Market Returns

Highlights The deceleration in global growth that began in 2018 is entering a transition phase. The bottoming out process could prove to be volatile, warning against betting the farm too early on pro-cyclical currencies. Tactical short USD bets should initially be played via the euro1 and Swedish krona. The poor Canadian GDP report last week could be a harbinger for more data disappointments down the road. Meanwhile, the dovish shift by the ECB could paradoxically be bullish for the euro beyond the near term. Go short USD/SEK and buy EUR/CAD for a trade. Feature A currency exchange rate is simply a measure of relative prices between two countries. As such, the starting point for any currency forecast should be how those values are likely to evolve over time. For much of 2018, U.S. growth benefited from the impact of the Trump tax cuts, a boost to government spending agreed in January of that year, and the lagged effect of an easing in financial conditions from December 2016 to January 2018. Outside the U.S., what appeared to be idiosyncratic growth hiccups in both Europe and Japan finally morphed into full-blown slowdowns. Slower Chinese credit growth and the U.S.-China trade war were the ultimate straws that broke the camel’s back, deeply hurting global growth (Chart I-1). Consequently, the greenback surged. Chart I-1The Global Growth Slowdown Persists Fading U.S. Dollar Tailwinds At first glance, the picture remains largely similar today, with global growth still slowing and U.S. growth still outperforming. However, a key difference from last year is that U.S. growth leadership is set to give way to the rest of the world. The U.S. ISM manufacturing PMI peaked last August and has been steadily rolling over relative to its trading partners. The U.S. economic surprise index tells a similar story, with last month’s disappointing retail sales numbers nudging the series firmly below zero. Relative leading economic indices also suggest that U.S. growth momentum has slowed relative to the rest of the world. Historically, the relative growth differential between the U.S. and elsewhere has had a pretty good track record of dictating trends in the dollar (Chart I-2). Chart I-2U.S. Growth Leadership Might Soon End Whether or not these trends persist beyond the first quarter will depend on the sustainability of China’s recent stimulus efforts. On the positive side, typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices have perked up in response to a nascent upturn in the credit impulse. On the other hand, policy shifts affect the economy with a lag, suggesting it is too early to tell whether the latest credit injection has been sufficient to turn around the Chinese economy, let alone the rest of the world. What is clear is that the bottoming processes tend to be volatile and protracted, suggesting it is still too early to bet the farm on pro-cyclical currencies. In the interim, investors could track the following indicators to help time a definitive turning point: Whether or not easing liquidity conditions will lead to higher growth is often captured by the CRB Raw Industrial index-to-gold, copper-to-gold, and oil-to-gold ratios. It is encouraging that these also tend to move in lockstep with the U.S. bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-3). The next confirmation will come with a clear break-out in these ratios. Chart I-3Reflation Indicators Are Perking Up Chinese M2 relative to GDP has bottomed. Historically, this ratio has lit a fire under cyclical stocks and, by extension, pro-cyclical currencies (Chart I-4). The growth rate is still at zero, meaning excess liquidity is not accelerating on a year-over-year basis. Meanwhile, our Emerging Markets team argues that broad credit growth is still decelerating.2 A break above the zero line, probably in the second half of this year, could be a catalyst to shift fully to a pro-cyclical currency stance. Chart I-4Chinese Excess Liquidity Improving On a similar note, currencies in emerging Asia that sit closer to the epicenter of stimulus appear to have bottomed. If those in Latin America can follow suit, it would indicate that policy stimulus is sufficient, and the transmission mechanism is working (Chart I-5). Chart I-5EM Currencies Are Trying To Bottom Finally, China-sensitive industrial commodities, especially metals and building materials, appear to have troughed and are perking up nicely. There was a supply-related issue with the Vale dam bursting in Brazil and a subsequent surge in iron-ore prices, but it is now clear that the entire industrial commodity complex has stopped falling (Chart I-6). Chart I-6Chinese Industrial Commodities Are Rallying Be Selective On USD Shorts Our strategy is to be selective as U.S. dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the euro and the Swedish krona. Last week, we highlighted the fact that investors are currently too pessimistic on Europe’s growth prospects. More importantly, most of the factors that toppled European growth domestically – the implementation of new auto-emission standards in Germany, the rising cost of capital in Italy via exploding bond yields, and the populist Gilets Jaunes protests in France – are mostly behind us. Fiscal policy is also set to be loosened this year, and last year’s weakness in the euro will contribute to easier financial conditions. The improvement in European investor sentiment relative to current conditions could be a harbinger of positive euro area data surprises ahead (Chart I-7). Chart I-7Euro Zone Data Might Surprise To The Upside The European Central Bank left rates unchanged at yesterday’s policy meeting but the decision for a new Targeted Long Term Refinancing Operation (TLTRO III – or in other words, cheap loans), could be paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that this is bearish for the currency. Our Global Fixed Income team nailed the move by the ECB in this week’s report.3 European banks have been in the firing line of sluggish growth, negative interest rates, and increased regulatory scrutiny. In the case of Italy, an NPL ratio 9.4% is nearly triple that of the euro area. And with circa 10% of total bank lending in Spain and Italy funded by TLTROs, re-funding by the ECB is exactly what the doctor ordered. In the case of the Sweden, the undervaluation of the krona has begun to mitigate the effects of negative interest rates – mainly a buildup of household leverage and an exodus of foreign direct investment. The GDP report last week was well above expectations, with year-on-year growth of 2.4%. Encouragingly, this was driven by net exports rather than consumption. The Swedish manufacturing PMI release for February was also very encouraging. Orders jumped from 50.4 to 54.0 while export orders jumped from 51.5 to 53.4. The growth in wages is beginning to catch up to new borrowings, meaning domestic consumption could be increasingly financed through income. This will alleviate the need for the Riksbank to maintain an ultra-accommodative policy. On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is facing strong resistance at the triple top established from the 2009 highs around 9.45 (Chart I-8). Aggressive investors should begin accumulating short positions, while being cognizant of the negative carry. Chart I-8The Swedish Krona Looks Like A Buy Bottom Line: Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio. Ever since the global financial crisis, gold has stood as a viable threat to dollar liabilities, capturing the ebb and flow of investor confidence in the greenback tick-for-tick (Chart I-9). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, USD short positions should be played via the euro and Swedish krona.   Chart I-9Pay Close Attention To The Gold-To-Bond Ratio Buy EUR/CAD For A Trade Last week saw an extremely disappointing GDP report out of Canada, which prompted the Bank of Canada to keep interest rates on hold this week, followed by quite dovish commentary. In a 90-degree maneuver from its January policy statement that rates will need to rise over time, BoC Governor Stephen Poloz said the path for future increases had become “highly uncertain.”   Like many central banks around the world, the BoC has been blindsided by the depth of the negative growth impulse outside its borders, which has begun to seep into the domestic economy. The economy grew at an annualized pace of 0.4% in the fourth quarter, the lowest in over two years. Capital expenditures collapsed at a rate of 2.7%, marking the third consecutive quarter of declines. The forward OIS curve is pricing in no rate hikes for Canada this year, meaning sentiment on the loonie is already depressed. However, our contention is that even if growth bottoms by the second half of this year, the Canadian dollar will offer little value to play this cyclical rebound. Our recommendation is to play the loonie’s downside via the euro. First, valuations and balance-of-payment dynamics favor the euro versus the CAD on a long-term basis. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada (Chart I-10). European rates are further below equilibrium, and the ECB’s dovish shift will help lift the growth potential of the euro area. Meanwhile, the Canadian neutral rate will be heavily weighed down by the large stock of debt in the Canadian private sector, exacerbated by overvaluation in the housing market. This means that expectations in the 2-year forward market are likely to favor the euro versus the CAD. Chart I-10Buy EUR/CAD For A Trade The biggest risk to this view is the price of oil. The EUR/CAD exchange rate is not as negatively correlated with oil as the USD/CAD, but nonetheless the CAD benefits more from rising oil prices than the euro does. BCA’s bullish oil view is a risk over the next six months. On the downside, the EUR/CAD could potentially test the bottom of the upward trending channel that has existed since 2012. This would put EUR/CAD in the vicinity of 1.45 (currently trading at 1.5049). However, initial upside resistance rests at the triple top a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Meanwhile, economically, Canada is benefiting less from oil prices today than it has in the past. First, the Canadian oil benchmark trades at a large discount to Brent, and second, Canada is having trouble shipping its own oil at a moderate cost due to lack of pipeline capacity.4  Bottom Line: Investors should buy the EUR/CAD for a trade. The Canadian dollar is likely to outperform its antipodean counterparts, but faces limited upside versus the U.S. dollar. There are better opportunities to play USD downside, namely via the Swedish krona and the euro. Stand Aside On The Australian Dollar For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities is rapidly morphing into a housing crash (Chart I-12). Chart I-12Australia: Anatomy Of A Hard Landing In addition, the upcoming general election could exacerbate the risks to the country’s banks and the housing market.5 The center-left Labour Party, which has moved further to the left in this electoral cycle, has promised several regulatory changes. First, the Labour government would want to get rid of “negative gearing,” the practice of using investment properties that are generating losses to offset one’s income tax bill. Second, the capital gains tax exemption from selling properties will be reduced from 50% to 25%. Third, the Labour government would end the policy of reimbursing investors for the corporate tax paid by the company. This would end the incentive for retirees to own high dividend yielding equities, such as those of Australian banks. This week, the Reserve Bank of Australia kept rates on hold and acknowledged risks to the housing market, but bank stocks suggest they remain well behind the curve (Chart I-13). The futures market is already pricing in 23 basis points of rate cuts by the end of the year, and the contention of our fixed income team is that more might be needed down the road. First, all the preconditions for a rate hike – underemployment below 8%, a rebound in Chinese economic activity and core CPI in the range of 2-3% – have not been met. The reality is that core CPI has lagged the target range since late-2015, and now faces downside risks. Chart I-13Australian Bank Stocks Are Pricing In A Curve Inversion That said, a lot of the bad news already appears priced into the Australian dollar, which is down 14% from its 2018 peak, and 37% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth, or simply the forces of mean reversion (Chart I-14). Chart I-14Stand Aside On The Australian Dollar For Now Bottom Line: Sentiment on the Aussie dollar is already bearish, warning against putting on fresh shorts. Our short AUD positions, expressed via the NZD and the CAD, are currently 6.74% and 1.99% in the money, respectively. Investors should hold onto these positions, but tighten stops to protect profits.   Chester Ntonifor,  Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report titled “A Contrarian Bet On The Euro,” dated March 1, 2019 available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report titled “EM: A Sustainable Rally Or False Start?,” dated March 7, 2019 available at ems.bcaresearch.com 3 Please see Global Fixed Income Strategy Special Report, titled “The ECB’s Next Move: Taking Out Some Insurance,” dated March 5, 2019, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Price Diffs: Global Convergence,” dated March 7, 2019, available at ces.bcaresearch.com 5 Please see Geopolitical Strategy Special Report, titled “A Year Of Change In Australia?,” dated December 5, 2018, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Annualized Q4 GDP growth came in line with expectations at 2.6%, but both the Atlanta and New York Fed models suggest sub 1% growth in Q1 this year. ISM manufacturing PMI missed expectations, falling to 54.2, while the non-manufacturing PMI increased to 59.7. Q4 unit labor costs increased to 2%, surprising to the upside. The DXY index has gained 1.17% this week. Upside on the dollar will be based on Fed’s capacity to continue tightening monetary policy later this year. However, there are increasing signs pointing to a weakening in leadership of U.S. growth this cycle, which could be a headwind for the counter-cyclical dollar. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area show some specter of stabilization: Yearly consumer price inflation increased to 1.5%, in line with expectations. Q4 GDP growth on a year-on-year basis fell to 1.1%, marginally in line. Encouragingly, the Markit composite PMI increased to 51.9. The manufacturing PMI came in at 49.3, while services PMI came in at 52.8.  Finally, retail sales grew higher than expected, with a reading of 2.2%. EUR/USD has fallen by 1.3% this week. The ECB kept interest rates on hold with a dovish tilt. Paradoxically, this could be bullish for the euro, if it allows growth to definitively bottom. Easing financial conditions in the euro area are reflationary and risks to the periphery have been curtailed. Report Links: A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Yearly inflation surprised to the upside, coming in at 0.6%. The core inflation excluding fresh food also came in higher than expected at 1.1%. January unemployment rate missed expectations, climbing to 2.5%; while the jobs-to-applicants ratio stayed at 1.63. Nikkei manufacturing PMI surprised to the upside, coming in at 48.9. USD/JPY has risen by 0.4% this week. While we are positive on the safe-haven yen on a structural basis, we struggle to see any near-term upside amid significant Japanese stock and bond outflows. We will be discussing the outlook for the yen in an upcoming report. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been improving: February consumer confidence came in at -13, slightly higher than expectations. Markit manufacturing PMI came in at 52, in line with expectations; while the services PMI surprised to the upside, coming in at 51.3. The Halifax house price index surprised to the upside, rising 5.9% mom in February. GBP/USD has fallen by 1.2% this week. During the speech on March 5, the Bank of England governor Mark Carney highlighted the market underestimates the potential for interest rate hikes. Overall, we remain bullish on the pound in the long-term, but volatility is set to rise in the near term as we approach the Brexit March 29 deadline. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been dismal: The RBA commodity price index advanced by 9.1% year-on-year in February, but this was supply related. Building permits continue to contract at 29% year-on-year. Finally, the annualized Q4 GDP growth fell to 0.2%, more than 50% below expectations. AUD/USD fell by 1.2% this week. The RBA kept the interest rate unchanged at 1.5%. Governor Philip Lowe acknowledged the downside risks to the housing market and overall economy, and warned about the “significant uncertainties around the forecast.” That said, AUD/USD has fallen by a 13% since the January 2018 highs, warning against establishing fresh shorts at this juncture. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Seasonally adjusted building permits increased 16.5% month-on-month in January, a huge jump. However, the ANZ activity business confidence dropped to -30.9. Most importantly, terms of trade fell to -3% in the fourth quarter, underperforming expectations. NZD/USD depreciated by 0.9% this week. The key for the Kiwi will be a pickup in agricultural commodity prices, which remain in a definitive bear market. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been disappointing: Q4 current account balance has deteriorated, coming in at C$ -15.48 billion. Moreover, annualized Q4 GDP growth missed analysts’ forecast, coming in at 0.4%. Finally, the Markit manufacturing PMI weakened to 52.6 in February. USD/CAD has gained 2.1% this week. The BoC kept interest rates on hold at 1.75% given that domestic economic conditions have now coupled to the downside with a bleak external picture. The caveat for the Canadian dollar is that rising oil prices could provide some support. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019   Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Annualized Q4 GDP growth missed analysts’ expectations by 50%, coming in at 0.2%.  In addition, the retail sales contracted 0.4% year-on-year. Lastly, CPI was in line at 0.6%, but this is a far cry from the March 2018 peak. EUR/CHF has been flat this week. Overall, we are bullish EUR/CHF on a cyclical basis. Stabilization in global growth will make safe-haven currencies like the franc less attractive. In addition, the foreign direct investment and portfolio investment outflows from Switzerland should put more downward pressure on the franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Monthly unemployment rate fell to 2.5%, in line with expectations. However, the Q4 current account balance fell to 46.8 billion from 91.36 billion in Q3. The manufacturing PMI has been stable for a few months now, coming in at 56.3 for the month of February. USD/NOK increased by 2.2% this week. We are optimistic on the NOK on a structural basis, given the positive outlook for oil prices. Moreover, the NOK is undervalued and trading at a large discount to its long-term fair value. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Retail sales was in line with expectations at 0.8% month-on-month. However, annualized Q4 GDP growth was double expectations at 1.2%. The February manufacturing PMI also came in higher at 52.5. In addition, industrial production yearly growth came in higher at 3.4%. Lastly, the Q4 current account balance increased to 39.6 billion. USD/SEK increased by 2% this week. The SEK is still trading at a large discount to its long-term fair value. We remain bearish on USD/SEK on a structural basis as we see many signs pointing to a recovery in the Swedish economy, which is a tailwind for the Swedish krona.   Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Analysis on Indonesia is available below. EM financial markets have diverged from the global growth indicators they have historically correlated with. This raises doubts about the sustainability of this rally. In China, broad bank credit has not accelerated at all, while non-bank credit growth rose sharply in January. The lack of recovery in broad bank credit growth is corroborated by lingering sluggishness in broad money growth. This refutes widespread perception in the global investment community that Chinese banks have re-opened the credit spigots again. Feature The headline news has all been positive for emerging markets over the past two months: The Federal Reserve is going on hold, China is stimulating its economy, the U.S. and China are nearing a trade agreement and risk-on market dynamics are permeating worldwide. Nevertheless, EM stocks have failed to outperform the global equity benchmark (Chart I-1, top panel). Notably, EM relative equity performance rolled over in late December when global share prices bottomed. Chart I-1EM Stocks Have Underperformed DM Ones Since Late December In absolute terms, EM equities have been attempting to break above their 200-day moving average, but have so far failed to do so decisively (Chart I-1, bottom panel). When a market struggles to break out or outperform amid favorable news flows and buoyant investor sentiment, the odds are that it is facing formidable headwinds under the surface, and is at risk of relapsing. We sense EM currently fits this profile. Needless to say, investor consensus is very bullish on EM, and dominated by the above-mentioned narrative, specifically the Fed turning dovish and China stimulating, which is reminiscent of 2016 when EM staged a cyclical rally. Consequently, investors have rushed to pile into EM stocks and fixed-income. Chart I-2 illustrates that asset managers’ net holdings of EM ETF (EEM) futures have doubled since October 2018. Chart I-2Investor Consensus Is Very Bullish On EM As of mid-February, EMs were by far the most overweight region within global equity portfolios, according to the most recent Bank of America/Merrill Lynch survey. The survey states that net 37% of global equity investors - who participated in the survey - were overweight EM. One of our clients that we met with on the road last week summed it up like this: “Investors have ‘recency bias’.” In other words, investors believe that 2019 will resemble 2016, and in turn have no appetite to bet against Chinese stimulus. We are in accord with this interpretation of investor behavior and the EM/China rally. Yet there are some noteworthy differences between today and 2016. First, in 2016, there was massive stimulus for China’s property market. At the time, the People’s Bank of China (PBoC) monetized the unsold housing stock in Tier-3 and -4 cities via its Pledged Supplementary Lending facility. At present, there is no stimulus for real estate. Second, by early 2016 EM profits had already contracted substantially. EM profits have yet to shrink in the current downtrend. Our thesis is that EM profits will contract this year for reasons we elaborated on in depth in our previous report, Mind The Time Gap. China’s credit and fiscal impulse leads EM/Chinese profits by about 12 months, and the recent improvement in this indicator, if sustained, suggests that a trough in EM/Chinese corporate earnings will only be reached in late 2019 (Chart I-3). Therefore, as EM profits shrink, investors will likely sell EM risk assets. Chart I-3EM Corporate Earnings Are Beginning To Contract Altogether, these differences with 2016 make us reluctant to chase the current EM rally, and we continue to expect a meaningful reversal in EM risk assets in the months ahead. Monitoring Global Growth We maintain that EM is much more leveraged to global trade and China’s growth than to Fed policy. For a detailed discussion on this matter, please refer to EM: A Replay of 2016 or 2001? report from February 7, 2019. Therefore, the Fed’s dovish turn is not a sufficient reason to buy EM risk assets. To buy EM cyclically, we would need to change our outlook on global trade and Chinese imports. China influences the rest of the world via its imports. A closer look at the indicators that correlate with EM risk assets and commodities do not justify the recent EM rebound. In particular: The import sub-component of China’s NBS manufacturing PMI strongly correlates with EM share prices, excess returns in EM sovereign credit, and industrial metals prices and suggest that investors should fade this rebound (Chart I-4). Chart I-4EM Stocks, EM Credit Markets, As Well As Commodities Prices Are Driven By Chinese Imports The Caixin manufacturing PMI for China was up in February, but the NBS manufacturing PMI fell. In turn, manufacturing PMI indexes in Korea, Taiwan, Japan and Singapore are all plunging, with several of them dropping well below the 50 boom-bust mark (Chart I-5). Chart I-5Asian Manufacturing Is Contracting Korean, Taiwanese, Japanese and Singaporean shipments to China were shrinking in January, while their exports to the U.S. were resilient (Chart I-6). This confirms that global trade has been weak due to China, and that there are no signs of its reversal. Chart I-6Asian Exports To China And U.S. Moreover, Korea released its February export data, and its aggregate outbound shipments are contracting (Chart I-7). Chart I-7Korean Exports: Deepening Contraction Further, China’s container freight index – the price to ship containers – has rolled over again after picking-up late last year due to front-loading of shipments to the U.S. which were induced by the U.S. import tariffs. This signals ongoing weakness in global demand, and does not justify the latest rebound in EM financial markets in general and currencies in particular (Chart I-8). Chart I-8Global Trade Is A Risk To EM Currencies Finally, even in the U.S. where manufacturing has been the most resilient globally, the odds point to notable weakness in this sector. Specifically, the continuous underperformance of U.S. high-beta industrial stocks to U.S. overall industrials beckons a further slowdown in American manufacturing (Chart I-9). Chart I-9U.S. Manufacturing Is In A Soft Spot Bottom Line: Although financial markets are forward-looking, the recent rally has been too fast and has already gone too far. This has created conditions for a material setback as global/China growth will continue to disappoint in the months ahead.  China: Credit Versus Money Growth We have been receiving questions from clients as to whether investors should heed to the message from China’s money or credit data, given they are presently sending contradictory messages (Chart I-10). Chart I-10China: Narrow, Broad Money, And Aggregate Credit Even though narrow money (M1) has historically been an excellent indicator for China/EM business cycles, the most recent (January) print – M1 annual growth rate registered a record low – was distorted due to technical/seasonal factors, and should be ignored. Specifically, deposits by enterprises plunged in January and household deposits surged as companies paid out bonuses to employees in late January ahead of the Chinese New Year that began on February 5 (Chart I-11). Provided enterprise demand deposits are in M1 but household demand deposits are a part of M2, M1 was artificially depressed in January. It will rebound in February. Chart I-11China: Technical Reasons For M1 Plunge In January Broad money provides a more comprehensive picture of money creation in China. As such, it is more relevant to compare broad money with aggregate credit. To compute aggregate credit, we add outstanding central and local government bonds to Total Social Financing (TSF). Chart I-12 illustrates the latest improvement in aggregate credit is not confirmed by either the PBoC’s broad money measure, M2, or our measure, M3 (M3 = M2 plus other deposits plus banks’ other liabilities excluding bonds). We created this M3 measure of broad money supply because in our opinion, M2 has been underestimating the extent of money creation in China in recent years due to financial engineering. Chart I-12The Recent Uptick In Aggregate Credit Is Not Confirmed By Broad Money As discussed in Box I-1 on pages 12-13, lending or purchasing of securities by banks simultaneously creates money. Therefore, bank broad credit acceleration should be mirrored in a broad money upturn. Does the lack of revival in broad money mean the latest uptick in aggregate credit data has been driven by non-bank credit? Our analysis suggests yes – non-bank credit is responsible for the strong rise in the aggregate credit numbers in January. We deconstructed aggregate credit into broad bank credit and non-bank credit (Diagram I-1). Chart I-13 illustrates that broad bank credit has not accelerated at all, while non-bank credit growth rose in January. Chart I-13China: Recent Credit Acceleration Is Due To Non-Bank Credit The lack of recovery in broad bank credit growth is corroborated by lingering sluggishness in broad money (both M2 and M3) growth (Chart I-14). Chart I-14Broad Bank Credit Is Consistent With Broad Money (As It Should Be) Consequently, this refutes the widespread perception in the global investment community that Chinese banks have re-opened the credit spigots. Chart I-15demonstrates the annual growth rate of each component of broad bank credit. While mainland banks’ loan growth to enterprises has accelerated, their lending to non-bank financial institutions has continued to shrink.  Chart I-15Broad Bank Credit And Its Components In sum, broad bank credit and broad money have not revived, and their impulses are rolling over, having failed to break above zero (Chart I-14, bottom panel). Bottom Line: The improvement in aggregate credit growth in January was due to credit provided/bonds purchased by non-banks rather than by banks. This does not tell us whether the credit growth acceleration is sustainable. For a more detailed discussion on the differences between money and credit, please refer to Box I-1 on page 12-13. Investors prefer simple narratives, and have readily embraced the story that China has opened up the credit faucets. Broad bank credit data and broad money supply data do not corroborate this thesis. It may change in the months ahead, but our point is that for the moment there is not yet a simple narrative about China’s credit cycle. Investment Implications Even though China’s aggregate credit impulse ticked up in January, the 2011-‘12 and 2015-‘16 episodes signify that its bottoming can last many months. Critically, EM financial markets have historically lagged turning points in the aggregate credit impulse. These time lags have been anywhere between three to 18 months over the past 10 years. Furthermore, in 2012 there was only a minor rebound in EM share prices – not a cyclical rally – in response to the significant rise in China’s aggregate credit impulse (Chart I-16, top panel). Chart I-16Beware Of The Time Lag Hence, even if January marked the bottom in the aggregate credit impulse – which is plausible in our opinion – EM risk assets will remain at risk based on historical time lags between the aggregate credit impulse and China-related financial markets.1 BOX 1 Why And When Money Supply Differs From Credit The following elaborates on the key differences between broad money supply and aggregate credit.  1. Why and when do broad money and credit diverge?  When commercial banks provide loans to or buy bonds (or any other asset) from non-banks, they simultaneously create new money supply/deposits. Broad money supply is the sum of all deposits in the banking system, which is why we use the terms money and deposits interchangeably. When non-bank financial institutions – in China's case financial trust and investment corporations, financial leasing companies, auto-financing companies and loan companies – as well as enterprises and households make loans or buy bonds, they do not create money. Hence, money supply/deposits is mostly equal to net cumulative broad bank credit creation. The difference between aggregate credit and money supply is due to lending activities of non-bank entities (see Diagram I-1 on page 9). Lending, purchasing of bonds, or any other forms of financing by non-bank entities does not change money supply. Thus, aggregate credit is more relevant than money supply to forecast business cycle fluctuations. Apart from the fact that banks still play a very large role in aggregate financing in China, there are a few other reasons why one should not ignore broad money and rely solely on aggregate credit: Banks can extend credit, but might choose not to classify it as loans on their balance sheet for regulatory reasons. Chinese banks did this in the past by booking loans as non-standard credit assets. In any case, when a bank lends to a non-bank it creates new deposits/money, and it is hard to conceal deposits/liabilities. In these cases, broad money supply gives a better signal about the true extent of credit growth than statistics on loans. If under regulatory pressures banks reclassify their non-standard credit assets as loans, the amount of loans will expand, even though no new lending occurs. Yet, money supply/deposits will not change. In this case, loan numbers will give a false signal and money supply will be a better indicator for new credit origination by banks and, thereby, for economic activity. The true measure of Chinese bank loans and credit data were probably disguised over the past several years because banks and non-bank financial institutions were involved in financial engineering. However, in the past two years, the regulatory clampdown forced Chinese commercial banks to unwind some of these structures and properly reclassify items on their balance sheets. Both the masking of credit assets and the ensuing reclassification could have distorted loan and credit data. This is why we use broad money supply as a litmus test to gauge banks’ broad credit origination. Given TSF includes bank loans but does not include banks’ non-standard credit assets, we believe TSF understates the amount of credit in the economy. As a result, we have not been able to calculate an accurate aggregate level of non-bank credit. Only since mid-2017, when under the regulatory clampdown, banks have stopped classifying loans as non-standard credit assets, can the annual growth rate of TSF serve as a meaningful statistic. Hence, we estimate the annual growth rate of non-bank credit only starting in 2018 (please refer to Chart I-13 on page 9). 2. Does the central bank (PBoC) create money by injecting liquidity into the system? Barring lending to or buying assets from non-banks – which does not typically occur outside of quantitative easing (QE) programs – central banks do not create broad money or deposits. Central banks create banking system reserves, which are not part of the broad money supply in any country. Money supply/deposits, the ultimate purchasing power for economic agents, is created solely by commercial banks “out of thin air,” as we have discussed and illustrated in our series of reports on money, credit and savings. 3. Why do we use impulses (second derivatives of money/credit) rather than growth rates? Our goal is to forecast a change in economic activity/capital spending/imports/enterprise revenues – i.e., a change in flow variables. Money and credit are stock variables. Therefore, a change (the first derivative) in outstanding money and credit produces flow variables. The latter measures new credit and money origination in a given period. These are comparable with flow variables like spending, income and profits. To gauge changes in flow variables, i.e., the growth rate of spending, one needs to calculate a change in new money and credit origination – i.e., change in their net flow. In brief, to do an apples-to-apples comparison, one needs to use the second derivative (a change in change) in money and credit – i.e., changes in their flows – to predict changes in flow variables such as GDP/capital spending/imports/enterprise revenues.   Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Lin Xiang, Research Analyst linx@bcaresearch.com   Indonesia: It Is Not All About The Fed Indonesian stocks have outperformed their emerging market peers significantly in the past few months as the Federal Reserve has turned dovish and U.S. rate expectations have declined. Although U.S. bond yields do strongly and inversely correlate with Indonesian stocks’ relative performance versus the EM equity benchmark (Chart II-1, top panel), we believe there are other factors – such as Chinese growth and commodities prices – that are also important to this market (Chart II-1, bottom panel). Chart II-1Indonesian Stocks: The Fed Versus Commodities In the next several months, slowing Chinese growth, lower commodities prices, and a renewed sell-off in EM markets will take a toll on Indonesian financial markets. Indonesian exports are contracting which will intensify as commodities prices fall and China’s purchases of coal and base metals drop (Chart II-2, top panel). Chart II-2Indonesia: Exports Are Shrinking Indonesia’s current account deficit is already large and will continue widening as the export contraction deepens (Chart II-2, bottom panel). Remarkably, the nation’s commercial banks have been encouraged to keep the credit taps open as the central bank – Bank Indonesia (BI) – has been injecting enormous amounts of liquidity (excess reserves) into the banking system (Chart II-3, top panel). Given these liquidity injections, bank credit and domestic demand growth have remained more resilient than would otherwise have been the case. Chart II-3The Central Bank Is Injecting Liquidity Yet, by injecting such enormous amounts of excess reserves into the system, the central bank has more than negated its previous liquidity tightening, resulting from the sales of its foreign exchange reserves in order to defend the rupiah (Chart II-3, bottom panel). The implications of such policy are that these excess reserves could encourage speculation against the rupiah, especially amid weakening global growth and falling commodities prices. Provided foreigners own large portions of Indonesian stocks and local-currency government bonds, a depreciation in the rupiah will produce a renewed selloff in the nation’s financial markets. A final point on Indonesian commercial banks: their net interest margins have been narrowing sharply (Chart II-4, top panel). Chart II-4Commercial Banks' Profits Will Weaken Moreover, as global growth slows, non-performing loans (NPLs) on the balance sheets of Indonesian banks will rise. In turn, provisioning for bad loans will also increase, and bank earnings will decline (Chart II-4, bottom panel). These dynamics will be bearish for Indonesian commercial banks, which account for 44% of the overall MSCI Indonesia index. Bottom Line: Continue avoiding/underweighting Indonesian stocks and fixed-income markets. We continue shorting the IDR versus the U.S. dollar. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Footnotes 1      Please note that this represents the Emerging Markets Strategy team’s view and is different from BCA’s house view on global risk assets and global growth. The key point of contention is the outlook for China’s growth.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Price differentials between global light-sweet crude oil benchmarks Brent and WTI will narrow over the next three years, as U.S. light-sweet crude oil exports expand and North Sea production growth remains challenged. U.S. product exports also will expand, as investments by Gulf Coast refiners allow them to take in more of the domestic light-sweet crude output. Growing volumes of WTI being exported to Europe are being priced relative to Brent. Over time, we expect the marginal light-sweet crude barrel for the global oil market – and the benchmark of refiners’ primary cost – will be directly linked to WTI – Houston pricing. Given this expectation of increased U.S. exports, we are initiating a long WTI vs. short Brent swap position at tonight’s close in 2020. The 2020 swap settled Tuesday at $6.6/bbl; we project it will average $3.25/bbl. In the heavy-sour markets, differentials – most prominently the Brent – Dubai spread – will remain tight, owing to OPEC 2.0 production cuts, lost Venezuelan and Iranian exports, due to U.S. sanctions, and ongoing difficulties getting Canadian heavy crude to refining markets. Energy: Overweight. OPEC 2.0 likely will decide to extend production cuts to year-end in June, as opposed to May, as was expected earlier.1 This will allow the Cartel to respond to whatever the U.S. decides on May 4 re extending waivers on Iranian export sanctions, and to export losses from U.S. sanctions on Venezuela’s state oil company. Base Metals/Bulks: Neutral. Chinese Premier Li Keqiang announced tax cuts amounting to almost $300 billion (~ 2 trillion RMB), as policymakers attempt to hit a GDP growth target of 6.0 to 6.5% this year. We are getting tactically long spot copper at tonight’s close, expecting this fiscal stimulus to boost prices over $3.00/lb in the next 3 – 6 months. Feature In a little more than two years from now, Exxon will add 1mm b/d of pipeline take-away capacity to the Permian Basin. The new pipe is in addition to the 2mm b/d of takeaway capacity currently being added to the basin, which is expected to be fully operational by the end of this year. Current production in the Permian is close to 4mm b/d, so the combined incremental new pipe will provide considerable room for production growth into the 2020s. Exxon’s pipeline expansion – undertaken with Plains All American and Lotus Midstream – was announced in January, just before the company proceeded with its final investment decision (FID) to expand the capacity of its Beaumont, TX, refinery by 250k b/d to 616k b/d. The new capacity is expected to come online in 2022, and will make Beaumont the largest refinery in the U.S. The refinery expansion will take in light-sweet crude from the Permian, where Exxon plans to triple production to 600k b/d by 2025.2 These announcements are not one-offs: Permian production, and shale-oil output generally, is booming. In the Permian, oil output rose just over 800k b/d last year, according to the U.S. EIA (Chart of the Week, panel 1). Overall U.S. shale output in the Big 5 basins – Anadarko, Bakken, Eagle Ford, Niobrara and Permian – rose close to 1.5mm b/d in 2018.3 Output growth in the Permian will remain super-charged on the back of the pipeline buildout, and the capex being poured into it as the Majors and large E&P companies industrialize production there, not unlike a manufacturing process. We expect the Permian to lead the development of shale-oil production, driving total crude and liquids growth in the U.S., which last year grew by 2.2mm b/d to reach 19mm b/d by December (Chart of the Week, panel 2). Chart of the WeekBrent Physical Liquidity Continues To Fall Continued investments in state-of-the-art refinery expansions in the U.S. Gulf are expected to continue as well, given the production growth we expect for the Permian, and the pipeline expansions that will take that output to the Houston refining market. Chevron, for example, is expected to close on an acquisition from Brazilian state oil company Petrobras for the 110k b/d Pasadena Refining System, also in the Houston Ship Channel. The company will feed this unit with light-sweet crude from the Permian, which it told analysts this week it expects to grow to 600k b/d by end-2020 and 900k b/d by 2023.4 At present, the U.S. Gulf Coast refining infrastructure cannot absorb all of the light-sweet crude that will be produced in the Permian and the other major basins in coming years. The export markets – particularly the Atlantic Basin, which is home to the physical Brent market – will be absorbing more and more of U.S. light-sweet production in coming years as North Sea production stagnates relative to the U.S. shales (Chart of the Week, panel 3). Output in the U.K. North Sea was at its lowest level since 1973 in 2017, following the price collapse of 2014 – 2017 instigated by the OPEC market-share war launched in 2014. UK output was flattish last year, while Norwegian production was down slightly more than 6% in 2018, bringing it to just under 1.5mm b/d. Drilling activity is picking up this year, along with M&A activity as private equity firms step in to buy properties being sold by the U.S. Majors. As can be seen in the Chart of the Week, production is expected to begin picking up at the end of this year, but base effects from the low levels of late exaggerate the gains in percentage terms. U.S. Crude Exports Set To Soar The North Sea Brent market is arguably the most important crude oil market in the world. It is the underlying physical market for the world’s benchmark crude oil – Brent Blend – against which up to two-thirds of the world’s crude oil prices are indexed.5 Production of the five constituent streams comprising the Brent index – the Brent, Forties, Oseberg, Ekofisk and Troll crudes – has been falling year on year, and one of the streams (Forties) is regularly being exported to Asian refining markets. This has prompted the main price-reporting agencies to consider adding to the constituents of the Brent index, and changing the type of pricing it records.6 At the same time, increasing volumes of WTI light-sweet crude are making their way into the Brent North Sea physical market.7 These export volumes will increase, supported by the buildout of pipeline takeaway and deep-water harbor capacity in the U.S. Gulf, which, when done, will expand the capacity of Gulf ports to accommodate very large crude carriers (VLCCs).8 On the back of these rising exports to the European market, Argus Media, one of the price-reporting agencies, this year began publishing U.S. waterborne pricing assessments as differentials to the ICE Brent futures. According to Argus, slightly over a quarter of the 2.6mm b/d of crude exports out of the U.S. last November went to Europe to compete with North Sea grades like Brent and Forties, two of the Brent index constituents. For the week ended February 22, 2019, the four-week average of crude oil exports from the U.S. was close to 3.1mm b/d, a record for average exports. According to S&P Global Platts, “There have been 48 VLCCs booked for loading out of the USGC so far in 2019 – about five times the amount booked in the first two months of 2018 and a drastic difference to the two VLCCs that were booked during the same period in 2017.”9 Most of the growth in U.S. exports is coming from the shale-oil production boom, which is swelling the volume of light-sweet barrels in the Gulf. While increasing volumes of WTI are making their way into European wet markets, it is too early to call WTI delivered to the Houston refining market (WTI – Houston) a benchmark; it’s more of a reference price for now. All the same, the necessary and sufficient conditions are falling into place for WTI – Houston to become a global benchmark: It has consistent quality; diversity of buyers (refiners and trading companies), sellers (producers and traders), and speculators to provide hedging liquidity to physical-market participants; and, in due course, will have reliable shipping facilities, including ports capable of handling VLCCs and smaller vessels. This last condition is the critical limiting factor at present.10 We expect that, by the early 2020s, the necessary and sufficient conditions will be in place to allow WTI – Houston to become a global benchmark. By that time, we project the U.S. will be exporting in excess of 10mm b/d of crude and liquids, and refined products, with crude exports alone exceeding 5mm b/d by then. Currently, the U.S. exports slightly more than 8mm b/d of crude oil and products (Chart 2). The six largest importers of U.S. crudes are found in the Atlantic and Pacific basins (Charts 3A & 3B). Chart 2U.S. Will Expand Its Lead As Largest Crude and Products Exporter Chart 3AU.S. Exports To Atlantic ... Chart 3B... And Pacific Growing Bottom Line: We expect the Brent vs. WTI crude oil differential to narrow next year, as U.S. light-sweet crude oil exports expand and North Sea production stagnates. On the back of this, we are opening a long WTI vs. short Brent position in 2020. We expect this differential to average $3.25/bbl next year versus current market levels of $6.6/bbl. Canadian WCS Differentials Could Relapse The Western Canadian Select (WCS) differential to WTI YTD contracted to a discount of $10.50/bbl from an average discount of $26.3/bbl in 2018, as the Alberta government’s production curtailment took effect (Chart 4).11 This is allowing Alberta’s excess inventories to start declining, which was one of the primary motivations of the government’s action. Chart 4Government-mandated Production Cuts Reverse Inventory Builds in Alberta Not all the news out of Canada is good for producers, however. An unexpected delay in Enbridge’s Line 3 replacement and expansion puts future Canadian production growth in jeopardy. This will complicate the Alberta government’s plan to stabilize the sound discount to WTI, which is necessary to maintain investors’ confidence in the sector. In our previous analysis of the Canadian oil sector, we assumed the Line 3 replacement project would be completed in the fourth quarter of this year. This is now pushed back by at least 6 months, likely into 2H20.12 The replacement was expected to restore Line 3’s original takeaway capacity of 760k b/d from 390k b/d, and was a crucial input in our Canadian oil output forecasts. The reduction of the production curtailment to ~ 95k b/d in 2H19 previously announced by the Alberta government will not be sufficient to maintain the WCS transportation discount below $15/bbl (Chart 5). Thus, the government most likely will extend part of the ~ 325k b/d mandatory cuts into 2H19. A rollback of the curtailment policy to 95k b/d ahead of the Line 3 replacement would push the differential back above the crude-by-rail range – i.e., a $15-to-$22/bbl discount over the quality discount for heavy sour crude vs. the light-sweet. We expect a combination of production decreases and increased crude-by-rail transport, which will have to go to record levels, could help alleviate the negative pressure on the WCS-WTI discount (Chart 6). For instance, maintaining a 225k-barrel-per-day production curtailment from April to December 2019, combined with an increase in crude-by-rail transport to ~ 460k b/d by year-end would be enough to maintain the discount in our estimated crude-by-rail range (Chart 7).13 Heavy Crude Differentials Will Remain Tight The prolongation of Canadian crude bottlenecks will contribute to keeping heavy-sour vs. light-sweet price differentials tight. Altogether, our expectation of high compliance to the output cuts agreed by OPEC 2.0 countries, which primarily export heavy-sour crudes; larger-than-expected Venezuelan output declines in heavy-sour output; and continued takeaway capacity constraints in Canada will keep the price differentials between light-sweet and heavy-sour crudes tight. This can be seen in the Brent – Dubai spread, which at times, favors the heavy-sour crude streams (Chart 8). Chart 8Heavy-Sour Crude Differentials Tighten As Supply Contracts Bottom Line: The WCS differential vs. WTI is at risk of weakening once again, following the unexpected delay in Enbridge’s Line 3 replacement and expansion. The Alberta government will have to get more deeply involved to keep unconstrained production from hammering the differential once again.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1 Please see “OPEC likely to defer output policy decision until June – sources,” published by uk.reuters.com, March 4, 2019. 2 Please see “Permian Majors Expand Downstream Processing,” published by Morningstar Commodities Research, February 11, 2019. 3 These data were sourced from the EIA’s Drilling Productivity Report for February 2019. 4 See fn 2 above. See also “Chevron, Exxon take turns wooing investors with shale boasts,” published by reuters.com March 5, 2019. 5 This estimate comes from ICE Brent Crude Oil, published by The Intercontinental Exchange (ICE), which runs the Brent futures market. 6 Please see “Viewpoint: North Sea benchmark changes looming” which was published by Argus Media on December 27, 2018. 7 Please see “US waterborne crude trade shifts toward Brent basis” published by Argus Media on February 15, 2019. 8 See, e.g., Carlyle Group’s recently announced involvement in such a venture. Carlyle expects its deep-water buildout to be done in late 2020. 9 Please see “In the LOOP: Record US crude exports boost VLCC tanker demand, rates,” published by S&P Global Platts on March 5, 2019. 10 Please see Liz Bossley’s article “There Can (Not) Be Only One,” beginning on p. 15 of the May 2018 issue of the Oxford Energy Forum – Oil Benchmarks – Issue 113, for a discussion of different oil-price benchmarks. 11 We discuss Canada’s take-away dilemma in our November 29, 2018, publication entitled “The Third Man At OPEC 2.0’s Meeting.” It is available at ces.bcaresearch.com. 12 Please see “Enbridge’s Line 3 pipeline replacement likely won’t be in service until second half of 2020,” published by The Globe and Mail on March 3, 2019. 13 The government intends to increase the production ceiling by 100k b/d by April 2019, this makes the mandatory cuts at 225k b/d from 325k b/d in January 2019. https://www.alberta.ca/protecting-value-resources.asp Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in Summary of Trades Closed in

Highlights Chart 1Track The CRB/Gold Ratio Earlier this year the Fed signaled a dovish policy shift in response to slowing global growth and tighter financial conditions. In large part due to the Fed’s move, financial conditions are now easing and the CRB Raw Industrials index – a timely proxy for global growth – is starting to perk up. But when will this improvement translate to higher Treasury yields? The CRB/gold ratio offers some clues. Gold moves higher when monetary policy eases. Then with a lag, that easier policy spurs stronger global growth and a rising CRB index. Eventually, that stronger growth puts rate hikes back on the table. A more hawkish Fed limits the upside in gold and sends Treasury yields higher. In fact, we find that the 10-year Treasury yield only starts to rise when the CRB index outpaces the gold price (Chart 1). The recent jump in the CRB index is a positive sign, but we shouldn’t expect Treasury yields to rise until the CRB/gold ratio heads higher. In the meantime, investors should maintain below-benchmark portfolio duration and initiate positive-carry yield curve trades (see page 10) to boost returns while we wait for the next upward adjustment in yields. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 59 basis points in February, bringing year-to-date excess returns up to +243 bps. The Federal Reserve’s pause opens a window for corporate spreads to tighten during the next few months. We recommend overweight positions in corporate bonds for now, but will be quick to reduce exposure once spreads reach our near-term targets (Chart 2). Chart 2Investment Grade Market Overview In last week’s report we published option-adjusted spread targets for each corporate credit tier.1 The targets are based on the median 12-month breakeven spreads during prior periods when the slope of the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.2 Currently, the Aa-rated spread of 59 bps is 3 bps above our target (panel 2). The A-rated spread of 91 bps is 6 bps above our target (panel 3). The Baa-rated spread of 156 bps is 28 bps above our target (panel 4). The Aaa-rated spread is already below our target. We advise investors to avoid the Aaa-rated credit tier. With profit growth poised to moderate during the next few quarters, it is unlikely that gross corporate leverage will continue to decline at its current pace (bottom panel). As such, we will be quick to reduce corporate bond exposure when spreads reach our targets. Renewed Fed hawkishness will be another headwind for corporate bonds in the second half of the year. High-Yield: Overweight High-Yield outperformed the duration-equivalent Treasury index by 175 basis points in February, bringing year-to-date excess returns up to +590 bps. In last week’s report we published near-term spread targets for each high-yield credit tier.3 The targets are based on the median 12-month breakeven spreads seen during periods when the yield curve is quite flat but not yet inverted, what we call a Phase 2 environment.4 At present, the Ba-rated option-adjusted spread is 224 bps, 37 bps above our target. The B-rated spread is 376 bps, 81 bps above our target. The Caa-rated spread is 780 bps, 208 bps above our target. Our default-adjusted spread is an alternative measure of high-yield valuation. It represents the excess spread available in the High-Yield index after accounting for expected default losses. It is currently 243 bps, very close to the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast during the next 12 months, high-yield bonds will return 243 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview The Moody’s baseline forecast calls for a default rate of 2.4% during the next 12 months. This appears a touch too optimistic, as our own macro model is calling for a default rate closer to 3.5%.5 In either case, junk bonds currently offer adequate compensation for default risk. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in February, bringing year-to-date excess returns up to +39 bps. The conventional 30-year zero-volatility spread tightened 2 bps on the month, driven by a 5 bps decline in the compensation for prepayment risk (option cost). The fall in option cost was partially offset by a 3 bps widening in the option-adjusted spread (OAS). The recent drop in the 30-year mortgage rate led to a jump in mortgage refinancings from historically low levels, putting some temporary upward pressure on MBS spreads (Chart 4). However, the relatively tepid pace of new issuance during the past few years means that the existing MBS stock is not very exposed to refinancing risk, even if mortgage rates fall further. All in all, we view agency MBS as one of the safest spread products in the current macro environment. Chart 4MBS Market Overview The problem with MBS is that valuation remains unattractive. The index option-adjusted spread for conventional 30-year MBS is well below its average pre-crisis level (panel 3) and the sector offers less compensation than normal compared to corporate bonds (panel 4). We continue to recommend a neutral allocation to agency MBS. An upgrade will only be appropriate when value in the corporate sector is no longer attractive relative to expected default risk. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 38 basis points in February, bringing year-to-date excess returns up to +92 bps. Sovereign debt outperformed duration-equivalent Treasuries by 97 bps on the month, bringing year-to-date excess returns up to +320 bps. Local Authorities outperformed the Treasury benchmark by 54 bps in February, bringing year-to-date excess returns up to +86 bps. Foreign Agencies outperformed by 44 bps in February, bringing year-to-date excess returns up to +109 bps, while Domestic Agencies outperformed by 12 bps on the month, bringing year-to-date excess returns up to +9 bps. Supranationals outperformed by 10 bps in February, bringing year-to-date excess returns up to +13 bps. The USD-denominated sovereign debt of most countries continues to look expensive relative to equivalently-rated U.S. corporate credit. However, in a recent report we highlighted that Mexican sovereign debt is an exception (Chart 5).6 Chart 5Government-Related Market Overview Not only is Mexican sovereign debt cheap relative to U.S. corporate credit, but our Emerging Markets Strategy service highlights that the Mexican peso is very cheap as measured by the real effective exchange rate based on unit labor costs.7 This is not surprising given that the peso has been relatively flat versus the dollar during the past two years, despite real interest rates being much higher in Mexico than in the U.S. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 85 basis points in February, bringing year-to-date excess returns up to +92 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 5% in February, and currently sits at 81% (Chart 6). This is more than one standard deviation below its post-crisis mean and right at the average level that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview In other words, municipal bonds on average are no longer cheap. Rather, they appear fairly valued compared to similar prior macro environments. But a pure focus on the average yield ratio across the curve hides an important distinction. The yield ratio for short maturities (2-year and 5-year) is very low relative to history, while the yield ratio for long maturities (10-year, 20-year and 30-year) remains quite cheap (panel 2). Investors should continue to focus on long-maturity municipal debt to add yield to U.S. bond portfolios. In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of +3 bps. In contrast, municipal bonds have delivered annualized excess returns of +64 bps (before adjusting for the tax advantage).8 Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields rose in February, led by the long-end of the curve. The 2/10 Treasury slope steepened 3 bps on the month and currently sits at 21 bps. The 5/30 slope steepened 1 bp on the month and currently sits at 57 bps. Our 12-month fed funds discounter remains below zero, meaning that the market is priced for rate cuts during the next year (Chart 7). We continue to view rate hikes as more likely than cuts on this time horizon, and therefore recommend yield curve trades that will profit from a move higher in our discounter. In prior research we found that the 5-year and 7-year Treasury maturities are most sensitive to changes in our discounter, so any trade where you sell the 5-year or 7-year bullet and buy a duration-matched barbell consisting of the long and short ends of the curve will provide the appropriate exposure.9 Chart 7Treasury Yield Curve Overview An added benefit of implementing a barbell over bullet strategy in the current environment is that barbells currently offer higher yields than bullets, meaning that you earn positive carry as you wait for the market to price rate hikes back into the curve (bottom 2 panels).10 Not surprisingly, barbell strategies also look attractively valued on our yield curve models, the output of which is found in Appendix B. TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 36 basis points in February, bringing year-to-date excess returns up to +120 bps. The 10-year TIPS breakeven inflation rate rose 11 bps on the month and currently sits at 1.96%. The 5-year/5-year forward TIPS breakeven inflation rate rose 7 bps on the month and currently sits at 2.07%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. After last month’s increase, the 10-year TIPS breakeven inflation rate is currently very close to the fair value reading from our Adaptive Expectations model (Chart 8).11 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ inflation expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value will trend steadily higher as long as core CPI inflation remains above 1.84%. The 1.84% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in the model. Chart 8Inflation Compensation On that note, core CPI has increased at an annual rate of 2.58% during the past four months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 3), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Cut To Underweight Asset-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in February, bringing year-to-date excess returns up to +38 bps. The index option-adjusted spread for Aaa-rated ABS narrowed 8 bps on the month and currently sits at 31 bps, 3 bps below its pre-crisis low (Chart 9). Chart 9ABS Market Overview Our excess return Bond Map, shown in Appendix C on page 18, shows that Aaa-rated ABS offer a relatively poor risk/reward trade-off compared to other U.S. bond sectors. Aaa-rated auto loan ABS in particular offer greater risk and lower potential return than the Aggregate Plus index (the Bloomberg Barclays Aggregate index plus high-yield).  Tight spreads look even more unattractive when you consider that the delinquency rate for consumer credit is rising, and according to the uptrend in household interest expense, will continue to march higher in the coming quarters (panel 4). Lending standards are also tightening for both credit cards and auto loans, a dynamic that often coincides with a rising delinquency rate and wider ABS spreads (bottom panel). Given the recent spread tightening, we advise investors to reduce consumer ABS exposure in U.S. bond portfolios. Other sectors, such as Agency CMBS, offer a more attractive risk/reward trade-off within high-rated spread product. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in February, bringing year-to-date excess returns up to +142 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 13 bps on the month and currently sits at 93 bps, below the average pre-crisis level but somewhat higher than the recent tights (Chart 10). Chart 10CMBS Market Overview The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (bottom 2 panels). This, coupled with decelerating CRE prices paints a relatively negative picture for non-agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Teasury index by 49 basis points in February, bringing year-to-date excess returns up to +77 bps. The index option-adjusted spread tightened 8 bps on the month and currently sits at 48 bps. The excess return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. 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. At present, the market is priced for 2 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Chart 11The Golden Rule's Track Record We can also use our Golden Rule framework to make 12-month total return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the change in the fed funds rate. 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. 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 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. 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 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of February 28, 2019) Table 5Butterfly Strategy Valuation: Standardized Residuals (As of February 28, 2019) 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 Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 7 Please see Emerging Markets Strategy Weekly Report, “Dissecting China’s Stimulus”, dated January 17, 2019, available at ems.bcaresearch.com 8 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 9  Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 10 Please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 11 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018 available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights It was easy to upgrade equities to overweight at the beginning of the year, … : The fourth-quarter selloff had reduced the S&P 500’s forward four-quarter multiple to 13.6 at its trough, and we never shared the market’s fear that the Fed was one false move from triggering a recession. … but what should someone who sat out January’s and February’s moves do?: Is it worth buying stocks now, after they’ve risen 10% since our upgrade, and 18% since the Christmas Eve bottom? Wait, in our opinion, but it’s not an easy answer: We find it hard to believe that the S&P 500 is going to go straight back to its late-September highs, reversing the fourth-quarter swoon in a mirror-image first-quarter blast. Our best guess is that the bull market is not yet over, but we think its upside is limited: It’s hard to see a bear market materializing in the absence of a recession, and the Fed’s pause has likely pushed the next one out to the second half of 2020 at the earliest. The potential gains are not unlimited, however, and an inflation-wary Fed will eventually cut off the bull’s oxygen. Feature Take two dozen opinionated people with backgrounds in markets and economics and scatter them around a boardroom table. Introduce the day’s key global economic data releases, market activity, corporate news, and geopolitical developments as potential discussion topics. Have the moderator remain alert for points of contention and seek to intensify them at every opportunity. Add four or five months of the worst winter weather North America’s got to offer, this side of Winnipeg and International Falls, Minnesota, and stir. If only economists were more telegenic, or Canadians could credibly be as unpleasant as their neighbors to the south, that might be the elevator pitch for a can’t-miss reality show. Instead, it’s the recipe for BCA’s daily morning meetings, and not one of its hard-working participants is likely to be able to use it as a step on the path to celebrity riches. It is a path to getting better at analysis and reasoning, however, and an ideal forum for stress-testing economic or market hypotheses. It can also furnish research ideas, as it did for us last week. “Let’s say you have a client who missed the equity run-up in January and February. What would you recommend s/he do now?” one of our colleagues called out to us late in Tuesday’s session. Someone else jumped in before we could reply, the thread was lost, and the meeting broke up so everyone could get back to their own research priorities. Had we gotten to reply, we would have recommended that the client wait for a better entry point, and this week’s report is devoted to explaining why, in the simplest back-of-the-envelope terms. How Much Can S&P 500 Earnings Grow? When analyzing equities, we like to decompose them into their component parts: forward earnings and the multiple investors are willing to pay for them. In the hall of mirrors as described in Keynes’ newspaper-beauty-contest metaphor,1 what matters for our purposes in projecting S&P 500 earnings is less what will happen, or what our own earnings models might project will happen, than what the analyst consensus thinks will happen. The consensus estimate of calendar 2019 S&P 500 earnings per share (EPS) is currently $168.37, a modest 4% increase over calendar 2018 EPS. This is a conservative estimate, relative to history, given that S&P 500 operating EPS have grown at an average rate of 8% over the last 40 years (Chart 1). Chart 1Outside Of Recessions, Earnings Typically Grow It is also conservative given the pattern earnings estimates have followed across the five bull markets that have occurred in the 40 years since estimates began to be compiled. We have previously observed that equity bull markets tend to sprint to the finish line. On average, they begin by being blasted out of a cannon, sharply cool off in the second quintile, and build back up in the third and fourth quintiles, before retrenching ahead of a latter-stages surge (Chart 2). The earnings estimate pattern is jumpier. Forward estimates stumble out of the first-decile gate before rising at a double-digit rate over the rest of the first half, then slow sharply to the first decile’s pace in preparation for posting their most potent growth in the final decile (Chart 3). Disaggregating the individual bull markets’ performance shows that the overall last-decile performance is not the product of a couple of outlier readings. In all but the December ’87 – July ’90 bull market that ended with flatlining estimates, estimated forward four-quarter earnings growth in the final decile of the bull market comfortably exceeded mean growth across the full bull market (Chart 4). Chart 4Optimistic At The Very End Analysts’ 2019 estimates additionally look low because median corporate revenue growth ought to converge with nominal GDP growth over time. With 40 basis points of fiscal stimulus slated to be deployed in 2019, we expect the U.S. will have no trouble growing above its 2 – 2.25% trend. Assuming GDP growth at the top of that range, no change in profit margins, share buybacks to reduce outstanding share count by 2%, and 2% inflation, the S&P 500 should be able to grow EPS by 6.25%. The 2.25% difference between the consensus estimate and the back-of-the-envelope projection aligns with corporations’ desire to manage analyst expectations. If the S&P 500 can grow earnings at a rate of 6.25% this year, calendar 2019 EPS would come in at $172.13. The default estimate for the following year would be the mean of historical EPS gains, or about 9%. Applying a 2% lower-the-bar haircut, corporate management teams might guide to 7% growth in 2020. Grossing up our estimated calendar 2019 earnings by 7% yields projected calendar 2020 earnings of $184.17 (Table 1). Table 1Estimating Consensus Expectations For Calendar 2020 S&P 500 EPS What Multiple Might Investors Pay? Estimating a plausible forward multiple is more of a challenge than coming up with a reasonable consensus S&P 500 EPS estimate. Multiples, like all market prices, are dictated in large part by emotion, which often defies prediction. We can make some inferences from the 40-year history of forward multiples nonetheless. That history suggests that the current 16.5 multiple is elevated, but not worryingly so, as it is only a little more than half of a standard deviation above the mean (Chart 5). Chart 5Elevated, But Not Stretched Multiple movements have followed a pattern across the last five bull markets, but their moves are much more volatile than moves in forward estimates, which never decline in a bull market. Broadly, multiples explode higher at the start, plateau, and then retrace some of their initial gains (Chart 6). Their growth pattern inflects higher in the second half before peaking near the end of the bull market and rolling over into the finish. The broad pattern applies to all of the bull markets except the October ’02 – October ’07 bull, in which the multiple peaked in the third decile before sinking for much of the rest of the way. Chart 6Multiples Usually Follow A Well-Defined Pattern Aggregating the multiple moves by decile shows the pattern with more clarity (Chart 7). A burst of re-rating in the first decile signals the beginning of the bull market. The multiple goes on to retrench through the fourth decile and then expands at a double-digit annualized rate until it runs out of steam at the beginning of the final decile. The empirical takeaway is that investors shouldn’t look for much in the way of multiple expansion over the rest of the bull market, and we therefore apply a 16.5 multiple to our $184.17 estimate of forward four-quarter earnings a year from now, yielding an S&P 500 target of 3,040. Mapping A Course Using forward four-quarter earnings four quarters out to develop our price target shows that we do not expect the S&P 500 to surpass its late September highs anytime soon. We have marveled at the way the index has moved straight up since its Christmas Eve bottom, and have been waiting for it to reveal the top of a tradeable range. We thought 2,640, which had marked a triple-bottom in October and November’s turbulence, might present some resistance, and then perhaps 2,700, but the S&P went through both levels like a warm knife through butter (Chart 8). This week’s action suggests that 2,800 – which was a significant level throughout much of 2018 – just might mark the top for a little while. Chart 8Trying To Find The Top Of The Range Our recommendation to an investor who spent January and February underweight equities is therefore to wait. It’s also our recommendation to anyone seeking to add more exposure. As for investors seeking to reduce exposure, the action Friday as we were going to press seemed to suggest that the current levels around 2,800 are a good place to lighten up on equity holdings. If we’re wrong, an investor could buy out-of-the-money calls, which are not too onerously expensive now that the VIX is back below 15, though we almost always think the insurance offered by options is cost prohibitive for investors who are judged on a relative-return basis. Closing Thoughts We are devoted followers of long-term-oriented investors with long-term records of success who are willing to share aspects of their approach in print or in public appearances. We avidly read Warren Buffett’s annual letter to Berkshire Hathaway shareholders this week, and were delighted to discover a transcript of Charlie Munger’s Q-and-A session with shareholders at the privately-held Daily Journal Corporation’s annual meeting. Howard Marks has been a particular favorite of ours over the years, and this exercise provided confirmation of his view that bull markets end when conditions appear to be at their very best. In line with the Buffett view that investors should be fearful when others are greedy, Marks has argued that bull markets are done in by too much optimism. The tendency for earnings estimates to grow at their most rapid pace in the final stages of a bull market supports Marks’ position. It seems improbable on its face that corporate earnings would make their biggest move at the end of the cycle (Chart 3). The fact that the growth in actual operating earnings tends to peak well before the end of the business cycle (Chart 1) suggests that analysts – and the corporate management teams whose guidance provides the starting point for their earnings models – get lulled to complacency by the successes in the rear-view mirror. In that sense, it may be good for equities that expectations are so beaten down now. Perhaps this bull market will not end until managers, analysts and investors get at least a little bit euphoric.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 In his General Theory of Employment, Interest and Money, Keynes compared financial markets to a newspaper contest in which every contestant chooses the six most attractive people from a set of one hundred head shots. The winner is the contestant whose choices best align with the most attractive photos as selected by all of the entrants. Sophisticated contestants don’t bother with the faces they consider to be the most attractive, but with the faces that best align with conventional notions of attractiveness. “It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects average opinion to be.”

Highlights Trade talks have been the primary driver of the rally in Chinese stocks and China-related assets over the past five months. While trade is important to China’s economy, Chinese domestic demand is the primary driver of China-related asset fundamentals, meaning that the recent equity rally has occurred on the back of a largely false narrative. The January surge in credit has brought the first concrete sign that Chinese domestic demand will eventually bottom, but the current pace of money & credit growth suggests that investable earnings are facing a “catch up” period of potentially material weakness. The need for a stabilization in the outlook for earnings argues against an immediate shift to overweight, but we agree that investors should put Chinese investable stocks on upgrade watch for the coming few months. Feature Chart 1 reviews the recent performance of the Chinese investable equity market, and highlights two important facts: Chinese equity performance bottomed in both absolute and relative terms at the end of October, and The relative performance trend versus global stocks has now retraced roughly 40% of the decline that occurred in 2018 Chart 1A Sizeable Retracement, Based On A (Largely) False Narrative For investors looking for an appropriate allocation to Chinese stocks and China-related assets more generally over the coming 6-12 months, it is important to understand what has driven this post-October outperformance. In our view, it is only the January surge in credit growth that has brought the first concrete sign that Chinese domestic demand will eventually bottom, meaning that China plays have been rallying for the past five months on a largely false narrative. This significantly complicates the cyclical investment outlook, even under the assumption of an imminent trade deal with the U.S. As we will detail below, several factors argue against an immediate shift to overweight, but we agree that investors should put Chinese investable stocks on upgrade watch. We will be watching closely over the next few months for confirmation that above-average credit growth will be sustained, and that the outlook for Chinese earnings is stabilizing. Dissecting The Rally: Mostly Driven By Trade Optimism, Not Easing During the week of October 29th, the equity market was buoyed somewhat by a statement emerging from the late-October politburo meeting. The statement cited the need for the government to take “more timely steps” to counter increasing downward pressure on the economy, which catalyzed a 6% bounce in investable stocks (3% for the domestic market) by Thursday, November 1st. However, to most investors, news of a much more significant event came on Friday, November 2nd: President Trump was looking to make a deal with China at the late-November G20 meeting in Argentina, and had asked key officials to begin drafting potential terms.1 The investable market rallied over 3% on the day in response to the news, and continued to rise until Monday December 3rd, the day after the 3-month trade talk agreement was struck. Chart 1 shows that while investible stocks nearly hit a new 2018 low in December, this was due to a significant sell off in global stocks: relative performance was flat during this period, and resumed its uptrend once global stocks began to rise. Chart 2 provides confirmation that trade talks have been the primary driver behind the rally in China-related assets as well. The chart shows the BCA Market-Based China Growth Indicator alongside a diffusion index of its 17 components, with the vertical line denoting the point where the prospect of a deal became public. The Fed’s shift to a more dovish posture following its December rate hike has certainly helped propel the global rally in risky assets, but Chart 2 makes it clear that a shift in the outlook for trade between the U.S. and China has been the more important factor driving the prices of China-related assets over the past few months. Chart 2Trump's Desire For A Deal Was The Turning Point For The Market In terms of its relative importance for the Chinese economy, the focus of investors on trade is mostly wrongheaded. Trade is important to China’s economy, but the domestic demand trend is a far more important driver for the fundamental performance of China-related assets. We have highlighted over the past year that investor attention has been focused on the wrong factor, underscoring the rally in Chinese stock prices over the past few months has been driven by a largely false narrative. From Trade, To Credit Chart 3 compares our leading indicator for the Chinese economy with a measure of coincident economic activity, and highlights that the sharp slowdown in growth that has occurred over the past few months represents a reversion to a level that would be more consistent with that of our leading indicator (which has been pointing to weaker economic activity for the better part of the past 18 months). In fact, Chart 3 implies that actual growth is still stronger than what monetary conditions, money, and credit growth would imply, meaning that a further slowdown should be expected over the coming several months. Chart 3Economic Activity Is Recoupling With Our Leading Indicator However, judging by January’s credit release, this further slowdown in growth may occur against the backdrop of a durable uptrend in our leading indicator. Our calculation of adjusted total social financing grew by nearly 5 trillion RMB in January, a very substantial rise that has seldom occurred over the past few years (Chart 4). Legitimate questions about the seasonal effects of the Lunar New Year remain, but Chart 5 shows that the January data was large enough to cause a visible tick higher in the YoY growth rate, caused a sharp rise in our ratio of new credit to GDP, and occurred alongside an easing in the contraction of shadow credit as a percent of total credit. These are clear signs that reluctant policymakers are responding to the need to stabilize a weak economy. Chart 4A Very Strong Surge In January Credit...Chart 5...Has Led To A Visible Uptick In Annual Growth The magnitude of the January surge suggests that there is now a legitimate basis to forecast an eventual bottom in Chinese domestic demand. Our December 5 Weekly Report outlined our key views for 2019,2 and in it we noted that “our base case view is that growth will modestly firm in the second half of 2019, which would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China”. The odds of a firming in growth have certainly gone up as a result of January’s data, although it remains unclear how strong the upturn in credit growth will ultimately be over the course of 2019. This, along with the desynchronizing effect of trade front-running and a truce-driven rally in Chinese stocks, significantly muddles the 6-12 month investment strategy outlook. From Credit, To Investment Strategy We noted in our December key views report that a tactical overweight stance towards Chinese stocks was probably warranted over the coming three months, in recognition of the fact that investors could bid up the market in the lead-up to a possible trade deal with the U.S. We argued that the conditions for a cyclical overweight stance (6-12 months) were not yet present but could emerge sometime this year, particularly if money & credit growth begin to pick up. Is the January surge in adjusted total social financing a sign that investors should increase their allocation to Chinese equities today? We agree that investors should put Chinese investable stocks on upgrade watch for the next few months, but three factors continue to argue against an immediate shift: Investors appear to have bid up Chinese stocks assuming not only that the trade deal with the U.S. will occur, but that it will result in a durable resolution to the dispute (including, presumably, the rolling back of all tariffs that have been imposed). Even under the assumption that a deal does occur, it may be less comprehensive than investors are assuming and could still cause some lasting negative implications for global trade. While the odds of a credit overshoot have legitimately risen,3 January’s credit number is only one data point and the month-over-month change in credit is always abnormally strong in the first month of the year. At a minimum, investors should wait until the February credit data is released in mid-March to judge whether a higher pace of credit growth will be sustained over the course of the year. The recent quarrel between Premier Li Keqiang and the PBOC over whether the January credit spike represented “flood irrigation-style” stimulus suggests that policymakers are still somewhat reluctant to significantly boost credit,4 underscoring the need to monitor whether the recent pace of growth will be sustained. As first highlighted in Chart 3 above, the inflection point in credit growth implies that economic activity will improve at some point in the months ahead, but the current pace of money & credit growth suggests that both activity and, crucially, the level of earnings are facing a “catch up” period of potentially material weakness before they durably bottom. Chart 6 illustrates this potential weakness by comparing the current circumstance of our leading economic indicator, our measure of coincident economic activity, and the level of forward earnings to the 2015/2016 episode. The chart shows that by comparison to today, the 2015/2016 episode had clearer sequencing: our leading indicator fell, coincident activity followed, and stock prices bottomed only once forward earnings had contracted materially. Chart 6In 2015/2016, Our Leading Indicator Led Activity, Earnings, And Relative Stock Performance This time around, our leading indicator peaked in Q1 2017, but activity remained stronger than our indicator would have suggested even though it peaked relatively soon afterwards. Incoming data over the past three months suggest that economic activity is now catching up to the downside, and forward earnings remain elevated. Chart 7 shows that Chinese net earnings revisions remain firmly in negative territory, at levels that have been historically been associated with contracting forward earnings growth. Chart 7Earnings Weakness Looks Set To Continue Panel 4 of Chart 6 is emblematic of the fact that the recent rally in Chinese relative performance, driven largely by a false narrative, has significantly complicated the cyclical investment outlook. If the January improvement in credit had instead come in late October when Chinese relative performance was near its low, it would have been much easier for us to recommend that investors move to an overweight stance in response to a legitimate fundamental improvement and to take the risk of being somewhat too early. Now, a razor sharp focus on the earnings outlook is necessary, and we are unlikely to recommend an increased allocation to Chinese stocks unless that outlook stabilizes. Table 1 presents one of the tools that we will be using to judge the outlook for earnings, based on a model that we presented in two recent reports.5 The table shows a series of earnings recession probabilities that are based on a variety of credit and exchange rate scenarios and conditional on a material improvement in Chinese exporter sentiment. Light colored cells represent an earnings recession probability of less than 1/3rd, and the circled cell shows roughly where we would be today if the new export order component of the NBS manufacturing PMI were to rise sharply back to its June 2018 level. Table 1Credit Needs To Rise Further And RMB Appreciation Needs To Slow For The Earnings Outlook To Stabilize The table makes two key points. First, even given January’s surge, new credit will have to improve relative to GDP over the coming months in order to stabilize the earnings outlook. Second, the more that China’s currency appreciates in response to a trade deal with the U.S., the higher the hurdle rate for credit. Chart 8 shows that CNY-USD is already deviating quite significantly from the level implied by interest rate differentials, suggesting that significant further currency appreciation may not be in the cards. But the bottom line for investors is that a rising currency has the potential to negate some of the reflationary effects of stronger credit, and is a risk that must be monitored alongside the effort to gauge the sustainable rate of credit growth. Chart 8While Policymakers Or Rate Differentials Drive CNY-USD Over The Coming Year? Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Footnotes 1 Please see “Trump Said To Ask Cabinet To Draft Possible Trade Deal With Xi”, dated November 2, 2018, available at Bloomberg News 2 Please see China Investment Strategy Weekly Report “2019 Key Views: Four Themes For China In The Coming Year”, dated December 5, 2018, available at cis.bcaresearch.com. 3 Please see China Investment Strategy and Geopolitical Strategy Special Report “China: Stimulating Amid The Trade Talks”, dated February 20, 2019, available at cis.bcaresearch.com. 4 Please see “Chinese Premier In Rare Spat With Central Bank”, Financial Times. 5 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks”, dated January 16, 2019, and Weekly Report “A Gap In The Bridge”, dated January 30, 2019 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Low Bond Volatility: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan, are likely to stay range bound. USTs vs Bunds/JGBs: Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars. Feature Bond Yields Are In Winter Hibernation Developed market (DM) government bonds, never the most exciting of asset classes to begin with, have become boring of late. While benchmark 10-year yields since the end of January have moved in line with our recommended country allocations - lower in Germany (-7bps), Japan (-3bps), the U.K. (-5bps) and Australia (-11bps) where we are overweight, higher in the U.S. (+5bps), Canada (+2bps) and Italy (+19bps) where we are underweight – government bonds have settled into trading ranges and lack direction. The proximate trigger for the muted yield volatility was the Federal Reserve shifting to a neutral stance on U.S. monetary policy in January. Investors have priced out any possibility of a Fed rate hike over the next year, and now even discount a modest rate cut, according to the U.S. Overnight Index Swap (OIS) curve. Yet while most of the attention for bond investors have been focused on the U.S., there are developments in other major economies that are also depressing yields – namely, weakening economic momentum and sluggish inflation. In particular, the downturn has shown no signs of stabilizing in the eurozone and Japan, with the latest readings on manufacturing PMIs now below the 50 line, signaling a contraction (Chart of the Week). The latest data in both regions still shows that core inflation is nowhere near the inflation targets of the European Central Bank (ECB) and Bank of Japan (BoJ). The story is much different in the U.S, with the manufacturing PMI still well above 50 and core inflation hovering close to the Fed’s 2% inflation target. Yet Treasury yield volatility has collapsed, with the MOVE index of Treasury options prices now back to the lows of this cycle. Chart Of The WeekAre Treasuries Leading Or Following? For the time being, non-U.S. factors are driving the direction of global bond yields. We think that will change later this year, as steady U.S. growth and surprisingly firm U.S. inflation readings will prompt the Fed to begin hiking rates again. Yet until there are signs that non-U.S. growth is stabilizing, the low yields in Europe and Japan will act as an anchor on U.S. Treasury yields, particularly given how wide U.S./non-U.S. yield differentials already reflect faster growth and inflation in the U.S. Decomposing Treasury-Bund & Treasury-JGB Spreads When looking at the pricing of the “Big 3” DM government bond markets – the U.S., Germany and Japan – there are some major differences but also some similarities as well. Even with the benchmark 10-year U.S. Treasury sitting at 2.68% compared to a mere 0.11% and -0.03% on the 10-year German Bund and 10-year Japanese government bond (JGB), respectively. Simply looking at the breakdown of those nominal 10-year yields into the real and inflation expectations components, there is not much of a comparison (Chart 2). The real 10-year Treasury yield is in positive territory at 0.6%, compared to -1.4% and +0.2% for JGBs and German bunds, respectively. Inflation expectations, measured by 10-year CPI swap rates, are 2.1% in the U.S., 1.5% in Germany and 0.2% in Japan. Thus, the current wide 10-year Treasury-Bund spread (just under +260ps) can be broken down into a real yield spread of +200bps and an inflation expectations gap of +60bps. In the case of the 10-year Treasury-JGB spread (just under +270bps), that breaks down into a real yield differential of +80bps and an inflation gap of +190bps. Chart 2Big Differentials Here... So while the Treasury-Bund and Treasury-JGB spreads are of similar magnitude, the valuation components driving the spread are much different. The former is more of a real yield gap, while the latter is more of an inflation expectations gap. That is no surprise given the BoJ’s Yield Curve Control policy that maintains a ceiling on the 10-year JGB yield of between 0.1% and 0.2%, limiting how much real yields can move (there are no BoJ restrictions on the level of CPI swap rates). Yet the U.S.-Japan inflation expectations gap is not too far off the spread between realized headline and core inflation measures in both countries - both are 1.4 percentage points higher in the U.S. as of January. Looking at other valuation metrics, the cross-county differentials are less pronounced (Chart 3). Chart 3...But Less So For Other Yield Measures Yield curves are quite flat, with the 2-year/10-year slope a mere +16bps in the U.S., +14bps in Japan and only +66bps in Germany. Our estimates of the term premia on 10-year government debt are negative for all three markets, most notably in the countries that have seen quantitative easing in recent years (-10bps in the U.S., -90bps in Germany and -60bps in Japan). Perhaps most importantly, our preferred measure of the market pricing of the real terminal policy rate – the 5-year OIS rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is +0.2% in the U.S., -0.5% in Germany and 0.0% in Japan. That means the market is pricing in only a +70bp differential, in real terms, between the neutral policy rates of the Fed and ECB. That gap is only +20bps between market pricing of the neutral real rates for the Fed and BoJ. That narrower gap between the market-implied pricing of the real neutral rate is consistent with the theoretical macroeconomic drivers of real rate differentials, like growth rates of potential GDP and labor productivity. According to OECD estimates, potential GDP growth is 1.8% in the U.S., 1.5% in the overall euro area and 1.2% in Japan (Chart 4). This implies a long-run real yield gap between the U.S. and Germany of +60bps and the U.S. and Japan of +30bps – very close to the market pricing for the real terminal rate differentials.1 When looking at the 5-year annualized growth rates of labor productivity data from the OECD, there is no difference between the three regions with all growing at a mere 0.5% (suggesting that either a faster growth rate of the labor input, or greater productivity of capital, accounts for the higher potential growth rate in the U.S.). Chart 4No Major Differences In Long-Run Real Growth With the cross-country yield spreads now effectively priced for the long-run real growth differentials between the U.S. and Europe/Japan, this will limit the ability for nominal Treasury-Bund and Treasury-JGB spreads to widen much further. Right now, U.S. inflation expectations are rising faster than those of Europe and Japan, in response to the Fed’s more dovish stance. Yet if those expectations continue to rise, likely in the context of stickier realized U.S. inflation alongside solid U.S. growth, then the Fed will return to a hawkish bias. That ultimately means higher U.S. real yields and, most likely, some pullback in U.S. inflation expectations since the markets would begin to price in the implications of the Fed moving to a restrictive policy stance (including a stronger U.S. dollar that will help dampen U.S. inflation, at the margin). So that means inflation differentials between the U.S. and Germany/Japan can move wider now but will narrow later; and vice versa for real yield differentials (narrower now and wider later). The main investment implication: nominal UST-Bund and UST-JGB spreads are unlikely to move much wider, likely for the remainder of this business cycle/Fed tightening cycle. The main takeaway is that bond yields in core Europe and Japan are effectively anchoring global yields, in general, and U.S. yields, in particular. Treasury yields will not be able to break out of the current narrow trading ranges until there are signs that growth has stabilized in Europe and Japan. Reduced global trade tensions and faster Chinese growth (and import demand) are necessary conditions to reflate the export-heavy economies of Europe and Japan. Yet even if that scenario does unfold in the months ahead (which is BCA’s base case scenario), there is still a case to prefer Bunds and JGBs over U.S. Treasuries on a currency-hedged basis in U.S. dollars. Given the wide short-term interest rate differentials between the U.S. and Europe/Japan, those near-zero 10-year Bund and JGB yields, after hedging into U.S. dollars, are actually higher than 10-year Treasury yields, which benefits the relative hedged performance of the low-yielders versus the U.S. (Chart 5) Chart 5Stay Overweight Bunds & JGBs Vs. USTs (Hedged Into USD) Thus, we continue to recommend an overweight stance on core Europe and Japan, versus an underweight tilt on the U.S., in global U.S. dollar-hedged government bond portfolios. Bottom Line: Weakening non-U.S. growth and a more dovish Fed have crushed global government bond volatility, especially in Europe and Japan where yields are struggling to stay above 0%. Treasury-Bund and Treasury-JGB spreads, which now largely reflect long-run real growth differentials between the U.S and Europe/Japan are likely to stay range bound. Stay overweight Bunds & JGBs versus Treasuries, on a hedged basis in U.S. dollars, given the boost to returns from hedging into higher-yielding dollars.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com    Footnotes 1      We are using the full euro area data for these economic comparisons, even though we are discussing U.S.-German yield differentials in this report. We think this is reasonable given the status of German government bonds as the benchmark for the euro area, and with the ECB setting its monetary policy for the overall euro area. The differences between the data for Germany and the overall euro area are modest, with German potential GDP and 5-year productivity growth both only 0.3 percentage points higher. 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 Portfolio Strategy The ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency financial market data and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector. Leading indicators of chip end-demand are flashing green, at a time when the chip liquidation phase is clearing excess supplies. It no longer pays to be bearish the S&P semiconductors index.             Recent Changes Lift the S&P semiconductors index to neutral today; it is now also on upgrade alert. Table 1 Feature The SPX continued to grind higher last week, and is now within reach of the key 2,800 level. We expect stiff resistance to persist at that mark; 2,800 has served as a barrier on several occasions last year as we highlighted in recent research (please refer to Chart 1 from the January 28 Weekly Report).1  Year-to-date, we have identified three pillars that would propel the market higher – a more dovish Fed alongside a softer U.S. dollar, a year-over-year increase in SPX EPS for calendar 2019 and a positive resolution to the U.S./China trade spat. As the S&P 500 has come full circle and returned to the early December level, this slingshot recovery suggests that there is positive progress on all three pillars. However, our sense is that the bond market now has to remain tamed in order to cement these equity market gains and vault to fresh all-time highs, likely in the back half of the year. Chart 1 highlights this goldilocks macro backdrop. Chart 1Staying Divorced For A While In other words, as U.S. GDP downshifts from last year’s fiscal easing-induced sugar-high back down to trend growth and most importantly avoids recession, equities should excel. Why? Not only will this entice the Fed to stand pat for longer, but the 10-year Treasury yield will also remain on a lower trajectory than previously anticipated. Crudely put, a neither too-hot nor too-cold economic backdrop will allow equities to reflate away. As such, there are high odds that stocks stay divorced from bond yields for a while longer, and we interpret this bond market backdrop as reflationary rather than recessionary. Meanwhile on the Chinese front, following news of the PBoC’s quasi QE that we highlighted in early February as a positive SPX and cyclicals over defensives catalyst,2 it appears that Chinese authorities could not stomach a below 50 print in the Chinese manufacturing PMI for long and are aggressively opening the fiscal taps anew (Chart 2). Chart 2Chinese reflation... This enormous lending/fiscal stimulus complements ongoing monetary easing and the recent PBoC’s quasi QE, and should ensure that the Chinese economy at least steadies. The upshot is that global growth should also stabilize and put an end to its yearlong deceleration (Chart 3).        Chart 3... Should Aid Global Growth In addition, as U.S. and Chinese negotiation teams race to the finish line in order to get some sort of a deal done before the March 1st deadline, it is clear that a positive outcome is already discounted by the stock market as the SPX enjoys one of the best starts to the year in recent memory. Once this trade policy uncertainty permanently dies down, then last year’s worst performing sectors that were hit hard by the trade dispute will turn into this year’s stock market champions (Chart 4). Chart 4Trade War Hit Deep Cyclicals The Most In that light, we reiterate our cyclical over defensive portfolio bent and this week we highlight that a deep cyclical sector stands to benefit greatly from China’s reflation and the apparent resolution of the U.S./China trade spat; another tech subsector weighed down by the trade tussle is also going to enjoy a reversal of fortune and it no longer pays to be bearish. Don’t Write Off Mighty Industrials Year-to-date, industrials stocks are the best performing GICS1 sector, outperforming the SPX by a massive 650bps (Chart 5). While such a breakneck pace is unsustainable and a short term breather is likely, from a cyclical perspective more gains are in store in this still underowned sector. In this report we highlight the top five reasons it still pays to be overweight this deep cyclical sector. Capex upcycle. The capex upcycle theme remains intact and while there has been some softness recently in the national accounts reported investment outlays, it is highly unlikely that spending plans will grind to a halt similar to the late-2015/early-2016 episode (third panel, Chart 6). Capital goods producers have since replenished their cash coffers and remain committed to develop their capital expenditure projects. Importantly, leading indicators of capex corroborate this backdrop; regional Fed surveys suggest that capital outlays will remain firm for the rest of the year (second panel, Chart 6). Chart 6Capex Upcycle Supports Industrials Resurgent credit growth. Loan growth is on fire in the U.S. and commercial and industrial loan growth is leading the pack, galloping higher and breaching the 10%/annum mark. Bankers are providing the needed fuel to bring to fruition industrials capex plans and, given that historically loan growth and relative profit growth have been positively correlated, the current message is upbeat (Chart 7). Chart 7Loan Growth Fueling The Fire Chinese easy policy trifecta: credit, fiscal & monetary. Beyond the positive resolution in the U.S./China trade dispute, China has opened up its central bank liquidity tap to complement ongoing easy monetary policy. Tack on the recent monster loan origination and reaccelerating infrastructure spending and factors are falling into place for a pick up in end demand, which is a boon for U.S. capitals goods producers (Chart 8). Chart 8Heed The Chinese Reflation Message... Upbeat signal from high frequency EM related financial market data. Emerging market stocks have been outperforming the MSCI ACW Index since early-October and even in absolute terms have troughed in late-October. The ultimate leading EM indicator, EM FX, put in a bottom in early September, sniffing out some sort of reflationary impulse. Meanwhile, momentum in the CRB raw industrials commodity index has also troughed, confirming the high-frequency EM data points. As a reminder, industrials stocks and the global commodity complex move in lockstep, and we heed the positive message all these financial market indicators are emitting (Chart 9). Chart 9...EM Financial Variables Concur Downtrodden sector sentiment and compelling valuations. Despite this year’s rebound in industrial equities, sour investor sentiment appears deeply ingrained. Relative EPS breadth and oversold technical conditions are contrarily positive. Relative valuations are also beaten down and still offer a compelling entry point (Chart 10). Even on a forward P/E basis industrials are trading at a 4% discount to the broad market and below the historical average. Finally, industrials profit and revenue expectations for the coming 12-months are forecast to trail the broad market according to the sell-side community. Were our thesis to pan out, these would represent low hurdles for capital goods producers to surpass. Chart 10Underowned And Unloved Nevertheless, there is a key macro variable, the U.S. dollar, that is a risk to our sanguine S&P industrials sector view. Chart 11 shows that the greenback and industrials sector fortunes are tightly inversely correlated. Not only is an appreciating U.S. dollar deflationary for global commodities that are priced in the reserve currency, but it also weighs on industrials P&Ls via negative translation effects. As a reminder, roughly 40% of industrials sales are international. Chart 11Rising Greenback Is A Risk Netting it all out, the ongoing capex upcycle, resurgent credit growth, easy Chinese policy trifecta, upbeat signals from high frequency EM related financial markets and depressed technicals, all suggest that a re-rating phase looms in the S&P industrials sector.         Bottom Line: Stay overweight the S&P industrials sector. The Chip Cycle Is Turning It no longer pays to be bearish chip stocks; lift the S&P semiconductors index to neutral from underweight today. There are high odds that the chip cycle will soon take a turn for the better. Global chip sales have been decelerating for 17 months and are now on the cusp of contraction (Chart 12). Over the past two decades, steep contractions have been associated with recession. Given that BCA’s view does not call for recession this year, it is highly unlikely for global semi sales to suffer a major setback. While we do not rule out a brief and shallow dip below zero similar to the 2011/12 and 2015/16 parallels, leading indicators of global semi sales suggest that a trough is near. Chart 12Global Semi Cycle... Namely, BCA’s Global Leading Economic Indicator (GLEI) diffusion index is in a V-shaped recovery signaling that global growth is close to a nadir (middle panel, Chart 12). Similarly the U.S. dollar is decelerating which is a boon to global growth and conducive to higher global chip sales (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 12). With regard to U.S. domiciled semi producers, a depreciating currency provides tremendous leverage to profits as foreign sourced revenues are roughly 80% of the total or twice as high compared with the SPX. Table 2, shows the one year trailing internationally- and China-derived revenues of the ten largest firms in the S&P semiconductors index, representing over 95% of the index. On a weighted basis, 80% of sales are sourced from overseas, including 36% of total sales coming from China. Clearly, global growth in general and Chinese growth in particular are key drivers of semi top line growth. Thus, any positive U.S./China trade dispute resolution would provide more relief for the S&P semi index. Table 2Semi Sales Geographical Exposure Moreover, electronics activity is an excellent gauge for semi end-demand. The all-important Chinese electronics imports have ticked up recently. In the U.S., consumer outlays on electronics are firing on all cylinders. Taken together, there is tentative evidence that global semi demand will soon bottom (Chart 13). Chart 13...Is Turning Importantly, the global semi inventory liquidation is ongoing and this supply backdrop should help balance the market. Already Asian DRAM prices, our pricing power gauge for the semi industry, are contracting, underscoring that the semi market is clearing (second & third panels, Chart 14). Importantly, global semi billings that tend to lead global semi sales by a few months have also ticked higher of late (top panel, Chart 14). Chart 14Improving Supply/Demand Dynamics Unfortunately, none of these positive catalysts are picked up by sell-side analysts. In fact, despite the recent rebound in relative share prices, 12-month forward EPS and revenue expectations remain in free fall. Net EPS revisions are as bad as they get, and have sunk near previous troughs that have coincided with durable relative share price rallies (second panel, Chart 15). Chart 15Analysts Have Thrown In The Towel On the relative technical and valuation fronts, pessimism reigns supreme. Our Technical Indicator hovers near one standard deviation below the historical mean and our Valuation Indicator is probing all-time lows. Interestingly, the S&P semi index sports a higher dividend yield than the SPX currently, underscoring that semi stocks are cheap (Chart 16). Chart 16Compelling Valuations And Technicals Our Chip Stock Timing Model (CSTM) does an excellent job in capturing all these moving parts and is currently sending a bullish signal (Chart 17). We heed the signal from our CSTM and are compelled to lift exposure to neutral. Chart 17Prepare To Deploy Capital Bottom Line: Lift the S&P semiconductors index to neutral and it is now also on our upgrade watch list; we are looking for an opportunity to boost to overweight on a pullback, stay tuned. Finally, from a risk management perspective we are enticed to increase our trailing stop to 15% in our tactical overweight in the S&P semi equipment index, in order to protect gains. The ticker symbols for the stocks in the S&P semiconductors index are: BLBG: S5SECO – INTC, AVGO, TXN, NVDA, QCOM, MU, ADI, XLNX, AMD, MCHP, MXIM, SWKS, QRVO.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Don’t Fight The PBoC” dated February 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Chart 1Look For Rate Hikes In H2 2019 First things first: The Fed’s rate hike cycle is not over. Last week’s FOMC statement told us that the Fed will be “patient” and Chairman Powell cited slower global growth and tighter financial conditions as reasons to keep the funds rate steady. However, both of those reasons could soon evaporate. With the market now priced for 8 bps of rate cuts during the next 12 months and the dollar off its highs, there is scope for financial conditions to ease and global growth to improve in the first half of the year. According to our Fed Monitor, only tight financial conditions warrant a pause in rate hikes (Chart 1). The economic growth and inflation components of our Monitor (not shown) continue to recommend a tighter policy stance. The message is that if risk assets rally during the next six months causing financial conditions to ease, then all else equal, the Fed will have the green light to re-start rate hikes in the second half of the year. Investors should maintain below-benchmark duration in U.S. bond portfolios. Feature Investment Grade: Overweight Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 183 basis points in January. The index option-adjusted spread tightened 25 bps on the month and currently sits at 127 bps. We upgraded our recommended allocation to corporate bonds three weeks ago because spreads had become too wide given the current phase of the credit cycle.1 Presently, we observe that the 12-month breakeven spread for Baa-rated corporate bonds has been tighter 43% of the time since 1989 (Chart 2). In the phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and 50 bps, corporate breakeven spreads are typically in the lower third of their distributions.2 Chart 2Investment Grade Market Overview Baa-rated bonds currently offer better value than higher-rated credits. The 12-month breakeven spread for A-rated debt has been tighter 29% of the time since 1989 (panel 2). Aa and Aaa-rated credits clock in at 25% and 4%, respectively. With the Fed in a holding pattern, we are comfortable taking credit risk for the next six months and recommend that investors move down in quality to capture the extra return. The Fed’s Q4 Senior Loan Officer Survey, released yesterday, showed that a net 3% of banks reported tightening lending standards on C&I loans. Tighter lending standards correlate with higher defaults and wider spreads, so this tentative development bears close monitoring going forward.   High-Yield: Overweight High-yield outperformed the duration-equivalent Treasury index by 408 basis points in January. The index option-adjusted spread tightened 103 bps, and currently sits at 416 bps. Our measure of the excess spread available in the High-Yield index after accounting for expected default losses is currently 224 bps, slightly below the historical average of 250 bps (Chart 3). In other words, if corporate defaults match the Moody’s baseline forecast for the next 12 months, high-yield bonds will return 224 bps in excess of duration-matched Treasuries, assuming no change in spreads. Chart 3High-Yield Market Overview Moody’s revised its baseline 12-month default rate forecast higher last month, from 2.6% to 3.4%, and as was discussed in last week’s report, the revised forecast looks reasonable given our economic outlook.3 Specifically, our measure of nonfinancial corporate sector gross leverage – calculated as total debt over pre-tax profits – is roughly consistent with a 4% default rate. This leverage measure improved rapidly during the past year, but should start to stabilize during the next few quarters as profit growth decelerates. All in all, baseline default rate expectations have moved higher in recent months, but junk spreads still offer adequate compensation for that risk. In fact, if we assume excess compensation equal to the historical average, then junk spreads embed an expected default rate of 3% (panel 4), not far from the Moody’s base case. While junk spreads offer adequate compensation given our 12-month default outlook, the near-term outlook for excess returns is somewhat brighter as the Fed’s dovish turn should lead to spread compression during the next few months. MBS: Neutral Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 32 basis points in January. The conventional 30-year zero-volatility spread tightened 3 bps on the month, driven by a 3 bps decline in the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat. The drop in the 30-year mortgage rate to 4.46%, from 4.94% in November, led to a sharp spike in mortgage refinancings. However, refi activity remains very low relative to history (Chart 4). With the longer-run uptrend in mortgage rates still intact, the recent spike in refinancings is bound to reverse in the coming months. This will keep MBS spreads capped near historically low levels. Chart 4MBS Market Overview Outside of refi activity, MBS spreads are also influenced by changes in mortgage lending standards. The Federal Reserve’s Senior Loan Officer Survey showed no change in residential mortgage lending standards in Q4 2018 (bottom panel), while reported mortgage demand took a significant dip. Periods of tightening lending standards tend to coincide with MBS spread widening, but faced with weaker demand banks are much more likely to ease standards going forward. This is particularly true because very little progress has been made easing lending standards since the financial crisis. The median FICO score for new mortgages peaked at 781 in Q1 2011, but had only fallen to 758 as of Q3 2018. With relatively little risk of spread widening we are comfortable with a neutral allocation to Agency MBS, though tight spreads make the sector less appealing than corporate bonds from a return perspective. Later in the cycle, when the risk of corporate spread widening is more pronounced, MBS will likely warrant an upgrade. Government-Related: Underweight The Government-Related index outperformed the duration-equivalent Treasury index by 53 basis points in January. Sovereign debt led the way, outperforming the Treasury benchmark by 221 bps. Foreign Agencies outperformed by 65 bps, Local Authorities outperformed by 32 bps, and Supranationals outperformed by 3 bps. Domestic Agency bonds were the sole laggard, underperforming Treasuries by 3 bps on the month. The Fed’s pause and the accompanying weakness in the dollar spurred last month’s outperformance of USD-denominated Sovereign debt. But given the current attractiveness of U.S. corporate credit, we are not eager to chase the outperformance in Sovereigns. The option-adjusted spread advantage in Baa-rated U.S. corporate credit relative to the Sovereign index is as wide as it was in mid-2016 (Chart 5), a period when corporate bonds outperformed Sovereigns by a significant margin. Chart 5Government-Related Market Overview At the country level, our analysis of USD-denominated Emerging Market Sovereign spreads shows that only Argentina, Mexico, Saudi Arabia, Qatar, UAE and Poland offer excess spread compared to equivalently-rated U.S. corporates.4 We continue to view the Local Authority sector as very attractive. The sector offers similar value to Aa/A-rated corporate debt on a breakeven spread basis (bottom panel), and it is also dominated by taxable municipal securities that are insulated from weak foreign economic growth. Municipal Bonds: Overweight Municipal bonds outperformed the duration-equivalent Treasury index by 7 basis points in January (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 2% in January, and currently sits at 84% (Chart 6). This is about one standard deviation below its post-crisis mean but above the average of 81% that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. Chart 6Municipal Market Overview In our research into the phases of the credit cycle, we often divide the cycle based on the slope of the yield curve. Since 1983, in the middle phase of the credit cycle when the 3/10 Treasury slope is between 0 bps and +50 bps (where it stands today), investment grade corporate bonds have delivered annualized excess returns of -14 bps. In contrast, municipal bonds have delivered annualized excess returns of +47 bps (before adjusting for the tax advantage).5  Given strong historical returns during the current phase of the cycle and the fact that our Municipal Health Monitor remains in “improving health” territory (bottom panel), we advocate an overweight allocation to municipal bonds. Long maturity municipal debt continues to offer a substantial yield advantage relative to the short-end of the curve. For example, a muni investor needs an effective tax rate of 35% to equalize the after-tax yields between a 5-year Aa-rated municipal bond and the equivalent-duration U.S. credit index. For a 20-year muni the same breakeven tax rate is between 10% and 17%. Treasury Curve: Favor 2/30 Barbell Over 7-Year Bullet Treasury yields declined in January, with the 5-year and 7-year maturities falling more than the short and long ends of the curve. The 2/10 slope flattened 3 bps on the month, from 21 bps to 18 bps. The 5/30 slope steepened 5 bps on the month, from 51 bps to 56 bps. In a recent report we looked at the correlations between different yield curve slopes and our 12-month Fed Funds Discounter.6 We found that the 5-year and 7-year maturities are most sensitive to changes in the discounter, while the short and long ends of the curve tend to be more stable. In other words, a decline in our 12-month discounter, like the one seen during the past two months (Chart 7), will tend to flatten the curve out to the 5-year/7-year maturity point and steepen the curve beyond that point. An increase in the discounter has the opposite effect. Chart 7Treasury Yield Curve Overview We expect the market to price some Fed rate hikes back into the curve as financial conditions ease during the next few months. Based on that view, we recommend adopting a yield curve strategy that benefits from a rise in our 12-month discounter. A position short the 7-year bullet and long a duration-matched 2/30 barbell provides the appropriate exposure and is attractively valued by our yield curve models (panel 4).7 TIPS: Overweight TIPS outperformed the duration-equivalent nominal Treasury index by 84 basis points in January. The 10-year TIPS breakeven inflation rate rose 14 bps on the month, and currently sits at 1.88%. The 5-year/5-year forward TIPS breakeven inflation rate rose 9 bps, and currently sits at 2.04%. Both rates remain below the 2.3% - 2.5% range that has historically been consistent with inflation expectations that are well-anchored around the Fed’s target. The 10-year TIPS breakeven inflation rate also remains below the fair value reading from our Adaptive Expectations Model (Chart 8).8 This model is based on a combination of backward-looking and forward-looking inflation measures and is premised on the idea that investors’ expectations take time to adjust to changing macro environments. The current fair value reading from the model is 1.97%, but that fair value reading will trend steadily higher as long as core CPI inflation remains above 1.83%. The 1.83% threshold is the annualized trailing 10-year growth rate in core CPI, and it is the most important variable in our model.   Chart 8Inflation Compensation On that note, core CPI has increased at an annual rate of 2.48% during the past 3 months, well above the necessary threshold. And while some forward-looking inflation measures have moderated, notably the ISM Prices Paid index (panel 4), this is largely a reaction to the recent drop in energy prices. A drop that should reverse as global growth improves in the coming months. ABS: Neutral Asset-Backed Securities outperformed the duration-equivalent Treasury index by 16 basis points in January. The index option-adjusted spread for Aaa-rated ABS tightened 8 bps on the month, and currently sits at 40 bps, 6 bps above its pre-crisis low. The Excess Return Bond Map in Appendix C shows that consumer ABS offer greater expected return than Domestic Agencies and Supranationals, though with a commensurate increase in risk. The Map also shows that Agency CMBS offer very similar return potential with much less risk. The Fed's Senior Loan Officer Survey for Q4 2018 showed that banks tightened lending standards slightly for both credit cards and auto loans. This is consistent with a continued gradual uptrend in consumer credit delinquencies (Chart 9). Chart 9ABS Market Overview Rising household interest expense further confirms that the consumer credit delinquency rate is biased higher, albeit from a low starting point (panel 4). All in all, ABS still offer a reasonable risk/reward trade-off but could warrant a downgrade in the coming quarters as credit quality worsens. Non-Agency CMBS: Underweight Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 67 basis points in January. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 11 bps on the month and currently sits at 105 bps. The Fed’s Senior Loan Officer Survey showed that banks tightened lending standards on commercial real estate (CRE) loans in Q4 and witnessed falling demand (Chart 10). This is a typical negative environment for CMBS spreads. Decelerating CRE prices are also a cause for concern (panel 3). Investors should maintain an underweight allocation to non-Agency CMBS. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The index option-adjusted spread tightened 4 bps on the month and currently sits at 57 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector continues to make sense. Chart 10CMBS Market Overview 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 8 basis points of rate cuts during the next 12 months. Given that we expect the Fed to deliver rate hikes in the second half of this year, we recommend that investors maintain below-benchmark portfolio duration. Appendix B- Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury yield curve. The models are explained in detail in the following two Special Reports: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of January 31, 2019)   Table 5Butterfly Strategy Valuation: Standardized Residuals (As of January 31, 2019)   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, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com 2 For further details on how we divide the credit cycle based on the slope of the yield curve please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Running Room”, dated January 29, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “Oil Supply Shock Is A Risk For Junk”, dated October 9, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearh 6 Please see U.S. Bond Strategy Weekly Report, “Don’t Position For Curve Inversion”, dated January 22, 2019, available at usbs.bcaresearch.com 7 The output from all of our yield curve models is shown in Appendix B of this report. 8 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation