The US Federal Reserve kept interest rates steady at its June meeting; it emphasized its data-driven approach to policy decisions but noted it believes the case for lower interest rates to be strengthening. Franklin Templeton Fixed Income CIO Sonal Desai offers her take on the meeting, and why the Fed might actually be exacerbating market volatility ahead.

Boxed in by financial markets pricing in 75 basis points (bps) of interest-rate cuts this year, Federal Reserve (Fed) Chairman Jerome Powell took another dovish twist today at the June Federal Open Market Committee Meeting—but in a way I believe will further increase uncertainty on the Fed’s strategy and therefore will likely increase market volatility.

In his post-meeting comments, Powell stressed increased uncertainty related to global trade tensions and noted that risk sentiment in financial markets has deteriorated. The latter assertion stands at sharp odds with equity markets holding at record highs, something that Powell seemed to ignore completely.

And perhaps in defense of future rate cuts, Powell emphasized that Fed policymakers felt it was important to “sustain the expansion” for the benefit of US consumers across socioeconomic groups. It is unclear to me, however, to what extent Fed rate cuts would sustain the economic expansion as opposed to sustaining a continued rally in financial markets, and particularly risk assets.


  • On My Mind: The EU—Singing From 28 Hymn Sheets
  • Should Markets Heed Recession Warnings?
  • On My Mind: The Fed Will Hike Again—Because It Can

In the Q&A with the media after the meeting ended, Powell said that the shift in rhetoric in today’s statement had been driven by data and events that emerged in the last couple of weeks, and noted that new data and information would of course become available between now and the next Fed policy meeting. But if the Fed’s language is going to shift with every new batch of data, this seems to guarantee more swings like we have seen since late last year—causing more market volatility. It also contradicts Powell’s claim that the Fed wants to react to clear trend change, not to individual data points and shifts in sentiment.


The Fed’s assessment of US economic conditions seems equally out of sync with this dovish shift in language: a very strong labor market (“prospects for job seekers have seldom been better”), wage growth in line with inflation and productivity growth, strong consumption, and the only shadow being some deceleration in business investment.

Here are the latest economic projections from the Fed:

  • The Fed maintained its 2019 US GDP growth forecast of 2.1%, but increased its 2020 forecast to 2.0% from its forecast of 1.9% in March.
  • The 2019 inflation projection (based on Core Personal Consumption Expenditures) was lowered to 1.5% from 1.8% in March.
  • The projection for the unemployment rate edged down slightly to 3.6% for 2019, from its prior projection of 3.7%.

The Fed today tried to appease the markets, and predictably markets are immediately clamoring for more: They now fully expect a rate cut next month with 2-3 more cuts to follow in the remainder of the year. I really doubt that the data in the next few weeks are going to show the deterioration in trend that would justify a Fed cut—so the Fed will again be in a very tough spot, in my view. I would note that the median dot in the Fed’s “dot plot” (as illustrated below) still shows no cuts this year.

US Interest Rate Expectations Implied Fed Funds Target Rate

US Interest Rate Expectations Implied Fed Funds Target Rate

Sources: Bloomberg, US Federal Reserve, Franklin Templeton Capital Market Insights Group. OIS (overnight index swap)/market consensus. Participants’ projections of the appropriate level of the target federal funds rate (rounded to the nearest 1/8 percentage point) at the end of the specified calendar year. Participants’ projections are summarized in the form of a median, weighted average, central tendency, and range. The central tendency is the range of participant projections, excluding the three highest and three lowest projections for each year. The straight lines between each calendar year-end projection are based on a simple linear interpolation. There is no assurance that any projection, estimate or forecast will be realized. For illustrative purposes only.


After today’s press conference, the balance of risk for the next monetary policy move is clearly towards a cut. I no longer expect the Fed to hike again this year—so my baseline has shifted to no change. My concern is that any rate cuts will be driven entirely by market pressures rather than economic developments. And if that is the case, the Fed will then exacerbate the financial froth and distortions we already observe in some asset markets.

In its attempt to pacify the markets, the Fed keeps trading less volatility today for greater volatility—and financial risks—later down the line.


All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.


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mid a renewed US-China trade spat and additional tariff tensions between the United States and Mexico, investor concerns about a possible recession have heightened, according to Ed Perks, executive vice president, and chief investment officer, Franklin Templeton Multi-Asset Solutions. He discusses how markets are reacting to the possibility of a US recession and explains why he favors a defensive stance for the multi-asset space during this period.

Across the globe, we’ve seen markets start to react differently to the likelihood of a US recession, whether they expect it to come later this year or sometime in 2020.

While we don’t expect an imminent US recession, we don’t think investors should ignore the possibility entirely. However, we tend to look at the broader backdrop and don’t think things are as bad as the market’s reaction to the latest trade fears might suggest.

In our view, the fundamental backdrop for the US remains pretty strong.


  • Trade War: The Second Front
  • On My Mind: Trade Wars—The Dog That Didn’t Bark
  • Market Resilience: Strength in Numbers

While Federal Reserve (Fed) Chairman Jerome Powell recently said the Fed would “act as appropriate” to sustain the US economic expansion, we don’t think a simple slowing of the very strong economic activity seen in the first quarter of this year would be sufficient to spur the US Federal Reserve to cut interest rates. We think it would take a bit more stress in the system for the Fed to loosen monetary policy, such as a significant shift in consumer and business sentiment or weakness in the labor market.

Still, we believe the Fed is at a point that it needs to set out its motivations for the market in the next two to three months, depending on economic data and continuing tensions between the US and Chinese governments.


As multi-asset investors, in light of recent geopolitical uncertainties, we’re looking to take a more defensive stance in our portfolios.

It doesn’t seem we are alone in our view, as more defensively oriented sectors have outperformed recently, including utilities. Health care is an area we see opportunity due to its recent weak performance as a result of the US political election cycle. We also believe US financials are well-positioned to handle a mild recessionary environment as banks’ capital positions generally look positive to us.

In addition, we’re exploring opportunities in the US corporate credit space. We’ve tended to take a more tactical approach and think there may be opportunities for investors willing to be selective around exposures in investment-grade bonds, to benefit from any incremental yield pick-up.

However, we remain more cautious about non-investment grade, lower-credit-quality assets, particularly in a worsening economy.


The escalating trade dispute between the United States and China, and the US’s heightened tensions with Mexico as US President Trump announced new tariffs on Mexican goods, are causing consternation for investors. There’s certainly a chance that things could get more difficult more quickly.

As we look for a resolution to the trade disputes, we’ll be keeping a close eye on the US inflation outlook over the next three to nine months.

If we start to see the impact of the higher tariffs on Chinese and Mexican goods filter into consumer prices and elevate inflation in the US economy, that could be a game-changer in terms of the economic and interest-rate outlook.

The question is how much of the tariff fallout is passed through to consumers and how much is absorbed by the companies themselves. We have been seeing high profitability in general among US companies, and US corporate fundamentals are very strong.

Productivity is also very high. Margins generally are elevated and have some room to give back.


Presidents Donald Trump and Xi Jinping are due to meet at the Osaka G20 summit on June 28-29, so we’d hope to avoid a further escalation between now and then. Meanwhile, Mexico Foreign Minister Marcelo Ebrard recently met with US Vice President Michael Pence to work out a solution to avoid potentially crippling tariffs of up to 25% on Mexican imports.

To the extent that global leaders can resolve some of the situations that are causing these jitters in the market, we believe we could see some of the recessionary fears ebb.

In the Sherlock Holmes story “The Adventure of Silver Blaze,” during the night a prized race horse gets spirited away from his stable and its trainer gets murdered. In the investigation, Sherlock Holmes calls attention to what didn’t happen: The dog on the property did not bark.

For over two years we have lived in fear of trade wars—fear that a spreading escalation of protectionist measures would cripple global trade flows and send the global economy tumbling into a severe downturn. The International Monetary Fund (IMF) has just stoked a fresh wave of alarmist media headlines with its newly released World Economic Outlook (WEO).

Yet global trade hasn’t collapsed, and the global economy hasn’t stalled. Global trade wars are the dog that didn’t bark.

I believe there are three reasons for this: The wars turned out to be limited skirmishes; free trade was never truly free to start with; and most importantly, the elasticity of global growth to global trade has undergone a structural change.


  • Market Resilience: Strength in Numbers
  • On My Mind: Modern Magical Thinking
  • On My Mind: The Fed Will Hike Again—Because It Can

This has two important implications for financial investors, on which I will elaborate at the end: (1) global growth will likely surprise to the upside, and bond yields with it; and (2) the real action is at the company, industry and country-specific level, making portfolio selection more important than ever.


Global trade did slow down during 2018, but that partly reflected payback from a very strong 2017, when global trade expanded 4.7%—more than three times as fast as the year before. Last year’s 3.3% pace still compares favorably to the 2.0% average of 2012–2016.

GLOBAL TRADE SLOWER BUT STILL SOLIDExhibit 1: World Trade Growth (annual % change) 2011-2018

Exhibit 1: World Trade Growth (annual % change) 2011-2018

Source: CPB Netherlands Bureau for Economic Policy Analysis.

Global trade slowed further at the end of last year: The three-month moving average held around 5% for most of 2017, then stepped down one notch to about 4% for the second and third quarters of 2018, and crawled to a halt by January 2019. This needs to be watched closely, but before panicking we should note that we have seen significant decelerations in global trade twice before in this decade (2015–2016 and 2011–2012), and both times trade rebounded nicely.

STRONG REBOUNDS HAVE FOLLOWED SHORT-TERM TRADE SLOWDOWNSExhibit 2: Global Trade (annual % change) June 2011–January 2019

Exhibit 2: Global Trade (annual % change) June 2011–January 2019

Source: CPB Netherlands Bureau for Economic Policy Analysis.

More importantly, note that global growth held steady at 3.7% last year, unchanged from 2017, even as global trade decelerated. Neither the fear of trade wars nor the actual slowdown in trade flows was serious enough to cripple global economic activity.

TRADE TENSIONS HAVE NOT DERAILED THE GLOBAL GROWTH PATHExhibit 3: Global Trade and Global Gross Domestic Product (GDP) (annual % change) 2011–2018

Exhibit 3: Global Trade and Global Gross Domestic Product (GDP) (annual % change) 2011–2018

Sources: CPB Netherlands Bureau for Economic Policy Analysis and International Monetary Fund (IMF).


There are three reasons why global trade tensions have had limited impact on global growth. First, the specter of an all-out trade war with protectionist measures spreading like wildfire, which has been constantly invoked by pundits and the press, has not materialized. Even the toughest bilateral negotiations continue to be punctuated by targeted and measured actions, not a tit-for-tat escalation of tariffs.

Why? Well, at least in part, because the United States does have a point: Almost everyone charges higher tariffs; even the European Union (EU) charges import tariffs that are on average 50% higher than the US (5.1% vs. 3.4%). The chart below shows that the countries that the US had the most contentious discussions with (highlighted in green) all have significantly higher tariffs than the US. No doubt, the US could be handling all this with greater finesse, but the reason other countries don’t just strike back in outraged vengeance is that they know this, and they have a lot more to lose from an escalation.


Exhibit 4: Average Tariff Rate (As of 2017)

Note—Countries highlighted in green are those that the US had the most contentious discussions with.
Source: World Trade Organization. Simple average tariff, most favored nation applied.

The impact on global commerce, therefore, has been limited, and I expect the coming months will show a stabilization in global trade flows after the recent deceleration.


Second, businesses have not panicked. The concern was that the uncertainty caused by rising trade tensions would cause businesses to freeze investment plans. Now, while anecdotal evidence does suggest that corporate leaders are concerned about trade tensions, the data show that investment accelerated robustly through 2017 and 2018: gross private domestic investment rose from 17.0% of gross domestic product (GDP) at the end of 2016 to 17.4% at the end of 2017 and 18.1% at the end of 2018. Albeit while complaining, many businesses appear to have taken the headlines with a pinch of salt, and their confidence in a well-entrenched global recovery has so far outweighed concern about trade tensions.

COMPANIES UNFAZED BY TRADE CONCERNS, CONTINUE TO INVEST FOR THE FUTUREExhibit 5: Gross Private Domestic Investment (March 2000–December 2018)

Exhibit 5: Gross Private Domestic Investment (March 2000–December 2018)

Source: Bureau of Economic Analysis, U.S. Department of Commerce.

Economists also appear to have underestimated companies’ ability to adapt to the limited supply chain disruptions seen so far. Also, to reiterate, free trade was never that free. As we have seen above, a number of countries levy significant tariffs. And the past decade had already witnessed a creeping rise in protectionism in the form of forced localization requirements in emerging markets (EMs) and other non-tariff barriers. Many businesses had already learned to adapt.


Third, and most important of all, the elasticity, or sensitivity of global growth to changes in global trade has dropped sharply over the last 10 years. In the decade and a half before the global financial crisis, global trade expanded twice as fast as global GDP. Over the past 10 years, the pace of growth of global trade has been one-fifth lower than that of global GDP. But the global economy kept expanding on average at the same pace as when global trade was booming.

This amounts to an important structural change, driven by three major factors:

First, strong economic growth in EMs created a burgeoning middle class that started to absorb a growing share of global consumption. A larger share of the goods and services produced in China, India and other major EMs are now consumed locally rather than exported. The McKinsey Global Institute notes that EMs’ share of global consumption has risen about 50% in the last 10 years, and it projects that EMs will consume almost two-thirds of global manufactured goods by 2025.1 China now exports just 9% of its production, a share that has almost halved from the 17% of 2007.

GLOBAL GROWTH LESS RELIANT ON GLOBAL TRADEExhibit 6: Global Trade Growth vs. Global GDP Growth (1992–2006 and 2011–2018)

Exhibit 6: Global Trade Growth vs. Global GDP Growth (1992–2006 and 2011–2018)

Sources: CPB Netherlands Bureau for Economic Policy Analysis and International Monetary Fund (IMF).

Second, several EMs have begun to develop stronger domestic supply chains, to improve efficiency and speed to market—for example, the McKinsey Global Institute report cited above notes that emerging Asia now imports just over 8% of the intermediate inputs needed for its production, down from over 15% just a year ago in 2017. This has increased the importance of intra-regional trade. And together with stronger EM consumption, it has boosted the so-called South-South trade (the proportion of trade that occurs across EMs rather than with advanced economies) by nearly 40% over the past decade.

Third, new advanced manufacturing technologies, from 3D printing to artificial intelligence-driven productivity solutions, have greatly reduced the importance of lower labor costs and encouraged advanced economies to reshore production to take advantage of better infrastructure, a more skilled workforce and, in the case of the US, declining energy costs. Similar technological innovations have also boosted the role of trade in services—including digital services and intangibles like intellectual property—which has been growing at a much faster pace than trade in goods.

These changes are likely to continue in the years ahead as living standards in EMs keep rising and technologies continue to evolve. Global trade still plays an essential role, but the current moderate pace of growth in global trade is consistent with robust global GDP growth.

To put it differently, the tariff wars that many are so worried about focus on traditional industrial sectors, while trade keeps shifting to the new sectors of the economy. This might explain why the impact of localized trade disputes remains limited. In its October WEO report, the IMF simulated a scenario in which the US-China trade war escalates, the US imposes a 25% tariff on all imported cars and parts and suffers a commensurate retaliation, business confidence gets hit and financial conditions for corporations tighten because of the hit to their margins. The net result? The level of global GDP would be 0.4% lower after five years—implying an even smaller impact on GDP growth rates. While a 0.4% lower GDP level is not insignificant, it is certainly not dramatic.

In its just-released April WEO, the IMF unveiled a new analysis that simulates the impact of a 25% tariff on all trade between the US and China, but without the spillover impact of uncertainty on investment. It uses a battery of different econometric models, including the one used in the October simulations. As this has generated a new wave of alarmist media headlines, I would like to make two observations:

  • The new simulation results are broadly consistent with the October ones, but are presented in a much more dramatic fashion, stating that “Annual real GDP losses range from -0.3% to -0.6% for the US and from -0.5% to -1.5% for China.” Predictably, this led even the Wall Street Journal to report that China’s GDP would decline by 0.5–1.5%. But this is not what the simulation implies. China’s GDP would not decline. It would keep growing, but at a slower pace.2
  • Most important, a 25% tariff on all US-China trade is a worst-case assumption that seems extremely unrealistic, and therefore of little use to guide business and market expectation. There is no doubt that if the US and China were to levy a 25% across-the-board tariff on all bilateral trade this would have a significant impact on the two economies. But this reminds me of Philip the II of Macedon threatening ancient Sparta that “…if I bring my army into your land…” The Spartans laconically replied “if.”


For investors, this has two important takeaways.

First, global growth will likely surprise to the upside, because fears on trade remain exaggerated. This, in turn, will support an upward drift in yields compared to market expectations, despite the markets pricing and re-pricing US Federal Reserve interest-rate moves.

Second, the real action is at the micro level: Targeted sanctions will impact pockets of the corporate world, including through trade diversion. More importantly, developments with intellectual property protection and related security issues (think of the Huawei case) will impact productivity and relative competitiveness trends for both corporations and countries for decades to come. We will all need to pay closer attention to this as we calibrate our exposure to countries, sectors and individual corporations. In sum, bottom-up fundamental research combined with active portfolio management has never been more important.

Concerns about where the financial markets are heading are at the forefront of many investors’ minds. The risks of a US or global recession this year continue to persist amid slowing global growth, trade tensions and worries about potential geopolitical shocks. Recognizing uncertainties, central banks globally—including the US Federal Reserve—have turned a bit more dovish, causing markets to price out US interest-rate hikes in 2019.

Our senior investment leaders see a different story unfolding. In this roundtable discussion, they outline why they think some market observers are misguided and where they see opportunities today.


  • Top market risks
  • Global growth expectations
  • Trade conflicts
  • Preparing for volatile shocks ahead

Q: Market risks are top of mind for many. What are your biggest concerns today?Sonal Desai

Let me start with what I’m most concerned about—it’s complacency. There is an enormous amount of complacency. Within days of US Federal Reserve (Fed) Chairman Jerome Powell’s turnaround in thinking earlier this year, markets not only priced out all interest-rate hikes in 2019, but see the next move as a rate cut next year. There is an idea that the Fed is going to be propping up the stock market on an ongoing basis. For me, that is very frightening. We saw an increase in market volatility at the end of last year, but clearly that is not enough if the markets are still not pricing in what I think is a very real possibility of additional rate hikes on the back of what’s happening in the economy. That’s where my greatest concern would be.


  • Sonal Desai, Ph.D.Chief Investment Officer,Franklin Templeton Fixed Income
  • Stephen H. Dover, CFAHead of Equities
  • Michael Hasenstab, Ph.D.Chief Investment Officer,Templeton Global Macro
  • Edward D. Perks, CFAChief Investment Officer,Franklin Templeton Multi-Asset Solutions

Michael Hasenstab

I completely share that view. US Treasury yields should go higher for many reasons: growing fiscal deficits, rising inflationary pressures, strong US growth and fewer foreign buyers. When that happens, we will likely get another interest-rate-led shock to broad assets. We think investors need to prepare for that risk. One way to do it is through assets that are negatively correlated to rate rising, and the other way is through idiosyncratic opportunities, which in our case take the form of a select group of emerging market countries. Ironically, there is a negative feeling about some of the state of the world, but for active managers, this is actually very fertile ground to take advantage of.

Stephen Dover

I think equity investors have been thinking a bit too much about the Fed and looking at this as sort of a Fed “put,” to use an options-related term, meaning the Fed is providing a type of insurance on the market going down. Traditionally, equity investors would look at earnings and the ratio of those earnings to stock prices. I think the last 10 years of monetary policy has made a lot of investors more macro-oriented rather than micro-oriented. They are not really looking at the differences in stocks.

In regard to emerging markets, I agree that they are so different and there are many different opportunities. The one thing I would look at in equities is China. I think there are some opportunities there, not just because of the economy and the growth story, but because of how the market is being looked at really has changed.Ed Perks

The multi-asset portfolios really blend a lot of these themes. One statement I can make that reflects how we are thinking about our portfolios today is how do we prepare for what’s next? We do have a lot of transition happening in the markets, and I think it’s incumbent upon us to ensure that we can react to opportunities that markets are inevitably going to give us as volatility increases.Michael Hasenstab

There have been some recent signals that might suggest US economic activity has been bottoming and that we are starting to see some normalization. I think there has been too much bearishness, and this view that the United States is about enter a recession is overstated. However, I do think there are some growing concerns fundamentally about long-term sustainability—particularly the massive, reckless deficit spending, and the populist politics that can lead to uncoordinated and often-volatile economic agendas. But in the short term, a strong labor market and supportive consumption drive US economic activity, which gives us some comfort.

US GDP Growth Driven by Consumption GrowthGDP Rate and Consumption Growth Rate (December 31, 2008–December 31, 2018)

US GDP Growth Driven by Consumption Growth

Source: Franklin Templeton Capital Market Insights Group, FactSet and US Bureau of Economic Analysis.Sonal Desai

It seems like currently there is near-complete consensus that the United States is going to hit a recession by the end of this year or in 18 months. But I find it difficult to determine what is going to cause it within this timeframe. We do have a strong labor market, and we don’t have—by any means— a hawkish Federal Reserve. The Fed is actually very dovish. Our team is also looking at energy prices, financial stability and asset price bubbles, and we don’t see conditions setting up for a recession in the near term.

Very Healthy Labor MarketTotal Private Job Openings, Hires and Quits (December 2003–December 2018)

Total Private Job Openings, Hires and Quits (December 2003–December 2018)

Source: Franklin Templeton Capital Market Insights Group and US Department of Labor.Stephen Dover

I don’t think the equity markets are pricing in a recession this year; I think they are pricing in the eventual recession in two years.Ed Perks

If you look back six months or so to fourth-quarter 2018—both in the equity and credit markets—we saw a pretty big dislocation. I would argue there may have been a point last year where risk assets were pricing in a near-term recession, but I’m not sure that’s actually the case today. I think the recovery since then has a lot to do with the pivot that the Fed made this year in moving to a more dovish tilt. The markets took a reprieve from that thinking, and we have seen a rally so far in 2019.Stephen Dover

At the end of last year the market was saying, “We are likely to go into recession, the Fed’s going to raise rates, we are worried about China and trade.” Algorithms were unwinding with all this hedge fund activity, and then we have had this big bounce back in early 2019. From an equity-market point of view, I actually think things seemed to be a little bit too pessimistic a quarter or so ago, and perhaps now it’s a little bit too optimistic.Play Video

Q: What are you expecting for global growth?Sonal Desai

I think a catalyst would be needed to push the United States off its current growth path. I wouldn’t anticipate gross domestic product (GDP) growth of 3.5% or 4%—it seems likely to be less than that—but we would need some trigger or shock to precipitate a recession, a bursting of a bubble.Stephen Dover

Recessions don’t happen from old age alone.Sonal Desai

They really don’t. I just don’t see what the triggering mechanism for a recession would be right now. It’s very odd right now to find such continued consensus about a near-term collapse of the US economy.Michael Hasenstab

Looking globally, we do see moderation in China’s growth, but the government has such incredible control over the economy and over its capital flows, that a domestically led collapse seems pretty unlikely. Growth in Europe has been slowing down a bit, and some emerging markets outside of China may be a little weaker, but we don’t see a massive downgrade of global growth as long as the United States can remain an anchor.

We don’t see a massive downgrade of global growth as long as the United States can remain an anchor.– Michael HasenstabStephen Dover

China has been the fastest-growing major economy over the last 20 or 30 years, but not the best-performing stock market. That’s particularly true today because there are other factors going on in China that are driving the market. One of those is that China’s market is now being included in global equity benchmark indexes, and it’s going to be included to such a degree that Chinese equities will represent upwards of half of the MSCI Emerging Markets Index1. So, if I were to look at a place of opportunity on the equity side right now, I would look at China and some of the changes that are going on and separate that from the economic news that China is slowing down a bit.Sonal Desai

Turning our eyes to Europe for a bit, there’s been a lot of noise about the European slowdown. GDP growth in the eurozone is likely slowing to around 1.5% this year, but this is still substantially above European GDP growth potential. So it’s certainly not a European-led global slowdown. Very rarely, apart from when we saw the eurozone debt crisis, has Europe really been at the forefront of the global move in any direction, so to speak.Stephen Dover

Some of the slowdown in Europe is tied to Germany—and Germany is very much tied to China’s growth. When there is some clarity on tariffs, that could help Germany in particular, and European growth overall.

China is a Key Export Partner for GermanyGermany’s Top 5 Export Partners (January 2009–January 2018)

Germany’s Top 5 Export Partners (January 2009–January 2018)

Source: Franklin Templeton Capital Market Insights Group and International Trade Centre. Most recent data available.

Also, for equity investors there’s a lot of concern about Brexit and what’s happening in the United Kingdom. We don’t know what’s going to happen, but I think some clarity will help the markets.

Q: Let’s talk about trade and politics. Specifically, could the trade conflict between the United States and China threaten growth in either of those countries?Michael Hasenstab

If you add up all the tariffs that could potentially happen and you carry that through to GDP, it’s not trivial, but it is manageable. To me, the bigger concern is what drove these trade conflicts. It’s a frustration of populations that don’t want globalization and want to turn inward. Trade conflict is just one of the symptoms of a very difficult political dynamic in the United States and other countries that will also manifest itself in fiscal deficits and, in some places, authoritarian control. So this is just the beginning of what I think is a decade-long shift toward very unorthodox economic policies. 

Populism is a huge global issue. I find it amazing that Argentina is the only country that has passed a bipartisan budget of meaningful change that will run a surplus over the next couple of years. The only country that will embark upon landmark social security pension reform is Brazil.Sonal Desai

There’s been a lot more talk than action on trade. Since President Trump came into power, we have been hearing about a trade war, but the war actually never took place. It’s been fought out in the press, but, in fact, there has been very little outcome. I think it’s far more important to actually consider those other areas of populism where trade is just one small piece of anti-globalization: its across-the-board immigration policy. Every policy you look at, there is this inward-looking nature to what’s going on and not just in the United States. It’s also happening in Europe.

How the US and China Trade Deficit Has GrownUS Imports, Exports and Trade Balance with China (30 year period ending December 31, 2018)

US Imports, Exports and Trade Balance with China (30 year period ending December 31, 2018)

Source: Franklin Templeton Capital Market Insights Group and US Census Bureau.Stephen Dover

The issue with China, I think, is really a geopolitical issue that trade is a part of. My view is that as investors—particularly equity investors—really have to look at China in a way that, in the past, maybe you looked at Europe. Not as part of emerging markets, but as its own area that probably will make some sense to look at and be invested in over the longer period of time. But there is this dichotomy with the trade talks. 

The United States wants to reduce the trade deficit, but at the same time it’s increasing the fiscal deficit. So as a country, if the US is going to lever itself—if it is going to borrow all this money—it is borrowing from other countries. That means the US is likely going to have trade deficits as the stimulus leads to increased spending. Putting tariffs on might reallocate the trade deficit, but it’s not going to stop the trade deficit, in our view. For the fourth quarter of last year, the US had the highest trade deficit ever.

We live in an age of tremendous technology disruptions. Yet, according to labor productivity statistics, this disruption has done surprisingly little to produce more outputs from an hour’s work. Looking forward, we think artificial intelligence (AI) is reaching a tipping point. Technologies like work automation and autonomous cars that promise to reshape society and economies, are creating significant risks and opportunities across credit markets.


  • Labor productivity growth rates have been falling globally across developed and emerging economies, raising concerns about future standards of living. Some economists think low productivity is here to stay, but we’re not in that pessimistic camp.
  • We think productivity is already rising among leading global companies, but it’s currently masked at the aggregate level due to lagging firms. We expect labor productivity growth will reignite in five to 10 years, fueled largely by technologies like machine learning and work automation.


  • New mobility technologies are reshaping how cars are powered, driven and used for years to come. We see three mega-trends—electrification, autonomous mobility and ride-hailing services—upending the old-world order.
  • As credit analysts, we recognize the payoffs and profitability of new mobility technologies are still years away for many companies in the auto sector. We favor firms that can still generate tangible near-term cash flows, while transitioning toward the new world order.


  • Artificial Intelligence: Real Opportunity
  • Is the Economic Cycle Shifting?

Top Down Views


We live in an age of fantastic and frustrating paradoxes. On one hand, inventions like self-driving cars, artificial intelligence (AI) and quantum computing aren’t science fiction any longer. They’re here, and very real. On the other hand, we’re in the midst of a labor productivity slowdown that threatens our standard of living. That’s not hyperbole.

Productivity growth, after all, is more than output per hours worked. For many economists it also measures the pace of improvement in our standard of living. Weak growth in labor productivity can therefore be a major challenge for an economy’s sustainability.1 For example, if we still had the productivity growth rate from the decade before the global financial crisis (GFC), the US standard of living could double in a generation. It may take a century at today’s rate, according to the US Federal Reserve.2

This slowdown isn’t just a US phenomenon, unfortunately. Labor productivity growth rates have been falling across developed economies for well over a decade, and emerging economies since the GFC.3 Long-term data presented by economist Gilbert Cette in Exhibit 1 illustrates how labor productivity has been trending downward across developed economies, although the US saw an uptick in the late 1990s when the “new economy” ushered in the internet and mobile phones to the masses.


Exhibit 1: Slower productivity growth as ongoing secular trend, from 1890 to December 31, 2016

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Source: Bergeaud, A., Cette, G. and Lecat, R. (2016): “Productivity Trends in Advanced Countries between 1890 and 2012.” Review of Income and Wealth, vol. 62(3), pages 420–444.

With dim prospects for standards of living, there’s been a lively debate in academic circles about what’s driving low labor productivity growth and the current technological paradox. Some pessimistic economists, like Robert Gordon, think low productivity growth is here to stay largely because all the big and consequential innovations have already been made.4 Compared to innovations like electricity, indoor plumbing and cars, smartphones are inconsequential. Economist Alan Blinder takes that position a step further, raising the possibility that digital technologies like emails and smartphones might be making us all less productive. Considering all the hours the average person spends staring into their phone, Blinder does have a point.

But don’t count us in that pessimistic camp. We think productivity gains from technology are already happening all around us. They’re just masked at the aggregate data level. Examining the previous waves of innovation and labor productivity can help to shed light on why this is happening, and how long it may take before labor productivity reignites at the aggregate level.

Reading the tea leaves of timing

History shows us it can take decades before a newly discovered technology manifests itself in productivity metrics. Consider electricity, the internal combustion engine and computers. Each technology was fundamental in driving labor productivity, but not at their inception. As economist Erik Brynjolfsson explains, a range of complementary coinventions needed to appear before widespread productivity gains could take hold.5 Core technologies eventually filter through the economy to boost productivity with enough time and experimentation.

Consider the impact of portable power, which combines the transformative effects of electrification and the internal combustion engine. Historian Paul David notes that nearly half of US manufacturers remained unelectrified until 1919—decades after Thomas Edison built the first commercial power plant in 1882.6Once electrified, factories could switch from using a single central source of power to giving each machine its own electric motor. This change gave managers the flexibility to rearrange machinery into assembly lines. Though many stuck with old habits, some embraced new manufacturing processes that drove down costs, as Henry Ford famously did in 1913 with his Model T car.

Economist Chad Syverson provides an updated illustration of how productivity gains can lag innovations in Exhibit 2.7 He overlays US labor productivity gains during the portable power era (1890– 1940) with today’s information technology (IT) revolution, starting in 1970. Both eras started with relatively slow productivity growth over a long stretch, before seeing decade-long accelerations spanning 1915–1924 for portable power and 1995–2004 for IT.

In the case of portable power, it took engineers and organizational architects like Frederik Taylor, who developed Henry Ford’s assembly lines, to redesign factories so they could harness the new electricity technology and the internal combustion engine more effectively. Boosting productivity therefore required conceptual changes in the ways production tasks were defined and organized on the factory floor. In other words, the productivity came from significantly changing the way workers performed their jobs. After much trial and error, a wave of robust labor productivity finally kicked off in 1915.


Exhibit 2: Portable power (1890–1940) and information technology (1970–2017)

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Source: Syverson, C. 2013. “Will History Repeat Itself? Comments on ‘Is the Information Technology Revolution Over?’” International Productivity Monitor, 25: 37–40.

The computer productivity paradox

Fast-forward to this era’s IT revolution (computer chips, software and telecommunications) and we see a similar productivity trend in Exhibit 2. The first commercial computer debuted in the 1950s, followed by Apple’s mass-market personal computer, the Macintosh, in 1984. And yet, labor productivity growth remained anemic through the early 1990s. This apparent contradiction was coined the “computer productivity paradox,” and famously summarized by Robert Solow in 1987—“you can see the computer age everywhere but in the productivity statistics.”8

So why did labor productivity growth reignite in 1995? Harvard professor Dale Jorgenson points to two factors: a rise in IT manufacturing productivity, followed by massive investments by US firms in cheaper IT hardware and software.9 The growth phase started with the doubling of computer chip density every 18–24 months, known as “Moore’s Law.” Companies’ costs to invest in computer hardware and software saw spectacular declines, since the same manufacturing inputs (labor) could now produce more computer processing outputs. US firms responded by making massive capital investments in newly affordable IT, followed by complimentary changes in business organization and human capital, impacting how they deployed the new technology to suit the business.

The promise of work automation

Growth in US labor productivity tapered off again after 2004, following computer integration into virtually every industry and economic sector. Looking forward, we believe work automation will eventually spark another wave of labor productivity globally, similar to the portable power era noted in Exhibit 2. Back then, labor productivity reaccelerated between 1933 and 1940 in the build up to World War II.

We think rapid developments in machine learning and robotics is making it easier for leading global firms to boost productivity. Consider the world’s first fully automated warehouse in Shanghai for leading e-commerce giant, It started operations this past June with twenty industrial robots picking, transferring and packing orders for online shoppers. Warehouses of comparable size in China typically employ 400–500 workers, but only needs five, mainly to service the machines. The technology relies on a team of “robot controllers” developed by Mujin, a Japan-based technology start-up. Using camera systems and motion planning software, the controllers teach the robotic arms how to master tasks like grasping and moving packages, without the need for manual instruction from humans.

Mujin’s American cofounder and chief technology officer, Rosen Diankov, thinks automation technology has reached a turning point. More companies are concluding they can earn attractive returns with robotic systems as the costs of robotics continue to fall.

Another example of significant manufacturing changes from work automation is Adidas. It opened “Speedfactory,” a heavily automated manufacturing facility in Germany in late 2015, which is the first manufacturing facility Adidas built on German soil in over 30 years. Last year Adidas opened its second Speedfactory in the US near the city of Atlanta, Georgia.

Each Adidas Speedfactory pairs a relatively small human workforce with technologies that include 3D printing, robotic arms, and computerized knitting to make the same running shoes it produces in China, Indonesia and Vietnam, only much faster. Adidas understands many shoppers expect same-day deliveries and customization. By placing its newly automated Speedfactories closer to its consumers, Adidas avoids production delays from its overseas factories.

The output from Adidas’ new robot factories, however, is quite small compared with its Asian supply chains. Its two Speedfactories are on track to produce one million shoes annually by 2020—about one day’s worth of the 403 million shoes Adidas produced last year in Asia.10 But there are other benefits to these innovative manufacturing facilities. By testing and refining the use of robots in its Speedfactories, Adidas plans on integrating its AI manufacturing processes into its Asian supply chain—helping an already massive manufacturing operation become faster, better and cheaper. Reducing the hours of human labor involved will also increase Adidas’ labor productivity.


Exhibit 3: Frontier = top 5% of manufacturing and services firms measured by labor productivity*, 2001 through December 31, 2013

Source: Andrews, D., Criscuolo, C., and Gal, P. (September 2016) “The Global Productivity Slowdown, Technology Divergence and Public Policy: A Firm Level Perspective.” Hutchins Center at Brookings Working Paper #24.
*Note: The global frontier is measured by the average log labor productivity for the top 5% of companies with the highest productivity levels. Laggards capture the average log productivity of all the other firms. Unweighted averages are shown for manufacturing and services, normalized to 0 in the starting year. The vertical axes represent log differences from the starting year: for instance, the frontier in manufacturing has a value of about 0.3 in the final year, which corresponds to approximately 30% higher in productivity in 2013 compared to 2001.

Productivity pioneers

With global companies increasing productivity through work automation, why aren’t we seeing a bigger surge in productivity growth? Research from the Organization for Economic Co-operation and Development (OECD) shows that slow productivity of the “average” firm masks the fact that a small cadre of “frontier” firms like Amazon and Apple are already seeing robust gains, as shown in Exhibit 3.11 By investing in 3D printing and robotics, companies like Adidas are positioning themselves to lower labor costs and squeeze out better margins, and gain market share with improved customer services.

Although frontier firms are pushing the envelope on work automation, these investments are still costly and not yet easy to implement for some firms. Therefore, we don’t see the productivity benefits trickling down to a wider swath of firms quite yet.

The new face of manufacturing

As the costs of machine learning and robotics decrease and spread beyond leading frontier firms, we expect aggregate labor productivity growth will rebound in five to 10 years to levels seen before the GFC. Through work automation, we see productivity growth coming mostly from reduced human hours worked—i.e., smaller labor input for a given output. One problem for workers displaced by robotic arms or driverless cars is they’ll need to acquire new and perhaps higher skills fairly quickly, or make do with lower pay.

This labor displacement is already underway in many developed countries. Since the mid-1990s middle-skill jobs typically found in manufacturing industries have declined, while low-skill and high-skill jobs are rising. In effect, the workforce is bifurcating into two groups doing non-routine work that machines currently can’t replicate: highly paid, skilled workers (such as architects) and low-paid, unskilled workers (such as cleaners). We believe the jobs most vulnerable to the next wave of automation are “routine” jobs, as US labor statistics from the US Federal Reserve show in Exhibit 4.


Exhibit 4: Routine work types remain flat for US employment, 1983 through November 1, 2018

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Sources: US Bureau of Labor Statistics; Federal Reserve Economic Data (FRED). Federal Reserve Bank of St Louis.

This potential dystopian outlook, however, isn’t predetermined. Indeed, in terms of self-driving cars, our auto analysts are more sanguine. In the following section we explain how the arrival of autonomous ride-hailing vehicles could jumpstart productivity and boost standards of living.

Bottom Up Views


It has been 106 years since the Model T rolled off Henry Ford’s new assembly line in Highland Park, Michigan. Ford’s mass production did more than bring lower prices to consumers and higher profits to Ford. It helped kick- start a consumer love affair with cars.

Fast forward to 2019, and the auto industry is at a new crossroads. Regulatory changes and “new mobility” technologies are reshaping how cars will be powered, driven and utilized for years to come. We see three mega-trends— electrification, autonomous mobility and ride-hailing services—as offering meaningful long-term benefits to societies and economies. These trends are also driving significant investment risks and opportunities across credit markets.


In this section we provide our perspective on where we think the auto industry is headed, and the credit qualities we look for from companies in the rapidly shifting auto industry. Expensive technology like electrification may disrupt the old-world order for the better, but payoffs and profitability are still years away in many cases.

Cleaner cars and profit pressures

Governments around the world continue to work toward reducing pollution from vehicle emissions, as shown in Exhibit 5. While the efficiency of the internal combustion engine (ICE) has improved over time, tightening global emissions regulations will require greater sales of hybrids and full battery electric vehicles (BEVs). Some industry analysts are predicting BEVs could reach 20% of the US market, 30% of the European market and 35% of the Chinese market by 2030.12


Exhibit 5: Targets are normalized to New European Driving Cycle (NEDC), 2000 through April 2018

Source: The International Council on Clean Transportation (ICCT) April 2018. There is no assurance that any estimate or projection will be realized.
*Note that Japan has already met its 2020 statutory target as of 2013.

As a relative newcomer to the industry, Tesla has led the market in BEVs. The rest of the auto industry is now working feverishly to catch up, spending billions to develop and launch a slew of electric vehicles in the coming years. This is pressuring near-term margins, while future investment returns remain uncertain due to high production costs and intense competition. As the Chief Executive Officer of France’s largest automaker, Peugeot, recently told Reuters, “What everyone needs to realize is that clean mobility is like organic food—it’s more expensive.”13

Automakers aren’t the only ones evolving. Auto parts suppliers with significant exposure to traditional ICE powertrains need to shift their product portfolios to serve electric vehicles (EVs). In some cases, companies are divesting business segments tied to powertrain components, as Honeywell recently did by spinning off Garrett Motion. Delphi Automotive split itself into two separate businesses—Delphi Technologies, which is a powertrain parts supplier, and Aptiv, which provides electronic and active safety products, and smart mobility technology.

We expect ICE powertrains to be around for years to come, but the auto supply chain will face burdens from the regulatory push to EVs. Over the long term this is environmentally positive. Our responsibility as credit analysts, however, is to ensure the costs of new technology don’t materially degrade a company’s credit profile, and are appropriately reflected in valuations.

Automating the automobile

Along with cleaner cars, the auto industry is deploying vehicle automation technology to make driving safer. Cars with collision warning, automatic emergency braking and lane-keeping assistance are already on the road, thanks to innovations in vehicle perception and sensing capabilities. Improving car safety not only saves lives, but also offers meaningful bene- fits to the economy. According to the National Highway Traffic Safety Administration (NHTSA), US motor vehicle crashes in 2010 cost a staggering US$242 billion in economic activity, including US$57.6 billion in lost workplace productivity, and an additional US$594 billion due to loss of life and decreased quality of life due to injuries. Volvo’s vision for 2020 is that no one should be killed or seriously injured in a new Volvo.

Three mega-trends rolled in one

As vehicle automation technology advances from driver assistance features to fully autonomous driving, self-driving cars have the potential to upend the auto industry, but not likely as privately owned vehicles. For economic reasons, we believe self- driving cars will most likely be electric and primarily used through ride-hailing services.

The rise of ride-hailing players like Uber, Lyft and Didi Chuxing has already had a profound impact on personal mobility by creating a new business model of transportation as a service (TaaS). When viewed on a cost per mile basis, however, ride hailing is currently more expensive than private car ownership. That equation could change when fully autonomous cars remove the cost of human drivers.

Fleets of self-driving “robotaxis” could also be better equipped to recover the cost of expensive sensor technology needed to navigate streets. Whereas the average private car sits idly parked much of the day, autonomous taxis will be busy moving passengers and collecting fees all day long. Ride sharing by multiple customers would further reduce trip costs, while additional cost reductions could come from using electric engines. BEVs offer the potential better fuel economy, as well as lower maintenance costs and a longer engine life given fewer moving engine parts.

All in, robotaxis have the potential to offer consumers a lower-cost alternative to vehicle ownership, in our view, by integrating these three mega-trends— electrification, autonomy and ride hailing. Academic studies estimate a shared autonomous vehicle could potentially replace up to 11 privately owned cars in dense urban areas. Once robotaxis are viable and deployed at scale, some automotive consultants and investment banks estimate private car sales may drop anywhere from 5% to 32% by 2030.14 The Boston Consulting Group estimates fleets of robotaxis will account for nearly 25% of all auto passenger miles traveled in the US by 2030.15

Automakers spring into action

The potential seismic implications of this shift away from private car owner- ship haven’t gone unnoticed by auto manufacturers. General Motors (GM), for example, purchased the Autonomous Vehicle (AV) start-up Cruise Automation for US$1 billion in 2016. Since then, Cruise has grown its staff from 40 to over 1,000 and plans to roll out a commercial fleet of automatous taxis in San Francisco in 2019.16 GM’s efforts got a huge vote of confidence from Japan’s SoftBank, which invested US$2.25 billion in Cruise.

Competition is fierce though, as a host of technology start-ups are all racing to develop AV technology, including Google’s Waymo division, and lesser-known players like Aurora, or Ford’s start-up partner Argo AI. It’s too soon to say who the eventual winners will be, but we see substantial investment spending taking place to address these auto mega-trends.

This November, CEO Herbert Diess announced VW would increase spending to US$50 billion on technologies for electric cars, autonomous driving and ride sharing over the next five years.17 The global consultant AlixPartners calculates that by 2023, a whopping US$255 billion earmarked for electric vehicles will be deployed, with another US$61 billion for AV technologies.18 AlixParters notes more than 50 major companies globally are now working on AV systems, operating in a wild-west environment that most likely will yield a few big winners, and many disappointed losers.

Some industry players are partnering to spread costs and accelerate their speed to market, given all the technical challenges and heavy investment requirements. BMW, for example, has partnered with computer vision company Mobileye, Fiat Chrysler Automobiles (FCA), and suppliers Aptiv, Magna, and Continental, as shown in Exhibit 6. Toyota is investing US$500 million with Uber to help develop autonomous driving technology. Semiconductor companies have entered the fray as evidenced by Intel’s 2017 acquisition of Mobileye for US$15 billion, while Nvidia has emerged as a key AV technology supplier through its autonomous driving platform. All of these players have an eye on participating in a future autonomous ride-hailing market.


Exhibit 6: Joining forces to deliver a self-driving platform

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Source: BMW.

Safer cars, productive society

The challenge to commercialize fully autonomous driving technology is monumental. But so too are the potential benefits to society and the economy, in our view. According to NHTSA, 94% of serious automobile crashes are caused by human error. In a world dominated by autonomous vehicles, it’s possible to see reductions in fatalities, medical expenses, and collision and repair costs, as well as insurance costs as claims decline. Economic productivity could benefit from commute time that isn’t wasted, while underutilized parking lots could be redeployed to higher-value purposes. Researchers at the University of Texas have estimated the US economic benefits of shared AVs could be US$1.2 trillion, or approximately US$4,000 on a per capita basis.19 While these types of estimates are of course difficult to make and include many key assumptions, they illustrate the magnitude of what may be some profound impacts across the economy.

Participating in the mega trend

When we evaluate the investment land- scape as credit analysts, we look for automotive companies that we believe can participate in these mega trends without enduring the risks of a volatile, binary outcome. Some cutting-edge leaders in ride hailing and BEVs are highly leveraged. Facing challenges on the horizon, they don’t currently offer the improving credit profiles we prefer. Instead, we favor companies like auto parts supplier Aptiv. Since spinning out of GM 20 years ago, Aptiv has evolved into a formidable tech company specializing in autonomous driving software. Boasting a staff of 15,000 scientists and engineers and a range of patents, Aptiv has expertise in vehicle electrical systems, active safety and connectivity products that its customers in Europe and North America are already using today.

With an eye toward future mega trends, Aptiv has been developing autonomous driving capabilities, and it recently launched a fleet of 30 autonomous vehicles in Las Vegas in a partnership with Lyft. Through December 2018, Aptiv’s vehicles have completed over 25,000 paid autonomous rides to more than 1,600 destinations. We see this as a key milestone for potential future growth in AVs, though still years away. In the meantime, Aptiv’s existing product portfolio is generating double digit revenue and cash flow growth, funding ongoing investment in autonomous mobility and driving a strong credit profile.

Navigating the road ahead

We believe the automobile sector is poised to see meaningful shifts in product composition, as emissions regulations force a transition from the ICE to electrified powertrains. While this transformation should be great for the environment, it will likely come at a cost initially born by the industry and hopefully recovered in future revenues. Automation stands to improve vehicle safety and potentially lead to shifts in vehicle ownership, furthering the rise of the TaaS model. Navigating these secular trends through business cycle ebbs and flows creates investment risks and opportunities for actively managed portfolios over the long term. If there is one certainly about the auto industry, it’s that the road forward will be a dynamic one.

  • Big Trucks and Shifting CyclesThe three mega trends transforming today’s auto industry portend a dynamic future. We believe these trends could bring more disruptive changes than anything seen since Henry Ford’s Model T. Importantly, however, we are also mindful of the cyclical nature of the automobile sector and the near-term implications for credit fundamentals.Autos are of course a consumer discretionary item, sensitive to employment, income and interest rates. Following the GFC, the US auto industry enjoyed a strong rebound in overall unit sales, as shown in Exhibit 7. It also witnessed a marked shift in consumer preferences—away from cars and toward the more profitable segment of trucks and SUVs, where US auto- makers are well-positioned.The pent-up demand that fueled sales coming out of the GFC has given way to flat to modestly lower sales of late. Investment spending on future mega trends, coupled with rising commodity costs, have pressured industry profitability. For automakers like Ford, margin and cash flow pressures have weighed negatively on bond values, despite its strong position in the truck market.Last year Ford announced it plans to discontinue manufacturing and selling most of its sedans in the US —a move that FCA made much earlier in 2016. FCA repositioned itself to benefit from the increased US consumer demand for trucks and SUVs by winding down production of the Chrysler 200 and Dodge Dart sedans and focusing instead on Jeep SUVs and Ram trucks. As a result, FCA has enjoyed rising profits and a strengthening balance sheet, which has been good for bond values.


Exhibit 7: Sales are shifting to a lower gear, 2008 through November 2018

Source: CMIG, Edmunds, NADA.