Market Returns

Special Report

Per the most commonly referenced growth and value indexes, growth has been outperforming value for over 11 years, the longest stretch in the history of the series. Growth's extended winning streak has split investors into two camps: those who believe that value is finished because of overexposure and shortened investor timeframes, and those who are trying to identify the point at which reversion to the mean will ensue. In this Special Report, we argue that the traditional off-the-shelf indexes are poor proxies for true value. Their methodology strays quite far from the principles enumerated by Benjamin Graham, the father of value investing, and Fama and French, the researchers who demonstrated that lower-priced stocks have outperformed over time. The headline S&P 500 indexes currently differentiate between growth and value stocks using simplistic metrics that introduce considerable sector bias, reducing the difference between growth and value to a binary choice between Tech and Financials. Using tools developed by BCA's Equity Trading Strategy service, we create sector-neutral U.S. value and growth indexes that correct for the off-the-shelf indexes' flaws, and broaden the range of metrics Fama and French employed to make style distinctions. The ETS-derived indexes appear to better distinguish between value and growth stocks. The ETS value-versus-growth portfolio beat its Fama and French counterpart by four percentage points annually over its 22-year life. We join our custom value and growth indexes to Fama and French's to study the impact of macro variables on relative style performance over time for the purpose of gaining insight into the most opportune points to shift between styles. Relative style performance has not corresponded consistently or robustly enough with the business cycle, inflation, interest rates, or broad market direction to support reliable style-decision rules. We find that monetary policy settings, as defined by our stylized fed funds rate cycle, are a consistently reliable predictor of relative style performance. Per the fed funds rate cycle, tight policy is most conducive to value outperformance. From this perspective, value's decade-long slump is not a surprise, given that the ultra-accommodative tide has been lifting all boats. There is no rush to increase value exposure while policy remains easy, but investors should look to load up on value once policy becomes tight, using the metrics in our ETS model to identify true value stocks. We expect that the policy inflection will occur sometime in the second half of 2019, or the first half of 2020. Growth stocks have been on a tear for the longest stretch in the history of the series, based on the most commonly referenced growth and value indexes, even if their gains haven't yet matched the magnitude of the 1990s (Chart II-1). It is no surprise, then, that growth stocks are as expensive as they have ever been, outside of the tech-bubble era in the late 1990s. Many investors are thus wondering if the next "big trade" is to bet on an extended reversion to the mean during which value regains the ground it has given up. Chart II-1A Lost Decade For Value Stocks In this Special Report, we argue that the traditional off-the-shelf indexes are not very good at differentiating growth from value stocks. Trends in relative performance have much more to do with sector performance than intrinsic value, making the indexes a poor proxy for investors who are truly interested in selecting stocks based on their value and growth profiles. We create U.S. value and growth indexes that are unaffected by sector performance, using stock selection software provided by BCA's Equity Trading Strategy service. The results will surprise readers who are used to dealing with canned measures of value and growth. What Is Value Investing? Value investing principles have been around at least since the days when Benjamin Graham was a money manager himself. Style investing has been a part of the asset-management lexicon for four decades. Yet there is no universally agreed-upon definition of a value stock versus a growth stock. Based on our reading of Graham's Intelligent Investor, we submit that an essential element of value investing is the identification of stocks that are temporarily trading below their intrinsic value. The temporary drag may persist for a while - stock markets can remain oblivious to fundamentals for extended stretches - but it is ultimately expected to dissipate. Value investing is a play on negative overreaction or neglect, and dedicated value investors have to be contrarians, not to mention contrarians with strong stomachs. The temporary nature of undervaluation is a recurring theme in Graham's book. The stock market's ever-present proclivity toward overreaction ensures a steady supply of value opportunities: "The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.1" "[W]hen an individual company ... begins to lose ground in the economy, Wall Street is quick to assume that its future is entirely hopeless and it should be avoided at any price.2" "[T]he outstanding characteristic of the stock market is its tendency to react excessively to favorable and unfavorable influences.3" Graham viewed security analysis as the comparison of an issue's market price to its intrinsic value. He advised buying stocks only when they trade at a discount to intrinsic value, offering an investor a "margin of safety" that should guard against significant declines. His favorite measure for assessing intrinsic value was a sober, objective estimate of average future earnings, grossed-up by an appropriate multiple. A low price-to-average-earnings ratio was the linchpin of his margin-of-safety mantra. Decades after Graham's heyday, University of Chicago professors Eugene Fama and Kenneth French bestowed the academy's seal of approval on value investing. Their landmark 1992 paper found that low price-to-book ("P/B") stocks consistently and convincingly outperformed high P/B stocks.4 Several "growth" and "value" indexes have been developed over the years, but they bear no more than a passing resemblance to Graham's, and Fama and French's, work. It is important to realize that the off-the-shelf indexes are far from an ideal proxy for the value factor that Fama & French tried to isolate. Traditional Growth And Value Indexes Are Wanting The off-the-shelf growth and value indexes shown in Chart II-1 all share similar cyclical profiles, with only small differences in long-term returns. Given the similarity of the indexes, we will focus on Standard & Poor's/Citigroup methodology for the purposes of this report.5 The headline S&P 500 indexes currently differentiate between growth and value stocks using the following metrics: 3-year growth rates in EPS, 3-year growth rates in sales-per-share, and 12-month price momentum; along with valuation yardsticks including price-to-book, price-to-earnings, and price-to-sales. Companies with higher growth rates in earnings and sales, and better price momentum, are classified as growth stocks, while those with lower valuation multiples are considered value stocks. Several stocks are cross-listed in both indexes, which is baffling and counterproductive for an investor seeking to implement a rigorous style tilt.6 Table II-1 contains a summary of the current sector breakdowns for the S&P 500 Growth and Value indexes. Table II-2 sheds light on each index's aggregate geographical and U.S. business cycle exposure, the former of which is based on our U.S. Equity Strategy service's judgment. Table II-1Current S&P 500 Style Index Exposures Table II-2The Value Index Has Less Global ##br##And Late Cyclical Exposure Growth is currently heavily weighted in Health Care, Technology and Consumer Discretionary sectors, while value has a high concentration of Financials, Energy and Consumer Staples (Table II-1). Table II-2 shows that the growth index has a clear current bias toward sectors with global economic exposure that typically outperform the broad equity market late in the business cycle. The value benchmark flips growth's global/domestic exposure, and has slightly more exposure to defensive sectors, while splitting its cyclical exposure evenly between early and late cyclicals. Sector Dominance Unfortunately, the reigning methodology creates a major problem - shifts in the relative performance of growth and value indexes are dominated by sector performance. Financials' higher debt loads, and banks' low-margin operations, depress their multiples relative to nonfinancial firms. Thus, Financials hold permanent residency in the off-the-shelf value indexes. Conversely, Tech stocks perennially account for an outsized proportion of most growth indexes' market cap. Value-versus-growth boils down to a binary choice between Financials and Tech.7 The growth/value price ratio has closely tracked the Technology/Financials price ratio since the late 1990s (Chart II-2, top panel). The correlation was much less evident before 1995, when Tech stocks accounted for a much smaller share of market capitalization. Chart II-3 demonstrates that the positive correlation between growth/value and Tech has steadily climbed over the decades to almost 1, while the correlation with Financials has become increasingly negative (currently at -0.75). Chart II-2The S&P 500 Style Indexes Merely Mimic Relative Sector Performance Chart II-3Style Capture In contrast, the Fama/French approach, which focuses exclusively on price-to-book while ensuring equal representation for large- and small-market-cap stocks, appears much less affected by sector skews; the growth/value index created from their data has not tracked the Tech/Financials ratio, even after 1995 (Chart II-2, second panel). Moreover, note that the extended downward trend in the Fama/French growth/value ratio is consistent with other academic research that shows that value stocks outperform growth over the long-term. The off-the-shelf indexes show the opposite, but that is because they are merely tracking the long-term outperformance of Tech relative to Financials. The bottom line is that the standard indexes incorporate flawed measures of growth and value that limit their usefulness for true style investing. Conventional Wisdom With respect to style investing and the economic cycle, the prevailing conventional wisdom holds that: Inflation - Growth stocks perform best during times of disinflation and persistently low inflation, whereas value stocks perform best during periods of accelerating inflation; Interest Rates - Periods of high and rising interest rates favor value stocks at the expense of growth; and Business Cycle - It is believed that growth stocks outperform value during recessions, because the latter tend to be more highly leveraged to the economic cycle than their growth counterparts. According to the conventional view, value stocks shine in the early and middle phases of a business cycle expansion. Growth stocks return to favor again in the late states of an expansion, when investors begin to worry about the pending end to the business cycle and are looking for reliable and consistent earnings growth. Do the traditional measures of growth and value corroborate this conventional wisdom? Chart II-4 shows that the S&P value/growth index and headline CPI inflation have both trended lower since the early 1980s, but there has been no tendency for value to outperform when inflation rises. Value has shown some tendency to outperform during rising-rate phases since the mid-1980s, but the relationship with the level of the fed funds rate is stronger than its direction, as we discuss below. The growth-over-value relationship with the business cycle is complicated by the tech bubble in the late 1990s, which heavily distorted relative sector performance. The Citigroup measure of growth began to outperform very late in the cycle and through the subsequent recession in some business cycles (1979-1981, 1989-1991, and 2007-2009; Chart II-5). The early and middle parts of the cycles, however, were a mixed bag. Chart II-4Spiting The Conventional Wisdom Chart II-5No Consistent Relationship With The Business Cycle The bottom line is that there appears to be some rough correspondence between the Citigroup index and the interest rate and growth cycles, but it is too variable to point to reliable rules for shifting between styles. Ultimately, determining the direction of the growth and value indexes is more about forecasting relative Tech and Financials performance than it is about identifying cheap stocks. A Better Value Approach We identify four broad shortcomings of off-the-shelf value indexes: They exclusively use trailing multiples, a rear-view mirror metric. They rely on simple price-to-book multiples, which flatter serial acquirers. They rely entirely on reported earnings, which are an imperfect proxy for cash flow. A share of stock ultimately represents a claim on its issuer's future cash flows. They make no attempt to place relative metrics into historical context. Without a mechanism to compare a particular segment's valuation relative to its history, structurally low-multiple stocks will be over-represented and structurally high-multiple stocks will be under-represented. BCA's Equity Trading Strategy (ETS) platform provides a way of differentiating value from growth stocks that avoids these problems. The web-based platform uses 24 quantitative factors to rank approximately 10,000 individual stocks in 23 countries. Users can rank and score individual equities to support a broad set of investment strategies and apply macro and sector views to single-name investments. The ETS approach has an impressive track record. Historically, the top decile of stocks ranked using the "BCA Score" methodology has outperformed stocks in the bottom decile by over 25% a year. The overall BCA Score includes all 24 factors when ranking stocks, but to develop our custom value index, we use only the five valuation measures in the ETS database: trailing P/E, forward P/E, price-to-tangible-book, price-to-sales and price-to-cash flow. Every quarter we rank the stocks within each of the 11 sectors based on an equally-weighted composite of the five valuation measures. Note that we are using the data to rank stocks only against other stocks in the same sector. We calculate the total return from owning the top 30% of stocks by value in each sector. We do the same with the bottom 30% and refer to this as our "growth" index.8 We then compute an equally-weighted average of the total returns for the growth indexes across the 11 sectors. We do the same for the value indexes. By comparing stock valuation only to other stocks in the same sector, this approach avoids the sector composition problem suffered by the off-the-shelf measures. Chart II-6 compares the ETS value/growth total return index to the Fama/French value/growth index. Data limitations preclude comparing the two measures before 1996, but the ETS index confirms the Fama/French result that value trumps growth over the long term. The ETS index follows a similar cyclical profile to the Fama/French index from 1997 to 2009, rising and falling in tandem. The two series subsequently diverge: per the criteria ETS uses to identify value and construct an index, lower-priced stocks have outperformed higher-priced ones for most of this expansion, while the Fama/French methodology suggests the reverse. Chart II-6The ETS Model Builds On Fama And French's Work By avoiding sector composition problems and using a wider variety of value measures, the ETS approach appears to be a superior measure of value. An investor that consistently over-weighted value stocks according to the ETS approach would have outperformed someone who did the same using the Fama methodology by an annual average of four percentage points from 1996 to 2018. The history of our ETS index only covers two recessions, limiting our ability to gauge its performance vis-Ã -vis a variety of macro factors, so we extend the ETS index back to 1926 using the Fama/French index. While joining two indexes with different methodologies is less than ideal, we feel the drawbacks are outweighed by the benefit of observing growth and value relative performance across more business cycles. The top panel of Chart II-7 shows U.S. real GDP growth, shaded for recessions. The bottom panel presents our extended ETS value/growth index, shaded for declines of more than 10%. The shaded periods overlap in many, but not all, cycles (indicated by circles in the chart). That is, growth stocks have tended to outperform during economic downturns, although this is not a hard-and-fast rule. Chart II-7No Hard-And-Fast Relationship With The Business Cycle... Value-over-growth relative returns exhibit some directionality with the overall equity market when looking at corrections (peak-to-trough declines of at least 10%, as shaded in the top panel of Chart II-8), though it should be noted that it is nearly impossible to flag a correction in advance. The relationship weakens when considering bear markets, i.e. peak-to-trough declines of at least 20%, which can be forecast with at least some reliability.9 The bottom panel is the same as in Chart II-7; the extended ETS index, shaded for periods of significant value stock underperformance. The correspondence between the shaded periods is hardly perfect, and there does not appear to be a practical style exposure message, even if an investor could call corrections in advance. Chart II-8...And Market Directionality Has Been An Imperfect Guide Over The Last 50 Years Valuation Relative valuation also provides some useful information on positioning, though it is not always timely. Chart II-9 presents an aggregate valuation measure for the stocks in our value index relative to that of the stocks in our growth index. Value stocks are expensive relative to growth when the valuation indicator is above +1 standard deviation, and value is cheap when the indicator is less than -1 standard deviation. Historically, investors would have profited if they had over-weighted value stocks when the valuation indicator reached the threshold of undervaluation, although subsequent outperformance was delayed by as much as a year in two episodes. In contrast, the valuation indicator is not useful as a 'sell' signal for value stocks because they can remain overvalued for long periods. Value was overvalued relative to growth for much of the time between 2009 and 2016. Value stocks have cheapened since then, although they have yet to reach the undervaluation threshold. The Fed Funds Rate Cycle While relative style performance may generally lean in one direction or another in conjunction with the business cycle, inflation, interest rates, or broad equity-market performance, there are no hard-and-fast rules. It is difficult to formulate any sort of rotation view between styles, and history does not inspire confidence that any such rule would generate material outperformance. The monetary policy backdrop offers a path forward. We have found the fed funds rate cycle offers a consistent guide to equity and bond returns in other contexts, and our Global ETF Strategy service has found a robust link between the policy cycle and equity factor performance.10 We segment the fed funds rate cycle into four phases, based on whether or not the Fed is hiking or cutting rates, and whether policy is accommodative or restrictive (Chart II-10). Our judgment of the state of policy is derived from comparing the fed funds rate to our estimate of the equilibrium fed funds rate, the policy rate that neither encourages nor discourages economic activity. Chart II-9Sizeable Undervaluation Flags Turning ##br##Points, But You May Have To Wait A While Chart II-10The Fed Funds Rate Cycle As defined by Fama and French, value stocks outperform growth stocks by a considerable margin when monetary policy is restrictive (Table II-3 and Chart II-11, top panel). Considering value and growth stocks separately, both perform extremely well when policy is easy (Chart II-11, second panel), but growth stocks barely advance when policy is tight, falling far behind their value counterparts. A strategy for generalist investors may be to seek out value exposure when policy is tight, while investing without regard to styles when it is easy. Table II-3The State Of Monetary Policy Is The Best ##br##Guide To Style Performance Chart II-11The State Of Monetary Policy ##br##Drives Style Performance Investment Conclusions: U.S. equity sectors that have traditionally been considered "growth" have outperformed value sectors for an extended period. The long slump has led some investors to argue that value investing is finished, killed by a combination of overexposure and short-term performance imperatives. Other investors see value's long drought as an anomaly, and are looking for the opportune time to bet on a reversal. We are in the latter camp. The difficulty lies in finding an indicator that reliably leads value stocks' outperformance. Most macro measures are unhelpful, though broad market direction offers some insight, as stocks with low price-to-book multiples have outperformed their high-priced peers by a wide margin during bear markets. Bear markets aren't the most useful timing guide, however, because one only knows in retrospect when they begin and end. The monetary policy backdrop holds the most promise as a practical guide. Although our determination of easy or tight policy turns on the modeled estimate of a concept and should not be looked to for absolute precision, it has provided a timely, reliable guide to value outperformance. We expect the relationship will persist because of the cushion provided by less demanding multiples. Earnings and multiples surge when policy is easy, lifting all boats. It is only when policy is tight, and the tide is going out, that the margin of safety offered by lower-priced stocks yields the greatest benefit. Per our estimate of the equilibrium fed funds rate, we are still firmly ensconced within Phase I of the policy rate cycle, and expect that we will remain there until sometime in the second half of 2019. We therefore expect that value, in Fama and French terms, will continue to underperform growth for another year. The clock is ticking for growth, though, as the expansion is in its latter stages and building inflation pressures will likely force the Fed to take a fairly hard line in this rate-hiking cycle. Once monetary policy turns restrictive, investors should hunt for value candidates using a range of valuation metrics, and combine them in a sector-neutral way, as we have via our Equity Trading Strategy service's model. Mark McClellan Senior Vice President The Bank Credit Analyst Doug Peta Senior Vice President U.S. Investment Strategy 1 Graham, Benjamin, The Intelligent Investor, Harper Collins: New York, 2005, p. 97. 2 Ibid, p. 15. 3 Ibid, p. 189. 4 Fama, Eugene F. and French, Kenneth R., "The Cross-Section of Expected Stock Market Returns," The Journal of Finance, Volume 47, Issue 2 (June 1992), pp. 427-465. 5 S&P currently brands its Growth and Value Indexes as S&P 500 Dow Jones Indexes, but Citigroup has the longest history of compiling S&P 500 Growth and Value Indexes, beginning in 1975, so we join the Citigroup S&P 500 style indexes to the Standard & Poor's series to obtain the maximum style-index history. We use the terms Citigroup and S&P interchangeably. 6 The Pure Value and Pure Growth indexes include only the top quartile of value and growth stocks, respectively, with no overlap between indexes, and are therefore better gauges of true style investing. 7 The Tech-versus-Financials cast of the indexes endures because all of the other sectors, ex-regulated Telecoms and Utilities, which account for too little market cap to make a difference, regularly move between the indexes as their fundamental fortunes, and investor appetites, wax and wane. The current Early Cyclical/Late Cyclical/Defensive profiles are not etched in stone and should be expected to shift, perhaps considerably, over time. 8 We created a second growth index by taking the top 30% of stocks ranked by earnings momentum. However, it made little difference to the results, so we will use the bottom 30% of stocks by value as our measure of "growth" for the purposes of this report, consistent with Fama/French methodology. 9 Please see The Bank Credit Analyst. September 2017, available on bca.bcaresearch.com 10 Please see the May 17, 2017 Global ETF Strategy Special Report, "Equity Factors And The Fed Funds Rate Cycle," available at getf.bcaresearch.com.

Special Report

Dear Client, This week, we are sending you a Special Report written by my colleague Juan Correa on the topic of carry trades. In this report, Juan builds on our previous work on the subject. He analyses the role of interest rates, spot fluctuations, and volatility in determining the risk profile of carry trade returns. He also provides suggestions to improve the return skew created by the occasional sharp drawdowns suffered by carry trades. I trust you will find this report interesting and informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Feature While the great financial crisis claimed many victims in its wake, none better embodies the promise and perils of carry strategies than John Devaney. The Florida-based fund manager was able to amass a great fortune by using cheap leverage to finance the purchase of high-yielding MBS; a popular and very profitable strategy during the U.S. housing bubble. Eventually, he paid tribute to the pillar of his success by naming his 62-meter yacht "Positive Carry", - as a reminder of the great riches that could be achieved by simply borrowing at low yields to invest at higher ones. But just as his success was great, so was his downfall. When the housing bubble popped, Mr. Devaney's fund found itself unable to meet its margin calls, causing it to shut down. Ultimately, every single penny of investors' money was lost, while Mr. Devaney had to liquidate millions in personal assets; the yacht "Positive Carry" being one of them.1 Of course, bonds have not been the only asset class where carry strategies have been popular. Foreign exchange in particular has historically been the market of choice for investors looking to take advantage of positive carry. Specifically, the seminal 1984 paper, "Forward and Spot Exchange Rates", where Eugene Fama made the empirical observation that uncovered interest rate parity (UIP) does not hold2 (Chart 1), officially formalized the idea that carry in currency markets was a factor that could be systematically exploited. Chart 1The Forward Premium Puzzle So where do FX carry strategies stand in reality? Is carry really a market inefficiency that can be taken advantage of in almost arbitrage-like fashion? Or is it more like playing Russian roulette? A strategy that is deceptively profitable, but one that in the long run will wipe out an investor's capital. Table 1The Mechanics Of The Carry Strategy Index To answer these questions, we analyze the properties of carry strategies by constructing a Carry Strategy Index as follows:3 Ranking the 10 countries in the G10 according to their 3-month interest rate. Using the 3-month rate implied by forward rates.4 Going long 3 crosses that have the following criteria: With 1/3 of the portfolio, long the currency from the country with the highest interest rate vs. Short the currency from the country with the lowest interest rate. With 1/3 of the portfolio, long the currency from the country with the second highest interest rate vs. Short the currency from the country with the second lowest interest rate. With 1/3 of the portfolio, long the currency from the country with the third highest interest rate vs. Short the currency from the country with the third lowest interest rate. Rebalance every three months. (For clarity Table 1 shows an example of the strategy at work) We did not take into account collateral return, as this component can vary depending on the home currency of the investor. While not taking into account collateral returns penalizes the profitability of the strategy, this method allows our Carry Strategy Index to be comparable across investors in the G10. Observations On Carry Returns Chart 2 shows our Carry Strategy Index, along with a breakdown of the strategy's two components: the spot component and the interest rate component. The Carry Strategy Index obtained an annualized rate of return of 4.1% from the beginning of the sample in March 1989 to the end in mid-September 2018, with an annualized daily standard deviation of 9.3%. Moreover, while many investors often laud carry strategies as an opportunity to earn a double whammy of positive carry and positive spot return, most of the sample return was attributable to the interest rate component, as the spot component earned a paltry -0.23% annualized sample return, while it was also responsible for all the risk. Which currencies does the Carry Strategy Index favor? Overall, the AUD and the NZD are overwhelmingly carry currencies while the CHF and the JPY tend to be funding currencies most of the time (Chart 3). Chart 2Carry Throughout The Years Chart 3The Usual Suspects: NZD, AUD, JPY & CHF The amount earned on yield differentials was not consistent over time. The best period for our carry index went from 1995 to 2008, where a relatively high level of carry earned remained stable for more than a decade (Chart 4 - top two panels). Meanwhile the convergence of G10 interest rates to near zero in the wake of the great financial crisis reduced the return from the interest rate component to an annualized rate of roughly 3%. Remarkably, while the return offered by the interest rate component decreased, the implied volatility of currencies stayed relatively constant (Chart 4 - third panel), suggesting that the ex-ante return-to-volatility ratio of these strategies has actually decreased since 2008 (Chart 4 - bottom panel). Although the return for the Carry Strategy Index across the sample is attractive, carry investors are unlikely to implement their position over such a long horizon. It is therefore important to recognize that while the interest rate component tends to be relatively stable through multi year periods, the spot component can make the total return of the carry strategy vary wildly across sub-periods (Chart 5). This sub-period performance is likely more relevant for portfolio managers, as these periods reflect with greater accuracy the length of the horizon used to evaluate them. Interestingly, the annualized returns for longer holding periods are more attractive, while carry returns also become more disentangled from spot returns the longer the time horizon becomes. Chart 4Risk Versus Return In ##br##Carry Strategy Index Chart 5The Spot Component Is The Main Driver Of ##br##Carry Returns On Realistic Time Horizons Bottom Line: Our Carry Strategy Index was overwhelmingly long AUD and NZD, while being short JPY and CHF. Moreover, the interest rate component decreased significantly after G10 central bank rates converged to the zero bound, without a corresponding decrease in volatility, resulting in a deteriorating return-to-volatility ratio. Finally, while spot returns had a very small contribution to the sample return, they are a crucial driver for total return in more realistic time horizons, particularly shorter ones. Structural Determinants Of Carry: Is There Really A Puzzle? Many investors have grown disillusioned with carry trades in recent years, as the spot component of the strategy has become much more mediocre than in the past. This general disenchantment with carry trades has only grown stronger, with recent research showing that since 2008 the relationship between rate differentials and spot returns has flipped from positive to negative.5 So where have the good old days gone? A deeper look at the data suggests that the strong positive relationship between spot returns and rate differentials might have been a temporary phenomenon. In fact, the correlation between rate differentials and spot returns can vary widely from year to year (Chart 6). Thus, while the period after 2008 has shown a decrease in correlation, it is not a particularly unique sub-sample, as there have been other periods in history where there has been a negative correlation between rate differentials and spot returns. In fact, the Fama puzzle is not quite a puzzle if one remembers that UIP is not an arbitrage condition like CIP (Covered Interest Rate Parity). Two currencies could very well offer different rates of return so long as they also offer different levels of risk.6 We can see evidence of this by looking at the characteristics of typical carry currencies vs the characteristics of typical funding currencies. Carry currencies tend to have large current account deficits, negative net international investment positions, and are highly levered to the global economic cycle (Chart 7). Not only does this mean they are correlated to other assets, but it also means they are more prone to sudden pullbacks when global liquidity dries up. Funding currencies on the other hand have the opposite characteristics, being typically safe havens that act as hedges against other assets (Chart 7). Chart 6No Stable Correlation Between Interest Rates ##br##And Currency Returns Chart 7No Puzzle: Yield Differentials Are ##br##Just Risk Differentials Does this mean that carry trades will regain their former glory? It is hard to tell. One reason to remain cautious on the long-term outlook for carry trades has been the trade rebalancing that has taken place since the financial crisis (Chart 8). Technically, a rebalancing in the G10 space implies that the risk differential between countries should be decreasing. However, this also means that the return differential has also decreased, which means that the low interest rate component of the Carry Strategy Index at present might be justified. As mentioned previously, the interest rate component is the ultimate driver of carry returns over long horizons (Chart 9). Therefore, carry investors should keep in mind that as imbalances are fixed, risk and yield differentials will narrow, implying that the long-term return of carry strategies will stay low by historical standards. Chart 8Decreasing Risk Differentials##br## In The G10... Chart 9...Imply A Reduced Long-Term Rate Of Return ##br##For Carry Trades Bottom Line: UIP is not an arbitrage condition, which explains why the correlation between spot returns and rate differentials has historically been highly unstable. Instead, rate differentials are often reflective of risk differentials between countries. Rebalancing within the G10 has likely reduced these risk differentials, and consequently carry returns. Cyclical Determinants Of Carry: The Role Of The U.S. Dollar While occasionally there are other currencies that become either funding or carry currencies, this tends to be a rare phenomenon. In fact, the ranking within the G10 rate distribution for any given country tends to remain stable throughout the years. There is only one glaring exception: the United States (Chart 10A and Chart 10B). Chart 10ASince The Mid 1990s Most Countries Remain ##br##Relatively Fixed In The Interest Rate Distribution (I) Chart 10BSince The Mid 1990s Most Countries Remain ##br##Relatively Fixed In The Interest Rate Distribution (II) The first half of the 1990s was the only time where there was significant interest rate migration for multiple countries. Since then, the U.S. is the only country whose interest rate has migrated significantly across the distribution. This is because it has become the de facto global price-maker of monetary policy. After all, the U.S. is the G10 country whose inflation dynamics are least sensitive to currency movements. Therefore, the Federal Reserve is less concerned with its interest rate differential relative to other G10 economies than other central banks. This allows the Fed to reposition U.S. rates within the G10 distribution according to its own business cycle (Chart 11). On the other hand, the central banks in the rest of the G10 are much more concerned with the way that currency fluctuations can potentially amplify the effect of monetary policy tightening or easing. This makes them much more prone to holding their place in the distribution, and following the rest of the pack accordingly as the business cycle progresses. Additionally, the U.S. economy tends to be less affected by the global business cycle than other economies in the G10. As a result, while other countries might move in unison, the U.S. can follow its own dynamics. The current business cycle is an exaggerated example of this phenomenon. Understanding this dynamic is crucial for carry trades, as the U.S. dollar is the only chameleon currency that can constantly shift from funding currency to carry currency and vice-versa. Chart 12 shows that returns from carry strategies suffer whenever U.S. rates are at the top of the distribution. By the same token, when the U.S. dollar becomes a funding currency, the return in our Carry Strategy Index increase significantly. Chart 11U.S.: Global Price Maker ##br##Of Monetary Policy Chart 12Carry Strategies Suffer When The##br## USD Is A Carry Currency Why does this relationship exist? External debt for the world in general and emerging markets in particular is denominated in U.S. dollars. Whenever U.S. rates rise, external debt servicing increases, causing the return of investment in emerging markets, commodity producers and other cyclical plays highly sensitive to U.S. dollar borrowing costs to deteriorate. Moreover, the high rates in the U.S. make cyclical plays like Australia or New Zealand relatively less attractive to global investors. This creates a dangerous environment for carry trades, given that the possibility of a risk-off event - where funding currencies can rally - becomes increasingly likely. Bottom Line: The U.S. dollar is the only currency that can consistently change from carry to funding currency. When the USD is a funding currency, overall carry returns are attractive. Conversely, when the USD is a carry currency, overall carry returns become poor. Tactical Determinants Of Carry: Fighting Against Negative Skew It is important to recognize that volatility is not the only risk that carry investors are exposed to. One of the most agreed upon hypotheses put forward is that carry strategies offer a positive return in exchange for exposure to negative skew in returns, or what is commonly known as the "Peso Problem". Essentially, when they work, carry strategies generate consistent small positive returns; however, they are subject to infrequent yet violent drawdowns. Hence, the return distribution is not normally distributed, but instead has a heavy left tail7 (Chart 13). Chart 13Negative Skew In Carry Strategy Index Why does skew matter? Carry trades are generally accompanied by leverage to amplify the return earned. However, the negative skew can become extremely dangerous at high levels of leverage, as it can lead to margin calls. In selloffs, investors who are not able to meet their margin calls are forced to quickly liquidate their positions, generating downward pressure on prices, and causing even more margin calls. This dynamic causes vicious cycles in carry trades, where losses can pile up very quickly.8 Chart 14Vega-M: An Enhanced Carry Strategy However, we can use the reflexive relationship between risk aversion and carry returns and turn it to our advantage. If we know that once it rises, volatility will create further downward price pressure, which in turn generates further volatility, then we can use the momentum in volatility to determine entry and exit points into carry trades. To take advantage of the above we created a strategy as follows: Long the Carry Strategy Index at day t if at day t-1 the 20-day moving average of the CVIX is below the 200-day moving average.9 Remain uninvested (earn 0% return) at day t if at day t-1 the 20-day moving average of the CVIX is above the 200-day moving average. We call this strategy the Vega-M Carry Index. Our Vega-M Carry Index manages to outperform the Carry Strategy Index within our sample, while also displaying significantly less volatility (Chart 14 - top panel). The Vega-M Carry Index also manages to closely track the interest rate component of the strategy, while eliminating some of the spot risk (Chart 14 - bottom panel). The Vega-M Carry Index also exhibits a much tighter return profile than the Carry Strategy Index (Chart 15 - top panel). Furthermore, while kurtosis in the Vega-M Index is still high, skew for the Vega-M Carry Index is actually positive (Chart 15 - bottom panel). This reduction in negative skew has important implications for investors using leverage. Chart 16 shows how the Vega-M Carry Index allows for a greater use of leverage, as the reduced negative skew eliminated margin calls, which means investors are not stopped out. This allows investors to have much better performance at high levels of leverage. Bottom Line: Given the reflexive relationship between volatility and carry trades, investors can use volatility momentum to generate buy/sell signals. Carry investors should remain invested when the volatility momentum is negative, while they should close their positions when momentum is positive. Chart 15Vega-M: More Compact Return Distribution And No Negative Skew Chart 16Vega-M: Better Performance When Using Margin Investment Implications With the above points considered, we have made a list of the three rules of thumb for carry investors to use: On a structural basis, the long-term rate of return of carry strategies will be determined by the interest rate differential. In general, this differential is a compensation for risk differentials between countries Cyclically, carry trades will deliver poorer returns whenever the U.S. dollar is a carry currency (at the end of the cycle), and will deliver better returns when the U.S. dollar is a funding currency (at the beginning of the cycle). Tactically, investors can use the momentum in volatility as a signal to enter or exit carry trades. Negative volatility momentum can be used as a long signal, while investors should exit their carry positions when volatility momentum becomes positive. While we have divided our rules into investment horizons, carry investors should use all rules in conjunction. The interest rate differential and the projected risk differential between countries can be used to establish an expected long-term rate of return to benchmark against. The position of U.S. rates within the distribution can be used to determine whether a high or low level of leverage is appropriate. Finally, the momentum in volatility can be used to assess entry or exit points from carry trades. What are all these signals telling us right now? The annualized rate of return of the interest rate component in carry strategies will likely remain low. This means that the long-term rate of return of carry strategies will remain at the low end of its historical distribution. Inflationary forces in the U.S. will continue to be greater than in the rest of the world. Thus, U.S. rates will remain at the top of the distribution, which means that leverage on carry strategies should be maintained at a minimum The momentum in volatility continue to be positive. This means investors should hold off from entering into carry trades, and instead wait for a better entry point. Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com 1 Story, Louise. "Hedge Fund Manager Describes Rock Bottom." The New York Times, The New York Times, 10 July 2008, www.nytimes.com/2008/07/10/business/10fund.html. 2 Please see Fama, E.F. (1984) "Forward And Spot Exchange Rates" Journal of Monetary Economics, 14(3), 319-338 3 We use a multi-currency strategy, as academic research has shown that this method outperforms single currency strategies. For more details, please see "Multiple Currencies Investment Strategy To Take Advantage Of The Forward Bias," Haas School of Business, University of California Berkeley, BA 285/E285 International Finance, Student Project. 4 Carry strategies in the FX markets are normally implemented through buying (selling) forward rates with a forward discount (premium) 5 Please see Bussiere, M., Chinn, M., Ferrara, L.,& Heipertz, J. (2018) "The New Fama Puzzle" NBER Working Papers 6 The UIP theory makes the assumption that economic agents are risk neutral. Given this is not the case in reality, much work has been done to try to explain deviations from UIP with currency risk premiums. For more information please see Menkhoff, L., Sarno, L. , Schmeling, M. and Schrimpf, A. (2012), "Carry Trades and Global Foreign Exchange Volatility". The Journal of Finance, 67: 681-718. 7 This makes the Sharpe ratio deceptive as a measure of risk-reward for carry strategies, as this measure does not account for skew. 8 For a more detailed description about the relationship between unexpected jumps in volatility and carry returns please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More Than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 9 We use 20-day and 200-day moving averages given that moving averages using these types of ranges tend to best capture the momentum in financial markets. For more details about momentum strategies please see Foreign Exchange Strategy Special Report, titled "Riding The Wave: Momentum Strategies in Foreign Exchange Markets", dated December 8, 2017, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights The presidential race between Haddad and Bolsorano will be very tight. At present, we put slightly higher odds on Haddad winning by a small margin in the second round. A Haddad victory would lead to a continuation of stress in financial markets. The prospects of Lula's release and populist policies will lead to further downside in Brazilian assets Bolsorano's victory in the second round will likely lead to a tradeable rally in Brazil's financial markets. For now continue underweighting Brazilian equities and credit and continue shorting the BRL. We will consider whether to upgrade Brazil after the outcome of the elections becomes clearer. Feature Chart 1Potential Roadmaps For Equities Relative Performance Brazil's upcoming general elections will be among the closest in recent history. Current polls show a tight race between right-wing candidate Jair Bolsonaro and left-wing candidate Fernando Haddad. A victory by Bolsonaro may spark a short-term rally in Brazilian assets on the expectation of structural reforms. On the other hand, a Haddad victory and return of the Worker's Party to power would be quite negative for financial markets. The upside of this election, regardless of outcome, is that a new government with a new mandate will be formed, restoring a semblance of legitimacy for the first time since the impeachment of President Dilma Rousseff in 2016. The downside is that this mandate will be weak, the odds of a "pro-market" government are uncertain, and Congress will be fragmented. Much-needed yet painful social security reforms will face an uphill battle, with potentially another market riot needed to motivate policymakers and legislators to enact social security reforms. On the macroeconomic front, Brazil does not have a lot of room and time for maneuver. Without drastic measures to cut the budget deficit or boost nominal GDP, public debt will most likely spiral out of control. Due to the current state of polarization, we cannot have a high conviction view on the election outcome until after the congressional elections on October 7. That said, the macro forces remain negative for EM overall and Brazil in particular. Barring Bolsorano's victory in the second round, there is little reason for Brazilian risk assets to rally (Chart 1). An Anti-Establishment Victory? Media attention has centered on Bolsonaro of the Social Liberal Party. He is the frontrunner in the first round of the race, despite his controversial rhetoric and overt sympathies with Brazil's military dictatorship of the past. In polling for the second round, his considerable lead has shrunk, as he is now neck and neck with the other contenders (Chart 2). Bolsonaro is a serious candidate not because of any overarching, international "Trumpian" narrative, but because Brazil itself is ripe for an anti-establishment electoral outcome: With Lula out of the race, the combined "right-wing" and "left-wing" vote is close in the first round (Chart 3). Chart 2Second-Round Polls Very Tight Chart 3A Tight Race The country is still in the throes of a political crisis and a historic recession (Chart 4). The major political parties have been discredited. Years of slow economic growth have resulted in extremely low levels of public trust in government (Chart 5). Chart 4Brazil In The Wake Of A Historic Recession Chart 5Low Growth Countries Suffer From Lack Of Trust In Their Government This is prompting voters to seek a "change in direction" and/or a "protest vote," from which Bolsonaro is apparently benefiting. There is even a sizable audience for Bolsonaro's authoritarianism and nostalgia for military rule. Brazilians are disillusioned with democracy - with 67% of respondents in a Pew Research poll saying they are "not satisfied" with democracy, compared to a global median of 52%.1 Almost a third of educated Brazilians favor military rule, and that number is as high as 45% among the uneducated (Chart 6).2 Bolsonaro's net approval is less negative than other candidates. In fact, only former Presidents Lula and Rousseff have higher net approval (Chart 7). This is a serious risk to Bolsonaro's likeliest rivals, Fernando Haddad of the Worker's Party and Ciro Gomes of the Democratic Labor Party. Bolsonaro's stabbing at a rally on September 6 has not taken him out of the race. His social media support has become an important tool to reach out to his fan base. Chart 6Brazilian Voters Harbor Some Authoritarian Tendencies Chart 7Net Approvals Advantage Bolsonaro However, there are two key reasons why Bolsonaro is not the favorite to win the election: First, Brazil's two-round electoral system works against Bolsonaro because it enables left-leaning voters to vote strategically in favor of the "least bad option," i.e. the available left-of-center candidate, in the second round. Thus while polling shows Bolsonaro very close to each of his potential opponents in the second round, his final opponent will receive a boost that will not be fully accounted for until after the first round eliminates other left-wing contenders. Recent polls suggest that Haddad stands to benefit much more than Bolsonaro from the "migration" of votes after the first round, as left-wing supporters team up against Bolsonaro in the second round (Table 1). Second, with Lula disqualified from the race, Lula supporters are now in the process of switching to support Haddad. Lula has carried a high approval rating of around 35%-40% for over a year, well above all other candidates. In our "poll of polls" (average of various polls) Haddad has risen rapidly in the one month since Lula's disqualification became clear, so that he is now at equal odds with Bolsonaro (see Chart 2 above). A few polls even suggest Haddad is ahead of Bolsonaro in the second round (Chart 8).3 Table 1Second Round Migration##br## Polls Advantage Haddad Chart 8Haddad Is Ahead##br## In These Polls To elaborate on this last point: First, about 59% of Lula's supporters say they will shift to Haddad (Chart 9), which should be enough to position him as one of the top two contenders in the first round of voting. Only 4% of Lula supporters will shift to right-of-center candidate Alckmin- a share that is overpowered by the 71% of the Lula vote that will go to left-leaning candidates. Second, the number of undecided and "blank" Lula voters is high at 18%. These voters - if they vote - will mostly go to Haddad, and then Gomes. From the above we can conclude that Haddad will face Bolsonaro in the second round runoff. Because of strategic voting, Haddad will be favored to win the Presidency. A major risk to the left-wing candidate in the second round is that as many as 18% of Lula voters may stay home and not vote. This would mean that Haddad could lose the final vote due to low turnout.4 Overall voter turnout has been falling slightly since 2006 (from 83.3% to 80.7% in 2014) and the disillusionment of voters could result in still lower turnout in 2018. This would favor Bolsonaro, whose supporters are the most likely to vote, whereas Haddad's are the least likely, according to surveys. The profile of the most likely voters favors Bolsonaro (Table 2).5 Chart 9Lula's Migration Vote Table 2Voter Profile Of Each Candidate As a consequence, we give Bolsonaro 40%-50% odds of winning the presidency, with the possibility of downgrading his probability to a flat 40% if the rise in Haddad's polling continues at the current pace. Strategic voting imposes a handicap on Bolsonaro, making it hard for him to increase his odds above 50%. The lower net approval for Haddad and Gomes, and the risk that Lula voters will fail to transfer in full force to Haddad, suggests that Bolsonaro has a fair chance of winning the second round. Elections are a Bayesian process and we will update our probabilities as more information comes in. In particular, it is important to see if Haddad exceeds expectations in the October 7 first round. Bottom Line: Given strategic voting in the second round and the momentum behind Haddad, the odds of a left-wing victory in the Brazilian election are 50%-60%. However, this is a low-conviction view. Bolsonaro's odds of winning are closer to 40%-50%, particularly if Lula voters stay home. The New Government's Mandate Will Be Weak No matter who wins, there will be at least one positive takeaway for Brazilian risk assets: a new government will be elected with a fresh mandate to lead the country. The Brazilian state has suffered from a crisis of legitimacy over the past few years. A countrywide anti-corruption campaign and economic depression has led to a general loss of confidence. The latter was further exacerbated by the impeachment of President Rousseff and paralysis of the interim government of Michel Temer. Hence this election will clear the air and give a new government the chance to tackle the country's economic and political problems. However, this clearly positive factor will be overwhelmed by negative factors as the election unfolds and in the aftermath: No first round winner: As outlined above, none of the candidates are likely to win a simple majority of the vote in the first round on October 7. This has been the norm in recent elections, but it precludes the possibility that the current crisis will be matched by a leader with a strong personal mandate, like Cardoso in the 1990s. A close election may lead to contested results: The current second-round polling suggests the outcome will be close. The losing side may challenge the results, a controversy that could cause significant political uncertainty for weeks or months. Bolsonaro has already suggested that he can only lose if the Worker's Party rigs the election. Congress will be fractured: Brazil's Congress is always fractious; with numerous parties and coalitions cobbled together by presidents whose own party has a relatively small share of seats (Chart 10). The upcoming president may even have a weaker congressional base than usual. The erstwhile dominant parties, the PDMB and the PSDB, are less popular than they once were and have put forward lackluster presidential candidates, suggesting they will not win large numbers of seats. The Worker's Party, with a large support base in recent decades, was at the epicenter of the impeachment crisis and suffered huge losses in the municipal elections of 2016, also suggesting it will not win as many seats.6 Meanwhile Bolsonaro's Social Liberal Party is starting from a low base (it currently has only eight out of 513 seats in the lower house and none in the senate). Hence, no party is in a position to sweep Congress, or even come close to a majority, ensuring high diffusion of power, horse-trading, and unstable, ad hoc coalitions. Such coalitions have been a hallmark of Brazilian politics and may even be more unstable this time around. Chart 10ABrazil's Parliament Is Fractious Chart 10BBrazil's Parliament Is Fractious No more pork: Given the focus on fiscal austerity and corruption, the next president of Brazil will struggle to command as much "pork-barrel spending" - politically-motivated fiscal handouts to individual congress members - to grease the wheels of politics. President Lula and President Cardoso both relied on pork to ensure passage of key legislation in the 1990s and early 2000s. Polarization: Polarization will remain high as a result of the economic crisis. If Haddad wins, we expect that he will pardon President Lula, despite his assertions to the contrary, and create ill-will among the roughly 52% of the population that views Lula as corrupt. If Bolsonaro manages a victory, he will face intense opposition and resistance from civil society and possibly a left-of-center Congress. Historically, a governing coalition with a majority of seats eventually emerges from Brazil's fragmented Congress. However, periods of political crisis - and transitions from one leading party to the next - often require more time to form such coalitions. It took Lula two years, from 2002-04, to form a majority coalition during his first term in office, according to research by Taeko Hiroi of the University of Texas at El Paso (Chart 11). Chart 11Historical Profile Of Governing Coalitions Bottom Line: The formation of a new government with a new mandate is positive but it will not bestow as much political capital as the market expects: in all likelihood the new president's mandate will be weak and Congress will, at least initially, be divided. Will Reforms Be Reactive Or Proactive? What are the likely market reactions from the different election scenarios? And will policymakers be proactive or reactive in their pursuit of any structural reforms? While we cannot rule out a knee-jerk rally if Bolsonaro wins, the length and breadth of the market reaction will depend on the government's political capital (e.g. popular margin of victory and strength in Congress) and willingness to be proactive about structural reforms. On the left, both Haddad and Gomes are "populist," left-leaning, candidates whose victory would exacerbate the selloff. Haddad's vice-presidential candidate and coalition partner is Manuela D'Avila, from the Brazilian Communist Party (PCdoB). Their platform states that the solution to low economic growth is expansionary fiscal and monetary policies, such as a removal of the cap on government spending and a reduction in interest rates. Meanwhile the Gomes campaign has denied that Brazil has a pension deficit.7 Neither Haddad nor Gomes faces the IMF-imposed constraints that Lula faced when he took power in 2002. The market pressure surrounding his election in 2002 and the IMF proposals at that time essentially forced Lula to continue his predecessor Cardoso's reforms. Compared to 2002-03, today's profile of Brazilian share prices suggests that more downside is warranted (see Chart 1, page 1). Hence, we believe more market turmoil would be necessary to force Haddad or Gomes to adopt any difficult and unpopular fiscal reforms. We believe that both could be capable of executing reforms if pressed by the market, but a market riot is needed first. On the other hand, a Bolsonaro victory would likely trigger a meaningful rally on the expectation of pro-market reforms. Bolsonaro's economic advisor Paulo Guedes, a University of Chicago economics PhD holder, is a supply-side reformer who has proposed to privatize state-owned assets, enact tax and pension reforms, and scale back the bureaucracy. Crucially, Bolsonaro's camp wants to use the proceeds from privatization to repurchase public debt and buy time before reforming the pension system. Hence, in the eyes of many investors, Bolsonaro represents a market-friendly candidate despite his tough talk and anti-establishment tendencies. The problem is that Guedes has spent far more time giving interviews to the financial press than campaigning on draconian structural reforms. As such, it is not clear that Bolsonaro's economic team's promises jive with the desires of the median voter in the country. Bolsonaro, meanwhile, will likely be limited in forming a coalition in the Chamber of Deputies.8 The ability to form and maintain alliances in the Chamber of Deputies is a key constraint for any Brazilian president, especially from a smaller party. Obstructionism is common.9 Even large parties with strong alliances have fallen into gridlock, most obviously in attempting structural reforms. In late 1998, for instance, President Cardoso's own PSDB party deprived him of the votes needed to seal a painstakingly negotiated deal with the IMF, which led to a loss of confidence among creditors and a sharp devaluation of the real in January 1999. In short, it will be difficult for the new president to implement reforms at the beginning of his term even though, as noted above, Brazilian presidents tend to cobble together a coalition over time. It should be noted that Bolsonaro's authoritarian tendencies and desire to rewrite the 1988 constitution - a partisan Pandora's Box - could result in a further deterioration of Brazilian governance (Chart 12). This would push up the risk premium on assets over the long run, though in the short run Bolsonaro may be positively received by financial markets. Bottom Line: Bolsonaro would likely want to be a proactive structural reformer, but he would also be constrained at first due to his small party base in Congress and need to form a coalition. In addition, the days of liberally soothing partisan battles with pork-barrel spending are over. Brazil is both fiscally constrained and increasingly sensitive to corruption. Moreover, fiscal austerity would come with a negative hit to growth in the short term. It is not clear whether Bolsonaro will be able to form a Congressional coalition that can push through the painful part of the "J-Curve" of structural reform (Diagram 1). Chart 12Brazilian Governance Set To Fall Further Diagram 1The J-Curve Of Structural Reform On the other hand, neither Haddad's nor Gomes's platforms are market-friendly. Neither is likely to attempt structural reforms proactively. The market would have to sell off further, as in 2002, to pressure them into such policies. At that point, however, they might ultimately have a better ability to push legislation through Congress than Bolsonaro due to their ability to form larger coalitions amongst leftist parties. Either way Brazilian risk assets have further downside from where they stand today. A market riot is likely necessary to galvanize the population's support for painful structural reforms. That support currently does not exist. What Is At Stake? Chart 13The Achilles Heel Of The Brazilian Economy Brazil's public debt is out of control. Weak nominal GDP growth and high borrowing costs are increasing the public debt burden. This debt stems in large part from a sizable social security deficit that will continue expanding without the above-mentioned reforms (Chart 13). Thus, the next president will face a dilemma: implement austerity to satisfy creditors or increase spending to satisfy voters. A close look at voter preferences suggests that top priorities are improving health services and raising the minimum wage, while pension reform is at the bottom of the list (Chart 14). This reinforces our view that the left-of-center candidates are likely to be the closest to the median voter, and that fiscal austerity is not forthcoming. However, voters are also demanding that inflation be controlled, taxes be cut, and jobs be created - all of which could result in support for right-of-center candidates. Two possibilities to stabilize or reduce the debt load are: (1) restoring a primary budget surplus by enacting social security cuts and/or (2) privatizing state assets to raise fiscal revenues. In Europe throughout the early 2000s, peripheral countries with large public debt imbalances ran large primary budget deficits, just as Brazil has been running (Chart 15, top panel). Portugal, Ireland, Italy, Greece, and Spain stabilized their debt-to-GDP ratios by cutting social spending and capping fiscal expenditures (Chart 15, bottom panel). This will prove challenging as Brazil's pension system is one of the most generous in the world, with retirement ages of 54 and 52 for men and women, respectively, and a much lower contribution period relative to other countries. Furthermore, replacement rates for both men and women are 61%, or 10 percentage points above the OECD average and over 15 percentage points above other countries' reformed pension systems.10 Finally, the dependency ratio will continue to increase, as rising life expectancy and a declining working-age population remain structural headwinds for years to come.11 In our conversations with clients, the reality of Brazil's aging demographics usually comes as a complete surprise. Chart 14Brazil's Population Is ##br##Not Open To Fiscal Austerity Chart 15Eurozone Debt Crisis Resulted ##br##In Lower Spending And Stable Debt Therefore, social security reforms require outright cuts in spending, rather than soft caps on the budget balance. The present soft cap on government expenditures is not adequate to stabilize or reduce government debt levels. Could privatization help stabilize public debt dynamics? The privatization program during the 1990s under the Collor, Franco, and Cardoso governments led to the sale of $91 billion (around R$ 100 billion or 9% of GDP) worth of assets from 107 state-owned enterprises over the course of a decade. Presently, in order to re-balance the primary deficits of R$93 and R$79 billion for 2018 and 2019 respectively, the government would be required to frontload the sale of large state-owned entities, such as Petrobras or Banco do Brasil. This will prove challenging, since the sale of state-owned enterprises requires legislative approval. In fact, over the past two years, under interim President Temer, the government has struggled to sell its assets such as Electrobras. Even assuming that a Brazilian government under Bolsonaro conducts large-scale asset sales, previous privatization programs have failed to yield targeted sums and have required a longer time to implement than originally expected. Overall, privatization is not a feasible option to reduce high debt levels in Brazil in the short run. Bottom Line: Stabilizing or reducing the public debt as a share of GDP will be challenging under the current set of preferences set by voters. Moreover, demographic headwinds and structural constraints embodied in Brazil's two-tier legislative system will slow down the process of privatization and pension reform. The market is forward-looking and will cheer attempts to enact supply-side reforms in the short run, should they emerge, despite long-term uncertainties. The key questions are (1) whether the election produces a proactive Bolsonaro regime or a reactive left-wing regime (2) whether coalition formation - in Bolsonaro's case - or exogenous market pressure - in Haddad's case - are sufficient to initiate reforms in a timely manner in 2019. Amidst a broad EM selloff driven by external factors as well as Brazil's and other EM's internal fundamentals, we expect the markets to be largely disappointed in 2019. The evolution of the political context throughout the year will then determine when and if a buying opportunity emerges. Investment Implications In the late 1990s, faced with high foreign debt levels, a large current account deficit, and weak nominal growth, the Brazilian central bank devalued the real by 66% in January 1999 (Chart 16). This led to a rebound in nominal growth which helped the country relieve itself from built up excesses. In today's context, a weaker currency and lower interest rates are required to boost nominal GDP and contain Brazil's public debt as a share of GDP. There are already signs that the central bank is easing liquidity amid currency depreciation - which stands in contrast of the recent past (Chart 17). More liquidity provisioning by the central bank will cause the real to depreciate further. In light of this, we recommend that investors continue shorting the currency versus the U.S. dollar. Furthermore, due to our expectation of further deceleration in global growth stemming from China and a strong dollar, investors should expect more downside in broader EM and Brazilian share prices in U.S. dollar terms. With respect to the outcome of the elections, investors should continue underweighting Brazilian equities and credit in their respective portfolios for now (Chart 18). Chart 16Brazil Needs A Weaker Currency To##br## Boost Nominal Growth Chart 17A New##br## Paradigm Shift? Chart 18Sovereign Credit Spreads Will##br## Continue Widening We will consider whether an upgrade of Brazil is warranted after electoral outcomes become known. Particularly, the balance of the parties in Congress and the new president's coalition formation options will dictate the relative performance of Brazilian equities and credit over the next 6-12 months. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see, Wike, R. et al., "Globally, Broad Support for Representative and Direct Democracy", October 16th, 2017, available at http://www.pewglobal.org/2017/10/16/many-unhappy-with-current-political-system/ 2 In addition to the Pew Research data cited in Chart 5, please see Dora Saclarides, "Do Brazilians Believe In Democracy?" InoVozes, The Wilson Center, November 21, 2017, available at www.wilsoncenter.org. 3 Please see "Brazil: Vox Populi Poll Gives Haddad Lead In Presidential Race," Telesur, September 13, 2018, available at www.telesurtv.net, & Data Poder 360 poll from September 21st, available at: https://www.poder360.com.br/datapoder360/datapoder360-bolsonaro-tem-26-e-haddad-22-os-2-empatam-no-2o-turno/ 4 Please see, BTG Pactual September 15-16 poll, page 18. The Polls states that 57% of Lula voters would "not vote at all" while 41% would vote for Haddad. While turnout will improve for the second round, this is a risk to Haddad. 5 A poll by Empiricus Research and Parana Pesquisas p56 shows that 89.5% intend to vote (which is unrealistic), and that 95.7% of Bolsonaro voters intend to vote while 91.6% of Haddad voters intend to vote. 6 "The PT lost four of the five state capitals it had run, including Sao Paulo, the country's economic powerhouse where the leftist party was born. The PT lost two-thirds of the municipalities it won in 2012, dropping to 10th place from third in the number of mayors controlled by each party." Please see Anthony Broadle, "Brazil parties linked to corruption punished in local elections," Reuters, October 2, 2016, available at www.reuters.com. 7 Gomes has, however, admitted the need for some adjustments to the retirement age and public sector worker privileges, which suggests that he could be brought to pursue structural reforms under the right circumstances. https://todoscomciro.com/en_us/pnd/ciro-gomes-previdencia-social/ 8 Bolsonaro's legislative experience is also surprisingly thin. As a congressional representative for 27 years, he has only passed two laws, after presenting a total of 171 bills and one amendment to the constitution. Only three of these bills presented were of economic nature. It is unclear whether he has what it takes to galvanize the legislature in pursuit of tricky reforms. 9 Please see BCA Geopolitical Strategy Special Report, "Separating The Signal From The Noise," dated September 10, 2014, available at gps.bcaresearch.com. 10 A replacement rate is the percentage of a worker's pre-retirement income that is paid out by a pension program upon retirement. 11 Ratio measuring number of dependent zero to 14 and over the age of 65 to total working age population

Special Report

Highlights Investors have piled into private equity (PE) in recent years, pushing assets under management (AUM) up to an all-time high of $3 trillion. However, there are increasing concerns about the outlook for the asset class over the next few years. In this report, we look at the fundraising and deal environment for PE, analyze historical risk-adjusted returns in comparison to traditional assets, and suggest how investors can optimize their PE allocation. Private equity and its two major sub-categories, buyouts and growth capital, have generated annualized returns of 13.4%, 13.7%, and 15.0% respectively over the past 32 years, significantly beating the returns from global equities and small-cap stocks of 8.4% and 9.1%. But the current environment is tougher. Dry powder (funds raised but not yet invested) exceeds $1 trillion. PE managers face increased competition from other investors and from companies with large cash balances looking to make acquisitions. Funds raised at the peak of bull markets have a higher probability of underperforming. The next two vintage years (2018 and 2019) face headwinds to making good returns, because of high entry valuations and a rising cost of borrowing. Manager selection is critical for a successful private-equity program. Top-quartile PE funds have outperformed second-quartile funds by as much as 8% a year over the past two decades. Feature Introduction The private equity (PE) market has grown more than five-fold since 2000, lifting assets under management from $577 billion to $2.97 trillion. However, its share of the private investment market has declined from 82% to 58% (Chart 1). Private equity and venture capital investing is said to date back to 1901 when J.P. Morgan purchased Carnegie Steel Co from Andrew Carnegie and Henry Philips for $480 million. The industry has evolved significantly over the years, and now encompasses a wide range of sub-strategies, offering investors a spectrum of exposures with very different risk/return profiles. Chart 1Private Equity Is A $3 Trillion Market Compared to public equity, private equity investing is harder because of: 1) long-term illiquidity, whereas public equities can be bought and sold quickly, 2) limited information on target companies, 3) the lack of a clear price discovery function, meaning that pricing in private markets depends heavily on negotiations, 4) less separation between ownership and control - finance providers in PE tend to be managers too. The PE space has matured over the years, and this is clearly seen in the compression of returns. However, many investors remain bullish on this asset class because of its historically attractive risk-adjusted return, and ability to diversify traditional portfolios. As of mid-2017, the median net return of the PE holdings of public pensions globally over the previous 10 years was 8.5% compared to 4.2% for public equities, 4.5% for real estate, and 5.2% for fixed income.1 In this report, we analyze in detail the PE market, with an overview of the fundraising cycle, deal environment, and exit channels. We include in-depth analysis of historical returns from the private equity market in aggregate, and from its two largest sub-categories, buyouts and growth capital. We end by listing the key risks for limited partners (LPs - the investors in PE funds), and include a brief note on private-equity secondary investing. Our key conclusions are: Private equity, including buyouts and growth capital, has had exceptionally good returns over the past three decades, but has been on a structural downtrend as competition has increased. Buyout funds generate a negative skew and moderate kurtosis, whereas growth capital tends to have a larger kurtosis and positive skew. Funds raised at the peak of bull markets have a greater probability of underperforming given their higher entry valuations. This is likely to be the case for funds raised over the next 18 months. The current economic cycle has produced fewer home-run deals - in 2002-2005, 35% of deals produced returns of 3x invested capital, but this fell to 20% in the 2010-2013 period. Megacap buyout funds produce the best returns, but this comes with significantly higher volatility pushing down the risk-adjusted return. These larger funds experience larger negative skew and kurtosis driven by greater use of leverage. Entry valuations of investments made by PE funds have been steadily rising, and so has leverage: the median debt/EBITDA has reached 5.5x. As multiples keep rising, general partners (GPs - the fund managers) have to make up the difference with equity infusion. Top-quartile managers have significantly outperformed. Third-quartile managers struggled even to outperform global equities, and fourth quartile managers failed to preserve their initial capital. The secondary PE market is growing. It provides access to mature portfolio assets deeper into their distributions phase, which reduces the duration of the LP's investment. Fundraising, Deals, And Exits Private equity investing consists of many different sub-categories (Chart 2) that differ in value creation techniques and the maturity of target companies. Buyouts and growth capital are over 90% of the total. Buyouts2 invest in established companies, usually with the intention of improving operations and financials. There is usually substantial use of leverage. Growth capital3 takes significant minority positions in profitable yet still maturing companies mostly without the use of leverage. Secondary funds acquire stakes in PE funds from other LPs. Co-investment funds make minority investments alongside a buyout, recapitalization, or any other non-controlling investment. Turnaround funds aim to revitalize companies that face operational difficulties. Chart 2Buyouts & Growth Capital Are 90% Of PE Private-equity firms raised $701 billion in 2017, making the past five years the strongest period for fundraising in history, with a total of $3.2 trillion (Chart 3). Additionally, more than two-thirds of the funds which closed in 2017 met or exceeded their target amounts, and 39% took less than a year to close. The last time fundraising peaked was in 2008, right in the middle of the last recession. However, since 2009, fundraising for buyouts has dropped from 85% to 70% of the aggregate for private equity, with growth capital picking up the slack, rising from 8% to 21%. As fundraising has gotten stronger, PE firms have been raising larger funds.4 These megafunds (with AUM greater than $5 billion) raised $174 billion in 2017, or 58% of that year's total buyout volume, a steep increase from $90 billion in 2016. For investment institutions with large amounts of capital to deploy, megafunds are an attractive and efficient outlet. Another reason for the very strong fundraising environment has been quick follow-up funds, where GPs race to launch new funds before predecessor funds have matured. Historically GPs have waited an average of 62 months between closing one fund and starting the next, but this has come down to 40 months in the past five years. With fundraising so strong, GPs are under pressure to deploy this capital wisely. Global PE deal volume increased by 14% in 2017, surpassing $1.2 trillion (Chart 4). But global deal count has been on the decline since 2015. Along with larger funds being raised, the average deal size in the private market has been rising steadily since the Global Financial Crisis (GFC). Despite increasing deal activity, the sheer volume of fundraising in recent years has led to massive accumulation of dry powder,5 which currently stands at $1.03 trillion. After 2008, dry powder as a percentage of AUM (Chart 5) was on a downward trend because of increased acquisition activity due to attractive valuations following the GFC. But this bottomed in 2012 at 29% and had risen to 35% at the end of 2017. If this level of dry powder accumulation continues, GPs will be forced to reduce hurdle rates and deploy capital into less attractive deals. Chart 3$3.2 Trillion Raised in 5 Years Chart 4Rising Deal Size Chart 5Harder To Find Attractive Deals Another reason for dry powder accumulation is increasing competition for deals both within the private equity market, and from external sources. The number of private equity funds is at an all-time high of 7,775.6 The external competition comes largely from corporate buyers with large cash balances looking for inorganic growth. Corporations have two advantages over PE firms: 1) potential built-in synergies when it comes to integrating the target, giving them the ability to pay a higher price, and 2) a lower cost of capital. An increasing number of corporations have been setting up corporate venture-capital units (Chart 6) to focus on acquisition-led growth. In 2017, there were 38,479 companies bought and sold globally for a total value of $3.3 trillion. But, private equity's share of this market was just 13% by deal value and 8% by deal count (Chart 7). Looking forward, PE funds are likely to act more aggressively and take a larger share of the market, as they did in 2006-2007. In order to increase their share of global deal activity, private-equity funds need to look at more strategic ways to pick up assets: Chart 6Corporations Setting Up VCs Chart 7Buyouts Only A Tiny Player In Global M&A Zombie Assets: Assets (portfolio companies) belonging to funds that last raised initial capital between 2003 and 2008 but have not executed a deal since 2015. Currently there are over 100 such companies that are possible targets for takeover in 2018-2019. Carve-Outs: Over the past few years, one in five deals in the U.S. has come from corporations disposing of non-core assets.7 This provides a steady deal flow for buyout and turnaround funds. Public To Private: As multiples in private markets converge with those in public markets, more and more publicly listed companies are being taken private, and this market has doubled since 2016 (Chart 8). Additionally, lenders have become more comfortable about financing these high-value transactions. Buy & Build/Add-Ons: Purchasing cheaper small assets and adding them to existing large established platform companies. This in turn transforms a group of smaller companies at lesser multiples into a larger corporation with a premium valuation. Add-ons made up one-third of deals a decade ago, but that has now reached 50%. But, since such deals are smaller in terms of dollar value, they make up less than 25% of the total deal volume. Finally, PE firms have also been increasing the holding period of the assets in their portfolio. The median holding period before the GFC was four years, and this has now increased to over five years (Chart 9). Additionally, private equity firms exited 40% of all deals in fewer than three years, but now these quick-flips have fallen to only 20%. This is partly a response to increased competition: GPs are skeptical about finding new attractive deals, and this forces them to hold onto assets for as long as possible. Additionally, the new U.S. tax code has increased from one to three years the threshold period for carry to be treated as capital gain with a lower tax rate, rather than taxed as ordinary income. With fundraising on fire but deal activity struggling to keep pace, the final pillar for a successful private equity program is the exit environment. Global PE-backed exits have been flat for the past two years at around $500 billion, with the deal count between 2,500 and 3,000 (Chart 10). The rise in exit activity in 2015 was fuelled by PE firms looking to exit portfolio companies acquired before the financial crisis. By 2017, the dynamic had changed since more than 80% of exits that year were companies acquired in 2009 or later. Finally, dividend recapitalizations8 reached $42 billion in 2017, but these are heavily dependent on an accommodative debt market and positive environment for high-yield bonds. With rising rates, dividend recapitalization, and other forms of special dividends or distributions that require borrowing, become harder to execute. Chart 8Public-To-Private Activity Chart 9Longer Holding Periods Chart 10Global PE Exits Are Healthy Historical Returns Before we look at the past risk-return profile of investing in this asset class, a note on the data used in this report. All return data are based on the Cambridge Associates Private Investment Benchmarks.9 We are satisfied with the methodology used and the format in which the returns are presented. The provider has taken sufficient steps to minimize survivorship bias. For more details on the data methodology, please see the Appendix. What can investors expect in terms of risk-return exposure from this asset class? Looking at Table 1, private equity and its sub-strategies have comfortably outperformed global equities, with lower volatility, over the past 32 years. Even after statistically adjusting returns for stale pricing,10 volatility for aggregate private equity and buyouts remains lower than for global equities and small-cap stocks. On the other hand, growth capital has had realized volatility greater than that of global equities, but with a significantly higher return; it is still the more attractive investment on a risk-adjusted basis. However, the significantly lower realized volatility of PE in aggregate, and buyout funds in particular, compared to growth capital makes them more attractive investments. Additionally, venture capital experienced volatility of close to 42%, more than double that of small-cap stocks, making it very unattractive from a risk-adjusted perspective. Table 1Risk-Return Spectrum However, comparing the performance of PE with that of publicly traded assets could be misleading given the uncertain timing of cash inflows and outflows from private equity programs. Therefore, we also show the Public Market Equivalent11 (PME) to adjust public-market indices for uncertain cash flow streams. Looking at Tables 2-4, we can see that private equity still outperforms equity indices on a PME basis over different time frames. Table 2Private Equity PME Analysis Table 3Buyout PME Analysis Table 4Growth Capital PME Analysis Another unique characteristic of private-market returns is the J-curve effect where investments in private markets take time to bear fruit, and fees are initially based on committed capital rather than invested capital. In addition, the biggest cash flows will be received towards the end, so the returns for the first few years can be misleading. IRR will remain negative until the point when distributions at least match contributions (the payback point). Given the non-linear return distribution of alternative assets such as PE and venture capital, risk analysis is not complete without skewness and kurtosis. Investing in buyout funds generates a negative skew and a moderate level of kurtosis, which means that investors can expect more stable, predictable returns, closer to a normal distribution. However, growth capital tends to have larger kurtosis and positive skew, thereby a higher probability of large upside gains. Since buyout capital structures tend to be more heavily geared, there is a higher skew towards negative returns driven by the leverage effect. Venture capital exhibits a return distribution similar to growth capital, where a few portfolio companies produce large positive returns given the start-up nature of its targets. PE returns remain attractive but, as with other alternative asset classes, performance has been on a downward trend (Chart 11) driven by increased competition. In the 1980s and 1990s, buyout firms exploited the poor performance of large U.S. conglomerates by acquiring underperforming divisions and using leverage. In the early 2000s, funds took advantage of the stock market rise, fuelled by low rates and levered returns. Within the structural downtrend in returns, PE has had a cyclical profile just like public equities. During bull markets there are more exits at higher valuations, and larger distributions to LPs. However, funds raised in bull markets have a higher probability of underperforming given their higher entry valuations. Looking forward, funds from recent vintages that are halfway through their life are likely to be able to take advantage of current tailwinds to build value and exit at the top. However, funds raised in the next two years will have to deal with high entry valuations and a possible increase in the cost of borrowing. There have been fewer write-offs and deals with capital impairments in the post-2009 period than in the years after the 2001 recession. However, the current economic cycle has produced fewer of the home-run deals that really drive PE performance. For example, in 2002-2005, 35% of deals produced returns of 3x invested capital or better, and more than 50% generated multiples of 2x or better. For the period 2010-2013, the equivalent percentages were 20% and 42% respectively. Looking at Chart 12, we can see that PE, buyout, and growth capital funds outperformed global equities and small-cap equities during recessions and equity bear markets. Chart 11Private Vs. Public Equity Chart 12Recession & Bear Markets Return persistence is the ability of top-performing manager to repeat the strong performance in their follow-up funds. In the PE industry, some large firms have proved able to repeat top-ranked performance time after time across multiple funds. We believe this is likely a function of their network of contacts that gives them access to proprietary deal flows. However, there are three factors that may be creating a spurious correlation here: 1) GPs tend to raise new funds 2-5 years into the life of an existing fund, thus creating overlapping structures of successive funds that are exposed to similar market environments, 2) investments in some portfolio companies are split between successive funds which induces a spurious patterns of performance persistence, 3) much of the top-quartile performance persistence came during periods of low competition. There is also a relationship between holding period and performance, whereby funds that hold onto portfolio companies for longer have lower performance, while quick-flips perform better. Funds have an incentive to exit successful investments earlier to show a good track record, and to extend the holding period of unsuccessful ones hoping for a better outcome. There is an intrinsic cyclicality in this relationship: in bear markets when valuations are low, funds will hold off from selling their assets in the hope of a better time to sell. Table 5 show the average returns LPs can expect from investing in companies with a specific sector focus. But, this comes with a large amount of idiosyncratic firm- and sector-specific risk; this tends to have a larger impact on buyouts than on venture capital which is already very industry focused. Geographic diversification gives investors access to different economic cycles and levels of market maturity across the globe. In the last recession, PE performance was very poor in some regions, while not that bad in others. There has been a clear cyclical pattern for U.S. versus ex-U.S. performance over the past 30 years, closely linked to the relative growth rates in the underlying economies (Chart 13). Table 5Returns By Sector Exposure Chart 14 shows that from Q3 1998 to Q4 2000 relative performance between buyout and growth capital funds tended to move along with the interest-rate trajectory - the former benefits from falling rates which lower the cost of borrowing. Additionally, looking at median net IRR for funds by vintage year, we see that buyouts outperformed growth capital in 17 out of the 21 years (Chart 15). This was driven by stronger distributions to buyout fund LPs. Additionally; it was achieved with a fairly similar standard deviation of fund performance across vintage years. Within the buyout space, the median U.S.-focused buyout fund outperformed its ex-U.S. counterpart only in 2004-2012. Chart 13U.S. Vs. Rest Of The World Chart 14Impact Of Rising Rates Chart 15Buyouts Vs Growth Capital Finally, when allocating to private-equity and especially buyout funds, investors have a choice between different deal sizes (small to megacap). Looking at Table 6, it is clear that megacap buyout funds have been able to produce the best returns, but this came with significantly higher volatility, pushing down risk-adjusted returns. Additionally, these megacap deals have a larger negative skew and kurtosis - investors should expect a higher probability of large negative returns. Looking at performance in recessions, one can find a relationship between the nature of the downturn and the performance of different buyout deal sizes. For example, during the 2001 recession, the smallest deal sizes produced the worst performance because smaller-cap tech stocks suffered in the aftermath of the dotcom bust. During the 2007-2009 recession, the worst hit were larger buyout deals because of the damage done to the credit market. An analysis of PE would not be complete without a discussion of valuations. The average deal size has risen by 25% since 2009: two-thirds of this increase is due to rising multiples, and the remaining one-third is organic (Chart 16). Median EV/EBITDA has risen from 5.6x in 2009 to 10.7x in 2017. Leverage levels have been rising alongside multiples, and so lenders will be more hesitant to offer debt financing for deals. GPs will have to to make up the funding shortage with equity infusion, and this leads to a decrease in IRR. Additionally, covenant-lite loans have been increasing since 2012 and are now 75% of overall loan volume in the U.S. The percentage of listed companies globally valued at more than 11x EV/EBITDA rose from 20% in 2012 to 54% in 2016. Table 6Size Matters Chart 16Private Equity Is Expensive Lastly, return dispersion is much larger for private-market investments compared to public markets, because of the more active nature of the investment process. If an LP had consistently picked only top-quartile managers from 2000, they would have outperformed second-quartile managers by an impressive 7.7% (Chart 17) a year. Top-quartile managers generated these higher returns with only a trivial increase in volatility, thereby producing far superior risk-adjusted returns. Additionally, skewness and kurtosis measures show no significant deterioration (Table 7). Third-quartile managers struggled even to outperform global equities, and fourth-quartile managers failed even to preserve initial capital. Therefore, manager selection is critical to building a successful private-equity program. Over the past decade, there has been clear compression in fees charged by private equity firms (Chart 18). Management fees tend to differ significantly between the smallest and largest funds; but they are fairly consistent at about 1.975% for funds with AUM between $100 million and $1.9 billion. Chart 17Manager Selection Is Critical Table 7Large Dispersion Chart 18Fee Compression? Risks In Private Equity Chart 19Strong Distributions The long-term investment horizon, illiquid nature, and unique structure of PE bring logistical challenges and unique risks. Given the erratic nature of capital draw-downs by GPs, some LPs might be unable to service capital calls which leads to their defaulting on their obligations. In this case, investors are exposed to funding risk and could lose their entire investment in the fund and all the capital already paid in. LPs tend to use distributions from a mature fund to finance capital calls of younger funds. But this may not be feasible in a slowdown when exits dry up and distributions slow, forcing LPs to raise additional capital from external sources12 for commitments. Many investors run an over-commitment strategy to avoid being under-exposed to their strategic allocation. The strong equity bull market has increased overall portfolio values, meaning that LPs have received large distributions, which have been double contributions since 2013 (Chart 19). Therefore, the net asset value (NAV) of PE holdings has not grown, and allocations even contracted in 2017, forcing LPs to keep plowing gains back into their programs to maintain the target allocation. Investors also face significant liquidity risk. GPs could be forced to sell portfolio companies in the secondary market at a discount to NAV, given the illiquid nature of the market. The secondary market tends to be very cyclical and is likely to experience a deal drought, as seen during the last financial crisis. Market risk is the impact of volatile markets on the quarterly changes in NAV of the portfolio. Capital risk relates to the realization value of the private-equity investments. There is a risk of a private-equity investment going bust and losing all its value. Holding a portfolio of funds exposed to many different companies can reduce this risk and generate a statistical distribution skewed towards positive returns. Additionally, diversification over multiple vintage years should create a right-skewed distribution that minimizes long-term capital risk. A Note On Private Equity Secondaries Chart 20Secondaries: Faster Return But Smaller Upside The secondary market for LPs' private-equity investments is growing. Direct secondaries are the sale of an interest in a direct PE investment or portfolio of direct PE investments to a new third-party investor. A secondaries fund is a PE fund raised by a fund-of-funds manager to acquire limited partnership interests in private equity from the original LPs. Secondary investing is no longer looked at as a source of liquidity for distressed investors, but as a differentiated investment strategy and a regular portfolio management tool to rebalance fund exposures and lock in realized gains. The secondary penetration rate (the percentage of total NAV across all PE strategies that trades in the secondary market) is still less than 2%13 but, as the secondary market continues to expand, investors may see a broader spectrum of assets on sale. Many investors look at the secondary market solely for opportunistic investments, making commitments only during or immediately following periods of market distress. Intuitively this makes sense, as secondary buyers should be able to negotiate steeper discounts during periods of elevated uncertainty and tight liquidity. However, there are many reasons to have a dedicated allocation: It Mitigates The J-Curve: Mature secondary investments cut off several years from the typical term of a PE fund because a good portion of the investment period is already completed. This generates immediate returns from the mature private-equity program. Many fund-of-funds managers will combine secondary interests with their primary portfolios to mitigate the J-curve. Less Blind Pool Risk: In private equity, LPs commit capital to a portfolio that is yet to be built. Secondary investing significantly reduces this risk because portfolios acquired are generally more than 50% invested and have less unfunded commitments. This provides investors with an actual portfolio of companies to evaluate. It Diversifies A Private-Equity Program: An allocation to secondaries can provide instant exposure to a highly diversified portfolio of mature private-equity interests. Lower Probability Of Poor Performance: The potential upside for secondary funds is not as high as that of primary funds, but the former produce poor returns much less frequently (Chart 20). Aditya Kurian, Senior Analyst Global Asset Allocation adityak@bcaresearch.com 1 Source: Bain Global Private Equity Report 2018. 2 Buyouts refers to deals in which a PE fund borrows a significant amount to acquire a target company or companies, which tend to be larger-cap private or publicly listed corporations. 3 Investments in mature companies with proven business models that are looking for capital to expand or restructure operations, enter new markets, or finance a major acquisition. 4 Apollo Investment Fund IX with an AUM of $24.7 billion raised in 2016-2017 is the largest buyout fund raised in history. 5 The amount of capital that has been committed to a private equity fund, but not yet deployed. 6 Source: Pitchbook. 7 The largest global buyout was the $17.9 billion carve-out of Toshiba Memory Corp in 2018. 8 Whereby a company owned by a private-equity fund issues debt in order to pay a dividend to the fund. 9https://www.cambridgeassociates.com/private-investment-benchmarks/ 10 To de-smooth returns, we used a first-order autoregressive model as shown by Rt = A0 + At Rt-1 + e, where At is the auto-regressive coefficient, and A0 is the intercept term. However, statistical methods do not always satisfactorily solve the problem of underestimated volatility for appraised asset values. 11 PME replicates the timing and size of private equity cash flows (purchases and sales) as if they had been invested in public equities. It is the dollar-weighted return that could have been achieved if funds had been invested in the index whenever a capital contribution was made and divested when the GP paid out a distribution. 12 In the Global Financial Crisis, Harvard Management Co issued a bond of more than $1 billion and considered selling a private equity stake of $1.5 billion at a 40%-50% discount to fund its capital calls. 13 Source: Preqin Ltd. Appendix: A Note On Data Sources And Definitions The performance indices all use quarterly unaudited, and annual audited fund financial statements produced by the GPs for their LPs. Partnership financial statements and narratives are the primary source of information concerning cash flows and ending residual/net asset values for both partnerships and portfolio company investments. The data providers' goal is to have a complete record of the quarterly cash flows and NAVs for all funds in the benchmark. All performance is calculated net of fees, expenses, and carried interest. Cambridge Associates (CA) uses two types of return calculation in its indices: Since Inception IRR: This calculates a discount rate which makes the NPV of an investment equal to zero. It is based on cash-on-cash returns over equal periods modified for the residual value of the partnership's equity or portfolio company's NAV. The residual value attributed to each respective group being measured is incorporated as its ending value. Transactions are accounted for on a quarterly basis, and annualized values are used for reporting purposes. End-To-End/Horizon IRR: A money-weighted return similar to the Since Inception IRR, except that it measures performance between two points in time. The calculation incorporates the beginning NAV, interim cash flows, and the ending NAV. All interim cash flows are recorded on the mid-period date of the quarter. With regards to avoiding survivorship bias, CA requires the complete set of financial statements from the fund's inception to the most current reporting date. When an active fund stops providing financial statements, CA reaches out to the manager to encourage them to continue to submit data. CA may, during this communication period, roll forward the fund's last reported quarter's NAV for several quarters. When CA is convinced that the manager will not resume reporting, the fund's entire performance history is removed from the database. Survivorship bias can affect all investment manager databases, including those of public asset managers. But the illiquid nature of private investments can actually help limit this impact, since the private investment partnerships owning illiquid assets will continue to exist and be legally required to report to the LPs even after the original manager ceases to exit. Over the past nine years the number of fund managers that stopped reporting to the database before liquidation averaged per year 0.7% of the total number of funds, and 0.6% of total NAV in the database. During that period the overall number of funds in the database increased by an average of 8% per year. Public Market Equivalent (PME): A private-to-public comparison that seeks to replicate private-investment performance under public-market conditions. The public index is recalculated as if shares were purchased and sold according to the private fund's cash flow schedule, with distributions calculated in the same proportion as the private fund. The PME NAV is a function of PME cash flows and public index returns. The PME attempts to evaluate the return that would have been earned had the dollars been deployed in the public markets instead of in private investments.

Highlights Portfolio Strategy The firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable new home sales expectations, all signal that it is time to buy homebuilders. On the flip side, we do not want to overstay our welcome in the S&P home improvement retail index as a number of leading industry profit indicators have started to wave a yellow flag. Recent Changes Boost the S&P Homebuilding index to overweight today. Trim the S&P Home Improvement Retail index to neutral and lock in gains of 13.3% today. Table 1 Feature Another week, another SPX all-time high. Investors have refocused their attention on the important macro drivers: solid profits, easing fiscal policy, and still-benign monetary policy with the real fed funds rate barely probing 0%. Trade-related rhetoric has taken the back seat as it has now become obvious that the rest of the world will bear the brunt of President Trump's trade escalation. Our EPS growth models are sniffing this out, with the SPX ticking higher, while our global profit model sinking close to nil (Chart 1). Chart 1Ex-U.S. EPS Will Bear The Brunt Of Trade Wars Importantly, we are impressed by how thick-skinned the market has become to negative trade-related news. Putting the looming Chinese tariffs into proper perspective is instructive. Assuming a 25% tariff rate on $250bn worth of Chinese manufactured goods and no relief from the renminbi's steep depreciation since April, results in a "tax" of $63bn. The net new "tax" is actually $53bn as an average 3.8%1 import tariff rate already exists on manufactured goods. The consumer and corporations will bear the brunt of this "tax", so it is worth examining the data on household net worth, consumer incomes, and corporate sales. Federal Reserve data show that household net worth increased by $8.1tn in the past year. BEA data reveal that total wage & salary disbursements increased by $400bn, and BCA's projections call for $600bn increase in SPX sales for 2019 (using IBES data for calendar 2019, Chart 2). In other words, it becomes clear that $53bn in a new tariff "tax" will barely eat into net worth, consumer incomes or corporate revenue flows. In addition, according to the IMF, fiscal easing in 2019 will surpass even this year's fiscal expansion in the U.S. The upshot is that over 1% of GDP in fiscal thrust in 2019 thwarts the specter of tariffs, before the fiscal impulse turns negative starting in 2020 (bottom panel, Chart 2). Meanwhile, following up from last week's report when we posited that the current macro backdrop resembles more the mid-2000s than the late-1990s, we are challenging ourselves and asking what if we are wrong in our assessment. Could we actually be replaying a late-1990s episode instead? Revisiting the late-1990s in more detail is in order, refreshing our memory on the sequence of events that led to the climactic LTCM bailout, and highlighting potential signposts that can be helpful in navigating today's macro and equity market maps. In March 1997 the Fed raised rates and pushed the fed funds rate to 5.5%. In hindsight that was a mistake as the Fed then paused the tightening cycle and watched as the Thai baht began to tumble in late-June 1997, eventually gripping all of the emerging world. True, the U.S. stock market modestly pulled back in October 1997 and the VIX spiked to 38. Then, as equities recovered in Q1/1998 and jumped to fresh all-time highs, suddenly the yield curve inverted in May 1998. Undeterred, the S&P 500 hit another peak in July of 1998 before falling roughly 20% in the subsequent month. Finally, once Russia defaulted and the Fed had to bail out the banks due to the LTCM fiasco, the FOMC, late in the game in September 1998, started to ease monetary policy, and engineered a steepening of the yield curve (Chart 3). Chart 2Trade "Tax" A Drop In The Bucket Chart 3Sequence Of Macro Events Matters The most important signpost from this trip down memory lane is the yield curve. In other words, heed the signal from the bond market: the yield curve inversion correctly predicted a reversal of Fed policy and naturally led the temporary peak in the stock market. Importantly, despite the peak-to-trough near-20% decline in the SPX between July and late-August 1998, if someone had bought the index on Jan 2, 1998 and held through the cathartic LTCM bailout, they remained in the black (bottom panel, Chart 3), and a buy the dip strategy was a winning one. As a last reminder, the SPX jumped another 65% from the August 1998 trough until the March 2000 peak that was preceded, once again, by another yield curve inversion. At the current juncture, were the yield curve to invert we would become overly cautious on the broad equity market as we highlighted in late-June2, and would begin to transition the portfolio away from cyclicals and toward defensives. But, we are not there yet. Thus, we sustain our sanguine broad equity market outlook on a 9-12 month horizon and our SPX target remains 10% higher with EPS doing all the heavy lifting as the multiple moves sideways (for more details, please refer to our April 30th, 2018 Weekly Report titled "Lifting SPX Target"). This week we are taking a deeper dive in housing and housing-related equities and making a subsurface portfolio shift. Look Through The Housing Soft Patch, And... While housing-related data releases have been slightly weaker than anticipated lately, we deem that this softness is transitory as housing market fundamentals rest on solid foundations. On the demand side, first-time home buyers still make only a third of total home sales and the homeownership rate is near generational lows, underscoring that pent up housing demand exists. In fact, the percentage of 18-34 year-olds that live with their parents remains close to 32% a multi-decade high and also represents another source of housing demand that has been dormant because of the Great Recession (Chart 4). Importantly, household formation is still running at a higher clip than housing starts and permits, signaling that the risk of a significant supply/demand imbalance is rising. Historically, this gets resolved via higher prices. Further on the supply side, inventories of existing and new homes for sale remain low and point toward a tight residential housing market (Chart 5). The 98.5% homeowner occupancy rate corroborates the apparent residential real estate market tightness. Chart 4Homeownership Still Well Within Reach Chart 5Positive Housing Demand/Supply Dynamics True, affordability has taken a hit both as a result of rising home price inflation and mortgage rates. But, putting affordability in historical context reveals that homeownership is still well within reach. Were we to exclude that aberration of the post 2007 surge in affordability owing to the collapse in house prices and all-time lows in mortgage rates, affordability is higher than the 1992-2007 range and only lower than the early 1970s. The reason is largely because of still generationally-low interest rates (Chart 5). While a rising interest rate backdrop and sustained house price inflation will continue to dent affordability, as long as job certainty remains intact and wage growth picks up steam as we expect (please see Chart 4 from last week's publication), we doubt that the U.S. housing market will suffer a relapse. ...Boost Homebuilders To Overweight, But... In that light, we recommend augmenting exposure to overweight in the S&P homebuilding index. With the labor market at full employment and unemployment insurance claims on the verge of breaking below the 200K mark, housing starts should regain their footing (Chart 6) and propel homebuilding profits. In addition, the latest Fed Senior Loan Officer survey showed that demand for residential real estate loans ticked higher, while simultaneously bankers remain willing extenders of mortgage credit. The implication is that new home sales will likely reaccelerate in the coming months (third & bottom panels, Chart 7). Chart 6Homebuilders Rest On Solid Foundations Chart 7Lumber Input Cost Relief While galloping lumber prices were previously a key reason for putting the S&P homebuilding index on our high-conviction underweight list, the recent liquidation, down $300/thousand board feet since the mid-May peak, in lumber prices represents a massive input cost relief for homebuilders (second panel, Chart 7). With regard to the relative pricing power front, previous price concessions (new home prices compared with existing home prices) are paying off as new home sales are steadily gaining a larger slice of the overall home sales pie (second & third panels, Chart 8). As input cost relief is slated to kick in during the next few months, especially on the framing lumber front, at a time when new home prices have stabilized, homebuilding sales and profits will likely overwhelm (bottom panel, Chart 8). While the latest NAHB/Wells Fargo National Home Market survey showed some softness on the overall housing market index (HMI), keep in mind that both the HMI and the sales expectations subcomponents of the survey are squarely above the 50 boom/bust line and only slightly below the recent cyclical highs (top and second panels, Chart 9). This healthy housing backdrop is also evident in plentiful construction job openings and expanding national house prices (third & bottom panels, Chart 9). Nevertheless, there are two risks to our upbeat S&P homebuilding view. First, interest rates. At the margin, rising mortgage rates can be a source of deficient housing demand especially for first-time home buyers. However, as mentioned earlier, interest rates are generationally low (middle panel, Chart 10) and the job market remains vibrant which should continue to entice first-time home buyers to make one of the largest purchase decisions of their lifetime. Chart 8Price Hikes Should Stick Chart 9Big Gaps Set To Narrow Chart 10Two Risks: Interest Rates & Wages Second, industry wage inflation. Construction sector wages are climbing rapidly, as much as 150bps faster than overall average hourly earnings (bottom panel, Chart 10). This is another key input cost for homebuilders that could eat into profit margins, especially if new home price inflation does not stick. In sum, a firming long-term housing demand backdrop, lumber price cost relief, steady new home prices and favorable leading indicators of new home sales will more than offset rising interest rates and industry wage inflation. Bottom Line: A playable opportunity has surfaced to ride the S&P homebuilding index higher. Lift exposure to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME - DHI, LEN, PHM. ...Don't Over Stay Your Welcome In Home Improvement Retailers Nevertheless, we do not want to overstay our welcome on the other residential real estate-levered consumer discretionary subgroup, the S&P home improvement retail (HIR) index. We recommend a downgrade to a benchmark allocation for a relative gain of 13.3% since the July 5, 2016 inception. Such a move does not reflect a worsening overall housing view; as we made clear in our analysis above, we remain housing market bulls. Instead, we are concerned that too much euphoria is already priced in HIR equities. Chart 11 shows that fixed residential investment as a percentage of GDP is up 50% from trough to the recent peak (similar to the advance in existing home sales), whereas relative HIR performance is up 170% in the same time frame. Our worry is that optimistic sell side analysts' relative profit forecasts will be hard to attain, let alone surpass (bottom panel, Chart 11). Three main reasons are behind our softening EPS backdrop for home improvement retailers. First, our HIR model has plunged on the back of the wholesale liquidation in lumber prices and rising interest rates (Chart 12). Lumber deflation in particular will prove a profit headwind as building supply Big Box retailers make a set margin on wood products. Chart 11Too Much Euphoria Chart 12Timberrrr! Second, household appliance and furniture & durable selling prices have tentatively crested, and represent another source of profit headaches for HIR (bottom panel, Chart 13). Finally, select industry operating metrics suggest that the easy profits are behind HIR. Not only is our productivity growth proxy (sales per employee) on the verge of deflating, but also an inventory surge has sunk the HIR sales-to-inventories ratio into the contraction zone (second & third panels, Chart 13). But there are still some pockets of strength in the home improvement retailing industry that prevent us from turning outright bearish on the S&P HIR index. Despite the aforementioned easing in appliance and furniture wholesale prices, our HIR implicit price deflator has spiked on a short-term rate of change basis, likely owing to firm demand for remodeling activity. Indeed, the latest NAHB remodeling survey remains perched near record highs. The implication is that the recent lull in industry sales growth may reverse (middle and bottom panels, Chart 14). Importantly, a large driver of the previous cycle's remodeling activity was the availability of HELOCs and the stratospheric rise in Mortgage Equity Withdrawal (popularized by Fed economist Dr. James Kennedy). Now that home equity has nearly doubled to near 60% from the depths of the GFC, there are rising odds that homeowners may begin to tap their rebuilt equity and embark upon more renovations (top & middle panels, Chart 15). Tack on rising disposable incomes (bottom panel, Chart 15) and a buoyant labor market and the outlook for remodeling activity brightens further. Chart 13Operational Trouble Brewing... Chart 14...But Offsets... Chart 15...Exist Netting it out, is it prudent to lock in gains in the S&P HIR index as profit drivers have downshifted at the margin. Bottom Line: Crystalize gains of 13.3% in the S&P HIR index since inception, and downgrade exposure to neutral. The ticker symbols for the stocks in this index are: BLBG: S5HOMI - HD, LOW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Source: The World Bank, https://data.worldbank.org/indicator/TM.TAX.MANF.SM.FN.ZS?locations=US&name_desc=true 2 Please see BCA U.S. Equity Strategy Weekly Report, "Has The Reward/Risk Tradeoff Changed?" dated June 25, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights Rates are going higher ... : Flight-to-quality episodes aside, the bond bear market that began in July 2016 remains in force. Investors should maintain below-benchmark Treasury duration. ... but that doesn't necessarily spell immediate trouble for stocks: Consistent with our work on the fed funds rate cycle, it appears that the level of rates matters more for equity returns than their direction. Empirical evidence of a rates tipping point is elusive ... : The notion that investors migrate from stocks to bonds at a particular level of rates exerts a powerful intuitive appeal, but the data fail to validate it. ... but a 10-year yield Treasury of 3.75 - 4% might halt the bull market in its tracks: Higher rates reliably slow equities only when they rise enough to slow the economy. We estimate that the pinch point is somewhere in the neighborhood of a 3.75 - 4% 10-year Treasury yield. Feature A share of stock is a pro rata claim on the future earnings of the company that issued it. Holding future earnings constant, the price an investor will be willing to pay for a share is wholly a function of the rate used to discount its earnings back to the present day. The simplicity and ubiquity of this valuation approach suggest that equity returns should be predictably related to moves in interest rates. It may also point the way to a tipping point - either in the level of rates, or the magnitude of their rise - at which capital and savings migrate from stocks to bonds. This Special Report reviews the historical record to see how U.S. equities have interacted with real 10-year Treasury yields. It considers the key variables that would logically seem to bear on equity performance and investors' propensity to rotate between asset classes. We find that the relationship between rates and equity returns is conditional, depending on which crosscurrent dominates in any given episode. We did not uncover any predictable rotation pattern. Do The Math As noted above, valuing a stream of future cash flows is a simple mechanical process once one settles on an appropriate discount rate for converting future dollars to current dollars. According to the security analysis textbooks, then, moves in stock prices are inversely related to changes in interest rates. But the textbooks leave out one key point: changes in interest rates don't occur in a vacuum. When they change, earnings estimates are likely to change, too, most often in the same direction as real rates. To be sure, the denominator discounting future cash flows rises when real rates rise, but the future-earnings numerator most likely rises, too. If real rates are rising, the economy is probably gaining momentum, and earnings estimates should probably be revised higher as well. Conversely, falling rates lead to a higher earnings multiple (ex-the not insignificant animal-spirits wild card), but will regularly be accompanied by downward revisions in future earnings. The net effect is uncertain, and depends on whether the multiple change outweighs the change in earnings or vice versa. Bonds Are A Snap Compared To Stocks It's far simpler to compute the impact on a bond portfolio from a given increase in interest rates because the denominator is the only variable that changes. The future-cash-flows numerator is contractually fixed, and it takes a big shift in the state of the economy to spark an economy-wide change in perceived repayment potential.1 This is why bonds' sensitivity to changes in interest rates can be captured in a single universal metric (duration). Stocks are pulled in so many different directions by factors affecting future cash flows that duration has no equity analogue. Investors should therefore be cautious about pinning too much on interest rates as they relate to equities. Bonds move in fixed orbits around the interest-rate sun, according to strictly ordered rules that establish a very clear cause-and-effect relationship. Equities improvise as they go along, taking their cues from a rotating cast of variables that interact differently over time. Attempts to stretch the concept of interest-rate sensitivity beyond bonds regularly trip up equity investors; we cannot know in advance how rates will come together with the other factors that influence equities. Confounding Intuition, Part 1: Equities Prefer Rising Rates (And Multiples Don't Care) U.S. postwar history makes it clear that equity investors need not run from rising rates. The S&P 500 has fared considerably better when real 10-year yields have risen by at least 100 basis points ("bps") than it has when they've declined by that magnitude (Chart 1), gaining 9.4% and 5%, respectively (Chart 2). Rates do not exhibit any sort of a consistent relationship with either forward (Chart 3) or trailing (Chart 4) S&P 500 multiples, though extremely high and extremely low real yields are both associated with lower trailing P/Es. Negative real yields carry an unwelcome whiff of deflation, and their scatterplot data points tend to cluster at below-the-mean forward and trailing multiples. Chart 1Stocks Actually Do Better When Rates Rise ... Chart 2... Considerably Better When Do Higher Rates Hurt The Economy? Charts 3 and 4 show that both forward and trailing multiples almost always decline when real 10-year Treasury yields cross above 5%. What's bad for multiples isn't necessarily bad for earnings, however, and a 5% real threshold is irrelevant to today's cycle. The steady decline in the average fed funds rate over the last several completed cycles (Chart 5) makes it clear that neutral rate thresholds are not constant across time periods. Assessing interest rates' impact on the economy over time requires a sliding scale. Chart 3Hard To See A Trend Through The Windshield ... Chart 4... Or The Rear-View Mirror Estimates of potential economic growth provide a useful yardstick for measuring the impact of real yields. Comparing real long rates to potential output offers insight into the burden of servicing debt across the economy. If real rates exceed the economy's potential growth rate by a material amount, several marginal borrowers are likely to be gasping for air, and their travails will weigh on the economy. Conversely, servicing debt should be easy when real rates are below potential growth, and investors are more likely to invest, businesses are more likely to expand, and consumers are more likely to spend. Chart 5One Size Does Not Fit All There have been 22 instances in the postwar era when real 10-year Treasury yields have increased by at least 100 bps, and Table 1 lists all of them, grouped by their relationship to real GDP's potential five-year growth rate. There are three possible states for interest rate increases in relation to potential output: starting and ending below trend growth, starting below trend growth and ending above it, and starting and ending above trend. The S&P 500 comfortably tops its overall postwar returns when rates go from Below-to-Below and Below-to-Above, but declines outright when rates start above potential growth and go even higher. Earnings consistently rise when rates start below potential growth, making multiples the swing factor - when they expand, S&P 500 gains tend to be very large (Box 1). Table 1Real Rates Versus Potential GDP Growth Box 1 Decomposing S&P 500 Returns Table 2 details the decomposition of S&P 500 returns during rising real rate episodes occurring after S&P 500 earnings estimates began to be compiled in 1979. Except in the crucible of 2009, when they were flat, forward earnings estimates have always risen when rates rise from a below-trend starting point, putting a tailwind behind the S&P 500 that regularly overcomes the multiple contraction that occurs in half of the Below/Above instances. Multiples are the swing factor; when they expand in conjunction with rising earnings estimates, U.S. equities soar. They always contract when rates go from high to higher, dragging stocks down against a mixed earnings expectations backdrop. The action is consistent with our fed funds rate cycle work: stocks do best when rates are below equilibrium and falling because earnings and multiples expand in tandem in that setting, but they do nearly as well after rate hikes commence, in spite of multiple contraction. Earnings surge when the Fed is confident enough about the economy to embark on a tightening cycle, but has not yet hiked enough to choke off the expansion. Multiple expansion in a majority of the Below/Above instances reveals that investors do not rotate out of equities en masse when rates rise, even by a considerable amount. The rotation story has intuitive appeal, but it doesn't show up in these data. Table 2Decomposition Of S&P 500 Returns During Rising Rate Periods A Little More Slicing And Dicing (Potential GDP Matters) Chart 6Mind The Gap Defining Below-to-Below and Below-to-Above states is easy in hindsight, but an investor cannot know in real time where a rising-rate instance that begins with rates below potential output will end. Earnings rise no matter where rates end relative to potential GDP, but re-rating in Below/Below can flip to de-rating in Below/Above, slamming the brakes on phase gains. The empirical data say investors should lighten up on S&P 500 exposure when real rates cross above real potential GDP. S&P 500 returns trounce their overall postwar gain when rates rise from below potential GDP to potential GDP but lag it once rates cross above potential GDP (Chart 6). Confounding Intuition, Part 2: Institutional Investors Don't Rotate Even if S&P 500 returns fail to demonstrate any consistent relationship with interest rates, one would expect that professional investors' asset-class positioning would. Bonds and stocks are alternatives for one another, and institutional investors presumably shift their allocations in line with the asset classes' relative prospects. We examine Pension Funds', Life Insurers', and Mutual Funds' asset-allocation profiles over time using balance-sheet data from the Federal Reserve's quarterly Flow of Funds report. The data show that asset-allocation decisions are made without apparent regard for relative valuations, at least as proxied by the equity risk premium. Pension funds' steady increase in equity allocations across the '90s appears to have been less a function of rate moves than buying into the bull market (Chart 7). Since the dot-com bubble burst in 2000, bond and equity allocations have mainly reflected the performance tides. The extended trend in pension funds' equity-to-bond allocation ratio suggests that the funds set a long-range goal and grind steadily toward achieving it, regardless of relative valuation movements. It also suggests that the funds may not bother with rebalancing, much less dynamic asset allocation. Life insurers kept their fixed income and equity allocations more or less fixed across the '70s (not shown) and most of the '80s. They then reduced equity exposure for three years after 1987's Black Monday, assiduously built it up across the '90s, and have more or less let it drift since the millennium (Chart 8). The equity risk premium does not appear to have been a consideration. Asset-allocation stasis may simply be a reflection of life insurers' stringent regulatory constraints, but their portfolio managers' limited discretion precludes opportunistic allocation shifts. Mutual fund allocations tend to depend much more on past events than future expectations. Equity holdings peak when the equity risk premium bottoms and bottom when the equity risk premium peaks (Chart 9). The problem is that mutual fund managers are structurally hostage to their investors' whims. They are sorted into narrow silos and then straitjacketed by the rigid allocation rules written into their fund prospectuses. Even if they think asset-class rotation is a great idea, only a tiny minority of fund managers can act upon it. Chart 7Pension Funds Don't Allocate Based On Yields Or The ERP ... Chart 8... While Life Insurers Appear To Allocate In Defiance Of Them Chart 9Mutual Funds##BR##Obey Their Owners ... Confounding Darwin's Intuition: Human Investors Never Learn Chart 10... Who Act On Real Emotion, Not Real Yields Kahneman and Tversky's groundbreaking research into decision-making under uncertainty revealed that our species is wired to make suboptimal investment decisions. Prospect theory, loss aversion and an unhealthy fixation on recent data all encourage retail investors to repeatedly shoot themselves in the foot. When it comes to asset allocation, households appear to focus exclusively on the action in the rear-view mirror (Chart 10). Retail investors as a group rotate between equities and fixed income retroactively, in response to recent past returns, not proactively in response to cues about future relative-return prospects. Investment Implications Despite the compelling intuition that investors should set their course by the interest-rate stars, there is no evidence in the flow of funds data that they have done so in the past. We posit that structural constraints on institutional investors, combined with humans' durable cognitive biases, offer no reason to expect that they will do so in the future. While there may not be any predictable rotation pattern, rising rates have given rise to a predictable performance pattern. Equities reliably perform better when real rates are rising by at least 100 basis points than they do when they're falling. Decomposition of S&P 500 returns indicates that the pattern holds because earnings rise a good bit more in rising-rate periods than multiples decline. And multiples don't always decline when rates rise, anyway; sometimes emotion overrides cash flow discounting mechanics. Investors should lighten up on Treasury allocations, while keeping the exposures they do hold at below-benchmark duration. They should not flee equities, however. Rates have not yet risen enough to cool off the economy in any material way, and we judge that they won't until somewhere around a 3.75% 10-year Treasury yield.2 Tight supplies in labor and goods markets will eventually stoke realized inflation and provoke the Fed into tightening enough to cut off the rally, but it hasn't happened yet, and it is far too early to de-risk portfolios on account of interest rates. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 An unusually large drop in rates may well be associated with economic distress, but default-adjusted bond payment streams are much less variable than near- and intermediate-term earnings estimates. 2 Based on the evolution of the Congressional Budget Office's longer-run estimates of real potential GDP growth, and the trend in our own model of long-term inflation expectations, it appears as if nominal potential GDP growth will be somewhere in the neighborhood of 3.75-4% next year. This is a much lower estimate than one would get from adding the Fed's 2% inflation target to the current rate of GDP growth, but we need to look past the immediate boost of the stimulus package to get a read on its longer-run effects. As with all of the estimates produced by our models, we look to it for a general guide to the future, not a precise point estimate.

Highlights So What? President Trump is treating the midterm election as a hurdle. Once cleared, he will restart "Maximum Pressure" policy towards China and Iran that will induce market volatility. The outcome of the election, however, has only a marginal investment relevance. Why? A Democrat-held Congress will not have the votes to overturn President Trump's signature economic policies: tax cuts, deregulation, and stimulus. Removal from power requires 67 votes in the Senate, out of the reach for Democrats. President Trump will pursue aggressive foreign and trade policies, regardless of the midterm outcome. As such, the midterm outcome is a non-diagnostic variable. Also... Rising stroke-of-pen risk, combined with President Trump's unorthodox foreign and trade policies, will likely intensify following the midterm election. Therefore, it is difficult to "buy on (midterm-related) dips," despite our call that the election does not matter. Feature Should investors care about the upcoming midterm election? The answer is yes, but marginally. A gridlocked Congress, our most likely outcome, is historically less positive for equities than an electoral outcome that results in a unified executive and legislature (Chart 1). The reality, however, is that economic and monetary variables are overwhelmingly more important for investors than politics.1 Table 1 illustrates the impact of four factors on monthly S&P 500 price returns. The first two columns demonstrate the effect on returns of recessions and tightening monetary policy, respectively, whereas the last two columns measure the effects of gridlock and reduced uncertainty in the 12-months following presidential and midterm elections.2 The table presents the beta of a simple regression based on dummy variables for each of the four components (t-statistics are shown in parentheses). Chart 1A Unified Congress Is A Boon For Stocks Table 1A Divided Government Is Marginally Negative For Stocks As expected, the macro context has a much larger impact on stock returns than politically driven effects. The impact of political gridlock is shown to be negative regardless of the timeframe, but only just. Could 2018 be different? Given the extraordinary level of polarization - captured in Chart 2 by the difference in presidential approval by party identification - this time could, indeed, be different. But, we do not think it will be. As we discussed last week,3 Democrats in Congress would not be able to impact the three crucial pillars of the Trump Reflation Trade: De-regulatory agenda: The executive branch is in charge of the deregulatory agenda, which investors should note kindled corporate animal spirits on day 1 of the Trump presidency (Chart 3). Chart 2Presidential Approval Variance Signals Peak Polarization Chart 3Trump's Mere Election Stoked Animal Spirits Tax cuts: Without 67 votes in the Senate, the Democrats cannot overturn a presidential veto that is certain to be used on any tax-hikes as long as President Trump is in power. They won't even get to the 60 votes necessarily to invoke cloture and thus avoid a Republican filibuster on tax, immigration, or other policy reforms. Fiscal policy: We see no chance of the Democratic Party becoming the party of fiscal discipline ahead of the 2020 election. Voters are not demanding budget discipline, despite the obvious rise in budget deficits (Chart 4), so why would the Democratic Party nail itself to the fiscal conservative cross over the next two years? What of the impeachment risk? There is no empirical evidence that impeachment proceedings have any impact on U.S. equity markets.4 And we would fade any concerns that an impeachment push would cause President Trump to seek relevancy abroad with aggressive foreign and trade policies because we expect him to do so regardless of the midterm outcome! Nonetheless, we do think that investors are in for a mild surprise this November (Chart 5). First, the data suggests that Democrats will have a wave election. In fact, we are raising our probability of a Democratic House victory to 70%, largely in line with current expectations. Second, we are also raising our call on the Senate to a "too-close-to-call." Essentially, we think that the Democratic Party may be able to pick up a Senate seat, which would be an extraordinary outcome given that they are defending 26 seats out of the 35 in contention.5 While such an electoral surprise may not have immediate investment implications in 2018 and 2019, it could have implications beyond 2020. The Senate electoral math significantly changes in 2020, with Republicans currently set to defend 21 seats out of 33 in contention (a number that could grow due to retirements). A Democratic sweep of U.S. institutions in 2020 could significantly alter the long-term earnings outlook in the U.S., especially if America's center-left party swings further to the left by then. Such an outcome would put an end to the two-decade long divergence in profits and wages as share of the total economy (Chart 6). But more on that at a later point. In this report, we focus on the upcoming election itself. Chart 4Voter Fiscal Preferences Are Not Fixed Chart 5Our Senate Call Is Out Of Consensus Chart 6What Is Not Sustainable Will Stop Midterm Election: The Twenty Charts To Watch History is stacked against the Republican Party. Chart 7 shows that the president's party has lost, on average, 24 seats since the 1950 midterm election. Only Clinton in 1998 - at the top of an epic bull market and with an approval rating of 66% (!) - and Bush Jr. in 2002 - following a once-in-a-generation terrorist attack on the U.S. homeland - managed to eke out positive gains. Even in those Goldilocks conditions, Clinton's Democrats only picked up a paltry five seats in the House (none in the Senate), while Bush's GOP gained two Senate and eight House seats. Chart 7Midterm Elections Normally Spell Doom For The President's Party Polls suggest that this time will not be different. Both the congressional generic ballot (Chart 8) and President Trump's popularity - at just 39% - (Chart 9) are signaling a wave election for the Democrats. Chart 8Polling Gives Dems The Advantage Chart 9President Trump Is A Drag On The GOP... But what about the roaring economy? Astonishingly, economic performance has a negative correlation with electoral outcomes in congressional elections (Chart 10)! This data point is so counterintuitive that it must be wrong. At the very least, history suggests that there is no clear relationship between the economy and congressional returns. Chart 10...Whereas The Economy Is Unlikely To Provide A Tailwind The economy only matters when things are going wrong. Current polls, in other words, are already pricing in a solid economic context, with the Democratic lead over the Republicans having narrowed from double-digits since the economy began roaring in January (Chart 11). At this point, however, it is highly unlikely that two more months of solid economic performance will have much of an effect on voter preferences. In fact, the importance of the economy, jobs, and budget deficits to voters has been declining since 2014 (Chart 12). Chart 11The Economy Is Already Baked In The (Polling) Cake Chart 12Voters Care Less About Economic Issues In addition, investors should remember that voter experience of the economic recovery is highly polarized. During Obama's presidency, Republican voter consumer sentiment and expectations were at recession levels. Magically, on November 8, 2016, both Republicans and Democrats changed their sentiment (Chart 13). Independent voters are, unsurprisingly, somewhere in the middle. Chart 13Voters Cannot Agree On Economic Performance Anyway Primary election turnouts are confirming that the economy is not the primary driver of voter enthusiasm. Democrats have seen 8.9 million more voters vote in the 2018 primaries, compared to the 2014 midterm election. Meanwhile, GOP voters - who are presumably more enthused about the economy - have only seen a pickup of 3.8 million new primary voters. The pattern of primary voting is similar to the one in 2010, when the Tea Party revolt energized the Republican base in opposition to President Obama. In 2010, Republicans increased primary turnout in 186 congressional districts compared to the 2006 election. Satisfied with President Obama's win in 2008, Democrats only increased the primary turnout in 35 districts. As a result, the GOP picked up 63 House seats and gained control of the lower chamber of Congress. This time around, the numbers foreshadow a similar wave, but in favor of the left. Democrats have seen their turnout increase in 123 electoral districts, compared to the 2014 election. This includes 20 of the most competitive races this year. Republicans, meanwhile, have seen an increase in enthusiasm in only 19 congressional districts this year. The death knell for Republicans in the House of Representatives, in our view, will be the abnormally large number of retirements (Chart 14). Incumbency has a powerful effect in congressional races. On average, incumbents easily win over 90% of their races for the House (Chart 15). Chart 14Double More GOP Retirements This Year Chart 15Incumbents Normally Carry The Day The average margin of victory for the Republican representatives not running for re-election in the 42 electoral districts in 2016 was 28.3%6 (Table 2). This sounds like too high of a hurdle for Democrats to leap over. However, that is precisely what Democratic candidates have done in the House and Senate special elections in 2017 and 2018. The average GOP lead in those races is down from 29.2% in 2016 to just 8.5% today, a 20.7% swing (Table 3). This math explains why the Cook Political Report, the premier U.S. election forecasting consultancy, sees the number of competitive Republican-held seats more than doubling in 2018 (Chart 16), whereas the number of competitive Democratic-held seats has collapsed. Table 2Republicans Not Seeking Re-Election In 2018 Table 3Non-Incumbent Republicans Lost 20% Advantage In Special Elections Our Senate model is similarly flashing red for the Republican Party. Despite an overwhelming structural advantage in the 2018 cohort - having to only defend nine seats - our model is predicting that the Democrats will hold all their Senate seats and pick up one (in Nevada) (Chart 17). Chart 16Number Of GOP Seats At Risk Has More Than Doubled! Chart 17Our Senate Model Is Generous To The Democrats We modeled the individual Senate races by combining the state and national economic and political variables with the latest available opinion polling.7 We only focused on the races that we believe are currently competitive and we may change the mix as new information becomes available. The results of our "beta" model, expressed as a margin of victory by the Republican candidate (GOP total vote minus Democrat total vote), show that the Democrats have a surprisingly decent chance of picking up the Senate. Highly concerning for President Trump and the GOP is that the Democratic Senate candidates have a healthy lead in three out of the four contested Midwest races (Chart 18), suggesting that Trump's crossover appeal to blue-collar voters is not working when he is not the candidate (or perhaps, even more alarming for the GOP, when Hillary Clinton is not his opponent). The only tight Midwest election is in Indiana, where Democratic incumbent Joe Donnelly's lead is within the margin of error. Another concern for the Republicans is that the Democrats have largely fielded centrist candidates in the House and Senate races. For example, former Tennessee Governor (2003-2011), Phil Bredesen, is a conservative Democrat currently leading in the polls against his Republican opponent. Democratic candidates for election in Republican-held Arizona and Nevada are similarly centrists and thus competitive (Chart 19). Furthermore, in the 42 seats where Republicans are fielding non-incumbents, our research suggests that Democrats only fielded 14 left-wing/progressive candidates.8 Despite the media's focus on left-wing/progressive candidates - such as Alexandria Ocasio-Cortez in the Bronx or Ayanna Pressley in Boston - the vast majority of Democratic candidates in the non-coastal U.S. have been centrists. This means that GOP candidates will have very few "lay-ups" in November. Putting it all together, we would give Democrats a 70% chance of picking up the necessary 23 seats to take over the House. In the Senate, the next two months will determine the outlook for GOP candidates. Investors should fade the message from the current polling - and thus our model - as voters have paid very little attention to local races before Labor Day. However, if the current trajectory in the congressional generic poll and Trump's popularity holds until November, the likelihood of a GOP hold in the Senate will fall. For President Trump, a result where he loses the House and the Senate would be a political disaster. Should investors prepare for the volatility of impeachment in that case? The midterm election is a non-diagnostic variable. The Senate requires 67 votes to convict the president and thus remove him from power. A 50 +1 majority will not help Democrats get to that level any more than a 50 -1 minority would. They will need Republican Senators to join them in the impeachment endeavor. For that to happen, Republican voters will have to lose confidence in President Trump in droves, as they once did in President Nixon. As Chart 20 clearly illustrates, we are nowhere near that point today. Chart 18The Midwest: Is The Trump Magic Gone? Chart 19The Sun-Belt: No Place To Hide For The GOP? Chart 20Trump Is Not Nixon (Yet) Investment Implications: Much Ado About Nothing Putting it all together, this year's midterm election has a good chance of dominating the news flow by producing a shocking electoral surprise. In the immediacy of an outcome that hands the control of the entire Congress to the fired-up Democrats, it would be smart to bet on a brief risk asset pullback. However, the Democrats will not be able to unravel any of President Trump's main economic policies. In fact, investors may be presented with higher odds of an infrastructure plan and even of an immigration deal, if President Trump faces reality and comes to the middle ground on some of his demands (as President Clinton did after his disastrous 1994 midterm election). As for impeachment and the risk of President Trump "seeking relevancy abroad," our high conviction view is that he will continue pursuing unorthodox foreign and trade policies regardless of the midterm outcome. The just-announced 10% tariff on $200 billion of Chinese imports confirms our alarmist view on trade tensions. In fact, President Trump has explicitly threatened an increase of the tariff rate to 25% by the end of the year in order to put more pressure on Beijing. The increase in the tariff rate would be a significant escalation in the trade war, one that we do not expect Chinese policymakers to simply roll over and accept. Meanwhile, the U.S. embargo on Iranian oil exports will officially begin on November 4, just two days before the midterm election date. This is not a coincidence, but a product of White House design. We expect President Trump to turn the screws on Iranian exports in ways that President Obama did not.9 Given the potential impact on domestic gasoline prices, the White House has decided to coincide the pressure on Tehran with the end of the election season. The midterm election, therefore, is important only in terms of timing. Once it is out of the way, President Trump will refocus on his "maximum pressure" tactic, which he believes (and we agree) led to a breakthrough in North Korea policy. Unfortunately for the markets, we do not expect that the maximum pressure tactic will work as smoothly with Iran and China.10 The final risk to markets is the creeping "stroke of pen" risk from potential regulation of technology enterprises. Joseph Simons, the Trump appointed new chair of the Federal Trade Commission, recently said that "the broad antitrust consensus that has existed... for about 25 years is being challenged... the U.S. economy has grown more concentrated and less competitive."11 His comments have dovetailed the threat to FAANG stocks that exists from a shift in U.S. anti-trust enforcement, one that would take the anti-trust practice away from the consumer-friendly approach of the "Chicago School."12 Chart 21FAANG Stocks + Microsoft Have Dramatically Outperformed... Table 4...Generating 50% Of The 2018 S&P 500 Return! This is a big risk for the ongoing bull market as the reason why the S&P 500 has performed well is due to the performance of a few (enormous) technology stocks that have seen both earnings and valuation multiples expand amid one of the longest economic growth phases in history (Chart 21 and Table 4). And yet the one thing that a plurality of Democrats and Republicans seem to agree with is that major tech companies should be regulated (Chart 22). Privacy advocates - who tend to lean left or libertarian - and conservatives, who feel that their commentators are being silenced by Silicon Valley, could form a classic "bootleggers and abolitionists" coalition against the FAANGs post midterm election. In fact, it is the one thing that Trump, and his supporters may (Chart 23), have in common with a potentially left-leaning Congress. Chart 22Majority Of Americans Want Tech Regulated Chart 23Conservatives Distrust Tech Companies How should investors play the midterm election? It is tough to say. We do not think the Democrats' takeover of Congress will be a catalyst for the markets. However, there are a slew of concerning geopolitical developments that will accelerate post-election, some specifically because President Trump will become more aggressive following the electoral hurdle. As such, we would be cautious. While it may serve investors well to "buy on dips" related to the fear of a "Socialist" takeover of Congress, it will be difficult to disassociate such hysteria from genuinely bearish narratives emanating from the Middle East, with trade policy, or stroke of pen risks looming over FAANG stocks. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA U.S. Investment Strategy Weekly Report, "A Party On The QE2," dated November 8, 2010, available at usis.bcaresearch.com. 2 We include the last factor in the regression because it could be that the market responds positively in the post-election period, irrespective of the election outcome, simply because political uncertainty is diminished. 3 Please see BCA Geopolitical Strategy Weekly Report, "Fade The Midterms, Not Iraq Or Brexit," dated September 12, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 We are counting Senators Angus King (Maine) and Bernie Sanders (Vermont) as "Democrats" in this tally as they both caucus with the Democratic Party and generally vote very much in line with their left-leaning peers. 6 Excludes Pennsylvania due to redistricting in early 2018, and OK-01, as the candidate ran unopposed. 7 The state variables include the annual percent change in personal income, the annual change in the Philadelphia Fed Coincident index, and incumbency. The national variables include presidential approval ratings, a variable indicating whether the last presidential election was close, and the annual percent change in real GDP, CPI, industrial production, and the DXY. We add to this mix of national and state data the latest opinion polling by state race and the generic congressional ballot. 8 This number is largely our judgement call based on the statements from the Democratic primary winners. However, the fact that there is no unified progressive movement - akin to the 2010 Tea Party revolution - confirms our view. 9 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Weekly Report, "Are You Ready For 'Maximum Pressure?'," dated May 16, 2018, available at gps.bcaresearch.com. 11 Please see Diane Bartz, "Trump's antitrust enforcer considers shifting up a gear," dated September 13, 2018, available at reuters.com. 12 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Is The Stock Rally Long In The FAANG?" dated August 1, 2018, available at gps.bcaresearch.com.

Highlights Portfolio Strategy Stick with a neutral weighting in the tech sector as rising interest rates, higher inflation and a firming greenback offset improving industry operating metrics on the back of the virtuous capex upcycle. Chip and chip equipment stocks will remain under pressure as global semi sales are under attack and leading indicators of semi demand suggest that more pain lies ahead at a time when chip selling prices are steeply decelerating. Recent Changes There are no changes to our portfolio this week. Table 1 Feature Equities regained their footing last week and remain perched near all-time highs. Investors are largely ignoring the trade-related uncertainty and are instead focusing on the upbeat economic backdrop. Both soft and hard data continue to send an unambiguously healthy signal for the U.S. economy, a potent tonic for corporate profitability. Chart 1EPS Will Do All The Heavy Lifting While a lot of parallels have been drawn between today and the late-1990s, our sense is that the current financial market and economic outlooks resemble more the mid-2000s. Chart 1 shows that, between 2004 and the stock market peak in late-October 2007, forward profit growth estimates peaked at over 20%/annum and the forward multiple drifted steadily lower. Nevertheless, stocks remained well bid and rose alongside forward EPS (top and third panels, Chart 1). In other words, despite decelerating forward profit growth estimates and a contracting forward multiple, expanding forward EPS did the heavy lifting, explaining all of the advance in the SPX. The similarities to today are eerie: while profit growth peaked in Q1/2018, 10% EPS growth is elevated for the tenth year of an expansion, and the forward multiple is coming in (Chart 1). On the policy front, the Bush tax cuts hit in the mid-2000s with the elimination of the double taxation of dividends and a drop in personal income tax rates, along with a one-time cash repatriation of corporate profits stashed abroad. With regard to the economic backdrop, capex was roaring and nominal GDP was firing on all cylinders as a housing bubble was getting inflated. The GDP deflator also hit a high mark. The ISM manufacturing survey eclipsed 61 in 2004 and non-farm payrolls were expanding smartly (Chart 2). But despite all that apparent overheating especially in the housing market, the real fed funds rate was near zero in 2004 (top panel, Chart 3). Finally, a number of financial market metrics were also similar to today. Oil prices were on their way to triple digits, high yield spreads were below 400bps and the VIX probed, at the time, all-time lows (Chart 3). However, one key difference between the mid-2000s and today is the strengthening U.S. dollar. The firming greenback remains a key risk to our positive equity market view (bottom panel, Chart 3), as it will eventually infiltrate EPS. Netting it all out, if history at least rhymes, an earnings-led advance in the SPX is the most likely outcome. Our sanguine cyclical (9-12 month) equity market view remains predicated on a 10%/annum increase in EPS and a sideways-to-lower move in the forward multiple. Meanwhile, wage inflation is slowly starting to rear its ugly head. In fact, we are surprised by the fits and starts in average hourly earnings growth. At this stage of the cycle, wage growth should start galloping higher as executives aggressively bid up the price of labor in order to fill job openings and bring expansion plans to fruition. A simple wage growth indicator comprising resource utilization and the unemployment gap suggests that wage inflation will really kick into higher gear in the coming 12 months (shown as a Z-score, Chart 4). Chart 2Eerie... Chart 3...Parallels With 2004 Chart 4Mind The Return Of Inflation Two weeks ago we highlighted that the S&P 500's profit margins are benefiting from lower corporate taxes and muted wage growth, a goldilocks backdrop. Despite evidence of a pending inflationary impulse, as long as businesses are successful in passing rising input costs down the supply chain and onto the consumer, then margins and EPS will continue to expand. Nevertheless, deconstructing the SPX's all-time high profit margins is in order. Chart 5 & Chart 6 show the 11 GICS1 sector profit margin time series using Standard & Poor's data, and Chart 7 is a snapshot of Q2/2018 profit margins for the 11 sectors and the broad market. Chart 5Sectorial Profit ... Chart 6...Margin Breakdown Chart 7Tech Is A Clear Outlier Five sectors (tech, industrials, materials, consumer discretionary and utilities) are enjoying record-high profit margins, and four (financials, consumer staples, telecom services and real estate) are on the verge of joining that club. This leaves two sectors with declining margin profiles: health care and energy. While most sectors are +/- five percentage points away from the S&P 500, the tech sector sports profit margins at twice the level of the SPX or eleven percentage points higher and is the clear outlier (Chart 7). The implication is that the broad market's EPS fortunes are closely tied to the high-flying tech sector that commands a 26% market cap weight. Thus, this week we are compelled to highlight the deep cyclical tech sector, and two of its hyper-sensitive and foreign exposed subcomponents. Tech On Steroids In late-August we published a chart on tech margins (which we are reprinting today) showing the upward force they have exerted on the broad equity market for the better part of the past decade (top panel, Chart 8). Naturally, stratospheric profits must underpin these parabolic margins. The middle panel of Chart 8 highlights that since 2006 tech EPS have almost quadrupled, pulling SPX profits higher. As a reminder, the S&P tech sector commands a 24% profit weight in the S&P 500, the highest since the history of this data series and almost double the weight during the previous cycle's peak (bottom panel, Chart 8). The implication is that in order for the broad market to suffer a severe blow, tech has to take a hit, and vice versa. Chart 8Secular Tech EPS Growth Has Boosted Margins Chart 9EPS Growth Model Flashing Green On the EPS front, our profit growth model has recently ticked higher from an already extended level, signaling that the profit outlook remains bright (Chart 9). The virtuous capex upcycle - BCA's key theme for the year - remains the key driver behind our EPS model. Chart 10 shows that the tech sector continues to make inroads in the overall capex pie, according to financial statement-reported data, and has now doubled its share since the GFC trough to roughly 12%. National accounts corroborate this data and underscore that pent up demand is getting unleashed, following a near 15-year hibernation period (bottom panel, Chart 10). The news on the operating front is equally encouraging. The San Francisco Fed's tech pulse index - an index of coincident indicators of technology sector activity1 - is reaccelerating. Tech new orders-to-inventories are also picking up steam and suggest that sell side analysts have set the relative EPS bar too low (Chart 11). Finally, the latest PCE report revealed that consumer outlays on tech goods are also gaining momentum, even relative to overall consumer spending. While this upbeat backdrop would point to an above benchmark tech allocation, three risks keep us at bay. First, the tech sector garners 60% of its revenues from abroad and thus the appreciating U.S. dollar is a significant profit headwind, especially for 2019 when the delayed negative FX translation effects will most likely emerge (third panel, Chart 12). Chart 10Capex On The Upswing... Chart 11...Underpinning Tech Operating Metrics... Chart 12...But Three Risks Keep Us At Bay Second, a rising U.S. inflation backdrop along with the related looming selloff in the bond market should knock the wind out of the tech sector's sails. Tech business models are built to withstand deflation and thrive in a disinflationary environment. Thus, when inflation re-emerges, tech stocks suffer (CPI and 10-year UST yield shown inverted, top two panels, Chart 12). Third, leading indicators of emerging Asian demand are souring rapidly and were the trade war to re-escalate, EM in general and tech-laden Korean and Taiwanese economic data in particular would retrench further (bottom panel, Chart 12). Bottom Line: We prefer to remain on the sidelines in the S&P information technology sector and sustain a barbell portfolio within the sector. As a reminder we continue to express our bullishness via two high-conviction overweight defensive tech sub-sectors, S&P software and S&P tech hardware, storage & peripherals (THSP), and our bearishness via avoiding their early cyclical peers, S&P semis and S&P semi equipment. Avoid Chip Stocks At All Costs While we are neutral the broad tech sector and prefer secular growth defensive tech sub-sectors, we continue to recommend shying away from chip and chip equipment stocks. Chart 13 shows the extreme sensitivity to changes in final demand of chip related stocks versus their defensive tech peers. In more detail, software and THSP indexes are in a secular advance with regard to EPS outperformance, whereas semis and semi equipment profits are hyper-cyclical with mean-reverting relative profit profiles. Granted, the commoditization of semiconductors explains this close correlation with the business cycle. But, as we highlighted last November when we put the semi equipment index on the high-conviction underweight list, extrapolating EPS growth euphoria far into the future was fraught with danger.2 In fact, late-November 2017 marked the peak in semi equipment performance versus the overall IT sector, confirming the early cyclical nature of chip stocks (Chart 14). Chart 13Bifurcated EPS Chart 14Good Times... Three factors have weighed heavily on this industry's growth prospects and there is no light at the end of the tunnel yet. Bitcoin's (and other cryptocurrencies) collapse is dealing a blow, at the margin, to demand for semi equipment (top panel, Chart 15). Taiwan's financials statement-reported data on IT capex and national data on overall Taiwanese capital outlays corroborates this downbeat demand backdrop (Chart 16). Finally, the drubbing in EM currencies is sapping purchasing power from the consumer and also warns that things will get worse for U.S. semi equipment stocks before they get better (bottom panel, Chart 15). Chart 15...Do Not Last Forever Chart 16Semi-Heavy Taiwan Emits A Grim Signal The outlook for their brethren, semi producers, is equally downtrodden. Global semi sales have crested and leading indicators of future semi revenue growth are sending a warning signal. Chinese imports of electronics have come to an abrupt halt, and the U.S. dollar's appreciation is also waving a red flag (second & bottom panels, Chart 17). BCA's calculated global leading economic indicator excluding the U.S. and BCA's calculated global ZEW Indicator of Economic Sentiment excluding the U.S. both herald a steep deceleration in global semi sales (Chart 17). On the pricing power front, using Asian DRAM prices as an industry pricing power gauge, DRAM momentum is on a trajectory to contract some time in Q1/2019. The implication is that semi earnings will surprise to the downside. Still expanding global chip inventories are not providing an offset and also confirm that semi EPS optimism is unwarranted (middle & bottom panels, Chart 18). Finally, another source of demand for chip stocks has reversed, as industry M&A activity has plummeted toward decade lows. Not only is this negative for pricing power, but inflated premia are also now working in reverse especially given this year's QCOM/NXPI and AVGO/QCOM flops (top panel, Chart 18). Our Chip Stock Timing Model (CSTM) does an excellent job encapsulating all these moving parts and is currently in the sell zone (bottom panel, Chart 19). Chart 17Global Semi Sales Trouble... Chart 18...Abound Chart 19Chip Stock Timing Model Says Sell Bottom Line: Continue to avoid the S&P semis and S&P semi equipment indexes. The ticker symbols for the stocks in these indexes are: BLBG: S5SECO - INTC, NVDA, QCOM, TXN, AVGO, MU, ADI, AMD, MCHP, XLNX, SWKS, QRVO, and BLBG: S5SEEQ - AMAT, LRCX, KLAC, respectively. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 2 Please see BCA U.S. Equity Strategy Weekly Report, "2018 High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Special Report

Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Table 3Risk Return Profiles Of Sub-Investment Grade Baskets 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Chart 10DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017.

Special Report

Dear Client, I am travelling in Europe this week visiting clients. Instead of our Weekly Report, we are sending you a Special Report written by my colleague Xiaoli Tang of BCA's Global Asset Allocation. The report examines three types of instruments investors can look to in order to enhance risk-adjusted portfolio returns at a time when interest rates and inflation are low but rising: floating-rate notes, leveraged loans and Danish mortgage bonds. I trust you will find it informative. Best regards, Peter Berezin, Chief Global Strategist Highlights In an environment where both interest rates and inflation are low but rising at a time of stretched equity valuations, what can investors do to enhance risk-adjusted portfolio returns? In this report, we investigate the roles of three types of popular instruments in a portfolio context: 1) Floating-Rate Notes, 2) Leveraged Loans and 3) Danish Mortgage Bonds. Floating-rate notes benefit from rising interest rates, but they are not a free lunch. Leveraged loans also benefit from rising interest rates; their very high correlation with high-yield bonds make them a good substitute for a portion of high-yield exposure in a rising-rate environment. Danish mortgage bonds have attracted foreign investors in recent years, but foreign ownership already accounts for about a quarter of the less than half a trillion USD market. Their positive correlation with aggregate bonds and negative correlation with equities in both Japan and the euro area make them a possible substitute for a portion of the bond basket in a balanced portfolio. Feature BCA has upgraded cash to overweight in the current environment, where inflation and interest rates are both low but rising, and equity valuations are stretched.1 For U.S. investors, holding cash is quite attractive as the cash yield is now higher than the equity dividend yield. For investors in the euro area, Switzerland, Sweden, Denmark and Japan, however, holding cash actually is a sure way to eat into portfolio returns, given the negative yields in these countries (Table 1). Table 1Current Yields* (%) Some clients, particularly those in Europe, have asked where to put cash to get higher returns. Unfortunately, it's hard to increase return without assuming additional risk. As shown in Table 1, investors could pick up some yield by putting money in 3-month deposits instead of 3-month Treasury bills, but even 3-month deposit rates are still negative in some European countries. In this report, we investigate the roles of three types of popular instruments in a low but rising rate environment: 1) Floating-Rate Notes (FRNs), 2) Leveraged Loans (LLs) and 3) Danish Mortgage Bonds (DMBs). 1. Floating-Rate Notes An FRN offers coupon payments that float or adjust periodically based on a predetermined benchmark rate. Typical benchmarks in the U.S. are Treasury bills, LIBOR, the prime rate or some other short-term interest rate. Once the benchmark is chosen, the issuer will establish an additional spread that it is willing to pay over the chosen benchmark rate. The spread mainly reflects an issuer's credit quality and the time to maturity of the note. Even though coupon reset frequency can vary between daily, weekly, monthly, quarterly and yearly, the average coupon rate has responded quickly to the fed funds rate, as shown in Chart 1. Issuers can be both government-sponsored enterprises and investment-grade corporations. Before the 2008 Great Financial Crisis, FRNs were mostly issued by corporations. Some of the notes, however, performed badly during the financial crisis, causing a drop in both total issuance and the share of corporate issuance (Chart 2). FRNs can be either callable or non-callable with or without caps and floors, so FRNs carry credit risk - and callable ones also carry call risk. In terms of interest rate risk, it applies mostly to the income received. Chart 1Rising Rate Environment Benefits FRNs Chart 2Corporate Dominance In FRN Market Because of the nature of floating rates, FRNs can benefit from rising interest rates and have limited price sensitivity to interest rates. As shown in Chart 3, the Bloomberg/Barclays U.S. Floating-Rate Note index has lower duration than the cash index, as represented by the Bloomberg/Barclays Treasury (<1 year) index, while it offers a nice yield pickup. Since the inception of the index in December 2003 it has, in general, outperformed the cash index. This reward, however, has come at a cost: it does not provide cash-like protection when such protection is needed in times like the Great Financial Crisis and the euro debt crisis in 2011 (Chart 3, panels 3 and 4). This is because the majority of FRNs are offered by corporations that carry credit risk. Consequently, FRNs have higher correlations to high-yield bonds and equities than to the aggregate bond index, as shown in Chart 4. Chart 3FRNs: Not A Free Lunch Chart 4FRNs: A Lower Risk Alternative To Junk Bonds The ideal time to invest in FRNs is when rates are low and are expected to rise. This is essentially our view on rates now. Instead of thinking of it as a cash alternative with higher risk, however, we recommend clients take the funding from the high-yield bucket, in line with our downgrade of high yield to neutral from overweight, and also our call of reducing portfolio duration. So how to invest in FRNs? According to Bloomberg Barclays, the U.S. FRN market has a market value of US$505.8 billion, which is small compared to the US$1,267.5 billion high-yield bond market. As such, FRNs are relatively less liquid to trade than corporate bonds. Therefore, they are mostly suitable for purchasing and holding to maturity. One can purchase individual floating-rate securities through a broker, or can invest in mutual funds that invest only in FRNs. Also, there are ETFs that only hold FRNs. Table 2 shows some basic information on three dedicated FRN ETFs. Table 2FRN ETFs* 2. Leveraged Loans Leveraged loans, also known as bank loans or senior secured loans, are a type of corporate debt that also have floating coupon rates, which, like the FRNs, adjust to changes in prevailing interest rates and hence benefit from rising rates. These loans tend to be senior to an issuer's traditional corporate bonds, and are collateralized by a pledge of the issuer's assets. However, secured does not mean safe. These loans are private investments which are generally held by funds or large institutional investors. Most of them carry sub-investment-grade ratings and can default. They also tend to be very illiquid to trade, because physical delivery to the buyer is often needed from a seller (by faxing the paperwork, for example). As such, during periods of market volatility, these loans can be subject to significant price declines. Even though bank loans share the same feature of having "floating coupon rates" as FRNs, they are higher risk securities. In the U.S., bank loans have been mostly inferior to FRNs on a risk-adjusted return basis, as their higher return is offset by much higher volatility (Chart 5A). In the euro area, however, these loans have become more favorable than FRNs since the start of 2018 (Chart 5B). Chart 5ALeveraged Loans Vs. FRNs: U.S. Chart 5BLeveraged Loans Vs. FRNs: Euro Area Historically, when interest rates have risen, bank loans have outperformed traditional fixed-income securities, and vice versa, because of their floating-rate feature, as shown in Charts 6A and 6B. This positive correlation with rates has been more consistent when the relative performance of bank loans is compared to government bonds and investment-grade corporate bonds. When compared to high-yield bonds, however, the correlation appears weak, as shown in the bottom panels of Charts 6A and 6B. This is not surprising given that these loans share similar "sub-investment grade" credit quality with junk bonds. In fact, as shown in Chart 7, bank loans have a highly positive correlation with junk bonds, yet a mostly negative correlation with the aggregate bond index both in the U.S. and the euro area. Chart 6ALLs Outperform When Rates Rise: U.S. Chart 6BLLs Outperform When Rates Rise: Euro Area Chart 7Bank Loan Correlations With Traditional Bonds This correlation feature has two very interesting implications: a) Adding bank loans to a standard aggregate bond portfolio could add diversification, and b) replacing some high-yield holdings with bank loans could generate a sub-investment grade basket with a better risk/reward profile compared to high-yield alone. Chart 8 and Table 3 show that historically there has existed an "optimal" combination of bank loans and high-yield bonds that somewhat improves the risk-adjusted return of the sub-investment grade basket. It's worth noting, however, that this historically "optimal" combination is subject to data frequency and time period, as is the case for the U.S. where the optimal weight for bank loans has been about 40% from 2002 to the present, but about 80% in the period from 1997 to the present. As such, in addition to thorough credit analysis to evaluate the suitability of bank loans, investors should also consider the variable nature of correlation when considering replacing part of their high-yield bond exposure with bank loans. Chart 8Junk Bonds - Leverage Loans Basket Profiles Table 3Risk Return Profiles Of Sub-Investment Grade Baskets 3. Danish Mortgage Bonds A Danish mortgage bond (DMB) is essentially a loan to a borrower who has taken out a mortgage on his or her home. Mortgage bonds are issued by mortgage credit institutions which often have high credit ratings. Some DMBs have fixed rates, while others have floating rates with a minimum of zero percent. Some of these bonds can also be callable, often at par (100). With a solid history of over 200 years, the DMB market has survived numerous occasions of economic and political turmoil, including the bankruptcy of the Kingdom of Denmark in 1813, the Great Depression of the 1930s and the Great Financial Crisis and ensuing recession in 2008. Over its entire history, every single issued bond has been repaid in full to investors, in large part due to the strong legislative framework that protects the bond investors (see Appendix 1). As of the end of July 2018, the DMB market consisted of kr. 2.672 trillion of AAA-rated covered bonds. Once largely dominated by local pensions and insurance companies, the DMB market has seen increasing interest from foreign investors in recent years. According to data from the Danish central bank, foreign ownership of fixed rate mortgage bonds stood at kr. 295 billion (29%) in July 2018 compared to kr. 154 billion (18%) in January 2016 (Chart 9). In terms of total holdings of all mortgage bonds (fixed rate, variable rate and bonds backing interest adjustment loans), foreigners held kr. 614 billion (23%), an increase of kr. 27 billion compared to the beginning of 2016. Japanese investors, who have suffered many years of extremely low yields domestically, have been quite active in the DMB market. According to data from the Bank of Japan, Japanese investors purchased some kr. 50 billion of long-term Danish non-government bonds in the period from 2016 to June 2018.3 In June 2018, Nykredit, the largest Danish mortgage bank with a market share of about 40%, even created a DMB index hedged to yen using one-month forward rates due to popular demand and corresponding requests from Japanese investors. As shown in Chart 10, since 2009, the DMB index hedged to yen has outperformed both JGBs and Japanese corporate bonds. Chart 9Foreign Ownership of Danish Fixed Rate Mortgage Bonds* Chart 10DMBs For Japanese Investors Even though interest rates in the U.S. are much higher than those in the euro area, investing in the U.S. after hedging the currency is not really attractive for euro investors. For example, U.S. bank loans have outperformed European bank loans in local currency terms; after being hedged into euro, however, the yield advantage disappears. In terms of government bonds, euro investors really have no incentive to invest in U.S. Treasurys, hedged or unhedged (Chart 11). Given the Danish krone's peg to the euro, it is natural for euro investors to look at the DMB market. Chart 12 shows that DMBs have indeed outperformed both government and corporate bonds in the euro area when 3-month deposit rate turns negative. During the 2008 financial crisis, DMBs also outperformed euro area corporate bonds. However, they did underperform both euro area corporate and government bonds when the European Central Bank started buying bonds after the euro debt crisis. So, how would the exposure of DMBs impact a portfolio's risk/return profile? We have two interesting observations from Chart 13: Chart 11Rate Advantage Vs. Currency Risk Chart 12DMBs For Euro Investors Chart 13DMBs As A Domestic Bond Substitute? In Japan, hedged DMBs have a very low correlation with equities, corporate bonds and JGBs, even though the correlation with equities has generally been negative, and with bonds generally positive. In the euro area, DMBs have a negative correlation with equities, but a highly positive correlation with both government and corporate bonds. And the correlation to government bonds is quite similar to that of corporate bonds. Therefore, in theory, replacing part of a standard bond portfolio with DMBs could improve a balanced portfolio's risk/return profile for both Japanese and euro area investors. Table 4 shows the risk/return profiles of hypothetical 60/40 standard domestic equity/bond portfolios for Japan and euro area that have a certain percentage of domestic bonds replaced with Danish mortgage bonds: for Japan, the DMBs are hedged to yen, and for the euro area they are unhedged but converted into euros. Table 460/40 Equity/Bond Portfolio Profile with DMB Exposures As expected, for Japan, substituting domestic aggregate bonds with hedged DMBs increases portfolio return more than volatility, thereby improving risk/adjusted returns. For the euro area, however, the story is not straightforward. Over a longer time frame, DMBs have not been a good substitute for euro area aggregate bonds. Since the 3-month euro rate turned negative in June 2015, however, DMBs have largely improved a balanced portfolio's risk/return profile. It is also worth noting that, unlike Japanese investors who benefit from a positive hedging gain since the Danish three-month rate has been lower than Japan's since 2015, euro area investors do not have such a benefit. Also, even though the DMB market is the largest covered bond market in the world, its market size is less than half a trillion USD. Given the fact that foreign investors already account for about a quarter of the market, it is not clear how euro area investors can significantly deploy more capital to enhance portfolio returns. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Appendix 1: The Danish Mortgage Act4 Danish mortgage bonds are issued under the Danish Mortgage Act. Two key features of the Act protect investors in DMBs. First, the central element in the Danish Mortgage Act is the "balancing principle." This principle requires that there is a match between the inflows and outflows of a mortgage-issuing bank, and limits the amount of risk (interest rate, FX, volatility and liquidity) that a Danish mortgage bank can undertake. In addition, Danish mortgage banks must meet minimum capital requirements of 8% of risk-weighted assets. Second, the "Danish title number and land registration systems and efficient compulsory sale procedure" ensures well-defined property rights through a general register of all properties in Denmark. Ownership and encumbrances on individual properties are easily identified, and that information is available to the public. If a borrower defaults on a payment, the mortgage bank can take over the property and the compulsory sale procedure ensures that a mortgage bank can sell the property in the real estate market or through a forced sale. The period from default to a forced sale to be completed can be as short as six months. 1 Please see Global Investment Strategy Special Report entitled, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 2 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 3 Please see "Fixed Rate Mortgage Bonds Are Attractive For Foreigners," Portfolio Investment, Danmarks Nationalbank, dated August 28, 2018. 4 Please see "Danish Covered Bond Handbook," Danske Bank, dated September 15, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades