usually been cheaper (at least over the past decade). This is particularly true for the A-share market (Chart 15). Chart 14Chinese Stocks Are Now Considerably Cheaper Than A Year Ago... Chinese Stocks Are Now Considerably Cheaper Than A Year Ago... Chinese Stocks Are Now Considerably Cheaper Than A Year Ago... Chart 15...Although They Have Been Cheaper In Relative Terms ...Although They Have Been Cheaper In Relative Terms ...Although They Have Been Cheaper In Relative Terms We struggle to answer the question, because while valuation usually predicts future returns quite well, deviations from this relationship can exist. Chart 13 shows that material differences between the actual and predicted 10-year returns existed during the 1970s/early-1980s and as well during the late-1990s, and would have as well in 2008/2009 had the valuation extremes of the late-1990s not lined up so well with the timing of the global financial crisis a decade later. In short, cheap stocks can be cheap for a reason, and the structural issues that we noted above certainly highlight the potential for the next 10-years of Chinese equity market performance to be anomalous relative to what would normally be implied by current valuation. For now, the best answer we can provide is that Chinese stocks are a great long-term buy for investors who do not share our structural concerns. On a risk-adjusted basis, we do not find the value proposition to be compelling, meaning that our recommended multi-year allocation to Chinese stocks is neutral. But we will be watching closely over the coming few years for signs of successful structural reform as detailed above, and we are likely to upgrade our structural recommendation on any material progress, particularly if that progress involves a cyclical deterioration in the economy that further cheapens equities. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 Pease see The Bank Credit Analyst “OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at cis.bcaresearch.com. 2 Pease see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Pease see China Investment Strategy Special Report “The Great Debate: Does China Have Too Much Debt Or Too Much Savings? ”, dated March 23, 2017, available at cis.bcaresearch.com. 4 Pease see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging”, dated August 29, 2018, available at cis.bcaresearch.com. 5 Pease see China Investment Strategy Weekly Report “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com. 6 IMF Working Paper WP/17/266 “Resolving China’s Zombies: Tackling Debt and Raising Productivity” 7 Note that we have included the consumer discretionary sector in Chart 8 owing to the recent GICS sector changes that have included e-commerce providers such as Alibaba in the discretionary sector. 8 Note that 2016 is the most recent data point for healthcare & social security, education, scientific research & technology services, public management & social organizations, and miscellaneous others. However, their change from 2010 – 2017 reflects almost all of the change in the sum of these categories from 2010 – 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights Dear Client, This is the final Global Fixed Income Strategy report for 2018. We will return with our first report of the new year on January 8th, 2019. Our entire team wishes you a very happy holiday season and a prosperous new year. Best regards, Rob Robis, Chief Strategist 2019 Model Bond Portfolio Positioning: Translating our 2019 key global fixed income views into recommended overall positioning within our model bond portfolio yields the following: target a modest level of active portfolio risk, with below-benchmark duration and only neutral exposure to corporate credit. Country Allocation: Government bond allocation should continue to reflect relative expectations for monetary policy changes. That means an overweight in countries where central banks will have little scope to increase rates (core Europe, Japan, the U.K., Australia, New Zealand) and an underweight where central banks are likely to tighten more than markets currently discount (U.S., Canada, Sweden). Corporate Credit: We currently prefer U.S. corporate bonds to European and EM equivalents based on better U.S. profit prospects, which enhances debt serviceability. However, we will look to pare U.S. exposure as the Fed shifts to a more restrictive stance later in 2019. Feature Last week, we published our 2019 “Key Views” report, outlining the thematic implications of the 2019 BCA Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations for next year. We also recommend changes to the allocations in the Global Fixed Income Strategy model bond portfolio to reflect our 2019 themes. The main takeaway is that 2019 will be another year of poor returns, with increased volatility, for most global fixed income markets. The greater pressures should come in the latter half of the year, after the U.S. Federal Reserve delivers additional rate hikes and decisive signs of a slowing U.S. economy unfold. Investors should maintain a defensive strategic posture on fixed income markets throughout the year, both for interest rate duration and credit exposure. Selling into market rallies, rather than chasing them, will prove to be the prudent strategy. Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from last week’s Key Views report were the following: Late-cycle pressures will keep bond yields elevated. Global growth will remain above trend in 2019, keeping unemployment rates low and preventing central banks from turning dovish. The unwind of crisis-era global monetary policies will continue. Slowing central bank asset purchases will worsen the supply/demand balance for both government bonds, resulting in gentle upward pressure on yields via higher term premia. It is too early to worry about inverted yield curves. The time to be concerned about the recessionary implications of an inverted U.S. Treasury curve will come after the Fed has lifted real interest rates to above neutral (R*), which should occur in the latter half of 2019. Expect poor corporate bond returns from an aging credit cycle. While default risk is likely to stay modest in 2019, the greater risk for corporates could come from concerns over future credit downgrades, as well as diminished inflows in a “post-QE” world. We now present the specific fixed income investment recommendations that flow from those themes in the following categories: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Risk: DEFENSIVE Government bond yields enter 2019 at very low (i.e. expensive) levels across the major developed markets, even after the cumulative rise in U.S. Treasury yields seen over the past twelve months. Real yields remain below trend real GDP growth rates, a consequence of central banks keeping policy rates below neutral levels as measured by concepts like the Taylor Rule (Chart of the Week). In addition, credit spreads remain near the low end of long-run historical ranges in all markets. Without the initial starting point of cheap valuations, fixed income return expectations in 2019 should be severely tempered (Charts 2& 3). Chart 1   Chart 2Low Yields = Low Expected Returns For U.S. Corporates … Low Yields = Low Expected Returns For U.S. Corporates... Low Yields = Low Expected Returns For U.S. Corporates...   Chart 3… And European Corporates ...and European Corporates ...and European Corporates Volatility measures like the VIX index will remain elevated until markets begin to sniff out a bottoming of global growth. Much will depend on developments in China, but our expectation is that policymakers there will only act to stabilize the economy rather than provide large, 2016-scale stimulus. That may be enough to create a tactical “risk-on” trading opportunity by mid-year but we recommend using any such rally to reduce credit exposure given the risk of a more lasting global economic downturn in 2020. Importantly, cross-asset correlations should continue to drift lower without broad support from coordinated global economic growth or expanding monetary liquidity via central bank asset purchases (Chart 4). Without those rising tides lifting all boats, more active security selection by country, sector and credit rating should help portfolio managers outperform their benchmarks in what is likely to be another down year for absolute returns. Chart 4High Volatilities With Low Correlations High Volatilities With Low Correlations High Volatilities With Low Correlations That combination of diminished return prospects and elevated volatility means investors should maintain a defensive bias in fixed income portfolios heading into 2019. Within our own GFIS recommended model bond portfolio, this means keeping our tracking error (the relative expected volatility versus our custom benchmark performance index) well below our maximum target level of 100bps (Chart 5). Chart 5Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Maintain Moderate Overall Portfolio Risk Overall Duration Stance: BELOW BENCHMARK We do not think that global bond yields have peaked for this business cycle. The current period of softening global economic momentum will not turn into a prolonged period of sub-trend growth that would push up unemployment rates in the major developed economies. With the global output gap nearly closed, and monetary policymakers firmly believing in the Phillips Curve framework (lower unemployment leads to higher inflation) to forecast inflation, a more dovish stance from the major central banks seems unlikely. As we discussed in last week’s report, global bond yields are in a process of normalization away from the depressed levels seen after the 2008-09 global financial crisis and recession (Chart 6). Term premia, inflation expectations and real yields all have upside potential as central banks slowly back away from quantitative easing and low interest rate policies. Thus, we continue to recommend a defensive, below-benchmark strategic stance on overall portfolio duration exposure (Chart 7). Chart 6Bond Yields Will Continue To Normalize In 2019 Bond Yields Will Continue To Normalize In 2019 Bond Yields Will Continue To Normalize In 2019   Chart 7Stay Below-Benchmark On Duration Risk Stay Below-Benchmark On Duration Risk Stay Below-Benchmark On Duration Risk Government Bond Country Allocation: Underweight U.S., Canada, Sweden, Italy. Overweight Germany, France, U.K., Japan, Australia, New Zealand At the country level, we recommend underweighting government bond markets where central banks will be more likely to raise interest rates (because of firm domestic economic growth and building inflation pressures), but where too few rate hikes are currently discounted in money market yield curves. The U.S., Canada and Sweden fit that description (Chart 8). The U.K. would also be part of this group, but the Brexit uncertainty leads us to maintain an overweight stance on U.K. Gilts entering 2019. Chart 8Monetary Policy Expectations Drive Country Allocations Monetary Policy Expectations Drive Country Allocations Monetary Policy Expectations Drive Country Allocations By the same token, we are recommending overweights in countries where rate hikes are unlikely to occur in 2019 because of underwhelming inflation, like core Europe, Japan and New Zealand. We are currently overweight Australian government bonds, but we expect to cut that exposure in 2019 as pressure builds for a rate hike in the latter half of the year as inflation picks up. Italian government bonds represent a special case of a developed market trading off sovereign credit risk rather than interest rate or inflation risk. We continue to treat Italian government bonds the same way we view corporate debt, as a growth-sensitive asset. On that basis, we will remain underweight Italian government bonds until Italy’s leading economic indicator bottoms out, mollifying concerns about debt sustainability. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will sustain wide differentials between Treasuries and non-U.S. bond yields (Chart 9). Chart 9ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets ECB, BoE, BoJ Resisting Pressure From Tight Labor Markets The greatest potential for spread widening will be for Treasuries versus JGBs, with no changes in the Bank of Japan’s monetary policy expected due to stubbornly low inflation. The 10-year Treasury-Gilt spread could also widen if the Bank of England stays on the sidelines for longer until Brexit uncertainty is resolved. The 10-year U.S.-New Zealand spread should also widen with the Reserve Bank of New Zealand staying on hold for a while due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be rangebound, with the Bank of Canada likely to match, but not exceed, Fed tightening in 2019. There are some markets, though, where yields could rise a bit more than Treasury yields due to shifting monetary policies. While the ECB will refrain from raising rates next year, there is a potential for the U.S. Treasury-German Bund spread to narrow marginally if the end of ECB new asset purchases lifts Bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads. After keeping monetary policy very loose for a long time, the beginning of rate hikes next year by the Reserve Bank of Australia and Riksbank could put meaningful upward pressure on deeply depressed longer-maturity Australian and Swedish yields. Yield Curve Positioning: Favor Bearish Steepeners Everywhere In The First Half Of 2019, Then Switch To Bearish Flatteners In The U.S., Canada, Australia And Sweden We expect some bearish steepening pressures to appear in most countries in the first quarter of 2019 with inflation breakevens likely to rebound if the bullish oil forecast of BCA’s Commodity & Energy Strategy team comes to fruition (Charts 10 & 11). The end of the net new buying phase of the ECB’s Asset Purchase Program in January will also put upward pressure on longer-dated European yields through a worsening supply/demand balance for European government bonds and a wider term premium, helping keep European yield curves steep. Chart 10Inflation Expectations & Bond Yields Will Rebound In 2019 … Inflation Expectations & Bond Yields Will Rebound In 2019... Inflation Expectations & Bond Yields Will Rebound In 2019...   Chart 11… As BCA’s Bullish Oil View Comes To Fruition ...As BCA's Bullish Oil View Comes To Fruition ...As BCA's Bullish Oil View Comes To Fruition Importantly, it is too soon to worry about an inversion of the U.S. Treasury curve, as we discussed in last week’s report, with the fed funds rate not yet at a restrictive level (i.e. real rates above measures of neutral like R-star). That outcome should occur by the end of 2019, when we expect the Treasury curve to move towards a true monetary policy-induced inversion. Similar patterns – steepening first from rising inflation expectations, flattening later from more hawkish central banks delivering rate hikes – should unfold in Canada, Australia and Sweden. Applying Our Global Golden Rule To Government Bond Allocations Back in September, we published a Special Report introducing a government bond return forecasting methodology called the “Global Golden Rule.”2 This is an extension of a framework introduced by our sister service, U.S. Bond Strategy, that links U.S. Treasury returns to changes in the fed funds rate that are not discounted in money markets (using our 12-month Discounters derived from Overnight Index Swap curves). In Table 1, we show the expected returns generated by the Global Golden Rule (shown hedged into U.S. dollars) for the countries in our model bond portfolio custom benchmark, based on monetary policy scenarios that we deem to be most plausible for 2019. In Table 2, we show the returns on a duration-adjusted basis (expected total return divided by duration). We then rank the return scenarios for overall country indices, aggregating the returns of the individual yield curve maturity buckets shown in those two tables, in Table 3. Table 1Global Golden Rule Return Forecasts For 2019 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense   Table 2Global Golden Rule Duration-Adjusted Return Forecasts For 2019 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense The shaded cells in Table 3 represent our base case forecasts for policy rate changes in each country. On this basis, the better return prospects for 2019 will be in markets where central banks will stand pat throughout the year (Germany, Japan). Conversely, the weaker returns will occur where we expect more rate hikes than currently discounted by markets (U.S., Canada). These returns fit with our recommended country allocation outlined above. Table 3Ranking The 2019 Return Scenarios 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense Corporate Credit Allocation: Neutral Overall, But Overweight In U.S. Investment Grade And High-Yield Relative To European And Emerging Market Equivalents. Look To Cut The U.S. To Underweight In The Latter Half Of 2019. We enter 2019 maintaining our recommended overall neutral exposure to corporate debt. As discussed earlier, we expect to see some stabilization of global growth in the first half of 2019. This will create a playable “risk-on” rally for growth sensitive assets like corporates, but we anticipate selling into that rally by downgrading our recommended U.S. credit allocations to underweight. Within U.S. credit markets, we are recommending a less aggressive medium-term stance, staying up in quality within investment grade debt (single-B and single-A rated names versus BBBs) and high-yield (BB-rated vs CCC-rated). With 50% of the investment grade benchmark index now rated just above junk, there is a growing risk of “fallen angel” downgrades to junk status in the event of a material slowing of U.S. economic growth. At the same time, default-adjusted spreads on U.S. high-yield debt only appear attractive if the current exceptionally low default rate backdrop persists (Chart 12). In other words, both U.S. investment grade and high-yield corporate debt are vulnerable to any major slowing of U.S. economic growth and slump in corporate profits. Chart 12U.S. Corporates Vulnerable To Slower Growth U.S. Corporates Vulnerable To Slower Growth U.S. Corporates Vulnerable To Slower Growth The confluence of above-trend U.S. growth and still pro-cyclical Fed policy will support U.S. credit in the near-term, but that will all change later in 2019. We expect the Fed to deliver at least 75bps of rate hikes in 2019 – perhaps only pausing from the current 25bps per quarter pace at the March meeting – which will push the funds rate into restrictive territory and invert the Treasury curve sometime in the 4th quarter of the year. This will cause investors to start to discount a deep growth slowdown in 2020, which will trigger systemic credit spread widening (Chart 13). We expect our next move on U.S. corporate debt to be a downgrade to underweight, likely sometime around mid-year. Chart 13Growth Differentials Continue To Favor U.S. Growth Differentials Continue To Favor U.S. Growth Differentials Continue To Favor U.S. We still prefer U.S. corporates to European or Emerging Market (EM) equivalents, however, thanks to the likelihood of better near-term growth prospects in the U.S. We are concerned about how the European corporate bond market will perform without the support of ECB asset purchases, which leads us to underweight both investment grade and high-yield European corporates (Chart 14).3 Chart 14Stay Overweight U.S. Corporates Vs European Corporates Stay Overweight U.S. Corporates Vs European Corporates Stay Overweight U.S. Corporates Vs European Corporates EM corporates will continue to suffer from the toxic combination of rising U.S. interest rates, a stronger dollar and global growth concerns. Our political strategists remain skeptical on the prospects for a permanent deal on thorny U.S.-China trade issues, leaving EM assets exposed to slowing momentum in China’s economy. We continue to prefer owning U.S. credit, given how the relative performance of EM and U.S. credit has not yet converged to levels implied by U.S./EM growth differentials (Chart 15). Chart 15Stay Overweight U.S. Corporates Vs EM Corporates Stay Overweight U.S. Corporates Vs EM Corporates Stay Overweight U.S. Corporates Vs EM Corporates Model Portfolio Adjustments To Begin 2019 In terms of our model bond portfolio, we recommend a few changes to our current allocations to reflect our 2019 outlook and key views (see the table below). We make a few adjustments to our individual country duration allocations, given our expectations of some re-steepening of global yield curves. We also bump up our allocation to core European debt given our expectation that the ECB will keep policy rates on hold throughout 2019. We fund that increase in European exposure from U.S. Treasuries, where too few Fed rate hikes are now discounted. Finally, we make a modest adjustment to our U.S. high-yield allocations, cutting CCC-rated exposure and upgrading B-rated credit.