Valuations
Highlights Duration: The odds of further bond bearish catalysts emerging during the next 6-12 months are still quite elevated. Maintain below benchmark duration. Global Bond Strategy: The most likely candidates for another bond bearish catalyst would be an announcement of substantial fiscal stimulus from Japan and/or a hawkish policy shift from the Fed. Investors should remain overweight core Europe, underweight U.S. Treasuries and neutral on JGBs. U.S. High-Yield: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal. Feature In a U.S. Bond Strategy Special Report1 published in August we observed that, since the financial crisis, material increases in global bond yields have all been associated with a policy catalyst (Chart 1). We identified three such catalysts: the Fed's 2010 announcement of QE2, the Fed signaling its willingness to slow the pace of asset purchases in 2013, and the European Central Bank's (ECB) announcement of its own QE program in 2015. Now we can add the election of Donald Trump as a fourth catalyst that has spurred a tantrum in global bond markets. Chart 1The Four Post-Crisis Bond Tantrums The common factor that links all of these catalysts is that each causes the market to quickly re-assess its expectations about the future pace of monetary tightening. Interestingly, this re-assessment can be caused by either the announcement of a program that is perceived to be extremely stimulative or the announcement that monetary stimulus will be scaled back. Examples of the former include both the Fed's and ECB's QE announcements as well as the recent U.S. election. An example of the latter would be the 2013 taper tantrum. As in August, the goal of this report is to perform a quick survey of the major global economies in order to assess the likelihood that another bond-bearish catalyst emerges during the next 6-12 months. While we find it difficult to see a catalyst of the same scale as those shown in Chart 1, we assign high odds to the possibility that the announcement of fiscal easing in Japan will add to the bearish pressure on global bonds. We also assign high odds to the possibility that upside inflation surprises in the U.S. cause the Fed to adopt a more hawkish forward guidance, further increasing the bearish pressure on global bonds. We assign low odds to the possibility that ECB policy will contribute to the global bond selloff. U.S. Chart 2Fed Wants Breakevens To Head Higher The recent "Trump Tantrum" has sent yields sharply higher, and expectations priced into the U.S. bond market are now not far from the Fed's median rate hike expectations, especially at the short-end of the curve (Chart 2). In the U.S., the next most likely catalyst for sharply higher global bond yields would be the Fed signaling that it will adopt a quicker pace of rate hikes. Specifically, the Fed would need to cease revising its funds rate forecasts lower - which has been the pattern for the last few years - and start revising them higher. While the market was quick to price-in the likelihood of greater fiscal stimulus and rising deficits under the incoming government, the Fed will take a more cautious approach. In fact, with inflation still below target (Chart 2, bottom panel) and market-based measures of inflation compensation still depressed, the Fed will be in no rush to signal a more hawkish policy stance. We expect the Fed will follow through with an expected rate increase in December, but that the median expectation will continue to call for only two more hikes in 2017. The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around levels consistent with the Fed's inflation target. This corresponds to a range of 2.4% to 2.5% on the 5-year, 5-year forward TIPS breakeven inflation rate (Chart 2, second panel). Assuming that U.S. economic growth continues to accelerate into next year, as we expect, then the 5y5y TIPS breakeven rate could reach this target sometime in the middle of 2017. At that point, a more hawkish Fed policy becomes more likely. In the meantime, while the "Trump Tantrum" is likely to take a pause in the near-term (next 1-2 months), it may not have run its course just yet. If U.S. growth is strong in 2017 and the Trump administration appears to be making progress implementing its more stimulative policies, then the Treasury curve will likely resume its bear-steepening trend in the first half of next year.2 Euro Area Chart 3Strong Growth, But Plenty Of Slack According to the OECD and others, including the European Commission and ECB, trend GDP growth in the Eurozone is below 1%. In fact, most estimates center around 0.7%. This means that as long as GDP growth is maintained above these levels we should expect the labor market to continue to tighten. At least for now, the data suggest that growth is likely to remain well above trend. Led by gains in both the services and manufacturing indexes, the euro area's composite PMI jumped from 53.3 to 54.1 in November. The composite PMI has a good track record of leading European GDP growth (Chart 3), and the current reading is consistent with GDP growth of 2%. Despite strong growth, the ECB's policy stance is likely to remain accommodative for quite some time and is unlikely to spur a global bond tantrum within our 6-12 month investment horizon. The fact that core inflation remains below 1% (Chart 3, panel 3) tells us that the output gap in the euro area is still very wide. It will take a prolonged period of strong growth for the output gap to close and for inflationary pressures to mount. In prior cycles inflation has not begun to accelerate until the unemployment rate was below 9% (shaded regions in Chart 3). An announcement from the ECB that it will cease its asset purchase program because the economy has made adequate progress toward its economic and inflation goals would likely spur a large rise in global bond yields. However, this is unlikely to occur until the unemployment rate is below 9% and inflation is in an uptrend. As we argued in a recent Global Fixed Income Strategy report,3 the ECB will be able to alter the rules regarding the quantity of bonds available for purchase as is necessary to keep the program in place. Japan The Bank of Japan (BoJ) recently switched to a policy framework that involves targeting a level of yields as opposed to a quantity of purchases. In our view, this sends a pretty strong signal that monetary policy is close to being exhausted and that fiscal policy must take up the baton of Abenomics. While the timing and amount of any additional fiscal spending is not clear, it is probably necessary if policymakers are serious about reaching their 2% inflation goal. Chart 4Policy Action Required In Japan At present, the Japanese Diet is currently deliberating the third revision to the second supplementary budget and government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. While any fiscal measures would not spur an increase in nominal JGB yields (because the BoJ will retain the cap), they would spur an increase in inflation expectations and a decline in real yields (Chart 4). We also think that the reflationary impulse would be felt by bond markets in the rest of the world, and that large enough fiscal stimulus from Japan would pressure global bond yields higher even though JGBs remain capped. Admittedly, the cap on nominal JGB yields would limit the contagion from Japanese fiscal stimulus to the rest of the global bond market. As would the impact of a depreciating yen relative to the euro and U.S. dollar. However, we also suspect that the shift toward greater fiscal stimulus in both the U.S. and Japan would cause investors to revise their global growth expectations higher, and that this impact would dominate in terms of the impact on global bond yields. Investment Conclusions The odds of further bond bearish catalysts emerging during the next 6-12 months remain quite elevated. The most likely candidates would be an announcement of substantial fiscal stimulus in Japan and/or a hawkish policy shift from the Fed. The ECB is unlikely to contribute to the bearish pressure on global bonds during the next 6-12 months. As such, we continue to recommend a below benchmark duration stance on a 6-12 month horizon. In global bond portfolios, investors should remain overweight core Europe, underweight U.S. Treasuries and neutral JGBs. Valuation & Expected Returns In U.S. High-Yield A commonly used tool for assessing value in the high-yield bond market is a default-adjusted spread. That is, we formulate an expectation for default losses during our investment horizon and compare it to the spread that is currently on offer. If the current spread is elevated compared to our expectation for default losses then the default-adjusted spread is high and we would see good value in high-yield bonds relative to equivalent-duration Treasuries. This week we examine two different formulations of a default-adjusted spread for the U.S. high-yield market and test how well each corresponds to excess junk returns. The first measure we look at is a true ex-ante measure. It relies only on data that are available in real time, and can therefore be used as part of a trading strategy. Specifically, our ex-ante default-adjusted spread is calculated as the average option-adjusted spread from the Bloomberg Barclays U.S. High-Yield index less an expectation of default losses for the subsequent 12 month period. Expected default losses are calculated by taking the Moody's baseline forecast for the U.S. speculative grade default rate during the next 12 months and multiplying it by 1 minus our forecast of the recovery rate for this same period. We forecast the recovery rate based on its historical relationship with the default rate. The second measure we examine is an ex-post default-adjusted spread. In this case we look at the average spread of the index less actual default losses that are realized during the subsequent 12 months. As such, this measure can only be calculated after the fact. Comparing the ex-ante and ex-post measures, we see that both tend to reside within a range of 200 to 300 basis points. However, the ex-post measure periodically shows a negative value while the ex-ante measure is more often above 300 bps (Chart 5). This tells us that when forecasting default losses it is more common to underestimate default losses, rather than overestimate them. Chart 5Distribution of Default-Adjusted Spreads Over Time The next thing we look at is how closely each measure aligns with high-yield excess returns (Charts 6 & 7). Our ex-ante measure explains 34% of the variation in high-yield excess returns since 2002 (when our sample begins). Predictably, the ex-post measure, which removes the error surrounding the default loss forecast, explains a greater proportion of the variation in excess junk returns (53%). Our sample period is also longer for the ex-post measure, beginning in 1995. Chart 612-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Chart 712-Month Excess High-Yield Returns Vs. ##br##Ex-Post Default-Adjusted Spread (1995 - Present) The current average option-adjusted spread for the High-Yield index is 459 bps. If we incorporate the Moody's baseline forecast for the default rate during the next 12 months (4.1%) and our forecast for the recovery rate (39%), then we calculate an ex-ante default-adjusted spread of 210 bps. Using the relationship in Chart 6, this translates into an expected 12-month excess return of -26 bps. If we assume there is no error in our forecast then we can use the relationship in Chart 7. In that case, our expected 12-month excess return would be +55 bps. Of course, that exercise imposes a linear relationship between excess returns and the default-adjusted spread and doesn't consider that there is considerable variation in actual excess returns around this trendline. For that reason, in Charts 8 & 9 we split both our default-adjusted spread measures into intervals of 50 basis points. For each interval we display the average 12-month excess return along with a 90% confidence interval for where those returns are likely to fall. Chart 812-Month High-Yield Excess Returns & 90% Confidence Intervals: ##br##Ex-Ante Default-Adjusted Spread Chart 912-Month High-Yield Excess Returns & 90% Confidence Intervals:##br## Ex-Post Default-Adjusted Spread Specifically, the blue dots in Charts 8 & 9 show the 12-month excess return that is earned on average when the default-adjusted spread falls into a particular interval. The top and bottom edges of the vertical lines correspond to the upper and lower limits of the 90% confidence interval. More statistics related to the 12-month excess returns that have been observed when the default-adjusted spread falls into a specific interval can be found in the Appendix to this report. The main message from these charts is that a default-adjusted spread below 100 bps is a powerful sell signal, while a default-adjusted spread above 350 bps is a powerful buy signal. Between those two thresholds the signal is less clear. Bottom Line: Given current spread levels and our default loss expectations, valuation in the U.S. high-yield market sends neither a strong buy nor sell signal, but is consistent with small positive excess returns. Our inclination is to remain cautious on U.S. high-yield for the time being, but to look for opportunities to upgrade from more attractive valuations. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com Appendix Table 112-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy The rise in Treasury yields is approaching a threshold that has often caused equity market indigestion. Stay focused on current monetary conditions rather than fiscal unknowns. The bear market in lodging stocks has played itself out: take profits on an underweight position. The sell-off in home improvement retail shares is overdone, and a contrarian long position should pay off despite the backup in mortgage rates. Recent Changes S&P Hotels Index - Take profits of 3% and raise to neutral. Table 1Sector Performance Returns (%) Feature Momentum may carry the market higher in the short run, but from current valuation levels, stocks, the dollar and bond yields can only climb sustainably in tandem if a non-inflationary economic boom is taking hold. In that sense, equities appear to be taking their cue solely from the anticipated U.S. political shift while ignoring the tightening in monetary conditions and hints of emerging market financial strains. The equity market outlook hinges on a judgement call as to whether the action in the currency and Treasury yields is reflective or restrictive? There are no easy answers, but below we discuss some of the variables that influence this decision. Chart 1 shows that the 10-year Treasury yield has climbed above fair value. Equity bulls may rejoice because yields have sauntered much deeper into undervalued territory before stocks have run into trouble. The big difference this time is that the greenback is also climbing. Parallel powerful rises in both the currency and yields are rare, and typically culminate in steep market pullbacks. Importantly, most of the recent yield rise reflects an increase in inflation expectations. The real component, i.e. economic growth expectations, has been far more muted (Chart 2). Chart 1Stocks, Yields, And The Dollar##br## Can't Climb Together For Long Chart 2Inflation Expectations ##br##Are Driving Up Yields Equities shrugged off the surge in yields during the 2013 taper tantrum. However, yields never rose above fair value then, and the increase was almost entirely due to the real component rather than a rise in inflation expectations, i.e. it was more reflective than restrictive (Chart 2). Meanwhile, equities had just been through a difficult stretch in 2012 on fears the euro was going to break apart, and sovereign yields in the periphery were in the early stages of a long descent (Chart 3). In other words, there was a structural tailwind for equities. In addition, the U.S. dollar was range-bound during that period, overall profit growth was strong, business lending was picking up and corporate bond spreads stayed tight (Chart 3). The outlook today is much different. Euro area periphery yields are up sharply, EM bond spreads are flaring out, profit growth is much weaker and the U.S. is importing deflation through U.S. dollar strength (Chart 3), particularly against China and other developing market currencies. Thus, we are uncomfortable making comparisons between today and 2013 broad market resilience. The speed of upward adjustment in Treasury yields also influences equity prices. At the moment, yields are rising faster than profit growth. The overall market has typically become more volatile and often corrects when the growth in yields outpaces profit growth (Chart 4). Chart 3The 2013 Taper Tantrum##br## Is Not A Good Guide Chart 4Too Far,##br## Too Fast? The most painful equity corrections have occurred when this gauge drops below -10%, as the latter suggests that inflation expectations are increasing rapidly, warning of valuation and monetary tightening ahead. This threshold is in danger of being breached on any further rise in yields. However, if the currency continues climbing, yields are unlikely to rise much further, if at all, underscoring that the next big tactical sub-surface market move may be a recovery in yield-dependent sectors as investors begin to fret about the deflationary and profit-sapping impact of a strong dollar. Against this backdrop, we caution against getting too comfortable extrapolating market momentum, because recent gains could be erased just as quickly as they accrued if monetary conditions keep tightening. On a sub-surface basis, value is being created in interest rate-sensitive sectors and destroyed in cyclical sectors, primarily industrials, as discussed last week. Meanwhile, we maintain a domestic vs. global focus, and recommend buying into the pullback in housing stocks. Buy Home Improvement Retailers Like many other interest rate-sensitive groups, home improvement retailers (HIR) have lagged recently, fueled by the surge in bond yields, and hence, mortgage rates. We doubt this is sustainable. U.S. currency strength will refocus attention on the lack of top-line growth in global-oriented industries, which will reverse recent countertrend intra-sector capital flows, and ensure that bond yields are capped. The housing market slowed this year by most metrics (housing starts, permits, sales growth), which undermined remodeling activity. In response, building supply store sales cooled (Chart 5, bottom panel). Recent earnings reports from housing-geared industries such as appliances and furniture vendors have also disappointed. Analysts have been quick to slash both sales and earnings growth estimates (Chart 5). However, as often happens, an overreaction appears to be occurring. There is little indication of a return to punitively deflationary industry conditions. In fact, the producer price index for appliance and furniture makers has shot up in recent months, heralding stronger HIR pricing power (Chart 6, second panel). Lumber prices are also up sharply, despite U.S. dollar strength, which will boost the top-line and profit margins (Chart 6). At a fixed spread over lumber prices, the higher the latter go, the more profit earned at a constant volume sold. We continue to be encouraged by the long-term outlook. Household formation is accelerating now that the unemployment rate is below 5%. Building permits are below average levels, even excluding the housing bubble period (Chart 7). Chart 5Housing Slowdown Already Reflected Chart 6No Sign Of Deflationary Stress Chart 7Still Early In The Mortgage Cycle Consumers have only recently become comfortable taking on mortgage debt, and first time buyers represent a rising share of total home sales. Banks are ready and willing to extend mortgage credit (Chart 7, bottom panel), unlike most other credit. Ergo, housing activity still has legs. While the backup in Treasury yields will no doubt make housing somewhat less affordable, Chart 8 shows that even a 100 basis point rise would not push affordability back to average levels. Mortgage payments would still be well below the long-term average as a share of income, and effective mortgage rates are still extremely low. Therefore, we would not be surprised to see stable housing metrics in the coming months, despite the yield back up. Existing house prices are flirting with new highs (Chart 7), despite the early stage of mortgage re-leveraging, which bodes well for future house price increases. If homeowners are confident that house prices will stay solid, they will be more inclined to make home improvement investments. These factors are represented in our HIR model. The model is climbing steadily, exhibiting a rare positive divergence from relative share prices (Chart 9). Our inclination is to side with the objective message from the model. The valuation case for the group has improved markedly. The forward P/E is well below the average of the last decade and the dividend yield is now on a par with that of the broad market. Typically, a positive yield differential has been a bullish relative performance signal (Chart 10). Chart 8Higher Yields Are Not A Game Changer Chart 9Our Model Remains Firm Chart 10Discounting A Weak Housing Market Most importantly, the industry continues to generate sky-high return on equity, and free cash flow is booming. The implication is that shareholder-friendly stock buybacks and dividend increases should continue apace, especially compared with the overall corporate sector. At current valuation levels, there is room for a playable recovery in relative performance, especially if Treasury yields level off on the back of relentless U.S. dollar strength. Bottom Line: Home improvement retail (BLBG: S5HOMI - HD, LOW) stock price weakness is a buying opportunity. We recommend an above-benchmark allocation. End Of The Bear Market In Hotel Stocks The S&P hotels index has been in a relative performance bear market since late last year when we reduced it to underweight, but downside risks have diminished even though a number of players have lowered 2017 guidance and revenue per room (REVPAR) expectations. Relative value has been created by the past year of underperformance. A variety of valuation metrics show that the price ratio is plumbing recessionary-type levels (Chart 11). Most notably, the relative price/sales ratio is almost on a par with the lows during the Great Recession, when a steep contraction was anticipated for the foreseeable future. Such a dire forecast is not in the cards, even if economic growth disappoints an increasingly optimistic consensus. The plunge in net earnings revisions has not been confirmed by a downturn in hours worked. Typically, these two series move hand-in-hand (Chart 12). Instead, hours worked continue to trend higher suggesting that reduced profit guidance is bringing analyst expectations to more attainable levels rather than signaling impending doom. After all, persistent hotel construction growth means that demand needs to run hot in order to keep deflationary pressures at bay. This has been a tall order in the past year, as tight business budgets and lackluster discretionary consumer spending have kept REVPAR under wraps (Chart 13). Occupancy rates remain below previous expansionary run rates, leaving revenue per room more exposed than normal to demand soft spots. Chart 11End Of Bear Market Chart 12An Undershoot In Estimates Chart 13Slow, But Steady, Growth REVPAR could be supported by decent consumer spending. Wage growth, and thus aggregate income, are perking up, job security has risen and income expectations are on the upswing. Consumers are behaving as if income gains will be permanent, given the increase in consumer loan demand. Low fuel prices and the surge in vehicle miles driven are consistent with solid lodging outlays. The latter have recently reaccelerated, and are supporting better than market hotel pricing power (Chart 13). Importantly, hotel profit margins are no longer under extreme duress. Decent pricing power gains and an easing in the industry's total wage bill inflation have combined to support an increase in our profit margin proxy (Chart 14). All of this implies that profit conditions are stabilizing, just as valuations have been squeezed, warranting an upgrade to neutral. Why not a full shift to overweight? There are a number of factors to consider. The lodging industry is battling secular crosscurrents. On the positive side, the lodging industry has consistently managed to increase its share of total consumer spending, in real terms (Chart 15), with periodic underperformance phases, typically during recessions. This likely reflects well-timed capacity investments and strong brands. As a result, hotel pricing power has also been in a structural uptrend (Chart 15). This cycle, pricing power has lagged, consistent with subdued REVPAR gains, but hotels have still managed to aggressively grow earnings per share. While buybacks have undoubtedly played a role in this advance, EPS is following a typical pattern. In the last four decades, hotels have suffered four major recession-related earnings contractions. After each contraction, profits ultimately surpassed their previous peak by more than 75%, on average. The duration of the upcycle averaged five years. This cycle the recovery has already lasted more than six years, but hotel profits have only increased 30% from the 2007 peak. That implies substantial profit upside ahead just to reach the average, albeit pricing power will need to kick in as it has in past cycles. On the downside, consumers are still showing a penchant for spending more on essentials compared with non-essentials. The ratio of retail sales at cyclical stores to non-discretionary stores has been highly correlated with relative performance (Chart 16, top panel). Chart 14The Margin Squeeze Is Over Chart 15Structural Tailwinds... Chart 16... And Headwinds That raises some question about the latest burst of strength in lodging outlays, especially in view of the pruning in business travel budgets, as confirmed by anecdotes from recent earnings reports. BCA's capital spending model is not forecasting any improvement (Chart 16, bottom panel). Lingering in the background has been the relentless increase in lodging construction. Capacity growth represents a long-term threat to pricing power (Chart 16), over and above the threat from new entrants such as AirBnB. Expansion explains why real hotel consumer prices have not come close to hitting new highs even though real hotel spending has. Hotel capacity expansion heralds intensifying deflationary pressure. Meanwhile, hotels have sizeable global operations, exposing profitability to risks of incremental U.S. dollar strength. Consequently, we would prefer to await signs of an impending improvement in capital spending, and thus, business travel, and/or a sharp downturn in hotel construction spending, before lifting positions all the way to overweight. Bottom Line: Lift the S&P hotels index (BLBG: S5HOTL - MAR, CCL, RCL, WYN) to neutral, locking in an 3% relative performance profit since our initial underweight call nearly a year ago. A further upgrade is tempting, but awaits relief from pricing power constraints. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In November, the model underperformed global equities and the S&P in USD and in local-currency terms. For December, the model reduced its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). Within the equity portfolio, most of the decrease in allocation came at the expense of EM, Sweden, Netherlands, U.S., and New Zealand. The model increased its weighting in Swedish, French, U.K., and Canadian bonds. The risk index for stocks deteriorated in November, while the bond risk index improved significantly. Chart 1Model Weights Feature Performance In November, the recommended balanced portfolio lost 1.5% in local-currency terms and was down 3.4% in U.S. dollar terms (Chart 2). This compares with a gain of 1.3% for the global equity benchmark, and a 3.7% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The sharp bond selloff and weakness in EM equity markets both took a toll on the model's performance in November. Weights The model cut its allocation to stocks from 66% to 53%, and increased its bond weighting from 26% to 47%. The allocation to cash was brought down to zero from 8%, while commodities remain excluded from the portfolio (Table 1). The model trimmed its allocation to Latin American equities by 4 points, Sweden by 3 points, and the Netherlands by 3 points. Also, weightings were reduced in U.S., New Zealand, Spanish, and Emerging Asian stocks. In the fixed-income space, the allocation to Swedish paper was boosted by 12 points, France by 7 points, Canada by 5 points, the U.K. by 3 points, and Italy by 1 point. Allocation to New Zealand bonds was decreased by 6 points and U.S. Treasurys by 1 point. Chart 2Portfolio Total Returns Table 1Model Weights (As Of November 24, 2016) Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated significantly in November following the U.S. presidential election. Our Dollar Capitulation Index spiked and is currently at levels that suggest the rally in the broad trade-weighted dollar could pause (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The momentum indicator for commodities has moved further into overbought territory, pushing up the overall risk index. This asset class remains excluded from the portfolio (Chart 4). The deterioration in the liquidity and momentum indicators has lifted the risk index for global equities to the highest level in over 2 years. Our model cut its weighting in equities for the fourth month in a row (Chart 5). Chart 4Commodity Index And Risk Chart 5Global Stock Market And Risk The risk index for U.S. stocks increased sharply in November. With stocks reaching new highs, the model trimmed its allocation to this bourse. The markets took note of the growth-positive aspects of Trump's policies, but seem complacent about the stronger dollar, higher interest rates, and the potential for trade protectionist policies (Chart 6). The risk index for euro area equities has ticked up slightly in November. However, unlike its U.S. peers, it remains in the low-risk zone. Above-trend growth could provide support for euro area equities. (Chart 7). Chart 6U.S. Stock Market And Risk Chart 7Euro Area Stock Market And Risk The risk index for Dutch equities ticked up slightly and the model has downgraded this asset. That said, the weighting in Dutch equities remains the highest among its euro area counterparts (Chart 8). Improvements in the value and momentum measures for Latin American stocks have been largely offset by a deteriorating liquidity reading. As a result, the risk index did not decline much after the selloff. The model decreased its allocation to this asset (Chart 9). Chart 8Dutch Stock Market And Risk Chart 9Latin American Stock Market And Risk Over the course of only a few months, the risk index for bonds has swung from an extremely high risk level to the low-risk zone. Momentum has been the primary driving force behind this move and currently suggests that yields could pull back in the near term (Chart 10). The risk index for U.S. Treasurys declined significantly in November. While the model used the latest selloff to boost its allocation to bonds, it preferred to add allocation to bond markets outside of Treasurys. (Chart 11). Chart 10Global Bond Yields And Risk Chart 11U.S. Bond Yields And Risk After the rise in yields, Canadian bonds are massively oversold based on our momentum measure. The extremely low-risk reading has prompted the model to allocate to this asset (Chart 12). German bonds are oversold, but the reading on the cyclical measure has become considerably more bund-unfriendly. The model opted not to include bunds in the overall boost to its bond allocation. (Chart 13). Chart 12Canadian Bond Yields And Risk Chart 13German Bond Yields And Risk The risk reading in French bonds is more favorable than for bunds. Apart from oversold momentum, the value reading has also improved. The model increased its allocation to French bonds (Chart 14). The cyclical component of the risk index for Swedish bonds keeps moving in a bond-bearish direction. But that is completely overshadowed by extremely oversold conditions. In fact, the overall risk index for Swedish bonds is the lowest within our bond universe. Much of the increase in overall bond allocation ended up in Swedish paper (Chart 15). Chart 14French Bond Yields And Risk Chart 15Swedish Bond Yields And Risk Following sharp gains, the 13-week momentum measure for the U.S. dollar has reached levels at which some consolidation may take place. But the recovery in the 40-week rate of change measure indicates that it would probably be a pause in the dollar bull market rather than a trend change. With the December rate hike baked in, the Fed's communication about the policy next year holds the key to the path of the dollar - in addition to the fiscal policy of the next administration (Chart 16). The Japanese yen has been a major victim of the dollar rally. The 13-week momentum measure is approaching levels that halted the yen weakening trend in 2013 and 2015. However, this time around, it is not coupled with the same signal from the 40-week rate of change measure. The BoJ is sticking to its easy monetary policy, and some additional support on the fiscal front could drag the yen lower, notwithstanding a possible hiatus in the short term. Short term the yen could benefit from an EM pullback (Chart 17). After the latest bout of depreciation, the euro seems poised for another attempt to break below 1.05. The 13-week and 40-week momentum measures do not preclude this from happening. However, it would probably take the ECB to reaffirm its dovish message to push EUR/USD technical indicators into more oversold territory (Chart 18). Chart 16U.S. Trade-Weighted Dollar* Chart 17Yen Chart 18Euro Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com
Highlights Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Portfolio Strategy The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth imminently accelerates. The spike in large cap industrial stocks represents a massive knee-jerk overreaction and we are adding the sector on our high conviction underweight list. Take profits in the S&P air freight & logistics group and cut to neutral, and downgrade the S&P electrical components & equipment group to underweight. Recent Changes S&P Air Freight & Logistics - Take profits of 6% and reduce to neutral. S&P Electrical Components & Equipment - Trim to underweight from neutral. S&P Industrials Sector - Add to our high-conviction underweight list. Table 1 Feature Equities are still in a post-election honeymoon phase. The savage reaction in the bond market has not yet backlashed onto the broad stock market. Instead it has sparked a rapid and powerful rotation in intra-sector capital flows. The danger is that an unwinding of the momentum trade in the bond market is being misinterpreted as a pro-growth, pro-cyclical investment shift. Investors appear to be equating a potential increase in economic growth with better profitability. However, basing equity strategy on unknown future policies is fraught with risk, as is equating GDP with corporate profits. Trump's signature policies, protectionism and fiscal spending, are inflationary and U.S. dollar bullish, and the timing of implementation and ultimate size of spending programs, remain anyone's guess. In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what's good for the economy should not be automatically extrapolated through to profits. Net earnings revisions fall when the currency is strong (Chart 1). Capital has won out handily vs. labor since the Great Recession, which allowed profits to boom even though economic growth was below-potential. This is changing. Labor costs are now on the upswing, and productivity has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. If labor expenses accelerate, it becomes even more critical for corporate sector sales to regain traction in order to offset the squeeze on profit margins. However, just under half of S&P 500 sales come from abroad. A strong U.S. dollar means the U.S. will be importing deflationary pressures, undermining pricing power. U.S. dollar appreciation also saps growth in developing countries. Emerging market capital spending is already contracting (Chart 2), and as shown last week, financial strains are flaring back up. Ergo, U.S. companies will be less competitive, and selling into weaker demand growth abroad. Chart 1A Strong Dollar Will Sink Profits... Chart 2... And Hit Global Growth Chart 3 shows that S&P 500 sales typically contract during major dollar bull markets. A recovery has only occurred once currency depreciation occurs. The equity market reaction has been mixed during these periods, as a strong dollar has capped growth and pushed down Treasury yields, supporting a valuation expansion. We do not recommend positioning for a bullish equity outlook, given already overvalued conditions and the rise in government bond yields. It is notable that the inflation component of yields has done the heavy lifting, rather than an upgrading in economic expectations (Chart 4). In other words, there is a sequencing issue, a strong currency saps profits now, while stimulus may only arrive much later. U.S. dollar-based global financial liquidity is now contracting as a consequence of U.S. dollar strength (Chart 4). If excess liquidity and low rates were the argument for supporting high valuations previously, tighter liquidity and rising rates can't also justify current multiples, especially if global growth is soft. As discussed in our November 3, 2014 Special Report, currency strength favors a mostly non-cyclical, domestically-oriented portfolio structure. One of our favored themes over the past few months has been to tilt portfolios in favor of domestic vs. globally-oriented industries. With the U.S. dollar breaking above its trading range, a catalyst now exists to spur an imminent recovery in the domestic vs. global share price ratio. The latter had become extremely oversold as the U.S. dollar consolidated and the Chinese economy began to stabilize, but economic fundamentals are shifting decisively back in favor of the U.S. The U.S. PMI is already making small strides vs. the Chinese and euro area PMI (Chart 5, second panel), heralding a rebound in the cyclical share price momentum. Chart 3No Sales Recovery Ahead Chart 4Tighter Liquidity, Rising Inflation Chart 5Domestic Will Beat Global World export growth remains anemic, and world export prices continue to deflate, albeit at a lesser rate. Sagging Asian currencies warn that trade is at risk, over and above protectionist rhetoric and/or policies. When compared with the reacceleration in U.S. retail sales, the outlook for domestic-sourced profits is even brighter. We reiterate our theme of tilting to domestic vs. globally-oriented industries. The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategy. This week we are taking some cyclicality out of our portfolio following the wild market gyrations in the past two weeks. Taking Advantage Of The Industrials Sector Overreaction... Industrials have vaulted higher, in relative terms, on the back of hopes for rampant fiscal stimulus and infrastructure spending as far as the eye can see, ignoring any negatives that may arise from protectionist policies and tighter monetary conditions. While defense contractors may see an increase in activity (we continue to recommend an overweight in the BCA defense index), in aggregate, the surge in the large cap industrials sector is an opportunity to retool exposure from a position of strength. Large cap industrials companies garner approximately 45% of their revenue from outside the U.S. The industrials sector has the second worst track record among all sectors during U.S. dollar bull phases, trailing only the materials sector. Regression analysis shows that industrial sectors sales would contract by 4.5% for every 10% in the trade-weighted dollar (Chart 6). Without revenue growth, it is hard for industrial companies to generate good profitability, given high operating leverage. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure spending. Commodity prices key off the U.S. dollar. Emerging markets (EM) are also sensitive to the currency. A strong U.S. dollar undermines income in commodity producing countries, creates financial strains related to EM foreign currency denominated debt and reins in domestic liquidity in countries that need to intervene to stop their currencies falling too far lest capital flight and inflation occur. As noted last week, emerging market currencies are already rolling over, and CDX spreads have begun to widen (Chart 7). EM equity markets are underperforming the global benchmark, reinforcing the lack of a regional growth impulse (Chart 7). It is rare for the industrial sector to deviate from relative EM equity performance. There has been no evidence of EM deleveraging, and the back up in global bond yields represents a financial stress. If U.S. industrials stocks are a high-beta play on EM, then contrarians should beware recent sector action. Chart 6Top-Line Trouble Ahead Chart 7Sell The Spike Importantly, capital spending is in retreat. Business investment is a function of confidence and expected return on investment. The gap between the return on and cost of capital is narrowing fast (Chart 8). Free cash flow is paltry, especially in resource sectors, major industrial sector end markets. It is hard to envision a major capital spending turnaround if the U.S. dollar keeps climbing and the cost of capital backs up further. Policy ambiguity will act as a weight for at least the next few quarters. During this period, the negative profit impact of the contraction in private and public sector construction activity will ultimately re-exert a major influence on sector risk premia. It will take at least several quarters before any hoped for fiscal spending will benefit industrial companies. Industrials sector pricing power has shifted from a deep negative to neutral. However, that appears to represent an unwinding of the rate of change shock more than a resumption of conditions conducive to companies lifting selling prices. Chart 9 shows that capital goods import price are still deflating. As the Chinese currency devalues, putting downward pressure on its regional counterparts, deflationary pressures will re-intensify for U.S. industrial firms (Chart 9). Chart 8Fiscal Stimulus Is Needed... Right Now! Chart 9The Dollar Will Do Damage ...By Selling Electrical Components & Equipment ... In terms of specifics, were we not underweight machinery shares already, we would institute a high conviction underweight today. In addition, the S&P electrical equipment and components (ECE) index looks equally vulnerable. While less exposed to commodity prices than machinery stocks, ECE shares have benefited alongside the overall sector from the post-election buying frenzy. Hefty short positions likely played a large role in powering the spike (Chart 10), and we are uncomfortable with paying a premium valuation for a dubious earnings outlook, particularly given the sector's brutal long-term track record during U.S. dollar bull markets (Chart 11, top panel, the currency is shown inverted). From a cyclical perspective, it is premature to position for a reversal in the relative earnings bear market. New orders for electric equipment are sensitive to EM currency movements. The current message is that new orders are likely to languish (Chart 11). Relief is not imminent from domestic sources. Chart 11 shows that real investment spending on electrical equipment is contracting at a steep rate. That is consistent with the trend in overall construction spending, which represents a long-term headwind. It is no surprise that industry productivity growth is contracting (Chart 11), reinforcing that the path of least resistance for profits is lower. It would take a major resurgence in top-line growth to restore productivity to positive levels. The ECE industry is one of the few 'smokestack' parts of the economy to have added capacity in recent years. That is confirmed by persistent growth in ECE wage inflation (Chart 12). Without a pickup in demand, this backdrop is conducive to ongoing deflation (Chart 12, bottom panel). Sell into strength. Chart 10Short Covering Will Not Last... Chart 11... As Fundamentals Erode Chart 12Cost Structures Are Too High ...And Taking Profits In Air Freight Stocks ... Elsewhere, we are taking profits on our overweight S&P air freight & logistics index. While we only recently went overweight in early-September, a much shorter time horizon than our desired cyclical calls, we are concerned that the index has front run an improvement in global trade that may be slow to materialize. Our upgrade was predicated on a tightening in inventories relative to GDP, which boosts the need for just-in-time air freight services, as well as a pickup in emerging markets activity. However, our confidence in the latter has been shaken. Air freight stocks are a reflation play, and a surging U.S. dollar is a threat to global liquidity (Chart 13). Global revenue ton miles have already crested after a muted rebound (Chart 14, second panel). Chart 13A Reflation Play Chart 14Take Profits Moreover, protectionist/anti-globalization sentiment may heat up, representing a risk to a recovery in global trade. The IFO export expectations index continues to sink, a warning for relative forward earnings estimates (Chart 14). The contraction in transport and warehousing hours worked confirms that transport activity is not yet on the mend (Chart 14). Relative performance has a history of violent oscillations, and the price ratio has soared to the top end of its multiyear range. Thus, even though the structural increase in online sales bodes well for long-term growth, and value remains appealing, we are booking profits and reducing positions in this globally-exposed group back to neutral in order to de-risk in our portfolio. Bottom Line: Take profits of 6% in the S&P air freight & logistics index and reduce to neutral. Downgrade the S&P electrical equipment index to underweight and add the overall industrial sector to our high conviction underweight list. The ticker symbols for the stocks in these indexes are: BLBG: S5AIRF - UPS, FDX, CHRW, EXPD, and BLBG: S5ELCO - AME AYI EMR ETN ROK. Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights Portfolio Strategy Retail food stocks are deep into the buy zone. Deflating food costs augur well for profit margins in the coming quarters. Lift the financial sector to neutral, via the asset manager and investment bank indexes. Recent Changes S&P Financials Sector - Raise to neutral, recording a loss of 8%. S&P Asset Manager & Custody Bank Index - Raise to overweight from underweight, locking in a profit of 5%. S&P Investment Bank & Brokerage Index - Raise to neutral, recording a loss of 3%. Table 1Sector Performance Returns (%) Equity markets celebrated the surprise Republican U.S. election victory. Investors believe the regime shift will entail fiscal stimulus and a lifting in regulatory constraints that stir animal spirits and lift the economy out of its growth funk. The reality is that it is premature to make long-term assumptions. Meanwhile, the underlying fragility of the U.S. economic expansion will be tested in the coming quarters. Indeed, it is easy to envision a hit to business confidence, causing delays in decision making and investment, especially given Trump's anti-trade rhetoric and penchant for profligacy. Policy uncertainty and confidence have been reliable leading indicators for valuations, and slippage would put upward pressure on the Equity Risk Premium (Chart 1). It will be critical to monitor aggregate financial conditions. The Goldman Sachs Financial Conditions index has tentatively edged up (Chart 1), and if corporate bond spreads, long-term yields and the U.S. dollar move much higher, upside risks will intensify. The low level of overall potential growth has made the economy increasingly sensitive to swings in financial conditions and deflationary impulses from abroad. Both the high yield and investment-grade corporate bond index are languishing, perhaps picking up on the deflationary signal from U.S. dollar strength and growth drag from higher Treasury yields (Chart 2, bottom panel). It is notable that emerging markets currencies have pulled back. These exchange rates are typically pro-cyclical. Sustained currency weakness typically leads to domestic corporate bond spread widening (Chart 2, CDX spreads shown inverted). In the past five years, it has paid to bet on defensive over cyclical sectors when EM currencies weaken and CDX spreads are this tight, i.e. contrarians should take note. At a minimum, it may be a signal that global growth is less robust than the rise in global bond yields implies. As a result, forecasts for double-digit profit growth in the next twelve months look very aggressive, even if our economic outlook proves too cautious. The tentative trough in third quarter S&P 500 profits has not yet been validated by other indicators. For example, tracking tax revenue provides a good real-time gauge on corporate sector cash flows. Federal income tax receipts have dropped into negative territory. Corporate income taxes are contracting. Previous major and sustainable overall profit recoveries have been either led by, or coincident with, corporate income tax growth (Chart 3). This argues against extrapolating positive third quarter earnings growth in the S&P 500. Chart 1Watch Confidence And Financial Conditions Chart 2Don't Get Caught Up In The Hype Chart 3Taxes And Profits Rather than get overly excited about the potential for a new fiscal spending impulse, it may be more appropriate to view the latter as truncating downside economic risks, given that the corporate sector remains a key headwind to stronger growth, even excluding its balance sheet stress. Consequently, we still expect undervalued defensives to retake a leadership role from overvalued cyclical sectors and we also retain a domestic vs. global bias. If the U.S. dollar breaks above its recent trading range, the odds of the broad market making further liquidity fueled gains will diminish significantly. Importantly, the last few days of market moves have been massively exaggerated, as industrials and materials have rallied as if fiscal stimulus is about to hit next month. Even when implemented, it is not a panacea for sector earnings. Drug and biotech stocks have soared as if pricing pressures will evaporate, when in reality price pressures emerged prior to any political interference. Tech stocks have been crushed because of fears they will be forced to move production back to the U.S. All of these knee-jerk reactions should be treated with caution, with the exception of financials, where a step function reduction in the risk premium may be underway. There Is A New Sheriff In Town: Lift Financials To Neutral Financials have celebrated the modest upshift in the interest rate structure and hopes for a reversal of the regulatory framework that has been a structural noose on profitability, and risk premiums. These factors, along with our domestic vs. global bias, argue against maintaining a below benchmark weighting on a tactical basis. As discussed last week, our view on banks remains cautious, however, asset managers and investment banks have lower odds of falling back toward recent lows even after election euphoria inevitably fades. The largest earnings drags from the past year have eased. M&A activity has troughed. New and secondary stock offerings have hooked back up and margin debt is back to new highs, suggesting that investor risk appetites have stopped shrinking (Chart 4). Thus, capital formation is unlikely to dry up, even if upside is limited given poor corporate sector balance sheet health and an upward creep in the cost of capital. In terms of asset managers and custody banks (AMCB), even modestly higher interest rates would reduce a major profit impediment. Fees on funds held in trust have been decimated by ZIRP, underscoring that the latest uptick in short-term Treasury yields is a plus. Relative performance had already diverged negatively from the stock-to-bond ratio, the equity risk premium and global economic sentiment (Chart 5). This gap could close with a prospective thawing in relations between lawmakers and the industry. There is still structural downward pressure on fees as low cost ETFs gain market share, but that is being partially offset by the renewed growth in total mutual fund assets (Chart 4, bottom panel). Bear in mind that both groups tend to do well when the stocks outperform bonds, as seems likely in the near run given creeping protectionism. In sum, despite our concerns about overall financial sector productivity growth, mainly owing to rising bank cost structures, and the risks of a renewed deflationary impulse from U.S. dollar strength, we are lifting sector weightings to neutral. This will put us onside with the objective message from our Cyclical Macro Indicator, the buy signal from our Technical Indicator (Chart 6) and our broader theme of favoring domestic vs. global industries. Chart 4Earnings Drivers Have Stabilized Chart 5Recovery Candidate Chart 6Following Our Indicators Bottom Line: The Republican victory has provided a fillip to the financials sector, and underweight positions putting underweight positions offside. We are lifting allocations to neutral, via the S&P AMCB and S&P investment banks & brokerage indexes. AMCB moves to overweight, and the latter to neutral, with an eye to downgrading again once euphoria fades and investor focus returns to economic durability. Food Retailers: Too Cheap To Overlook Food retailers offer attractive value, defensive and domestic equity exposure with the potential for upside profit surprises. This group will benefit if U.S. wage inflation persists. The latter would boost consumer purchasing power and could lead to tighter financial conditions, either through U.S. dollar strength and/or a tighter Fed. The defensive appeal of retail food equities would shine through under that scenario. The starting point for grocery stocks is extremely appealing. The price ratio is extraordinarily oversold. It fell farther below its 200-day moving average than at any time since 2002, before recently bouncing (Chart 7). Valuations are cheap, return on equity is solid and share prices have diverged negatively from a number of macro indicators. For instance, relative performance has been tightly linked with the U.S. dollar, but the former plunged even as the currency firmed (Chart 8, top panel). A strong exchange rate will keep a lid on imported food costs, boost the allure of domestically-oriented industries while lifting consumer spending power. Chart 7Extraordinarily Oversold Chart 8Top-Line Improvement Ahead Outlays on food products have climbed as a share of total spending in the past six months, reversing a long-term downtrend (Chart 8). If consumer confidence stays firm as a consequence of rising wage growth and a positive wealth effect, then it is conceivable that store traffic and total grocery spending will accelerate. The surge in capital spending in recent years reflects store upgrades and a refreshed shopping experience, which could also translate into faster sales growth. Now that capital spending growth is cooling, it will reduce a profit margin drag. Profitability should also benefit from cost deflation. The food manufacturing PPI is contracting, reflecting shrinking raw food prices (Chart 9, top panel, shown inverted). It is normal for food stocks to outperform when raw food prices fall. Importantly, capacity utilization rates in the packaged food industry are very low (Chart 9), which augurs well for ongoing pricing pressure among suppliers. Tack on deflation in industry wage inflation, and it is no wonder profit margins have been able to grind back toward previous highs without a strong sales impulse. If sales rebound, as seems likely given evidence of market share gains away from hypermarkets (Chart 10, bottom panel), then grocery stores should continue to demonstrate decent pricing power gains (Chart 10, middle panel). Chart 9Cost Deflation Chart 10Gaining Market Share Adding it up, the ingredients for a powerful rally in the S&P retail food store index exist, with good downside protection should the economy disappoint on the back of tighter financial conditions. Bottom Line: We recommend an overweight position in the S&P retail food store index (BLBG: S5FDRE - KR, WFM). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.
Highlights Chart 1Targeting 2% The Fed did its best to avoid roiling markets so close to today's election, but still managed to hint at a December rate hike. The post-meeting statement was tweaked so that now only "some further evidence" rather than "further evidence" is required in order to lift the funds rate. We remain below benchmark duration in anticipation of a December rate hike. Before the end of the year we expect our 12-month discounter to reach at least 40-50bps (meaning the market will expect a further 1-2 hikes in 2017) from its current level of 28bps, and for the 10-year Treasury yield to reach 1.95-2%. While our global PMI model pegs fair value for the 10-year Treasury yield at 2.27%, the uptrend in the 10-year yield will face severe technical resistance as it approaches 2% (Chart 1). Positioning has already moved to net short duration, signaling that the bond sell-off is becoming stretched. While a Clinton victory would all but ensure a December rate hike, a Trump victory could cause a large enough market riot that the Fed delays until 2017. This would only be a brief hiccup in the return of the 10-year yield to the 1.95-2% range, and would not signal a long-lasting trend reversal. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by +56bps in October, but have already given back -26bps of those gains so far this month (Chart 2). The index option-adjusted spread is -2bps tighter than at the end of September and, at 136bps, it remains very close to its historical average. Corporate credit performance faces two immediate risks. The first is today's election and the second is the prospect of a Fed rate hike in December. A Clinton victory would likely prompt a knee-jerk rally in risk assets and virtually ensure a rate hike next month. In that case we would be inclined to further trim exposure to credit risk in the coming weeks as the rate hike approaches. Already, we recommend investors avoid the Baa credit tier within a neutral allocation to investment grade corporates. In a recent report we pointed out that highly-rated credit (A-rated and above) performed well in the initial stages of last year's run-up in rate hike expectations, but then started to suffer once market-implied rate hike probabilities approached 100%.1 Conversely, a Trump victory would likely prompt a flight-to-safety event in markets which, depending on its severity, could also cause the Fed to delay the next rate hike into 2017. In that event, the prospect of delayed Fed tightening would make us more likely to increase credit exposure in the near term, especially if any knee-jerk sell-off in risk assets creates better value in corporates. Table 3Corporate Sector Relative Valuation And Recommended Allocation* (Continued) Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by +92bps in October, but has already underperformed the Treasury benchmark by -108bps so far in November. The index option-adjusted spread is +25bps wider since the end of September and, at 505bps, it is 16bps below its historical average. In a Special Report2 published last week we noted that while the default rate will not re-visit its previous lows (at least until after the next recession), it should decline from 5.4% to close to 4% during the next 12 months (Chart 3). However, even a slightly brighter default outlook will not be enough for junk bonds to sustain their current pace of outperformance. A simple model of lagged junk spreads and default losses explains more than 50% of the variation in 12-month high-yield excess returns. This model suggests that even with lower default losses, excess junk returns will be +264bps during the next 12 months (panel 3). The reason is that lower default losses are more than offset by the lower starting point for spreads. Junk spreads should also come under widening pressure in the very near term, as a December Fed rate hike spurs an increase in implied volatility. Maintain a maximum underweight allocation to high-yield and await a better entry point for spreads in the New Year. MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +2bps in October, but are underperforming the benchmark by -7bps so far in November. Year-to-date, MBS have outperformed the duration-equivalent Treasury index by a mere +22bps. Since the end of September, the conventional 30-year MBS yield has risen +23bps, driven by a +21bps increase in the rate component. The option-adjusted spread has widened +2bps, while the compensation for prepayment risk (option cost) has remained flat. Unattractive option-adjusted spreads and the prospect of further increases in issuance make for bleak long-run return prospects in MBS. However, the likelihood that Treasury yields will continue to rise in the near-term means that MBS could outperform due to a decline in the option cost component of spreads (Chart 4). We will likely reduce exposure to MBS once a December rate hike has been fully digested by the market, and the uptrend in Treasury yields starts to taper off. The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to ease standards on GSE-eligible mortgage loans, while demand for these same loans continues to increase. The combination of easing lending standards and strengthening demand means that issuance is likely to continue its march higher, as does the persistent uptrend in existing home sales (bottom panel). Government Related: Overweight Chart 5Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by +5bps in October, but has already underperformed the Treasury benchmark by -9bps so far in November. The Foreign Agency and Local Authority sub-sectors drove October's outperformance, returning +24bps and +14bps in excess of Treasuries respectively. Domestic Agency debt outperformed the Treasury benchmark by +3bps, while Supranationals (-7bps) and Sovereigns (-10bps) both underperformed. After adjusting for differences in credit rating and duration, Foreign Agency and Local Authority bonds still appear attractive relative to investment grade U.S. corporate debt. Sovereigns, on the other hand, appear modestly expensive. We continue to recommend avoiding Sovereign issues while remaining overweight the other sub-sectors of the government related index. In a recent report,3 we observed that the performance of sovereign debt relative to equivalently-rated and duration-matched U.S. corporate credit tends to track movements in the U.S. dollar. As such, a continued bull market in the U.S. dollar will remain a significant headwind for sovereigns. At the country level, the only nations whose USD-denominated debt offers a spread advantage over Baa-rated U.S. corporate debt are Hungary, South Africa, Colombia and Uruguay. Unusually, bullet agency debt outperformed callable agency debt last month even though Treasury yields moved higher (Chart 5). Within Domestic Agency bonds, we continue to favor callable over bullet issues on the expectation that this divergence will not persist. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by -12bps in October, dragging year-to-date excess returns down to -152bps (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio is largely unchanged since the end of September, and remains close to its post-crisis average. In recent months, trends in M/T yield ratios have fluctuated alongside the betting market odds for today's Presidential election. A Trump victory would cause yield ratios to widen sharply, as President Trump's promised tax cuts would substantially de-value the tax advantage in municipal bonds. We expect yield ratios to tighten in the event that Clinton prevails, as any expectation of a Trump victory works its way out of the price. Due to attractive yield ratios relative to recent history, we are inclined to remain overweight municipal bonds in the near-term. However, we will likely downgrade the sector if yield ratios move back to previous lows. As we detailed in a recent Special Report,4 historical lags between the corporate and municipal credit cycles suggest that municipal bond downgrades will start to increase in the second half of next year, alongside a deterioration in state & local government balance sheets. Further, state & local government investment spending is poised to move higher next year, regardless of the election result, leading to even greater muni issuance (Chart 6). Elevated fund flows have offset the impact of strong issuance this year, the risk is that they will not keep pace going forward. Treasury Curve: Stay In Flatteners Chart 7Treasury Yield Curve Overview The Treasury curve has bear-steepened significantly since the end of September. The 2/10 Treasury slope has steepened +16bps and the 5/30 slope has steepened +14bps. As a result, our two curve flattener trades have struggled. Our 2/10 Treasury curve flattener has returned -41bps since initiation on September 6. Our 10/30 Treasury curve flattener has returned -25bps since initiation on September 20. Our other tactical trade - short December 2017 Eurodollar - has returned +16bps since initiation on July 12. All three of the above tactical trades are premised on the view that the Fed will deliver a rate hike in December, and that such a rate hike has not yet been fully discounted by the market. At present, we calculate that the market-implied probability of a December rate hike is 62%, as discounted in fed funds futures. The historical pattern suggests the yield curve should bear flatten as the rate hike probability approaches 100%. Unusually, the correlations between both the 2/10 and 10/30 Treasury slopes and the level of Treasury yields have moved into positive (bear-steepening) territory (Chart 7). This is especially unusual for the 10/30 slope, where the correlation has been firmly in negative (bear-flattening) territory since 2013. We continue to recommend holding curve flatteners, and expect both correlations to revert into negative (bear-flattening) territory in advance of a December rate hike, as they did last year. Any surge in bullish dollar sentiment between now and December would only increase the flattening pressure on the curve (bottom panel). So far bullish dollar sentiment has remained relatively flat, but we cannot discount a large increase in the run-up to the next rate hike, as occurred last year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by +112bps in October. The 10-year breakeven rate has increased +8bps since the end of September, and currently sits at 1.68%. The 10-year TIPS breakeven rate has increased substantially during the past couple months, and has now converged with the fair value reading from our TIPS Financial model (Chart 8). Rising expectations of a Fed rate hike and a flatter Treasury curve will weigh on TIPS during the next month, and we would not be surprised to see breakevens temporarily cease their uptrend as attention turns to Fed hawkishness following today's election. But we also expect that TIPS breakevens will resume their uptrend heading into next year. As we flagged in a recent report,5 the sensitivity of TIPS breakevens to core inflation has increased since the financial crisis. We posit that the reason for this increased sensitivity is that the Fed's ability to control long-dated inflation expectations has been impaired by the zero-lower bound on rates. As a result, the trend in breakevens is increasingly taking its cue from the realized inflation data. Realized inflation continues to trend steadily higher (bottom two panels), and diffusion indexes suggest that further gains are ahead (panel 4). Given that breakevens remain well below pre-crisis levels, we intend to remain overweight TIPS relative to nominal Treasuries and ride out any near-term volatility related to a Fed rate hike. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by +10bps in October, bringing year-to-date excess returns up to +101bps. Aaa-rated ABS outperformed the Treasury benchmark by +8bps on the month, while non-Aaa issues outperformed by +24bps. The index option-adjusted spread for Aaa-rated ABS has tightened -3bps since the end of September and, at 45bps, is considerably below its pre-crisis average (Chart 9). According to our days-to-breakeven measure, there still exists a valuation advantage in Aaa-rated auto ABS relative to Aaa-rated credit card ABS, but that advantage is rapidly evaporating (panel 3). We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 10 days of average spread widening for Aaa-rated credit card ABS to underperform. Moreover, credit card ABS exhibit superior collateral credit quality relative to autos. Credit card charge-offs remain near all-time lows, while the auto net loss rate appears to have bottomed (bottom panel). Further, the Fed's senior loan officer survey shows that auto lending standards have tightened for two consecutive quarters, while credit card lending standards were unchanged in Q3 following 25 consecutive quarters of net easing (panel 4). We recommend investors favor Aaa-rated credit cards over Aaa-rated auto loans within a maximum overweight allocation to consumer ABS. CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date outperformance up to +194bps. The index option-adjusted spread for non-agency Aaa-rated CMBS has tightened -3bps since the end of September, and remains very close to its pre-crisis average (Chart 10). The Fed's Senior Loan Officer Survey for the third quarter, released yesterday, showed that banks continue to tighten standards on all classes of commercial real estate (CRE) loans (panel 3). The survey also shows that CRE loan demand continues to increase, though at a less rapid pace than in prior quarters. While CRE prices continue to march higher (bottom panel), tightening lending standards and a rising delinquency rate (panel 4) make us cautious on non-agency CMBS. Agency CMBS outperformed the duration-equivalent Treasury index by +4bps in October, bringing year-to-date excess returns up to +105bps. Agency CMBS still offer 56bps of option-adjusted spread. This is greater than what is offered by Aaa-rated consumer ABS (45bps) and conventional 30-year MBS (19bps) for a similar amount of spread volatility. We continue to recommend overweight positions in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our Global PMI Treasury model places fair value for the 10-year Treasury yield at 2.27% (Chart 11). This model is based on a linear regression of the 10-year Treasury yield on three factors, using a post-financial crisis time interval.6 The three factors are: Global Growth: Measured using the Global Manufacturing PMI (sourced from JP Morgan and Markit) Global Growth Divergences: Proxied by bullish sentiment toward the U.S. dollar (sourced from Marketvane.net) Economic Uncertainty: Measured using the Global Economic Policy Uncertainty Index (sourced from policyuncertainty.com) The correlation between the global PMI and the 10-year Treasury yield is strongly positive (panel 3). However, improving global growth is offset by any increase in bullish sentiment toward the U.S. dollar. For a given level of global growth any increase in bullish sentiment toward the dollar represents a drag on interest rate expectations. As such, bullish dollar sentiment enters our model with a negative sign (panel 4). The final component of our model - global economic policy uncertainty - captures changes in Treasury yields related to headline risk and "flights to quality". This factor enters our model with a negative sign - more uncertainty correlates with lower bond yields (bottom panel). Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching", dated September 13, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 6 For additional details on the model please see U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, 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)