Financial Markets

Special Report

Dear clients, Please note that in next week’s China Macro And Market Review, we will include a section explaining our view on the coronavirus outbreak and its economic as well as financial market implications. We maintain our overweight stance on both Chinese investable and A-share equities, over a tactical (0-3 months) and cyclical (6-12 months) time horizon. Please stay tuned. Jing Sima, China Strategist   Highlights BCA’s “Golden Rule of Bond Investing” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, also works in China. The relationship between unexpected changes in China’s de facto short-term policy rate and government bond yields has been surprisingly strong over the past decade. Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, we believe that bond yields are more likely to structurally rise than fall. Over the coming 6-12 months, investors should underweight Chinese government bonds versus Chinese equities and onshore corporate bonds. Within a regional government bond portfolio, however, investors should overweight USD-hedged China versus US and developed markets ex-US, as well as in unhedged terms. Feature Last year’s inclusion of Chinese onshore government and policy bank bonds in the Bloomberg Barclays Global Aggregate Index was a significant milestone of China’s journey to internationalize its capital markets. Other bond benchmark providers have since followed suit, highlighting that the trend of increased passive exposure to Chinese assets is likely to continue. Over the past year, the bulk of the market discussion concerning the addition of China to the major bond indices has focused on estimating the size of potential capital inflows that could be triggered and the related impact on onshore bond yields. By contrast, comparatively little work has been done to analyze the core drivers of Chinese government bond yields, and how they compare to the factors that influence yields in the developed markets that dominate the bond indices. This Special Report attempts to fill a hole in the analysis of Chinese bonds. This Special Report attempts to fill that hole in the analysis of Chinese bonds. We look at the predictability of China’s government bond market through the lens of BCA’s “golden rule” framework, and find a surprisingly strong relationship between changes in China’s de facto short-term policy rate and government bond yields. We then present our cyclical (6-12 month) and secular outlooks for government yields given this relationship, and conclude by presenting four specific investment recommendations pertaining to China’s fixed-income market with two audiences in mind: mainland/onshore investors who are focused on returns in unhedged RMB terms, and global fixed-income investors who are primarily focused on hedged US-dollar regional bond exposure. The Golden Rule Of Bond Investing, With Chinese Characteristics In a July 2018 Special Report,1 BCA’s Chief US Bond Strategist, Ryan Swift, elegantly distilled the cyclical US government bond call into a simple question: During the next 12-months, will the Federal Reserve move interest rates by more or less than what is currently priced into the market? Chart 1The (US) Golden Rule Of Bond Investing In Practice Ryan argued that a predictive framework for US Treasury returns built around the answer to this question has historically worked so well that it should be referred to as the “Golden Rule of bond investing” (Chart 1). In a follow-up report, our Global Fixed Income Strategy service confirmed that the Golden Rule also largely works in non-US developed market economies, with the exception of Japan due to the absence of any meaningful fluctuation in policy rates over the past two decades.2 The Golden Rule provides a very strong framework to aid fixed-income investors with their cyclical (i.e. 6-12 month) asset allocation decisions, by quantitatively linking government bond returns relative to cash – in other words, the excess return earned by taking duration risk - to policy rate “surprises” compared to what is discounted in shorter-term money markets. The practical application is that a decision to allocate to longer-maturity government bonds is reduced to a bet on whether a central bank will adjust policy rates by more or less than the market expects. The first question we address in this report is to what degree does the Golden Rule apply in China (in yield space rather than in return space), along with an explanation of any differences that may exist. However, we must first note why the Golden Rule of bond investing works, particularly in the US. The first reason is that there is a strong relationship between the US 3-month T-bill rate and Treasury yields of all other maturities. Conceptually, all fixed income investors have a choice when buying US government bonds: they can purchase a 3-month Treasury bill and simply perpetually roll over the position as it matures, or they can purchase a Treasury bond of a longer maturity. This means that yields on longer maturity Treasury bonds simply reflect investor expectations for the average 3-month T-bill rate over the life of the bond, plus some positive risk premium to compensate for the inherent uncertainty of the path and tendency of short-term yields. This helps explain the close link between cyclical changes in 3-month T-bill rates and yields on longer maturity Treasurys. Chart 2In The US, The 3-Month T-Bill Rate Perfectly Tracks The Fed Funds Rate The second reason for the Golden Rule’s success is that there is a very tight relationship between the effective Fed funds rate and the 3-month T-bill rate. While it is the (higher) discount rate that is the theoretical no-arbitrage ceiling for the 3-month rate, in practice T-bill rates trade extremely close to the Fed funds rate (Chart 2). This means that Fed funds rate “surprises” (relative to traded market expectations) are akin to surprises in the 3-month rate, which in turn strongly influence the expected future path of short-term interest rates and thus yields on longer maturity Treasurys. In China, we noted in a February 2018 Special Report3 that the 7-day interbank repo rate is now the de jure short-term policy rate in China following the establishment of an interest rate corridor system in 2015. Chart 3 presents our first test of the Golden Rule in China (in yield space rather than in return space), by plotting the annual change in the level of Chinese government bond yields alongside the 7-day repo rate “surprise” over the past year from 2010 to the present. Here, we use the first principal component of zero coupon Chinese government bond yields to represent the average level of yields (rather than selecting a particular maturity), and we use the 12-month RMB swap rate (versus 7-day repo) to represent market expectations for the policy rate. The chart highlights that the fit is good, as measured by a 50% R-squared between the two series. However, deviations in the relationship do exist, with the most notable exception having occurred in 2017: Chinese government bond yields rose considerably more than what the annual surprise in the 7-day repo rate would have suggested. Chart 3In China, The Golden Rule Works Decently Well Using 7-Day Repo... Chart 4...And Extremely Well Using 3-Month SHIBOR Chart 4 helps resolve a good portion of the 2017 discrepancy, and clarifies the link between Chinese monetary policy and government bond yields. Chart 4 is similar to Chart 3, except that it replaces the 7-day repo rate surprise with that of 3-month SHIBOR (which trades very closely to the 3-month repo rate). The chart illustrates an even closer fit between the two series (with an R-squared close to 80%), and shows that the 3-month SHIBOR surprise does a meaningfully better job at explaining the 2017 rise in Chinese government bond yields. The Golden Rule of bond investing works surprisingly well in China. The fact that the annual surprise in 3-month SHIBOR has done a better job at predicting changes in bond yields over the past decade underscores that the 3-month repo rate is the de facto short-term policy rate in China, a point that we have made in several previous reports. We have noted that the spike in the 3-month/7-day repo rate spread that occurred in late-2016 and lasted until mid-2018 happened because of China’s crackdown on shadow banking activity. This crackdown caused a funding squeeze for China’s small & medium banks, which caused a material rise in lending rates and government bond yields. This episode highlights that future changes in the 3-month repo rate are likely to reflect both underlying changes in net liquidity provided to large commercial banks (measured by the 7-day repo rate), and any dislocations in the interbank market that have the potential to push up lending rates and government bond yields. Bottom Line: BCA’s “Golden Rule” framework, which links developed economy government bond returns to central bank policy rate “surprises” versus market expectations, works for China as well – using the correct measure of the PBOC policy rate. This provides a useful investment framework for Chinese government bonds, which are now significant part of major global bond market benchmarks. The Cyclical Outlook For Chinese Government Bond Yields Given the establishment of the relationship between Chinese short-term interbank rates and government bond yields detailed above, we are now able to more precisely discuss the likely cyclical trajectory of Chinese government bond yields as a function of Chinese monetary policy. Two opposing forces have the potential to affect China’s government bond market this year. The first, a stabilization and modest rebound in Chinese economic activity, may exert upward pressure on yields due to expectations of eventual policy tightening. The second, continued attempts by the PBoC to ease corporate lending rates, may exert downward pressure on yields as it will reflect not just easy but easier monetary conditions. Yields at the long-end are likely to move modestly higher this year, at most. For investors, the raises the obvious question of whether Chinese government bond yields are likely to move up, down, or trend sideways this year. In our view, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. Yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. There are two reasons why yields at the short-end of China’s government bond curve are likely to stay flat for most of this year. The first is that the PBoC is generally a reactive central bank and has historically lagged a pickup in economic activity, as illustrated in Chart 5. The chart shows the historical path of 3-month SHIBOR in the year following a bottom in economic activity in 2009, 2012, and 2015, and makes it clear that there has been no precedent for a significant rise in interbank rates in the first nine months of an economic recovery. The 2012 episode did see a very sharp rise in 3-month SHIBOR once the PBoC shifted into tightening mode, but we doubt that this experience will be repeated again unless economic growth accelerates much more aggressively than we expect. The second reason why we expect yields at the short-end of the curve to remain muted this year is because any additional easing by the PBoC is likely to be focused on reducing corporate lending rates, not interbank rates. Chart 6 highlights that while there is a strong correlation between changes in Chinese government bond yields and average lending rates in the economy, the former leads the latter. In the past, this relationship has existed because changes in interbank rates have coincided with reductions in the now obsolete benchmark lending rate, with the former usually occurring earlier than the latter. But in a scenario where the PBoC reduces the loan prime rate (LPR) and keeps net banking sector liquidity roughly constant, the extremely tight relationship shown in Chart 4 suggests that short-term bond yields are unlikely to be affected by a reduction in lending rates. Any meaningful decline in short-term yields below short-term interbank rates would simply prompt banks to stop buying these bonds. Chart 5The PBoC Is Generally A Reactive Central Bank Chart 6Average Lending Rates Lag Short-Term Bond Yields Chart 7China's Yield Curve Is Generally Pro-Cyclical Additional easing by the PBoC does have the potential to impact the long-end of the government bond curve if investors view these actions as a sign that interbank rates will remain low for some time. This view is reinforced by the fact that China’s yield curve is not particularly flat, and thus has room to move lower. However, Chart 7 also shows that China’s yield curve, defined here as the second principal component of zero coupon Chinese government bond yields, is positively correlated with the relative performance of investable Chinese equities. This suggests that there is a procyclical element to the curve. We suspect that this procyclical element will dominate a potential decline in expectations for future short-term interest rates, but that yields at the long-end are likely to move modestly higher this year, at most. Bottom Line: Any additional easing by the PBoC this year is likely to be focused on reducing lending rates to the real economy, not interbank rates (which drive government bond yields). As such, yields at the short-end are likely to be flat until later this year at the earliest, whereas yields at the long-end are likely to move modestly higher, at most. The Secular Outlook For Chinese Government Bond Yields A common approach to forecasting the likely structural trend for nominal government bond yields is to estimate the trajectory of real long-term potential output growth and to add the monetary authority’s inflation target. This framework is based on the idea that interest rates are in equilibrium when the cost of borrowing is roughly equal to nominal income growth, a condition that results in no change in the burden to service existing debt. Chart 8China's Potential Growth Is Likely To Trend Lower... Based on this framework, we would expect Chinese government bond yields to trend down over time, or possibly flat if the PBoC were to tolerate higher inflation over the coming decade. Chart 8 illustrates the IMF’s forecast of falling real potential growth in China over the coming several years, which is consistent with a shift in the composition of growth from investment to consumption as well as China’s looming demographic crisis. But Chart 9highlights an obvious problem with applying this framework to forecast the secular trend in Chinese government bond yields: over the past decade, yields have persistently averaged below actual nominal GDP growth, both in China and in the developed world. In the latter case, it is an open question whether this will continue to be true in the future, but in China’s case it is clear that government bond yields have little connection (in magnitude) to the pace of GDP growth. This reflects the longstanding strategy of Chinese policymakers to promote investment via persistently low interest rates, as has occurred in other manufacturing and export-oriented Asian economies (Chart 10). Chart 9...But Bond Yields Are Well Below GDP Growth, Just Like In Developed Markets Chart 10In Industrial Asian Economies, Low Bond Yields Are A Policy Choice   The persistent historical gap between economic growth and bond yields in China makes it difficult to forecast the structural outlook for yields using conventional methods, and largely limits us to inference. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to rise than fall over time. This is because as long as interest rates remain well below the pace of income growth, the incentive to excessively borrow (and invest) is likely to persist. Chart 11China Needs Higher Interest Rates, But Only To A Point However, even in a scenario where Chinese government bond yields structurally trend higher, we expect the rise to be modest. Chart 11 highlights that China’s “private sector” debt service ratio is extremely elevated, underscoring that the country’s ability to tolerate significantly higher bond yields is not strong. In addition, since 2015, China’s debt service ratio has been mostly flat despite rising a rising debt-to-GDP ratio, which has been achieved through lower short-term interest rates. To the extent that policymakers fail to make meaningful progress in shifting China’s growth drivers away from investment over the coming few years, lower (potentially sharply lower) bond yields would appear to be all but inevitable to cope with what would become a permanently growing drag on economic activity from the servicing of debt. For now, we would characterize this scenario as a risk to our base case view, but it is a risk that we will be closely monitoring over the coming years. Bottom Line: The persistent gap between Chinese nominal GDP growth and government bond yields is likely contributing to the problem of excessive leveraging. To the extent that Chinese policymakers succeed at shifting the drivers of growth from investment to consumption, bond yields are more likely to structurally rise than fall. Investment Conclusions Our analysis above points to four recommendations for investors over the coming year: Overweight Chinese stocks versus Chinese government bonds in RMB and USD terms Overweight Chinese onshore corporate bonds versus duration-matched Chinese government bonds in RMB terms Overweight 7-10 year USD-hedged Chinese government bonds versus their US and developed market (DM) counterparts For offshore US dollar-based investors, long 7-10 year Chinese government bonds in unhedged terms Regarding the first two recommendations, our view that yields are likely to be flat at the short-end and modestly higher at the long-end suggests that investors can expect total returns on the order of 2-3% from Chinese government bonds this year. Barring a major and lasting economic slowdown from the 2019-nCoV outbreak, we expect Chinese domestic and investable equities to outperform government securities over the coming 6-12 months. Onshore corporate bonds have a similar outlook: onshore spreads are pricing in (massively) higher default losses than we believe is warranted, meaning that they will outperform duration-matched government equivalents without any changes in yield. Chart 12Within Global Fixed-Income, Hedged Chinese 10-Year Yields Are Relatively Attractive Chart 13Unhedged Yield Spreads Predict Hedged Relative Performance Versus The US For global fixed-income investors, Charts 12-14 present USD-hedged 10-year Chinese government yields versus the US and DM/DM ex-US, along with the historical relative return profile of USD-hedged Chinese bonds versus hedged and unhedged returns. In hedged space, Chinese 10-year government bond yields are modestly attractive: 2.2% versus 1.6% in the US and 1.8% in DM ex-US. China’s historically low yield beta to the overall level of global 10-year bond yields (Chart 15) suggests that Chinese yields should perform well in 2020 – a year where we expect global bond yields to drift higher as economic growth rebounds. Combined with relatively attractive valuation, this bodes well for the relative performance of Chinese debt versus DM equivalents. A low yield beta against a backdrop of drifting higher global yields implies that longer-maturity Chinese government bonds will outperform their DM equivalents. Chart 14Unhedged Yield Spreads Predict Hedged Relative Performance Versus DM Chart 15China's Yield Beta Has Been Rising, But Is Still Japan-Like   We would also recommend longer-maturity Chinese government bonds in unhedged terms versus a USD-hedged global government bond portfolio. Chart 16 highlights that the relative return of this trade is strongly (negatively) linked to USD-CNY, and we expect further (albeit more modest) gains in RMB over the cyclical horizon. Chart 16Modest Further RMB Upside Means Unhedged Chinese Bonds Will Outperform As a final point, investors should note that today’s report is part of a heightened focus on China’s fixed income market, in terms of both forecasting fixed income returns and analyzing the cyclical and structural implications of the increasing investability of China’s financial markets. More research on this topic is likely to come in 2020 and beyond: Stay Tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com         Footnotes 1    Please see US Bond Strategy Special Report "The Golden Rule Of Bond Investing," dated July 24, 2018, available at usbs.bcaresearch.com 2   Please see Global Fixed Income Strategy Special Report "The Global Golden Rule Of Bond Investing," dated September 25, 2018, available at gfis.bcaresearch.com 3   Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Special Report

Highlights Historically, the stocks with the lowest volatility have outperformed the stocks with the highest volatility, a trend that defies some of the most fundamental theories in finance. The low-volatility factor has outperformed the market in absolute return terms, with a substantial reduction in downside risk, in every major equity market. Compensation structure, benchmarking, analyst bias, and the preference for lottery-like stocks are all plausible explanations for why the low-volatility anomaly persists. Shifting some exposure from bonds to minimum-volatility equities might be an attractive way to keep returns high while remaining hedged against downside risk in a world of low interest rates. Feature Chart 1The Low-Volatility Anomaly Conventional wisdom suggests that achieving the right mix between risk and return requires a tradeoff: Take on too little risk, and returns will be subpar, but take on too much, and a large loss becomes likely. However, the empirical evidence shows that no such tradeoff exists in the equity market: Historically, the return of stocks with the lowest volatility has been better than the return of stocks with the highest volatility (Chart 1, top panel). Even when using a measure of systematic risk such as beta, there appears to be very little relationship between risk and return – a result that emphatically contradicts what is predicted by the CAPM (Chart 1, bottom panel). The success of low risk stocks – a well-documented phenomenon known as the low-volatility anomaly1  – challenges some of the most fundamental premises of finance and economics. After all, how could taking on less risk result in better returns? In this report, we dive into this anomaly, with the intent of answering the following questions: What kind of portfolios can exploit this anomaly? What are the risk/return characteristics to this factor and what sectors is it exposed to? Why does this factor work? How can investors use the low-volatility factor in their asset allocation process? To answer these questions we explore the historical performance of the MSCI minimum-volatility index. Additionally, we explore the academic research surrounding the low-volatility anomaly. Finally, we look into how low-volatility equities have performed as a hedge for a global equity portfolio when compared to government bonds. Low Volatility Vs. Minimum Volatility There are two types of portfolios that are generally used to exploit the low-volatility anomaly: Low-volatility portfolios are built first by sorting the stock universe according to the stocks' trailing standard deviation, and then by buying the stocks with the lowest standard deviation. Usually the index buys the bottom quintile of stocks ranked by volatility. Minimum-volatility portfolios are built through an optimization procedure, by which funds are allocated to the stock mix that would have minimized the historical volatility of a portfolio (subject to certain constraints). Chart 2No Dramatic Difference Between Low Vol And Min Vol The main advantage of minimum-volatility portfolios over low-volatility portfolios is that they do not consider only low-volatility stocks but also stocks with low covariance between each other. However, the construction of these portfolios also requires estimating large covariance matrices, which are prone to a significant degree of noise, and thus often have to be adjusted by statistical methods.2 That being said, there is little performance difference between these two methodologies in practice, though minimum-volatility portfolios do tend to be much more constrained than low-volatility portfolios (Chart 2). In this report we will focus on the more popular MSCI minimum-volatility portfolios, given that their historical data is more readily available.   Risk-Return Characteristics Of Minimum Volatility At the global level, minimum volatility has outperformed not only the market since 1990, but also the most popular equity factors, with the exception of momentum (Chart 3, top panel). The outperformance relative to the benchmark has proved to be robust, as minimum volatility has beaten the returns for the benchmark in the biggest developed markets as well as emerging markets for almost two decades (Chart 3, bottom panel). The most attractive feature of minimum volatility is the significant reduction in risk it provides. Since 1988, the annualized volatility of minimum volatility has been 10%, a considerable improvement vis-à-vis the market and relative to other popular equity factors (Chart 4, top panel). Meanwhile, even though return skew of minimum volatility has been more negative than the benchmark, minimum volatility achieved a substantial reduction in tail risk with a 10% conditional VaR of only 5% (Chart 4, middle and bottom panel). Chart 3Min Vol Outperformance Is Broad-Based Chart 4Min Vol Provides A Substantial Reduction In Risk In addition to its risk reduction, minimum volatility also has a countercyclical relative return profile, outperforming during bear markets, and underperforming slightly during bull markets (Chart 5, top panel). This return profile occurs partly due to the sector skew of this factor, which overweights defensive sectors such as Utilities and Consumer Staples relative to the global benchmark3 (Chart 5, middle panel). At the global level, this defensive tilt exposes minimum volatility to significant duration risk, given that the stocks in this index tend to have bond-like properties (Chart 5, bottom panel). The negative relationship between interest rates and the low-volatility factor has been well documented by the academic literature: Some studies estimate that up to 80% of the outperformance of low-volatility equities can be explained by exposure to duration risk.4 Chart 5Global Min Vol Is Sensitive To Interest Rates Chart 6Min Vol Is Expensive     On average, minimum volatility also tends to overweight stocks with a higher dividend yield than the market (Chart 6, panel 1). This yield difference accounts for roughly a quarter of the return difference between minimum volatility and the benchmark since 1990. However, high dividend yield and minimum volatility are not synonymous: Over the past decade, minimum volatility has selected stocks that are more expensive than the benchmark, a stark difference from high dividend yield portfolios, which exclusively select very cheap stocks (Chart 6, panel 2). The current high overvaluation of minimum volatility relative to the market could spell bad news for this factor in the near future: While valuation and returns do not have a straightforward relationship, extreme levels of valuation relative to the benchmark have historically resulted in subsequent underperformance of this factor relative to the market (Chart 6, panels 3 and 4). Why Does The Low-Volatility Factor Work? Analyst Forecasts It has been shown empirically that equity analysts tend to have an optimistic bias, due to the need of the analyst to maintain good relationships with the companies they cover. Moreover, investors do not adjust for this bias, meaning that the stocks of companies that receive an overly optimistic forecast tend to rise initially when the forecast is released, but then mean-revert once the forecast does not materialize. Chart 7Analyst Bias Is Larger In High-Vol Stocks It seems that this dynamic might be more pervasive in high-volatility stocks. In their paper “When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle,” Hsu et al. show that analysts’ positive bias is larger for more volatile stocks, even when adjusting for confounding variables like size, sector and country5 (Chart 7).  It is easy to see why this might be the case: An extremely optimistic bias on a low variance stock would look unrealistic to most investors. Thus, analysts are more prone to express a large positive bias on high variance stocks, where bias is harder to detect. Ultimately, this bias causes these stocks to become chronically overvalued. Salary Structure of Managers Chart 8Institutions Favor High Vol The payoff structure of fund managers has also been suggested as a possible cause of the low-volatility anomaly.6 The structure of compensation for fund managers often resembles an option: A bonus is granted if the portfolio returns are higher than a certain threshold. In such a structure, the compensation of portfolio managers resembles a call option: The probability of a payoff increases with volatility, creating an incentive to invest in high-volatility stocks.  However, this preference for high-volatility stocks will overbid them, causing them to underperform. There is some evidence that this is in fact the case. Once the effect of size is neutralized, stocks with high institutional ownership tend to be more volatile than stocks with low institutional ownership (Chart 8). Moreover, a study on the exposure of hedge funds to popular risk factors from 2000 to 2016, showed that hedge funds have a large short exposure to the anomaly, indicating that they favor high-volatility over low-volatility stocks.7   Lottery Stocks Chart 9The Low-Volatility Anomaly Is Most Prevalent In Lottery-Like Stocks Not all high-volatility stocks are chronic underperformers. In the paper “The Low Volatility Anomaly and the Preference for Gambling,” Hsu et al. identify that the low-volatility anomaly is largest in stocks with strong lottery-like characteristics (the authors define lottery-like as the stocks that had the highest maximum daily return the previous month)8 (Chart 9). Meanwhile, other high-volatility stocks are much more likely to have higher or equal returns than their low-volatility counterparts. Why is this the case? Investors tend to have a preference for “home-run” stocks, which have a large probability of a small loss, but a small probability of a large gain – a well-documented behavioral bias known as the long-shot bias.9 This bias might cause investors to overbid for lottery-like stocks, causing them to underperform as a cohort. This phenomenon might be related to the incentives in the money management industry. Flows to equity funds tend to be very skewed to the very best performing funds. This means that fund managers have a high incentive to invest in stocks that have the potential of an extremely high payoff. Benchmarking Chart 10Benchmarking Could Be To Blame For The Low-Vol Anomaly While the low-volatility anomaly has been found in other asset classes,10 it is interesting to note that the anomaly occurs only within asset classes and not across asset classes. Indeed, the traditional risk-return relationship is conserved when looking at a multi-asset universe (Chart 10, top panel). One possible solution to this puzzle might be the effect of benchmarking. Within an asset class, benchmarked managers are not only measured according to their return relative to their benchmark but also to their tracking risk (volatility of return difference). Under this structure, investors do not have a large incentive to exploit the alpha from low-volatility or low-beta stocks, since such a strategy would result in a relatively high tracking error.11 This high tracking error will make the excess return of low-volatility stocks relatively less attractive for benchmarked managers, even if these stocks are clearly superior in terms of raw risk-adjusted returns (Chart 10, bottom panel). How Can Minimum Volatility Be Used In Asset Allocation? Chart 11Sensitivity Of Min Vol To Interest Rates Has Increased In The Last Decade The interest rate sensitivity of low-volatility stocks has been a topic of significant interest for academic researchers. A study that attempted to measure this sensitivity found that equities in the lowest volatility decile have an interest-rate exposure equivalent to a 66% equity/34% bond portfolio.12 Moreover, this sensitivity has increased in recent years: Factor analysis shows that while the beta of the excess returns of minimum volatility to the equity market has remained constant, the beta to the bond market has increased significantly over the last decade13 (Chart 11, top panel). Interestingly this process seems to have accelerated as bond yields fell below dividend yields – a result which might arise because the market starts perceiving bonds, and low-volatility equities as close substitutes when they provide a similar cash flow (Chart 11, bottom panel). At first glance, this relatively high duration risk appears to be a red flag, particularly if you share our view that interest rates have reached a multi-year bottom. After all, an environment where interest rates rise would imply that minimum volatility would underperform global equities on a structural basis.  However, the sensitivity of minimum volatility to interest rates can be used to the advantage of an asset allocator. Specifically, in a world of low bond yields, it could be attractive for an investor to shift some of the exposure he or she has from bonds to minimum-volatility equities. Why would an investor do this? As we discussed in our October 2019 report, low bond yields will cause bonds to generate returns that are much lower than their historical averages. This means that using government bonds as a hedge for an equity portfolio is likely to result in a severe drag on performance.14 On the other hand, while minimum-volatility equities do not have the same hedging potency as bonds, their returns are much higher, which suggests that at the right allocation they could prove to be a better hedge. In a world of low bond yields, it could be attractive for an investor to shift some of the exposure he or she has from bonds to minimum-volatility equities. How has such a strategy worked historically? Chart 12 shows how allocating incremental amounts of global minimum-volatility equities to an equity portfolio compares to adding incremental amounts of global government bonds. Overall, allocating an additional 3% of minimum-volatility equities to a portfolio had the same effect as adding 1% of government bonds in terms of downside protection and volatility reduction, but with a much higher return. This effect was robust throughout the sample period. Consider a portfolio with 30% government bonds, 30% minimum volatility and 40% global equities. With the exception of the 1990-1994 period, this portfolio had roughly the same 10% conditional VaR in all sub periods as a portfolio with 40% government bonds and 60% equities, but a significantly higher return (Chart 13). Moreover, the volatility of the portfolio that includes minimum volatility has also been lower than the 60/40 portfolio since 2000. Chart 12Min Vol Provides Protection With A Relatively High Return Chart 13Min-Vol Protection Has Been Robust Bottom Line The low-volatility anomaly contradicts what is perhaps the most fundamental pillar in finance: The tradeoff between risk and return. As such, this anomaly might be the most puzzling inefficiency in markets. But will it persist? The evidence suggests that the anomaly is caused by strong institutional incentives, which are likely to continue. Thus, investors should strongly consider investing in low-volatility stocks in the future. However, the following points should be taken into account: Investors who are evaluated according to their information ratio should avoid low/minimum-volatility stocks, given that their large volatility difference with the benchmark will result in a relatively high tracking error. Relatively high valuations and an uptrend in interest rates may hurt the performance of low/minimum-volatility stocks relative to the broad equity market in the near future. However, the interest-rate exposure of low/minimum-volatility stocks might prove attractive to multi-asset investors. Specifically, investing in minimum-volatility equities and reducing bond exposure might be a way to boost returns while remaining hedged.   Juan Correa Ossa, CFA Senior Analyst juanc@bcaresearch.com   Footnotes 1  The discovery of the low-volatility anomaly predates the discovery of both the size and value anomalies. For more details, please see Michael C. Jensen, Fischer Black, and Myron S. Scholes, “The Capital Asset Pricing Model: Some Empirical Tests,” Studies in the Theory Of Capital Markets, Praeger Publishers Inc., 1972. 2 For more details on the construction of minimum-volatility portfolios, please see Tzee-man Chow, Jason C. Hsu,Li-Lan Kuo, and Feifei Li, “A Study of Low Volatility Portfolio Construction Methods,” The Journal of Portfolio Management, Vol. 40, No. 4, 2014. 3 However, research has shown that the low-volatility anomaly still holds within sectors, suggesting that its outperformance is not only a result of sector bias. For more details, please see Raul Leote de Carvalho, Majdouline Zakaria, Lu Xiao, and Pierre Moulin, “Low Risk Anomaly Everywhere - Evidence from Equity Sectors,” (November 19, 2014). 4 Please see Joost Driessen, Ivo Kuiper, Korhan Nazliben, and Robbert Beilo, “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Journal of Banking and Finance, Vol. 103, 2019. 5 Please see Jason C. Hsu, Hideaki Kudoh and Toru Yamada, “When Sell-Side Analysts Meet High-Volatility Stocks: An Alternative Explanation for the Low-Volatility Puzzle,”  Journal Of Investment Management (JOIM), Second Quarter 2013. 6 Please see Nardin L. Baker and Robert A. Haugen, “Low Risk Stocks Outperform within All Observable Markets of the World,” (April 27, 2012). 7 Please see David Blitz, “Are Hedge Funds on the Other Side of the Low-Volatility Trade?”  The Journal of Alternatives Investments, Vol. 21, No. 1, Summer 2018. 8 Please see Jason C. Hsu and Vivek Viswanathan, “The Low Volatility Anomaly and the Preference for Gambling,” Risk-Based and Factor Investing, pages 291-303; (2015). 9 There is some debate as to whether the long-shot bias is truly irrational in financial markets, where payoffs and probabilities are not known with precision. 10 Researchers have found that the low-volatility anomaly exists in the government and corporate bond market. For more details please see, Raul Leote de Carvalho, Patrick Dugnolle, Lu Xiao, and Pierre Moulin, “Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets,” The Journal of Fixed Income, vol. 23, No. 4, Spring 2014. 11 Please see Malcolm Baker, and Brendan Bradley, and Jeffrey Wurgler, “Benchmarks as Limits to Arbitrage: Understanding the Low-Volatility Anomaly,” Financial Analysts Journal, Vol. 67, No. 1, 2011. 12 Please see Joost Driessen, Ivo Kuiper, and Korhan Nazliben, and Robbert Beilo, “Does Interest Rate Exposure Explain the Low-Volatility Anomaly?” Journal of Banking and Finance, Vol. 103, 2019. 13 We calculate sensitivity for US stocks instead of global stocks due to the effects of currency returns. 14 Please see Global Asset Allocation Strategy Report “Safe Haven Review: A Guide To Portfolio Protection In The 2020s,” dated October 29 2019, available at gaa.bcaresearch.com.

Highlights Portfolio Strategy There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. Rising total mutual fund assets under management, improved trading revenue prospects, rising investor confidence along with a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index. Recent Changes There are no changes in our portfolio this week. Table 1 Feature “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” - Charles Owen "Chuck" Prince III (ex-CEO of Citigroup) The SPX remains near all time highs and the invincible tech sector continues to lead the pack. Two weeks ago we showed that the market capitalization concentration of the top five stocks in the S&P 500 surpassed the late-1990s parallel (Chart 1), and Table 2 shows that late in the cycle a handful of stocks explain a sizable part of the broad market’s return.1 However, in terms of valuation overshoot the current forward P/E of these top five stocks is roughly half the late-1990s parabolic episode (Chart 2). Chart 1Vertigo Warning Chart 2Unlike The Late-1990s While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. Table 2Contribution To Late Cycle Rallies In The SPX Chart 3Correlation Breakdown Contrary to popular belief, during manias historical correlations break down and the forward multiple becomes positively correlated with the discount rate. So in the late 1990s, the fed funds rate and the 10-year yield jumped 200bps in a short time span and the SPX forward P/E soared 40% from roughly 18x to 25x (Chart 3) before collapsing to 14x soon thereafter. Simultaneously, the US dollar was roaring as real interest rates were 4%, but the NASDAQ 100 outperformed the emerging markets, another break in historical correlations. As Chuck Prince mused in 2007, there is a narrative in the equity market today that, “as long as the music is playing, you’ve got to get up and dance”. While the overall market does not fully resemble the excesses of the dot.com bubble era, at least not yet, there are elements that are eerily reminiscent of the late-1990s. We filtered for large cap stocks that are at all-time highs and have increased in value at a minimum 10x since 2010. Among the stocks that met these criteria, five really stand out, Apple, Tesla, Lam Research, Amd & Salesforce, and comprise our “ATLAS” index; the mania in these stocks will likely end in tears (Chart 4). Even their forward P/E ratio has gone exponential, hitting a 60 handle last year similar to top five SPX stocks in the late-1990s. Chart 4ATLAS: Holding The World On His Shoulders Currently, SPX profits are barely growing and the sole reason equities are higher is the massive injection of liquidity via the drubbing in interest rates and the restart of QE. From peak-to-trough the 10-year yield fell 175bps in nine months, and the Fed commenced expanding its balance sheet by $60bn/month since last September; yet profits have barely budged. Ultimately, profits have to show up and the news on this front remains grim. The current non-inflationary trend-growth backdrop is a “goldilocks” scenario especially for tech stocks that thrive during disinflationary periods. While stocks can go higher defying weak EPS fundamentals as they have yet to reach a fully euphoric state according to our Complacency-Anxiety Indicator (Chart 5), a sell-off in the bond market will likely cause some consternation in equities in general and tech stocks in particular similar to early- and late-2018. Chart 5Not Max Complacent Yet Other catalysts that can suddenly cause “the music to stop” are either the recent coronavirus becoming an epidemic or a geopolitical event that would result in a risk off backdrop. Ultimately, profits have to show up and the news on this front remains grim. Our mid-January “Three EPS Scenarios” analysis still suggests that the SPX is 9% overvalued.2 This week we are updating our capital markets view and adding a sixth long-term theme and a related investment implication to our mid-December 2019, Special Report titled, “Top US Sector Investment Ideas For The Next Decade”.3 Sixth Big Theme For The Decade And Investment Implications China’s ascendancy on the world scene was a mega driver of equity markets in the 2000s following its inclusion in the WTO. The commodity super-cycle captured investors’ imaginations and China’s insatiable appetite for commodities caused a massive bubble in the commodity complex in general and commodity-related equities in particular. Nevertheless, the Great Recession posed a severe threat to China and the authorities injected an extraordinary amount of stimulus into the economy (15% of GDP over two years). This succeeded in doubling real GDP growth, but only temporarily. The unintended consequence was an enormous debt binge fueled by cheap money. Moreover, this debt burden along with falling labor force growth and productivity forced the government to re-think its policies as they caused a steady down drift in real output growth. The sixth big theme for the 2020s is a sustained deceleration of Chinese real GDP growth to a range of 4% to 2% (Chart 6). Not only is the debt overhang weighing on real output growth, but Chinese leaders are adamant about transitioning the economy to developed market status, which is synonymous with higher consumption expenditures at the expense of gross fixed capital formation. Chart 6From Boom… Chart 7…To Bust In other words, China remains committed to weaning its economy off of investment and reconfiguring it toward consumption (Chart 7). This is a strategic plan but it is possible that the Chinese economy can achieve this transition in due time. While this will not happen overnight, the implication is steadily lower real GDP growth as is common among large, mature, developed market economies. China will remain one of the top commodity consumers in the world, as urbanization is ongoing, but the intensity of commodity consumption will continue to decelerate (Chart 8). At the margin, this change in consumption behavior will have knock on effects on the broad basic resources sector in general and the S&P 1500 metals & mining index in particular. Were this Chinese backdrop to pan out in the coming decade as we expect, it would sustain the relative underperformance of metals & mining equities as Chart 6 & 7 depict. Chart 8Commodity Consumption Deceleration Will… Chart 9…Continue To Weigh On Metals & Mining Profits Importantly, these commodity producers will have to adjust their still bloated cost structures to lower run rates which is de facto negative both for relative sales and profit growth (Chart 9). Tack on the large negative footprint mining extraction has on the environment, and if ESG investing (our fifth big theme for the decade4) also takes off, investors should avoid the S&P 1500 metals & mining index on a secular basis. Bottom Line: There are high odds that China’s real GDP deceleration will continue for the next decade, casting a shadow over the profit prospects of the S&P 1500 metals & mining index. A structural below benchmark allocation is warranted. The ticker symbols for the stocks in this index are: BLBG S15METL – NEM, FCX, NUE, RS, RGLD, STLD, CMC, ATI, CRS, CLF, CMP, X, KALU, WOR, MTRN, HCC, AKS, SXC, HAYN, CENX, TMST, ZEUS. Capital Markets Update Capital markets stocks have come out of hibernation recently and are on the cusp of breaking out – in a bullish fashion – of their 18-month trading range. A number of the indicators we track signal that an earnings-led outperformance period is in the cards for this financials sub-group and we reiterate our overweight stance. Sloshing liquidity has pushed investors out the risk spectrum and high yield bond option adjusted spreads are flirting with multi-year lows. Such a tame junk bond market backdrop coupled with easy financial conditions are conducive to rising M&A activity (Chart 10). Importantly, the Fed’s Senior Loan Officer Survey paints an improving profit backdrop for investment banks. Not only are bankers willing extenders of credit, but demand for credit for the majority of loan categories that the Fed tracks is squarely in positive territory (top panel, Chart 11). Chart 10Subsiding Risks Are A Boon To Capital Markets Chart 11Positive Profit Catalysts This is likely a consequence of last year’s drubbing in the price of credit. M&A activity usually goes hand in hand with loan growth, underscoring that business combinations are on track to accelerate (third panel, Chart 10). This will revive a lucrative business line for capital markets firms. Total mutual fund assets are expanding at a brisk rate and hitting fresh all-time highs, signaling an uptick in risk appetite (third panel, Chart 11). Rising investor confidence will facilitate both new and secondary share issuance, an important source of fee generation for capital markets firms. Moreover, equity trading volumes have sprang back to life in recent weeks underscoring that the recent impressive Q4 earnings results will likely continue into Q1/2020 (bottom panel, Chart 10). Meanwhile, the three Fed rate cuts last year should work through the economy and at least stem further losses in the ISM manufacturing survey. The US/China trade détente will also lead to a stabilization in global growth. In fact, the V-shaped recovery in the global ZEW survey suggests that capital markets profits will likely outpace the broad market this year (second & bottom panels, Chart 11). Finally, the recent surge in the stock-to-bond ratio reflects a massive psychological shift, from last year’s recessionary fears to growing investor confidence that tail risks are abating (Chart 12). Still depressed valuations neither reflect the firming capital markets profit outlook nor the rising industry ROE (bottom panel, Chart 12). Adding it all up, accelerating total mutual fund assets under management, improved trading revenue prospects, rising investor confidence and a revival in IPO and M&A activity, all signal that it still pays to be overweight the S&P capital markets index.  Bottom Line: Stay overweight the S&P capital markets index. The ticker symbols for the stocks in this index are: BLBG S5CAPM – GS, CME, SPGI, MS, BLK, SCHW, ICE, MCO, BK, TROW, STT, MSCI, NTRS, AMP, MKTX, CBOE, NDAQ, RJF, ETFC, BEN, IVZ. Chart 12Valuation Re-Rating Looms     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     1     Please see BCA US Equity Strategy Weekly Report, “Three EPS Scenarios” dated January 13, 2020, available at uses.bcaresearch.com. 2     Ibid. 3     Please see BCA US Equity Strategy Special Report, “Top US Sector Investment Ideas For the Next Decade” dated December 16, 2019, available at uses.bcaresearch.com. 4     Ibid.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights Commercial rents have fallen in real terms, revealing that the commercial property price rally has been fueled exclusively by low rates. Limited upside for rents and an upward direction for future rates are two significant headwinds. However, commercial real estate is especially pro-cyclical and inflationary pressures need to work their way into the economy before the risk of a downturn becomes imminent. The good news is that the economy is less vulnerable to slipping commercial property prices. Large banks have shrunk their commercial property loan books and their composition has shifted towards safer categories of commercial loans. While the macroeconomic outlook remains somewhat neutral, CMBS’ risk/reward profile appears reasonably attractive relative to other US bond sectors. Feature Real estate was a bane for markets and the banking system in the last recession, and commercial properties have lately become an increasingly popular source of concern among investors. Average prices have grown by 90% over the past decade, rising well above their pre-Great Financial Crisis peaks. We have made the case that we are heading into the expansion’s last stretch. The study of economic cycles and our relentless quest to identify inflection points ahead of time become more timely as the bull market ages. To this end, current commercial property valuations deserve close scrutiny and we explore whether any underlying excesses could potentially disrupt financial stability or precipitate a recession in the US. We conclude that although commercial property prices have little hope of appreciating significantly from current levels, a reversal is not imminent until inflationary pressure forces rates higher. When prices eventually slip, the impact on the overall economy should be more attenuated than it was in the last recession, as the banking system has become less vulnerable to a downturn in commercial real estate. While the fundamental macro outlook remains neutral, suggesting no imminent pressure on spreads, US bond investors can find relative value in non-agency Aaa-rated CMBS (vs. corporate bonds rated A or higher) and in agency CMBS (vs. agency residential mortgaged-backed securities). A Rate-Driven Rally Chart 1Commercial Rents Have Decoupled From Property Prices Like all financial assets, commercial property prices are derived from discounting future cash flows to their present value. Since the crisis, a low rate environment, supported by a sluggish inflation backdrop and continuously accommodative monetary policy, has depressed the valuation equation’s denominator. Meanwhile, strong economic fundamentals and demographic trends - such as urbanization and the millennials’ tendency to marry and purchase a home at a later age - have helped boost the numerator for commercial and multi-family residential properties in the past decade. However, with the exception of multi-family residential real estate - for which price appreciation has also been the strongest - real rents have fallen (Chart 1), revealing that low rates have propelled commercial properties’ price appreciation over the past decade. The combination of falling real rents and surging property prices has depressed commercial real estate cap rates1 to cyclical low levels, raising the question of a potential unwind. Mathematically, an increase in cap rates could result, on the one hand, from rent growth outpacing inflation growth, translating into an increase in real rents on the numerator. Alternatively, cap rates could rise from falling property prices, reducing the denominator. On a cyclical horizon, the latter outcome seems more likely than the former. Little Upside Left For Rents First, the fact that rents in real terms have decreased in spite of sluggish inflation is a bad omen for the outlook for future real rents. We have made the case that there is more inflationary pressure than meets the eye beneath the surface of the US economy. The combination of an already very tight labor market and a pickup in manufacturing activity point towards further wage growth. Inflation is a lagging indicator that has more scope to rise than roll-over at this stage of the cycle. All else equal, upward inflationary pressure will depress real rents further. Second, nominal rents themselves are also facing significant headwinds. Office buildings’ and retail shopping centers’ vacancies have barely recovered from the hit they took in the last recession, while new inventory is struggling to get absorbed by new demand (Chart 2). A strong labor market generally supports the demand for office spaces but a tight labor market limits its future upside. The latter, though, increases potential wage gains and consumers’ purchasing power, whose fundamentals are already strong. We have shown that US consumers’ increased savings rates and lower debt levels put them in a good position to spend their incremental income. Chart 2Post-Crisis Office And Shopping Center Vacancies Remain Elevated... Chart 3...As These Sectors Face Structural Disruptions However, both sectors are facing structural disruptions. Co-working has introduced a new player in the office segment – a sub-lessor who signs long-term leases on space it rents out in short-term chunks. If a sizable sub-lessor like WeWork were forced to shrink its footprint, a lot of office supply would come back on to the market, while demand is shrinking as businesses attempt to reduce the area each employee occupies. Brick-and-mortar retailers continue to be buffeted as e-commerce captures an increasing share of consumer spending, keeping downward pressure on retail rents (Chart 3). The picture looks slightly brighter in the industrial properties space, where vacancies have recovered to healthier levels, though low vacancies have failed to lift rents as demand for properties is being met by new inventory (Chart 4). The revival in global manufacturing activity that we are expecting to occur this year should support industrial property rents in the near term, but the advanced age of the cycle limits future upside. Chart 4A Brighter Picture For Industrial And Apartment Buildings... Chart 5...Thanks To Rising Renters Income Chart 6Over-Construction Of High-Tier Properties Multi-family residential housing is the only sector that has experienced steady real rent growth, fueled by a combination of rising rentership rates and rising household income amongst renters (Chart 5). Homebuilders’ focus on building higher-end units has led to an oversupply of more expensive properties, and their prices have already started to contract on a year-on-year basis (Chart 6). Multi-family residential properties rents should lose momentum as the alternative cost of owning homes falls, especially as homebuilders attempt to right-size their mix of properties to offer more lower-end supply. Exhausted Demand A commercial real estate rally fueled by perpetually falling rates is unsustainable. Although the market sees the potential for an additional rate cut, we think the Fed is done cutting. Labor market strength and a revival in global manufacturing activity argue that no further accommodation or insurance rate cuts are necessary. From current levels, the path of least resistance for rates is upwards (Chart 7). Strong demand from institutional investors has also contributed to fueling prices. Pension funds and insurance companies’ holdings of mortgages and agency-backed securities have nearly doubled since 2010 (Chart 8, first panel) and their allocation as a percentage of total assets is nearing pre-recession highs (Chart 8, second panel). These levels allow them little flexibility to sustain their demand impulse, as there is only so much they can allocate to real estate and other alternative investments. Chart 7Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 8Saturated Demand From Institutional Investors... Demand from yield-hungry investors may also get exhausted if CMBS yields deflate to the point where they lose competitiveness relative to other income-producing investments. CMBS yields have broadly moved with other bond yields since the crisis, though US high-yield corporates have widened somewhat over the last few years, making them a slightly more appealing alternative to CMBS, all else equal (Chart 9). The steady downward pressure on multi-family cap rates since 2010 (Chart 10) reveals that the collateral underlying multi-family loans has become increasingly ambitiously priced, suggesting that losses given default on multi-family backed CMBS without agency backing may be rising, eroding prospective default-adjusted returns. Chart 9...And From Yield-Hungry Investors? Chart 10Cap Rates Have Reached Cyclical Lows New regulations also have the potential to retract a significant share of demand for commercial mortgages. The severe housing market deterioration during the Great Financial Crisis and the government intervention required to ensure Freddie Mac’s and Fannie Mae’s solvency led the Federal Housing Finance Agency (FHFA) to place these two government sponsored enterprises (GSEs) under conservatorship in 2014 and to cap their holdings of multi-family mortgages to US$ 100 billion for each GSE. A commercial real estate rally fueled by perpetually falling rates is unsustainable. Current holdings of multi-family residential loans far exceed the stated limits (Table 1). GSEs hold nearly half of all multi-family residential loans outstanding. The post-crisis growth in GSE-guaranteed loans is largely attributable to the exclusion from the cap of certain categories of loans such as green energy loans (Chart 11). The FHFA eliminated these exemptions last year, making the US$ 200 billion cap more binding and applicable to all multi-family loans without exception.2 The impact on mortgage originators and investors is yet to be seen but it would naturally follow that demand for multi-family mortgages to bundle into CMBS would decline if the GSEs are forced to take a step back from the space. Table 1Commercial Real Estate Loans By Holder ($US Mn) Chart 11Multi-Family Mortgage Debt Outstanding By Mortgage Holder Late-Cycle Dynamics Commercial mortgages are typically non-recourse (in case of default, the borrower can only recover the value of the collateralized property) making the loss given default a function of property prices. When times are good and property prices rise, borrowers can easily refinance their loans. The opposite holds in bad times. Therefore, commercial real estate prices are especially pro-cyclical. In spite of the headwinds outlined above, a commercial property downturn does not seem imminent. In spite of the headwinds outlined above, a commercial property downturn does not seem imminent. First, the US economy still has momentum, is supported by highly accommodative monetary policy and should get a boost from a global growth revival. Absent any major exogenous shock to the global economy, we expect that a recession is at least eighteen months away. For as long as the economy keeps expanding, commercial real estate prices can remain elevated. Second, sources of financing remain abundant as the emergence of alternative lenders (Chart 12) has offset the banks’ tighter lending standards for commercial properties (Chart 13). The proliferation of non-bank lenders is typically a late-cycle indicator. Chart 12The Proliferation Of Alternative Lenders… However, when the economy starts contracting, a commercial real estate downturn could have an outsized impact on banks with significant exposure. In the late 1980s, the commercial property downturn induced a recession and the subprime mortgage bust gave rise to the Great Financial Crisis. Healthier Balance Sheets The good news for the economy today is that banks are less vulnerable to a downturn in commercial real estate than they were back then. The good news for the economy today is that banks are less vulnerable to a downturn in commercial real estate. Banks have decreased their overall exposure to commercial property loans to levels below their 2008 and 1989 peaks (Chart 14). It is worth noting, though, that smaller banks have taken an increasingly important role in the commercial property market as they now finance 65% of all commercial property loans. However, a stronger concentration in smaller banks represents a localized rather than systemic risk, as smaller banks tend to have a more concentrated geographic exposure. Conversely, large banks have significantly shrunk their commercial real estate loan books.3 Chart 14Large Banks Have Shrunk Their CRE Books... Chart 15...And Shifted Away From Speculative-Grade Loans Most importantly, the composition of the commercial property loan book has changed drastically since the Great Financial Crisis. Banks have significantly reduced their exposure to more speculative construction and development loans (Chart 15). Risk appetite typically increases in the latter stages of an expansion, yet construction loans remain at relatively depressed levels. The growth in commercial property loans since 2013 has entirely been explained by the rise in relatively less risky multi-family and non-residential non-farm loans. Investment Implications A commercial real estate downturn is probably not a 2020 event. Inflationary pressures need to make their presence felt across a wide swath of the economy before Fed hikes will give rates the scope to move sustainably higher. In the meantime, bond investors with a mandate to remain exposed to CMBS can reap the benefits of attractive risk/reward profiles relative to other segments of the US bond market. US Bond Strategy’s Excess Return Bond Map measures the number of standard deviations of spread widening a sector would need to experience, before losing 100 basis points relative to a duration-matched position in Treasuries4 (Chart 16). Sectors plotting near the top-right of the Map carry both high expected return and low risk. Sectors plotting near the bottom-left carry low expected return and high risk. Chart 16BCA US Bond Strategy’s Excess Return Bond Map Chart 17Tighter Standards And Decelerating Prices This valuation framework currently suggests that CMBS look reasonably attractive. Non-agency Aaa-rated CMBS’ expected return is more promising than Aaa-and Aa-rated corporate bonds and somewhat similar to the expected return on an A-rated corporate bond. Meanwhile, CMBS exhibit a lower risk of losing 100 bps. Similarly, Agency CMBS offer greater expected return than Conventional 30-year Agency-backed residential MBS, along with a similar risk of losses. Although relative valuations appear attractive, the fundamental outlook remains neutral for CMBS spreads, for now. Periods of tightening commercial real estate lending standards and weakening commercial loan demand have historically coincided with decelerating commercial real estate prices and widening CMBS spreads. The Fed’s Q3 2019 Senior Loan Officer Survey revealed only a small net tightening of lending standards and unchanged demand (Chart 17). Overall, the lack of inflationary pressure suggests that neither a commercial real estate downturn nor a meaningful widening of CMBS spreads is an imminent threat.   Jennifer Lacombe Senior Analyst JenniferL@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 A capitalization rate is the ratio of net operating income (rent) to price and measures the expected rate of return on a real estate investment. As such, a property’s price can also be derived by dividing its rent by its cap rate. 2 More information about GSE’s conservatorship can be found on the FHFA’s website (https://www.fhfa.gov/Conservatorship/Pages/History-of-Fannie-Mae--Freddie-Conservatorships.aspx and https://www.fhfa.gov/Media/PublicAffairs/Pages/New-Multifamily-Caps-9132019.aspx). 3 An analysis of the largest banks’ earnings call we carried out last October also revealed that large banks were unanimously shrinking their commercial real estate books. For more details, please refer to US Investment Strategy Weekly Report from October 28, 2019, "What The Biggest Banks See", available at usis.bcaresearch.com. 4 For more details on the methodology behind our Excess Return Bond Map please see US Bond Strategy October 15, 2019 Weekly Report "A Perspective On Risk And Reward", available at usbs.bcaresearch.com.

Highlights Most central banks still consider economic risks asymmetrical to the downside. This means that even if global growth rebounds in earnest, policy is likely to stay pat over the next three to six months. The conclusion is that relative growth fundamentals rather than central bank policy will likely drive FX price action in the next few months. Our bias remains that the growth impulse will be strongest outside the US during the first half of this year. Stay short the DXY index. The BoJ’s inaction this week makes long yen bets cheap insurance against a rise in FX volatility.  Remain short USD/JPY and go short CHF/JPY. The pound remains a buy on dips but will likely underperform the euro over the next few months. EUR/GBP should touch 0.88. The BoC kept rates on hold, but erred on the dovish side, in line with our expectations. Stay short CAD/NOK and long AUD/CAD. We were stopped out of our long NOK/SEK trade for a profit of 1.8%. We will look to rebuy the cross at lower levels. Feature Chart I-1Currency Markets Have Priced In A Benign Recovery The powerful bounce in global equity markets since the August lows has pushed many stock indices into overbought territory. Chart I-1 shows that the rise in global stocks has already discounted an improvement in global manufacturing in order of magnitude similar to the 2012 and 2016 episodes. However, currency markets have been discounting a much more benign outcome (bottom panel). The divergence between currency and equity performance is a marked change from what has prevailed during past cycles. For example, trough to peak, AUD/JPY, a key barometer of greed versus fear in currency markets, appreciated 40% during the 2012 episode, and 25% in 2016-2017, along with rising equity prices. The performance of even more high-octane currency pairs such as the RUB/JPY, the ZAR/JPY, or even the BRL/JPY, was explosive. More muted currency action this time around therefore calls into question the durability of this recovery. Perhaps given that equities are long-duration assets, it is quite plausible that the drop in interest rates in 2019 has increased their relative appeal, boosting nominal values. While that makes sense, most bond markets have also seen higher yields over the past few months, making this explanation questionable. Alternatively, the easing in trade tensions and/or the Federal Reserve’s liquidity injections may have rekindled animal spirits among domestic investors. Or perhaps, a synchronized recovery has narrowed G10 growth differentials, muting currency performance in the process but boosting share prices. The rise in global stocks has already discounted an improvement in global manufacturing. However, currency markets have been discounting a much more benign outcome. Either way, the resolution to this dissonance will be either through marked improvement in global economic data in the coming months (which will support pro-cyclical currencies), or a period of indigestion for stock markets (which will lift volatility) – or a combination of both. At a minimum, this suggests tweaking currency portfolios in anticipation of these dynamics.   On Volatility And The Dollar Everyone understands that currency markets are about relative trends. Therefore, the implicit assumption that the dollar will weaken as global growth picks up is that the epicenter of this recovery will be outside the US. Chart I-2 shows that economic data is not yet surprising to the upside outside the US, even though there has been marked improvement on a rate-of-change basis. Beneath the surface, the strongest data surprises have been in the euro area, Switzerland, New Zealand and Australia, while disappointments have been in Canada and the UK. In hindsight, the chart also highlights why the Canadian dollar was the best performing G10 currency in 2019, while the Swedish krona was the weakest. Chart I-2Growth Dispersion Has Fallen The drop in economic dispersion has pushed currency volatility near record lows (Chart I-3). Every seasoned investor does and should pay attention to low volatility. This is because what destroys portfolios is not exuberance, but complacency. This might sound like a tautology, but during the last three episodes of volatility dropping to these levels, the dollar soared and pro-cyclical currencies suffered severe losses. Everyone remembers 1997-1998, 2007-2008 and 2014-2015. Will this time be the same? While a rise in volatility is usually associated with a higher dollar, there are three key differences this time around. First, real rates turned positive in the US relative to its G10 counterparts in 2014 (Chart I-4). This meant the US dollar, which has typically been a funding currency (not least because it is a reserve currency), became the object of carry trades. It is a fair contention that any capital that wanted to find its way into US Treasurys has had more than five years of positive real carry to do so. With real relative yields in the US now rolling over, which way will capital gravitate? Chart I-3Volatility Near Record Lows Chart I-4Real Rates Lower In The US The dollar has been in a bull market since 2011, which has shifted valuations towards expensive quartiles. This is a key difference from previous low-volatility episodes when the dollar was much earlier into bull-market territory (Chart I-5). The dollar tends to run in long cycles, and a spike in volatility can either mark the beginning or the end of a cycle. As we have emphasized numerous times in previous reports, being long the US dollar is a consensus trade. Our primary basis for this is CFTC positioning data. However, a timelier leading indicator to watch is the gold-to-bond ratio. Currencies are about confidence, and a key measure of confidence in the US dollar is the total return in the US 10-year Treasury compared to gold bullion, which has collapsed (Chart I-6). The budget deficit in the US is about to explode, while it was low and falling during prior dollar riot points.   Chart I-5The Dollar Is Expensive Chart I-6Tug Of War Between US Bonds And Gold More importantly, currency markets are likely to gyrate with relative fundamentals. The slowdown in the global economy was driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Historically, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services (and consumption). More specifically, the currencies that have borne the brunt of the manufacturing slowdown should logically be the ones to experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the US. For example, yields in Norway, Sweden, Switzerland and Japan have risen significantly versus those in the US since the bottom. A synchronized recovery in global growth will go a long way in further eroding the US’ yield advantage. Currencies are about confidence, and a key measure of confidence in the US dollar is the total return in the US 10-year Treasury compared to gold bullion. Bottom Line: Remain short the DXY index with an initial target of 90 and a stop loss at 100.  The Yen As Portfolio Insurance Should our thesis that the dollar is in a downtrend for 2020 be correct, it is unlikely to occur in a straight line. This argues for having some portfolio insurance. The Bank of Japan’s inaction this week may have been a red herring, since one of the most potent moves in asset markets in recent months has been the +130-basis-point move in favor of Japanese yields (Chart I-7). The gap between the USD/JPY and real rates has opened up a rare arbitrage opportunity. Should a selloff in global risk assets materialize, the yen will strengthen. On the other hand, if global growth does eventually accelerate, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This keeps short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. The rise in Japanese yields has been driven by three key pivotal developments: For most of the past five years, the BoJ was one of the most aggressive central banks in terms of asset purchases. This was a huge catalyst for a downturn in the trade-weighted yen (Chart I-8). With a renewed expansion in the Fed’s balance sheet, monetary policy is tightening on a relative basis in Japan. Total annual asset purchases by the BoJ are currently running at about ¥20 trillion, while JGB purchases are running at ¥15 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon. Chart I-7Japanese Bond Yields Have Surged Chart I-8The Yen And QE Movements in the yen are as influenced by external conditions as what is happening domestically, given Japan’s huge export sector. Credit default swap spreads of cyclical sectors are collapsing to new lows, symptomatic of an improving profit outlook (Chart I-9). This suggests it is the growth component driving Japanese yields higher (Japanese CPI swaps have indeed been flat). This also mirrors the recent outperformance of Asian cyclical sectors relative to defensive ones. The Abe government announced a huge fiscal package last year, in part driven by the disastrous typhoons as well as the upcoming Olympics. This allowed the BoJ to upgrade its growth forecasts in its latest policy minutes. The relative performance of construction and engineering stocks are an important barometer for when the funds are flowing into the economy (Chart I-10). Chart I-9Default Risk Easing In Japan Chart I-10Fiscal Stimulus And Construction Stocks As a defensive currency, the yen tends to weaken as global growth improves, given it is usually used to fund carry trades. That said, our contention is that the yen will surely weaken at the crosses, but could still strengthen versus the dollar. As mentioned above, one catalyst is the divergence from the traditional relationship with real rates. More importantly, the USD/JPY and the DXY tend to have a positive correlation, because the dollar drives the yen most of the time. Meanwhile, net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-11). Given extremely low volatility, this places short USD/JPY bets as an attractive vehicle to play a rise in volatility. Chart I-11Investors Are Short The Yen More conservative investors could go short CHF/JPY. The recent rise in the Swiss franc threatens the nascent recovery in inflation (Chart I-12), while weakness in the Japanese yen will help lift domestic tradeable goods prices. This puts more pressure on the Swiss National Bank rather than the BoJ. Meanwhile, as a safe haven, the yen is cheaper than the franc. This is confirmed by many of our in-house models. In simple terms, relative inflation with the US has been lower in Japan over the last several decades, but the franc has been stronger. In simple terms, relative inflation with the US has been lower in Japan over the last several decades, but the franc has been stronger (Chart I-13). Meanwhile, over the last two years, a rise in volatility has benefited the yen more than the franc. Chart I-12Strong Franc Is A Headwind For Swiss Inflation Chart I-13The Yen Is Cheaper ##br##Insurance Bottom Line: The yen is the most attractive safe-haven currency at the moment. Remain short USD/JPY and sell CHF/JPY. Housekeeping We were stopped out of our long NOK/SEK trade for a profit of 1.8%. We will look to rebuy this cross at lower levels. The trade is mostly about carry, and we are both positive on the NOK and SEK. This makes market timing important. NOK/SEK at 1.04 will be attractive. There were no new insights from the Norges bank this week, in the context of all the central bank meetings. We will also be looking to opportunistically buy the pound, but buying EUR or GBP volatility might be a better bet. For now, despite the robust labor report, economic surprises in the UK remain negative (Chart I-14). Stay tuned. Chart I-14GBP Is Vulnerable Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mixed: Industrial production fell by 1% year-on-year in December. The preliminary Michigan consumer sentiment index fell slightly to 99.1 in January. MBA mortgage applications fell by 1.2% for the week ended January 17th. However, existing home sales surprised to the upside, rising 3.6% month-on-month in December. Chicago Fed national activity index fell to -0.35 from 0.41 in December. Initial jobless claims increased to 211K for the week ended January 17th, better than expectations. The DXY index increased by 0.4% this week. There are growing concerns over whether China's coronavirus would significantly drag down global growth. While this is a hiccup in the short term, we remain positive and believe that global growth will accelerate this year on easy financial conditions and faded trade war risks. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly positive: The current account balance came in at €33.9 billion in November. Headline and core inflation were both unchanged at 1.3% year-on-year respectively in December. The ZEW economic sentiment survey soared to 25.6 from 11.2 in January. The euro fell by 0.8% against the US dollar this week. On Thursday, the ECB maintained interest rates at -0.5%. The key takeaway from the ECB is that they are grappling with a review of their monetary policy objective in a manner that might increase accommodation. A switch to an explicit 2% inflation target and/or including a climate change objective into quantitative easing decisions heralds a much more dovish ECB. We are tightening our stop on long EUR/CAD to 1.42. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Industrial production fell by 8.2% year-on-year in November. The trade deficit widened to ¥152.5 billion in December. Imports and exports both fell by 4.9% and 6.3% year-on-year, respectively. All industry activity index increased by 0.9% month-on-month in November. Both the coincident index and the leading economic index fell to 94.7 and 90.8, respectively in November. The Japanese yen appreciated by 0.3% against the US dollar this week. The BoJ kept interest rates unchanged, in line with expectations. More importantly, the outlook report revised the growth forecast upward to 0.9% from 0.7% for the fiscal year 2020. Moreover, the BoJ revised down the inflation forecast by 10 bps due to lower crude oil prices. Please refer to our front section this week for a more in-depth analysis on the Japanese yen. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been positive: Retail sales grew by 0.9% year-on-year in December. The Rightmove house price index increased by 2.7% year-on-year in January. The ILO unemployment rate was unchanged at 3.8% in November. Average earnings grew by 3.2% year-on-year in November. This followed a 3-month improvement in employment of 208K, after what had been a dismal employment report for most of 2019. The British pound appreciated by 0.7% against the US dollar this week. The biggest volatility in European currencies in the next few weeks is likely to emerge in the EUR/GBP cross. European economic data has had the best positive surprises in the last few weeks, in part due to base effects.  However, the ECB’s transcript this week suggests leaning against any currency strength. In the UK, the pound will still trade partly on politics for now. Buying GBP and EUR volatility looks like a good bet. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: The Westpac consumer confidence index fell by 1.8% in January. Consumer inflation expectations increased to 4.7% from 4% in January. 28.9K new jobs were created in December, above consensus. This was a combination of 29.2K part-time jobs but a loss of 0.3K full-time jobs. The participation rate was unchanged at 66% in December, while the unemployment rate fell further to 5.1%. The Australian dollar fell by 0.6% against the US dollar this week. The positive jobs report placed a bid under AUD, but that quickly dissipated as the coronavirus scare started to dominate headlines. We discussed AUD in depth last week and are buyers at 68 cents. Our primary rationale is that this is a potent contrarian bet. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Visitor arrivals fell by 3.5% year-on-year in November. Net migration fell to 2610 from 3400 in November. The performance services index fell to 51.9 from 52.9 in December. The New Zealand dollar fell by 0.5% against the US dollar this week. While we believe that the kiwi dollar will outperform the US dollar this year amid improving global growth, domestic constraints including decreasing net migration might limit upside potential. Stay long AUD/NZD and SEK/NZD. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been soft: Manufacturing sales fell by 0.6% month-on-month in November. Headline inflation was unchanged at 2.2% year-on-year in December. Core inflation however, fell to 1.7% from 1.9% in December. New house prices grew by 0.1% year-on-year in December. The Canadian dollar fell by 0.8% against the US dollar this week. On Wednesday, the BoC decided to put interest rates on hold, while opening the door for possible rate cuts later this year if the Canadian data disappointed. In short, like most other central banks, the BoC is data dependent. Our story for CAD is simple – if the epicenter of a growth rebound is outside the US, CAD will underperform its antipodean counterparts. Stay long AUD/CAD. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There have been scant data from Switzerland this week: Producer prices fell by 1.7% year-on-year in December, compared with a decrease of 2.5% the previous month. Money supply (M3) grew by 0.7% year-on-year in December. The Swiss franc has been more or less flat against the US dollar this week. We continue to favor the Swiss franc as global risks persist, including concerns about the coronavirus. However, as discussed in the front section of this report, the yen is a better hedge than the franc at the current juncture. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The Labor Force Survey recorded an increase in the unemployment rate to 4% in November.  The Norwegian krone fell by 1.3% against the US dollar this week amid lower energy prices. On Thursday, the Norges Bank kept interest rates on hold at 1.5%, as widely expected. Moreover, the Bank Governor Øystein Olsen said that "The Committee’s current assessment of the outlook and the balance of risks suggests that the policy rate will most likely remain at the present level in the coming period," implying no change in the policy rate in the near-term. This suggests that going forward, relative fundamentals rather than policy decisions will dictate NOK’s path. Our bias is that a valuation cushion offers a margin of safety for long NOK positions. Remain short USD/NOK and CAD/NOK. Report Links: On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 There was scant data out of Sweden this week: After rising from 6% to 6.8% in November, the unemployment rate fell back to 6% in December. The Swedish krona fell by 0.2% against the US dollar this week. Going forward, improving global growth, diminished trade tensions, and fewer concerns about a near-term recession all underpin the Swedish economy and the krona. SEK is the most potent G10 cross to play a global manufacturing rebound. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The Wuhan coronavirus outbreak in China is now being priced into commodity markets, with comparisons to the 2003 SARS outbreak serving as an early benchmark.1 If it follows the SARS trajectory its impact likely will be limited, although oil demand could fall at the margin as global travel falls. The IMF expects growth in EM economies, the engine for commodity demand, to come in at 4.4% and 4.6% this year and next, respectively, down two-tenths of a percent from its previous forecast, but still up from 2019’s 3.7% rate. The Fund’s risk assessment tilts slightly to the upside, nonetheless, in the wake of global monetary and fiscal stimulus. We introduce our 2021 oil balances and price forecasts this week. We expect Brent crude oil to average $70/bbl next year, and for WTI to average $4/bbl below that. We are maintaining our $67/bbl Brent and $63/bbl WTI 2020 forecasts (Chart of the Week). Chart of the WeekCrude Oil Price Forecasts For 2020, 2021 Feature In its latest World Economic Outlook – Tentative Stabilization, Sluggish Recovery? – the IMF flags key risks to EM growth, which will continue to feed the economic policy uncertainty that dogs commodity demand.2 The Fund’s “downward revision primarily reflects negative surprises to economic activity in a few emerging market economies, notably India, which led to a reassessment of growth prospects over the next two years. In a few cases, this reassessment also reflects the impact of increased social unrest.” That said, the Fund sees the balance of risk slightly tilted to the upside versus its earlier assessment in October, in the wake of global monetary and fiscal stimulus. This is in line with our view that the effects of monetary stimulus – deployed over the better part of last year and still expected to remain accommodative this year – will boost growth this year. Our view remains tempered by risks we’ve been highlighting that keep political and economic policy uncertainty elevated – e.g., trade tensions, civil unrest, and the still-underappreciated risks to oil markets arising from US-Iran tensions and social unrest in Iraq, which remains high (Chart 2). The loss of 800k b/d from Libya is significant, but the world does not lack spare light-sweet crude oil production capacity – the US shales, in particular, abound in this type of crude oil. Chart 2Policy Uncertainty Will Trend Lower, But Continues To Dog Commodities Oil Fundamentals Improving As is typically the case, we expect global oil-demand growth this year will be led by EM economies. Crude oil fundamentals continue to favor higher prices: Production management and capital discipline will constrain the rate of growth of oil supplies, and, as discussed above, demand will benefit from policy stimulus globally (Chart 3). Oil demand growth will recover this year, following a lower-than-normal rate of just 830k b/d last year, based on the US EIA’s most recent estimates of historical consumption. We continue to expect demand to grow 1.4mm b/d this year.  For 2021, we expect growth of just under 1.5mm b/d, reaching 103.65mm b/d globally. For its part, the EIA’s estimating growth of 1.34mm and 1.37mm b/d for 2020 and 2021, respectively. As is typically the case, we expect global oil-demand growth this year will be led by EM economies, proxied by non-OECD oil consumption, of 1.26mm b/d. For next year, we expect EM demand growth to come in at 1.34mm b/d, or just over 90% of global oil consumption growth in 2021. On the supply side, we continue to expect OPEC 2.0 output to increase slightly in 2Q20 and return to levels consistent with its previous agreement to cut 1.2mm b/d of production. Our modeling also assumes this level of production remains flat for the rest of 2020. Chart 3Fundamental Supply-Demand Balances Support Higher Crude Oil Prices Next year, we assume the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia to increase production by 350k b/d in 1H21. In addition, we gradually remove 300k b/d of KSA’s overcompliance of 400k b/d next year, which moves its crude oil output in 2021 to 9.94mm b/d vs 9.76mm b/d this year. For Russia, we anticipate an increase in its condensate production, which it lobbied for last year. This will put our estimate of Russia’s crude and condensate production at 11.4mm b/d in 2020 and 11.64mm b/d in 2021.3 Most of the production cuts realized by OPEC 2.0 – ~ 2mm b/d – come at the expense of Venezuela and Iran, both of which are under sanctions limiting their production imposed by the US. We are holding Venezuela’s production at ~ 700k b/d in 2021, and will be monitoring this closely for any indication it is significantly changing. For Iran, we are keeping its production at 2.10mm b/d this year and next, assuming US sanctions remain in place. Oil production in both countries could be impacted by the outcome of US elections in November, and right now this is a near-impossible call to make. US Shales: No Longer A Growth Story? We continue to see slower production growth in the US than the EIA, particularly in the shales, as we expect capital markets to continue to discipline shale producers by only funding those firms that are able to return capital to shareholders or to deliver steady and increasing dividends. In our modeling, total US onshore production this year and next is expected to rise 800k b/d, and 310k b/d for 2021. We also continue to expect drilled-but-uncompleted (DUC) wells to continue to make significant contributions to overall shale-oil production in the US. Indeed, we expect DUCs to continue to offset part of the decline implied by lower rig counts, as they require less capex than drilling and completing new wells. We add ~ 500k b/d of production from DUCs completion over 2020 and 2021. Future production will depend heavily on the Majors and on productivity and lateral length. Our US crude and condensate production estimates for 2020 and 2021 reflect these constraints, and the slowing rate of growth being imposed by capital markets. For 2020, we expect total US crude and condensate production of 13.16mm b/d, of which 9.20mm b/d will come from the main shale basins led by the Permian.4 Tighter Fundamentals, Steeper Backwardations Our fundamental supply-demand balances are tighter than those assumed by the US EIA and the Paris-based IEA (Table 1). We expect US crude and liquids production to grow 1.6mm b/d this year, and only 500k b/d next year. We see global production growing 1.15mm b/d and 1.39mm b/d in 2020 and 2021, respectively. With demand growing 1.4mm b/d and close to 1.5mm b/d in 2020 and 2021, respectively, against this supply backdrop, our balances point to a deficit this year vs. the surplus expected by the IEA  (Table 2 and Chart 4). Table 1Fundamentals Comparison Table 2BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Chart 4BCA Research's Balances Estimates Point To Falling Inventories Chart 5Tighter Storage, Steeper Backwardation For this reason, we continue to anticipate a steepening in the Brent and WTI forward curves – i.e., more backwardation – which will support our long 2H20 Brent vs. short 2H21 Brent curve trade (Chart 5). As a result of the steeper backwardation, we expect higher volatility, and will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls (Chart 6). Bottom Line: We continue to expect crude oil markets to tighten, given persistent production restraint by OPEC 2.0, capital-market-imposed restraint on US shale-oil producers, and revived global demand growth in 2020 and 2021. The IMF’s assessment re the balance of risk being tilted to the upside, in the wake of global monetary stimulus, is broadly consistent with our maintained view. While we expect global policy uncertainty to fall following the so-called phase-one US-China trade deal and a definitive Brexit vote in the UK, geopolitical tension remains high, particularly in the Persian Gulf. Chart 6Steeper Backwardation To Higher Implied Volatility We will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories. As a result, we are keeping our 2020 Brent forecast at $67/bbl, and are expecting 2021 Brent to trade at $70/bbl; WTI is expected to trade $4/bbl below Brent this year and next, on average. At tonight’s close, we will be getting long 4Q20 Brent $65/bbl calls vs. short 4Q20 Brent $70/bbl calls, in anticipation of higher volatility in the wake of lower inventories.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight Brent prices traded sideways ~ $64/bbl since last Tuesday, dismissing the US and China phase-one agreement and disruptions to Libyan production and exports which could total as much as 800k b/d.  Over the weekend, concerns re the Wuhan coronavirus outbreak in China started being priced into commodities, particularly oil.  Separately, the US Treasury Department renewed Chevron’s waiver to operate in Venezuela for another three months.  The company is scheduled to export 1mm barrels of oil produced by PDVSA via a joint-venture, partially dodging US sanctions on Venezuelan oil.5  We expect the country’s output to stabilize close to its current level of 710 kb/d this year. Base Metals: Neutral On Tuesday Beijing reported more than 400 people had been infected with the Wuhan coronavirus, confirming person-to-person transmission of the virus. Concerns that a wider spread over the lunar New Year holidays starting this weekend will impact economic growth in the world’s top metal consumer brought copper prices down 1.8% on Tuesday.  Zinc reached two-month highs this week amidst concerns of low LME warehouses stocks, now close to their 20-year lows at 50,900 MT (Chart 7).  Supply concerns stemming from low iron ore stocked in China’s ports, along with good Chinese macro data, lifted iron-ore prices. Precious Metals: Neutral The US dollar is a key missing piece needed to propel gold prices higher from current levels. The 2.4% decline in the trade-weighted dollar index supported gold’s 5% increase since October 1, 2019 (Chart 8).  We expect the dollar to continue depreciating in 2020, as global growth rebounds and the Fed remains accommodative, keeping gold prices well bid.  Most precious metals have followed gold’s lead this year; palladium and platinum are up 17.63% and 3.15%, respectively. Chart 7 Chart 8 Ags/Softs:  Underweight CBOT Corn and soybeans futures traded lower on Tuesday as markets awaited evidence of China purchasing additional U.S. agricultural goods, fulfilling its commitment to buy $32 billion of agricultural goods over two years per the phase-one deal negotiated between China and the US earlier this month.  Corn traded lower, as US grain elevators have yet to confirm any Chinese buying.  Soybeans, further weakened by expectations of a massive harvest in rival exporter Brazil.  Wheat was the only ag posting gains early in the week on the back of strong Black Sea export demand.     Footnotes 1     Please see CDC SARS Response Timeline, published by the US Centers for Disease Control and Prevention.  The SARS outbreak was identified in February 2003 and lasted six months.  The CDC noted: “Globally, WHO received reports of SARS from 29 countries and regions; 8,096 persons with probable SARS resulting in 774 deaths. In the United States, eight SARS infections were documented by laboratory testing and an additional 19 probable SARS infections were reported.”  According to Chinese officials, there were 440 confirmed cases of the new coronavirus as of Wednesday; nine people were reported to have died thus far.  The World Health Organization met Wednesday to assess the Wuhan coronavirus outbreak.  The 2003 coronavirus outbreak was minor compared to the typical influenza outbreak: by way of comparison, every year there are an estimated one billion cases of influenza, resulting in 290,000 to 650,000 deaths, according to the International Federation of Pharmaceutical Manufacturers & Associations in Switzerland. 2               Economic policy uncertainty is a recurrent theme in our research.  It has been driving safe-haven demand for the USD and gold for months, as we recently discussed in Iran Responds To US Strike; Oil Markets Remain Taut.  It is available at ces.bcaresearch.com. 3     We use World Bank growth estimates to drive our EM demand forecasts.  Earlier this month, the Bank forecast EM GDP growth of 4.1% for 2020 and 4.3% for next year.  This will outpace last year’s growth rate of 3.5%. 4     US production growth, particularly in the Permian and Bakken basins, could be constrained by environmental restrictions, if state regulators crack down on the massive flaring occurring in both states.  Please see Lingering Oil-Demand Weakness Will Fade, published November 21, 2019, where we discuss this risk in more depth. 5     Please see Exclusive: PDVSA's partners act as traders of Venezuelan oil amid sanctions - documents, published by reuters.com January 13, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q4 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Highlights An analysis on India is available on page 12. There is extreme complacency in global financial markets. With currency markets’ implied volatility at a record low, we recommend going long EM currency volatility. The latter will rise in the next six month regardless the direction of global risk assets. For now, we remain long the EM MSCI equity index with a stop point at 1050. In India, nominal income growth has fallen below lending rates. The latter have not declined despite monetary easing. The authorities will force banks to reduce their lending rates, which will hurt bank stocks. Feature “…we have probably seen the end of the boom-bust cycle.” Bob Prince, Co-CIO of Bridgewater World Economic Forum, Davos January 22, 2020 Low Volatility = Complacency Chart I-1Go Long Currency Volatility The comment above by co-CIO of the largest hedge fund declaring the end of boom-bust cycle is consistent with lingering complacency in global financial markets. Any time an influential person made a similar declaration in the past, it marked a major turning point in financial markets. Remarkably, implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies and a wide range of equity markets. Chart I-1 illustrates the implied volatility for EM currencies and the US dollar. Such low levels of implied currency market volatility historically preceded major moves in currency markets and often led to a material selloff in broad EM financial markets. It does not mean that the world economy will crash but financial markets volatility in general and currency market volatility in particular are bound to rise considerably in the months ahead. The risk-reward profile of going long EM currency or US dollar volatility appears very attractive. Today we recommend investors to go long EM currency volatility. The latter will rise regardless the direction of global risk assets. Concerning overall strategy, EM financial markets are entering a testing period. How broader EM risk assets and currencies perform in the coming weeks will signal how durable and long-lasting the current EM rally will be. Given global risk assets are overbought, a correction or consolidation phase is overdue. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. If during budding market turbulence EM risk assets and currencies underperform their DM peers, it will signal their vulnerability in 2020.Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. Implied volatility for the US dollar has plummeted to a record low, as it has for EM currencies. For now, we remain long the EM MSCI equity index with a stop point at 1050. We will upgrade our EM equity and credit market allocations versus DM if the EM universe generally exhibits relative resilience in the coming weeks, and more of our indicators confirm China’s growth recovery. Hints Of Recovery… December economic data out of China were strong, and it seems that the credit and fiscal stimulus are finally beginning to lift growth: Chinese imports and nominal industrial output – among the most reliable measures of the Chinese business cycle – posted very robust growth numbers in December (Chart I-2). DRAM and NAND semiconductor prices are climbing, and China’s container freight index is also in revival mode (Chart I-3). These high-frequency (daily and weekly) data confirm improving business activity in both the global semiconductor sector and in overall world trade. Chart I-2China's December Economic Data Were Strong Chart I-3Asia's Trade Is Recovering   There are tentative signs of amelioration in our proxies for marginal propensity to spend by households and enterprises in China (Chart I-4). A more decisive improvement in these indicators is needed to reinforce the positive outlook for China’s growth. …But Doubts Still Linger Despite the recent improvement in Chinese economic data and the rebound in China-related plays, there are a number of financial market indicators that are not yet confirming a sustainable business cycle recovery in China and global trade. In particular: First, apart from semiconductor stocks, global cyclical equity sectors and sub-sectors – industrials, materials, and freight and logistics – have begun, once again, underperforming defensive sectors (Chart I-5). Outperformance by these cyclical sectors against defensives is essential in confirming that global and Chinese capital spending – which were the primary sources of the most recent slowdown – are picking up again. Chart I-4China: Tentative Improvement In Household And Corporate Marginal Propensity To Spend Chart I-5Global Equities: Cyclicals Are Again Underperforming Defensives   Notably, the relative performance of EM share prices to the global equity benchmark historically tracks the relative performance of global materials versus the global overall stock index.1 However, the two have recently diverged (Chart I-6). In short, global materials are not corroborating sustainability in the recent EM outperformance. If EM equities, currencies and credit markets outperform, or at least do not underperform their DM peers in the course of this indigestion phase, it will beckon more upside for EM risk assets in 2020. Second, the rebound in Chinese and EM shares prices is not corroborated by Chinese onshore government bond yields, which are dipping to new cyclical lows (Chart I-7). In other words, interest rate expectations in China are falling – i.e., they are not confirming a robust recovery. Chart I-6Unsustainable Decoupling Chart I-7A Message From The Chinese Fixed-Income Market   Third, EM ex-China currencies have not yet broken out versus the US dollar (Chart I-8). Consistently, the broad trade-weighted US dollar has not yet broken down. Chart I-9 illustrates that the greenback’s advance-decline line has not yet fallen below its 200-day moving average, a condition that has historically been required to confirm the dollar’s cyclical bear market. Chart I-8EM Currencies: No Breakout Yet Chart I-9The US Dollar Is At A Critical Juncture   We view these exchange rate patterns as a litmus test to validate turning points in the global business cycle. Finally, the technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive (Chart I-10). These markets have rebounded but seem to be confronting a critical technical test. If they decisively break above these technical levels, it will be a sign that the EM bull market will be lasting and durable. Otherwise, caution is still warranted. Bottom Line: There is a good amount of complacency among global investors at a time when there are several market signals that are still challenging the view of enduring revival in China/EM growth. Corporate Profits Will Be The Arbiter Ultimately, economic growth and corporate profits will determine the direction of not only share prices but also EM sovereign and corporate credit spreads as well as their currencies. So far, the EM equity rebound of the past 12 months has been solely due to multiples expansion amid a deepening EM profit recession: Earnings per share in US dollar terms has been contracting by 10% from a year ago, and the rate of change has so far not turned around (Chart I-11). Chart I-10The KOSPI And Copper Are Facing A Resilience Test Chart I-11EM Equities: A Profitless Rally?   Going forward, however, EM corporate profits growth is set to improve. Our indicator for semiconductor companies’ revenues is heralding a revival in semi sector profits (Chart I-12, top panel). The rate-of-change improvement in commodities prices is also foreshadowing potential amelioration in corporate earnings growth among energy producers and materials (Chart I-12, middle and bottom panels). Chart I-12EPS Growth In EM Technology, Energy And Materials We are negative on EM bank profits due to their need to recognize and provision for non-performing loans as well as the authorities’ mounting pressures on them to reduce lending rates. The latter will shrink banks’ elevated net interest rate margins. The profit profile of other EM equity sectors is illustrated in Chart I-13A and I-13B. Chart I-13AEM EPS Growth By Sectors Chart I-13BEM EPS Growth By Sectors   Provided technology, materials and energy stocks account for 33% of the MSCI EM aggregate equity index’s earnings (banks account for another 28% of total profits), it is safe to assume that the growth rate of EM EPS will move from -10% currently to zero or mildly positive territory by mid-2020. Nevertheless, beyond the next several months, our leading indicators on the EM profit outlook are not positive. China’s narrow money growth leads EM EPS by 12 months, and currently suggests the EPS recovery will be both muted and short-lived (Chart I-14). The technical profiles of the KOSPI, EM small cap stocks and copper prices are inconclusive. Further, China’s broad money impulse points to a peak in the credit impulse in the first half of the year (Chart I-15). Given that EM share prices bottomed a year ago, simultaneously with China’s credit impulse, odds are that EM equities could slump with a rollover in the latter. Chart I-14EM EPS: Marginal Improvement Ahead But No Robust Recovery Chart I-15China: A Signpost Of A Potential Top In The Credit Impulse   Chart I-16DM Central Banks' Assets And EM Stocks And Currencies: No Stable Correlation What if the current liquidity-driven rally continues? In our report last week titled A Primer On Liquidity, we elaborated at great length about the different liquidity measures and how they influence financial asset prices. Empirically, changes in DM central banks’ balance sheets have had no stable correlation with either EM share prices or EM local currency bonds, as demonstrated in Chart I-16. There have been periods over the past 10 years when EM risk assets and currencies have performed poorly, despite an accelerating pace of QE programs worldwide (Chart I-16). The true and critical driver for EM equity and currency performance has been EM’s own domestic fundamentals and China’s business cycle (please refer to Chart I-11 on page 7). To be sure, we are not suggesting that DM central bank policies have not affected global and EM financial markets at all. They have done so in spades. By purchasing and withdrawing about $9 trillion in high-quality securities from the marketplace, the monetary authorities have shrunk the stock of available financial assets. Consequently, even though QE programs have expanded broad money supply only modestly,2 the upshot has been that more money has been chasing fewer financial assets. Also, low interest rates reduce the opportunity cost of owning risk assets. These two phenomena have led investors to bid up prices of various securities, including EM ones. Nevertheless, despite the ongoing and indiscriminate global search for yield, EM share prices in US dollar terms and EM ex-China currencies (including carry, i.e. on a total-return basis) are still below their 2010 levels. Such poor performance of EM risk assets has been a corollary of just how bad EM fundamentals have been. Bottom Line: EM corporate profits will improve on a rate-of-change basis in the coming months. However, forward-looking indicators do not yet point to a robust recovery in EM corporate profits as occurred in 2017. Investment Conclusions We are maintaining our long EM equities position with a stop point at 1050 for the MSCI EM stock index (7% below the current level). If EM share prices, credit markets and currencies outperform their DM peers during a correction/consolidation phase, we will upgrade EM allocations to overweight in global equity and credit portfolios. At the moment, EM is confronting a resilience test. Within the EM equity universe, our overweights are Russia, Korea, Thailand, Mexico, UAE, Pakistan and central Europe. Our recommended equity underweights include Indonesia, the Philippines, Hong Kong domestic stocks, South Africa, Turkey and Colombia. In sovereign credit and local bond markets, our overweights are Mexico, Russia, Thailand, Malaysia, Pakistan and Ukraine. In turn, South Africa, Turkey, Philippines and Indonesia warrant an underweight stance. Today we are upgrading Indian bonds from neutral to overweight (see page 17).  In the currency space, we continue holding a short position versus the US dollar in the following basket of currencies: BRL, ZAR, CLP, COP, IDR, PHP and KRW. As always, the full list of our positions is presented at the end of report (please refer to pages 18-19 and on our website).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com India: Beware Of Private Banks And Consumer Perils Indian private banks and consumer staple stocks have been holding up the Indian equity market at a time when the rest of the bourse has been sluggish. Both sectors, however, are extremely expensive and thus tremendously sensitive to minor profit disappointments. Remarkably, private banks now trade at a price-to-earnings (P/E) ratio of 31 and price-to-book value (PBV) ratio of 4. Indian consumer staple stocks, on the other hand, trade at a P/E ratio of 41 (Chart II-1 and Chart II-2). Chart II-1Indian Private Bank Stocks Are Expensive Chart II-2Indian Consumer Staple Stocks Are Very Pricey   Chart II-3A Credit Boom Among Indian Private Banks Given that private banks have been specializing in both mortgages and non-mortgage consumer lending, the call on both private bank and consumer staple stocks is contingent on consumer financial health. The loan book of private banks has expanded tremendously: since 2010 it has grown at a compounded annual growth rate (CAGR) of 20% and 14% in nominal and real (inflation-adjusted) terms, respectively (Chart II-3).3 In turn, the share of household loans is reasonably large at around 52% of private banks total loan book.  Unfortunately, India’s consumer sector appears to be fragile at the moment. Employment and wage growth have downshifted – the Manpower employment index is at a 14-year low (Chart II-4). Consequently, household disposable income growth has decelerated to 9% in nominal terms (Chart II-5). Critically, households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs, i.e., bank lending rates (Chart II-5). This development is precarious not only because it makes it more difficult for consumers to service their debt – causing NPLs to rise – but it also dampens consumer credit demand. Consequently, private banks’ considerable exposure to consumers could reverse the fortunes of the former as consumers face increasing difficulties servicing their debt. Moreover, with borrowing costs above nominal income growth, banks in India could face adverse selection problem. The latter is a phenomenon when loan demand primarily comes from riskier borrowers who are in desperate need for funding. In such a case, non-performing loans are bound to mushroom. Chart II-4India's Labor Market Is In Doldrums Chart II-5India: Household Nominal Income And Lending Rate Overall, household spending is in the doldrums. Two- and three-wheeler and passenger car unit sales have all been contracting. In the meantime, consumer demand for non-durable goods has also weakened, as reflected by stalling non-durable consumer goods production. Residential property demand has plummeted. According to the Reserve Bank of India’s December Financial Stability Report – quoting data from PropTiger DataLabs – housing sales units contracted by 20% in September from a year ago. In turn, growth in house prices has been anemic (Chart II-6). Prices are now growing below core inflation, i.e. property prices are deflating in real terms. Households’ ability to service debt has deteriorated as nominal disposable household income growth has fallen slightly below borrowing costs. Going forward, odds are that employment and wage growth will remain weak in India. The basis is the corporate sector is also struggling and still reluctant to invest and hire. Chart II-7 illustrates that the number of investment projects has collapsed, while capital goods production and capital goods imports are both shrinking (Chart II-7). Chart II-6India: Housing Market Is Feeble Chart II-7India: Companies Are Not Investing   Overall, the entire Indian economy is suffering from high borrowing costs in real (adjusted for inflation) terms (Chart II-8, top panel). Chart II-8Lending Rates Have Not Declined Despite Monetary Easing Importantly, the monetary policy transmission mechanism has not been working effectively in India. Even though the central bank has cut its policy rate by 135 basis points in 2019, prime borrowing did not budge (Chart II-8, middle panel). Consequently, loan growth has decelerated sharply (Chart II-8, bottom panel). On the whole, for the economy to recover, it requires considerably lower borrowing costs or a substantial fiscal boost. Indian central and state fiscal aggregate budget deficit is already wide at 6% of GDP. With public debt-to-GDP ratio at 68%, there is some but not enormous room for boosting government expenditures drastically. This makes reducing commercial bank lending rates the most feasible mechanism to jump-start the economy. Consequently, the authorities will become more aggressive in forcing commercial banks to cut their lending rates. This seems to be taking place as in September 2019 the RBI asked Indian commercial banks to link lending rates on certain types of loans more closely to the central bank’s policy rate to ensure more effective monetary policy transmission. Yet doing so will squeeze down commercial banks’ net interest rate margins – which have widened – and will hit banks’ profits. Alternatively, if lending rates do not fall, non-performing loans (NPLs) will increase because only risky borrowers will be willing to borrow while existing debtors will struggle to service their debt at current elevated interest rates. This will also depress bank profits. These two negative scenarios are probably reflected in low valuations of public bank share prices, but they are not yet priced in among private banks stocks. Given the latter’s exuberant valuations, only a small drop in net interest rate margins or a small rise in NPLs, will be enough to drag their share prices lower. Investment Conclusions Chart II-9India Vs. EM Relative Equity Performance Is Often About Oil Travails of the Indian economy will persist for now. Much more policy support is required to turn the business cycle around. EM equity investors should keep a neutral allocation to Indian stocks within an EM equity portfolio. Indian share prices often outperform their EM peers when oil prices drop and lag when crude prices rally (Chart II-9). Given our negative view on oil prices,4 we are reluctant to downgrade this bourse to underweight. Private banks are susceptible to a drawdown as either their net interest rate margins will drop or they will face rising non-performing loans. Consumer staples stocks are expensive and, hence, are vulnerable to marginal profit disappointments. We are upgrading our allocation to Indian domestic bonds from neutral to overweight within an EM local bond portfolio. Consistently, we are closing our yield curve steepening trade in India. This position has produced a 30 basis points gain since July 2016. Low inflation, weak real growth, a struggling credit system and ineffective transmission of monetary easing argue for even lower interest rates in India. The surge in food prices should be viewed as a relative price shock, not inflation. Higher food prices will curb the spending power of consumers and weaken their expenditures on non-food items. In addition, core inflation remains very low. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes 1  Please click on the link to access EM: Perception versus Reality report. 2  Commercial banks’ reserves at central banks do not constitute and are not a part of narrow or broad money supply. 3  The calculation is based on the annual reports of four large Indian private banks: HDFC Bank, ICICI Bank, Kotak Mahindra Bank, and Axis Bank. 4   This is the Emerging Markets Strategy team’s view and it differs for BCA’s house view on oil. Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The bank credit 6-month impulse is likely to drop sharply in Europe, drop modestly in the US, but remain positive in China. Hence, the momentum of first-half economic data is likely to be worse in Europe than in China – albeit the Wuhan coronavirus scare is an unknown risk to this view. Initiate long CNY/GBP on a 6-month horizon. Underweight banks and the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. There will be a better time to enter these positions later in the year when 6-month impulses are improving. Long-term investors seeking value in Europe should focus on the main currencies and not on the main equity indexes. Fractal trade: long EUR/GBP. Europe And China Play A Role-Reversal In recent dispatches we have highlighted that the euro area bond yield 6-month impulse stands near +100 bps, posing the strongest headwind to growth for three years. To make matters worse, the impulse has flipped from a strong -100 bps tailwind last summer into the current strong headwind, equating to a marked deterioration in the weather. But in China, it is the opposite story. Last summer, the China bond yield 6-month impulse constituted a strong +80 bps headwind; today the headwind has disappeared. Indeed, it has morphed into a tailwind, albeit a very mild tailwind at just -10 bps. In this sense, Europe and China are now playing a role-reversal. The momentum of first-half economic data is likely to be worse in Europe than in China – albeit with the caveat that the Wuhan coronavirus scare is an unknown risk to this view (Chart of the Week). Chart of the WeekBond Yields In Europe And China Play A Role-Reversal For the sake of completeness, we should address the world’s other large economy, the United States. Just as in the euro area, the US bond yield 6-month impulse has flipped from a strong -100 bps tailwind last summer into a current headwind. But the headwind, at +50 bps, is not as strong as it is in the euro area (Chart I-2). Chart I-2Headwind Impulses In The Euro Area And The US, But Not In China The Four Impulse Framework For Short-Term Growth The bond yield 6-month impulse is the first component of our proprietary ‘four impulse framework’ for short-term growth. The bond yield 6-month impulse is important because it usually leads the framework’s second component, the bank credit 6-month impulse, by a few months. This relationship makes perfect sense as, at the margin, it is the price of credit that drives credit demand. Indeed, to the extent that monetary policy drives growth, this is the main mechanism by which it operates, albeit with a slight delay. The bond yield impulse usually leads the credit impulse. On this compelling theoretical and empirical evidence, the bank credit impulse is now likely to drop sharply in the euro area (Chart I-3), drop modestly in the US (Chart I-4), but remain positive in China (Chart I-5). Chart I-3The Credit 6-Month Impulse Is Likely To Drop Sharply In The Euro Area... Chart I-4...Drop Modestly In ##br##The US...   Chart I-5...But Remain Positive In China But we must also consider the other two impulses in our four impulse framework. In the case of the euro area, the third important impulse is the oil price 6-month impulse. This is because the euro area relies on oil imports whose volumes tend to be price inelastic. Hence, when the oil price falls it subtracts from imports, thereby adding to net exports and growth – and vice-versa when the oil price rises. In the middle of 2019, the oil price impulse constituted a very strong headwind which helps to explain the midyear sharp slowdown in Germany. Subsequently, the headwind eased, even reversing into a modest tailwind which facilitated a recovery. But the tailwind is now fading (Chart I-6).  Chart I-6A Fading Tailwind From The Oil Price 6-Month Impulse The fourth and final component of our four impulse framework is geopolitical risk. This is not an impulse in the strict mathematical sense, but it is the same broad idea applied to the flow of geopolitical tail-events, both negative and positive. Europe’s positive events came several months ago: first in early-August when Italy ousted the firebrand Matteo Salvini from government; then in early-October when the UK parliament legislated against a no-deal Halloween Brexit. The tailwind from these positive events has now likely faded. For China, a positive geopolitical event and potential mild tailwind has come more recently, with the signing of the phase one trade deal with the US. Against this, the Wuhan coronavirus scare is a new risk – though based on the latest information it is unlikely to impact a 6-month view. The tailwind from the oil price impulse is now fading. On the four impulse framework, the momentum of first-half economic data is likely to favour China over Europe. We have found that the best way of playing this is through the exchange rate (Chart I-7), though given recent moves our preferred expression is versus the pound rather than the euro. Hence, on a 6-month horizon, initiate long CNY/GBP. Chart I-7Play Relative Impulses Through Currencies More generally, can the mild tailwind in China counter the headwinds in the West? No. Despite the improvement in China, the aggregate global bond yield impulse still constitutes a +50 bps headwind, which is almost certain to weigh down the global credit impulse through the early months of 2020 (Chart I-8). Chart I-8The Global Credit 6-Month Impulse Will Weaken In Early 2020 Therefore, as discussed last week in Strong Headwind Warrants Caution In H1, we recommend an underweight stance to banks and to the cyclical-heavy Eurostoxx 50 versus other markets, again on a 6-month horizon. This is not to say that these positions cannot do better on a 12-month view, as per the BCA house view. But if so, any outperformance will be back-end loaded, and there will be a better time to enter these positions later in the year when 6-month impulses are improving. Where Is The Value In Europe? One of the most common questions we get is: are European equities cheaper than US equities? Usually, this question comes from our US clients who are aware that their own stock market is expensive and wish that Europe might be less so. Unfortunately, the wishful thinking won’t make it come true! Major stock market indexes comprise multinational companies with global footprints. For these multinationals, there is no such thing as a ‘European’ company or a ‘US’ company. They are simply global companies that could list their shares on any major stock market. Now ask yourself this: is it really plausible that such a multinational would be cheaper if its primary listing was in Frankfurt as opposed to New York? Of course not. The valuation depends on the industry and company specifics, but it is highly unlikely to depend on whether the company is listed in Frankfurt or New York. It is not European equities that are cheap, it is European currencies that are cheap. But then why do companies with dual listings in Europe and outside Europe trade at a valuation discount in their European listing? For example, Carnival Cruises trades around 8 percent dearer in New York than in London (Chart I-9); and BHP Billiton trades around 15 percent dearer in Sydney than in London (Chart I-10). The answer is that the London listing is quoted in pounds, the New York listing is quoted in US dollars, the Sydney listing is quoted in Australian dollars, but Carnival’s and BHP’s sales and profits are denominated in a mix of international currencies. Chart I-9Carnival Cruises Trades Dearer In New York Than In London Chart I-10BHP Trades Dearer In Sydney ##br##Than In London Hence, Carnival and BHP are trading dearer in New York and Sydney because the market is expecting their mixed currency earnings to appreciate more in US dollar and Australian dollar terms respectively than in pound terms. Put another way, the market is expecting the pound to appreciate structurally versus the major non-European currencies. Therein lies the important message. It is not European equities that are cheap, it is European currencies that are cheap. For those of you still in doubt, just visit the ECB website. The central bank’s own currency valuation indicator admits that the trade-weighted euro is 10 percent undervalued (Chart I-11). Chart I-11The ECB Admits That The Euro Is 10 Percent Undervalued Hence, investors seeking value in Europe should not focus on the main equity indexes. Instead, they should focus on the main currencies. That said, valuation based investing only works if you have a long enough time horizon, meaning at least two years. For shorter horizons, economic momentum and technical factors dominate. In this regard, the pound’s strong rally faces resistance once post-Brexit trade deal negotiations begin in earnest after January 31. As a tactical trade, go long EUR/GBP (see next section). Fractal Trading System* The Brexit deal unleashed a strong rally in the pound, but this is vulnerable to a countertrend setback once the trade deal negotiations begin in earnest. Accordingly, this week's recommendation is long EUR/GBP. Set a profit target at 2 percent with a symmetrical stop-loss. In other trades, long tin achieved its 5 percent profit target at which it was closed. The rolling 1-year win ratio stands at 62 percent. Chart I-12EUR/GBP When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Highlights Global Corporates: The cyclical backdrop – accommodative monetary policies, improving global growth momentum, moderate inflation and subdued volatility – is supportive for the continued outperformance of global corporate bonds over sovereign debt in 2020. Corporate Bond Valuation: Extending a valuation framework we’ve introduced for US corporates to non-US credit – looking at volatility-adjusted spreads relative to both their own history and the “phase” of the monetary policy cycle - we calculate spread targets for non-US corporates in the euro area, UK and Canada. 2020 Opportunities: Current corporate spread levels are furthest above our targets (i.e. cheap) for US high-yield (most notably for Ba- and Caa-rated credit), UK high-yield and UK investment grade. Spreads are furthest below our targets (i.e. expensive) for euro area high-yield (mostly Ba-rated), US investment grade (all credit tiers) and Canadian investment grade. Feature Chart 1Deviations From Corporate Spread Targets One of our main investment themes for 2020 is that accommodative monetary policies and faster economic growth will delay the peak in the aging global credit cycle, giving investors another year of corporate bond outperformance versus sovereign debt in the developed economies. Returns this year will be nowhere near as robust as in 2019, however, given rich valuation starting points for much of the global corporate universe. Against this backdrop, fixed income investors will have to be more selective in allocations by country, sector and credit quality in order to outperform. To that end, in this Special Report we extend a valuation framework for corporate bond spreads first introduced for US corporates by our sister service, US Bond Strategy, to non-US credit. This methodology looks at spreads on a volatility-adjusted basis, allowing comparison of valuations versus their own history and relative to similar stages of past monetary policy cycles. Chart 1 shows the deviations of current benchmark index option-adjusted spreads (OAS) from spread targets derived from our methodology for different countries (the US, euro area, the UK and Canada) and credit quality tiers (investment grade vs. high-yield). Positive deviations imply current spreads are above the targets derived from our framework – in other words, relatively undervalued - and vice-versa. Returns this year will be nowhere near as robust as in 2019, however, given rich valuation starting points for much of the global corporate universe. Against this backdrop, fixed income investors will have to be more selective in allocations by country, sector and credit quality in order to outperform. The conclusions are that there are still opportunities for additional spread tightening from current levels for lower-rated US high-yield and both UK investment grade and high-yield corporates. At the same time, valuations are looking most stretched for euro area high-yield, US investment grade (all credit tiers) and Canadian investment grade. A Brief Word On The Outlook For Global Corporate Credit In 2020 Chart 2Positive Backdrop For Corporate Bonds The backdrop for global corporate bond markets will remain positive in 2020 for three main reasons: Global monetary policies will remain accommodative. Central bankers are now focusing more on boosting soft growth and low inflation expectations. Real policy interest rates in the US, euro area, UK and Canada are already below estimates of neutral like r-star (Chart 2, top panel), and will likely remain so throughout 2020. In the past, periods of credit market underperformance have occurred when monetary policy was restrictive, with real rates above neutral or government bond yield curves that were very flat or inverted (more on that later). Global growth momentum will improve. Recent data releases (global manufacturing PMIs, sentiment surveys like the global ZEW and German IFO) have shown that the 2019 global industrial downturn was in the process of bottoming out during the 4th quarter of the year. Additional improvement is likely in the coming months, based on the steady gains of the BCA Global Leading Economic Indicator (LEI). The elevated level of our global LEI diffusion index – measuring the share of individual country LEIs that are rising and which is itself a leading indicator of both the global LEI and corporate bond returns - suggests that additional outperformance of global corporates versus sovereign bonds is likely within the next 12 months (Chart 2, middle panel). Financial conditions are stimulative. Global equities and credit are off to a strong start in 2020, while market volatility is subdued across a variety of asset classes. For example, the US VIX index is now just above its 2019 low, which is consistent with narrow global corporate bond spreads (Chart 2, bottom panel). That low volatility backdrop – supported by market-friendly central bank policies - is helping keep financial conditions easy enough to lift economic growth, while also boosting investor risk appetite for corporate credit. The overall outlook for global corporate credit is still positive and investors should expect another year of corporate bond outperformance versus sovereign debt in the developed economies. Nonetheless, returns will be lower in 2020 than in 2019 due to expensive valuation starting points. As can be seen from Chart 3, global corporate bond spreads are already fairly tight relative to their long-term historical range. Also, outright index yields in many asset classes, like US high-yield, are now at new all-time lows. We interpret this as a sign that the “easy money” has already been made in being generally long corporate credit versus government bonds. Having the right tools to assess the relative values among differing credit markets will be critical to finding the best investment opportunities in this environment. Chart 3Rich Valuation Starting Points In Corporate Credit We can use the breakeven spread as a valuation tool by looking at the percentile rank relative to its own history, effectively showing the percentage of time that the breakeven spread has been lower in the past. Bottom Line: The cyclical backdrop – accommodative monetary policies, improving global growth momentum, moderate inflation and subdued volatility – is supportive for the continued outperformance of global corporate bonds over sovereign debt in 2020. Valuations are likely to be more of a headwind for corporate bond returns, though. Using Breakeven Spreads As A Credit Valuation Tool As a reminder to existing readers (and to new clients), one of our main valuation tools for credit instruments is the 12-month breakeven spread. That is, the amount of spread widening required for corporate bond returns to break even with a duration-matched position in government bond securities over a 12-month horizon. It can be approximated by dividing the OAS of a bond (or a benchmark bond index) by its duration. More specifically, we can use the breakeven spread as a valuation tool by looking at the percentile rank relative to its own history, effectively showing the percentage of time that the breakeven spread has been lower in the past. We find this valuation tool to be superior to others for two main reasons: (i) using the breakeven spread rather than the average index OAS allows us to control for the changing average duration of the benchmark bond indices; and (ii) the percentile rank is often a better representation of credit spreads than the spread itself.1 BCA Research US Bond Strategy and Global Fixed Income Strategy have both regularly shown the percentile rankings of US investment grade and high-yield breakeven spreads as part of our discussion of US corporate bond markets. We have never produced such rankings for non-US credit, until now. InCharts 4- 7, we show those percentile ranks relative to history for credit in the US and, for the first time, the euro area, UK, Canada, Japan, Australia and Emerging Markets US dollar denominated corporates. We also provide the breakeven spread historical percentile ranks for each individual credit tier in the Appendix charts on pages 13-16. Chart 4US: Corporate Bond Breakeven Spreads Chart 5Euro Area: Corporate Bond Breakeven Spreads Chart 6UK: Corporate Bond Breakeven Spreads Using these charts, we can gauge which markets offer the best (or worst) level of spread, adjusted by its own volatility and compared to its own history. The most attractive corporate credit spreads on a volatility-adjusted basis are: US high-yield (mostly Caa-rated and B-rated) Japan investment grade (mostly Baa-rated and A-rated) Canada Aaa-rated UK high-yield (excluding financials) Chart 7Other Countries: Corporate Bond Breakeven Spreads The least attractive corporate credit spreads on a volatility-adjusted basis are: US investment grade (all credit tiers) UK Aaa-rated Canada Baa-rated Euro Area high-yield Using this metric, US Caa-rated junk bonds look most “undervalued”, with a volatility-adjusted spread in the upper 20% of all observations. Chart 8 displays the current breakeven spread historical percentile ranks across countries and credit quality, with high-yield markets shown in red. Using this metric, US Caa-rated junk bonds look most “undervalued”, with a volatility-adjusted spread in the upper 20% of all observations. While this chart provides a quick overview of which corporate bond markets are cheap/expensive with respect to their own history, it does not allow for comparisons of the relative cheapness between markets. To do this, we need to find a way to convert the percentile rankings into some measure of a “fair value” credit spread. Chart 8Global Corporate Bond 12-Month Breakeven Spreads By Percentile Rank (%) Using Monetary Policy Cycles To Determine Corporate Spread Targets Our colleagues at BCA Research US Bond Strategy have come up with a novel approach for determining spread targets for US corporate credit, based on the breakeven spread percentile rankings.2 Essentially, the stance of US monetary policy, as measured by the slope of the US Treasury curve, is used to predict changes in the US credit cycle, helping to determine “cyclical” spread targets relative to the stance of monetary policy. The first step of this process is to group corporate bond excess returns (vs government debt) into buckets defined by the following “phases” of the US monetary policy cycle, measured by the yield differential between 10-year and 3-year Treasuries: Phase 1: from the end of the previous recession until the slope goes below 50 bps. Phase 2: from the time that the slope crosses below 50 bps until it inverts. Phase 3: from the time that the yield curve first inverts to the start of the next recession. Recessionary periods are not included in these phases, as all corporate credit exhibits the worst returns during those episodes. That is because economic growth and downgrade/default risks, and not the state of monetary policy, are the driving factor behind credit spread moves during recessions. Chart 9 shows the history of the US corporate bond markets broken down into “curve-defined” cycles.3 Dating back to 1974, the earliest date for investment grade bond index data, there have been five such cycles. Chart 9US Corporate Bond Performance And The Yield Curve In Charts 10-12, we show the same phases for the euro area, the UK and Canada, using their own government bond yield curves to determine the phase of the monetary policy cycle in the same fashion as was done for the US.4 Once the phases of the monetary policy cycle are defined, we can then calculate corporate bond excess returns during each phase. Chart 10Euro Area: Corporate Bond Performance And The Yield Curve Chart 11UK: Corporate Bond Performance And The Yield Curve Chart 12Canada: Corporate Bond Performance And The Yield Curve Table 1 shows the average corporate bond annualized excess returns under each phase across every cycle that can be defined with available data. Excess returns tend to be highest in Phase 1, quite low but still positive in Phase 2, and usually turn negative during Phase 3, once the yield curve has inverted. Table 1Corporate Bond Annualized Excess Returns* (%) Under Each Phase Of The Cycle Currently, we are in Phase 2 in the US, euro area and UK, with yield curves that are relatively flat but still positively sloped. Historically, such periods have generated positive excess returns for corporate debt versus duration-matched government bonds, although of far smaller magnitudes compared to Phase 1 periods. Given our expectation that the Fed, ECB and Bank of England will maintain a dovish bias throughout 2020, we expect the no shift from Phase 2 for the US, euro area and the UK that would hurt corporate bond excess returns in those countries. With the Canadian yield curve now slightly inverted, however, Canada is now in Phase 3. This raises the risk that the recent strong outperformance of Canadian investment grade corporate bonds could end if the Bank of Canada does not deliver the monetary easing currently discounted in the Canadian yield curve. How We Determine Corporate Spread Targets Having defined the three phases of the monetary policy cycle, we then re-calculate our corporate bond breakeven spread percentile ranks within each phase. We then back-out a spread target for each credit tier by taking the median 12-month breakeven spread seen in similar monetary policy environments, as determined by the slope of the yield curve.5 Finally, we convert those “median” breakeven spreads into OAS targets using the current benchmark index duration and credit rating distribution. We are assuming that a reasonable spread target for any corporate bond market is determined by adjusting for both spread volatility AND the monetary policy cycle. So, essentially, we are assuming that a reasonable spread target for any corporate bond market is determined by adjusting for both spread volatility AND the monetary policy cycle. Charts 13-16 show the index OAS and their respective targets for the US (both investment grade and high-yield), euro area (both investment grade and high-yield), the UK (both investment grade and high-yield excluding financials), and Canada (only investment grade). Further, the spread targets for each individual credit tier are provided in the Appendix on pages 17-19. Chart 13US: Corporate Bond Spread Targets Chart 14Euro Area: Corporate Bond Spread Targets Chart 15UK: Corporate Bond Spread Targets Chart 16Canada: Corporate Bond Spread Targets For example, our spread target for US B-rated high-yield is 227bps, which is 80bps below the current index OAS. From the charts, we can make the following conclusions about the relative attractiveness of current spread levels: The largest deviations from our spread target (i.e. potentially most undervalued) are: US high-yield (mostly Caa-rated and B-rated) UK high-yield (excluding financials) The lowest deviations from our spread target (i.e. potentially most overvalued) are: Euro Area high-yield (mostly Ba-rated) Canada investment grade US investment grade (all credit tiers) This framework is an interesting way to derive corporate bond value, by adjusting for both the volatility and monetary policy backdrop. Of course, there are other factors that are more difficult to quantify that can keep spreads too tight or too wide versus these fair value levels, like investor risk tolerance or risk premia for political uncertainty. In terms of factors that are quantifiable, however, this spread target methodology is a useful way to get a sense of the richness or cheapness of global corporate debt. In terms of factors that are quantifiable, however, this spread target methodology is a useful way to get a sense of the richness or cheapness of global corporate debt. We will regularly update these targets in future BCA Research Global Fixed Income Strategy reports. Bottom Line: Current corporate spread levels are furthest above our targets (i.e. cheap) for US high-yield (most notably for Ba- and Caa-rated credit), UK high-yield and UK investment grade. Spreads are furthest below our targets (i.e. expensive) for euro area high-yield (mostly Ba-rated), US investment grade (all credit tiers) and Canadian investment grade.   Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 This is because credit spreads often tighten to very low levels and then remain tight for an extended period. Thus, by showing the percentage of time that a given spread has been tighter than its current level, the percentile rank gives a better sense of this pattern than the actual spread. 2 Please see US Bond Strategy Special Report, “2019 Key Views: Implications For US Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com. 3 Note that the Treasury curve used for this analysis is the spread between the 10-year Treasury and the 3-year Treasury yield. The more widely-followed 2-year Treasury was not used as there was more historical data available for the 3-year maturity. 4 Note that there are fewer cycles to analyze for these countries due to the shorter available history of corporate bond market data outside the US. 5 For more details on the spread targets please see US Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com. Appendix Chart 1AUS: Investment Grade Breakeven Spreads Chart 1BUS: High-Yield Breakeven Spreads Chart 1CEuro Area: Investment Grade Breakeven Spreads By Credit Tiers Chart 1DEuro Area: High-Yield Breakeven Spreads By Credit Tiers Chart 1EUK: Investment Grade Breakeven Spreads Chart 1FCanada: Investment Grade Breakeven Spreads Chart 1GJapan: Investment Grade Breakeven Spreads Chart 2AUS: Investment Grade Spread Targets Chart 2BUS: High-Yield Spread Targets Chart 2CEuro Area: Investment Grade Spread Targets By Credit Tiers Chart 2DEuro Area: High-Yield Spread Targets By Credit Tiers Chart 2EUK: Investment Grade Spread Targets By Credit Tiers Chart 2FCanada: Investment Grade Spread Targets By Credit Tiers

Special Report

Highlights Macro winds are slowly changing, compelling investors to take a second look at highly cyclical sectors such as industrials. In this Special Report we highlight that the S&P industrials index is trading at a nearly 10% discount to the market on a forward P/E basis, meanwhile a list of welcoming omens has appeared on the horizon which will serve as a foundation for the relative share price outperformance. Increasing odds of a modest rebound in the US manufacturing PMI Stabilization in EM in general and Chinese economy in particular BCA’s House View of a weaker dollar Healthy industry operating metrics Table 1 Feature While US manufacturing remains in recession, investors have already positioned for a V-shaped recovery according to the spectacular run-up in the S&P 500. However, drilling beneath the surface is revealing. Instead of hypersensitive industrials equities sniffing out a recovery in the manufacturing sector, the SPX’s advance has been solely driven by tech mega caps, and thus leaving in the dust all their deep cyclical peers. Why? Because the industrials complex has borne the brunt of the trade war (Chart 1). However, our expectation remains for a natural healing of the economy sometime in the first half of the year, and a rotation out of tech equities into capital goods stocks. Industrials equities will be among the first beneficiaries of this improving macro backdrop. Specifically, four key themes underpin our bullish stance on the S&P industrials index: Increasing odds of a modest rebound in the US manufacturing PMI Stabilization in EM in general and Chinese economy in particular BCA’s House View of a weaker dollar Healthy industry operating metrics Chart 1Trade War Echoes The ISM Will Soon Turn The Corner ISM’s manufacturing PMI survey is still below the 50 boom/bust line, but much of the macro pessimism is likely already reflected in the data, as it is set to bottom by the end of Q1 2020 and rebound into Q2 2020. To be clear, we are not expecting a jump into the high 50s, but rather look for a more balanced recovery into the low 50s. Nevertheless, it is a 5-point rise from the current recessionary level, and the S&P industrials index will cheer a relief in macro data. Charts 2 & 3 clearly depict that the ISM manufacturing PMI is set to improve in the coming months. First, our demand/supply proxy for the overall US economy (comprising of retail and industrial production data) is signaling that industrial production will likely bottom by mid-2020, despite Boeing’s ails (Chart 2, bottom panel). Industrial production is also known to lag PMI by roughly three months, which translates into PMI bottoming in Q1 2020, if history at least rhymes. Moreover, the bond market is also sending a similar message (Chart 2, third panel). As a reminder, BCA’s House View calls for a sell-off in the bond market to a range of 2.25-2.5% for this year. Chart 2Long Term And … Chart 3… Short Term Drivers Are Positive Both coincident and short-term leading economic variables also emit a positive signal. Lumber prices have recovered sharply over the past year (Chart 3, second panel), and given their close correlation with the ISM manufacturing PMI, the move underscores that the bottoming process in the latter has already begun. Moreover, survey internals have made a modest turn on a three-month moving average basis, suggesting that the path of least resistance is to the upside (Chart 3, bottom panel). On the political front, our sister Geopolitical Strategy service has been right on Trump having to retreat and to agree on a “ceasefire” deal as the 2020 elections are looming. Following the October and December tariff “postponement/cancelation” coupled with lower chances of any tariff hikes at all until the 2020 election will likely provide a further boost to the “soft” survey data. As a reminder, the increase in trade policy uncertainty over 2018-2019 has been a large contributor to data deterioration (Chart 1). EM And Chinese Green Shoots A rising share of international sales for the S&P industrials index originates from the EM, as those countries are responsible for a large percent of world total commodity consumption and construction activity. The EM manufacturing PMI has done a good job at tracing the S&P industrials relative share price performance, and the current divergence between the two can serve as yet another catalyst for a rally (Chart 4, top panel). Most importantly, China is also enjoying green shoots. BCA’s Chinese credit & fiscal impulse has been grinding higher over the past year foreshadowing a further rebound in EM data, and consequently benefiting US industrials. Finally, Chinese infrastructure spending that managed to climb out of negative territory will, at the margin, further boost industrials end-demand (Chart 4, middle & bottom panels). Chart 4International Arena Improving The Dollar Is Petering Out Switching gears to the greenback, more good news is in store for the S&P industrials index. Forty-four percent of sales are international for the S&P industrials sector, making it sensitive to FX fluctuations. BCA’s House View for 2020 calls for a weaker USD and should it be proven correct, industrials P&Ls will enjoy positive currency translation tailwinds. Chart 5 shows a newly created dollar model first published by our sister The Bank Credit Analyst service, heralding a softer greenback in the coming months. The real trade-weighted US dollar has been a key driver for the S&P industrials’ sales ever since 1975 as they remained in positive territory even during the recent manufacturing recession. A turn in the US dollar will reignite sales growth and underpin the relative share price ratio (Chart 6, bottom panel). Chart 5The Softening US Dollar … In addition, a depreciating US dollar has been synonymous with a relative multiple expansion phase, and a definitive fall in the dollar will likely serve as a catalyst to unlock excellent value in bombed out relative valuations (Chart 6, third panel). Looking at sales from a different angle, our industrials sector exports proxy has a tight inverse correlation with the USD, and is likely to hook higher given that the US dollar is flat on a year-over-year basis (Chart 6, second panel). Chart 6… Holds The Key … Chart 7… And So Do Our EPS Models Finally, our relative earnings growth model does an excellent job at encapsulating all the profit drivers and is signaling that an earnings-led outperformance period looms (Chart 7). Enticing Operating Metrics Drilling down and away from macro and toward industry-level data is instructive. First, industrials forward earnings breadth – defined as the net number of sub-sectors with higher forward earnings revisions – has bounced off extreme lows signaling that the sell-off in relative share prices is reaching exhaustion. Historically, similar sharp bounces have marked previous price reversals (Chart 8, second panel). Chart 8Selling Climax? Chart 9More Welcoming News Expanding profit margins since mid-2018 also reflect positive sector dynamics as the industry managed to shrug off falling selling prices at the expense of labor (Chart 8, third & fourth panels). Importantly, the CRB raw industrials index is tracing a bottom and a depreciating US dollar will assist in orchestrating a recovery in industrials PPI (Chart 9). With regard to balance sheet health, interest coverage and net debt-to-EBITDA ratios are not sounding alarm bells as they are comparable to the broad market. Industrials are also steadily pumping out healthy free cash flow numbers, which should be a welcoming sign for investors (Chart 10). Despite all these tailwinds, sell-side analysts are still overly pessimistic on relative long-term profit prospects (Chart 11, fourth panel). Chart 10Good B/S All Around Chart 11No Red Flags Neither BCA composite Valuations nor Technical Indicators caution against overweighting the S&P industrials index (Chart 11, second and third panels). In fact, on a forward P/E basis, the sector is trading at a nearly 10% discount to the broad market making it an historically “cheap” addition to one’s portfolio (Chart 11, bottom panel). Risks To Monitor There are a few key risks to our view. First, we treat the current de-escalation in the trade war as temporary. Should Trump get reelected in 2020 for another term, all of the pre-election constraints will be lifted, likely allowing him to get back to his tariff hawkishness. Second, the US economy has already suffered too much damage making it vulnerable to an external shock. Were a black swan to materialize, the dollar would skyrocket putting our industrials view offside. Finally, should the Chinese government miscalculate the amount of stimulus required to reignite their economy, US industrials will again be among the first ones to suffer the consequences via the final-demand link. Put simply, any combination of these risks would slay animal spirits and postpone capex-led US industrials sector recovery. Bottom Line: Increasing chances of a rebound in the ISM manufacturing PMI coupled with green shoots in the EM, expectations for a weaker US dollar and sound industry level data, argue for an above benchmark allocation in the S&P industrials index. Please stay tuned for an upcoming Special Report on how to position within the industrials complex.     Arseniy Urazov Research Associate ArseniyU@bcaresearch.com