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com   Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “2019 Key Views: Normalization Is The “New Normal””, dated December 12th 2018, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Special Report, “The Global Golden Rule Of Bond Investing”, dated September 25th 2018, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “Stubbornly Resilient Bond Yields”, dated November 13th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index 2019 Key Views, Part II: Time To Play Defense 2019 Key Views, Part II: Time To Play Defense Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy The drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound, warranting an above benchmark allocation. An oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Recent Changes Boost the S&P Semiconductor Equipment index to overweight today, on a tactical three-to-six month time horizon. Table 1 Signal Vs. Noise Signal Vs. Noise Feature Equities attempted to stage a recovery last week and are in a triple bottom technical formation, still consolidating the October tremor. The Fed meeting later this week will likely prove a catalyst on the monetary policy front, especially if the closely watched FOMC median dots decrease for 2019 as the bond market has been expecting. As we mentioned in our 2019 High-Conviction calls Report two weeks ago,1 the Fed will dominate markets next year and any dovish change in interest rate expectations will breathe a sigh of relief into the SPX. Given the heightened volatility and violent recent equity market oscillations, it is important to separate the noise from the actual signal. While distinguishing between the two is hard at times, we are relying on a few key indicators to aid us in this process. First, our S&P 500 EPS growth model is still expanding near the 10% mark for next year as clearly 25% EPS growth is not sustainable. While the risk is that this growth rate decelerates further, as long as EPS do not contract next year, stock prices should recover (Chart 1). From a macro perspective, at this stage of the cycle with nominal GDP growth between 4-5%, organic EPS growth should at least mimic nominal output growth. Tack on a 2% buyback yield or artificial EPS growth and attaining a 7% EPS growth rate is likely next year. Chart 1 Second, while the 5/2 and 5/3 yield curve slopes have inverted and we heed these signals, the 10/2 and the Fed’s spread (2-year yield minus the fed funds rate) have yet to invert. Historically, the most significant yield curve signals for the equity market are when simultaneously all the different yield curve slopes are inverted. While everyone is infatuated with the yield curve inversion implications of recession, we are laser focused on the interplay between the yield curve and stock market peaks. Importantly, typically the 10/2 yield curve inversion occurs before stock market peaks. Going back to the mid-1960s there has been only one time when the stock market peaked prior to the yield curve inversion, in 1973: the SPX crested on January 11 and the yield curve inverted on January 16 (due to lack of data we use the effective fed funds rate instead of the 2-year yield prior to 1976). In all the other iterations, the yield curve inverts prior to the stock market top. Even in 1998 the yield curve inverted in late-May and the SPX peaked in mid-July before suffering a 20% drawdown. Similarly, on February 2, 2000 the yield curve inverted and on March 24, 2000 the SPX topped out for the cycle. Chart 2 Chart 3… And Then The SPX Peaks ...And Then The SPX Peaks ...And Then The SPX Peaks In other words, the yield curve inversion is a leading indicator and once the curve inverts, it signals that the stock market highpoint will follow soon thereafter (Charts 2 & 3). The broad market tops on average 248 days (median 77 days) following the yield curve inversion (Table 2), though the large variability in each iteration limits the usefulness of this average as an accurate predictor. Nevertheless, the implication remains that the SPX has yet to peak for the cycle. Table 2Yield Curve Inversions And S&P 500 Peaks Signal Vs. Noise Signal Vs. Noise Third, a slew of economically sensitive indicators have troughed. Sweden’s PMI and Swedish stock market relative performance have been in a V-shaped recovery. As we highlighted earlier this week,2 Sweden is a small open economy and it is likely sniffing out an improvement in global export volume growth and a likely de-escalation in the U.S./China trade tussle. EM FX, the CRB raw industrials commodities index, the Baltic Dry Index and semi equipment stocks (see more details in the next section) all suggest that the worst is over, and global trade will likely resume its advance in the coming months (Chart 4). Chart 4Hyper-sensitive Indicators Sniffing Out A Trough? Hyper-sensitive Indicators Sniffing Out A Trough? Hyper-sensitive Indicators Sniffing Out A Trough? Finally, inflation is coming off the boil and will likely decelerate in the months ahead courtesy of the fall in WTI crude oil prices. Were oil to move sideways from here, headline inflation would decelerate further, likely overwhelming core CPI (Chart 5). This is significant, as it could serve as a monetary policy catalyst. Put differently, decelerating inflation may cause the Fed to reconsider the pace of its interest rate hikes. A pause in the tightening cycle in March 2019 would be a welcome development for stocks, especially if the fed funds rate is nearing the terminal rate as we recently highlighted in our trough-to-peak fed funds rate tightening cycle analysis.3 Chart 5Inflation Will Decelerate Inflation Will Decelerate Inflation Will Decelerate Adding it all up, our still expanding SPX EPS growth model, a lack of a 10/2 yield curve inversion, a trough in a number of economically sensitive indicators and the potential for a temporary Fed hike pause in March next year, all signal that the equity bull market is not over and fresh all-time highs are looming in 2019. This week we are upgrading, on a tactical basis, a bombed out tech subgroup, and updating our view on a deep cyclical index. Semi Equipment: Enough Is Enough We are lifting exposure in the niche S&P semi equipment index from underweight to a modest overweight. Putting this in perspective, this small index comprises only 1.5% of the tech universe and commands a mere 0.3% weight in the S&P 500. There are high odds that most of the carnage in semi equipment stocks is already reflected in the violent swing of the sell side community from extreme bullishness up until August of this year to the current extreme bearishness. As a reminder, the S&P semi equipment index was part of U.S. Equity Strategy’s high-conviction underweight call revealed in November 27, 2017 when the sell-side could not have enough of semi equipment stocks as analysts were also mesmerized last winter by the near $20,000/bitcoin related mania.4 This timing coincided with the peak in performance of this hypersensitive early-cyclical tech index (Chart 6). Chart 6Extreme Bearishness... Extreme Bearishness... Extreme Bearishness... To get a sense of how far the pendulum has swung on the bearish camp, we note the following: The relative 12-month forward EPS growth has deflated from positive 60% to negative 20% (Chart 6). The index’s forward P/E is trading at a 40% discount to the SPX, relative 5-year EPS growth estimates are near previous troughs and even compared to the overall tech sector; semi equipment long-term EPS growth is now forecast to trail their tech brethren (Chart 7). Even forward sales growth has collapsed, falling to a multi-year low. Analysts now expect an outright contraction in revenues to the tune of 4% or 10 percentage points below the S&P 500 (Chart 6). Net EPS revisions have also been sinking like a stone, approaching the 2012 nadir (Chart 6). Technical conditions are oversold with cyclical momentum as bad as it gets (Chart 7).  Chart 7...Reigns ...Reigns ...Reigns Beyond this overly pessimistic backdrop, there are some macro indicators that, were they to sustain their recent budding recoveries, would serve to catalyze the chip equipment group. First, trade policy uncertainty has dealt a blow to this tech subindex (trade policy uncertainty shown inverted, top panel, Chart 8). Not only are 90% of sales foreign sourced, but a large chunk is also China-related sales. Table 3 highlights the excessive sensitivity these stocks have to the U.S. dollar. In fact, the correlation with J.P. Morgan’s EM FX index is an almost perfect one (Chart 8). If President Trump is serious about striking a deal with China, then this group would enjoy a relief rally. Chart 8Potential Positive Catalysts Potential Positive Catalysts Potential Positive Catalysts Table 3U.S. Semi Equipment Geographical Sales Breakdown Signal Vs. Noise Signal Vs. Noise Second, emerging market manufacturing PMIs are showing some signs of life, underscoring that semi equipment demand may turn out to be marginally less grim than currently anticipated (Chart 9). Chart 9EM Green Shoots? EM Green Shoots? EM Green Shoots? Third, while global semi sales will continue to decelerate for the next three-to-six months, the semi market is functioning as if the inventory liquidation cycle is in the later innings, with our industry pricing power proxy plummeting 180 percentage points from peak-to-the-recent trough, just below the contraction zone (Chart 10). Chart 10Inventory Liquidation Is In Late Stages Inventory Liquidation Is In Late Stages Inventory Liquidation Is In Late Stages Finally, any bounce in cryptocurrencies may also serve as a positive catalyst for additional demand for the semi equipment companies that enjoy monopolies in their respective manufacturing niches (Chart 10). In sum, the drubbing in the S&P semi equipment index is overdone and even a modest improvement on either the trade policy, industry demand or currency fronts could result in a reflex rebound. Bottom Line: Lift the S&P semi equipment index from underweight to overweight today, as a tactical move for the next three-to-six months. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX and KLAC. Oil Majors Are Holding Firm In early-February we upgraded the heavyweight integrated oil & gas energy subindex to an above benchmark allocation. Our thesis centered on a capex upcycle recovery and firming oil price backdrop that would unlock excellent value in this key energy subgroup. Since then, the relative share price ratio has moved laterally. Interestingly, this defensive 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 (Chart 11). 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 11Defensive Oil Equities Defensive Oil Equities Defensive Oil Equities While the Trump Administration’s flip-flop on the Iranian sanctions has injected extreme volatility into oil prices, some semblance of normality has returned to the crude oil markets as last week OPEC and Russia agreed to a production cut in order to help balance the market. Another key factor that has contributed to the recent fall in oil prices at the margin has been U.S. shale oil supplies. 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, along with OPEC/Russia discipline, would likely balance the oil market and pave the way for an oil price recovery (oil production shown inverted, Chart 12).   Chart 12U.S. Supply Response Is Looming U.S. Supply Response Is Looming U.S. Supply Response Is Looming Given that BCA’s Commodity & Energy Strategy service continues to forecast higher oil prices into 2019, the S&P integrated oil & gas index should stage a sustainable rebound next year. While the recent swift drop in oil prices is jeopardizing the still recovering capital expenditure cycle, we doubt $50/bbl oil would make current projects uneconomical and result in mothballing or outright canceling of ongoing oil exploration projects (Chart 13). Granted, a big assumption is that oil prices at least hold near the current level and do not suffer a relapse to the early-2016 lows. Historically, rising oil exploration outlays and integrated oil & gas share prices move in lock step and the current message is to expect a rebound in the latter (Chart 14). Chart 13Low Odds Of A Total... Low Odds Of A Total... Low Odds Of A Total... Chart 14...Capex Collapse ...Capex Collapse ...Capex Collapse Finally, sell-side analysts are throwing in the towel. Net earnings revisions have taken a beating of late, which is positive from a contrary point of view (second panel, Chart 15). Relative valuations are extremely compelling on a number of metrics including relative price-to-book, price-to-sales and relative forward price-to-earnings (third panel, Chart 15). Tack on a near 200bps positive delta in the dividend yield versus the broad market and yield hungry investors will also seek the relative safety of this defensive energy subindex (bottom panel, Chart 15). Chart 15Integrated Stocks Are On Sale Integrated Stocks Are On Sale Integrated Stocks Are On Sale Netting it all out, an oil price rebound on the back of a more balanced supply/demand backdrop, a continuation in the global capex energy upcycle and compelling relative valuations all suggest that the path of least resistance is higher for oil majors. Bottom Line: Stay overweight the heavyweight S&P integrated oil & gas energy subindex. The ticker symbols for the stocks in this index are: BLBG: S5IOIL – XOM, CVX and OXY. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Sector Insights, “Can Sweden Lead The SPX?” dated December 12, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “2019 Key Views: High-Conviction Calls,” dated December 3, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “2018 High-Conviction Calls,” dated November 27, 2017, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Below-Benchmark Duration: Below-benchmark duration positions will continue to pay off in 2019 as the Fed delivers more than the 32 bps of rate hikes that are priced into the curve for the next 12 months. While tighter financial conditions will probably necessitate a pause in the Fed’s gradual rate hike cycle at some point next year, this is already more than discounted in current market prices. A further deterioration in housing starts and new home sales, or a significant uptick in initial jobless claims would call our below-benchmark duration view into question. Neutral Corporate Credit: In an environment where the yield curve is quite flat but still positively sloped, excess returns to corporate bonds also tend to be quite low, but still positive on average. Investors should be looking for low, but positive, excess returns from credit on a 12-month investment horizon. However, credit spreads will probably widen further in the near-term and then tighten once the Fed signals a pause and global growth improves. Overweight Munis and Local Authorities: Tax-exempt municipal bond yields are very attractive relative to corporate bonds and both municipal and Local Authority bonds are relatively insulated from the weakness in global growth that will threaten the corporate profit outlook in the coming quarters. Both of these sectors should perform well in 2019. Overweight TIPS: Long-maturity TIPS breakeven inflation rates have shifted down in recent weeks, but will move higher in 2019, eventually stabilizing in a range between 2.3% and 2.5%. The rebound in oil prices that our commodity strategists expect will help, but TIPS outperformance will largely be driven by investor expectations slowly adapting to the new reality that inflation will remain much closer to the Fed’s target than it has in recent years. Yield Curve Inversion In Late 2019: Below-target TIPS breakeven inflation rates and an inverted yield curve cannot coexist. As such, investors should not worry about a sustained inversion of the yield curve until later in 2019. To profit from this view, investors should position for steepeners at the front-end of the curve. We recommend going long the 2-year bullet and short a duration-matched 1/5 barbell. The belly (5-7 year) part of the curve has become very expensive and should be avoided at all costs. Feature BCA published its 2019 Outlook two weeks ago.1 That report lays out the macroeconomic themes that our strategists think will drive markets next year. In this Special Report, we specify how investors should implement those views in the context of a U.S. bond portfolio. Key Views The main conclusions from the 2019 Outlook are: Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. […] that means capacity pressures will intensify, causing inflation to move higher. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. […] Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. In the verbiage of monetary policymakers, the BCA view is that U.S. interest rates remain below the neutral level that is consistent with trend GDP growth and stable inflation. This means that the Fed’s rate hike cycle will continue in 2019, and that monetary policy will not turn restrictive until later in the year. It is this view of U.S. interest rates remaining below neutral until late 2019 that drives our portfolio recommendations. Key Risks Given our main premise, the biggest risk to our recommended portfolio allocation is that interest rates move above neutral sooner than we anticipate. We will be monitoring three main risks in the coming months to help us decide whether our main premise needs to be re-evaluated. Risk #1: Housing Since a large amount of leverage is employed in the acquisition of new homes, there is good reason to believe that housing is the main channel through which interest rates impact the real economy. This is validated by the empirical data which show that residential investment, housing starts and new home sales all provide a good indication of when monetary policy turns restrictive and of when Treasury yields peak for the cycle.2 With that in mind, the housing data have clearly deteriorated during the past 6-9 months. However, with the 12-month moving averages of housing starts and new home sales still trending higher, it is too soon to say that housing has peaked for the cycle (Chart 1). Our sense is that the recent deterioration is a result of the sharp move higher in mortgage rates that occurred earlier this year. Now that rates have moderated, the housing data should improve.3 Chart 1The Housing Market Predicts Recessions The Housing Market Predicts Recessions The Housing Market Predicts Recessions A decisive breakdown in the 12-month moving averages of housing starts and new home sales would cause us to question our premise that U.S. interest rates remain below neutral. Risk #2: Jobless Claims With the unemployment rate at 3.7%, the U.S. labor market is in rude health. That being said, a move higher in the unemployment rate would be a clear sign that monetary policy is restrictive and that a recession is right around the corner. In the post-war era, there has never been a case where the 3-month moving average of the unemployment rate has risen by more than one-third of a percentage point without a recession taking place. Often, a turn higher in the unemployment rate is preceded by an increase in initial jobless claims, and the 4-week moving average in claims has increased for four consecutive weeks (Chart 2). So far, that increase is no cause for concern. Historically, the 6-month change in jobless claims needs to reach +75k before a recession occurs (Chart 2, bottom panel). Nevertheless, the recent upturn in claims will bear monitoring in the months ahead. Chart 2Initial Jobless Claims Are Worth Monitoring Initial Jobless Claims Are Worth Monitoring Initial Jobless Claims Are Worth Monitoring Risk #3: Weak Foreign Growth & A Strong Dollar It is a bit misleading for us to include weak foreign growth and a strong dollar in the “key risks” section. In fact, our base case outlook involves weak foreign economic growth migrating to the U.S. via a stronger dollar and leading to a mild slowdown in U.S. economic activity during the next few quarters (Chart 3).4 This will probably even cause the Fed to pause its gradual rate hike cycle, but will not bring it to an end. This report also contains our recommendations for how to tactically position for this pause. Chart 3Weak Global Growth Will Drag The U.S. Lower Weak Global Growth Will Drag The U.S. Lower Weak Global Growth Will Drag The U.S. Lower The Awkward Middle Phase When constructing U.S. bond portfolios on a cyclical (6-12 month) investment horizon, we find it useful to split the economic cycle into phases based on the slope of the yield curve. Our economic view informs what phase (or phases) of the cycle will reign during the next 6-12 months, and the phase of the cycle informs our investment posture. We define three phases of the cycle as follows (Chart 4): Chart 4The Three Phases Of The Cycle The Three Phases Of The Cycle The Three Phases Of The Cycle Phase 1: From the end of the prior recession until the 3-year/10-year Treasury slope flattens to below 50 bps. Phase 2: When the 3-year/10-year Treasury slope is between 0 bps and +50 bps. Phase 3: From when the 3-year/10-year Treasury curve inverts until the start of the next recession.5 Table 1 shows how each U.S. fixed income asset class has performed in each phase. We use excess returns from the Bloomberg Barclays Treasury index versus cash to track the returns earned from taking portfolio duration risk. For other fixed income sectors we display excess returns versus duration-matched Treasuries. We also include the performance of the S&P 500 versus the Bloomberg Barclays Treasury index. Table 1Risk Asset Performance In Different Yield Curve Regimes 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income As should be clear from the macro view discussed above, we believe that we will remain in Phase 2 of the cycle for the bulk of 2019. With the 3/10 Treasury slope a mere 13 bps at present, temporary curve inversions might occur earlier in the year, but they will not be sustained (see Key View #5 below). The first implication of being in Phase 2 is that corporate bond excess returns (both investment grade and high-yield) are likely to be positive on average, but will be very low. The bulk of corporate bond excess returns are earned in Phase 1 of the cycle when the yield curve is very steep. Excess returns don’t turn decisively negative until after the curve inverts and we enter Phase 3. Like corporate credit, Treasury excess returns are also lower in Phase 2 than in Phase 1. This makes Phase 2 an awkward one for portfolio positioning. The expected return from taking an extra unit of credit risk is quite low, as is the expected return from taking an extra unit of duration risk. In fact, cash tends to be one of the best performing asset classes in Phase 2. The excess returns from most other spread products present a similar pattern to those from corporate bonds. Elevated excess returns in Phase 1, much lower – though typically still positive – excess returns in Phase 2, negative excess returns in Phase 3. One exception to this pattern is tax-exempt municipal debt which, outside of the mid-1990s cycle, has performed similarly or better in Phase 2 than it has in Phase 1. Domestic Agency bonds and Supranationals also stick out as being very defensive sectors. They both almost always provide a small positive excess return versus Treasuries, but never provide a large reward. In the remainder of this report we discuss the five key implications for U.S. bond portfolio positioning that follow from remaining in Phase 2 of the cycle for most of 2019. Key View #1: Below-Benchmark Duration We think below-benchmark portfolio duration positions will continue to pay off in 2019. We have already shown that Phase 2 of the cycle tends to coincide with relatively low excess Treasury returns, but the slope of the yield curve is not the best indicator for Treasury returns versus cash. For that, we turn to our Golden Rule of Bond Investing which says that Treasuries tend to underperform (outperform) cash on a 12-month investment horizon when the Fed delivers more (fewer) rate hikes than what was discounted at the beginning of the 12-month period (Chart 5).6 Chart 5The Golden Rule's Track Record The Golden Rule's Track Record The Golden Rule's Track Record At present, the market is priced for only 32 bps of rate hikes during the next 12 months. More specifically, the market is pricing-in a rate increase this month, followed by one more in 2019 and then rate cuts in 2020 (Chart 6). Chart 6Market's Rate Expectations Are Too Low Market's Rate Expectations Are Too Low Market's Rate Expectations Are Too Low This extremely depressed market pricing makes us reluctant to increase duration, even tactically. While we do expect U.S. growth to slow during the next few quarters, probably by enough to necessitate a pause in the Fed’s tightening cycle, this pause is already more than reflected in current market prices. Key View #2: Neutral Corporate Credit Cyclical Horizon (6-12 Months) Being in Phase 2 of the cycle warrants a relatively defensive posture toward credit risk. For now, we recommend a neutral allocation to corporate bonds with an up-in-quality bias. We will further reduce exposure to underweight when we transition to Phase 3 of the cycle, likely late in 2019. We also recommend looking at the long-end of the credit curve to increase the average spread of your portfolio.7 Table 2 makes the importance of correctly identifying the phase of the cycle even more apparent. It shows the excess returns to both investment grade and high-yield corporate bonds for different investment horizons directly after the 3/10 Treasury slope flattens into a given range. For example, the median excess return to investment grade corporate bonds in the 12 months after the 3/10 slope breaks below 25 bps is -1.02%. Table 2Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income As in Table 1, Table 2 shows that excess returns are much higher when the yield curve is steep and that they tend to turn negative after the curve inverts. But unlike the results in Table 1, the analysis in Table 2 includes recessionary periods and makes no attempt to split the cycle into different phases. It is a purely forward looking rule that calculates excess returns after different “trigger points” are reached. For example, the 12-month median excess return of -1.02% after the 3/10 slope breaks below 25 bps is biased downward because of periods when the slope broke below 25 bps and then continued to flatten until it inverted. An environment where the slope stayed range-bound between 0 bps and +25 bps for an extended period – closer to what we expect in 2019 – will deliver somewhat better excess returns. Tactical Horizon (< 6 Months) The phase of the cycle helps us specify our excess return expectations for the next 12 months, and based on our outlook, we expect excess returns will be positive, but close to zero. However, as we write this report, corporate spreads are widening at a fairly rapid clip. We expect the carnage will continue in the near-term, but are monitoring catalysts to initiate a tactical overweight recommendation on corporate credit.8 As they were in 2015, corporate spreads are widening at the moment due to the toxic combination of slowing global growth and relatively hawkish monetary policy. We expect that sometime in early 2019, Fed policy will ease at the margin and this will coincide with a near-term peak in credit spreads and a period of improved global growth. To determine when spreads peak we are monitoring several indicators of global growth and Fed policy that successfully called the last peak in early-2016. On the global growth side, the key indicators are (Chart 7A): The CRB Raw Industrials Index The BCA Market-Based China Growth Indicator9 The price of global industrial mining stocks On the monetary policy front, the key indicators are (Chart 7B): The 12-month Fed Funds Discounter The gold price The trade-weighted dollar Chart 7AKey Indicators: Global Growth Key Indicators: Global Growth Key Indicators: Global Growth Chart 7BKey Indicators: Monetary Policy Key Indicators: Monetary Policy Key Indicators: Monetary Policy All in all, our conviction that we will remain in Phase 2 of the cycle for most of 2019 suggests we should maintain a neutral allocation to corporate bonds on a 6-12 month investment horizon, looking for small positive excess returns. In the near-term, we expect spreads will continue to widen in the next few weeks, but will peak once the Fed signals a pause in its rate hike cycle and global growth indicators show some improvement. We are monitoring several catalysts that will help us decide when to initiate a tactical overweight position in corporate bonds. Key View #3: Overweight Munis And Local Authorities The analysis in Table 1 showed that tax-exempt municipal bonds often provide strong excess returns in Phase 2 of the cycle. This makes them an attractive place to position in the current environment, especially given the relative attractiveness of muni yields. Table 3 shows that the average yield on the Bloomberg Barclays Municipal Index is 2.75%. If we assume even a 30% effective tax rate, the taxable-equivalent yield becomes 3.93%, well above the average yield offered by the Aa-rated Corporate index. Table 3Municipals Are Attractive 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income Another reason to like munis in the current cycle is that state & local government revenues are relatively insulated from weakness in the global economy. As foreign growth weakens and drives up the dollar, corporate profits will suffer much more than state & local government tax revenues. A similar case can be made for the Local Authority sub-index of the Bloomberg Barclays Aggregate. This index is comprised largely of taxable municipal debt (and some Canadian provincial debt), and while the average yield is lower than for tax-exempt munis, it is still competitive compared to corporate bonds. But most importantly, the sector is relatively insulated from weak foreign growth and a strong dollar. Municipal bonds and the Local Authority sub-index are important overweights in our recommended portfolio as we head into 2019. Key View #4: Overweight TIPS Versus Nominal Treasuries Though long-maturity TIPS breakeven inflation rates have fallen in recent weeks, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. We believe that both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates will reach our target range of 2.3% to 2.5% in 2019. At present, TIPS breakevens are caught between being pulled down by weakening global growth and pushed up by mounting U.S. inflationary pressures (Chart 8). Most recently, weaker global growth has been winning and breakevens have moved lower alongside the plunge in oil prices. Chart 8TIPS Breakevens Face Opposing Forces TIPS Breakevens Face Opposing Forces TIPS Breakevens Face Opposing Forces Taking a step back, it is very unlikely that global growth and commodity prices will continue to fall at their current rates throughout 2019. At some point, a dovish turn from the Fed will lead to some depreciation of the dollar and global growth will stage a rebound. Our commodity strategists also expect a rebound in the oil price. They target an average of $82/bbl for Brent crude oil in 2019.10 In the meantime, core U.S. inflation will continue to print close to the Fed’s 2% target, and maybe even a bit higher in late 2019. At some point, inflation expectations will need to adapt to the new reality of inflation being near the Fed’s target. Historically, this suggests a range of 2.3% to 2.5% for TIPS breakeven inflation rates. Inflation expectations can be slow to adapt to a changing environment, and after several years of the Fed missing its inflation target from below, many investors remain trapped in a deflationary mindset. To get an idea of how long it takes inflation expectations to adjust to changes in the economy, we use our Adaptive Expectations Model of TIPS breakevens (Chart 9).11 The model is based on three factors: Chart 9The Adaptive Expectations Model Of The 10-Year Breakeven Rate The Adaptive Expectations Model Of The 10-Year Breakeven Rate The Adaptive Expectations Model Of The 10-Year Breakeven Rate The 12-month rate of change in headline CPI The New York Fed’s Underlying Inflation Gauge The 120-month rate of change in core CPI Of the three factors, the 120-month rate of change in core CPI carries the largest weight in the model. In other words, the catalyst for moving TIPS breakeven rates higher will simply be core U.S. inflation continuing to print near the Fed’s target for a prolonged period of time. All in all, investors should maintain overweight allocations to TIPS versus nominal Treasuries in 2019, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. The current slowdown in global growth and commodity prices will not last for the entire year, and U.S. inflationary pressures will continue to mount as the U.S. economy grows at an above-trend pace with a very tight labor market. Key View #5: No Yield Curve Inversion Until Late 2019 The final key view that falls out of our main macro premise, which is that the fed funds rate will remain below neutral for the bulk of 2019, is that the yield curve will not sustainably invert until late 2019. This is also probably the most contentious of our key views, given recent market moves. The main reason why we think the slope of the yield curve will remain quite flat, but positive, for most of 2019 is that sustainable yield curve inversion cannot coexist with below-target TIPS breakeven inflation rates. An inverted yield curve is a signal that the market views monetary policy as overly restrictive. It means that investors expect U.S. growth and inflation to fall in the future, necessitating rate cuts. However, long-maturity TIPS breakeven inflation rates below the 2.3% - 2.5% range that has historically been consistent with well-anchored inflation expectations signal that the market believes that inflation will not sustainably return to the Fed’s target. In other words, for an inverted yield curve and below-target TIPS breakeven inflation rates to coexist, we would have to believe that the Fed would tighten monetary policy into restrictive territory without sufficient inflationary pressures to meet its target. It is difficult to envision the Fed committing such an egregious policy error. In the event that the yield curve does invert while TIPS breakevens are below target, it is much more likely that either the Fed will adopt a more  dovish policy stance, leading to a bull-steepening of the curve; or, inflation will rise leading to higher TIPS breakevens and causing the curve to bear-steepen. In either scenario, it is hard to see how yield curve inversion will last very long without significantly higher TIPS breakevens. We will call an end to Phase 2 of the cycle only when the yield curve is inverted and long-maturity TIPS breakeven inflation rates are above 2.3%. Curve Positioning As for how to position on the yield curve in 2019, the biggest change since the end of last year is that the belly (5-7 year) of the curve is now very expensive (Chart 10). In fact, the 2/5 slope is slightly inverted as we go to press, meaning there is actually negative rolldown in the 5-year note. Chart 10Par Coupon Treasury Curve 2019 Key Views: Implications For U.S. Fixed Income 2019 Key Views: Implications For U.S. Fixed Income By far, the best place to position on the curve is the 2-year maturity point.12 Our model of the 1/2/5 butterfly spread (2-year bullet over duration-matched 1/5 barbell) shows that the 2-year is cheap relative to the 1/5 slope. Conversely, our model of the 2/5/10 butterfly spread shows that the 5-year bullet has become expensive relative to the 2/10 slope (Chart 11). Chart 11Favor The 2-Year Bullet Favor The 2-Year Bullet Favor The 2-Year Bullet Butterfly trades where you favor the bullet maturity versus the barbell perform well when the curve steepens. For example, the 2-year tends to outperform the 1/5 barbell when the 1/5 slope steepens. At present, the cheapness of the 2-year suggests that the butterfly spread is priced for significant 1/5 flattening in the coming months. Even stability in the 1/5 slope will cause the 2-year to outperform, and our key yield curve recommendation at the moment is to go long the 2-year bullet and short a duration-matched 1/5 barbell.   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1  Please see The Bank Credit Analyst, "OUTLOOK 2019: Late-Cycle Turbulence”, dated November 27, 2018, available at bca.bcaresearch.com 2  Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity?”, dated August 21, 2018, available at usbs.bcaresearch.com 5 We use the 3-year/10-year Treasury slope because it closely approximates the 2-year/10-year slope, but with more back-data. 6 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “What Kind Of Correction Is This?”, dated October 30, 2018, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 9 A combination of 17 different financial market variables that are highly levered to Chinese growth. Please see China Investment Strategy Weekly Report, “Trade Is Not China’s Only Problem”, dated November 21, 2018, available at cis.bcaresearch.com 10 Please see Commodity & Energy Strategy Weekly Report, “The Third Man At OPEC 2.0’s Meeting”, dated November 29, 2018, available at ces.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 12 Please see U.S. Bond Strategy Weekly Report, “The Sweet Spot On The Yield Curve”, dated November 13, 2018, available at usbs.bcaresearch.com

Feature An infrastructure bill has been the focus of economists and strategists as the next leg in fiscal easing to sustain the economy. On the face of it, such a thesis appears eminently believable. Despite historically low unemployment, 2018 has seen tremendous fiscal easing (Chart 1), both via the tax cuts at the end of 2017 and through the bipartisan spending agreement in early 2018, implying the current administration fears neither inflation nor deficits in its pursuit of economic growth. Further, after the Republicans’ shellacking in the midterm elections, it is also logical to expect the GOP to double down on their Trump card through the 2020 presidential election cycle. Chart 1An Already-Strong Fiscal Thrust An Already-Strong Fiscal Thrust An Already-Strong Fiscal Thrust As such, much hope has been placed in the passage of an infrastructure bill, which began in late 2016 following the election of the Trump administration and its promise “to invest $550 billion to ensure we can export our goods and move our people faster and safer”. The excitement surrounding infrastructure diminished following the passage of the Tax Cuts and Jobs Act and the implied much lower probability of an infrastructure bill in light of the debt implications of the unfunded tax cut. Further, the White House released their infrastructure plan in February, 2018 which sought only $200 billion in funding, but planned to stimulate $1.5 trillion in new investment via the multiplicative effect of public-private partnerships (PPP). However, the midterm elections have made infrastructure a hot topic once again for our clients. Is passage of an infrastructure bill likely? Would such a bill prolong the business cycle? At first glance, the market’s dimmed hopes of an infrastructure bill seem justified, in the context of the already-powerful fiscal thrust. Still, our sister Geopolitical Strategy service believes the odds of passage are above 50%.   BOX 1 Will Trump And The Democrats Pass An Infrastructure Bill? President Donald Trump, laser focused on reelection in 2020, faces a big decision about how to conduct domestic policy in the wake of the midterm election. Will he negotiate and compromise with the opposition in the House, like President Bill Clinton did after 1994? Or will he become mired in disagreements, like President Barack Obama after 2010? Infrastructure spending is one of the few areas where Trump and the Democrats have a clear basis for passing a major piece of legislation. It is much harder for these two to agree on immigration – given Trump’s demand for funding the border wall – or health care – given Trump’s opposition to Obama’s Affordable Care Act (Obamacare). By contrast, Trump campaigned vociferously on the need for more infrastructure and proposed a $1.5 trillion spending plan ($200 billion in federal funds) in February.1 Democrats are fully in support of infrastructure investment. The likeliest next Speaker of the House, Nancy Pelosi (D-CA), has been saying “build, build, build” both before and after the midterms, and her lieutenant, Representative Steny Hoyer (D-MD), has recently emphasized his eagerness to work with Trump on this issue. There is no doubt whether the public will approve – infrastructure spending always receives high levels of support, and it is one of the few policy areas unaffected by partisanship and polarization (Chart 2). Senate Majority Leader Mitch McConnell (R-KY) and Pelosi have begun negotiations and Democratic Representative Peter DeFazio (D-OR), likely the next head of the House Transportation Committee, has already outlined a plan. Chart 2U.S. Public Wants Infrastructure Spending BCA’s Outlook For Infrastructure Stocks BCA’s Outlook For Infrastructure Stocks The chief constraint is funding, obviously. Republicans want to use a limited amount of federal seed money in order to spur public-private partnerships but Democrats want direct federal funding sourced through indexing the federal fuel tax to inflation and issuing government bonds. There will have to be a new Democratic-authored bill, which may or may not merge with aspects of Trump’s plan.  How much money are we talking about? Trump’s plan called for $1.5 trillion over 10 years, of which $200 billion would be federal. Hence $20 billion in federal spending per year, but with cuts to existing programs. Some analysts have argued that Trump’s plan would actually have seen a net reduction in federal infrastructure spending over the long run due to its cuts to existing federal programs (which happen to be infrastructure-oriented) in order to offset his proposed spending increases. Democrats will insist on no cuts to existing programs, plus funding for new building.2   The mainstream Democrats are proposing $100 billion in new spending per year for 10 years, but this number includes zero cuts to existing programs. Mainstream Democrats are therefore asking for less in actual new spending than meets the eye, but are unlikely to go for less than Trump’s $20 billion. As a reference, President Obama’s last budget proposal was looking at $32 billion in federal infrastructure increases per year.3 An agreement on $20-$40 billion per year in new spending is not insurmountable given that both sides agree that they could raise the $0.18 per gallon tax on gasoline, which has not been raised since 1993 and is not indexed to inflation. Trump has proposed raising it by $0.25 per gallon, and this is more than other proposals (at $0.15 per gallon) or than merely indexing to inflation. This would raise an estimated $375 billion over 10 years.4 In addition, the Democrats are looking to revise aspects of Trump’s tax cuts to fund infrastructure. While Secretary of Treasury Steve Mnuchin says no one in the administration is considering paring back the recent sharp reductions in the corporate rate, Trump has already signaled willingness to negotiate on the corporate rate to provide for a middle-class tax cut. This suggests that modifications to his 2017 Tax Cut and Jobs Act are not out of the question as infrastructure funding. Signature pieces of major legislation help presidents get reelected. The tax cuts were a product of traditional conservative policy, with limited popularity, whereas a populist compromise to the tax cuts in order to fund an infrastructure package (as long as it is still a net tax cut from pre-2017) could produce a signature piece of legislation from Trump “the builder” going into 2020. In other words, Trump can refrain from vetoing a federal gasoline tax hike or an adjustment to his own corporate tax cuts in order to pass a popular infrastructure initiative. The Democratic opposition will have written the bill, so both parties would “share the blame.” And the Democrats in the Senate would only need 15-18 GOP Senators to support a profligate infrastructure plan. Given popular and presidential support, and that the GOP-controlled Senate agreed with the budget spending blowout in early 2018, we think that more than enough Republican Senators can go along with an infrastructure plan. The bill will come at a time when other major legislative options are on ice and when both Trump and the Democrats will need at least one achievement to sell to voters in 2020. Might the Democrats sabotage such a bill in order to deny the president any fiscal help ahead of the 2020 election? Possibly. But they would have to pretend to negotiate before pulling out of the deal. It could backfire mightily. Whereas passing a big infrastructure bill would demonstrate their ability to govern and would help them win over voters in the vital Midwestern battleground states, where collapsing bridges and poisonous water systems have made headlines. Bottom Line: There is a greater than 50% chance that a bill will pass. As a baseline estimate, a bill worth $200-$400 billion over ten years is a reasonable estimate for a bill that could pass in late 2019 or (less likely) early 2020. Needless to say, $200-$400 billion over 10 years is a far cry from headline numbers like $1.5 trillion. It is an even farther cry from the progressive Democrats’ “People’s Infrastructure Plan” which calls for $2 trillion over ten years. Net new spending of $20-$40 billion per year is about 10%-20% of existing annual infrastructure spending and only 0.1%-0.20% of American GDP.   In our examination, we will frequently reference the 2009 American Recovery and Reinvestment Act (ARRA), the most recent major infrastructure bill aimed at stimulating the economy. This bill cost $787 billion, of which $500 billion was cash outlays (the remainder was tax incentives). However, only $105 billion of the ARRA was targeted at infrastructure spending ($20 billion per year). Still using the 2009 ARRA as an analogy, the midpoint of high and low estimates from the CBO’s post-mortem of the ARRA’s efficacy, the ARRA added 1.1% to real GDP in 2009, followed by 2.4% in 2010. If we assume the goal of this bill is truly to prolong the business cycle to align with the election cycle, it stands to reason that time is of the essence. Further, the PPP requirements to achieve the $1.5 trillion in new investment envisaged by the White House raise a host of issues. Buy-in from private partners, the associated incremental planning and an assumed dearth of shovel-ready PPP-appropriate projects lead us to believe that a Q1 passage of a bill would be necessary for it to achieve its goals. Lastly, when the 2009 ARRA became effective, the unemployment rate was 8.3%. It is 3.7% now (Chart 3). We would anticipate an inflation-fearing Fed to deliver a monetary response to this fiscal slack in the form of interest rate hikes that would at least partially offset the stimulus. With two opposing forces pushing on the economy, it is ambiguous to us whether the stimulus would, in fact, stimulate. Chart 3Historically Low Unemployment Historically Low Unemployment Historically Low Unemployment What Drives Domestic Infrastructure Stocks Anyway? As equity strategists, our role is to offer clients insights into the best way to play the anticipated fiscal largesse. Accordingly, we have created an index from a range of industrials and materials GICS3&4 indexes that should see a positive reaction to a spur in infrastructure demand; we present the BCA Infrastructure Basket in Chart 4 with details of its constituents included in an appendix following this report. Chart 4BCA's Infrastructure Basket… BCA's Infrastructure Basket… BCA's Infrastructure Basket… Much like the initial excitement surrounding the prospect of an infrastructure bill following Trump’s election, our infrastructure basket leapt in November 2016. However the diminishing hopes of a bill, especially of the size discussed on the campaign trail, are reflected in the basket’s mostly steady decline from its late 2016 peak. This decline accelerated following the passage of the tax cuts at the end of 2017. A reasonable assumption would be that the price of our basket of equities would track in line, by and large, with most leading economic indicators as they are broadly a reflection of the industrial economy. Testing this hypothesis over the past 30 years is revealing: we found no material correlation between domestic leading indicators, even capital expenditures and planned capital expenditures that should be significant top line drivers (Chart 5). The upshot is that domestic private sector sentiment is unrelated to infrastructure stock performance. Chart 5...Is Not Correlated With Leading Indicators ...Is Not Correlated With Leading Indicators ...Is Not Correlated With Leading Indicators When plotted against the historic budget deficit and government debt levels, a better picture emerges (Chart 6). Our inference is that public spending and the infrastructure basket tend to move together, which is corroborated by the aforementioned recent moves around rising and falling hopes for a Trump infrastructure bill. Still, this analysis is incomplete as the infrastructure basket and fiscal growth were inversely correlated between 2004 and 2009 before reestablishing a positive relationship and even then the relationship is relatively loose. Chart 6Fiscal Expansion And Infrastructure Stocks Mostly In Sync Fiscal Expansion And Infrastructure Stocks Mostly In Sync Fiscal Expansion And Infrastructure Stocks Mostly In Sync Accordingly, we widened our analysis to global indicators excluding the U.S., where we found a significantly tighter correlation (Chart 7), though only post-2001. We ascribe the close post-2001 relationship to China’s joining of the WTO and their resulting ascendency in driving equity returns in the emerging market space. Chart 8 confirms our hypothesis; our infrastructure basket and the EM equity index overlap. Chart 7Global Leading Indicators Are Better Global Leading Indicators Have a Tighter Correlation Global Leading Indicators Have a Tighter Correlation Chart 8EM And Infrastructure Go Hand In Hand EM And Infrastructure Go Hand In Hand EM And Infrastructure Go Hand In Hand Drilling down on China seems appropriate in this context and further corroborates our assertion that China is increasingly the driver of U.S. domestic infrastructure stock performance. Particularly in the post-GFC era, the slowdown in Chinese capex and money supply growth appear to be the principal drivers of these stocks (second and bottom panels, Chart 9). This message is echoed when we compare the infrastructure basket to the Chinese credit growth impulse and the Keqiang index (Chart 10). Chart 9Chinese Growth Drives Domestic Infrastructure Stocks Chinese Growth Drives Domestic Infrastructure Stocks Chinese Growth Drives Domestic Infrastructure Stocks Chart 10Slowing Growth In China Points To A Down Leg bca.uses_sr_2018_12_10_c10 bca.uses_sr_2018_12_10_c10 Bottom Line: Domestic private sector sentiment has little impact on the BCA Infrastructure Basket, though U.S. government spending clearly has a significant impact on the performance of the stocks. Still, it appears that Chinese growth is at least as important as domestic government spending to the relative performance of the infrastructure basket. In light of BCA’s view of flat or slowing growth in China, at least for the year ahead, we would wait for a positive catalyst before adding this basket as a holding.  A Value Trap In The Making Investors may correctly point out that our infrastructure basket has already been beaten up and the stage may be set for a relief rally. In fact, the basket has already notched two months of outperformance, lifting it off its decade low relative to the S&P 500 (Chart 11). However, as shown in the middle panel of Chart 12, this rally has come while forward EPS growth estimates have trailed the broad market, meaning that the rally has been exclusively a valuation rerating rather than a fundamental turning point in earnings (bottom panel, Chart 12). Chart 11Fairly Valued Over Long Term... Fairly Valued Over Long Term... Fairly Valued Over Long Term... Chart 12...And A Value Trap In The Short Term ...And A Value Trap In The Short Term ...And A Value Trap In The Short Term Further, while the bear market for this basket of stocks is set to enter its second year, we would caution that a turning point may be further off in the distance than optimists may hope. Witness the six year period from 1995 to 2001 when the infrastructure basket dramatically underperformed the market (Chart 11). Valuations in the infrastructure basket were only a third of the broad market before a rally occurred, a far cry from where they are now. As well, the relative rally likely had more to do with the souring of the tech sector than a particular affection for infrastructure stocks; it took another five years for the basket to reach its average valuation. We would further note that on a longer-term basis, while still a discount to the broad market, valuations remain roughly in line with their historical average (Chart 11). Bottom Line: History has shown bear markets for infrastructure stocks can be deep and prolonged. Thus while the infrastructure basket is relatively cheap compared to the recent past, looking further back in history tells us that this may not be the case. Accordingly, we think the BCA Infrastructure Basket has all the markings of a value trap. So What Does It All Mean The passage of an infrastructure bill seems likely, though the form it will take remains subject to debate. As well, the timing and efficacy of such a bill may mean that it both undershoots expectations with respect to its size and eventual economic impact. The BCA Infrastructure Basket has tended to trade off of domestic fiscal expansion but EM in general and China in particular appear to have taken over as the core drivers of relative stock performance. While bearishness has reigned in this basket for the past year, we caution that this still looks like the early stages of underperformance. We would wait for a positive catalyst in the EM and/or China before chasing the BCA Infrastructure Basket. Details on the composition of this basket are in an appendix that follows.   Chris Bowes, Associate Editor chrisb@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix BCA’s Outlook For Infrastructure Stocks BCA’s Outlook For Infrastructure Stocks Footnotes 1      Please see the White House, “Legislative Outline for Rebuilding Infrastructure in America,” 2018, available at www.politico.com. 2      Please see Jacob Leibenluft, “Three Key Questions About The Trump Infrastructure Plan,” Center on Budget and Policy Priorities, January 30, 2018, available at www.cbpp.org. 3      Please see Senate Democratic Caucus, “Senate Democrats’ Jobs & Infrastructure Plan For America’s Workers,” March 7, 2018, available at www.democrats.senate.gov. 4      Please see Lauren Gardner, Tanya Snyder, and Brianna Gurciullo, “Trump endorses 25-cent gas tax hike, lawmakers say,” Politico, February 14, 2018, available at www.politico.com.

Highlights Chart 1Looking For Peak Credit Spreads Looking For Peak Credit Spreads Looking For Peak Credit Spreads   The sell-off in spread product continued through November, driven by that toxic combination of weakening global growth and tightening Fed policy. With spreads now looking more attractive, we have begun to search for catalysts that could throw the current sell-off into reverse. Chart 1 shows two catalysts that called the peak in credit spreads in early 2016: A move higher in the CRB Raw Industrials index – a sign of improving global demand – and a shift down in our 12-month Fed Funds Discounter – a sign of easier Fed policy. The recovery in the CRB index is so far only tentative, and despite Chairman Powell’s dovish tone last week, the Fed will need to see more credit market pain before hitting pause on the rate hike cycle. As such, we anticipate further spread widening during the next few months. On a cyclical (6-12 month) horizon, we continue to recommend a neutral allocation to spread product versus Treasuries and, given that the market is only priced for 44 bps of rate hikes during the next 12 months, a below-benchmark portfolio duration stance. Feature Investment Grade: Neutral Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 120 basis points in November, dragging year-to-date excess returns down to -216 bps. The index option-adjusted spread widened 19 bps on the month and currently sits at 137 bps. Corporate bonds are no longer expensive. The 12-month breakeven spread for Baa-rated debt is almost back to its average historical level (Chart 2). However, as was noted in last week’s report and on the first page of this report, the combination of weakening global growth and Fed tightening makes further widening likely in the near term.1 Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview A period of outperformance will follow the current bout of spread widening once global growth re-accelerates and/or the Fed adopts a more dovish policy stance. Therefore, on a cyclical (6-12 month) horizon we maintain a neutral allocation to corporate bonds. Pre-tax corporate profits grew 22% (annualized) in Q3 and a stunning 16% during the past year, well above the rate of corporate debt accumulation (bottom panel). But going forward, the stronger dollar and accelerating wages will cause profit growth to slow in the first half of 2019, triggering a renewed increase in gross leverage (panel 4). With that in mind, we continue to recommend that investors maintain an up-in-quality bias within a neutral allocation to corporate bonds. We prefer to pick-up extra spread by favoring the long-end of the credit curve.2 High-Yield: Neutral High-Yield underperformed the duration-equivalent Treasury index by 155 basis points in November, dragging year-to-date excess returns down to +4 bps. The average index option-adjusted spread widened 47 bps on the month, and currently sits at 418 bps. Our measure of the excess spread available in the High-Yield index after accounting for default losses is currently 308 bps, nicely above its long-run average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast during the next 12 months, high-yield bonds will return 308 bps in excess of duration-matched Treasuries, assuming no change in spreads. Factoring-in enough spread compression to bring the default-adjusted spread back to its historical average leads to an expected excess return of 534 bps. Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview For a different perspective on valuation, we can also calculate the default rate necessary for the High-Yield index to deliver 12-month excess returns in line with the historical average. As of today, this spread-implied default rate is 3.20%, well above the 2.26% default rate anticipated by Moody’s (panel 4). While the elevated spread-implied default rate is certainly a sign of improved value, our sense is that the actual default rate will end up closer to the spread-implied level than to the level expected by Moody’s. Job cut announcements – an excellent indicator of corporate defaults – have put in a clear bottom (bottom panel) and the third quarter Senior Loan Officer Survey showed a decline in C&I loan demand, often a precursor of tighter lending standards.3  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* More Pain Required More Pain Required   Table 3BCorporate Sector Risk Vs. Reward* More Pain Required More Pain Required MBS: Neutral Mortgage-Backed Securities performed in line with the duration-equivalent Treasury index in November, keeping year-to-date excess returns steady at -43 bps. The conventional 30-year zero-volatility spread was flat on the month. A basis point widening in the option-adjusted spread (OAS) was offset by a basis point drop in the compensation for prepayment risk (option cost). Although very low mortgage refinancings have kept overall MBS spreads tight, the option-adjusted spread has widened in recent months, bringing some value back to the sector (Chart 4). Chart 4MBS Market Overview MBS Market Overview MBS Market Overview In last week’s report we ran a performance attribution on excess MBS returns for 2018.4 We found that interest rate volatility had been a drag on MBS returns early in the year, but the sector’s most recent underperformance was almost entirely due to OAS widening. Mortgage refinancing risk, typically the most important risk factor, contributed positively to excess returns throughout most of the year. With Fed rate hikes likely to keep refinancings low, and with mortgage lending standards still easing from restrictive levels (bottom panel), the macro back-drop remains very supportive for MBS spreads. We maintain a neutral allocation to the sector for now, but will likely upgrade when it comes time to further pare our allocation to corporate credit. Government-Related: Underweight The Government-Related index underperformed the duration-equivalent Treasury index by 33 basis points in November, dragging year-to-date excess returns down to -50 bps. Sovereign debt underperformed the Treasury benchmark by 70 bps, dragging year-to-date excess returns down to -188 bps. Foreign Agencies underperformed by 68 bps, dragging year-to-date excess returns down to -128 bps. Local Authorities underperformed by 51 bps, dragging year-to-date excess returns down to +11 bps. Supranationals outperformed Treasuries by 5 bps, bringing year-to-date excess returns up to +19 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to +1 bp. Sovereign debt has underperformed this year, but spreads remain expensive compared to U.S. corporate credit and the dollar’s recent strength suggests that the sector will continue to struggle (Chart 5). Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview In a recent report we looked at USD-denominated Emerging Market Sovereign debt by country and found that only a few nations offer excess spread compared to equivalently-rated U.S. corporates.5 Those countries are Argentina, Turkey, Lebanon and Ukraine at the low-end of the credit spectrum and Saudi Arabia, Qatar and UAE at the upper-end. 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 underperformed the duration-equivalent Treasury index by 6 basis points in November, dragging year-to-date excess returns down to +99 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell 2% in November, and currently sits at 86% (Chart 6). This is about one standard deviation below its post-crisis mean and only slightly above the average of 81% that was observed 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 1975, 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 -11 bps. In contrast, municipal bonds have delivered annualized excess returns of +156 bps before adjusting for the tax advantage. We attribute this mid-cycle outperformance to the fact that state & local government balance sheet health tends to lag the health of the corporate sector. At present, our Municipal Health Monitor remains in “improving health” territory, consistent with an environment where ratings upgrades will outpace downgrades (bottom panel). Meanwhile, corporations are already deep into the releveraging process. Treasury Curve: Favor The 2-Year Bullet Over The 1/5 Barbell Treasury yields fell in November, led by the 5-10 year maturities. The 2/10 slope flattened 7 bps to end the month at 21 bps. The 5/30 slope steepened 5 bps to end the month at 46 bps. In a recent report we demonstrated that the best place to position on the Treasury curve has shifted from the 5-7 year maturity point to the 2-year maturity point.6 Our sense is that the 2-year note offers the best combination of risk and reward of any point on the Treasury curve, both in absolute and duration-neutral terms. The 2/5 Treasury slope was 31 bps at the beginning of 2018, but has flattened all the way down to 4 bps over the course of this year. Factoring in the greater roll-down at the short-end of the curve, we find that the 2-year note would actually outperform the 5-year note in an unchanged yield curve scenario. This sort of carry advantage in the 2-year note is relatively rare, and tends to occur only when the yield curve is inverted. Attractive compensation at the front-end of the curve provides an opportunity for investors to buy the 2-year note and short a duration-matched 1/5 barbell. Our model shows that the 2 over 1/5 butterfly spread is priced for 18 bps of 1/5 flattening during the next six months (Chart 7). In other words, if the 1/5 slope steepens or flattens by less than 18 bps, our position long the 2-year and short the 1/5 will outperform.   Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview TIPS: Overweight TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in November, dragging year-to-date excess returns down to +21 bps. The 10-year TIPS breakeven inflation rate fell 8 bps on the month and currently sits at 1.97%. The 5-year/5-year forward TIPS breakeven inflation rate fell 3 bps on the month and currently sits at 2.17%. Long-maturity TIPS breakeven inflation rates finally capitulated and have fallen sharply alongside the prices of oil and other commodities during the past two months. Breakevens continue to grapple with the competing forces of falling commodity prices on the one hand, and relatively strong U.S. inflation on the other. Eventually, the decisive factor in the TIPS market will be core U.S. inflation continuing to print close to the Fed’s 2% target. This will drive both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates back into a range between 2.3% and 2.5%, although the headwind from weak commodity prices could persist for a while longer. In a recent report we showed that the 10-year TIPS breakeven rate is very close to the fair value reading from our Adaptive Expectations Model (Chart 8).7 This model is based on a combination of long-run and short-run inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. In other words, the market will need to see core inflation print close to the Fed’s target for some time before deciding that it will remain there on a sustained basis.    Chart 8Inflation Compensation Inflation Compensation Inflation Compensation ABS: Neutral Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in November, dragging year-to-date excess returns down to +21 bps. The index option-adjusted spread for Aaa-rated ABS widened 4 bps on the month and now stands at 42 bps, 8 bps above its pre-crisis low. The Fed’s Senior Loan Officer Survey for Q3 showed that average consumer credit lending standards eased for the first time since early 2016 (Chart 9). Consistent with a somewhat more supportive lending environment, the consumer credit delinquency rate has been roughly flat on a year-over-year basis. However, given the continued uptrend in household interest coverage, consumer credit delinquencies are biased higher (panel 4). Chart 9ABS Market Overview ABS Market Overview ABS Market Overview The excess return Bond Map on page 15 shows that consumer ABS offer greater expected returns 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. We maintain a neutral allocation to consumer ABS for now. As consumer credit delinquencies continue to rise, our next move will likely be a reduction to underweight. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 37 basis points in November, dragging year-to-date excess returns down to +82 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps on the month and currently sits at 80 bps (Chart 10). Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview A typical negative environment for CMBS is characterized by tightening bank lending standards on commercial real estate loans as well as falling demand. The Fed’s Q3 Senior Loan Officer Survey showed that lending standards are close to unchanged and that demand deteriorated. All in all, a slightly negative macro picture for CMBS that will bear close monitoring in the coming quarters. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in November, dragging year-to-date excess returns down to +14 bps. The index option-adjusted spread widened 5 bps on the month and currently sits at 56 bps. The Bond Maps on page 15 show that Agency CMBS offer high potential return compared to other low risk spread products. An overweight allocation to this sector continues to make sense. The BCA Bond Maps The following page presents excess return and total return Bond Maps that we use to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Maps employ volatility-adjusted breakeven spread/yield analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Maps do not impose any macroeconomic view. The Excess Return Bond Map The horizontal axis of the excess return Bond 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 in excess of Treasuries. The Total Return Bond Map The horizontal axis of the total return Bond Map shows the number of days of average yield increase required for each sector to lose 5% in total return terms. Sectors plotting further to the left require more days of yield increases and are therefore less likely to lose 5%. The vertical axis shows the number of days of average yield decline required for each sector to earn 5% in total return terms. Sectors plotting further toward the top require fewer days of yield decline and are therefore more likely to earn 5%. Chart 11Excess Return Bond Map (As Of November 30, 2018) More Pain Required More Pain Required   Chart 12Total Return Bond Map (As Of November 30, 2018) More Pain Required More Pain Required   Table 4Butterfly Strategy Valuation (As Of November 30, 2018) More Pain Required More Pain Required   Table 5Discounted Slope Change During Next 6 Months (BPs) More Pain Required More Pain Required ​​​​​​​   Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com​​​​​​​ Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What Kind Of Correction Is This?”, dated October 30, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Checklist For Peak Credit Spreads”, dated November 27, 2018, available at usbs.bcaresearch.com 5 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 6 Please see U.S. Bond Strategy Weekly Report, “The Sweet Spot On The Yield Curve”, dated November 13, 2018, available at usbs.bcaresearch.com 7 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 Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

Highlights Portfolio Strategy Higher interest rates, with the Federal Reserve tightening monetary policy three more times in the next seven months, will be the dominant theme next year. All four of our high-conviction underweight calls are levered to this theme. The later stages of the U.S. capex upcycle underpin three of our high-conviction overweight calls for 2019. Recent Changes Downgrade the S&P Home Improvement Retail index to underweight today. Trim the S&P Interactive Media & Services index to a below benchmark allocation today.  Table 1 2019 Key Views: High-Conviction Calls 2019 Key Views: High-Conviction Calls Feature Fed policy will dominate markets next year as the dual tightening backdrop – rising fed funds rate and accelerated downsizing of the Fed balance sheet – remains intact. Two weeks ago we raised the question: is the Fed tightening monetary policy too far too fast?1 In more detail, we put the latest monetary tightening cycle in historical perspective and examined trough-to-peak moves in the fed funds rate since the 1950s (Chart 1). Chart 1Too Far Too Fast? Too Far Too Fast? Too Far Too Fast? A good friend I call “the smartest man in California” correctly pointed out that 500bps of tightening today is not the same as in the 1970s or 1980s. Chart 2 adjusts for that by including the average nominal GDP growth rate during these tightening episodes and adds more color to each era. As a reminder, the latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect, and above-average nominal output growth. Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median 2019 Key Views: High-Conviction Calls 2019 Key Views: High-Conviction Calls Trying to answer the question, we are concerned that as the Fed remains committed to tighten monetary policy three more times by mid-2019, a yield curve inversion looms, especially if the U.S. economy suffers a soft patch in the first half of next year (please refer to our Economic Impulse Indicator analysis in the October 22ndand November 19th Weekly Reports). This would signal at least a pause, if not reversal, in Fed policy. With that in mind, this week we are revealing our high-conviction calls for 2019. Four of our calls are a play on this tightening monetary backdrop that is one of BCA’s themes for next year.2 The later stages of the U.S. capex upcycle underpin three of our high-conviction calls. Table 22018 High-Conviction Calls Recap 2019 Key Views: High-Conviction Calls 2019 Key Views: High-Conviction Calls However, before we highlight our 2019 high-conviction calls in detail, Table 2 tallies our calls from last year. We had a stellar performance in our 2018 high-conviction calls with an average excess return of 11.6% versus the S&P 500. As the year turns the corner, closing out the remaining calls brings down the average relative return to 7.5%, still a very impressive number, with a total of ten hits and only two misses for the year.    Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com     Software (Overweight, Capex Theme) Software stocks are our first hold out from last year’s high-conviction overweight list, levered to the capex upcycle theme. Chart 3 shows that relative capital outlays and the share price ratio are joined at the hip. Software upgrades offer the simplest, quickest and most effective capital deployment, especially when productivity gains ground to a halt. Importantly, leading indicators of overall capex remain upbeat and should continue to underpin software profits. Beyond capex, M&A has been fueling software stock prices. It did not take long for the large CA acquisition to get surpassed by RHT and more recently SYMC was also rumored to be in play (Chart 3). Inter-industry M&A activity is reaching fever pitch and this frenzy is bidding up premia to stratospheric levels. The push to the cloud, SaaS and even AI has boosted the appeal of software stocks and brought them to the forefront of potential takeout candidates. These are secular trends and will likely continue to gain steam irrespective of the different stages in the business cycle. As a result, software stocks should remain core tech holdings in equity portfolios. The recovery in the software price deflator (Chart 3), a proxy for industry pricing power, corroborates the upbeat demand backdrop. With regard to financial statements, software stocks have pristine balance sheets with more cash on hand than debt, which sustains the net debt-to-EBITDA ratio in negative territory. Interest coverage is great at 10x and free cash flow generation is expanding smartly. The ticker symbols for the stocks in this index are: BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, RHT, ADSK, SNPS, CTXS, ANSS, CDNS, FTNT and SYMC. Chart 3Software Software Software   Air Freight & Logistics (Overweight, Capex Theme) Air freight & logistics stocks are the second hold out from our high-conviction overweight list, although we added it to list only in late-March. This transportation sub-index laggered is a capex and trade de-escalation play for the first half of 2019. Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 4). On that front, there are high odds that this holiday sales season will be another record setting one, as wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (Chart 4). Firming industry operating metrics also tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures. While the U.S./China trade tussle and the appreciating greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals (Chart 4). The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Chart 4Air Freight & Logistics Air Freight & Logistics Air Freight & Logistics   Defense (Overweight, Capex Theme) We have been overweight the pure-play BCA defense index since late-2015 and there are high odds that this juggernaut that really commenced with the George Walker Bush presidency remains in a secular growth trajectory. Our strategy is to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index. The recent drawdown offers such an opportunity and we are adding this index to the 2019 high-conviction overweight list. The rise of global "multipolarity" - or competition between the world's great nations - and the decline of globalization, along with a global arms race and increased risk of cyber-attacks, have been documented in our "Brothers In Arms" Special Report. These trends all signal that global defense related spending will remain upbeat in the coming decade.3 In the U.S. in particular, where military spending in absolute terms is greater than the rest of the world put together, defense spending and investment have bottomed and will continue to accelerate (Chart 5). In fact, the CBO continues to project that defense outlays will jump further next year. While such a breakneck pace is clearly unsustainable, President Trump is serious about upgrading and updating the U.S. military in order to keep China's geopolitical and military ascendancy in check (as well as to deal with Russia and Iran).4 The upshot is that defense outlays will continue to expand into the 2020s. Such a buoyant demand backdrop is music to the ears of defense contractor CEOs, and represents a boost to defense equity revenue growth prospects. This capital goods sub-industry has extremely high fixed costs and thus any increase in top line growth flows straight to the bottom line. Put differently, defense contractors enjoy high operating leverage. No wonder M&A activity is robust: at least four large deals have been announced in the past year that are underpinning takeout premia. A closer look at operating metrics corroborates that defense goods manufacturers are firing on all cylinders. New orders recently jumped to fresh all-time highs and the industry's shipments-to-inventories ratio is rising, on track to surpass the 2008 peak. Unfilled orders are also running at a high rate, signaling that factories will keep on humming at least for the next few quarters. Importantly, the industry is not standing still and is making significant investments. U.S. defense capex as reported in the financial statements of constituent firms is growing at roughly 20%/annum or twice as fast as overall capex (Chart 5 on page 7). While interest coverage has been modestly deteriorating, it is twice as high as the overall market (Chart 5 on page 7). Impressively, defense ROE is running near 30%, again roughly double the rate of the broad market. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN. Chart 5Defense Defense Defense   Consumer Discretionary (Underweight, Higher Fed Funds Rate Theme) We recommend investors avoid the consumer discretionary sector that suffers when interest rates rise. Chart 6 depicts this inverse correlation consumer discretionary equities have with interest rates, especially the fed funds rate. Most discretionary equites are levered off of floating rates and thus any increase in the fed funds rates gets reflected immediately in banks' prime lending rate. Also, most consumer debt is floating rate debt and thus tighter monetary conditions, at the margin, dampen consumer debt uptake and, as a knock-on effect, weigh on discretionary consumer outlays. Recently we highlighted that, now that the Fed has been raising rates and allowing bonds to roll off its balance sheet, volatility is making a comeback. Unsurprisingly, the consumer discretionary share price ratio is inversely correlated with the VIX index, signaling that more pain lies ahead for this early cyclical index (VIX shown inverted, Chart 6). Sentiment and technical indicators also point to more downside ahead for this interest-rate sensitive index. Our sector advance/decline line is waning and EPS breadth has plunged. Worrisomely, sell-side analysts are penciling in an extremely optimistic 5-year outlook with EPS growth 23.4%/annum or 1.4 times higher than the overall market. Clearly this is not realistic as it assumes a tripling of EPS in the coming 5 years. Relative EPS estimates have already given way as AMZN commands very little EPS weight, despite its massive market cap weight (30% of the S&P consumer discretionary sector), and suggests that relative share prices will converge lower (Chart 6 on page 9). As a result, the 12-month forward P/E ratio is trading at a 24% premium to the broad market and significantly above the historical mean. Technicals are almost as extended as relative valuations and cyclical momentum has likely peaked, warning that a downdraft in relative share prices looms (Chart 6 on page 9). Chart 6Consumer Discretionary Consumer Discretionary Consumer Discretionary   Home Improvement Retail (Underweight, Higher Fed Funds Rate Theme) While the probablity of a housing recession remains low, we are concerned that too much euphoria is already priced in the S&P home improvement retail (HIR) index, and there are high odds that next year HIR will suffer the same fate as homebuilders did this year (Chart 7). Thus, we are downgrading the S&P HIR index to underweight and adding it to the high-conviction underweight list for 2019. Fixed residential investment (FRI) as a percentage of GDP is up 50% from trough to the recent peak, whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass as FRI is steadily sinking (Chart 7). Worrisomely, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 7). Lumber deflation will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone. Finally, there is rising supply of new and existing homes for sale already on the market, and that puts off remodeling activity at least until this supply glut clears (months' supply shown inverted, Chart 7). The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Chart 7Home Improvement Retail Home Improvement Retail Home Improvement Retail   Short Small Caps/Long Large Caps (Higher Fed Funds Rate Theme) The days in the sun are over for small cap stocks and we are compelled to put the size bias favoring large caps in our high-conviction calls list for 2019. Small caps are severely debt saddled. Sustained small cap balance sheet degradation is worrying, with S&P 600 net debt-to-EBITDA close to 4 compared with less than 2 for the SPX (Chart 8). Such gearing is fraught with danger as the default rate has nowhere to go but higher. Small and medium enterprises (SMEs) have a higher dependency on bank credit as opposed to the bond market access that mega caps enjoy. Most bank credit is floating rate debt and so are lines of credit, and as the Fed remains firm on tightening monetary policy, interest expense costs are skyrocketing for SMEs. In a relative sense this will weigh on net profits. Moreover, small caps are a lot more sensitive to interest rates, and the selloff in the 10-year Treasury note heralds more pain in 2019 (Chart 8). Small caps are high(er) beta stocks and when volatility spikes they underperform large caps. When the Fed ballooned its balance sheet and dropped the fed funds rate to zero it suppressed volatility. Now that the Fed has been decreasing the size of its balance sheet and raising interest rates, this is working in reverse and volatility is making a comeback as we have been highlighting in our research, and will continue to weigh on small caps (VIX shown inverted, middle panel, Chart 8). Another way to showcase small caps' riskier status is the close correlation they have with the relative EM equity share price ratio. When EMs outperform the SPX, small caps follow suit and vice versa. Importantly a wide gap has opened recently and we suspect that it will narrow via small caps following the EM higher beta stocks lower (SPX vs. EM ratio shown inverted, fourth panel, Chart 8 on page 12). Chart 8Small Vs. Large Small Vs. Large Small Vs. Large   Interactive Media & Services (Underweight, Higher Fed Funds Rate Theme) In our initiation of coverage on the S&P interactive media & services index,5 we highlighted three key risks that offset the revenue & profit growth vigor of this group, comprised almost entirely of Alphabet (Google) and Facebook. These were a renewed regulatory focus, rapid unpredictable changes in tastes & technology and an appreciating U.S. dollar. It is the first of these that has risen most dramatically since that report. Tack on the inverse correlation these growth stocks have with interest rates (top panel, Chart 9) and that is causing us to lower our recommendation to underweight and include this index in the high-conviction underweight list for 2019. Increasing regulatory efforts on technology will be a key theme next year, one we explored this past summer.6 Our conclusion was that both antitrust (particularly in the case of Alphabet) and privacy regulation (particularly in the case of Facebook) added significant risk to these near monopolies; calls for legislating both have dramatically amplified. Tim Cook, Apple’s CEO, recently commented that more regulation for Facebook and Alphabet was inevitable; we agree. While the form such regulation might take remains open to debate (for example, the U.S. could adopt an EU-style General Data Protection Regulation (GDPR)), we fear the associated headline risk (not to mention likely profit headwinds) will impair stock prices in the S&P interactive media & services index. This communication services sub-index is particularly prone to such a risk when it already trades at close to a 40% valuation premium to the broad market (middle panel, Chart 9 on page 14). Adding insult to injury is the PEG ratio that is trading at a 60% premium to the broad market (bottom panel, Chart 9 on page 14). In the face of the Fed’s sustained tightening cycle these extreme growth stocks are vulnerable to massive gravitational pull. The ticker symbols in the stocks in this index are: S5INMS – GOOGL, GOOG, FB, TWTR and TRIP. Chart 9Interactive Media & Services Interactive Media & Services Interactive Media & Services Footnotes 1      Please see BCA U.S. Equity Strategy Report, "Manic Market," dated November 19, 2018, available at uses.bcaresearch.com. 2      Please see BCA The Bank Credit Analyst Report, "OUTLOOK 2019: Late-Cycle Turbulence", dated November 26, 2018, available at bca.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Special Report, "Brothers In Arms," dated October 31, 2016, available at uses.bcaresearch.com. 4      Please see BCA Geopolitical Strategy Special Report, "A Global Show Of Force?" dated October 10, 2018, available at gps.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Special Report, "New Lines Of Communication," dated October 1, 2018, available at uses.bcaresearch.com. 6      Please see BCA U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?", dated August 1, 2018, available at uses.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Dear Client, Early next week, we will be sending you our BCA Outlook 2019 - our annual dialogue with the bearishly inclined Mr. X and his family. In this report, BCA editors will highlight the most impactful themes for the global economy next year, and the opportunities and risks they create for international asset markets. Next Friday, we will also send you our take on the implications of this discussion for the FX market. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights A bearish consensus is forming around the dollar for 2019 as U.S. growth is falling prey to global economic deterioration. However, slowing global growth and inflation create the best environment for the dollar, suggesting the greenback could perform very well in early 2019. While EUR/USD should trade below 1.10 before mid-2019, the dollar should be strongest against the AUD, the NZD and the SEK. The yen faces a trickier picture. With a low degree of conviction, we anticipate USD/JPY to depreciate; but with a high level of confidence, we foresee additional strength in the JPY against the AUD, the NZD and the SEK; EUR/JPY should move below 120. Close short CAD/NOK. Feature The end of the year is approaching, which means that like BCA, banks and research houses around the world are rolling out their major forecasts for the upcoming year. The near-uniform bearishness toward the greenback of the current vintage of forecasts has struck us. Our contrarian streak inclines us to re-assert our bullish dollar stance, but being contrarian for the sake of it is often the perfect recipe to lose money. Welcome To The Jungle A bearish tone on the dollar appears justified right now. Speculators hold near-record long bets on the dollar, yet U.S. economic data seem to finally be succumbing to the gravitational pull of slowing global economic activity. U.S. core inflation has disappointed, orders have been weak, capex intentions have softened, the Conference Board's leading economic indicator has rolled over, and financial conditions have tightened as junk bonds have sold off. This combination could easily generate the perfect recipe for the dollar to sell off. The dollar's strength has been rooted in the divergence of U.S. growth from a weak world economy (Chart I-1). As the narrative goes, without U.S. strength, the Federal Reserve will not be tightening policy anymore, and the dollar will sag. Interest rate markets are already on this page, as after the December meeting they only foresee one more rate hike over the coming two years. Chart I-1Will The Dollar Lose A Key Support? Will The Dollar Lose A Key Support? Will The Dollar Lose A Key Support? Despite this tantalizing narrative, the dollar rarely weakens because of poor U.S. growth alone. To the contrary, dives in our diffusion index of 16 key U.S. economic variables are most often associated with a strengthening greenback (Chart I-2). The recent sharp fall in this diffusion index would actually point to an appreciating USD. Chart I-2The Plot Thickens The Plot Thickens The Plot Thickens This relationship is obviously paradoxical. It exists because the dollar is not a normal currency: it is the premier reserve currency of the world. Resting at the center of the global financial system, the dollar is more sensitive to global growth and inflation conditions than to U.S. growth and policy alone. As Chart I-3 shows, the dollar's behavior is a function of where we stand in the global economic and inflation cycle. We looked at the performance of G-10 currencies versus the dollar since 1986, decomposing the period in four samples based on trends in global activity and global headline inflation. We observed the following patterns: When global growth is accelerating but inflation is decelerating, the dollar tends to weaken, especially against the very pro-cyclical AUD, NZD and SEK (Bottom right quadrant). This is often an environment observed in the early days of a business cycle recovery. When global growth and global inflation are both accelerating, the dollar also tends to weaken, but the pattern is much less clear than in the previous stage (Top right quadrant). This is generally a mid-cycle environment. When global growth is decelerating but global inflation is accelerating, the dollar weakens much more clearly than in the mid-cycle stage (Top left quadrant). In this stage, global growth has begun to decelerate but is still elevated. Risk assets are doing well, but some clouds are gathering on the horizon. European currencies perform best. The most distinct change in the dollar's behavior happens when both global growth and global inflation are decelerating (Bottom left quadrant). In this context, the dollar is strong across the board. This is an end-of-cycle environment where global growth is poor and inflation sags. Investors become very risk averse and they favor the dollar. Commodity currencies and Scandinavian currencies are the worst performers, while the yen is the best. We were surprised that the yen did not manage to appreciate during the periods described by the bottom-left quadrant. However, this is due to the long sample used (since 1986). Prior to the mid-1990s, the yen was a decidedly pro-cyclical currency. This taints the study's overall results. If we only use a shortened time span, the yen in fact appreciates in the last stage of the global business cycle. The yen is the only currency to experience such a sharp regime shift in its relationship to the global business cycle. Chart I-3The Dollar And The Global Business Cycle Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Bottom Line: Dividing the business cycle into four periods shows that only when global growth and inflation are very weak can the dollar unequivocally rally. This is exactly what we would anticipate of a reserve currency. Investors flock to it when they are looking for safety. Moreover, since being the global reserve currency also means that most of the world's foreign-currency borrowing is in dollars, periods of tumult force debtors to repay their debt, prompting them to buy the greenback in the process. Finally, the low beta of the U.S. economy to the global industrial cycle only adds fuel to the fire, as it means that U.S. growth outperforms global growth when global activity deteriorates meaningfully. Paradise City Under this lens, the dollar's strength this year was rather impressive. We have seen global growth slow, but global inflation accelerate. This could have been a disastrous year for the dollar, but it was not. Markets have been sniffing out slower growth and its potentially deflationary impact; hence, the dollar has responded well. Moreover, the dollar started the year trading at a 5% discount to its fair value, and investors were massively short. Finally, as we have previously showed, the dollar is the epitome of momentum currencies within the G-10 space, and this year, our momentum measure flagged a very bullish signal for the dollar (Chart I-4).1 Chart I-4Momentum Has And Continues To Support The Greenback Momentum Has And Continues To Support The Greenback Momentum Has And Continues To Support The Greenback While the dollar has already been strong, the next three to six months could generate considerably more dollar strength. The dollar may not be cheap anymore, but as we argued last week, it is not expensive either.2 Moreover, while investors are already very long the dollar - a source of concern for us - momentum still favors the greenback. Finally, the global economy might spend some time in the bottom-left quadrant described above where global growth and global inflation both decelerate - the quadrant where the dollar strengthens. Thus, both momentum and economics could line up to enhance the dollar's appeal. First, we have already highlighted that global growth is in the process of weakening. Under the weight of China's deleveraging efforts, of uncertainty surrounding global trade under the Trump administration, and of the tightening in EM financial conditions, global export growth has been flailing.3 Now, our global economic and financial advance/decline line shows that enough variables are pointing in a growth-negative direction that global industrial production - not just orders and surveys - is set to deteriorate sharply (Chart I-5). Chart I-5Global Growth Will Slow Materially In The First Half Of 2019 Global Growth Will Slow Materially In The First Half Of 2019 Global Growth Will Slow Materially In The First Half Of 2019 This message is confirmed by the OECD's leading economic indicator, which is falling faster than it was in late 2015. Most crucially, the very poor performance of EM carry trades financed in yen, which have been a reliable forecaster of global industrial activity, point to a sharp deterioration of our Global Nowcast (Chart I-6), an indicator that measures the evolution of global industrial activity while bypassing the long publishing lags inherent in global IP statistics. Chart I-6The Canaries Are Suffocating The Canaries Are Suffocating The Canaries Are Suffocating Second, while global inflation has been on an uptrend, we expect it to soon relapse, potentially for six months or so. To begin with, we are already seeing some key global inflation measures soften. Recent U.S. core inflation releases have disappointed, Japan's GDP deflator has grown more negative, Germany's producer prices have decelerated, and both producer and core consumer prices in China are slowing sharply. If we are to believe financial markets, this development has further to run. The change in 10-year and 5-year/5-year forward U.S. inflation break-evens has collapsed, and the performance of U.S. industrial stocks relative to utilities suggest that global core inflation will soon decelerate noticeably (Chart I-7). Additionally, the annual total returns of EM equities relative to EM bonds, adjusted for their mutual volatility, has fallen, which normally also foreshadows a decline in underlying global inflation (Chart I-8). Chart I-7U.S. Financial Market Point To Slower Global Inflation... U.S. Financial Market Point To Slower Global Inflation... U.S. Financial Market Point To Slower Global Inflation... Chart I-8...So Do EM Stocks And Bonds ...So Do EM Stocks And Bonds ...So Do EM Stocks And Bonds The trend in some of the most important globally traded good prices is also very worrisome for inflation hawks, at least for the first half of 2019. Oil has fallen 26% since its October peak, but also, after rising nearly 90% from April to August, the Baltic Dry index has tumbled by nearly 45%. Another risk could exacerbate these deflationary forces: the Chinese yuan. The Chinese authorities are afraid of the potentially deeply negative impact on their economy of a trade war with the U.S. As a result, they have slowly been injecting monetary stimulus into the economy and are also adjusting fiscal policy to support the Chinese consumer. However, until now, these measures have not been enough to lift Chinese growth and investment. Chinese interest rates are thus likely to continue to lag behind U.S. rates. Deeper cuts to the reserve requirement ratio for commercial banks are also forthcoming. Historically, these developments have been associated with a weaker renminbi (Chart I-9). Chart I-9A Falling CNY Will Further Curtail Inflation A Falling CNY Will Further Curtail Inflation A Falling CNY Will Further Curtail Inflation A softening CNY is deflationary for the world for three reasons: It decreases the purchasing power of China abroad; it cuts Chinese export prices; and it forces competitors to China to also lower their prices and let their currencies depreciate in order to maintain their own competitiveness in international markets. In other words, a falling yuan unleashes China's own deflationary forces onto the rest of the world. Bottom Line: While momentum has already been a tailwind for the dollar, now the global economy is likely to enter the quadrant where both growth and inflation decelerate. This means the greenback is likely to pick up an additional strong tailwind. Stay long the dollar. Nightrain Based on this analysis, the first half of 2019 could be very positive for the dollar. The Bottom left quadrant of Chart I-3 implies that EUR/USD is unlikely to suffer the greatest downside. Nonetheless, based on our preferred fair-value model for the euro - which is based on real short-rate differentials, yield curve slope differences, and the price of lumber relative to copper - the common currency needs to move below 1.1 before trading at a discount (Chart I-10). We expect the euro will settle between 1.10 and 1.05. Chart I-10EUR/USD Will Fall Below 1.1 EUR/USD Will Fall Below 1.1 EUR/USD Will Fall Below 1.1 If business cycle analysis is any guide, the dollar should shine most brightly against commodity currencies - the AUD and NZD in particular - and Scandinavian currencies. We closed our long NZD trades last week, and this week's analysis implies completely curtailing our positive bias toward the kiwi. Positive domestic economic results have lifted the AUD, but slowing global growth and inflation will hurt this very pro-cyclical economy. A key support for the expensive AUD will dissipate as quickly as it appeared. We had sold CAD/NOK, but this trade is not panning out. Global business cycle dynamics suggest that we should terminate this bet. Slowing global growth and inflation historically hurt the NOK more than the CAD. As Chart I-11 shows, under these circumstances, CAD/NOK does not depreciate, it appreciates. However, we remain committed to our long-term short AUD/CAD trade. This cross performs poorly in this quadrant of the global business cycle. This view is reinforced by the fact that Robert Ryan, BCA's head of commodities, continues to favor energy over base metals. Furthermore, the Canadian government unveiled C$14billion of corporate tax cuts this week, creating a marginal additional positive for the Canadian economy. We therefore do not expect AUD/CAD to break above the important technical resistance it currently faces. Instead, it is likely to embark on the last leg of a downtrend started in March 2017, which could culminate with AUD/CAD trading between 0.88 and 0.86 (Chart I-12). Chart I-11The Global Business Cycle Votes Nay To Short CAD/NOK, But Yea To Long AUD/CAD Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Appetite For Destruction? FX Investing For Slowing Global Growth And Inflation Chart I-12Attractive Spot To Sell AUD/CAD Attractive Spot To Sell AUD/CAD Attractive Spot To Sell AUD/CAD The yen is potentially the trickiest of all the currencies. At face value, the global business cycle analysis suggests the yen could depreciate against the dollar, but as we argued, this is an artefact of the long sample used in this analysis. A shorter sample would show the yen appreciating against the dollar. We are inclined to agree with this conclusion. Slowing global growth and inflation as well as a strong trade-weighted dollar could very well put a bid under the price of Treasury bonds over the next few months, especially as speculators are still large sellers of the whole U.S. government bond universe (Chart I-13). Since the yen remains broadly inversely correlated to Treasury yields, it may appreciate against the dollar over the coming three to six months. Chart I-13Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Extreme Positioning And A Poor Global Business Cycle Outlook Point To A Tactical Rally In Treasurys... Our view has been and remains that the yen offers its most attractive reward-to-risk ratio on its crosses, not against the U.S. dollar. The business cycle analysis confirms that the yen has upside against all the other currencies when both global growth and inflation slows (Chart I-3, bottom left quadrant). The yen should, therefore, offer plentiful upside against the AUD, the NZD, the SEK and the NOK. Moreover, since the beginning of the year, a core view of this publication has been that EUR/JPY would depreciate4 - a trend that has materialized, albeit in a volatile fashion. Since the global business cycle is likely to put downward pressure on global yields for another three to six months, it should also push EUR/JPY lower (Chart I-14). Hence, a move in EUR/JPY below 120 is likely over the coming months. Chart I-14...Which Will Hurt EUR/JPY ...Which Will Hurt EUR/JPY ...Which Will Hurt EUR/JPY Bottom Line: While EUR/USD could fall slightly below 1.1, the greenback is likely to experience its sharpest upside against the AUD, NZD, SEK and NOK. While selling CAD/NOK does not work when global growth and inflation decelerate, selling AUD/CAD does. The JPY is likely to experience more upside against the dollar, but the JPY is most attractive against commodity currencies and the euro. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies In Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Weekly Report, titled "Six Questions From The Road", dated November 16, 2018, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, titled "Clashing Forces: The Fed And EM Financial Conditions", dated October 19, 2018, available at fes.bcaresearch.com 4 Please see Foreign Exchange Strategy Weekly Report, titled "The Unstoppable Euro?", dated January 19, 2018, and Foreign Exchange Strategy Weekly Report, titled "The Yen's Mighty Rise Continues", dated February 16, 2018, 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: Capacity utilization came in above expectations, coming in at 78.4%. However, both initial jobless claims and continuing jobless claims surprised negatively, coming in at 224 thousand and 1.688 million. Finally, durable goods orders also disappointed expectations DXY has been roughly flat this week. Several indicators point to a slowdown on economic data. At face value this could imply that the dollar could fall. However, falling oil prices, point to a slowdown in global inflation. This factor, alongside slowing global growth has historically been very positive for the U.S. dollar. Thus, we maintain our long dollar position. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 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 Recent data in the euro area has been mixed: Both core and headline inflation came in line with expectations, coming in at 1.1% and 2.2%, respectively. Headline inflation in Italy also came in line with expectations, at 1.6%. EUR/USD has risen by roughly 0.5% this week. Overall, we continue to be bearish on the euro, given that we expect an environment of declining growth and inflation, which usually is negative for EUR/USD. Moreover, large exposure to vulnerable emerging markets by European banks will continue to be a drag on how much the ECB can tighten policy. Report Links: Six Questions From The Road - November 16, 2018 Evaluating The ECB's Options In December - November 6, 2018 Updating Our Intermediate Timing Models - November 2, 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: The All Industry Activity Index monthly change underperformed expectations, coming in at -0.9%. Meanwhile, national inflation ex-fresh food came in line with expectations at 1%. Finally, national inflation also came in line with expectations, coming in at 1.4%. USD/JPY has been flat this week. We remain positive on the trade-weighted yen, given that the continued slowdown in global growth, fueled by the dual tightening of policy by Chinese authorities and the Fed, will help safe haven currencies like the yen. Moreover, the current selloff in U.S. markets could also provide a boon for this currency if it forces the Fed to tamper its hawkishness. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 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 GBP/USD has risen by 0.9% this week. The market reacted positively to the draft of the Brexit agreement. Even if risks have begun to decline, the all clear for the pound has not been reached as political risks will continue to regularly inject doses of volatility into British assets. Moreover, the strength in the dollar should continue to weigh on cable. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 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 AUD/USD has been flat this week. We are most negative on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that global inflation will start to roll over. This deceleration in prices, coupled with slowing growth will provide a dangerous cocktail for this cross. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 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 NZD/USD has been flat this week. While we were positive the NZD and capitalized on this view, we are becoming more cautious. We cannot rule out any further short-term upside, but on a six month basis, the NZD will likely experience heavy downside, as slowing global growth and inflation are major hurdles for this currency. 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 USD/CAD has risen by 0.6% this week. The weakness in oil prices have caused the Canadian dollar to be one of the worst performing currencies in the G10 in recent weeks. We are reticent to be too bullish on the CAD, given that markets are now pricing in a BoC that will be more hawkish than the Fed. Nonetheless the CAD tends to outperform other commodity currencies when the global business cycle slows. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 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 EUR/CHF has fallen by 0.7% this week. While global volatility can temporarily support the swiss france versus the euro, w continue to be bearish on the franc on a 12 to 18 months basis, given that Swiss growth and inflation remain too tepid for the SNB to hike policy rates. This point is confirmed by the recent rollover in industrial production. Moreover, the SNB will also have to intervene in currency markets if the franc becomes more expensive in response to the current risk-off environment. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 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 USD/NOK has risen by 0.4% this week. Overall, we expect for the krone to have further downside as oil continues to fall while U.S. rates continue to rise. Moreover, if the fall in oil prices causes a large fall in inflation the krone could depreciate even more against the CAD, as this cross has historically fallen when this particular set of circumstances occur. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 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 USD/SEK has been flat this week. Overall, we are bullish on the krona on a long-term basis. After all, the Riksbank is on the verge of beginning a tightening cycle, as imbalances in the Swedish economy are only growing more dangerous. The optimism on domestic factors is tempered by global risks. The krona tends to perform very poorly when global growth slows, as Sweden is very exposed to the gyrations of the global economy. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Structurally, EM corporate leverage is elevated and the interest coverage ratio is low. Cyclically, China/EM growth slowdown will lead to corporate spread widening. Rising U.S. dollar corporate bond yields in EM herald lower share prices. The recent underperformance in Mexican financial markets versus their EM peers is not sustainable. We reiterate our overweight position in Mexico. In Indonesia, the central bank is attempting to fight the Impossible Trinity, a battle that by definition cannot be won. Investors should keep underweighting this market. Feature This report focuses on the corporate health of emerging market (EM) companies, as well as the outlook for corporate bonds. We review the key drivers behind credit spreads and provide an up-to-date snapshot of overall corporate health. We also illustrate the travails in China's offshore corporate bond market, which are of high importance to the broad EM outlook. With respect to scope of coverage and data comparability, please refer to Box 1. BOX 1 Data Relevance And Its Application As there is no aggregate financial dataset for EM corporate bond issuers, we use corporate financial data provided by Worldscope for the EM equity universe - the constituents of the MSCI EM equity index. While from an individual country perspective this makes a difference, from an EM sector perspective the differences are not substantial. Excluding the technology sector, it is often the case that the same companies have both publicly traded stocks and bonds. This is especially true in sectors such as basic materials, energy, industrials, telecom, utilities and financials. This is why, in this report, we focus our attention on sectors rather than countries, and why we examine the EM companies' financial health excluding technology and banks. Banks' relevant financial ratios vary greatly from those of non-banks. For the technology sector, the largest tech names in the equity space have minimal bonds outstanding, so using financial data from the equity space for credit analysis is inappropriate. In short, the analysis below on corporate health is pertinent to both equity and corporate bond investors. However, its emphasis is on creditworthiness and ability to service debt, which is more attuned to credit investors. Drivers Of EM Credit Spreads Cyclical swings in EM corporate and sovereign credit spreads are driven by changes in borrowers' revenues, cash flow and profits. Hence, the business cycle is one of the important drivers of corporate creditworthiness. When global and EM growth accelerate, revenue and free cash flow improve, causing credit spreads to narrow (Chart I-1). The EM business cycle drives EM sovereign spreads too (Chart I-2). Chart I-1EM Corporates: Cash Flow From Operations And Credit Spreads bca.ems_sr_2018_11_22_s1_c1 bca.ems_sr_2018_11_22_s1_c1 Chart I-2EM Sovereign Spreads Move In Tandem With Business Cycle EM Sovereign Spreads Move In Tandem With Business Cycle EM Sovereign Spreads Move In Tandem With Business Cycle This is why we spend a lot of time gauging the global business cycle outlook and cover this topic extensively in our reports. For now, the growth outlook for China/EM and global trade remains gloomy: Chart I-3China Is A Major Risk For EM Profits China Is A Major Risk For EM Profits China Is A Major Risk For EM Profits China's credit and fiscal spending impulse projects further weakness in the mainland's business cycle and EM corporate earnings (Chart I-3). China's slowdown is no longer limited to the industrial sector - household spending growth has downshifted considerably since early this year, as we discussed in last week's report.1 Weakening sales of consumer goods and autos in China are one of the primary reasons behind the ongoing slump in the global technology and semiconductor sectors. Consistently, plunging growth in Taiwanese electronics exports points to both weaker global trade and EM tech earnings in the months ahead (Chart I-4). In short, even though we have excluded technology from our analysis of corporate financial health, hardware tech companies' profits remain at risk. The latter is not relevant for EM corporate bond investors, but it is critical for the EM equity space. Chart I-4Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Taiwanese Shipments Foreshadow A Relapse In EM Tech Earnings Other pertinent financial market indicators for EM credit spreads are commodities prices, EM exchange rates and EM local rates. The basis is as follows: (1) Energy and materials make up 25% of the J.P. CEMBI EM corporate bond index, and commodities prices drive their revenues and in turn credit spread fluctuations (Chart I-5, top panel); (2) Outside the resource sector, corporate bond issuers by and large do not feature exporters, and their capacity to service foreign currency debt is greatly affected by exchange rate movements (Chart I-5, bottom panel); (3) Financials make up 30% of the J.P. CEMBI EM corporate bond index, and their credit spreads are greatly influenced by domestic interest rates and banking system health (Chart I-6). We exclude financials from our corporate health analysis because their financial ratios differ vastly from those of non-financials. Chart I-5Drivers Of Credit Spreads: Commodities And Currencies Drivers Of Credit Spreads: Commodities And Currencies Drivers Of Credit Spreads: Commodities And Currencies Chart I-6EM Bank Credit Spreads Will Widen If Local Bond Yields Rise EM Bank Credit Spreads Will Widen If Local Bond Yields Rise EM Bank Credit Spreads Will Widen If Local Bond Yields Rise Overall, we expect global trade to weaken, commodities prices to drop further and EM currencies to depreciate. The latter will push up local interest rates. In turn, several EM banking systems remain saddled with bad assets from previous credit booms that have not been recognized, and banks have not been recapitalized. These factors point to a widening in bank credit spreads. All in all, EM corporate and sovereign spreads will widen further. A Snapshot Of EM Corporate Health The following financial ratios - which are calculated for EM companies excluding technology and financials - do not justify currently tight corporate spread. Leverage measured as net debt (total debt minus cash assets) divided either by EBITDA or cash flow from operation2 (CFO) remains elevated (Chart I-7, top panel). Among 9 sectors, only energy, basic materials and consumer discretionary have seen their leverage fall over the past two years. Chart I-7EM Corporate Health: Leverage And Interest Coverage Ratios EM Corporate Health: Leverage And Interest Coverage Ratios EM Corporate Health: Leverage And Interest Coverage Ratios Interest coverage ratios computed as EBITDA- or CFO- to- interest expense are well below their 2007 and 2011 levels (Chart I-7, middle panel). These figures corroborate that neither EM corporate indebtedness nor companies' ability to service debt using cash from operations is back to levels that prevailed before the global financial crisis in 2008 when EM financial markets were in a secular uptrend. Crucially, this is inconsistent with presently still-tight EM corporate spreads (Chart I-7, bottom panel). This mispricing, in our opinion, reflects the global search for yield that was induced by the crowding out of investors from DM bond markets by global central banks' QE programs. A contraction in corporate profits and cash flows from operation - for the reasons discussed above - will cause issuers' credit matrixes to deteriorate. With respect to cross-sectional analysis, Table I-1 presents interest coverage ratios (computed as an average of EBITDA- and CFO-to-interest expense ratios) for mainstream countries and all sectors. The cells in red present pockets of distress where the interest coverage ratio is below 3. The cells in blue illustrate segments where moderate financial stress is present: these are sectors with an interest coverage ratio of above 3 but below 5.5. Table I-1Interest Coverage Ratios EM Corporate Health And Credit Spreads EM Corporate Health And Credit Spreads On a positive note, the rally in commodities and cutbacks in capex have allowed energy and basic materials companies to drastically improve their leverage and interest coverage ratios in the past 2 years. However, even though their present financial health is great, their cash flow from operations is set to deteriorate again as commodities prices continue to relapse. The key motive behind our negative view on credit markets in Latin America, Russia, the Middle East and Africa - which is de facto the EM universe excluding emerging Asia - is because with the exception of Turkey, they are very exposed to commodities prices. As commodities prices drop and these nations' currencies depreciate, their sovereign and corporate credit spreads will widen. We are not implying that these issuers are facing default risks. Simply, lower revenues from commodities and higher debt servicing costs due to currency depreciation warrant a re-pricing of risk. Within credit portfolios, we recommend favoring defensive low-beta credit, excluding banks, versus riskier high-beta ones. We are underweight EM banks within the EM equity space and recommend the same strategy for the EM credit universe. Based on the matrix in Table I-1, credit portfolios should overweight consumer services, tech, energy and basic materials and underweight industrials, utilities and healthcare. China's Corporate Health And Credit Market There has been little deleveraging among Chinese companies. On the contrary, the country's massive credit and fiscal stimulus in 2016 bailed out many indebted companies, lifting corporate debt levels and augmenting the misallocation of capital. In particular: Chart I-8China's Corporate Debt Is Enormous China's Corporate Debt Is Enormous China's Corporate Debt Is Enormous China's corporate debt remains enormous, at $19.5 trillion, or RMB 140 trillion. It is the highest in the history of any country (Chart I-8). Some 95% of corporate debt is in local currency terms. My colleague Jonathan LaBerge from China Investment Strategy has calculated that Chinese state-owned enterprises' adjusted return on assets, has fallen below the cost of capital (Chart I-9). This indicates that these companies have for now exhausted profitable investment opportunities and should arguably scale back on their investment expenditures. Further borrowing and investing by these enterprises will augment the amount of bad assets held by Chinese banks and reduce the country's overall productivity and hence, potential growth. Yet, denying these debtors financing will result in a major slump in capex, and probably labor market weakness. Chart I-9Chinese SOEs: Capital Misallocation Chinese SOEs: Capital Misallocation Chinese SOEs: Capital Misallocation Chart I-10Leverage And Interest Coverage For Chinese Companies Leverage And Interest Coverage For Chinese Companies Leverage And Interest Coverage For Chinese Companies Dissecting sectoral data, indebtedness is elevated for industrials, utilities and property developers. Consistently, the interest coverage ratio is extremely low for industrials, utilities and property developers (Chart I-10). Financial health of Chinese materials has improved tremendously due to de-capacity reforms - the shutdown of excess capacity that has boosted both steel and coal prices. Interestingly, this has occurred at the expense of utilities and some other heavy consumers of steel and coal. Notably, steel and coal prices are beginning to relapse (Chart I-11). For reasons discussed in our previous report,3 these commodities prices will drop further and will hurt producers' cash flow and profits, causing their creditworthiness to deteriorate. Chart I-11Steel And Thermal Coal Prices Steel And Thermal Coal Prices Steel And Thermal Coal Prices Offshore corporate bond yields and spreads are surging, foreshadowing rising borrowing costs and reduced availability of financing (Chart I-12A). The problem is especially acute for property developers (Chart I-12B). In a nutshell, Chinese corporate U.S. dollar bond yields are at their highest levels of the past five-six years. The same is true for emerging Asian corporate bond issuers. Chart I-12AChinese Offshore Aggregate Corporate Bonds Chinese Offshore Aggregate Corporate Bonds Chinese Offshore Aggregate Corporate Bonds Chart I-12BChinese Offshore Property Developers Chinese Offshore Property Developers Chinese Offshore Property Developers Not only do Chinese corporate bonds now account for 32.5% of EM and 56% of emerging Asian corporate bond indexes, but investment expenditures by Chinese companies are also critical to companies elsewhere in Asia and globally. Chinese gross fixed capital formation accounts for 6% and 5.4% of global GDP in nominal and real terms, respectively. By contrast, these numbers are 4.6% and 4.3% for the U.S. We have deliberated at great length on why China's growth will likely continue to downshift, despite the policy stimulus, and we will not repeat our arguments today.4 The financial health of Chinese companies will worsen due to dwindling sales and cash generation. This, along with less credit/financing available onshore and offshore, will erode their capacity to undertake large investment expenditures. Consequently, capital expenditures in general and construction in particular will suffer substantially. This is the main rationale behind our negative view on resources, raw materials and industrials worldwide. Investment Observations And Conclusions Apart from Turkey and Argentina, there has been no liquidation and capitulation in EM assets in general and the credit space in particular. It would be unusual if this extended selloff ends without capitulation. EM credit markets appear technically vulnerable. In particular, the excess returns on EM sovereign and corporate bonds are splintering below their 200-day moving averages (Chart I-13). Odds are there will be more downside. Chart I-13A Bad Signal A Bad Signal A Bad Signal Rising U.S. dollar corporate bond yields in both EM overall and in emerging Asia herald lower share prices (Chart I-14). So long as the drop in U.S. Treasury yields is offset by widening EM credit spreads, EM corporate bond yields will continue to rise and EM share prices will sell off. However, as and when EM corporate (or sovereign) yields start falling, irrespective of whether because of declining U.S. Treasury yields or narrowing EM credit spreads, EM equity prices will rally. EM sovereign and corporate bond yields are an imperative indicator to watch for equity investors. Chart I-14Rising Corporate Yields = Lower Share Prices Rising Corporate Yields = Lower Share Prices Rising Corporate Yields = Lower Share Prices We continue to recommend defensive positioning in EM sovereign and corporate bonds. In terms of asset allocation, EM dollar-denominated sovereign and corporate bonds should not be compared with EM local currency bonds or equities or U.S. Treasurys.5 These are credit instruments, and they should be a part of a credit portfolio with U.S. and European corporate bonds. Credit portfolios should presently be underweight EM sovereign and corporate bonds relative to U.S. corporate bonds (Chart I-15A & Chart I-15B). Chart I-15AEM Sovereign Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns Chart I-15BEM Corporate Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns EM Credit Versus U.S. Credit: Relative Excess Returns Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Analyst andrijav@bcaresearch.com Mexico: Is The Underperformance Overdone? Despite having a sound macroeconomic backdrop,6 Mexican financial markets have lately substantially underperformed their emerging market peers due in large part to domestic politics. Odds are that Mexican risk assets will continue to sell off in absolute terms, especially given the broad turmoil in the EM universe, which we expect to continue. That said, the recent underperformance of Mexican markets versus their EM peers is overdone, and odds are that Mexican stocks, local bonds and sovereign credit will outperform their EM peers over the coming six to 12 months: First, the Mexican authorities have been pursuing orthodox macro policies, including very tight monetary and fiscal policies. The central bank hiked its policy rate again last week in the face of a currency relapse, and the fiscal stance has been tight. Currently, the real policy rate is 4% and the 10-year local currency government bond yield is 5.5%, both deflated by core consumer price inflation (Chart II-1, top and middle panel). Real rates are very high by historical standards and are now above most other EMs. Chart II-1Mexico: Tight Monetary And Fiscal Policies Mexico: Tight Monetary And Fiscal Policies Mexico: Tight Monetary And Fiscal Policies The government's non-interest expenditures deflated by core consumer price inflation have been contracting (Chart II-1, bottom panel). Such a tight monetary and fiscal policy mix will not change considerably with AMLO taking the office and it should benefit the currency. We expect the peso to start outperforming its EM peers on a total-return basis. Second, the Mexican peso is very cheap - close to one standard deviation below fair value, according to the unit labor cost-based real effective exchange rate (Chart II-2). The latter is our favorite currency valuation measure. Chart II-2The Mexican Peso Is Cheap The Mexican Peso Is Cheap The Mexican Peso Is Cheap Third, economic growth is improving, as the effects from monetary and fiscal tightening are diminishing (Chart II-3). This should at the margin support Mexican financial markets versus their EM peers where growth is slowing. Chart II-3Mexico: A Moderate Cyclical Recovery Mexico: A Moderate Cyclical Recovery Mexico: A Moderate Cyclical Recovery Fourth, Mexico's business cycle is much more leveraged to the U.S. economy than to China's. In line with our view that U.S. growth will fare better than China's growth, the Mexican economy will likely outperform other EMs that are more leveraged to China. Finally, an important rationale behind our recommendation to maintain an overweight stance on Mexico is that Mexican risk assets are defensive plays within the broad EM universe. In other words, whenever there is broad EM turbulence and an ensuing flight to quality, Mexican risk assets tend to outperform their EM peers. This is even more likely to happen now that Mexican sovereign spreads are already elevated and local currency government bonds offer a very attractive yield relative to other EMs (Chart II-4). Chart II-4Mexican Domestic And U.S. Dollar Bonds Offer Value Mexican Domestic And U.S. Dollar Bonds Offer Value Mexican Domestic And U.S. Dollar Bonds Offer Value Still, a few words are warranted on the recent domestic political developments. Our view is that the latest measures announced by the incoming administration regarding the new airport and banking fees are more indicative of a strategy to test the markets before the AMLO administration takes office, rather than declaring war against both markets and investors. It is noteworthy how fast the AMLO government came out after each of these announcements to calm investors. This suggests to us that fears of Mexico taking an irreversible sharp political turn to the left are overblown. AMLO is likely to be pragmatic and deliberate in the way he pushes forward his policies. In a nutshell, our bias is that these announcements represent an attempt by the AMLO administration to promote competition and reduce rent-seeking activities in the economy. This can be negative for shareholders of incumbent large companies, as it will hurt corporate profits of oligopolies. However, in the long term these polices will be positive for overall economic growth as they will reduce the cost of doing business, appease structural inflation and boost the nation's competitiveness. From a structural perspective, these policies are positive for the currency and local bonds. One way to play this theme is to favor small-cap over large-cap companies. Given the oligopolistic structure of some industries, Mexican large-cap companies are much more likely to be hurt by the incoming administration's open competition policies than small-cap companies. As such, small-caps will likely outperform large-caps in Mexico over at least the next six to 12 months (Chart II-5). Moreover, small-caps are currently trading at a significant discount compared to large-caps, with the former trading at multiples that are half of the latter. Chart II-5Mexico: Small-Caps Will Outperform Large-Caps Mexico: Small-Caps Will Outperform Large-Caps Mexico: Small-Caps Will Outperform Large-Caps Investment Conclusion Dedicated EM investors should overweight Mexican equities, local currency bonds and sovereign credit within their respective universes. Concerning the exchange rate, we are maintaining our long MXN / short ZAR position. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Indonesia: Defying The Impossible Trinity? Indonesian stocks are attempting to rally and have lately outperformed the EM equity benchmark. The outlook for this bourse remains negative and we recommend investors to fade this rally and outperformance. Critically, Indonesian domestic interbank rates and corporate U.S. dollar bond yields are rising. Historically, this is a negative signal for share prices (Chart III-1, rates and yields are shown inverted). Chart III-1Rising Rates/Yields = Falling Stocks Rising Rates/Yields = Falling Stocks Rising Rates/Yields = Falling Stocks Weakening rupiah and rising interest rates are forcing the central bank (BI) into a policy dilemma: Should it defend the currency and allow interest rates to rise further or should it cap interest rates and let the currency find a market equilibrium? It appears the BI is trying to do both - to stop the currency from depreciating, while also capping or bringing down interbank rates simultaneously. This defies the Impossible Trinity thesis which stipulates that a central bank of a country with an open capital account has to choose between controlling either the exchange rate or interest rates. On the surface, it would seem that the BI has been focused on targeting a stable rupiah. The monetary authorities have sold foreign exchange reserves (Chart III-2, top panel), and raised the key policy rate. Chart III-2Aggressive Monetary Policy Tightening... Aggressive Monetary Policy Tightening... Aggressive Monetary Policy Tightening... Selling of foreign exchange reserves is a form of tightening as it drains the banking system's excess reserves at the central bank. Shrinking interbank liquidity, however, pushes up interbank rates and borrowing costs (Chart III-2, bottom panel). Higher borrowings costs not only make the currency more appealing to investors, but they also curb domestic demand and, thereby, improve the current account balance. This is an ultimate mechanism of how policy tightening leads to exchange rate stability. Yet the full picture of BI's policies is a lot murkier. While on the one hand, the central bank has sold its foreign exchange reserves and hiked policy rates to defend the rupiah, it has also offset some of the tightening by injecting local currency reserves into the banking system. Chart III-3 shows that the BI purchased/redeemed back central bank certificates from commercial banks, which has led to a sharp increase in commercial banks' excess reserves. Chart III-3... And Liquidity Injections By Central Bank ... And Liquidity Injections By Central Bank ... And Liquidity Injections By Central Bank Central bank liquidity injections are akin to monetary easing aimed at capping or even bringing down interbank rates. Hence, they come as a contradiction to the central bank's restrictive policies. If the BI chooses to stabilize the rupiah, then interbank rates and borrowing costs in general will have to rise and the economy will take a hit. Corporate earnings will then contract which will be bearish for the equity market. If the central bank opts to cap interbank rates, it has to inject as much liquidity (excess reserves) into the banking system as required. In this scenario, the currency could depreciate triggering capital flight and selloffs in equity and local bond markets. The BI can continue the muddle-through policy - offsetting or sterilizing its foreign exchange interventions by turning the backdoor liquidity taps on. These injections of local currency liquidity into the banking system could encourage speculation against the rupiah and allow banks to lend more, maintaining robust imports and a large current account deficit. It is not certain, but if the market perceives that interest rates are lower than warranted, the currency could very well depreciate amid this policy mix. In this scenario, the result could be a mix of gradual currency depreciation and somewhat higher interest rates. Financial markets will still do poorly in dollar terms. Overall, odds are high that the rupiah will resume its depreciation and interest rates will move higher. Indonesia's balance of payment dynamics remain a risk to the exchange rate. The current account deficit is still large and exports are heading south (Chart III-4). Chart III-4Current Account Deficit Is Large Current Account Deficit Is Large Current Account Deficit Is Large First, Chart III-5 illustrates that the sharp slowdown in the average manufacturing PMIs of Japan, Korea, Taiwan and Germany are pointing to an imminent contraction in Indonesian export volumes. Chart III-5Exports Are Heading South Exports Are Heading South Exports Are Heading South Second, thermal coal prices seem to be breaking down. Chart III-6 shows that the stock price of Adaro - a large Indonesian coal producing company - has already fallen by 45% in U.S. dollar terms since January, and is heralding a dismal outlook for coal prices. Chart III-6Coal Prices Are To Break Down Coal Prices Are To Break Down Coal Prices Are To Break Down Lower coal prices will shrink Indonesia's coal export revenues. The latter accounts for 12% of total Indonesian exports. In terms of the outlook for banks, which is a key equity sector, their share prices have been surprisingly resilient. Rising interest rates, however, will cause their NPLs to move higher hurting banks' profits, and pulling their share prices down (Chart III-7). Chart III-7Bank Stocks Are At Risk Bank Stocks Are At Risk Bank Stocks Are At Risk Finally, overall Indonesian equity valuations are still not attractive either in absolute terms or relative to the EM benchmark. Meanwhile, foreigners own 32% of the equity market and 37% of local currency bonds. As the rupiah slides, foreigners will rush to the exits, amplifying the currency depreciation. Bottom Line: The path of least resistance for the rupiah is down. Continue underweighting Indonesian equities and bonds and continue shorting the rupiah versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1 Please see Emerging Markets Strategy Weekly Report, "On Domino Effects And Portfolio Outflows," dated November 15, 2018, available at ems.bcaresearch.com. 2 Cash flow from operations represents net cash flow from operating activities & excludes net cash flow financing and investing activities. 3 Please see China Investment Strategy Special Report, "Revisiting China's De-Capacity Reforms," dated October 17, 2018, available at cis.bcaresearch.com. 4 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth," dated October 25, 2018, available at ems.bcaresearch.com. 5 Please see Emering Markets Strategy Weekly Report, "Strategic Asset Allocation For Emerging Markets," dated May 7 2013, available at ems.bcaresearch.com. 6 Please see Emerging Markets Strategy Special Report, "A Mexican Standoff - Markets Vs. AMLO," dated June 28 2018, available at ems.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Dear Client, Next week on November 26th instead of our regular weekly publication you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 3rd with our high-conviction trades for 2019. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy We maintain our sanguine U.S. equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our Economic Impulse Indicator represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals, especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Take profits and boost to an overweight stance today. Burgeoning domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals, suggest that the path of least resistance is higher for the S&P air freight & logistics group. Recent Changes Book gains in the S&P Airlines index of 18% since inception and lift from below benchmark to overweight today. Table 1 Manic Market Manic Market FEATURE The SPX was rudderless last week, as the tug-of-war between bears and bulls has yet to be decided. Equities have been experiencing mini-aftershocks following October's seismic move because the Fed has injected some volatility back into the markets via raising interest rates and allowing bonds to roll off its balance sheet at an accelerating pace. While the Fed stayed pat in November, it will most definitely tighten monetary policy next month for the ninth time this cycle. Fed policy is at the epicenter of recent S&P 500 oscillations, which raises the question: is the Fed tightening monetary policy too far too fast to cause equity market consternation? To put the latest monetary tightening cycle in perspective, we examined trough-to-peak moves in the fed funds rate since the 1950s. Chart 1 shows the results of our analysis. During the past ten Fed tightening cycles, the median trough-to-peak delta in the fed funds rate heading into recession has been 495bps. The latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect (Chart 2). Were the Fed to hike three more times by the first half of 2019, as our fixed income strategists expect, this will push the current cycle 100bps above the historical median. Chart 1Too Far Too Fast? Too Far Too Fast? Too Far Too Fast? Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median Manic Market Manic Market While almost everyone raves about the stellar U.S. economic performance squarely focused on levels of different economic indicators (Chart 3), drilling beneath the surface reveals that small cracks are forming, as we first highlighted in the October 22nd Weekly Report when we introduced our Economic Impulse Indicator (EII).1 The EII is a second derivate equally-weighted composite of six indicators of the U.S. economy, highlighting that peak economy was likely hit this year in Q2, when nominal GDP grew 7.6% on a quarter-over-quarter annualized growth rate basis. Chart 3Do Not Focus On Levels Alone... Do Not Focus On Levels Alone… Do Not Focus On Levels Alone… Chart 4 shows that 5 out of the 6 indicators included in the EII are losing steam, 4 out of 6 are in outright contraction, and only capex is showing modest signs of life. While this backdrop in isolation does not portend recession, were the Fed to go ahead with three additional hikes by mid-year 2019 that would push the fed funds rate to a range of 2.75%-3% and a possible negative Q2/2019 GDP print could then easily invert the yield curve, ticking the box in one of our three recession indicators we track.2 Chart 4...Impulses Tell A Different Story …Impulses Tell A Different Story …Impulses Tell A Different Story The latest Fed Senior Loan Officer survey released last week also struck a nerve. While bankers are willing extenders of credit throughout most loan categories, demand for loans is declining across the board (Chart 5A); only other consumer (likely student) loans are in high demand, and subprime residential loans are also threatening to break above the zero line.3 Nevertheless, before getting too bearish, a bond valuation examination is in order. BCA's 10-year bond valuation index has been an excellent predictor of cycle ends dating back to the 1960s. It has accurately forecast 6 out of the last 7 recessions missing only the 1974 iteration. When this valuation metric swings to extremely undervalued territory - defined as at least one standard deviation above the historical mean - it signals that a recession is approaching. Why? Typically a selloff in the bond market is associated with a fed tightening cycle and such steep monetary tightening slams the breaks on the economy via the slowing housing market and the dent in consumer spending power. True, we are closing in on this level, but we are not there yet (Chart 5B). Chart 5ALoan Demand In Freefall Loan Demand In Freefall Loan Demand In Freefall Chart 5BWatch Bond Valuations Watch Bond Valuations Watch Bond Valuations Finally, we bought the proverbial dip on October 26th as we did not (and still do not) foresee recession in the coming 9-12 months, underscoring that likely the trough is in place.4 On that front the Minneapolis Fed's implied probability of a 20%+ correction remains tame near the 10% probability mark, corroborating our sense that the worst is behind the equity market, at least for now (Chart 6). Chart 6Risk Of A Bear Market Is Low Risk Of A Bear Market Is Low Risk Of A Bear Market Is Low Netting it all out, we maintain our sanguine equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our EII represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. This week we crystalize gains in the smallest transportation sub-index we cover and boost exposure to overweight, and reiterate our high-conviction overweight stance on a large transportation sub-index. Airlines: Up In The Air Within transports we have been advocating a barbell portfolio preferring air freight & logistics (see below for an update) to airlines (as a reminder we recently downgraded rails to neutral5). The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. Chart 7 shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. Thus, we are compelled to trigger our upgrade alert and cement gains of 18% in our underweight and lift exposure to overweight in the niche S&P airlines index. Chart 7Energy Price Plunge Is Bullish For Airline EPS Energy Price Plunge Is Bullish For Airline EPS Energy Price Plunge Is Bullish For Airline EPS Not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (Chart 8). Chart 8Air Travel Demand... Air Travel Demand… Air Travel Demand… In fact, a larger proportion of the consumer's wallet is used for air travel, a trend that has been recently gaining steam according to national accounts. Airline load factors are pushing cyclical highs and passenger revenue per available seat mile is also gaining momentum, corroborating the U.S. government consumption expenditure data (Chart 9). Chart 9...Is Upbeat... …Is Upbeat… …Is Upbeat… As a result, airlines have been successful at raising selling prices and will soon exit the deflationary zone. International airfares are also in positive territory. Taken together, robust demand and higher selling prices along with declining fuel costs are a harbinger of rising margins and profits (Chart 10). Chart 10Firming Ticket Prices Is A Boon To Margins Firming Ticket Prices Is A Boon To Margins Firming Ticket Prices Is A Boon To Margins This is not yet reflected in depressed relative forward sales and profit growth estimates. Net earnings revisions have also recovered to the zero line and there is scope for additional positive EPS revisions, especially if jet fuel prices stay tamed and travel demand remains healthy. The implication is that relative share price momentum can lift off further (Chart 11). Chart 11Low Hurdle Low Hurdle Low Hurdle Finally, valuations are perched deeply in the undervalued zone while technicals have only recently returned to a neutral setting (Chart 12). Chart 12Unloved and Under-owned Unloved and Under-owned Unloved and Under-owned Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: Take profits in the S&P airlines index of 18% since inception and lift exposure to an above benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. Air Freight & Logistics: We Have Liftoff Air freight & logistics stocks have been bouncing along the bottom for the better part of the past year and have formed a base that should serve as a launch board higher in the coming months. Firming industry operating metrics tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures, at a time when industry executives have been showing labor restraint, with employment growth decelerating steadily over the past two years (Chart 13). This is a conducive backdrop for air freight profit margins and sell-side analysts have taken notice, penciling in higher margins in the coming 12 months. Chart 13Enticing Margin Prospects Enticing Margin Prospects Enticing Margin Prospects Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 14). Chart 14Holiday Selling Season Beneficiary Holiday Selling Season Beneficiary Holiday Selling Season Beneficiary On that front, there are high odds that this holiday sales season will be another record setting one, especially given that corporations have paid out bonuses and shared part of the lowering in corporate taxes and also wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (middle & bottom panels, Chart 14). With regard to the global macro and trade backdrop, while global revenue ton miles and G3 capital goods orders remain near cyclical highs (Chart 15), were Trump's trade rhetoric to re-escalate then global exports would give way. Already international and U.S. export expectations are on the verge of contracting - according to the IFO World Economic Survey and ISM manufacturing survey, respectively. Tack on the appreciating U.S. currency and the clouds darken further (bottom panel, Chart 15). The U.S./China trade tussle and the greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex. Chart 15Greenback And Decelerating Global Growth Are Key Risks... Greenback And Decelerating Global Growth Are Key Risks… Greenback And Decelerating Global Growth Are Key Risks… Nevertheless, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals. In sum, firming domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals suggest that the path of least resistance is higher for the S&P air freight & logistics group (Chart 16). Chart 16...But Already Reflected In Depressed Valuations And Washed Out Technicals …But Already Reflected In Depressed Valuations And Washed Out Technicals …But Already Reflected In Depressed Valuations And Washed Out Technicals Bottom Line: We reiterate our high-conviction overweight status in the S&P air freight & logistics index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 https://www.federalreserve.gov/data/documents/sloos-201810-charts.pdf 4 Please see BCA U.S. Equity Strategy Insight Report, “Time To Bargain Hunt” dated October 26, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Report, "Critical Reset" dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps