Corporate Bonds

Highlights Duration: A survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Credit Cycle: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. IG Valuation: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk. Feature Chart 1Recession Risk Getting Priced Out The bond sell-off continued last week, driven by positive developments in US/China trade negotiations and tentative signs of stabilization in some global growth indicators. The renewed sense of economic optimism has reduced the recessionary risk priced into bond markets. The 2/10 Treasury slope has steepened 30 bps since it briefly inverted in late August. During that same period, the 2-year Treasury yield is up 15 bps, the 10-year yield is up 45 bps and the Bloomberg Barclays Treasury index has underperformed a position in cash by 2.7% (Chart 1). These recent developments raise two important questions. First, should investors chase or fade the back-up in Treasury yields? And second, if the sell-off does continue, how high can yields go? To answer these questions we turn to the five macro factors that drive trends in US bond yields. These factors were outlined in our “Bond Kitchen” report from last April, and are listed right here:1 Global growth Policy uncertainty The US dollar The output gap Sentiment Back In The Kitchen Global Growth Chart 2CRB Index Needs To Rebound Three global growth indicators are particularly relevant for US Treasury yields. They are the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index. The latter is especially useful because it updates on a daily basis. Considering the CRB index, we notice that, while it is no longer in a steep downtrend, it has also not rebounded alongside the jump in bond yields (Chart 2). This should give us pause. Continued low readings from the CRB index make it more likely that bond yields will fall back in the coming weeks. We should also note that the ratio between the CRB index and Gold is more highly correlated with the 10-year Treasury yield than the CRB index itself.2 This ratio has bounced off its lows (Chart 2, top panel), but only because Gold has come under downward pressure. With the Fed committed to maintaining an accommodative policy stance until inflation expectations are re-anchored, we expect the Gold price to remain well bid. This means that raw industrials prices must rebound to keep the ratio trending higher. The CRB/Gold ratio has bounced off its lows, but only because Gold has come under downward pressure. More encouraging than the CRB index is the Global Manufacturing PMI, which has moved off its lows during the past three months (Chart 3). The increase has been partially driven by stronger US readings (Chart 3, panel 2), but principally by a significant jump in China’s PMI (Chart 3, bottom panel). Chart 3China Pulling The Global Manufacturing PMI Higher Somewhat stronger China PMI readings should be expected, given the rebound in our China Investment Strategy’s Li Keqiang Leading Indicator – a composite measure of monetary conditions, money and credit growth (Chart 4).3 We should also expect further modest policy stimulus from China, as long as the labor market remains under pressure (Chart 4, bottom panel). Turning to the US, we have seen three very positive developments in the economic data during the past month. First, the ISM Services PMI jumped from 52.6 to 54.7 in October (Chart 5). A drop in this index to 50 or below would be consistent with a US recession, while the combination of a strong service sector and a depressed manufacturing sector is consistent with our baseline 2015/16 roadmap. This roadmap leads to an eventual rebound in the manufacturing index. Second, the ISM Manufacturing PMI rose a tad in October, but the New Export Orders component jumped significantly from 41 to 50.4 (Chart 5, panel 2). Since the global slowdown began as a non-US phenomenon, a rebound in this export component sends a strong signal that we are at an inflection point. Finally, consumer confidence rose in October following a sharp decline in September. A year-over-year decline in the consumer confidence index is a reasonably strong recession signal, but recent data suggest that this signal is fading (Chart 5, bottom panel). Chart 4Modest Stimulus In China Chart 5Three Positive Developments All in all, the global growth data have turned more positive during the past month. US indicators, in particular, are no longer sending strong recessionary signals. A rebound in the CRB Raw Industrials index would give us more confidence in the durability of the recent rise in Treasury yields. Policy Uncertainty Uncertainty about the US/China trade conflict has eased considerably during the past few weeks, as the two sides appear to be working toward a “phase 1” deal that would prevent the imposition of new tariffs and roll back some that are already in place. Heightened uncertainty about the trade war played a large role in dragging bond yields lower in 2019. This becomes apparent when you notice that survey and sentiment (aka “soft”) data about the economic outlook have been significantly worse than the actual “hard” data on US economic activity.4 It is clear that negative sentiment about the trade war has held survey data and bond yields down, even as underlying US economic activity has been solid. Less bullish dollar sentiment supports a continued uptrend in Treasury yields.  We see a continued easing of trade tensions as we head into the first half of next year. President Trump has an incentive to support the economy in an election year, given the historical record of incumbent presidents being re-elected when the economy is strong. However, if this strategy doesn’t work and Trump finds himself behind in the polls by the end of next summer, then he could decide that ramping up the trade war again is the best course of action. In other words, another spike in policy uncertainty in the second half of 2020 is possible if President Trump is trailing in the polls. The US Dollar Chart 6Dollar Sentiment Points To Higher Yields The US dollar is important for the path of US Treasury yields because it signals whether US yields are decoupling from yields in the rest of the world. In other words, if the dollar appreciates significantly alongside rising Treasury yields, then we should view those yields as increasingly out of step with the rest of the world, and thus more likely to fall back down. So far, the dollar has been relatively flat as yields have risen and bullish sentiment toward the US dollar has declined significantly (Chart 6). Less bullish dollar sentiment supports a continued uptrend in Treasury yields. But if yields do in fact continue to rise, it will be important to watch the dollar’s reaction. The Output Gap Chart 7Wage Gains Hurting Margins, Not Raising Prices Some sense of the output gap is important for forecasting bond yields. This is because the same amount of global growth will lead to more inflationary pressure and higher bond yields when the output gap is small than when it is large. The fact that the output gap is smaller now than it was in 2016 is probably the reason why the 10-year Treasury yield bottomed 10 bps above its 2016 trough this year, and why the average Treasury index yield bottomed 47 bps above its 2016 trough. We have found wage growth to be an excellent indicator of the output gap, and noted in a recent report that wage growth should continue to accelerate.5 In this vein, another crucial variable to monitor is labor compensation as a percent of national income (Chart 7). The rise in this series indicates that wage gains during the past few years have come at the expense of corporate profit margins, and have not been passed through to higher consumer prices. If this series proves to have a lot more cyclical upside, then it could be some time before wage acceleration translates to higher inflation. Sentiment Chart 8Surprise Index Says Sentiment Is Neutral The final factor we consider when forecasting US Treasury yields is sentiment. We have found that the Economic Surprise Index is the single best measure of aggregate market sentiment. That is, when the Surprise index reaches a positive or negative extreme, it usually means that sentiment is too positive or too negative, and will mean-revert in the months ahead. Also, we have observed a strong correlation between the Surprise index and changes in Treasury yields (Chart 8). At present, the Surprise index is roughly neutral, and therefore does not send a strong signal about where sentiment might push bond yields during the next few months. Investment Conclusions To summarize, the outlook from our five macro factors suggests that Treasury yields will rise further in the coming months. Global growth indicators are showing tentative signs of bottoming, and should rise to levels more consistent with the “hard” economic data as policy uncertainty continues to wane. The fact that the US economic data look less recessionary than they did one month ago makes us more confident that our global indicators will rebound. Chart 9A Clear Path To 2.5% We would become concerned about a renewed downtick in yields if the CRB Raw Industrials index fails to rebound, or if the dollar strengthens significantly in the coming weeks. At the beginning of this report, we asked how high Treasury yields can go if the global growth rebound proves durable. To answer that question we refer to current estimates of the long-run neutral fed funds rate. The FOMC’s median estimate of the long-run neutral fed funds rate is 2.5% and the median estimate from the New York Fed’s Survey of Market Participants is 2.48%, with an interquartile range of 2.25% - 2.5%. If recessionary fears move to the back burner, it would be logical for long-dated yields to converge toward those levels. That is in fact what happened in recent years, with the 5-year/5-year forward Treasury yield peaking several times at levels close to the Fed’s median neutral rate estimate (Chart 9). With this in mind, we see a clear path to 2.5% on the 5-year/5-year forward Treasury yield, with the 10-year yield reaching similar levels since the 5/10 Treasury slope is likely to remain flat (Chart 9, bottom panel). For yields to eventually move above 2.5%, the market would have to re-consider its outlook for the long-run neutral fed funds rate. We discussed what factors to monitor in this regard in a recent report.6 Bottom Line: Treasury yields have moved significantly higher in recent weeks, but a survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Checking In On The Credit Cycle In previous reports, we mentioned that three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health Monetary conditions Valuation We last presented a detailed examination of these factors in a report from mid-September, concluding that accommodative monetary conditions will support corporate bond excess returns, despite deteriorating balance sheet health.7 Three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health, monetary conditions,and valuation. But since then, C&I lending standards – an important indicator of monetary conditions – moved into “net tightening” territory for the third quarter of 2019 (Chart 10). Tightening C&I lending standards, if they persist, would put significant upward pressure on corporate defaults and credit spreads. Chart 10Credit Cycle Checklist: Monetary Conditions While the recent move in lending standards is concerning, we expect it to reverse in the near future. The yield curve, another indicator of monetary conditions, has steepened in recent months, suggesting that conditions are becoming more accommodative. Also, loan officers reported that the terms on C&I loans continued to ease in Q3, even as overall standards tightened (Chart 10, panel 3). Most importantly, inflation expectations remain extremely low (Chart 10, bottom panel). This gives the Fed every incentive to maintain accommodative monetary conditions. This should give lenders the confidence to ease lending standards, leading to tight credit spreads and a low corporate default rate. Bottom Line: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. Downgrade Investment Grade Corporates To Neutral Last week, we downgraded our recommended allocation to investment grade corporate bonds from overweight to neutral.8 We maintain a positive view of the credit cycle, and expect that corporate bonds will continue to outperform Treasuries. However, investment grade corporate spreads no longer provide adequate compensation for their level of risk. We maintain an overweight allocation to high-yield corporates, where spreads remain attractive. Chart 11 shows that investment grade corporate spreads have tightened somewhat in recent months, but that they remain well above the tights seen in early 2018. However, the chart also shows that average index duration has increased considerably this year. All else equal, higher index duration justifies a wider spread. In contrast, notice that high-yield index duration fell this year (Chart 11, bottom panel). This is because high-yield bonds usually carry embedded call options, making them negatively convex. All else equal, lower index duration makes the spread offered by the high-yield index more attractive. Because changes in spread and duration are both important, we prefer to use the 12-month breakeven spread as our main valuation tool. This measure is the spread widening required on a 12-month investment horizon to underperform a duration-matched position in Treasuries. It can be approximated by dividing the option-adjusted spread by duration. Chart 12 shows investment grade 12-month breakeven spreads as a percentile rank since 1995. The overall message is that spreads have rarely been lower. Chart 11Higher Durations Makes IG Spreads Look Too Tight Chart 12Investment Grade Corporate Spreads Have Rarely Been Lower Finally, we can also recognize that spreads tend to be tight in the middle and late stages of the credit cycle. In the current environment, that means we should expect spreads to be near the bottom of their historical ranges. To control for this fact, we re-calculate our breakeven spread percentile ranks using only mid-cycle periods when the slope of the yield curve is between 0 bps and 50 bps. We can then back-out spread targets for each credit tier based on the median 12-month breakeven spreads seen in similar macro environments. Chart 13 shows that spreads for all investment grade credit tiers have moved below our targets. High-yield spreads are not shown, but they remain well above target levels.9 Chart 13Spreads For All IG Credit Tiers Are Below Target In place of investment grade corporates, which have become expensive, we recommend upgrading Agency MBS. MBS now offer expected returns that are comparable with corporate bonds rated A or higher, with considerably less risk.10 Bottom Line: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 For details on why the ratio between the CRB Raw Industrials index and Gold tracks the 10-year Treasury yield please see US Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com 3 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 4 For more details on the divergence between “soft” and “hard” data please see US Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Portfolio Allocation Summary, “The Fed Will Stay Supportive”, dated November 5, 2019, available at usbs.bcaresearch.com 9 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 10 For more details on the positive outlook for MBS please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The mood among investors is shifting from the recessionary gloom of this past summer. Equities worldwide are rallying, buoyed by a combination of dovish monetary policies, tentative signs of bottoming global growth and expectations of some sort of trade détente between the US and China. The latter is fueling more bullish sentiment towards equities in regions most exposed to global trade and manufacturing like Emerging Markets (EM) and Europe. Feature Chart 1Global Corporates: 2016 Revisited? Credit investors, in an unusual twist, have been far more optimistic than their equity brethren. Corporate bonds have delivered solid performance in 2019, with the Bloomberg Barclays Global Corporates total return index up +9.5% year-to-date. This is a surprising development, as global growth concerns triggered a major decline in developed market government bond yields but no widening of credit risk premia (Chart 1). With that in mind, this week we are presenting the latest update of our Corporate Health Monitor (CHM) Chartbook. The CHMs are composite indicators of balance sheet and income statement ratios (using both top-down and bottom-up data) designed to assess the financial well-being of the overall non-financial corporate sectors in the major developed economies. A brief overview of the methodology is presented in Appendix 1 on page 15. The overriding message from the latest read of our CHMs is that the manufacturing-led slowing of global growth this year has not resulted in much deterioration in overall corporate creditworthiness. There are fascinating cross-currents within the data, however. On a regional basis, the CHMs in the euro area, the UK and Canada are in better shape than in the US and Japan. The most interesting differences are across credit quality, with our “bottom-up” high-yield (HY) CHMs looking better than the investment grade (IG) equivalents in both the US and euro area, mostly due to greater relative increases in IG leverage. Our current global corporate bond investment recommendations broadly follow the trends signaled by our CHMs: an aggregate overweight stance versus global government debt, but with a “reverse quality bias” favoring HY over IG in the US and Europe. With government bond yields now on the rise across the developed markets – and with credit spreads fairly tight across the majority of countries - the period of hyper-charged absolute corporate bond returns is over. Expect more carry-like excess returns over sovereigns during the next 6-12 months. US Corporate Health Monitors: Steady Deterioration, Mostly Within Investment Grade Our top-down US CHM is sending a negative message on credit quality, staying in the “deteriorating health” zone since 2015 (Chart 2). The structural declines in the profitability ratios (return on capital and operating margin), debt coverage and, more recently, short-term liquidity are the main causes of that deterioration in US corporate health. Not all the news is negative, however. While operating margins have clearly peaked, they remain at a very high level. The top-down interest coverage ratio is also improving, thanks to low corporate borrowing rates. That is a welcome development that will help extend the US credit cycle by keeping downgrade/default risk, and the credit spreads required to compensate for it, subdued. When looking at our bottom-up US CHMs, the story becomes more nuanced. The bottom-up US high-yield CHM is signaling a surprisingly positive story, spending the past two years in “improving health” territory. The bottom-up US IG CHM remains above the zero line, as has been the case since 2012 (Chart 3). The multi-year increase in the debt-to-equity ratio, and declines in return on capital and interest coverage over the same period, are the main reasons why US IG corporate health has worsened, even as profit margins have stayed high. Chart 2Top-Down US CHM: Steadily Worsening Chart 3Bottom-Up US IG CHM: Some Areas Of Concern The bottom-up US HY CHM is signaling a more positive story, spending the past two years in “improving health” territory (Chart 4), led by stable balance sheet leverage and improvements in operating margins and return on capital. The absolute levels of interest and debt coverage ratios for US HY remain low – a potential future risk for US HY when the US economy goes into its next prolonged downturn. One common signal from all our US CHMs, both top-down and bottom-up, is that short-term liquidity ratios have declined. Those moves are driven by increases in the denominator of the ratios (the market value of assets for the top-down CHM, and the value of current liabilities in the bottom-up CHMs), rather than declines in working capital or cash on corporate balance sheets – trends that would typically precede periods of corporate distress. Just last week, we downgraded US IG to neutral, while maintaining an overweight tilt on US HY.1 The rationale for the move was based on value, as spreads for all US IG credit tiers had tightened to our spread targets, which is not yet the case for HY. The message from our bottom-up US CHMs supports that recommendation. The combination of improving global growth and a Fed that will stay dovish until US inflation has sustainably moved higher paints a favorable backdrop for the relative performance of all US corporate debt versus Treasuries. However, given our expectation that US bond yields will continue to move higher over the next 6-12 months, the lower interest rate duration of US HY relative to IG also supports favoring the former over the latter (Chart 5). Chart 4Bottom-Up US HY CHM: Looking Better Than IG (!) Chart 5US Corporates: Stay Overweight HY & Neutral IG Euro Corporate Health Monitors: Some Cyclical Weakness Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area IG, the gap between domestic and foreign issuers has been widening, with the former now in “deteriorating health” territory (Chart 6). Leverage has gone up for all issuers, with debt/equity ratios now above 100%, but the pace of increase has been faster for domestic issuers. Return on capital and profit margins for domestic issuers have declined since the start of 2018 alongside the prolonged slowing of euro area economic growth. For domestic euro area IG issuers, interest coverage has been steadily climbing since 2015 when the ECB went to negative rates and, more importantly, started its Asset Purchase Program that included corporate debt. Our bottom-up euro area CHMs are sending different messages for lower-rated and higher-quality issuers, similar to the divergence in our bottom-up US CHMs. For euro area HY, the signal from the bottom-up CHM is more positive for both domestic and foreign issuers (Chart 7), with both CHMs sitting just in the “improving health” zone. Leverage has declined, but profit-based metrics have worsened for both sets of issuers. Interest/debt coverage and liquidity, however, are far worse for domestic issuers than foreign issuers. Chart 6Bottom-Up Euro Area IG CHMs: Weak Growth Hitting Domestic Issuers Chart 7Bottom-Up Euro Area HY CHMs: Healthy, But Leverage Now Rising Within the euro area, our bottom-up IG CHMs for Core and Periphery countries have worsened over the past year, from healthy levels, with both above the zero line (Chart 8). Interest coverage is considerably stronger for Core issuers, although profitability metrics are remarkably similar. Short-term liquidity ratios have also fallen for both regional groups over the past year. We have maintained a moderate overweight stance on euro area corporates, both for IG and HY, since the summer of this year (Chart 9). This view was based on expectations that the European Central Bank (ECB) would ease monetary policy, not on a forecast that euro area growth would revive organically. That outcome came to fruition when the ECB cut rates in September and restarted asset purchases earlier this month. The ECB’s moves create a more supportive monetary backdrop (along with an undervalued euro) that will help keep euro area credit spreads tight – a trend that is reinforced by decent corporate health. Chart 8Bottom-Up Euro Area Regional IG CHMs: Heading In The Wrong Direction Chart 9Euro Area Corporates: Stay Overweight IG & HY Chart 10Relative Bottom-Up CHMs: Turning In Favor Of The US? We see no reason to alter our recommendations on euro area credit, based on our forecast of better global growth, with no change to the ECB’s ultra-accommodative monetary stance, in 2020. However, a stronger growth backdrop could benefit euro area HY performance more than IG, based on the comparatively healthier signal from the bottom-up euro area HY CHM. The gap between the combined IG/HY bottom-up CHMs for the US and euro area aligns with credit spread differentials between euro area and US issuers (Chart 10).2 latest trends show a narrowing of the gap between the US and euro area CHMs, suggesting relative corporate health favors US names (middle panel). At the same time, the stronger performance of the US economy, which is much less levered to global trade and manufacturing compared to Europe, continues to support US corporate performance versus euro area equivalents (bottom panel). UK Corporate Health Monitor: Some Improvement, Even With Brexit Uncertainty Despite the persistent uncertainty over the UK-EU Brexit negotiations that has weighed on UK economic confidence, our top-down UK CHM remains in the "improving health" zone (Chart 11). All of the individual components are contributing to the strength of the CHM, which even improved from those healthy levels in Q2/2019 (the most recent data available). A sustained easing of UK financial conditions – easy monetary policy alongside a deeply undervalued currency – have helped boost interest/debt coverage ratios by keeping UK corporate borrowing costs low. Top-down operating margins for UK non-financial firms have surprisingly increased and now sit just under 25%. Short-term liquidity remains solid with leverage holding at non-problematic levels. As we discussed in a recent Special Report, the UK economy has been holding up fairly well despite the political uncertainty that has driven a prolonged slowdown in productivity growth through weak business investment.3 The UK consumer has continued to spend, however, seemingly desensitized to the political drama, and the labor market has remained tight enough to support a decent pace of household income growth. Despite the persistent uncertainty over the UK-EU Brexit negotiations, our top-down UK CHM remains in the "improving health" zone. The near term performance of the UK's economy is highly dependent on the final result of Brexit negotiations. If a negotiated Brexit occurs, UK corporates can start to ramp up the capital spending that has been delayed due to the political uncertainty, which will eventually lead to an improvement in UK productivity growth and overall corporate performance. A strengthening pound and rising government bond yields, driven by markets unwinding Brexit risk premia, will mitigate some of that growth thrust, but the net effect will still boost the relative performance of UK corporate debt versus Gilts. There are still near-term political risks stemming from the UK parliamentary election next month, with the deadline for a UK-EU Brexit deal delayed until after the election. Thus, we continue to maintain only a neutral stance on UK IG corporates in our model bond portfolio, despite our overall bias to be overweight global corporate debt versus government bonds. We will reconsider that stance after we have more clarity on the final resolution of the Brexit uncertainty. At a minimum, however, we expect UK corporates to continue to deliver solid excess returns versus UK Gilts (Chart 12). Chart 11UK Top-Down CHM: Solid Improvement, Despite Brexit Chart 12UK Corporates: Stay Neutral Japan Corporate Health Monitor: A Further Cyclical Deterioration Our bottom-up Japan CHM remains in the "deteriorating health" zone, as has been the case since the start of 2018 (Chart 13).4 The message from the individual CHM components, however, is that this is a cyclical, not structural, deterioration in Japanese corporate credit quality, and from a very healthy starting point. Leverage, defined here as the ratio of total debt to the book value of equity, is slightly above 100%, well below the 100-140% range seen between 2006 and 2015. A similar trend exists for return on capital, which has dipped below 5% but remains high relative to its history (although very low by global standards). Operating margins, debt coverage and short-term liquidity are down from recent peaks but all remain well above the lows of the decade since the 2008 financial crisis. Interest coverage has suffered a more meaningful deterioration relative to its history. However, this is more a cyclical issue related to falling profits (the numerator of the ratio) rather than rising interest costs (the denominator), with the latter remaining subdued thanks to the Bank of Japan’s hyper-easy monetary policy. For the former, the cyclical momentum in Japan’s economy is not improving, despite some recent evidence that global growth may be stabilizing. According to the latest Tankan survey, Japanese manufacturers – who saw profits fall -31% on a year-over-year basis in Q2/2019 - reported a worse business outlook than previously expected, both for large and small firms. This is not surprising, as Japan’s economy remains highly levered to global growth and export demand, in general, and China, in particular. Yet the less trade-sensitive services sector has also weakened – forecasts of the Tankan non-manufacturing index have already rolled over and the services PMI dropped to 49.7 in October. Japan’s corporate spread has widened slightly (+10bps) since the beginning of this year (Chart 14), in contrast to the spread tightening seen in other major developed economy corporate bond markets. This is sign that the markets have responded to the slowing growth momentum in Japan with a bit of a wider risk premium. Yet despite that widening, Japanese corporates with small positive yields continue to generate positive excess returns (on a duration-matched basis) versus Japanese Government Bonds (JGBs); yields on the latter will remain anchored near zero by the Bank of Japan’s Yield Curve Control policy. Thus, we continue to recommend an overweight stance on Japanese corporates vs JGBs as a buy-and-hold carry trade, even with the softening in our Japan CHM.  Chart 13Japan Bottom-Up CHM: Cyclical Deterioration Chart 14Japan Corporates: Stay Overweight Vs JGBs For Carry Canada Corporate Health Monitors: Continuous Improvement Our top-down and bottom-up Canadian CHMs indicate an improving trend in Canadian corporate health, with both remaining in the “improving” zone as of the latest data available from Q2/2019 (Chart 15). The cyclical components (return on capital and operating margins) have gradually improved over the past three years, but remain relatively weak compared to history. Leverage is rising (now above 120% in our bottom-up CHM), but interest/debt coverage ratios remain steady and, in the case of the bottom-up CHM, have outright improved over the past year. We reviewed the Canadian economy last week5 and concluded that a Bank of Canada interest rate cut was unlikely because of signs of improving domestic growth momentum at a time when core inflation was at the midpoint of the BoC’s 1-3% target range. Overall, Canadian growth has been resilient in the face of the 2019 global manufacturing downturn, and should re-accelerate in the next year led by a firm consumer with rebounding housing and business investment. This should help boost the cyclical components of our Canada CHMs, especially if some improvement in global growth helps lift demand for Canadian commodity exports. We also introduced a framework to analyze Canadian corporate bonds in a Special Report published in late August.6 We concluded that Canadian companies’ financial health remains a positive for corporate bond returns on a cyclical basis, but high leverage and mediocre profitability were longer-term concerns. We also noted that the higher credit quality of Canadian corporates, where only 40% of the investment grade index is rated BBB, made them more potentially appealing on a creditworthiness basis relative to the lower quality markets in the US (50% BBB share) and euro area (52%). We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. We continue to recommend an overweight position in Canadian corporate debt relative to Canadian government bonds as a carry trade. Spreads have held in a well-established range of 100-200bps since the 2009 recession (Chart 16), even during periods when our CHMs were indicating worsening corporate health. Accommodative monetary conditions and relatively low Canadian interest rates will continue to make Canadian corporates relatively attractive, in an environment of decent growth and firm corporate health. Chart 15Canada CHMs: Still Healthy, Despite Slower Growth Chart 16Canadian Corporates: Stay Overweight Vs Canadian Govt. Debt   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Appendix 1: An Overview Of The BCA Corporate Health Monitors The BCA Corporate Health Monitor (CHM) is a composite indicator designed to assess the underlying financial strength of the corporate sector for a country. The Monitor is an average of six financial ratios inspired by those used by credit rating agencies to evaluate individual companies. However, we calculate our ratios using top-down (national accounts) data for profits, interest expense, debt levels, etc. The idea is to treat the entire corporate sector as if it were one big company, and then look at the credit metrics that would be used to assign a credit rating to it. Importantly, only data for the non-financial corporate sector is used in the CHM, as the measures that would be used to measure the underlying health of banks and other financial firms are different than those for the typical company. The six ratios used in the CHM are shown in Table 1 below. To construct the CHM, the individual ratios are standardized, added together, and then shown as a deviation from the medium-term trend. That last part is important, as it introduces more cyclicality into the CHM and allows it to better capture major turning points in corporate well-being. Largely because of this construction, the CHM has a very good track record at heralding trend changes in corporate credit spreads (both for Investment Grade and High-Yield) over many cycles. Table 1Definitions Of Ratios That Go Into The CHMs Top-down CHMs are now available for the US, euro area, the UK and Canada. The CHM methodology was extended in 2016 to look at corporate health by industry and by credit quality.7 The financial data of a broad set of individual US and euro area companies was used to construct individual “bottom-up” CHMs using the same procedure as the more familiar top-down CHM. Some of the ratios differ from those used in the top-down CHM (see Table 1), largely due to definitional differences in data presented in national income accounts versus those from actual individual company financial statements. The bottom-up CHMs analyze the health of individual sectors, and can be aggregated up into broad CHMs for Investment Grade and High-Yield groupings to compare with credit spreads. In 2018, we introduced bottom-up CHMs for Japan and Canada. With the country expansion of our CHM universe, we now have coverage for 92% of the Bloomberg Barclays Global Aggregate Corporate Bond Index (Appendix Chart 1). Appendix Chart 1We Now Have CHM Coverage For 92% Of The Developed Market Corporate Bond Universe Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcareseach.com. 2 We only use the CHMs for euro area domestic issuers in this aggregate bottom-up CHM, as this is most reflective of uniquely European corporate credits. This also eliminates double-counting from US companies that issue in the euro area market that are part of our US CHMs. 3 Please see BCA Research Global Fixed Income Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated September 20, 2019, available at gfis.bcaresearch.com. 4 We do not currently have a top-down CHM for Japan given the lack of consistent government data sources for all the necessary components. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, “How Sweet It Is”, dated November 6, 2019, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Special Report, “The Great White North: A Framework For Analyzing Canadian Corporate Bonds”, dated August 28, 2019, available at gfis.bcaresearch.com. 7 Please see Section II of The Bank Credit Analyst, “U.S. Corporate Health Gets A Failing Grade”, dated February 2016, available at bca.bcaresearch.com. Appendix 2: US Bottom-Up CHMs For Selected Sectors     The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US: The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. Canada: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. Feature After knocking on the door several times in recent weeks, global equity markets are finally enjoying a true breakout.  In the U.S., the S&P 500 is setting new all-time highs on a daily basis, while equities in Europe and emerging markets (EM) are also registering solid gains. There is no conflicting signal from global corporate credit markets where spreads remain stable, or from the volatility space with measures like the US VIX index hovering near the 2019 lows. Chart Of The WeekThings Are Looking Up Despite this positive price action, many remain skeptical that this “risk rally” is sustainable.  Just last week, a headline in the Financial Times declared that the “U.S. stock market’s new highs baffles investors”. We find that reluctance to accept the equity market strength to be even more baffling, as the current macro backdrop is a perfect “sweet spot” for risk assets to do well.  Global economic momentum is bottoming out, with improving leading indicators suggesting better days lie ahead for growth.  A majority of central banks worldwide have eased monetary policy over the past several months, providing a more supportive liquidity backdrop for financial markets.  The world’s most important central bank, the Federal Reserve, has delivered a cumulative -75bps of rate cuts since July, helping to cool off the US dollar, which is now flat on a year-over-year basis in trade-weighted terms (Chart Of The Week).  A softening dollar is also often a signal that global growth is improving, as it indicates a shift in capital flows into more economically-sensitive non-U.S. markets like Europe and EM.  Thus, a weaker greenback combined with better global growth prospects should help lift global bond yields by raising depressed inflation expectations (middle panel).  The “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. Yet with policymakers worldwide still playing the stimulus game, fearful of persistent negative impacts on growth from the U.S.-China trade dispute and other political uncertainties, it will take a large and sustained increase in inflation expectations before there is any shift to a more hawkish global policy bias.  This is critical for bond markets, as a much bigger move higher in global bond yields would require not just a pricing out of rate cut expectations, but the pricing in of future rate hikes. Such a repricing will not occur before there is clear evidence that global growth, broadly speaking, is accelerating for a sustained period and not just stabilizing in a few countries. The earliest we can envision such a hawkish shift for global monetary policy would be late in 2020, led by the Fed signaling a removal of some of the “insurance” rate cuts of 2019.  Until that happens, the “sweet spot” of accelerating growth and easy money will support the continued outperformance of global equities and credit over government bonds, in an environment of gently rising bond yields. The Art Of Analyzing Economic Data At Turning Points Typically, at turning points in the global growth cycle, there are always data available to support the arguments of both optimists and pessimists. That is certainly the case today, where so-called “hard” economic data that is reported with a lag (i.e. exports, durable goods orders) remains weak, but leading indicators are starting to improve. For example, the global manufacturing PMI data for October released last week shows the following (Chart 2): strong pickup in China, with the Caixin manufacturing PMI now up to 51.7; slight improvement in the US ISM manufacturing index, which rose from 47.8 to 48.3 in the month but remains below the 50 boom/bust line; bounce in the U.K. Markit manufacturing PMI index, rising from 48.3 to 49.6; the slightest of increases in the overall euro area Markit manufacturing PMI, from 45.7 to 45.9, still below the 50 line but showing marginal improvement in the critical German PMI; Continued weakness in the Japanese Markit manufacturing PMI, which fell to 48.4. The relative message from the PMIs fits with the signals sent from the OECD leading economic indicators (LEI) for those same countries, with the China LEI strengthening the most and the LEIs in Europe and Japan still struggling. The US is a mixed bag, with the ISM ticking up but the LEI languishing. There is, however, a sign of optimism in the export sub-index of the ISM manufacturing data. That measure surged nine points in October from 41.0 to 50.4, signaling a potential bottoming of the overall ISM index within the next three months (Chart 3).  While the ISM exports index is volatile, the modest improvement seen in the export order series from the China manufacturing PMI over the past few months (bottom panel) suggests that there may be a more significant improvement in global trade activity brewing – as signaled by the improvement in our global LEI index. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Chart 2Global PMIs Are A Mixed Bag Chart 3Momentum Turning For The Trade Warriors? Bottom Line: Global growth momentum is bottoming out, leading indicators are improving, inflation is subdued, and central bankers are biased to maintain accommodative monetary policies. This is a bullish “sweet spot” for financial markets, suggesting further upside for global risk assets like equities and corporate credit, especially relative to government bonds. US Capital Spending Slowdown:  Only A Cautious Pause Chart 4Rising Uncertainty? Or Just Slowing Profit Growth? For growth pessimists in the US, a modest boost to “soft” data like the ISM does not allay their concerns about a broadening US economic slowdown. The trade war with China and the global manufacturing recession have had a clear negative impact on business confidence when looking at measures like the Conference Board CEO survey.  At the same time, US capital spending has contracted in real terms during the 2nd and 3rd quarter of 2019.  A logical inference would be to say that uncertainty over the trade war has led to a reduction in capex. Another possible explanation for the reduction in U.S. capital spending is slowing growth in corporate profits, which is related to a number of factors beyond the impact of tariffs and the trade war. Like the fading impact of the 2018 U.S. corporate tax cuts (that helped trigger a surge in after-tax earnings growth) and the squeeze on profit margins from higher labor costs. On a year-over-year basis, US profit growth has slowed from nearly 25% in 2018 to 1.8% in the 3rd quarter (a projection based on the 76% of S&P 500 companies that have already reported).  The real non-residential investment spending category from the US GDP accounts has slowed alongside profits, from 6.8% to 1.3% on a year-over-year basis (Chart 4). At the same time, annual growth in US non-farm payrolls has slowed only modestly from 1.91% to 1.4%, with average hourly earnings growth falling from a 2019 peak of 3.4% to 3.0% in October. Given the tightness of the US labor market, with firms continuing to report difficulties in finding quality labor, it should come as no surprise that employment and wages have not slowed as much as capital spending, despite the sharp downturn in profit growth.  Businesses that see their earnings getting squeezed will seek to protect profits by cutting back on investment and hiring activity. With a tight labor market, however, cutting capital spending is an easier and less costly decision than laying off workers, as it may be even harder to re-hire those employees if the economy starts to improve once again. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer. That can also be seen when breaking down the US non-residential investment data into its broad sub-components (Chart 5).  On a contribution-to-growth basis, the only part of US investment spending that is outright contracting year-over-year is Structures. There is still modest positive annual growth in Equipment investment, although that did contract on a quarter-on-quarter basis in Q3/2019. The Intellectual Property Products category (which includes Software, in addition to Research & Development) continues to expand at a steady pace. Chart 5Slowing US Capex Focused On Structures Chart 6The Fed Has Dis-Inverted The UST Curve So similar to signals from global PMIs and LEIs, the U.S. capital spending and employment data are sending a mixed message about U.S. growth. Yes, capital spending has slowed but the bulk of the deceleration has come in the component where canceling or delaying investment plans is easiest – buildings and construction. It is not necessarily an indication that a deeper economic downturn is unfolding. Similar cutbacks in Structures investment, without a broader decline in overall capital spending, occurred in 2013 and 2015/16.  During the past two U.S. recessions in 2001 and 2008, however, all categories of capital spending contracted. If we look at the breakdown of the contribution to US investment spending today, the backdrop looks more like those non-recessionary years. With the US Treasury curve no longer inverted, after -75bps of Fed rate cuts and with longer-dated Treasury yields starting to increase, the US economy is stepping back from the recessionary abyss that worried investors during the summer (Chart 6).  The trade détente between the US and China will help boost depressed business confidence, especially with global growth already showing signs of bottoming out. This, along with a softer US dollar and some easing of wage pressures, will help put a floor underneath US corporate profit growth. Treasury yields have more upside from here, as markets are still priced for -25bps of Fed rate cuts over the next year that is unlikely to happen if the US economy rebounds, as we expect.  Bottom Line:  The overall US economy is weathering the storm from the global manufacturing slump, which is showing signs of bottoming out.  Stay below-benchmark on US Treasury duration, with an initial yield target of 2.25% for the benchmark 10-year. The Bank Of Canada’s Newfound Caution Is Unwarranted Chart 7Canada Is A High-Beta Bond Market The Bank of Canada (BoC) has been one of the few central banks to resist the shift towards easier global monetary policy in 2019.  This has resulted in Canadian government bonds trading at relatively wide yield spreads to other countries in the developed world, even as global growth has slowed in 2019 (Chart 7).  With global growth now set to improve over the next 6-12 months, Canada’s historic status as a “high yield beta” bond market during periods of rising global yields suggests that Canadian government bonds should underperform in 2020. However, in the press conference following last week’s policy meeting, BoC Governor Stephen Poloz noted that the BoC was “mindful that the resilience of Canada’s economy will be increasingly tested as trade conflicts and uncertainty persist.” Poloz even revealed that an “insurance” rate cut was discussed at the policy meeting, although the BoC Governing Council decided against it.  This is similar language to that parroted by the more dovish global central bankers over the past several months, raising the risk that Canada could be a lower-beta bond market if the Canadian economy falters. That outcome seems unlikely, given the indications of improving growth momentum, occurring alongside tight labor markets and stable inflation: The RBC/Markit Canadian manufacturing PMI has climbed from a trough of 49 in May to 51 in October, indicating that real GDP growth accelerated in Q3 (Chart 8, top panel); The BoC’s Autumn 2019 Business Outlook Survey (BoS) showed that an increasing share of firms are reporting labor shortages, coinciding with a sharp pickup in the annual growth rate of average weekly earnings to just over 4% (middle panel); Core inflation measures remain right at the midpoint of the BoC’s 1-3% target range, although breakeven inflation rates from Canadian Real Return Bonds remain closer to the bottom end of that range (bottom panel); After a long period of adjustment, house prices and housing activity are showing some signs of recovery in response to easier financial conditions, rising household incomes and improved affordability (Chart 9); Chart 8Resilience In Canadian Growth & Inflation Chart 9Canadian Housing Showing Improvement Canadian investment spending is set to pick up, as the Autumn 2019 BoS reported a modest improvement in overall business sentiment and an increase in capital spending plans with a growing number of firms facing capacity pressures (Chart 10). Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Chart 10Signs Of Life For Canadian Capex? Looking forward, reduced U.S.-China trade tensions should provide a boost to Canadian capex. Firms that had previously held off in the past few months due to the slowdown in the economy, caused partially by worries over global trade, will start to invest again. The BoC’s updated forecasts in the latest Monetary Policy Report released last week showed that the central bank expects Canadian exports to resume their expansion in 2020 – despite Governor Poloz’s stated concerns over global growth. Oil and gas exports are expected to improve as pipeline and rail capacity gradually expand, while consumer goods excluding automobiles should remain strong. Improvement in Chinese economic activity would provide a meaningful lift to Canadian exports, as Chinese imports from Canada are still contracting at a double-digit rate (Chart 11).  More importantly, Canadian exports to the country’s largest trade partner, the US, have already stabilized and should accelerate as the US economy gains momentum in the next 6-12 months. As Governor Poloz mentioned during the press conference, the BoC's decisions are not going to be directly influenced by political events such as Prime Minister Justin Trudeau’s recent re-election. Yet the odds of Canadian fiscal stimulus have shot up after Trudeau could only secure a minority government in the Canadian Parliament. Any fiscal stimulus is starting from a healthier place with the budget deficit currently at only -1% of GDP and the net government debt-to-GDP ratio falling towards a low 40% level (Chart 12).  Expected fiscal stimulus will provide an incremental boost to Canadian growth in 2020. Chart 11The Global Trade Slump Has Hurt Canada Chart 12Canada Can Afford A Fiscal Stimulus Net-net, the Canadian economy appears to be in good shape, with momentum starting to improve.  Inflation remains close to the BoC target, with rising pressures stemming from a tight labor market. This is not a backdrop that would be conducive to an “insurance” rate cut in December or even in early 2020.  Only -18bps of rate cuts over the next twelve months are discounted in the Canadian Overnight Index Swap (OIS) curve. Yet there is only a 16% chance of a -25bp cut expected at the December 2019 meeting, according to Bloomberg.  In other words, the markets are not taking the threat of a BoC rate cut seriously – a view that we agree with. Chart 13Stay Neutral On Canadian Government Bonds We suspect that Governor Poloz’s comments about a potential BoC policy ease were more designed to take some steam out of the strengthening Canadian dollar (Chart 13), which was threatening a major breakout going into last week’s BoC meeting.  We would be surprised if a rate cut was delivered at the December 2019 BoC meeting, but the dovish message sent last week does raise the possibility that the BoC could shock us. For now, we are choosing to stick with our neutral recommendation on Canadian government bonds, but we will re-evaluate after the December 4 BoC meeting. Our bias is to downgrade Canadian government bonds to underweight heading into 2020, as we expect a return to their typical high-beta status during a period of accelerating global growth and rising bond yields. Bottom Line: The Bank of Canada is hinting that “insurance” rate cuts may be needed, but with the Canadian economy and inflation both remaining resilient, the central bank is more likely to keep rates steady until global growth improves.  Stay neutral on Canadian government bonds, for now, but prepare to move to underweight in early 2020. A Brief Follow Up To Our US MBS Versus IG Corporates Recommendation Chart 14Spread Targets Reached - Downgrade US IG To Neutral In last week’s report, we made the case for raising allocations to US Agency MBS while reducing exposure to higher-quality US investment grade (IG) corporate credit.1 We implemented the trade in our model bond portfolio, lowering our recommended allocation to US IG and increasing the weighting to US Agency MBS.  We now see a case for shifting to a formal strategic recommendation, upgrading US Agency MBS to overweight (a ranking of 4 out of 5 in the tables on page 14) and downgrading US IG to neutral (3 out of 5).  The rationale for the shift is based on valuation. Our colleagues at BCA Research US Bond Strategy calculate spread targets for each credit tier within US IG (Aaa, Aa, A and Baa). The targets are determined using a methodology that ranks the option-adjusted spread (OAS) of the Bloomberg Barclays index for each credit tier relative to its history, while controlling for the “phase” of the economic cycle as determined by the slope of the US Treasury yield curve.2 The latest rally in IG has driven the OAS for all tiers below those targets, with the Baa tier looking less expensive than the others (Chart 14).  As a result, we now advise only a neutral allocation to US IG corporates, with a preference for the Baa credit tier. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1Please see BCA Research Global Fixed Income Strategy Weekly Report, “Big Mo(mentum) Is Turning Positive”, dated Oct 29, 2019, available at gfis.bcaresearch.com 2For details on how those spread targets are determined, please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

  Highlights While the Caixin PMI is pointing to improving economic conditions, other data series still reflect weak growth. China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. The failure of Chinese stocks to significantly outperform the global benchmark and the continued underperformance of cyclical stocks underscore the near-term risks to equities if this month’s trade & manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, the data remains mixed: the strength in the October Caixin PMI and the September pickup in electricity production are positive signs, but other important datapoints still point to weak conditions. We continue to expect that China’s business cycle is likely to bottom in Q1 of next year, rather than in Q4. We continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, Chinese stocks have rallied in absolute terms over the past month in response to greatly increased odds of a trade truce between China and the US, but have failed to outperform the global benchmark. This, in combination with the continued underperformance of cyclical stocks, suggests that hard evidence of an economic improvement in China will be required before Chinese stocks begin to rise in relative terms. The risk of near-term underperformance is still present, especially if October’s hard trade and manufacturing data disappoint. We continue to recommend a neutral tactical stance (0-3 months) towards Chinese equities versus global stocks, but expect them to outperform on a cyclical (6-12 month) time horizon after economic growth firmly bottoms. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1Not Yet A Clear Change In Trend The Bloomberg Li Keqiang index (LKI) ticked up in September, led by an improvement in electricity production. An improvement in the LKI in lockstep with a rising Caixin manufacturing PMI (discussed below) raises the odds that the Chinese economy may be bottoming earlier than we expect, but for now only modestly so. Chinese economic data is highly volatile, and Chart 1 shows that the improvement in the LKI is very muted when shown as a 3-month moving average. In addition, a slight improvement also occurred earlier this year, but proved to be a false signal. All told, for now we continue to expect that growth will bottom in Q1 of next year, rather than in Q4. Our leading indicator for the LKI was essentially flat in September on a smoothed basis, with sequential declines in M3 growth and the credit components of the indicator offsetting improvements in monetary conditions and M2. From a big picture perspective, the story of our LKI leading indicator remains unchanged: it continues to trend higher, at a much shallower pace than has been the case during previous easing cycles. The uptrend is the basis of our forecast that China’s growth will soon bottom, but the uncharacteristically shallow nature of the rise suggests that the eventual recovery will be modest. On a smoothed basis, Chinese residential floor space sold improved again in September, following a very significant rise in August. Over the past 12-18 months, we had emphasized that the double-digit pace of growth in China’s housing starts was unsustainable because it had entirely decoupled from the trend in sales (which have reliably led construction activity over the past decade). This gap disappeared over the summer due to a significant slowdown in starts, which is what we predicted would occur. However, the recent acceleration in floor space sold represents a legitimate fundamental improvement in the housing market, that for now is difficult to attribute to the recent drivers of housing demand (Chart 2).1 Still, investors should continue to watch China’s housing demand data closely over the coming few months, for further signs of a potential re-acceleration in housing construction. Investors need to see meaningful sequential improvements in China’s October trade and manufacturing data. The October improvement in China’s Caixin PMI was quite notable, as it appears to confirm the full one-point rise in the index that occurred in September and suggests that manufacturing in China’s private-sector is now durably expanding. Still, conflicting signals remain: the official PMI fell in October and remains below 50, and the significant September improvement in the Caixin PMI was not corroborated by an improvement in producer prices or nominal import growth (Chart 3). As PMIs are simply timely coincident indicators that do not generally have leading properties, investors will need to see meaningful sequential improvements in China’s October trade and manufacturing data in order to have confidence that the Caixin PMI improvement is not a false signal. Chart 2It Is Not Yet Apparent What Is Driving A Pickup In Housing Demand Chart 3If The Caixin PMI Is Not A False Signal, A Hard Data Improvement Must Occur Soon Chinese stocks have rallied 6-7% over the past month in absolute terms, but have modestly underperformed global equities. The rally in global stock prices has occurred largely in response to the mid-October announcement of a trade truce between China and the US. The failure of Chinese stocks to outperform during this period suggests hard evidence of an economic improvement in China will be required before Chinese stocks begin to outpace their global peers. At the regional equity level, the other notable development over the past month has been the continued outperformance of the MSCI Taiwan Index versus the global benchmark. Taiwan’s outperformance has been boosted by a rising TWD versus the dollar, but Taiwanese stocks have also outperformed in local currency terms. Taiwan province is highly exposed to global trade, and it is not surprising that equities have reacted positively to the prospect of a trade truce between the US and China. Further meaningful outperformance, however, will likely require a re-acceleration in Taiwanese exports, as export growth has merely halted its contraction (Chart 4). Within China’s investable equity market, cyclicals have underperformed defensives over the past month after having rallied significantly from late-August to mid-September (Chart 5). We noted in our October 30 Special Report that these cyclical sectors have historically been positively correlated with pro-cyclical macroeconomic and equity market variables,2 and their underperformance versus defensives is thus consistent with the failure of Chinese stocks in the aggregate to outperform global equities over the past month. In both cases, outperformance likely requires hard evidence of an upturn in China’s business cycle. Chart 4Export Growth Needs To Improve In Order To Expect Further Taiwanese Relative Outperformance Chart 5Cyclical Underperformance Underscores The Near-Term Risks To Chinese Vs. Global Stocks We do not take the rise in Chinese government bond yields as necessarily indicative of an imminent breakout in relative equity performance. Chart 6Chinese Relative Equity Performance Leads Bond Yields, Not The Other Way Around Chinese 10-year government bond yields have risen roughly 15bps over the past month, and are now 30bps off of their mid-August low. Many market participants view Chinese government bond yields as a leading growth barometer, but 10-year yields have actually lagged Chinese investable stock performance over the past two years (Chart 6). As such, we do not take the rise in yields as necessarily indicative of an imminent breakout in relative equity performance. Chinese onshore corporate bond spreads have declined over the past month as government bond yields have been rising, continuing a pattern of negative correlation between the two that has prevailed since early-2018. A negative correlation between yields and corporate bond spreads is a normal relationship, and it suggests that spreads may narrow over the coming year if the Chinese economy bottoms in Q1, as we expect. Spreads remain elevated despite the substantial easing in monetary conditions that occurred last year, due to persistent concerns about rising onshore defaults. While we acknowledge that defaults are indeed occurring, we have argued on several occasions that the pace of defaults would have to be much faster in order for current spreads to be justified.3 We continue to recommend a long RMB-denominated position in China’s onshore corporate bond market. The RMB has appreciated over the past month in response to news of a likely trade truce between the US and China, with most of the rise having occurred versus the US dollar. USD-CNY is likely to sustainably trade below the 7 mark in a trade truce scenario, but how much further downside is possible in the near-term absent a re-acceleration in Chinese economic activity remains an open question. With the Fed very likely on hold for the next year, stronger than expected economic growth in China would likely catalyze a persistent selloff in USD-CNY barring a re-emergence of the Sino-US trade war. This, however, is not our base-case view, meaning that we expect modest post-deal strength in the RMB.   Jonathan LaBerge, CFA Vice President Special Reports jonathanl@bcaresearch.com Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1. Please see China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018. 2. Please see China Investment Strategy Weekly Report, “A Guide To Chinese Investable Equity Sector Performance,” dated October 30, 2019. 3. Please see China Investment Strategy Weekly Reports, “A Shaky Ladder,” dated June 13, 2018, "Investing In The Middle Of A Trade War,” dated September 19, 2018 and "2019 Key Views: Four Themes For China In The Coming Year,” dated December 5, 2018. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1The Fed Must Remain Dovish Many were quick to label last week’s FOMC decision a “hawkish cut”. This is somewhat true in the near-term. The Fed lowered rates by 25 basis points while signaling that it doesn’t expect to have to cut more. But this focus on the near-term rate path misses the big picture. In the post-meeting press conference, Chairman Powell mentioned inflation expectations several different times. At one point, he called them “central” to the Fed’s framework and said “we need them to be anchored at a level that’s consistent with our symmetric 2 percent inflation goal.” As of today, the 5-year/5-year forward TIPS breakeven inflation rate is 1.69%, well short of the 2.3%-2.5% range that is consistent with the Fed’s goal (Chart 1). The Fed will take care to maintain an accommodative policy stance until inflation expectations are re-anchored. This will provide strong support for risk assets, and we recommend overweight positions in spread product versus Treasuries. We also expect that global growth will improve enough in the coming months for the Fed to keep its promise to stand pat. With the market still priced for 29 bps of cuts during the next 12 months, investors should keep portfolio duration low. Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 60 basis points in October, bringing year-to-date excess returns up to +429 bps. We consider three main factors in our credit cycle analysis: (i) corporate balance sheet health, (ii) monetary conditions and (iii) valuation.1 On balance sheets, our top-down measure of gross leverage is elevated and rising (Chart 2). In contrast, interest coverage ratios remain solid, propped up by the Fed’s accommodative stance. With inflation expectations still depressed, the Fed can maintain its “easy money” policy for some time yet. The Fed’s Senior Loan Officer survey shows that C&I lending standards tightened in Q3 (bottom panel). We expect the Fed’s accommodative stance to push standards back into “net easing” territory in Q4. But if standards continue to tighten, it could indicate that monetary conditions are not as accommodative as we think. For now, we see valuation as the main headwind for investment grade credit spreads. Spreads for all credit tiers are now below our targets, with the Baa tier looking less expensive than the others (panels 2 & 3).2 As a result, we advise only a neutral allocation to investment grade corporate bonds, with a preference for the Baa credit tier. We also recommend increasing exposure to Agency MBS in place of corporate bonds rated A or higher. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield performed in line with the duration-equivalent Treasury index in October, keeping year-to-date excess returns steady at +621 bps. The junk index’s option-adjusted spread (OAS) has been fairly stable for most of the year, but the sector has become increasingly attractive from a risk/reward perspective.3 This is because the index’s negatively convex nature has caused its average duration to fall alongside declining Treasury yields. Chart 3 shows that while the index OAS has been rangebound, the 12-month breakeven spread has widened considerably.4 In other words, while junk expected returns have been stable, those expected returns now come with considerably less risk. As a result, the junk index OAS looks increasingly attractive relative to our spread target.5 Specifically, we now view the junk index OAS as 141 bps cheap (panel 3). Falling index duration also explains the divergence between quality spreads and the index OAS. Many have observed that the spread differential between Caa and Ba-rated junk bonds has widened in recent months, while the overall index OAS has been stable (panel 4). However, the divergence evaporates when we look at 12-month breakeven spreads instead of OAS (bottom panel). MBS: Overweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +3 bps. The conventional 30-year zero-volatility spread widened 4 bps on the month, as a 5 bps widening of the option-adjusted spread (OAS) was partially offset by a 1 bp decline in option cost (i.e. the expected losses from prepayments). This week we recommend upgrading Agency MBS from neutral to overweight, and in particular, we recommend favoring Agency MBS over corporate bonds rated A or higher. We have three main reasons for this recommendation.6 First, expected compensation is competitive. The conventional 30-year MBS OAS is now 53 bps. This is above its pre-crisis average (Chart 4), and only 4 bps below the spread offered by a Aa-rated corporate bond. All investment grade corporate bond credit tiers also look expensive relative to our spread targets. Second, risk-adjusted compensation heavily favors MBS. The Excess Return Bond Map in Appendix C shows that Agency MBS plot well to the right of investment grade corporates. This means that the sector is less likely to see losses versus Treasuries on a 12-month horizon. Finally, the macro environment for MBS remains supportive. Mortgage lending standards have barely eased since the financial crisis (bottom panel), and most people have already had at least one opportunity to refinance their mortgages. This burnout will keep refi activity low, and MBS spreads tight (panel 2). Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 20 basis points in October, bringing year-to-date excess returns up to +183 bps. Sovereign debt outperformed duration-equivalent Treasuries by 38 bps on the month, bringing year-to-date excess returns up to +475 bps. Local Authorities outperformed the Treasury benchmark by 9 bps, bringing year-to-date excess returns up to +220 bps. Meanwhile, Foreign Agencies outperformed by 63 bps, bringing year-to-date excess returns up to +261 bps. Domestic Agencies underperformed by 2 bps in October, dragging year-to-date excess returns down to +40 bps. Supranationals underperformed by 8 bps on the month, dragging year-to-date excess returns down to +31 bps. We continue to recommend an underweight allocation to USD-denominated sovereign bonds, given that spreads remain expensive compared to U.S. corporate credit (Chart 5). However, we noted in a recent report that Mexican and Saudi Arabian sovereigns look attractive on a risk/reward basis.7 This is also true for Foreign Agencies and Local Authorities, as shown in the Bond Map in Appendix C. Our Emerging Markets Strategy service also thinks that worries about Mexico’s fiscal position are overblown, and that bond yields embed too high of a risk premium (bottom panel).8  Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to -64 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio fell almost 2% in October, and currently sits at 85% (Chart 6). We recently upgraded municipal bonds from neutral to overweight.9 The decision was based on the fact that yield ratios had jumped significantly. Yield ratios continue to look attractive relative to average pre-crisis levels, especially at the long-end of the Aaa curve (panel 2). Specifically, 2-year and 5-year M/T yield ratios are close to average pre-crisis levels at 73% and 77%, respectively. Meanwhile, M/T yield ratios for longer maturities are all above average pre-crisis levels. M/T yield ratios for 10-year, 20-year and 30-year maturities are 86%, 94% and 97%, respectively.   Fundamentally, state & local government balance sheets remain solid. Our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage has improved considerably in recent quarters (bottom panel). Both of these trends are consistent with muni ratings upgrades continuing to outnumber downgrades going forward. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve steepened considerably in October, as short-dated yields came under downward pressure even as long-maturity yields edged higher. The 2/10 Treasury slope steepened 12 bps on the month, and currently sits at 17 bps. The 5/30 slope steepened 9 bps on the month, and currently sits at 66 bps (Chart 7). Last week’s report discussed the outlook for the 2/10 Treasury slope on a 6-12 month horizon.10 We considered the main macro factors that influence the slope of the yield curve: Fed policy, wage growth, inflation expectations and the neutral fed funds rate. We concluded that the 2/10 slope has room to steepen during the next few months, as the Fed holds down the front-end of the curve in an effort to re-anchor inflation expectations. However, we see the 2/10 slope remaining in a range between 0 bps and 50 bps, owing to strong wage growth and downbeat neutral rate expectations. Despite the outlook for modest curve steepening, we continue to recommend holding a barbelled Treasury portfolio. Specifically, we favor holding a 2/30 barbell versus the 5-year bullet, in duration-matched terms. This position offers strong positive carry (bottom panel), due to the extreme overvaluation of the 5-year note, and looks attractive on our yield curve models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 27 basis points in October, bringing year-to-date excess returns up to -64 bps. The 10-year TIPS breakeven inflation rate rose 1 bp on the month, and currently sits at 1.60%. The 5-year/5-year forward TIPS breakeven inflation rate fell 8 bps on the month, and currently sits at 1.69%. Both rates remain well below the 2.3%-2.5% range consistent with the Fed’s target. The divergence between the actual inflation data and inflation expectations is becoming increasingly stark. Trimmed mean PCE inflation has been fluctuating around the Fed’s target for most of the year (Chart 8). However, long-maturity TIPS breakeven inflation rates remain stubbornly low. As we have pointed out in prior research, it can take time for expectations to adapt to a changing macro environment.11 That being said, the 10-year TIPS breakeven rate is currently 32 bps too low according to our Adaptive Expectations Model, a model whose primary input is 10-year trailing core inflation (panel 4). It is highly likely that the Fed will have to tolerate some overshoot of its 2% inflation target in order to re-anchor inflation expectations near desired levels. We anticipate that the committee will do so, and maintain our view that long-dated TIPS breakevens will move above 2.3% before the end of the cycle. ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 5 basis points in October, dragging year-to-date excess returns down to +67 bps. The index option-adjusted spread for Aaa-rated ABS widened 5 bps on the month. It currently sits at 39 bps, 5 bps above its minimum pre-crisis level (Chart 9). Our Excess Return Bond Map (see Appendix C) shows that Aaa-rated consumer ABS rank among the most defensive U.S. spread products and also offer more expected return than other low-risk sectors such as Domestic Agency bonds and Supranationals. However, we remain wary of allocating too much to consumer ABS because credit trends continue to shift in the wrong direction. The consumer credit delinquency rate is still low, but has put in a clear bottom. The same is true for the household interest expense ratio (panel 3). Senior loan officers also continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, our favorable outlook for global growth causes us to shy away from defensive spread products, and deteriorating ABS credit metrics are also a cause for concern. Stay underweight. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in October, bringing year-to-date excess returns up to +233 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS was flat on the month. It currently sits at 73 bps, below its average pre-crisis level but somewhat above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate (CRE) is somewhat unfavorable, with lenders tightening loan standards (panel 4) in an environment of tepid demand. The Fed’s Senior Loan Officer survey shows that banks saw slightly stronger demand for nonfarm nonresidential CRE loans in Q3, after four consecutive quarters of falling demand (bottom panel). CRE prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in October, bringing year-to-date excess returns up to +100 bps. The index option-adjusted spread was flat on the month, and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer a compelling risk/reward trade-off. An overweight allocation to this high-rated sector remains appropriate. Appendix A: The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 29 basis points of cuts during the next 12 months. We anticipate a flat fed funds rate over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuations: Raw Residuals In Basis Points (As Of November 1, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of November 1, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 48 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 48 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 12Excess Return Bond Map (As Of November 1, 2019) Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 4 The 12-month breakeven spread is the spread widening required to break even with a duration-matched position in Treasuries on a 12-month horizon. It can be approximated by OAS divided by duration. 5 For details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 8 Please see Emerging Markets Strategy Weekly Report, “Country Insights: Malaysia, Mexico & Central Europe”, dated October 31, 2019, available at ems.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Two Themes and Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Special Report

Highlights Rising recession risk, shaky economic fundamentals, and absence of positive yielding assets motivate us to reexamine which assets can be counted on to protect a portfolio in the future. We analyze 10 safe havens on four different dimensions: consistency, versatility, efficiency, and costs. Using this framework, we examine the historical performance of each safe haven and provide an outlook on their likely effectiveness over the next decade. We conclude that U.S. TIPS and farmland should provide the best portfolio protection. Cash, U.S. Treasuries and gold are other good alternatives. Meanwhile, U.S. investment-grade bonds, global ex-U.S. bonds, silver, and currency futures are likely to be poor protection choices. Feature For most investors, capital preservation is the most important goal when managing money. However, how to go about it remains a difficult question.  Investing in safe havens can be painful during bull markets, as their returns are usually lower than those of equities. Moreover, economic, political, and financial regimes change over time, which means that an asset that protected your portfolio in the past might not do so in the future. Therefore, it becomes good practice to review one’s safety measures periodically, even if one does not think that a crash is imminent. The current environment in particular, is a propitious time to review safe havens given that: Chart I-1A Great Time To Review Safety Measures A key recession signal is flashing red: The yield curve inverted in the United States in August (Chart I-1 – top panel). An inversion of the yield curve does not necessarily imply a recession, but historically it has been a very reliable signal of one, given that it indicates that monetary policy is too tight for the economy. Structural risks are rising: Rich equity valuations in the U.S. and high leverage levels elsewhere are signs that the pillars supporting this bull market might be fragile (Chart I-1 – middle panel). In addition, protectionism and populism, forces that BCA has long argued are here to stay, threaten to upend the regime of free trade that has benefited equities since the 1950s.1 Yields are near all-time lows: Historically, investors have been able to endure bear markets by hiding in safe assets with positive yield, as these assets will normally provide a reliable cash flow regardless of the economic situation. However, these type of assets are increasingly hard to find, particularly in the government bond space, where 50% of developed country bonds have negative yields (Chart I-1 – bottom panel). Considering these factors, how should investors protect their portfolios in the next decade? To answer this question, we analyze 10 safe havens divided into five broad asset classes: Nominal government bonds: U.S. Treasuries and global ex-U.S. government bonds. Other fixed income: U.S. investment-grade credit and U.S. TIPS.2 Currencies: yen futures and Swiss franc futures. Precious metals: gold futures and silver futures. Other assets: farmland and U.S. cash. We look at historical performance since 1973 for all safe havens except for global ex-U.S. bonds and farmland. For these assets, we look at performance since 1991 due to limited data availability. We mainly look at quarterly returns in order to compare illiquid assets to publicly traded ones. We do not consider each safe haven in isolation, but rather as an addition to equities within a portfolio. Specifically, we explore our safe haven universe relative to the MSCI All Country World equity index from the perspective of a U.S. investor. For our non-U.S. clients, we will release a report from the perspective of other countries if there is sufficient interest. Importantly, we do not look only at historical performance. We also examine whether there is a reason to believe that future returns will be different from past ones, by analyzing how the properties of each safe haven might have changed. When evaluating each safe haven, we focus on four properties: Consistency: a safe haven should generate consistent positive returns during periods of negative equity performance, with returns increasing with the severity of the equity drawdown. Versatility: safe havens should perform well across different types of crises. Efficiency: a safe haven should produce enough upside during crises, so only a small allocation to the safe haven is necessary to reduce losses. Costs: drag to portfolio overall performance (opportunity costs) should be as small as possible. Readers who wish to see just our overall conclusions should read our Summary Of Results section below. For our analysis of how safe havens have performed in the past, please see the Historical Performance section. Finally, for our analysis of how we expect the performance of safe havens to change, please see our Outlook section. Summary Of Results The Best Safe Havens U.S. TIPS should be an excellent safe haven to protect a portfolio in the next decade. While TIPS might not be as cheap to hold as they have been in the past, upside potential remains strong, which means that a moderate allocation can provide substantial protection to an equity portfolio. Moreover, U.S. TIPS are one of the best hedges against crises triggered by rising rates and inflation, which in our view are the biggest structural risks that asset allocators face. Farmland could also be a great safe haven for investors who have the ability to allocate to illiquid assets given that it is the cheapest safe haven in terms of portfolio drag. However, investors should be aware that the current low yield could potentially affect its performance during crises. Good Alternatives Cash can be a good alternative to protect an equity portfolio, given its outstanding performance during equity drawdowns caused by inflation. Moreover, its opportunity costs should decrease relative to the past. However, investors should take into account that the efficiency of cash at the current juncture is poor, which means that a relatively large allocation is needed in order to achieve meaningful portfolio protection. A portfolio with a 30% allocation to Treasuries historically provided the same downside protection as a portfolio with a 44% allocation to gold. We also like gold futures as a safe haven since they offer some of the most attractive opportunity costs. In addition, their upside is greater than that of most safe havens due to their negative correlations with real rates. However, gold’s volatility makes it an unreliable asset, which prevents us from placing it higher in the safe haven hierarchy. Historically, U.S. Treasuries have been one of the best safe havens to hedge an equity portfolio. Will this performance continue in the future? We do not think so. While yields are still high enough to provide plenty of upside potential, they have fallen to the point where they have increased the opportunity costs of U.S. Treasuries and reduced their consistency. The Rest Global ex-U.S. bonds have very limited upside due to their low yields. Meanwhile U.S. investment-grade credit remains at risk from poor corporate balance sheets, compounded by the fact that credit no longer has an attractive yield cushion. Currencies like the yen and the Swiss franc will continue to be unreliable and very expensive safe havens. Finally, while silver’s costs and reliability could improve, its high cyclicality relative to other safe havens will make silver a poor protection choice. Historical performance Consistency How did safe havens perform when equities lost money? To assess consistency, we plot the performance of each safe haven during all quarters when global equities had losses (Chart I-2). Cash and farmland were the only assets to have positive returns during every equity drawdown. U.S. Treasuries and U.S. TIPS were also very consistent, and had the additional advantage that their returns tended to increase as equity losses worsened. Global ex-U.S. bonds, while not as consistent, generated positive returns most of the time. Chart I-2Safe Haven Returns During Drawdowns In Global Equities On the other hand, investment-grade bonds, the yen, the Swiss franc, gold, and silver were much more inconsistent. In general, even though these assets had larger positive returns than other assets, they were prone to deep selloffs concurrent with equity drawdowns. Silver was the worst of all safe havens, being mostly a negative return asset during quarters of negative equity performance. Versatility How did the type of crisis affect the performance of safe havens? We classify crises according to their catalyst into the following four categories: bursts of U.S. asset bubbles (tech bubble, 2008 housing crisis), ex-U.S. crises (1998 EM crisis, European debt crisis), flash crashes/political events (1987 Black Monday, 9/11 terrorist attack),  rate/inflation shocks (1974 oil crisis, 1980 Fed shock) and others (every other equity drawdown we could not classify).3  We look at the performance of seven safe havens since 1973 (Chart I-3A) and of all 10 since 19914 (Chart I-3B): Chart I-3ASafe Haven Return During Different Type Of Crisis (1973 - Present) Chart I-3BSafe Haven Return During Different Type Of Crisis (1991 - Present)   During bursts of U.S. asset bubbles, U.S. Treasuries were the most effective hedge in both sample periods, followed by U.S. TIPS and farmland. Corporate bonds, cash, gold, and the Swiss franc also had positive returns, though they were small. Finally, the yen and silver had negative returns. During crises happening outside of the U.S., U.S. Treasuries were once again the best option. U.S. TIPS, yen futures, farmland, gold, and U.S. investment-grade bonds also provided strong returns.  