Corporate Bonds

Highlights Duration: Hawkish trade policy will continue to weigh on bond yields for at least the next few months, but a rebound in global economic growth should take hold before the end of the year. Ultimately, a growth rebound will lead to higher bond yields on a 12-month horizon, but the timing is difficult and investors should keep portfolio duration close to benchmark for the time being. High-Yield: The Fed’s accommodative policy stance and the likelihood of a global growth recovery argue for maintaining an overweight allocation to corporate credit. Within that allocation, junk bonds should outperform investment grade due to much more attractive valuations. 10-Year Treasury Yield: The current shock to global economic growth is of a similar magnitude to the one that occurred in 2015/16. However, wage and inflationary pressures are higher now than they were back then. This means that the 10-year Treasury yield will not re-visit the 2016 trough of 1.37%, and is probably already close to its floor. Feature Regular readers will be aware of our Fed Policy Loop framework for analyzing the wiggles in financial markets. The Loop works as follows: Step 1: A dovish shift in Fed policy leads to a favorable market reaction, easing financial conditions. Step 2: Easier financial conditions suggest to the Fed that economic growth will strengthen in the future. The Fed can therefore respond by adopting a more hawkish policy stance. Step 3: The Fed’s hawkish policy shift leads to a negative market reaction, tightening financial conditions. Step 4: Tighter financial conditions suggest to the Fed that economic growth will weaken in the future. The Fed is forced to ease monetary policy at the margin. Return to Step 1 But it appears that BCA readers aren’t the only ones aware of the Fed Policy Loop. President Trump has also been exploiting the two-way relationship between Fed policy and financial conditions as he escalates his trade war with China. Chart 1 illustrates how this has been working. Step 1 of the Fed policy loop continues to function exactly as described above. However, the last few times that financial conditions have eased, the President has seized the opportunity to ratchet up trade tensions. Much like the Fed, the President reasons that periods of easier financial conditions are when the economy and financial markets can best handle a negative shock. The fall-out is that financial conditions tighten in response to the hawkish trade announcement, and the Fed is forced to respond to tighter financial conditions by turning even more dovish. The end result is that the part of the Fed Policy Loop labeled “Hawkish Fed” is by-passed. Without that step it is impossible for bond yields to rise (Chart 2). Chart 2The Back-Drop Of The Interrupted Fed Policy Loop Our Geopolitical Strategy service provided a comprehensive breakdown of U.S./China trade negotiations in last week’s report.1 The overall message is that the 2020 election is the President’s main constraint. He views hawkish trade policy as a winning issue, but only insofar as it can be accomplished without a significant decline in the stock market or economic activity. Faced with that constraint, the President will continue to interrupt the Fed Policy Loop, and the Fed will continue to do its job by adopting a more dovish monetary policy to offset possible trade shocks. At present, this means that another rate cut is likely in September. Against the back-drop of the “interrupted” Fed Policy Loop, Treasury yields can only move higher if global economic growth strengthens. In that case, the policy loop will remain operative, but at an overall higher level of yields. With that in mind, while hawkish trade policy will continue to weigh on bond yields for at least the next few months, a rebound in global economic growth should take hold before the end of the year. This will lead to higher bond yields on a 12-month horizon. Still Tracking The 2015/16 Roadmap In our research, we have repeatedly pointed out the similarities between the 2015/16 episode of flagging global growth and the current period. Specifically, we continue to witness weak manufacturing data – both in the U.S. and abroad – but a resilient service sector and strong labor market. Much like in 2015/16, we expect that the shifts toward easier monetary policy in the U.S. and more accommodative credit conditions in China will eventually put a floor under the global manufacturing cycle. The Fed will continue to do its job by adopting a more dovish monetary policy to offset possible trade shocks. At present, this means that another rate cut is likely in September. Case in point, even as President Trump has tightened global financial conditions at the margin through his hawkish trade policy, overall global financial conditions have eased since the beginning of the year (Chart 3). In 2016, easier financial conditions eventually led to upturns in crucial measures of global growth such as the Goldman Sachs Current Activity Indicator (Chart 3, top panel), the Global Manufacturing PMI (Chart 3, panel 2), and the CRB Raw Industrials index (Chart 3, bottom panel). The same dynamic should play out this time around. It’s likely that the main reason why global growth has not responded as quickly as it did in 2016 is that Chinese policy easing has not been as rapid (Chart 4). Our China Investment Strategy service’s Li Keqiang Leading Indicator – a composite measure of money and credit indicators designed to lead Chinese economic activity – has clearly bottomed, but has not yet surged as it did in 2015/16. However, Chinese policy easing continues to ramp up, a process that will continue in the months ahead. The most recent indication of this trend was China’s decision to de-value its currency versus the U.S. dollar, causing the exchange rate to jump above the important psychological threshold of 7 yuan per dollar (Chart 4, bottom panel). China took similar measures to de-value its currency in August 2015, a move that initially roiled markets but eventually helped usher in a rebound in global growth. Chart 3The 2015/2016 Scenario Has Yet To Play Out... Chart 4...As Long As China Does Not Stimulate More When it comes to strategy, we remain confident that global growth is close to a trough, but admit that timing the rebound is difficult. One indicator that should help with timing is the ratio between the CRB Raw Industrials index and Gold (Chart 5). This ratio is tightly correlated with the 10-year Treasury yield, and will only rise when the perceived improvement in global growth – proxied by the CRB index – starts to outpace the perceived dovish tilt to Fed policy – proxied by the rising gold price. Chart 5Keep Tracking The CRB / Gold Ratio In light of these difficulties with timing, we recommend that investors keep portfolio duration close to benchmark, but position for a rebound in global growth by maintaining an overweight allocation to credit risk and by running a heavily barbelled Treasury portfolio, overweighting the long and short ends of the curve while avoiding the 5-year and 7-year maturities. The barbell strategy increases average portfolio yield, and also avoids the part of the yield curve that will suffer the most when yields rise. Take Credit Risk In Junk As mentioned above, we recommend that investors maintain an overweight allocation to corporate credit versus Treasuries, despite our recent shift to benchmark duration.2 This is particularly true for high-yield bonds, where spreads are very attractive. Charts 6A and 6B show one of our favorite ways of looking at corporate bond spreads. The charts show the 12-month breakeven spread for each credit tier as a percentile rank relative to history.3 We show each credit tier individually to control for the time-varying average credit rating of the overall indexes. Similarly, we show breakeven spreads instead of the average option-adjusted spreads to control for the time-varying average duration of the bond indexes. Chart 6A shows the following valuation for investment grade credit tiers: Throughout history, Aaa credits have been more expensive than they are today only 13% of the time. Aa credits have been more expensive than they are today 19% of the time. A-rated credits have been more expensive 20% of the time. Baa credits have been more expensive 33% of the time. Chart 6B shows that the corresponding valuation for high-yield is much more compelling: Ba credits have been more expensive than today 55% of the time. B credits have been more expensive 81% of the time. Caa credits have been more expensive 84% of the time. Chart 6AInvestment Grade Breakeven Spreads Chart 6BHigh-Yield Breakeven Spreads In general, this way of looking at spreads shows that investment grade credits are quite expensive, while high-yield credits are either fairly valued or cheap. However, there is one more adjustment we can make to get an even better picture of corporate bond value. Adjusting For The Phase Of The Cycle A useful tool for cyclical portfolio allocation is to split the cycle into three phases based on the slope of the yield curve (Chart 7). We define the three phases as: Chart 7The Three Phases Of The Cycle Phase 1: From the end of the last recession until the 3/10 Treasury slope flattens to below 50 bps. Phase 2: When the 3/10 slope is between 0 bps and +50 bps. Phase 3: From when the 3/10 slope inverts until the start of the next recession. We have previously discussed the implications of the different phases for bond portfolio allocation in more depth.4 This week, we simply want to point out that credit spreads tend to be tighter during Phase 2 of the cycle, when monetary policy has tightened, but not by enough to cause a surge in corporate defaults. The recent surge in investment grade net debt-to-EBITDA likely reflects the shift toward a greater concentration of Baa-rated issuers. With this cyclical decomposition in mind, we can calculate the median breakeven spread for each credit tier in past Phase 2 periods and use that as a spread target for this cycle. We then convert our breakeven spread targets into average option-adjusted spread targets using current index duration. Charts 8A and 8B show how far each credit tier’s spreads are from target. The message is quite clear. Outside of Aaa, investment grade credits are more or less fairly valued, while high-yield credits appear very cheap. Chart 8AInvestment Grade Spread Targets Chart 8BHigh-Yield Spread Targets One might reasonably challenge this approach to corporate bond valuation by noting that, outside of looking at credit tiers individually, we have not taken fundamental credit quality trends into account. That is, we have made no adjustment for the fact that the credit quality of a Ba-rated issuer might be worse today than in prior cycles. We are skeptical that fundamental credit metrics matter more than the phase of the monetary policy cycle when it comes to corporate bond spread forecasting.5 However, this point of view is still worth exploring, especially considering that net debt-to-EBITDA for the median corporate bond issuer is quite elevated compared to history (Chart 9). Note that we have not attempted to maintain consistent weightings between the different credit tiers in the bottom-up samples shown in Chart 9. This means that the recent surge in investment grade net debt-to-EBITDA likely reflects the shift toward a greater concentration of Baa-rated issuers. Nonetheless, the net debt-to-EBITDA ratio of the median junk issuer is clearly worse than during the past two recoveries. But even if we take this into account by looking at the ratio between the junk index 12-month breakeven spread and the median net debt-to-EBITDA, we see that the ratio is still close to its historical median (Chart 10). In other words, at current spread levels junk investors appear reasonably compensated for the elevated median net debt-to-EBITDA ratio Chart 9Elevated Corporate Leverage Chart 10Favor Junk Bonds Bottom Line: The Fed’s accommodative policy stance and the likelihood of a global growth recovery argue for maintaining an overweight allocation to corporate credit. Within that allocation, junk bonds should outperform investment grade due to much more attractive valuations. Close To The Floor Chart 11Now Vs. Mid-2016 In a prior report we walked through the process of creating a macroeconomic fair value model for the 10-year Treasury yield, with a focus on describing the different independent variables that might be included in such a model, and the rationale for each one.6 This week, we focus on two vital macroeconomic variables and use them to demonstrate why the 10-year Treasury yield is unlikely to re-visit its mid-2016 trough of 1.37%. The two main variables we focus on are (i) the pace of economic growth, and (ii) the size of the output gap. All else equal, a stronger pace of economic growth leads to expectations for a higher policy rate in the future and a higher 10-year Treasury yield today. However, it is not just the pace of growth that matters. The same rate of economic growth generates more inflationary pressure when the output gap is small than when it is large. This means that bond yields should be higher when the output gap is smaller (or more specifically, less negative). We have found that the Global Manufacturing PMI is probably the indicator of economic growth that correlates best with the 10-year Treasury yield. Similarly, measures of wage growth – and to a lesser extent core inflation – tend to give the best read on the output gap. With that in mind, we can see how these factors look today relative to when the 10-year yield troughed at 1.37% in mid-2016 (Chart 11). Global economic growth looks slightly worse, but not dramatically so. The Global Manufacturing PMI is at 49.3 today. It troughed at 49.9 in 2016. If this were the only variable that mattered, we might reason that the 10-year yield should be below 1.37% already. But we also need to consider that wage growth and inflation are both much higher than in 2016. Average hourly earnings are growing at a year-over-year rate of 3.2%, compared to a rate of 2.8% when the 10-year troughed in 2016. Similarly, the Atlanta Fed’s measure of median wage growth is up to 3.7% for the un-weighted sample and 3.9% for the sample that is weighted to more closely match the demographic characteristics of the overall population (Chart 11, panel 3). It’s true that core PCE inflation is running below where it was in mid-2016, but the trimmed mean measure is much higher (Chart 11, bottom panel). The core PCE inflation measure also has a strong track record of converging toward the trimmed mean, a process we expect is playing out again. The core PCE inflation measure also has a strong track record of converging toward the trimmed mean, a process we expect is playing out again. Bottom Line: The current shock to global economic growth is of a similar magnitude to the one that occurred in 2015/16. However, wage and inflationary pressures are higher now than they were back then. This means that the 10-year Treasury yield will not re-visit the 2016 trough of 1.37%, and is probably already close to its floor.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “The Rattling Of Sabers”, dated August 9, 2019, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Portfolio Allocation Summary, “Underinsured”, dated August 6, 2019, available at usbs.bcaresearch.com 3 The 12-month breakeven spread is the basis point widening required on a 12-month horizon for each credit tier to break even with a duration-matched position in Treasuries. 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chinese economic growth slowed in June & July, but at a more moderate pace than had been the case earlier this year. The housing market is a notable exception, which appeared in June to slow in a broad-based fashion. The near-term (0-3 month) outlook is bearish for China-related assets, and investors should bet on further weakness in the RMB. However, investors should remain cyclically bullish (i.e., over a 6-12 month time horizon) in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the intensifying drag from weak external demand. 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, coincident measures of economic activity suggest that China’s economy experienced “controlled weakness” in June and July: growth continued to slow, but at a more moderate pace than had been the case in late-2018 and early-2019. The housing market appeared to be the exception to this relative stability; all 10 of the core housing indicators that we track decelerated in June, suggesting that a moderation in housing-related activity was broad-based. This implies that a further slowdown in construction is likely over the coming months, barring a meaningful pickup in sales. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, all of the key developments have occurred over the past several trading days, in response to President Trump’s threat last week to further hike U.S. import tariffs at the beginning of September. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark, as have Hong Kong stocks in response to intensifying protests in the city. A sharp decline in the RMB and the U.S. designation of China as a currency manipulator have unnerved Chinese and global investors, and our bias is to expect even further weakness in the yuan. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Otherwise stated, we expect Chinese relative performance to trend lower in the near-term, but to be higher 12-months from today. Investors should also continue to hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks with a long USD-CNH position. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Our leading indicator for the Li Keqiang Index is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth. Chart 1Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Chart 2Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator The Li Keqiang index (LKI) rose moderately in June after a significant decline in May, but remains in a downtrend (Chart 1). The June increase was driven entirely by a pickup in electricity production (which had nearly contracted in May); bank loan growth and rail cargo volume both decelerated. The takeaway for investors is that while the Chinese economy did not slow meaningfully further in June, the pace of growth remained tepid, suggesting the economic activity remains vulnerable to a further increase in U.S. import tariffs. Our leading indicator for the LKI is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth (Chart 2). However, the magnitude of the rise in the indicator is being held back by growth in the money supply, which has only slightly accelerated over the past few months, as well as a “half strength” recovery in credit. Our view is that Chinese policymakers are likely to wait for further economic weakness before allowing money & credit growth to significantly overshoot, which increases the odds of a continued market riot in the short-term. Chart 3Decelerating House Price Appreciation Is Coming All 10 of the housing indicators shown in Table 1 decelerated in June, suggesting that a moderation in housing-related activity was broad-based. Our BCA 70-city diffusion index for (YoY) house prices has an excellent track record at leading inflection points in overall price growth (Chart 3), and is currently suggesting that house price appreciation is at risk of falling back to mid-2018 levels (which would imply a 5-6 percentage point deceleration). Continued weakness in floor space sold continues to suggest that the ongoing pace of housing construction is unsustainable; we expect a further moderation in floor space started over the coming several months barring a meaningful pickup in sales. Both the Caixin and official manufacturing PMI for China rose in July, including the official new export orders component (which we have been closely following). However, the survey was taken prior to President Trump’s renewed tariff threat last week, and we expect the July gains to reverse in August barring a major de-escalation in the conflict. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark over the past week due to President Trump’s threat to impose tariffs on all remaining imports from China. We noted in our May 29 weekly report that a financial market riot point remained likely over the coming few months,1 and we explicitly recommend an underweight position in Chinese stocks for the remainder of 2019 in last week’s report.2 Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Investors who are already positioned in favor of Chinese stocks should stay long, despite the likelihood of further near-term losses. ​​​​​​​Investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Chart 4Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance The MSCI Hong Kong index has also significantly underperformed the global benchmark since late-July, in response to intensifying protests in the city (Chart 4). The protests have been driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. However, Hong Kong has no real alternative to Beijing’s sovereignty, and the unrest should gradually die down as long as the imposition of martial law is avoided. Nonetheless, Hong Kong’s stock market is likely to remain under pressure in the interim; for now, we recommend that investors stay underweight versus China and Taiwan.​​​​​​​ The sector performance within China’s investable and domestically-listed equity markets over the past month has largely been along cyclical / defensive lines. In the investable market, consumer staples, health care, financials, information technology, communication services, and utilities have all outperformed, in contrast to energy, materials, industrials, consumer discretionary, and real estate stocks. The pattern has been similar in the domestic market, with two exceptions: modest staples underperformance, and material underperformance of comm services. Real estate stocks have been among the worst performers in both markets over the past month, possibly in response to the deteriorating housing market data that we highlighted above. China’s 3-month repo rate has fallen approximately 20 bps over the past month, and is now back close to its one-year low. We continue to believe that a cut to the benchmark lending rate is unlikely in the near-term, but could occur in Q4 if economic conditions in China weaken materially further.​​​​​​​ Chinese onshore corporate spreads increased modestly over the past month, but have not yet risen to a new high for the year. The uptrend in spreads that began in late-May does reflect renewed risks to the Chinese economy from a further increase in U.S. import tariffs, but annualizing the most recent pace of onshore corporate defaults suggests that onshore bond spreads are still much too high. Our long China onshore corporate bond trade continues to register gains in local currency terms (Chart 5), and we recommend that investors stick with a long/overweight currency-hedged stance. ​​​​​​​Our bias is to bet on further RMB weakness until policymakers aggressively ramp up their reflationary efforts. The yuan weakened sharply this week, with the U.S. dollar breaking above 7 versus both the onshore and offshore RMB (Chart 6). This is the weakest level for the currency since the global financial crisis, and the decline has clearly occurred in response to last week’s tariff threat. We noted in our May 15 report that a meaningful decline in the exchange rate would likely be required in order to stabilize the outlook for earnings & the economy,3 and we recommended at that time that investors should hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. It is difficult to forecast how much further the RMB is likely to fall, but our bias is to bet on further weakness until policymakers aggressively ramp up their reflationary efforts. Stay tuned. Chart 5Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Chart 6Weakest RMB In A Decade, And Further Declines Are Likely   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com 1      Please see China Investment Strategy Weekly Report, “Waiting For The Pain,” dated May 29, 2019. 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?” dated July 24, 2019. 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019.   Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Keep Tracking The CRB / Gold Ratio The Fed cut rates by 25 basis points last week, a move that Chairman Powell described as an “insurance” cut meant to counter the risks from trade tensions and global growth weakness. Powell also described the move as a “mid-cycle adjustment to policy” and not “the beginning of a lengthy cutting cycle”. We agree with the Fed’s “mid-cycle” view of the U.S. economy and think an extended cutting cycle is unwarranted, but the market clearly disagrees. Long-end yields fell on Powell’s remarks and fell further as U.S. / China trade tensions re-escalated during the past few days. The 2015/16 period continues to be a good roadmap for the current environment, and we expect the next big move in Treasury yields will be higher. The timing of that move, however, is highly uncertain. Our political strategists expect an increase in saber-rattling between the U.S. and China in the coming months, and bond yields will not rise until either trade tensions ease and/or the global growth data recover. We recommend a tactical neutral allocation to portfolio duration, but expect to switch back to below-benchmark when those conditions are met. The CRB / Gold ratio will continue to be a good guide for the 10-year yield (Chart 1). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in July, bringing year-to-date excess returns up to +432 bps. Corporate spreads widened somewhat following Jerome Powell’s perceived hawkishness at last week’s FOMC meeting, but that spread widening will prove fleeting. The Fed remains committed to keeping monetary policy accommodative and that means doing everything it can to prevent a significant tightening of financial conditions.1 The soaring price of gold is the strongest indicator of the Fed’s dovishness, and it is also a buy signal for corporate credit (Chart 2). In terms of valuation, Baa-rated securities offer the most value in investment grade corporate bond space. Baa spreads remain 7 bps above our cyclical target.2 Conversely, Aa and A-rated spreads are 3 bps and 4 bps below target, respectively (panel 4). Aaa spreads are 16 bps below target (not shown). The Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed that commercial & industrial (C&I) lending standards eased for the second consecutive quarter. C&I loan demand continued to contract, but less aggressively than its recent pace (bottom panel). Easing lending standards usually coincide with spread tightening, and vice-versa.  High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +673 bps. The average index option-adjusted spread tightened 6 bps in July, then widened 26 bps in the first two days of August. At 397 bps, it is currently well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 71 bps above our target (Chart 3), B-rated spreads are 142 bps above our target (panel 3) and Caa-rated spreads are 298 bps above our target (not shown).3 Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.9% over the next 12 months, not far from our own projection.4 This would translate into 238 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +32 bps. The conventional 30-year zero-volatility spread tightened 10 bps on the month, consisting of a 9 bps tightening in the option-adjusted spread (OAS) and a 1 bp decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS moved all the way back to its pre-crisis mean, before tightening last month (panel 3). However, as we noted in a recent report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment MBS exposure, especially given the recent downleg in Treasury yields that could spur another small jump in refis. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in July, bringing year-to-date excess returns up to +164 bps. Sovereign debt outperformed duration-equivalent Treasuries by 68 bps on the month, bringing year-to-date excess returns up to +490 bps. Local Authorities outperformed the Treasury benchmark by 31 bps, bringing year-to-date excess returns up to +244 bps. Meanwhile, Foreign Agencies outperformed by 49 bps, bringing year-to-date excess returns up to +153 bps. Domestic Agencies outperformed by 6 bps in July, bringing year-to-date excess returns up to +31 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +36 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 102 basis points in July, bringing year-to-date excess returns up to +58 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 8% in July, and currently sits at 78% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, and even below the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We noted the strong outperformance of municipal bonds in our report two weeks ago, and recommended cutting exposure from overweight to neutral, based on how expensive the bonds have become.6 In that report we noted that Aaa-rated Municipal / Treasury yield ratios for 2-year, 5-year and 10-year maturities were all more than one standard deviation below average pre-crisis levels. Only 20-year and 30-year Aaa-rated municipal bonds continue to look cheap, and we recommend that investors focus muni exposure on that segment of the market. Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our shift to a more cautious stance is driven purely by valuation, and not any immediate concern for municipal bond credit quality. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in July, before undergoing a roughly parallel shift down of about 30 bps in the first two days of August, following the FOMC meeting and news about the escalation of the U.S./China trade war. As we go to press, the 2/10 Treasury slope stands at 16 bps, 9 bps flatter than at the end of June. The 5/30 slope is currently 76 bps, exactly equal to its end-of-June level. Our 12-month Fed Funds Discounter is currently -78 bps (Chart 7). This means that the market is priced for roughly three more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of the uncertainty surrounding the timing of the next move higher in yields, three rate cuts on a 12-month horizon still seems excessive given the underlying strength of the U.S. economy. For this reason we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts spread over the next four FOMC meetings. A short position continues to make sense. On the yield curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +71 bps. The 10-year TIPS breakeven inflation rate rose 8 bps in July to reach 1.77%, before falling back to 1.67% in the first few days of August (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate followed a similar path and currently sits at 1.88%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.7 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at an annualized rate of 2.48% during the past three months. However, the 12-month rate of change remains at 1.5%. The 12-month trimmed mean PCE inflation rate is currently running at 2%, exactly equal to the Fed’s target. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.8 We see continued upside in core inflation over the remainder of the year, and therefore recommend an overweight allocation to TIPS versus nominal Treasuries.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in July, bringing year-to-date excess returns up to +59 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. It currently sits at 31 bps, well below the pre-crisis mean of 64 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed a continued tightening in lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). On the bright side, stronger demand for both credit cards and auto loans was reported for the first time since the fourth quarter of 2016. All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.       Non-Agency CMBS: Neutral     Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to +234 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 64 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation compared to other similarly-rated fixed income sectors.9 Agency CMBS: Overweight   Agency CMBS outperformed the duration-equivalent Treasury index by 26 bps in July, bringing year-to-date excess returns up to +119 bps. The index option-adjusted spread tightened 3 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector 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 78 basis points of cuts during the next 12 months. We anticipate fewer rate cuts 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 Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of August 2, 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 August 2, 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 +55 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 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. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more 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 For more 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 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Special Report

Highlights Mutual Funds & ETFs: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. BBB Securities: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. Leveraged Loans: The rapid surge in leveraged loans has been partially offset by reduced high-yield issuance, helping mitigate a potentially destabilizing rise in all riskier corporate debt. At the same time, bank exposure is focused on the safest CLO tranches, limiting the potential systemic risks from bank losses. Feature In April, we published a Special Report that investigated whether corporate debt poses a risk to the U.S. economy.1 That report focused on what economic theory and empirical evidence say about the relationship between corporate debt and future economic growth. We arrived at the following conclusions: The empirical evidence decisively shows that private (household + business) debt helps predict future economic outcomes. Some evidence shows that household debt is more important than corporate debt in this regard. In contrast to mainstream economic theory, the level of private debt-to-GDP does not help predict future economic outcomes. Rather, it is rapid private debt growth that is linked to more severe economic downturns. Ebullient credit market sentiment is also shown to predict weak economic growth. Tight credit spreads should be viewed as a warning sign, similar to rapid private debt growth. In this follow-up Special Report, we consider three credit market developments that are unique to this cycle: The large ownership stake of open-ended mutual funds and ETFs in the U.S. corporate bond market. The elevated amount of BBB-rated debt outstanding relative to other credit tiers. The rapid issuance of leveraged loans. All three of these developments could mediate the relationship between corporate debt and economic growth, potentially increasing risks to the economy. We consider each factor in turn. 1. Fund Flows One unique feature of the current cycle is that open-ended mutual funds and ETFs own a much larger share of outstanding corporate bonds than in the past. Back in 1990, insurance companies and pension funds were the largest holders of corporate debt, controlling 54% of the market. Meanwhile, open-ended funds owned a paltry 3%. Since then, fund ownership has surged to 16%, mostly at the expense of financial institutions, insurance companies and pensions. Foreign holdings of U.S. corporate bonds have also increased during this period, from 13% of the market to 28% (Charts 1 & 2). Chart 2Mutual Funds Now An Important Market Player Why Does Fund Ownership Matter? We focus on fund ownership of corporate bonds because it has been theorized that flows into and out of open-ended mutual funds can have a similar impact on market prices as leverage, amplifying price moves in either direction. As described in a 2014 paper by Feroli, Kashyap, Shoenholtz, and Shin:2 [W]hen asset flows for certain fixed income securities are high, prices persistently rise and a feedback loop emerges. High flows lead to rising prices, which attract more flows, which further raises prices. Obviously, the proposed feedback loop also works in reverse: Outflows cause prices to decline, and lower prices lead to further outflows. This sort of feedback loop is unique to mutual funds. Insurance companies and pension funds, for example, do not experience investor capital flight in response to a near-term price drop. This makes the larger presence of mutual funds in the corporate bond market potentially destabilizing. Fund ownership has surged to 16%, from a paltry 3% back in 1990. Why Do Fund Flows Behave This Way? Mutual fund shares are much more liquid than the corporate debt securities they hold. As described in a 2017 paper by Goldstein, Jiang and Ng:3 When [mutual] fund investors redeem their shares, they get the net asset value as of the day of redemption. The fund then has to conduct costly liquidation that hurts the value of the shares for investors who keep their money in the fund. Hence, the expected redemption by some investors increases the incentives for others to redeem. In other words, during times of stress, mutual fund investors have an incentive to withdraw their money before other fund shareholders get the chance. Otherwise, they could be stuck holding a basket of illiquid corporate bonds. This bank-run like behavior is well documented for corporate and municipal bond funds, though it appears not to exist for funds that traffic in more liquid instruments, such as Treasuries and equities. In fact, when Goldstein et al looked at how flows into and out of individual corporate bond and equity funds respond to past fund performance, they found that the Flow-Performance curve for an individual corporate bond fund exhibits a pronounced concave shape. Meanwhile, the same curve for an individual equity fund is convex (Chart 3). This means that corporate bond mutual fund shareholders are quick to redeem their shares in response to poor fund performance, while equity fund shareholders are more inclined to stand pat. On the flipside, positive fund performance leads to large equity fund inflows, but doesn’t attract capital to corporate bond funds to the same extent. The above results apply to individual funds, but Goldstein et al also performed the same analysis for corporate bond funds in the aggregate. That is, rather than measuring whether investors sold a particular corporate bond mutual fund in response to its poor performance, they measured whether investors exited the corporate bond mutual fund space altogether in response to poor corporate bond performance. Interestingly, they found a very similar result (Chart 4). Investors are inclined to exit the corporate bond space entirely following periods of poor performance. Meanwhile, they found no relationship between aggregate equity fund flows and performance. Investors might switch between different equity funds in response to recent performance trends, but they don’t exit the asset class altogether.   These results provide a clear indication for why the large presence of corporate bond mutual funds might be destabilizing. Corporate bond fund investors are quick to flee the space during periods of poor performance. For more liquid securities, such as equities and Treasuries, a large mutual fund presence in the market is not a concern, since flows do not respond as aggressively to price shocks. Empirical Evidence For The Flow-Performance Feedback Loop The evidence presented above shows that fund flows respond to performance, but for the theorized feedback loop between fund flows and corporate bond prices to exist, we also need evidence that fund flows impact corporate bond performance. In that regard, a 2019 Banque de France working paper examines the impact of aggregate flows into French corporate bond funds on the yields of the underlying securities.4 It finds that not only do flows impact yields contemporaneously, but also that outflows have a larger influence on yields than inflows. Using a different methodology, a 2015 paper by Hoseinzade finds no material impact of fund flows on underlying corporate bond yields, but for an interesting reason.5 The paper confirms that corporate bond fund shareholders demonstrate bank-run like behavior in response to poor performance, but also argues that “bond fund managers hold a significant level of liquid assets, allowing them to manage redemptions without excessively liquidating corporate bonds.” Chart 5Funds Deploy Cash Before Selling Bonds It’s true that corporate bond mutual funds often hold significant allocations to cash and U.S. Treasuries, and Hoseinzade shows that fund managers tend to discharge their most liquid holdings first, before attempting to sell corporate bonds. This result lines up with our casual observation. Chart 5 shows the aggregate liquid asset (cash and Treasury) holdings of corporate bond mutual funds. It is apparent that they tend to fall during periods of spread widening. We also note that corporate bond mutual funds, in aggregate, currently hold about 6% of their assets in liquid securities. This buffer can probably withstand a sizeable shock, but liquid assets fell from similar levels into negative territory during each of the past two recessions. One other factor that could help break the feedback loop between fund flows and prices is the institutional ownership of corporate bond mutual funds. Goldstein et al find that mutual funds mostly owned by institutional investors exhibit less of a feedback loop between flows and performance. That is, large institutional investors are less likely to redeem their shares in response to a bout of poor performance. While we don’t have data on corporate bond mutual fund ownership specifically, Federal Reserve data reveal that insurance companies and pension funds own a significantly larger proportion of outstanding mutual fund shares than in the 1990s, though less than they did in the mid-2000s (Chart 6). Note that Chart 6 shows data for all mutual funds, including equity funds, Treasury funds, etc… Chart 6Institutional Ownership Of Mutual Funds We conclude that there is enough evidence of a feedback loop between fund flows and corporate bond prices that we should be wary of the growing presence of open-ended mutual funds and ETFs in the corporate bond space. Cash holdings and institutional ownership can help mitigate negative flow/performance feedback loops to some extent, but probably shouldn’t be counted on in the event of a severe shock. What’s The Economic Impact? In our corporate debt Special Report from April, we postulated that changes in corporate bond spreads might, themselves, cause an economic downturn, rather than simply reflect one. The mechanism is summarized nicely by Lopez-Salido, Stein and Zakrajsek (2016):6 [a] sentiment-driven widening of credit spreads amounts to a reduction in the supply of credit, especially to lower credit-quality firms. It is this reduction in credit supply that exerts a negative influence on economic activity. With that in mind, in the current environment it seems very possible that an initially sentiment-driven credit spread widening could be exacerbated by outflows from corporate bond mutual funds. A larger shock to credit spreads leads to a larger reduction in credit supply and a more severe economic impact. Aggregate liquid asset holdings of corporate bond mutual funds tend to fall during periods of spread widening. Bottom Line: The liquidity mismatch between easily tradeable mutual fund shares and the less liquid underlying corporate bonds makes it possible for negative feedback loops to emerge between fund flows and corporate bond spreads. The growing presence of open-ended mutual funds and ETFs in the corporate bond market should be seen as a risk that could exacerbate future periods of spread widening, leading to worse economic outcomes. 2: BBB Debt Outstanding Chart 7The Large Amount Of BBB Debt It has been widely reported that an unusually large amount of outstanding corporate bonds are rated BBB, the lowest credit rating that is still considered investment grade. In fact, the par value of BBB-rated securities now makes up 50% of the Bloomberg Barclays Investment Grade index, up from 21% in 1990 (Chart 7). The amount of outstanding BBB securities is more than double the par value of the Bloomberg Barclays High-Yield index, and BBBs represent 41% of the total combined par value of the investment grade and high-yield indexes. The reason to be wary about the large amount of outstanding BBB debt is that when the credit cycle turns and ratings downgrades start to occur, a larger than normal amount of debt will be downgraded from investment grade into high-yield. When that happens, any investors with an investment grade-only mandate will be forced to sell. The concern is that such forced selling could set off a negative feedback loop very similar to the one discussed in the first section. An added layer of risk comes from the fact that in addition to investment grade-only mutual funds, insurance companies and pension funds – who still control 35% of the corporate bond market (see Chart 2 on page 3) – are often burdened with larger capital costs for high-yield debt. This means that a very large pool of investors could be impacted by a spate of BBB downgrades. In terms of the potential market impact, a 2010 paper by Ellul, Jotikasthira and Lundblad investigated fire sales of downgraded corporate bonds induced by regulatory constraints.7 The authors found that insurance companies often engage in the forced selling of bonds that have been recently downgraded into high-yield. Further, the downgraded bonds experience negative near-term price pressure from the fire sale, but that pressure tends to reverse after a few months. The finding that the negative price pressure is fleeting is important. In contrast to the negative feedback loop that can be generated by mutual fund flows, BBB securities can only be downgraded to high-yield once. In other words, once the initial fire sale of fallen angel debt takes place, there is no mechanism to force the downward price pressure to continue.8 Bottom Line: The large amount of outstanding BBB debt could lead to fire sales from corporate bond holders with investment grade-only mandates when the debt is downgraded to junk. However, in contrast to the negative feedback loop that can be generated by mutual fund flows, the evidence shows that the negative price pressure from fallen angel fire sales is fleeting. 3. Leveraged Loans The rapid growth of leveraged loans – lending made to below investment-grade borrowers - over the past couple of years has caught the attention of global central banks and financial regulators. That concern is understandable, as it would be a dereliction of duty for any policymaker or regulator who lived through the 2008 financial crisis to not consider the potential risks to financial stability and future economic growth from a surge in lower quality lending. This is especially true given the increase in the number of securitized instruments linked to leveraged loans – collateralized loan obligations, or CLOs – which evokes memories of the toxic subprime mortgage products that helped trigger the 2008 crisis. Although as the Fed’s Vice Chair for Supervision, Randal Quarles, recently noted, the financial media has been overplaying the leveraged loan story in such a way that it felt like “the Earth must be getting hit by an asteroid.” The BoE estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. The leveraged loan and CLO markets can be opaque. However, based on the information we do have from credible sources like central banks, the IMF and the BIS, some conclusions can be made about the potential economic risks from the rapid build-up of U.S. leveraged loans: Leveraged loan expansion has been partially offset by high-yield contraction. Chart 8More Leveraged Loans, Less Junk Bonds Based on estimates from the BIS and IMF, there are around $1.4 trillion in U.S. leveraged loans outstanding, which is greater than the $1.2 trillion U.S. high-yield bond market (Chart 8). That is an all-time high in the dollar amount of leveraged loans, as well as for the share of all lower-rated corporate debt accounted for by loans. The annual growth rate of U.S. leveraged loans is now a whopping 29% - the fastest pace seen since 2007. Yet the growth of the total amount of leveraged loans plus high-yield bonds is a much lower 12%. While that is still a large number, it is below the peak growth rates seen during the past fifteen years. This is because the amount of high-yield bonds outstanding has been modestly contracting since 2015. Much of that run-up in leveraged loan growth has been to satiate the demand for loans created by private equity funds and, more importantly, CLOs. The strong risk appetite from investors resulted in a notable deterioration in lending standards, with loans coming out at higher leverage multiples (debt/EBITDA) and with reduced investor covenant protection. Yet since lower-rated companies were not ramping up high-yield bond issuance at the same time, the economic stability risks from a rapid run-up in total riskier borrowing are lower, on the margin. The ownership structure of leveraged loans (and CLOs) is diverse enough to not create systemic problems. To date, the Bank of England (BoE) has compiled the most detailed estimates of the ownership breakdown of both leveraged loans and CLOs.9 In Chart 9, we have recreated a chart from the BoE’s July 2019 Financial Stability Report, which colorfully shows the ownership of global leveraged loans and CLOs. The way to read the chart is that each square represents a 1% share of the estimated $3.2 trillion of global leveraged loans and CLOs. The split in the chart is 75% loans and 25% CLOs (CLO ownership is shown on the right side of the thick dotted line). The biggest category of leveraged loan investor is what the BoE titled “U.S. and other global banks”, a group that represents 38% of total loans and CLOs. European banks own 12%, U.K. banks own 3% and Japanese banks own 3% (entirely through CLOs), thus bringing the global bank exposure to 56% of all leveraged loan instruments. While that sounds like a large number, the majority of that is in the form of revolving credit facilities – effectively, overdraft facilities to lower-rated borrowers. Revolving credit facilities are typically less risky than leveraged loans, because credit facilities have greater covenant protection and even more seniority in terms of creditor claims on borrower assets. The BoE estimates that 40% of all global leveraged loans and CLOs are owned by non-bank investors. This includes pension funds, insurance companies and investment funds (mutual funds and ETFs). Chart 9 shows how much more diverse the investor base is for CLOs than for other leveraged loans. It suggests that any future potential losses from CLOs will be distributed more evenly within the financial system, rather than being concentrated in the banks. Chart 10Leveraged Loan Losses Are Typically Lowered Compared To Junk Even within the bank holdings of CLOs, the systemic risks are lessened. The BoE noted that the increased amount of subordination (i.e. lower-rated tranches) of more recent CLO deals helps protect the senior tranches from losses. According to the BoE, the AAA-rated piece of a representative sample of CLOs issued in 2018 was 63%; this compares to 70% for CLOs issued in 2006.10 Furthermore, the central bank estimates that the CLOs would have to suffer a loss more than twice as severe as seen during the 2008 financial crisis for the AAA-rated piece of CLOs issued in 2018 to incur losses. That would be an extraordinary outcome, given how 2008 generated losses on leveraged loans that were over twice as bad as the previous worst year in 2002 (Chart 10). Potential losses from AAA tranches are important from a financial stability perspective. The BoE estimates that 40% of all CLOs are owned by global banks (including a large 13% share from yield-chasing Japanese banks). These banks tend to focus on safer AAA-rated CLO tranches. The demand for leveraged loan products is volatile, but that might actually be a good thing for economic stability. The surge in leveraged loans over the past two years has not only been related to demand from private equity funds and CLOs. U.S. retail investors have also been big buyers of mutual funds and ETFs linked to the leveraged loan market, as a way to seek out higher credit returns against a backdrop of Fed rate hikes. Chart 11Fed Rate Expectations Drive The Demand For Loans Vs Bonds Leveraged loans are floating rate instruments. Thus, they are more desirable than fixed-rate high-yield corporate debt when short-term interest rates are rising. This is seen in Chart 11, where we show net flows into the largest U.S. junk bond and leveraged loan ETFs. These flows are plotted with the JP Morgan survey of bond investor duration positioning (top panel) and our Fed Funds Discounter that measures the market-implied expected change in the fed funds rate over the next year (bottom panel). The conclusion is obvious – there was very strong retail demand for floating-rate leveraged loans over fixed-rate junk bonds during 2016-18 when expected rate hikes justified defensive duration positioning. In 2019, the tables have turned. The Fed is more dovish, rate cuts are now expected, investors have been adding duration exposure, and demand for leveraged loan funds has plunged while high-yield bond funds have been seeing inflows. The exodus from all leveraged loan funds has been historically large, with Lipper reporting that there were 33 straight weeks of outflows to July 3, 2019, for a total of $32 billion.11 Already, that reduced demand for leveraged loans has translated into sharply reduced issuance of new U.S. CLOs, which was 73% lower in the first half of 2019 versus the same period in 2018 (Chart 12). At the same time, high-yield bond issuance was up 20% in the first six months of 2019 versus 2018. The reduced demand for leveraged loans has also shifted the balance of power back to lenders, as the share of U.S. leveraged loans that have been issued with limited covenant protection (“cov-lite”) has plunged from 72% in 2018 to around 40% (Chart 13). Chart 12Lower-Rated Issuance Is "Self-Regulating" Chart 13Reduced Covenant-Lite Issuance So Far In 2019     This is a critical point on the potential stability risks from leveraged loans – the market for those loans is “self-regulating”, based on final demand from investors who “toggle” between floating rate and fixed rate credit instruments. This helps limit the growth in overall corporate indebtedness, helping to put off the date when credit booms turn into future credit busts. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1      Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 2     https://www.nowpublishers.com/article/DownloadEBook/9781680834864?format=pdf 3     http://finance.wharton.upenn.edu/~itayg/Files/bondfunds-published.pdf 4     https://ideas.repec.org/p/bfr/banfra/706.html 5     https://pdfs.semanticscholar.org/5a60feab84a7d10de084abfce414b5888d5586e2.pdf 6     https://www.nber.org/papers/w21879 7     https://pdfs.semanticscholar.org/55a4/8602b17bc7e7f8428695ab6a3ef2c87756ab.pdf 8      Corporate bonds that are downgraded from investment grade to high-yield are called fallen angels. 9      The Financial Stability Board, the international body that monitors and makes recommendations on the global financial system, is due to publish a comprehensive analysis of the ownership structure of the leveraged loan market in the autumn of 2019. 10     For a more detailed description of this analysis, see pages 28 & 29 of the Bank of England’s July 2019 Financial Stability report, which can be found here: https://www.bankofengland.co.uk/financial-stability-report/2019/july-20… 11     https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/leveraged-loan-news/leveraged-loan-fund-withdrawal-streak-hits-record-33-weeks-totaling-32b  

Highlights Q2/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -19bps in the second quarter of the year. Winners & Losers: Our below-benchmark overall duration stance expressed through country underweights in the U.S. (-25bps) and Italy (-10bps) hurt Q2 returns. This dwarfed the gains from U.S. corporate bond overweights (+14bps) and selective sovereign bond overweights in Germany, Australia and the U.K. Scenario Analysis For Next Six Months: We are adding credit exposure to our model portfolio, increasing spread product allocations in U.S. high-yield and European corporates. In our Base Case scenario, the Fed is likely to deliver some “insurance” rate cuts in the next few months, but by less than the markets are currently discounting, while global growth momentum will stabilize. The resulting price action will favor relative returns from spread product versus government debt. Feature The first half of 2019 produced a surprising result across the global fixed income universe – practically everything delivered a positive total return. From U.S. Treasuries to Italian BTPs to U.S. investment grade industrial corporates to emerging market hard currency sovereigns, all the year-to-date returns are colored green on your Bloomberg screen. Those returns have occurred despite all the uncertainties that investors have had to navigate during the past three months, from shock Trump tariff tweets to persistent weakness in global manufacturing data to swift dovish turns by global central bankers (rate cuts in Australia and New Zealand, the Fed hinting at easing and the ECB signaling a potential restart of asset purchases). In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful second quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2019 Model Portfolio Performance Breakdown: Credit Overweights Help Limit Damage From Below-Benchmark Duration Chart of the WeekBelow-Benchmark Duration Overwhelms Credit Overweights In Q2/19 The total return for the GFIS model portfolio (hedged into U.S. dollars) in the second quarter was 2.8%, underperforming the custom benchmark index by -19bps (Chart of the Week).1 The bulk of the underperformance came from the government bond side of the portfolio (-33bps) - a function of our below-benchmark duration tilt and underweight stance on sovereign bonds, both occurring against a backdrop of rapidly falling bond yields (Table 1). Partially offsetting that was the outperformance from our recommended overweights in U.S. corporate debt, which helped the spread product side of our model portfolio outperform the benchmark by +14bps. Table 1GFIS Model Bond Portfolio Q2/2019 Overall Return Attribution The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. investment grade industrials (+5bps) Overweight U.S. high-yield Ba-rated (+4bps) Overweight U.S. high-yield B-rated (+4bps) Overweight U.S. investment grade financials (+2bps) Overweight German government bonds with maturity of 7-10 years (+2bps) Biggest underperformers Underweight U.S. government bonds with maturity beyond 10+ years (-10bps) Underweight Italy government bonds with maturity beyond 10+ years (-6bps) Underweight Japanese government bonds with maturity beyond 10+ years (-6bps) Underweight U.S. government bonds with maturity of 1-3 years (-5bps) Underweight U.S. government bonds with maturity of 3-8 years (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q2/2019 (red for underweight, blue for overweight, gray for neutral).2 Ideally, we would look to see more blue bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Our underweight tilts on European Peripheral sovereign debt were our biggest “miss” in the quarter, as Spanish and Italian yields plunged after the ECB signaled future rate cuts and a potential return to bond purchases in order to boost flailing European growth. We had been viewing Spain and Italy as growth-focused credit stories rather than yield plays, leaving us to maintain a cautious stand on both markets given worsening economic momentum (but with an imbedded “long Spain/short Italy” tilt by having a smaller relative underweight in Spain). In terms of our best “hits” in the quarter, our overweight stance on U.S. investment grade corporates and Australian government bonds performed relatively well. We also avoided a big “miss” by upgrading emerging market U.S. dollar-denominated sovereign debt to neutral from underweight on April 30.3 We also avoided a bigger hit to the portfolio through tactical adjustments made in late May, when we added back some interest rate duration to the portfolio given the increasing uncertainties from slowing global growth and rising U.S. trade policy hawkishness.4 We also reduced our U.S. corporate bond overweights at the same time, but the additional duration exposure was the more important factor – without those changes, the portfolio would have lagged the benchmark index by another -8bps in Q2. In terms of our best “hits” in the quarter, our overweight stance on U.S. investment grade corporates and Australian government bonds performed relatively well. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index in the second quarter of the year, with the drag on performance from underweight exposure to U.S. Treasuries and Italian BTPs overwhelming the gains from credit overweights in the U.S. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will be driven by two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt versus government bonds. In terms of the specific high-level weightings in the model portfolio, we currently have a moderate overweight, equal to three percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on future global growth, with early leading economic indicators starting to bottom out to the benefit of growth-sensitive assets like corporate debt. That faster growth backdrop will also benefit our below-benchmark duration stance through a rebound in government bond yields. This should happen only slowly, however, as global central bankers are likely to keep their newly-dovish policy bias in place for some time until there are more decisive signs of accelerating growth AND inflation. Chart 6Overall Portfolio Duration: Below-Benchmark We are maintaining our below-benchmark duration tilt (0.5 years short of the custom benchmark), but we recognize that the underperformance from duration seen in the first half of 2019 will only be clawed back slowly over the next six months (Chart 6). As for country allocation, we continue to favor regions where looser monetary policy is most likely (core Europe, Australia, Japan and the U.K.). We are staying underweight the U.S., however, as the market’s expectations for the Fed are too dovish, with -82bps of rate cuts now discounted over the next twelve months. We are also keeping our underweight stance on Italian government bonds, which we now see as overvalued after the recent rally. We are maintaining our below-benchmark duration tilt (0.5 years short of the custom benchmark), but we recognize that the underperformance from duration seen in the first half of 2019 will only be clawed back slowly over the next six months We are, however, making some adjustments to the portfolio allocations to reflect our expectation of less negative news on global growth and easier monetary policies from global central bankers facing uncertainty alongside too-low inflation expectations: Increasing the overweight to U.S. high-yield corporates, boosting the allocation to Ba-rated and B-rated credit tiers by one percentage point each. This is funded by reducing our U.S. Treasury allocation by two percentage points. Upgrading euro area corporates to overweight, increasing the allocation to both investment grade and high-yield by one percentage point each. This is funded by reducing our German government bond allocation by two percentage points. Upgrading U.K. investment grade corporates to neutral, funded by reducing U.K. Gilt exposure by 0.5 percentage points. Upgrading Spanish government bonds to neutral, funded by reducing German exposure by 0.3 percentage points. These changes will boost the overall spread product allocation to 50% of the portfolio (an overweight of seven percentage points versus the benchmark index). This will also boost the overall yield of the portfolio to 3.2%, +6bps greater than that of the benchmark. That relative yield advantage looks even better in U.S. dollar terms, with currency hedging adding an additional +16bps to the relative portfolio yield given the current powerful carry advantage of the greenback (Chart 7). Chart 7Portfolio Yield: Small Positive Carry Chart 8Portfolio Risk Budget Usage: Cautious Even though we have decent-sized overall tilts on global duration and spread product allocation, our estimated tracking error (excess volatility of the portfolio versus its benchmark) remains low (Chart 8). We remain comfortable with a portfolio tracking error of 38bps, well below our self-imposed 100bps ceiling, as the internal weightings in the portfolio are helping keep overall portfolio volatility at a modest level. Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.5 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, are all driven by what we believe will be the most important driver of market returns over the rest of 2019 – the momentum of global growth and the path of U.S. monetary policy. Our Base Case: the Fed delivers -50bps of easing by the end of 2019, the U.S. dollar depreciates by -3%, oil prices rise by +10%, the VIX index hovers around 15, and there is a mild bear-steepening of the U.S. Treasury curve. This is a scenario where the Fed delivers a rate cut in July and one more “insurance cut” before year-end, while signaling that no other easing beyond that. The model bond portfolio is expected to beat the benchmark index by +57bps in this case. Global Growth Rebounds: the Fed stays on hold to year-end, the U.S. dollar is flat, oil prices increase +10%, the VIX index falls to 12 and there is a mild bear-flattening of the U.S. Treasury curve. This is a scenario where improving economic data outside the U.S. diminishes the fears of a U.S. recession, allowing the Fed to stand pat and keep rates unchanged as financial market volatility stays muted. The model bond portfolio is expected to outperform the benchmark by +50bps here. Global Downturn Intensifies: the Fed cuts the funds rate by -75bps by year-end, the U.S. dollar falls by -5%, oil prices decline -15%, the VIX index increases to 30 and there is a bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth momentum continues to fade, prompting the Fed to deliver a series of curve-steepening rate cuts to try and stabilize elevated financial market volatility amid increasing recession risks. The model portfolio will severely underperform the benchmark by -41bps with this outcome. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are different than what was presented in our last model bond portfolio review in mid-April (Chart 9). Then, we were contemplating scenarios involving the Fed keeping rates stable and even potentially looking for an opportunity to deliver another rate hike by year-end. Now, given the Fed’s clear dovish shift after the downshift in global growth momentum, two of our three main scenarios involve rate cuts in the U.S. The only scenario where Treasury yields can fall further, however, is if the global economic downturn deepens – a scenario we view as more of a tail risk rather than a higher-probability possibility (Chart 10). Chart 9Risk Factors Assumptions For The Scenario Analysis Chart 10U.S. Treasury Yield Assumptions For The Scenario Analysis In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. Bottom Line: We are adding credit exposure to our model portfolio, increasing spread product allocation in U.S. high-yield and European corporates. In our Base Case scenario, the Fed is likely to deliver some “insurance” rate cuts in the next few months, but by less than the markets are currently discounting, while global growth momentum will stabilize. The resulting price action will favor spread product over government bonds, helping boost the returns of our model portfolio.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Note that sectors where we made changes to our recommended weightings during Q2/2019 will have multiple colors in the respective bars in Chart 4. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “It’s Time To Break Out The Fine China”, dated April 30, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “The Message From Low Bond Yields”, dated May 28, 2019, available at gfis.bcaresearch.com. 5 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.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 Chart 1Looks Like 2016 & 1998 The Treasury market continues to price-in a recession-like outcome for the U.S. economy, embedding 83 basis points of Fed rate cuts over the next 12 months. But last week’s economic data challenge that narrative. First, the ISM Non-Manufacturing PMI held above 55 in June, even as its Manufacturing counterpart plunged toward the 50 boom/bust line (Chart 1). This divergence between a strong service sector and weak manufacturing sector is more reminiscent of prior mid-cycle slowdowns in 2016 and 1998 than of any pre-recession period. Second, nonfarm payrolls added 224k jobs in June, a strong rebound from the 72k added in May and enough to keep the 12-month growth rate at a healthy 1.5% (bottom panel). Still-low inflation expectations provide sufficient cover for the Fed to cut rates later this month, likely by 25 bps. But beyond that, continued strong economic data could prevent any further easing. Keep portfolio duration low and stay short the February 2020 fed funds futures contract. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 144 basis points in June, bringing year-to-date excess returns up to +368 bps. We removed our recommendation to hedge near-term corporate credit exposure after the Fed’s clear dovish pivot at the June FOMC meeting.1  At that time, we also noted that the surging gold price, weakening trade-weighted dollar and outperformance of global industrial mining stocks were all signaling that corporate spreads have peaked (Chart 2). Of our “peak credit spread” indicators, only the CRB Raw Industrials index has yet to turn the corner. The macro environment supports tighter spreads. But in the investment grade space, value only looks attractive for Baa-rated securities. Baa spreads remain 7 bps above our target (panel 3), while Aa and A-rated spreads are 1 bp and 4 bps below, respectively (panel 4). Aaa bonds are even more expensive, with spreads 19 bps below target (not shown).2  Investors should focus their investment grade corporate bond exposure on Baa-rated securities. Our measure of gross leverage – total debt over pre-tax profits – jumped in Q1, as corporate debt grew at an annualized pace of 8.5% while corporate profits contracted by an annualized 18% (bottom panel). Leverage will likely rise again in Q2, as profit growth will almost certainly remain weak, but should then level-off as global growth recovers. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 154 basis points in June, bringing year-to-date excess returns up to +603 bps. The average index option-adjusted spread tightened 56 bps on the month. At 366 bps, it remains well above the cycle-low of 303 bps. As with investment grade credit, we removed our recommendation to hedge near-term exposure following the June FOMC meeting (see page 3). Further, we see the potential for much more spread tightening in high-yield than in investment grade. Within investment grade, only the Baa credit tier carries a spread above our target. In High-Yield, Ba-rated spreads are 42 bps above our target (Chart 3), B-rated spreads are 108 bps above our target (panel 3) and Caa-rated spreads are 263 bps above our target (not shown).3  Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.7% over the next 12 months, not far from our own projection.4 This would translate into 224 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. We will continue to monitor job cut announcements, which have moderated so far this year (bottom panel), and C&I lending standards, which remain in net easing territory, to assess whether our default expectations need to be revised. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in June, bringing year-to-date excess returns up to -11 bps. The conventional 30-year zero-volatility spread widened 1 bp on the month, as a 4 bps widening in the option-adjusted spread (OAS) was partially offset by a 3 bps decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS has risen all the way back to its average pre-crisis level (panel 3). However, as we noted in last week’s report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment our recommended allocation to MBS, especially given the favorable environment for corporate bonds, where expected returns are higher. We are equally disinclined to downgrade MBS, given that refi activity could be close to peaking. All in all, we expect that the next move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise in the second half of the year. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 26 basis points in June, bringing year-to-date excess returns up to +133 bps. Sovereign debt outperformed duration-equivalent Treasuries by 208 bps on the month, bringing year-to-date excess returns up to +419 bps. Local Authorities underperformed the Treasury benchmark by 6 bps, dragging year-to-date excess returns down to +213 bps. Meanwhile, Foreign Agencies underperformed by 26 bps, dragging year-to-date excess returns down to +103 bps. Domestic Agencies underperformed by 4 bps in June, dragging year-to-date excess returns down to +25 bps. Supranationals outperformed by 1 bp on the month, bringing year-to-date excess returns up to +28 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario, given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 73 basis points in June, dragging year-to-date excess returns down to -44 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio rose 2% in June, and currently sits at 81% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but exactly equal to the average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Recent muni underperformance has been broad-based across the entire maturity spectrum, but long-end (20-year and 30-year) yield ratios continue to look attractive relative to the rest of the curve. 20-year and 30-year Aaa-rated yield ratios are more than one standard deviation above their respective pre-crisis averages. Meanwhile, 10-year, 5-year and 2-year Aaa yield ratios are very close to average pre-crisis levels. State & local government balance sheets are in decent shape and a material increase in ratings downgrades is unlikely (bottom panel). We therefore recommend an overweight allocation to municipal bonds, but with a preference for 20-year and 30-year Aaa-rated securities. We showed in a recent report that value declines sharply if you move into shorter maturities or lower credit tiers.6 Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-steepened in June, alongside a large drop in our 12-month Fed Funds Discounter from -75 bps to -90 bps (Chart 7). June’s bull-steepening was reversed last week, as the strong employment report caused our discounter to jump back up to -83 bps, resulting in a bear-flattening of the Treasury curve. All in all, the 2/10 Treasury slope steepened 6 bps in June, then flattened 8 bps in the first week of July. It currently sits comfortably above zero at 17 bps. The 5/30 slope steepened 11 bps in June, then flattened 6 bps last week. It currently sits at 70 bps. In last week’s report we reviewed the case for barbelling your U.S. bond portfolio.7 That is, favoring the short and long ends of the yield curve while avoiding the 5-year and 7-year maturities. This positioning continues to make sense. Not only does the barbell increase the average yield of your portfolio, but our butterfly spread models all show that barbells are cheap relative to bullets (see Appendix B). The 5-year and 7-year yields will also rise more than long-end and short-end yields when the market eventually moves to price-in fewer Fed rate cuts. In addition to our recommended barbell positioning, we advocate keeping a short position in the February 2020 fed funds futures contract. That contract is currently priced for a fed funds rate of 1.69% next February, the equivalent of three 25 basis point rate cuts spread over the next five FOMC meetings. The Fed is unlikely to deliver that much easing. TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 11 basis points in June, dragging year-to-date excess returns down to +28 bps. The 10-year TIPS breakeven inflation rate fell 5 bps on the month and currently sits at 1.69% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate fell 4 bps on the month and currently sits at 1.83%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.8 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at a healthy 2.3% (annualized) clip in May, following an even higher 3% (annualized) rate in April. However, it has only grown 1.6% during the past year. 12-month trimmed mean PCE is running almost exactly in line with the Fed’s target at 1.99%. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.9   ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to +51 bps. The index option-adjusted spread for Aaa-rated ABS widened 9 bps on the month, moving back above its minimum pre-crisis level (Chart 9). At 36 bps, the spread remains well below its pre-crisis mean of 64 bps. In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey revealed that average consumer lending standards tightened in Q1 for the second consecutive quarter. Tighter lending standards usually coincide with rising consumer delinquencies (bottom panel). Loan officers also reported slowing demand for credit cards for the fifth consecutive quarter, and slowing auto loan demand for the third consecutive quarter. Second quarter data will be made available in early August, but current trends are not promising. The combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in June, dragging year-to-date excess returns down to +191 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 2 bps on the month. It currently sits at 68 bps, below its average pre-crisis level but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation relative to other similarly-rated fixed income sectors.10  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in June, bringing year-to-date excess returns up to +93 bps. The index option-adjusted spread widened 1 bp on the month and currently sits at 50 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector 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 83 basis points of cuts during the next 12 months. We do not anticipate any rate cuts during this timeframe, and therefore recommend that investors maintain below-benchmark portfolio duration. 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 Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of July 5, 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 July 5, 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 +56 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 56 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. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more 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 For more 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 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Full Speed Ahead”, dated April 16, 2019, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 10  Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The Chinese economy slowed in May following two months of improvement, but the June PMI data suggests that the pace of decline is moderating. Still, the economy remains highly vulnerable in a full-tariff scenario. This weekend’s agreement to continue trade talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. Our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. Feature The Caixin PMI decline in June appears to have been preceded by the official PMI in May. No change in the latter in June is thus somewhat encouraging. 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, May’s activity data shows that the economy slowed following two months of improvement, which underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy and is vulnerable to a further deterioration in external demand. The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI. June’s official PMI was flat on the month, which in combination with only a modest further decline in new export orders, implies that the May slowdown in activity noted above did not repeat itself in June (at least not in terms of magnitude) Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, Chinese stocks actively outperformed the global benchmark over the past month as the latter rallied. The rally was in response to assurances from the PBoC about the capacity to ease further if needed, and the steadily rising odds over the course of the month that a new tariff ceasefire would be reached at the G20 meeting in Osaka. While this expectation was indeed validated, our view is that the agreement to continue talks was a weaker result compared with what emerged from the G20 meeting in Argentina, and did not represent any real progress toward a final trade agreement that includes a substantial tariff rollback. As such, our 6-12 month investment outlook remains unchanged: Chinese stocks face potentially acute near-term risks, but are likely to outperform global stocks over the coming year as mounting economic weakness forces policymakers to overcome their reluctance to act and to ultimately stimulate as needed. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1A Sharp Decline In Electricity Production China’s economy slowed in May according to the Bloomberg Li Keqiang index, after having picked up for two months in a row. While both electricity production and rail cargo volume fell in May, the former fell sharply, almost into negative territory (Chart 1). This underscores that the budding, credit-driven recovery in China’s investment relevant economic activity remains in its infancy, and that economic activity is set to deteriorate meaningfully in a full-tariff scenario. Our LKI leading indicator rose modestly in May, with all six components showing an improvement. Still, the uptrend in the indicator is slight, and is being held back by the money supply components, particularly the growth in M2. Much stronger money & credit growth will be required if Chinese economic activity relapses and no deal to end U.S. import tariffs has occurred, but policymakers are likely to be reactive rather than proactive in this regard. The picture painted by China’s housing data continues to be a story of weak housing demand arrayed against seemingly strong housing construction and stable growth in house prices. However, we noted in a May 9 joint Special Report with our Emerging Market Strategy service that the strength observed in floor space started over the past year reflected a funding strategy by cash-strapped real estate developers.1 Launching new projects aggressively last year – i.e., more property starts – allowed real estate developers to pre-sell property units in order to raise cash in a tight credit environment. On the demand side, the annual change in the PBOC’s pledged supplementary lending injection has strongly predicted floor space sold over the past four years; it remains deeply in negative territory and our measure declined in May for the 8th month in a row. Given that housing construction cannot sustainably decouple from housing demand, we expect floor space started to slow meaningfully over the coming several months absent a major pickup in housing sales. Chart 2The Flat Official PMI In June Is Somewhat Encouraging The Caixin manufacturing PMI fell back below the 50 mark in June, but this appears to have simply confirmed the prior decline in the official PMI (Chart 2). The official PMI was flat in June with only a modest further decline in new export orders, which implies that the May slowdown in activity noted above did not repeat itself in June, at least not in terms of magnitude. Chinese stocks have rallied 8-9% over the past month in U.S. dollar terms, outpacing the EM and global equity benchmarks. The rally initially followed comments from Governor Yi Gang that the PBoC had “tremendous” room to ease monetary policy if needed, and was sustained by expectations later in the month of a second tariff truce emerging from the G20 meeting in Osaka. For China-exposed investors, the issue is not whether Chinese policymakers have the capacity to support China’s economy, but rather the willingness to ease materially. From our perspective, the renewal of trade talks with the U.S. does not represent material progress towards the ultimate removal of tariffs. But the existence of talks is likely to give Chinese authorities a reason (for now) to avoid aggressively stimulating the economy, meaning that our 6-12 month investment outlook remains unchanged. Chart 3The BAT Stocks Will Outperform China If Chinese Stocks Outperform Global The significant outperformance of the investable consumer discretionary has been the most meaningful equity sector development over the past month. We have noted in past reports that changes last December to the global industry classification standard (GICS) mean that trends in investable consumer discretionary are now largely driven by Alibaba’s stock price, and Chart 3 highlights that the BAT stocks (Baidu, Alibaba, and Tencent) have indeed risen relative to the overall investable index. We noted in last month’s macro & market review that investors appeared to be wrongly conflating the risks facing Huawei (U.S. supply chain reliance) with those facing the BATs (the outlook for Chinese consumer spending), and the outperformance of the latter over the past month, as expectations mounted of another tariff truce emerging from the G20, would appear to validate this view. This implies that the outlook for the relative performance of the BATs versus the Chinese equity benchmark is likely to be the same as that of Chinese stocks versus the global benchmark: near-term risk, but likely to outperform over a 6-12 month time horizon. Chinese interbank rates fell over the past month, in response to an injection of liquidity by the PBoC following the collapse and takeover of Baoshang bank. The event marked the first takeover of a commercial bank in China since 1998, and has been described by authorities as an isolated event that was caused, in part, by the illegal use of bank funds. Market participants have clearly been concerned that Baoshang is not an isolated event; China’s 3-month interbank repo rate rose nearly 60bps from early-April to mid-June, and the PBoC’s response was intended to help prevent a significant tightening in credit conditions for China’s smaller lenders. While bad debt concerns have clearly impacted the interbank market over the past several weeks, there has been little impact on China’s onshore corporate bond market (Chart 4). Spreads on bonds rated AA+ did rise meaningfully in June, but have since nearly returned to late-May levels. We continue to recommend an overweight stance towards Chinese onshore corporate bonds, on the basis that market participants are pricing in a much higher default rate than we expect over the coming 6-12 months. The risk to Hong Kong is not the stability of the peg, but the impact of higher interest rates on an extremely leveraged economy. Chart 4The Onshore Corporate Bond Market Is Not Concerned By The Baoshang Takeover Chart 5HKD Strength Reflects More Than Just Falling U.S. Rate Expectations The Hong Kong dollar has strengthened significantly over the past month, with USD-HKD having retreated to the midpoint of its band. This has occurred in part because of declining U.S. interest rate expectations, but also because of a sharp rise in 3-month HIBOR versus the base rate (Chart 5). The strengthening in HIBOR seems linked to the anti-extradition bill protests, implying that HKD has strengthened due to anti-capital flight measures by the HKMA. We see no major risk to the currency peg at the moment, but discussed the negative implications of higher interest rates in Hong Kong on the region’s property market and share prices in last week’s joint report with our Emerging Market Strategy service.2   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Footnotes   1      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “China’s Property Market: Making Sense Of Divergences”, dated May 9, 2019, available at cis.bcaresearch.com. 2      Please see Emerging Markets Strategy and China Investment Strategy Special Report, “Hong Kong’s Currency Peg: Truths And Misconceptions”, dated June 27, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Corporate Spreads: The Fed’s dovish pivot prolongs the period of time before the yield curve inverts, thus extending the window for corporate bond outperformance. Investors should remain overweight corporate bonds, with a preference for securities rated Baa and below, where spreads remain wide relative to our fair value estimates. Yield Curve: Investors should barbell their U.S. bond portfolios, favoring long-maturity (> 10 years) and short-maturity (< 2 years) securities while avoiding the 5-year and 7-year notes. This positioning will boost average portfolio yield and will benefit from any future hawkish re-assessment of Fed policy. MBS: Lower mortgage rates have led to a jump in mortgage refinancings and wider MBS spreads. However, MBS spreads remain quite low compared to history. Maintain a neutral allocation to MBS in U.S. bond portfolios. Feature Last December, we laid out our key fixed income themes for 2019 in a Special Report.1 In that report we also introduced a framework for splitting the economic cycle into three phases based on the slope of the yield curve. Specifically, we use the 3-year/10-year Treasury slope to divide each cycle into the following three phases:2 Phase 1 runs from the end of the last recession until the 3/10 slope flattens to below 50 bps. Phase 2 encompasses the period when the 3/10 slope is between 0 bps and 50 bps. Phase 3 begins after the 3/10 slope inverts and ends at the start of the next recession. Clearly, as is illustrated in Chart 1, we are smack dab in the middle of a Phase 2 environment. This has implications for how we should think about positioning a U.S. bond portfolio. Chart 1Firmly In Phase 2 What Makes The Middle Phase Awkward? Table 1 shows annualized excess returns for Treasuries and corporate bonds (both investment grade and high-yield) in each phase of every cycle stretching back to the mid-1970s. Treasury excess returns are calculated relative to cash, as a proxy for the returns from taking duration risk. Corporate excess returns are relative to a duration-matched position in Treasury securities. Table 1Bond Performance In Different Yield Curve Regimes A look at Table 1 reveals why we call Phase 2 the “awkward” middle phase of the cycle. The excess returns earned from taking both duration and corporate spread risk tend to be underwhelming. On duration, we observe that in three of the four complete cycles in our sample, Treasury excess returns are lowest in Phase 2. This lines up well with intuition. The flatter yield curve means that Treasuries offer a lower term premium in Phase 2 than in Phase 1. Meanwhile, Phase 3 periods tend to coincide with rapid Fed rate cuts, and thus large capital gains. Phase 2 periods, in contrast, often contain Fed tightening cycles. On corporate credit, we observe that excess returns tend to be lower in Phase 2 than in Phase 1, but are usually still positive. Returns tend not to turn consistently negative until after the 3/10 slope inverts and we enter Phase 3. Overall, if we know nothing other than that we are in Phase 2 of the cycle, our results suggest that we should take less duration risk in our portfolio than in Phases 1 or 3. Overall, if we know nothing other than that we are in Phase 2 of the cycle, our results suggest that we should take less duration risk in our portfolio than in Phases 1 or 3. The results also suggest that we should prefer corporate credit over Treasuries, though to a lesser extent than in Phase 1. What Makes The Middle Phase Long? In last December’s Special Report, we argued that the U.S. economy would remain in a Phase 2 environment for a long time, at least until late 2019. Our reasoning was that, in the absence of inflationary pressures, the Fed would be reluctant to tighten policy enough to invert the 3/10 curve. The Fed’s recent dovish pivot, and the resultant steepening of the curve (see Chart 1), only prolongs the current Phase 2 environment. We now think it will be well into 2020, and possibly later, before the 3/10 slope inverts and the economy enters Phase 3. One obvious investment implication of an extended Phase 2 environment is that we should remain overweight corporate bonds relative to duration-matched Treasuries. However, we also need to consider valuation before drawing too firm of a conclusion. Charts 2A and 2B show spreads for each corporate credit tier, encompassing both investment grade and high-yield, along with our spread targets. The spread targets are the median levels observed in prior Phase 2 environments, adjusted for changes in the average duration of the bond indexes over time.3 The charts reveal that Aaa-rated bonds already look expensive, while Aa and A-rated bonds are close to fairly valued. Baa-rated bonds are 13 bps cheap relative to our target, while the high-yield credit tiers offer significantly more value. Chart 2AInvestment Grade Spread Targets Chart 2BHigh-Yield Spread Targets As discussed in last week’s report, the Fed’s dovish pivot will cause corporate spreads to tighten in the near-term, but it will take longer before Treasury yields respond by moving higher.4 For Treasury yields to move higher, investors must first become convinced that the Fed’s reflationary efforts are translating into stronger global economic growth. Ultimately, we expect this will occur in the second half of this year and Treasury yields will be higher 12 months from now, as the Fed will fail to deliver the 92 bps of rate cuts that are currently priced. The flat yield curve means that the yield give-up is small, and we expect global growth to improve in the second half of the year. Bottom Line: The Fed’s dovish pivot prolongs the period of time before the yield curve inverts, thus extending the window for corporate bond outperformance. Investors should remain overweight corporate bonds, with a preference for securities rated Baa and below, where spreads remain wide relative to our fair value estimates. Investors should also keep portfolio duration low. The flat yield curve means that the yield give-up is small, and we expect global growth to improve in the second half of the year. Barbell Your Portfolio Chart 3Barbell Your Portfolio For those unwilling or unable to deviate portfolio duration significantly from benchmark, there is another way to bet on the Fed delivering fewer cuts than are currently priced into the market. Investors can run a barbelled portfolio, favoring short-maturity (< 2 years) and long-maturity (> 10 years) securities, while avoiding the belly (5-year/7-year) of the curve. This sort of positioning has a few advantages. First, since the financial crisis, the yield curve has tended to steepen out to the 5-year/7-year point and flatten beyond that point whenever our 12-month Fed Funds Discounter rises (Chart 3). Conversely, whenever the market prices in more cuts/fewer hikes and our discounter falls, the yield curve has flattened out to the 5-year/7-year maturity point and steepened beyond that point. This correlation has been very consistent during the past few years, and continued to hold during the most recent decline in rate expectations. Notice that the 5-year yield has fallen by more than either the 2-year or 10-year yields since our Discounter's early-November peak (Table 2). Table 2The Belly Of The Curve Is Most Sensitive To Rate Expectations The upshot is that, if rate expectations rise during the next 12 months, as we expect, the 5-year and 7-year notes will endure the most damage. The second reason why a barbelled portfolio makes sense is that valuation is very attractive. Chart 4 shows that the 5-year yield is below the yield on a duration-matched 2/10 barbell. It also shows that this 2/5/10 butterfly spread is very low relative to our model’s fair value.5  Chart 42/10 Barbell Is Attractive Versus 5-Year Bullet We run similar fair value models for every possible bullet/barbell combination along the yield curve, and barbells appear universally cheap (see Appendix). Bottom Line: Investors should barbell their U.S. bond portfolios, favoring long-maturity (> 10 years) and short-maturity (< 2 years) securities while avoiding the 5-year and 7-year notes. This positioning will boost average portfolio yield and will benefit from any future hawkish re-assessment of Fed policy.   MBS & Housing: The Implications Of Lower Mortgage Rates Alongside bond yields, mortgage rates have fallen sharply during the past few months, a trend that has important implications for both MBS spreads and future housing data. We consider the outlook for both. MBS Spreads Lower mortgage rates encourage homeowners to refinance their loans, and any increase in refinancing activity puts upward pressure on MBS spreads. Not surprisingly, as mortgage rates have declined we have seen a jump in the MBA Refinance Index and a widening of nominal MBS spreads (Chart 5). Chart 5MBS Spreads Still Historically Tight While spreads have widened somewhat, they remain low compared to history (Chart 5, top panel). As such, we do not see a compelling buying opportunity in MBS. This is especially true relative to corporate credit where spreads are more attractive. Chart 6Limited Upside For Refis With the mortgage rate now below 4%, our rough calculation suggests that approximately 44% of the Bloomberg Barclays Conventional 30-year MBS index is refinanceable. A regression of the MBA Refi Index versus the refinanceable share suggests a fair value of 2014 for the Refi Index, slightly above its actual level of 1950 (Chart 6). We also calculate that a further drop in the mortgage rate to below 3.5%, where it troughed in mid-2016, would increase the refinanceable share to 77%. Our regression translates this 77% share to a level of 3309 on the Refi Index. It should be noted that when the refinanceable share rose to 77% in 2016, the MBA Refi Index peaked at 2870. This means that our simple regression analysis probably overstates the surge in refis that would occur if mortgage rates fell another 50 bps. In addition, we think it’s unlikely that mortgage rates will actually fall back to 3.5%, as they did in 2016, and as such, we are hesitant to position for further MBS spread widening. The improvement in housing actitivty is not uniform across all indicators. We recommend maintaining a neutral allocation to MBS for now. If mortgage rates drop and spreads widen further in the near-term, then a buying opportunity may present itself. Housing Activity Chart 7Housing Activity: A Mixed Picture The drop in mortgage rates will also have a significant impact on housing activity data. This is important because, as we have demonstrated in prior reports, housing activity data – particularly single-family housing starts and new homes sales – are reliable indicators of U.S. recessions and interest rates.6 By all measures, housing activity weakened significantly as mortgage rates surged in 2018. But it has improved somewhat now that mortgage rates have declined. However, the improvement is not uniform across all indicators (Chart 7): New home sales jumped sharply early this year, then fell back more recently. The current trend is neutral, with the latest monthly print very close to the 12-month moving average (Chart 7, top panel). Housing starts and permits are both trending below their respective 12-month moving averages, though by less than in 2018 (Chart 7, panel 2 & 3). Existing home sales have popped, and are now exerting upward pressure on the 12-month average (Chart 7, panel 4). Likewise for mortgage purchase applications (Chart 7, panel 5). Homebuilders also report that lower mortgage rates have led to a jump in sales activity (Chart 7, bottom panel).  With mortgage rates still low, the tentative rebound in housing activity data should continue in the coming months. Looking further out, we see significantly more upside in single-family housing starts and new home sales as builders shift construction toward lower-priced properties. The Bifurcated Housing Market Beyond the large swings in mortgage rates, another trend has significantly influenced housing activity in recent years. For the past few years, homebuilders have focused their attention on higher priced homes, and that segment of the market now looks oversupplied. Data from the American Enterprise Institute Housing Center show that the recent deceleration in home prices has been driven by falling prices for the most expensive homes. Homes in the lowest price tier have seen prices accelerate (Chart 8).7 The divergence is also evident in the supply data. New home inventories are roughly consistent with average historical levels, while existing home inventories are incredibly low (Chart 9). In fact, new home inventories now represent 6.4 months of demand while existing home inventories represent 4.3 months of demand (Chart 9, panel 3). Such a wide divergence is historically rare. Chart 8An Oversupply Of High ##br##Priced Homes... Chart 9...And An Undersupply Of Low Priced Homes   The divergence between an oversupply of new homes and an undersupply of existing homes is a result of new construction having focused on higher priced homes in recent years. The median price for a new home used to be only slightly above the median price for an existing home, but the difference shot up to above 75k during the past few years (Chart 9, bottom panel). More recently, the price differential between new and existing homes has started to fall, as builders are starting to recognize that the greater growth opportunity lies at the low-end of the market where demand is strong relative to supply. As this supply-side adjustment plays out, it will provide an additional boost to new homes sales and housing starts going forward. Appendix 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 3 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 3Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of June 27, 2019) Table 4 scales the raw residuals in Table 3 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 4Butterfly Strategy Valuation: Standardized Residuals (As of June 27 2019) Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 2 We use the 3/10 Treasury slope in place of the more commonly referenced 2/10 slope because it is a close proxy that provides an additional 14 years of historical data. 3 For more 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 4 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 5 For more details on our yield curve models please see U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “More Than One Reason To Own Steepeners”, dated September 25, 2018, available at usbs.bcaresearch.com 7 Low-tier homes are those in the bottom 40% of the price distribution in each metro area. High-tier homes are those that are both in the top 20% of the price distribution and exceed the GSE loan limit by more than 25%. For further details: http://www.aei.org/wp-content/uploads/2019/06/HPA_market_conditions_report_June_2019.pdf Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Central banks globally have turned dovish, with the Fed virtually promising to cut rates in July. But this will be an “insurance” cut, like 1995 and 1998, not the beginning of a pre-recessionary easing cycle. The global expansion remains intact, with the fundamental drivers of U.S. consumption robust and China likely to ramp up its credit stimulus over the coming months. The Fed will cut once or twice, but not four times over the next 10 months as the futures markets imply. Underlying U.S. inflation – properly measured – is trending higher to above 2%. U.S. GDP growth this year will be around 2.5%. Inflation expectations will move higher as the crude oil price rises. Unemployment is at a 50-year low and the U.S. stock market at an historical peak. These factors suggest bond yields are more likely to rise than fall from current levels. The upside for U.S. equities is limited, but earnings growth should be better than the 3% the bottom-up consensus expects. The key for allocation will be when to shift in the second half into higher-beta China-related plays, such as Europe and Emerging Markets. For now, we remain overweight the lower-beta U.S. equity market, neutral on credit, and underweight government bonds. To hedge against the positive impact of China stimulus, we raise Australia to neutral, and re-emphasize our overweights on the Industrials and Energy sectors. Feature Overview Precautionary Dovishness – Or Looming Recession?   Recommendations Central banks everywhere have taken a decidedly dovish turn in recent weeks. June’s FOMC statement confirmed that “uncertainties about the outlook have increased….[We] will act as appropriate to sustain the expansion,” hinting broadly at a rate cut in July. The Bank of Japan’s Kuroda said he would “take additional easing action without hesitation,” and hinted at a Modern Monetary Theory-style combination of fiscal and monetary policy. European Central Bank President Draghi mentioned the possibility of restarting asset purchases. There are two possible explanations. Either the global economy is heading into recession, and central banks are preparing for a full-blown easing cycle. Or these are “insurance” cuts aimed at prolonging the expansion, as happened in 1995 and 1998, or similar to when the Fed went on hold for 12 months in 2016 (Chart 1). Our view is that it is most likely the latter. The reason for this is that the main drivers of the global economy, U.S. consumption ($14 trillion) and the Chinese economy ($13 trillion) are likely to be strong over the next 12 months. U.S. wage growth continues to accelerate, consumer sentiment is close to a 50-year high, and the savings rate is elevated (Chart 2); as a result core U.S. retail sales have begun to pick up momentum in recent months (Chart 3). Unless something exogenous severely damages consumer optimism, it is hard to see how the U.S. can go into recession in the near future, considering that consumption is 70% of GDP. Moreover, despite weaknesses in the manufacturing sector – infected by the China-led slowdown in the rest of the world – U.S. service sector growth and the labor market remain solid. This resembles 1998 and 2016, but is different from the pre-recessionary environments of 2000 and 2007 (Chart 4). There is also no sign on the horizon of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation (Chart 5). Chart 1Insurance Cuts, Or Full Easing Cycle? Chart 2Consumption Fundamentals Are Strong... Chart 3...Leading To Rebound In Retail Sales Chart 4Manufacturing Weak, But Services Holding Up   Chart 5No Signs Of Usual Recession Triggers China’s efforts to reflate via credit creation have been somewhat half-hearted since the start of the year. Investment by state-owned companies has picked up, but the private sector has been spooked by the risk of a trade war and has slowed capex (Chart 6). China may have hesitated from full-blown stimulus because the authorities in April were confident of a successful outcome to trade talks with the U.S., and a bit concerned that the liquidity was going into speculation rather than the real economy. But we see little reason why they will not open the taps fully if growth remains sluggish and trade tensions heighten.1 Chinese credit creation clearly has a major impact on many components of global growth – in particular European exports, Emerging Markets earnings, and commodity prices – but the impact often takes 6-12 months to come through (Chart 7). A key question is when investors should position for this to happen. We think this decision is a little premature now, but will be a key call for the second half of the year. Chart 6China's Half-Hearted Reflation Chart 7China Credit Growth Affects The World Chart 8Fed Won't Cut As Much As Market Wants... The Fed has so clearly signaled rate cuts that we see it cutting by perhaps 50 basis points over the next few months (maybe all in one go in July if it wants to “shock and awe” the market). But the futures market is pricing in four 25 bps cuts by April next year. With GDP growth likely to be around 2.5% this year, unemployment at a 50-year low, trend inflation above 2%,2 and the stock market at an historical high, we find this improbable. Two cuts would be similar to what happened in 1995, 1998 and (to a degree) 2016 (Chart 8). In this environment, we think it likely that equities will outperform bonds over the next 12 months. When the Fed cuts by less than the market is expecting, long-term rates tend to rise (Chart 9). BCA’s U.S. bond strategists have shown that after mid-cycle rate cuts, yields typically rise: by 59 bps in 1995-6, 58 bps in 1998, and 19 bps in 2002.3 A combination of rising inflation, stronger growth ex-U.S., a less dovish Fed that the market expects, and a rising oil price (which will push up inflation expectations) makes it unlikely – absent an outright recession – that global risk-free yields will fall much below current levels. Moreover, June’s BOA Merrill Lynch survey cited long government bonds as the most crowded trade at the moment, and surveys of investor positioning suggest duration among active investors is as long as at any time since the Global Financial Crisis (Chart 10). Chart 9...So Bond Yields Are Likely To Rise Chart 10Investors Betting On Further Rate Decline The outlook for U.S. equities is not that exciting. Valuations are not cheap (with forward PE of 16.5x), but earnings should be revised up from the currently very cautious level: the bottom-up consensus forecasts S&P 500 EPS growth at only 3% in 2019 (and -3% YoY in Q2). We have sympathy for the view that there are three put options that will prop up stock prices in the event of external shocks: the Fed put, the Xi put, and the Trump put. Relating to the last of these, it is notable that President Trump tends to turn more aggressive in trade talks with China whenever the U.S. stock market is strong, but more conciliatory when it falls (Chart 11). For now, therefore, we remain overweight U.S. equities, as a lower beta way to play an environment that continues to be positive – but uncertain – for stocks. But we continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Chart 11Trump Turns Softer When Market Falls   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Temporary Forces Drove Inflation Downturn Why Is Inflation So Low? After reaching 2% in July 2018, U.S. core PCE currently stands at 1.6%, close to 18 month lows. This plunge in inflation, along with increased worries about the trade war and continued economic weakness, has led the market to believe that the Fed Funds Rate is currently above the neutral rate, and that several rate cuts are warranted in order to move policy away from restrictive territory. We believe that the recent bout of low inflation is temporary. The main contributor to the fall in core PCE has been financial services prices, which shaved off up to 40 basis points from core PCE (Chart 12, panel 1). However, assets under management are a big determinant of financial services prices, making this measure very sensitive to the stock market (panel 2). Therefore, we expect this component of core PCE to stabilize as equity prices continue to rise. The effect of higher equity prices, and the stabilization of other goods that were affected by the slowdown of global growth in late 2018 and early 2019, may already have started to push inflation higher. Month-on-month core PCE grew at an annualized rate of 3% in April, the highest pace since the end of 2017. Meanwhile, trimmed mean PCE, a measure that has historically been a more stable and reliable gauge of inflationary pressures, is at a near seven-year high (panel 3). The above implies that the market might be overestimating how much the Fed is going to ease. We believe that the Fed will likely cut once this year to soothe the pain caused by the trade war on financial markets. However, with unemployment at 50-year lows, and inflation set to rise again, the Fed is unlikely to deliver the 92 basis points of cuts currently priced by the OIS curve for the next 12 months. This implies that investors should continue to underweight bonds. Chart 13Turning On The Taps Will China Really Ramp Up Its Stimulus? The direction of markets over the next 12 months (a bottoming of euro area and Emerging Markets growth, commodity prices, the direction of the USD) are highly dependent on whether China further increases monetary stimulus in the event of a breakdown in trade negotiations with the U.S. But we hear much skepticism from clients: aren’t the Chinese authorities, rather, focused on reducing debt and clamping down on shadow banking? Aren’t they worried that liquidity will simply flow into speculation and have little impact on the real economy? Now the government has someone to blame for a slowdown (President Trump), won’t they use that as an excuse – and, to that end, are preparing the population for a period of pain by quoting as analogies the Long March in the 1930s and the Korea War (when China ground down U.S. willingness to prolong the conflict)? We think it unlikely that the Chinese government would be prepared to allow growth to slump. Every time in the past 10 years that growth has slowed (with, for example, the manufacturing PMI falling significantly below 50) they have always accelerated credit growth – on the basis of the worst-case scenario (Chart 13, panel 1). Why would they react differently this time, particularly since 2019 is a politically sensitive year, with the 70th anniversary of the founding of the People’s Republic in October and several other important anniversaries? Moreover, the government is slipping behind in its target to double per capita income in the 10 years to end-2020 (panel 2). GDP growth needs to be 6.5-7% over the next 18 months to achieve the target. The government’s biggest worry is employment, where prospects are slipping rapidly (panel 3). This also makes it difficult for the authorities to retaliate against U.S. companies that have large operations, such as Apple or General Motors, since such measures would hurt their Chinese employees. Besides a significant revaluation of the RMB (which we think likely), China has few cards to play in the event of a full-blown trade war other than fully turning on the liquidity tap again. Aren’t There Signs Of Bubbliness In Equity Markets? Clients have asked whether the current market environment has been showing any classic signs of euphoria. These usually appear with lots of initial public offerings (IPO), irrational M&A activity, and excess investor optimism. The IPO market has some similarities to the years leading up to the dot-com bubble, but it is important to look below the surface. The percentage of IPOs with negative earnings in 2018 was similar to the previous peak in 1999. However, the average first-day return of IPOs in 2019, while still above the historical average, has been much lower than that during the dot-com bubble period (Chart 14, panel 1). There is also a difference in the composition of firms going public. There are now many IPOs for biotech firms that have heavily invested in R&D, and so have relatively low sales currently but await a breakthrough in their products; by their nature, these are loss-making (panel 2). Cross-sector, unrelated M&A activity has also often been a sign of bubble peaks. It is a consequence of firms stretching to find inorganic growth late in the cycle. Such deals are characterized by high deal premiums, and are usually conducted through stock purchases rather than in cash. The current average deal premium is below its historical average (panel 3). Additionally, 2018 and 2019-to-date M&A deals conducted using cash represented 60% and 90% of the total respectively, compared to only 17% between 1996 and 2000. Investor sentiment is also moderately pessimistic despite the rally in the S&P 500 since the beginning of the year (panel 4). This caution suggests that investors are fearful of the risk of recession rather than overly positive about market prospects, despite the U.S. market being at an historical high. Given the above, we do not see any signals of the sort of euphoria and bubbliness that typically accompanies stock market tops. Will Japan Benefit From Chinese Reflation? Japan has been one of the worst-performing developed equity markets since March 2009, when global equities hit their post-crisis bottom in both USD (Chart 15) and local currency terms. Now with increasing market confidence in China’s reflationary policies, clients are asking if Japan is a good China play given its close ties with the Chinese economy. Our answer is No. Chart 16Downgrade Japan To Underweight   It’s true that Japanese equities did respond to past Chinese reflationary efforts, but the outperformances were muted and short-lived (Chart 16, panel 1). Even though Japanese exports to China will benefit from Chinese reflationary policy (panel 5), MSCI Japan index earnings growth does not have strong correlation with Japanese exports to China, as shown in panel 4. This is not surprising given that exports to China account for only about 3% of nominal GDP in Japan (compared to almost 6% for Australia, for example). The MSCI Japan index is dominated by Industrials (21%) and Consumer Discretionary (18%). Financials, Info Tech, Communication Services and Healthcare each accounts for about 8-10%. Other than the Communication Services sector, all other major sectors in Japan have underperformed their global peers since the Global Financial Crisis (panels 2 and 3). The key culprit for such poor performance is Japan’s structural deflationary environment. Wage growth has been poor despite a tight labor market. This October’s consumption tax increase will put further downward pressure on domestic consumers. There is no sign of the two factors that have historically triggered recessions: a sharp rise in private-sector debt, or accelerating inflation. As such, we are downgrading Japan to a slight underweight in order to close our underweight in Australia (see page 16). This also aligns our recommendation with the output from our DM Country Allocation Quant Model, which has structurally underweighted Japan since its inception in January 2016. Global Economy Chart 17Is Consumption Enough To Prop Up U.S. Growth? Overview: The tight monetary policy of last year (with the Fed raising rates and China slowing credit growth) has caused a slowdown in the global manufacturing sector, which is now threatening to damage worldwide consumption and the relatively closed U.S. economy too. The key to a rebound will be whether China ramps up the monetary stimulus it began in January but which has so far been rather half-hearted. Meanwhile, central banks everywhere are moving to cut rates as an “insurance” against further slowdown. U.S.: Growth data has been mixed in recent months. The manufacturing sector has been affected by the slowdown in EM and Europe, with the manufacturing ISM falling to 52.1 in May and threatening to dip below 50 (Chart 17, panel 2). However, consumption remains resilient, with no signs of stress in the labor market, average hourly earnings growing at 3.1% year-on-year, and consumer confidence at a high level. As a result, retail sales surprised to the upside in May, growing 3.2% YoY. The trade war may be having some negative impact on business sentiment, however, with capex intentions and durable goods orders weakening in recent months. Euro Area: Current conditions in manufacturing continue to look dire. The manufacturing PMI is below 50 and continues to decline (Chart 18, panel 1). In export-focused markets like Germany, the situation looks even worse: Germany’s manufacturing PMI is at 45.4, and expectations as measured by the ZEW survey have deteriorated again recently. Solid wage growth and some positive fiscal thrust (in Italy, France, and even Germany) have kept consumption stable, but the recent tick-up in German unemployment raises the question of how sustainable this is. Recovery will be dependent on Chinese stimulus triggering a rebound in global trade. Chart 18Few Signs Of Recovery In Global Ex-U.S. Growth Japan: The slowdown in China continues to depress industrial production and leading indicators (panel 2). But maybe the first “green shoots” are appearing thanks to China’s stimulus: in April, manufacturing orders rose by 16.3% month-on-month, compared to -11.4% in March. Nonetheless, consumption looks vulnerable, with wage growth negative YoY each month so far this year, and the consumption tax rise in October likely to hit consumption further. The Bank of Japan’s six-year campaign of maximum monetary easing is having little effect, with core core inflation stuck at 0.5% YoY, despite a small pickup in recent months – no doubt because the easy monetary policy has been offset by a steady tightening of fiscal policy. Emerging Markets: China’s growth has slipped since the pickup in February and March caused by a sharp increase in credit creation. Seemingly, the authorities became more confident about a trade agreement with the U.S., and worried about how much of the extra credit was going into speculation, rather than the real economy. The manufacturing PMI, having jumped to almost 51 in March, has slipped back to 50.2. A breakdown of trade talks would undoubtedly force the government to inject more liquidity. Elsewhere in EM, growth has generally been weak, because of the softness in Chinese demand. In Q1, GDP growth was -3.2% QoQ annualized in South Africa, -1.7% in Korea, and -0.8% in both Brazil and Mexico. Only less China-sensitive markets such as Russia (3.3%) and India (6.5%) held up. Interest rates: U.S. inflation has softened on the surface, with the core PCE measure slipping to 1.6% in April. However, some of the softness was driven by transitory factors, notably the decline in financial advisor fees (which tend to move in line with the stock market) which deducted 0.5 points from core PCE inflation. A less volatile measure, the trimmed mean PCE deflator, however, continues to trend up and is above the Fed’s 2% target. Partly because of the weaker historical inflation data, inflation expectations have also fallen (panel 4). As a result, central banks everywhere have become more dovish, with the Australian and New Zealand reserve banks cutting rates and the Fed and ECB raising the possibility they may ease too. The consequence has been a big fall in 10-year government bonds yields: in the U.S. to only 2% from 3.1% as recently as last September. Global Equities Chart 19Worrisome Earnings Prospects Remain Cautiously Optimistic, Adding Another China Hedge: Global equities managed to eke out a small gain of 3.3% in Q2 despite a sharp loss of 5.9% in May. Within equities, our defensive country allocation worked well as DM equities outperformed EM by 2.9% in Q2. Our cyclical tilt in global sector positioning, however, did not pan out, largely due to the 2% underperformance in global Energy as the oil price dropped by 2% in Q2. Going forward, BCA’s House View remains that global economic growth will pick up sometime in the second half thanks to accommodative monetary policies globally and the increasing likelihood of a large stimulus from China to counter the negative effect from trade tensions. This implies that equities are likely to rally again after a period of congestion within a trading range, supporting a cautiously optimistic portfolio allocation for the next 9-12 months. The “optimistic” side of our allocation is reflected in two aspects: 1) overweight equities vs. bonds at the asset class level; and 2) overweight cyclicals vs. defensives at the global sector level. However, corporate profit margins are rolling over and earnings growth revisions have been negative (Chart 19). Therefore, the “cautious” side of our allocation remains a defensive country allocation, reflected by overweighting DM vs. EM. Our macro view hinges largely on what happens to China. There is an increasing likelihood that China may be on a reflationary path to stimulate economic growth. We upgraded global Industrials in March to hedge against China’s re-acceleration. Now we upgrade Australia to neutral from a long-term underweight, by downgrading Japan to a slight underweight from neutral, because Australia will benefit more from China’s reflationary policies (see next page). Chart 20Australian Equities: Close The Underweight Upgrade Australian Equities To Neutral The relative performance of MSCI Australian equities to global equities has been closely correlated with the CRB metal price most of the time. Since the end of 2015, however, the CRB metals index has increased by more than 40%, yet Australian equities did not outperform (Chart 20, panel 1). Why? The MSCI Australian index is concentrated in Financials (mostly banks) and Materials (mostly mining), as shown in panel 2. Aussie Materials have outperformed their global peers, but the banks have not (panel 3). The banks are a major source of financing for the mining companies (hence the positive correlation with metal prices). They are also the source of financing for the Aussie housing markets, which have weighed down on the banks’ performance over the past few years due to concerns about stretched valuations. We have been structurally underweight Australian equities because of our unfavorable view on industrial commodities, and also our concerns on the Australian housing market and the problems of the banks. This has served us well, as Australian equities have done poorly relative to the global aggregate since late 2012. Now interest rates in Australia have come down significantly. Lower mortgage rates should help stabilize house prices, which suffered in Q1 their worst year-on-year decline, 7.7%, in over three decades. Australian equity earnings growth is still slowing relative to the global earnings, but the speed of slowing down has decreased significantly. With 6% of GDP coming from exports to China, Aussie profit growth should benefit from reflationary policies from China (panel 4). Relative valuation, however, is not cheap (panel 5). All considered, we are closing our underweight in Australian equities as another hedge against a Chinese-led re-acceleration in economic growth. This is financed by downgrading Japan to a slight underweight (for more on Japan, see What Our Clients Are Asking, on page 11). Government Bonds Chart 21Limited Downside In Yields Maintain Slight Underweight On Duration: After the Fed signaled at its June meeting that rates cuts were likely on the way, the U.S. 10-year Treasury yield dropped to 1.97% overnight on June 20, the lowest since November 2016. Overall, the 10-year yield dropped by 40 bps in Q2 to end the quarter at 2%. BCA’s Fed Monitor is now indicating that easier monetary policy is required. But that is already more than discounted in the 92 bps of rate cuts over the next 12 months priced in at the front end of the yield curve, and by the current low level of Treasury yields. (Chart 21). We see the likelihood of one or two “insurance” cuts by the Fed, but the current environment (with a record-high stock market, tight corporate spreads, 50-year low unemployment rate, and 2019 GDP on track to reach 2.5%) is not compatible with a full-out cutting campaign. In addition, the latest Merrill Lynch survey indicated that long duration is the most crowded global trade. Given BCA’s House View that the U.S. economy is not heading into a recession but rather experiencing a manufacturing slowdown mainly due to external shocks, the path of least resistance for Treasury yields is higher rather than lower. Investors should maintain a slight underweight on duration over the next 9-12 months. Chart 22Favor Linkers Over Nominal Bonds Favor Linkers Vs. Nominal Bonds: Global inflation expectations have dropped anew in the second quarter, with the 10-year CPI swap rate now sitting at 1.55%, 41 bps lower than its 2018 high of 1.96%. However, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. BCA’s Commodity & Energy Strategy service revised down its 2019 Brent crude forecast to an average of US$73 per barrel from US$75, but this implies an average of US$79 in H2. (Chart 22). This would cause a significant rise in inflation expectations in the second half, supporting our preference for inflation-linked over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds. Corporate Bonds Chart 23Profit Growth Should Still Outpace Debt Growth We turned cyclically overweight on credit within a fixed-income portfolio in February. Since then, corporate bonds have produced 120 basis points of excess return over duration-matched Treasuries. We believe this bullish stance on credit will continue to pay dividends. The global leading economic indicators have started to stabilize while multiple credit impulses have started to perk up all over the world. Historically, improving global growth has been positive for corporate bonds (Chart 23, panel 1). A valid concern is the deceleration in profit growth in the U.S., as the yearly growth of pre-tax profits has fallen from 15% in 2018 Q4 to 7% in the first quarter of this year. In general, corporate bonds suffer when profit growth lags debt growth, as defaults tends to rise in this environment. Is this scenario likely over the coming year? We do not believe so. While weak global growth at the end of 2018 and beginning of 2019 is likely to weigh on revenues, the current contraction in unit labor costs should bolster profit margins and keep profit growth robust (panel 2). Additionally, the Fed’s Senior Loan Officer Survey shows that C&I loan demand has decreased significantly this year, suggesting that the pace of U.S. corporate debt growth is set to slow (panel 3). How long will we remain overweight? We expect that the Federal Reserve will do little to no tightening over the next 12 months. This will open a window for credit to outperform Treasuries in a fixed-income portfolio. We have also reduced our double underweight in EM debt, since an acceleration of Chinese monetary stimulus would be positive for this asset class. Commodities Chart 24Watch Oil And Be Wary Of Gold Energy (Overweight): Supply/demand fundamentals continue to be the main driver of crude oil prices. However, it seems as though the market is discounting something else. President Trump’s tweets, OPEC+ coalition statements, and concerns about future demand growth are contributing to price swings (Chart 24, panel 1). According to the Oxford Institute for Energy Studies, weak demand has reduced oil prices by $2/barrel this year. That should be offset, however, by a much larger contribution from supply cuts, speculative demand, and a deteriorating geopolitical environment. We see crude prices tilted to the upside, as OPEC’s ability to offset any supply disruptions (besides Iran and Venezuela) is limited (panel 2). We expect Brent to average $73 in 2019 and $75 in 2020. Industrial Metals (Neutral): A stronger USD accompanied by weakening global growth since 2018 has put downward pressure on industrial metal prices, which are down about 20% since January 2018. However, we now have renewed belief that the Chinese authorities will counter with a reflationary response though credit and fiscal stimulus. That should push industrial metal prices higher over the coming 12 months (panel 3). Precious Metals (Neutral): Allocators to gold are benefiting from the current environment of rising geopolitical risk, dovish central banks, a weaker USD, and the market’s flight to safety. Escalated trade tensions, falling global yields, and lower growth prospects are some of the factors that have supported the bullion’s 18% return since its September 2018 low. Until evidence of a bottom in global growth emerges, we expect the copper-to-gold ratio – another barometer for global growth – to continue falling (panel 4). The months ahead could see a correction, as investors take profits with gold in overbought territory. Nevertheless, we continue to recommend gold as both an inflation hedge as well as against any uncertain escalated political tensions. Currencies Chart 25Stronger Global Growth Will Weigh On The Dollar U.S. dollar: The trade-weighted dollar has been flat since we lowered our recommendation from positive to neutral in April. We expect that the Fed will cut rates at least once this year, easing financial conditions, and boosting economic activity. This will eventually prove negative for the dollar. However as long as the global economy is weak the greenback should hold up. Stay neutral for now. Euro: Since we turned bullish on the euro in April, EUR/USD has appreciated by 1.5%. Overall, we continue to be bullish on EUR/USD on a cyclical timeframe. Forward rate expectations continue to be near 2014 lows, suggesting that there is little room for U.S. monetary policy to tighten further vis-à-vis euro area monetary policy, creating a floor under the euro (Chart 25, panel 1). EM Currencies: We continue to be negative on emerging market currencies. However, some indicators suggest that Chinese weakness, the main engine behind the EM currency bear market might be reaching its end. Chinese marginal propensity to spend (proxied by M1 growth relative to M2 growth), has bottomed and seems to have stabilized (panel 2). The bond market has taken note of this development, as Chinese yields are now rising relative to U.S. ones (panel 3). Historically, both of these developments have resulted in a rally for emerging market currencies. Thus, while we expect the bear market to continue for the time being, the pace of decline is likely to ease, making EM currencies an attractive buy by the end of the year. Accordingly, we are reducing our underweight in EM currencies from double underweight to a smaller underweight position. Alternatives Return Enhancers: Hedge funds historically display a negative correlation with global growth momentum. Despite growth slowing over the past year, hedge funds underperformed the overall GAA Alternatives Index as well as private equity. Hedge funds usually outperform other risky alternatives during recessions or periods of high credit market stress. Credit spreads have been slow to rise in response to the slowing economy and worsening political environment. A pickup in spreads should support hedge fund outperformance (Chart 26, panel 2). Inflation Hedges: As we approach the end of the cycle, we continue to recommend investors reduce their real estate exposure and increase allocations towards commodity futures. Our May 2019 Special Report4 analyzed how different asset classes perform in periods of rising inflation. Our expectation is that inflation will pick up by the end of the year. An allocation to commodity futures, particularly energy, historically achieved excess returns of nearly 40% during periods of mild inflation (panel 3). Volatility Dampeners: Realized volatility in the catastrophe bond market is generally low. In fact, absent any catastrophe losses, catastrophe bonds provide stable returns, with volatility that is comparable to global bonds (panel 4). In a December 2017 Special Report,5 we tested for how the inclusion of catastrophe bonds in a traditional 60/40 equity-bond portfolio would have impacted portfolio risk-return characteristics. Replacing global equities with catastrophe bonds reduced annualized volatility by more than 1.5%. Risks To Our View Chart 27What Risk Of Recession? Our main scenario is sanguine on global growth, which means we argue that bond yields will not fall much below current levels. The risks to this view are mostly to the downside. There could be a full-blown recession. Most likely this would be caused either by China failing to do stimulus, or by U.S. rates being more restrictive than the Fed believes. Both of these explanations seem implausible. As we argue elsewhere, we think it unlikely that China would simply allow growth to slow without reacting with monetary and fiscal stimulus. If current Fed policy is too tight for the economy to withstand, it would imply that the neutral rate of interest is zero or below, something that seems improbable given how strong U.S. growth has been despite rising rates. Formal models of recession do not indicate an elevated risk currently (Chart 27). We continue to watch for the timing to move into higher-beta China-related markets as the effects of China’s stimulus start to come through. Even if growth is as strong as we forecast, is there a possibility that bond yields fall further. This could come about – for a while, at least – if the Fed is aggressively dovish, oil prices fall (perhaps because of a positive supply shock), inflation softens further, and global growth remains sluggish. Absent a recession, we find those outcomes unlikely. The copper-to-gold ratio has been a good indicator of U.S. bond yields (Chart 28). It suggests that, at 2%, the 10-year Treasury yield has slightly overshot. In fact, in June copper prices started to rebound, as the market began to price in growing Chinese demand. Chart 28Can Bond Yields Fall Any Further? Chart 29Are Analysts Right To Be So Gloomy?   For U.S. equities to rise much further, multiple expansion will not be enough; the earnings outlook needs to improve. Analysts are still cautious with their bottom-up forecasts, expecting only 3% EPS growth for the S&P500 this year (Chart 29). This seems easy to beat. But a combination of further dollar strength, worsening trade war, further slowdown in Europe and Emerging Markets, and higher U.S. wages would put it at risk. Footnotes 1 Please see What Our Clients Are Asking on page 9 of this Quarterly for further discussion on why we are confident China will ramp up stimulus if necessary. 2 Trimmed Mean PCE inflation, a better indicator of underlying inflation than the Core PCE deflator, is above 2%. Please see What Our Clients Are Asking on page 8 of this Quarterly for details. 3 Please see U.S. Bond Strategy Weekly Report, “Track Records,” dated June 18, available at usb.bcaresearch.com. 4 Please see Global Asset Allocation Special Report “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com 5 Please see Global Asset Allocation Special Report “A Primer On Catastrophe Bonds,” dated December 12, 2017 available at gaa.bcaresearch.com   GAA Asset Allocation