Meanwhile, global ex-U.S. bonds and cash provided relatively weak returns, while both the Swiss franc and silver accrued losses. During flash crashes/political events, the Swiss franc had the best performance followed by global ex-U.S. bonds, though in general all safe havens but silver provided positive returns. Rate/inflation shocks were the most difficult type of crisis to hedge. Cash and U.S. TIPS were by far the best performers. Moreover, while U.S. Treasuries were able to eke out a small positive return, all other safe havens lost money during these crises. Efficiency How much allocation to each safe haven was needed to protect an equity portfolio? Chart I-4 show how adding incremental amounts of each safe haven5 to an equity portfolio reduced the overall portfolio’s 10% conditional VaR (the average of the bottom decile of returns).6 Since 1973, U.S. TIPS and U.S. nominal government bonds were the most efficient safe havens, providing the most protection per unit of allocation (Chart I-4 – top panel). Conditional VaR was reduced by almost half when allocating 40% to either Treasuries or TIPS. Cash, U.S. investment-grade, the yen, the Swiss franc, gold, and silver followed in that order. The difference between the safe havens was significant. As an example, a portfolio with a 30% allocation to U.S. Treasuries historically provided the same downside protection as a portfolio with a 36% allocation to U.S. IG credit, a 39% allocation to the yen or a 44% allocation to gold. Meanwhile, there was no allocation to silver which would have provided the same level of protection. When using a sample from 1991, the main difference was the reduced efficiency of cash – the result of lower average interest rates when using a more recent sample. Other than cash, the efficiency of most safe havens remained unchanged: U.S. Treasuries were the best option, followed by U.S. TIPS, farmland, U.S. investment-grade bonds, global ex-U.S. government bonds, cash, the yen, gold, the Swiss franc, and silver in that order (Chart I-4 – bottom panel). Chart I-4Historically, Fixed-Income Assets Were The Most Efficient Safe Havens Costs How do safe haven returns compare to equities? To evaluate opportunity costs, we compare the difference of the historical return of each safe haven versus global equities. Overall, hedging with currencies was extremely costly, as their return was well below that of equities in both samples (Chart I-5). Cash was also an expensive safe haven to hedge with, particularly in the most recent sample. On the other hand, fixed-income assets like U.S Treasuries, investment-grade credit, and U.S. TIPS had very low costs (global ex-U.S. bonds also had cost of around 2% in a limited sample).  Farmland had negative opportunity costs because it outperformed equities during the sample period.7 Chart I-5Historically Fixed Income Assets And Farmland Had The Lowest Opportunity Cost Outlook Chart I-6No More Yield Cushion Chart I-7Silver Has Become Less Cyclical For our outlook, we assess how the four traits under study have changed for all safe havens: Consistency: Will safe havens continue to be reliable in the absence of high coupons? Many of the safe havens in our sample were effective at hedging equities due to their high yield. Even if they had negative capital appreciation, total returns stayed positive thanks to the offsetting effect of the yield return. However, as rates have declined, yield return has also decreased substantially (Chart I-6). Therefore, safe havens, like cash, government bonds, and even farmland will not be as consistent as they were in the past. Credit could be even more vulnerable: the combination of a low yield, and unhealthy fundamentals will turn U.S. corporate bonds into a negative-return asset in the next crisis. Silver might be the lone safe haven to improve its consistency. Industrial use for silver has fallen substantially in the past 10 years, decreasing its cyclical nature (Chart I-7). Thus, while silver might still be an erratic safe haven, it should be more consistent in the future than its historical performance would suggest.   Versatility: What will the next crisis look like? Chart I-8Inflation and Political Crisis Will Plague The 2020s Determining what the next crisis will look like is crucial for safe haven selection. Below we rank the types of crises in order of how likely and severe we think they will be in the future: Inflation/rate shock: We expect inflation to be significantly higher over the next decade. This will be the highest risk for asset allocators in the future. As we explained in our May 2019 report, a change in monetary policy framework, procyclical fiscal policy, waning Fed independence, declining globalization, and demographic forces are all conspiring to lift inflation in the next decade.8 Importantly, we believe that the Fed will be dovish initially, as it cannot let inflation continue to underperform its target after missing the mark for the last 10 years (Chart I-8 – top panel). However, this will cause an inflationary cycle, which will eventually lead the Fed to raise rates significantly and trigger a recession. Political events/flash crashes: Political events will also pose a risk to the markets on a structural basis. The rise of China as a superpower has shifted the world into a paradigm of multipolarity, which historically has resulted in military conflict. Moreover, animus for conflict is not dependent on President Trump. The American public in general feels that the economic relationship with China is detrimental to the United States (Chart I-8 – bottom panel). This means that any president, Democrat or Republican will have a political incentive to jostle with China for economic and political supremacy for years to come. Ex-U.S. crises: We expect Emerging Markets in general, and China in particular, to be among the most vulnerable parts of the global economy as we enter the next decade. Over the last 10 years, China’s money supply has increased four-fold, becoming larger than the money supply of the U.S. and the euro area combined. In addition, corporate debt as a % of GDP stands at 155%, higher than Japan at the peak of its bubble and higher than any country in recorded history (Chart I-9). We rank this type of crisis slightly below the first two because Emerging Market assets are depressed already. Thus, while we believe that there is further downside to come for these economies, some weakness has already been priced in. U.S. asset bubble burst: We believe that there are no systemic excesses in the U.S. economy, making a U.S. asset bubble burst a lesser risk than other types of crises. Although it is true that U.S. corporate debt stands at all-time highs, it is still at a much lower level than in other countries. Moreover, weakness of corporate credit is not likely to have systemic consequences on the economy, given that leveraged institutions like banks and households hold only a small amount of outstanding corporate debt (Chart I-10). Chart I-9EM crises Are Also A Risk Chart I-10A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences What does this ranking mean in terms of safe haven performance? U.S. TIPS and cash should be held in high regard as they will be some of the only assets that will perform well during an inflation/rate shock. The Swiss franc and global ex-U.S. bonds should be best performers during political crises, although U.S. TIPS could also provide adequate protection. Efficiency: Is there any upside left for safe havens when interest rates are near zero? As yields go below the zero bound it becomes harder for bonds to generate large positive returns. European or Japanese government bonds in particular would need their yields to go deep into negative territory to counteract a large selloff in equities (Table I-1). But can interest rates go that low? We do not think so. The recent auction of German bunds, where a 0%-yielding 30-year bond attracted the weakest demand since 2011, suggests that interest rates in these countries might be close to their lower bound.  On the other hand, though U.S. yields are low, they are still high enough for U.S. Treasuries to provide high returns in case of a crisis. Table I-1No Room For Positive Returns In The Government Bond Space Outside Of The U.S. Low rates also have an effect on the efficiency of U.S. investment-grade bonds, cash, and farmland because their upside during crises does not come from capital appreciation but rather from their yield, (the price of IG credit actually declines during most crisis). As mentioned earlier, their yield has declined substantially compared to the past, which means that a larger allocation will be necessary to counteract a selloff. Chart I-11Switzerland Has A High Incentive To Prevent The Franc From Appreciating The upside of the yen could also be compromised. The Bank of Japan is likely to intervene aggressively in the currency market to prevent the Japanese economy from falling into a deflationary spiral, since it is very difficult for it to lower Japanese rates further. The Swiss franc is even more vulnerable. In contrast to Japan, Switzerland is a small open economy that has to import most of its products (Chart I-11). This means that the Swiss National Bank has a very high incentive to intervene in currency markets during a crisis, given that a rally in the franc could depress inflation severely. What about U.S. TIPS? In contrast to nominal government bond yields or even yields on corporate debt, U.S. real rates are not limited by the zero bound (Chart I-12).  This makes TIPS a more attractive option than other fixed-income assets, since real rates can have much more room for further downside than nominal ones. To be clear, this will only be the case if our forecast of an inflationary crisis materializes. Likewise, since gold is heavily influenced by real rates, it should also offer significant upside during the next crisis.9 Chart I-12Real Rates Have More Downside Potential Than Nominal Ones Costs: Can I afford to hold safe havens in a world of low returns? To provide an outlook for the expected cost of each safe haven, we use the return assumptions from our June Special Report.10 We subtract the expected return on global equities from the expected return for each safe haven to reach an expected cost value. However, three of the safe havens (global ex-U.S. government bonds, the Swiss franc and silver) did not have a return estimate. We compute their expected returns as follows: For the Swiss franc we use the methodology we used for all other currencies in our report. We base the expected return on the current divergence from the IMF PPP value, as well as the IMF inflation estimates. In addition, we add the relative cash rate assumed return for both our yen and Swiss franc estimates, as futures take into account carry return. For global ex-U.S. bonds we take the weighted average of the expected return of the euro area, Japan, U.K., Canada, and Australia government bonds. We weight the returns according to their market capitalization in the Bloomberg/Barclays government bond index. Due to silver’s dual role as an inflation hedge and industrial metal, silver prices are a function of both gold prices and global growth. To obtain a return estimate we run a regression on silver against these two variables and use our growth and gold return estimate to arrive at an assumed return for silver. Chart I-13 shows our results: while their cost will improve, currency futures remain the most expensive hedge. The opportunity cost of precious metals and cash will decrease, making them more attractive options than in the past. Meanwhile, low yields will increase the opportunity costs of most fixed-income assets. Finally, farmland will remain the cheapest safe haven, even with decreased performance. Chart I-13Oportunity Cost For Fixed Income Safe Havens Will Be Higher Than In The Past Juan Manuel Correa Ossa Senior Analyst juanc@bcaresearch.com Appendix A Footnotes 1 Please see Geopolitical Strategy Special Report, "The Apex Of Globalization – All Downhill From Here, " dated November 12, 2014, available at gps.bcaresearch.com. 2 We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 3 For a detailed list of how we classified each equity drawdown, please see Appendix A. 4 The only crises caused by a rate/inflation shock occurred in 1974 and 1980. Thus we have this type of drawdown only in Chart 3A and not in Chart 3B. 5 For yen, Swiss franc, silver and gold futures we assume an allocation to an ETF which follows their performance. Since futures have zero initial costs they cannot be directly compared to traditional assets in terms of percentage allocation. 6 We prefer this measure over VaR given that it captures the properties of the left tail of returns more accurately. 7  While the farmland index subtracts management fees, we recognize that there are costs involved in holding these illiquid assets which are not necessarily captured by the return indices. Thus, the real historical cost of holding farmland was not negative but likely close to zero. 8 Please see Global Asset Allocation Strategy Special Report "Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises," dated May 22, 2019, available at gaa.bcaresearch.com. 9 Please see Commodity & Energy Strategy Special Report "All that Glitters…And Then Some" dated July 25, 2019, available at ces.bcaresearch.com. 10 Please see Global Asset Allocation Strategy Special Report "Return Assumptions - Refreshed and Refined" dated June 25, 2019,  

Highlights Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Chart 4… Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification