Developed Countries

A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus compelled us to examine S&P sector performance during inflationary periods. Specifically, health care stocks have consistently outperformed during inflationary periods (see chart). Over the long haul, it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is on a secular rise around the globe, and most recently further catalyzed by the COVID-19 pandemic: in the developed markets driven largely by the aging population and in the emerging markets by the accelerating adoption of health care safety nets and higher standards. As a reminder, we are currently overweight the S&P health care sector. For more details on S&P GICS1 sector performance during inflationary periods, please refer to our recent Special Report.

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend Chart I-10Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP   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 Closed Fractal Trades 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  

Our reinstated long XOP / short GDX pair trade hit its rolling 10% stop intraday yesterday, forcing us to crystalize 32% gains in just over a month. While our original thesis for this pair trade that was outlined in the April 27th Weekly Report has not changed, we adhere to the risk management tool we put in place and act on our profit-taking stop. We will be looking to reopen this trade later in the summer at a better entry point, especially if as we highlighted on Monday’s Weekly Report the rise in (geo)political risks serve as a catalyst for a much need broad equity market breather. Bottom Line: Crystallize 32% gains in the long XOP / short GDX pair trade, but stay tuned. ​​​​​​​

Special Report

Highlights The economic and health crises since Q1 2020 have accelerated the breakdown in the US-China relationship. Although the US is in a much weaker economic position this year than in 2019, President Trump may have fewer political constraints to an escalation in the trade war. President Xi Jinping is fueling provocations with the US, adding instability and unpredictability to the geopolitical equation. The Phase One trade deal may be collapsing. We recommend a defensive stance on Chinese risk assets and the RMB during the summer. Feature The outbreak of COVID-19 this year has sparked the worst economic contraction in China and the US in decades. Economic calamities and social unrest should have tied the hands of leaders in both countries. However, as our Geopolitical Strategist Matt Gertken reminds us, this is an atypical election year in the US and some constraints that previously deterred both sides from taking aggressive actions may be diminishing.1 We agree that the economic and health crises have likely accelerated the possibility of a breakdown in the relationship between the US and China. The risk will likely reach a new height in the summer, when pressure on Trump’s election campaign intensifies leading up to the vote in November. While there is a growing bipartisan hawkish view on China in Washington, China is also playing a part in fanning the flames. The USD/CNY exchange rate will be extremely volatile during this episode of heightened geopolitical turbulence. We continue to hold a long USD-CNH position, with the expectation that the RMB will likely weaken further in the summer. Trump Facing Fewer Constraints Whether Trump’s chances of reelection increase through a strong recovery in the US stock market and economy, or decrease through an economic recession and/or weak public support, either scenario could remove constraints preventing Trump from confronting China.     Trump’s current priority may be to secure a recovery in the equity market and improve his polling, which will require economic improvement. Ironically, the US stock market has been on fire despite the battered real economy. The S&P 500 Index has gone up by 44% since its trough on March 23, nearly erasing its losses for the year. The higher the market rises, the more Trump may believe that the market can sustain a shock even if he resorts to imposing tariffs on Chinese export goods - particularly if his approval rating does not rise along with the market. The market’s reaction in 2018 and 2019 provides a good example of how the US financial markets shrugged off any negative impact from a trade war between the US and China (Chart 1). If the pandemic prevents the US economy from fully reopening and/or recovering in the summer, then an equity market correction could send a negative signal about Trump’s reelection prospects. In this case, Trump may not be as enslaved by financial constraints as he would have been if the economy was in an expansionary state.  A falling approval rating, coupled with domestic social unrest, would make Trump a “lame duck” President (Chart 2).  Therefore, he may try to divert attention away from the economy and adopt an aggressive foreign and trade policy. China is already perceived negatively by a majority of American voters and certain political communities, thus there could be a political upside for Trump to escalate his confrontation with China. Chart 1US Stocks Kept Reaching New Highs In 2019 Despite An Ongoing Trade War Chart 2Trump’s Polling Drops Below Average All bets are off if Trump’s approval rating continues to trend downwards, regardless of whether the US equity market continues to rally and/or if the US economy is mired in recession. Our Geopolitical Strategy illustrates the scenarios as follows (Diagram 1). If Trump’s approval rating is high and the market is up, then Trump is “winning” and the only risk of a tariff hike would come from overconfidence or Chinese provocation. If his approval is up but the market falls, then he may become more inclined to use tariffs. If his approval rating is low but the market is up, then he has ammunition to get tougher on China. If his approval and the market are collapsing, then he is a “lame duck president” and all bets are off. Combined, these scenarios imply there is a 59% probability that Trump refrains from large tariffs, and a 41% chance that he reverts to large tariffs. Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election Bottom Line: All bets are off if Trump’s approval rating continues to trend downwards, regardless of whether the US equity market continues to rally and/or if the US economy is mired in recession. Both scenarios would remove financial and economic constraints that Trump faced in 2019. If Trump's polling is weak, he may spend financial ammunition to shore up his “America First” credentials.      Adding China To The Geopolitical Instability Equation China itself may be an independent source of geopolitical instability and unpredictability. While President Xi Jinping does not have any electoral constraints, he needs to restore the confidence of Chinese people in the wake of the worst public health crisis and economic performance in decades. Like Trump, the pandemic gives President Xi an incentive to distract his populace from domestic crises by adopting hawkish foreign policies.  This hawkish approach was demonstrated when a new Hong Kong SAR national security law was proposed and approved at this year’s National People’s Congress (NPC). The new law would give Beijing greater direct control over Hong Kong, in contravention of its promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984.  China’s foreign policy tone recently shifted to a more combative one. This “wolf warrior diplomacy" has gained popularity among Chinese diplomats.2 During a news conference at this year’s NPC, China’s Foreign Minister Wang Yi defended the “wolf warrior diplomacy” by stating that the country will stand firm in defending its national interest and combating “smears.”  Chart 3Chinese Imports Of American Goods Are Falling Far Short Of The Target Set By The Trade Deal The response from the Trump administration has been lukewarm. While Secretary of State Mike Pompeo will strip Hong Kong of its autonomous status, President Trump is taking limited sanctions on mainland China and eschewing more drastic punitive measures. China may see the timid response as a sign that Trump is reluctant to take action on China and tip the bilateral relationship into an outright confrontation. This perception is, in itself, a risk that may lead to more provocation on both sides. Lastly, the Phase One trade deal is tenuous. US Trade Representative Robert Lighthizer last week stated that "China has done a pretty good job" at meeting its trade-deal quotas,3 but we have long argued China was never going to honor the commitment to its full extent.4 The latest data shows that Chinese purchases of American exports in the first four months of 2020, from manufacturing goods to agricultural produce and energy, have fallen far short of the huge expansion agreed in the deal (Chart 3). The recent depreciation in the RMB may be another sign that China is abandoning the Phase One trade deal.5 Weakness in economic fundamentals and renewed tensions between the US and China may have contributed to the RMB’s recent depreciation. However, the decline was reinforced by the PBoC’s move to set the CNY/USD fixing rate to its lowest point since 2008 (Chart 4). Given that the RMB has become an anchor for emerging market currencies, a rapid drop in the RMB would lead to selloffs in emerging Asian and Latin American currencies and, in turn, would strengthen the USD (Chart 5). The Trump administration may see a swift RMB depreciation as China is deliberately violating the Phase One trade deal, which will prompt Trump to seek retaliatory actions against China. Chinese purchases of American goods in the first four months of 2020 have fallen far short of the Phase One trade agreement. Chart 4Is The PBoC Sending A Warning Signal To Trump? Chart 5The RMB Has Been The Anchor Currency In EM Bottom Line: While China is prioritizing its own economic recovery, its foreign policy stance has decisively swung to a more combative one. Additionally, the Phase One trade deal is on the verge of collapsing.  Investment Conclusions The USD/CNY exchange rate will likely be extremely volatile in the next quarter amid heightened geopolitical turbulence, with more downside risks to the RMB. As such, we continue to recommend that investors hedge their RMB exposure in Chinese stocks by holding a long USD-CNH position. We remain neutral on Chinese stocks in relative terms in view of the non-trivial, near-term vulnerability of risk assets. As in 2019, investable stocks are particularly exposed to an escalation in the US-China conflict (Chart 6). Chart 6Large Divergence In Onshore Versus Offshore Stock Performance During The Trade War Chart 7Stocks In Some Domestic Demand-Oriented Sectors Are Still Relatively Safe Bets Price corrections in both China’s onshore and offshore aggregate equity markets are likely to occur during the summer. Nevertheless, cyclical plays that closely track Chinese stimulus are relatively safe bets, especially for China’s domestic investors and in absolute terms (Chart 7).   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see Geopolitical Strategy Weekly Report "Spheres Of Influence (GeoRisk Update)," dated May 29, 2020, available at gps.bcaresearch.com 2South China Morning Post, “Chinese Foreign Minister Wang Yi defends ‘wolf warrior’ diplomats for standing up to ‘smears’”, May 24, 2020 3Bloomberg, “Lighthizer Says He Feels ‘Very Good’ About Phase One China Deal”, June 4, 2020 4Please see China Investment Strategy Weekly Report "Managing Expectations," dated January 22, 2020, available at cis.bcaresearch.com 5The Phase One trade deal prohibits both the US and China from manipulating exchange rates to devalue their currencies for competitive purposes. Cyclical Investment Stance Equity Sector Recommendations

The SPX catapulted to fresh recovery highs, on the back of optimism surrounding the successful reopening of the economy along with the ongoing support of easy fiscal and monetary policies. Sentiment is not as extended as in February or during previous SPX tops in the past few years, as we highlighted in recent research.1 Equity market internals signal that there is likely a bit more gas left in the tank, despite the roughly 1000 point rise since the March 23 lows. The S&P deep cyclicals/defensives share price ratio, has led the broad equity market bottom and continues to herald additional gains for the SPX (not shown). Deep cyclicals include tech stocks, but even if IT were excluded, the cyclicals ex-tech/defensives ratio still troughed prior to the SPX and is gaining steam. Importantly, the turn in our Global Trade Activity Indicator corroborates the message that the cyclicals/defensives ratio is emitting (see chart). Further, the recent breakout in the JPM EM currency index along with budding evidence of China’s economic recovery and likelihood of a stimulus package (not as large as the GFC, but bigger than the early-2016 manufacturing recession one) suggest that global growth is slated to recover in the back half of the year. Bottom Line: We remain constructive on the broad market’s prospects  over the coming 9-12 month time horizon. For more details, please refer to this Monday’s Weekly Report.   Footnotes 1  Please see BCA US Equity Strategy Weekly Report, “There’s No Limit” dated May 26, 2020, available at uses.bcaresearch.com.

Highlights Rising Bond Yields: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Central banks will remain highly accommodative given the lack of inflationary pressures after the deep COVID-19 recessions. There are still significant risks in the coming months from a potential second wave of coronavirus after economies reopen, worsening US-China relations and domestic US sociopolitical turmoil. Duration Proxy Trades: Given those lingering uncertainties, we prefer to focus on “duration-lite” trades in the developed economies, like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months. Feature Dear Client, Next week, instead of publishing a regular Weekly Report, we will hold a webcast on Tuesday, June 16 at 10:00 am ET, discussing our latest views on global fixed income markets. The format will be a short presentation, followed by a Q&A session. We hope you will join us, armed with interesting questions. Kind regards, Rob Robis, Chief Fixed Income Strategist Chart of the WeekBond Yields Bottoming, But Backdrop Not Yet Bearish Bond yields around the world awoke from their COVID-19 induced slumber last week, responding to a growing body of evidence indicating that global growth has bottomed. Over a span of four days, benchmark 10-year government bond yields rose in the US (+20bps), Germany (+13bps), Canada (+20bps), China (+14bps), Japan (+4bps), Mexico (+13bps) and the UK (+12bps). There is potential for yields to continue drifting higher over the next few months, as more countries reopen from virus-related shutdowns. The bounce already seen in survey data like manufacturing and services PMIs, as well as economic sentiment measures like the global ZEW index, should soon translate into real improvements in activity data. This comes at a time when rising commodity prices, most notably oil, suggest that depressed inflation expectations can lead bond yields higher. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator (Chart of the Week). However, economic policy uncertainty remains elevated as devastated economies try to reopen from lockdowns. In addition, our Central Bank Monitors continue to indicate pressure on policymakers to keep interest rates as low as possible to maintain easy financial conditions as easy as possible. Tighter monetary policies remain a distant prospect, given very high unemployment rates. The cyclical bottom for global yields has likely passed, based on the improvement already seen in our own Global Duration Indicator. Amid those uncertainties, we recommend maintaining a neutral strategic (6-12 months) and tactical (0-6 months) stance on overall duration exposure in fixed income portfolios. Instead, we prefer focusing on lower volatility trades that will benefit from improving global growth and policy reflation, like going long inflation-linked bonds versus nominal government debt throughout the developed markets with breakevens looking too low on our models. Why Are Bond Yields Rising Now? We see five main reasons why global bond yields have started to move higher: 1) Investor risk aversion is declining There has been a sharp recovery in global risk appetite since late March, diminishing the demand for risk-free global government debt. In the US, the S&P 500 is up 43% from its March lows, while the NASDAQ index is back to the all-time highs reached before the coronavirus turned into a global pandemic (Chart 2). US corporate debt has also performed well since the March 23rd peak in spreads, with investment grade and high-yield spreads down -227bps and -564bps, respectively. Non-US assets are also flying, with emerging market (EM) equities up 29% and EM USD-denominated corporate debt up 14% in excess return terms over US Treasuries since the March trough. Even severely lagging assets like European bank stocks are showing a pulse, up 38% since the lows of May 15. Commodity prices are also improving, led not only by gains in oil after the April crash by recoveries in the prices of growth-sensitive commodities like copper (+17%) and lumber (+42%). Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds. The flipside of the boom in risk appetite is weakening prices for safe haven assets (Chart 3). The price of gold in US dollar terms is down -4% from the 2020 high on May 20, while the euro price of gold is down –6%. Safe haven currencies like the Japanese yen and Swiss franc have underperformed, while interest rate volatility measures like the US MOVE index and long-dated euro swaption volatility are back to the pre-coronavirus lows. Chart 2Risk Assets Are Booming Worldwide Chart 3Safe Haven Trades Losing Luster Add it all up, and the message is clear: investors now prefer risk to safety, which has tempered the demand for government bonds that helped drive yields lower when risk assets were tanking in late February and March. 2) Global growth is improving One of the reasons for the improvement in investor risk appetite is belief that the world economy has exited from the severe COVID-19 global recession. While timely real data is still coming in slowly given reporting lags, there has been a notable bounce in survey data in many countries. PMIs for both manufacturing and services climbed higher in May (Chart 4). The expectations components of economic confidence measures like the ZEW indices have also recovered the losses seen in February and March. Data surprises have also been increasingly on the positive side of late in China, Europe and the US, including the shocking 2.5 million increase in US employment in May. However, the US unemployment rate remains very high at 13.3%, indicating abundant spare capacity that will likely take years, not months, to work off – a problem that most of the world will continue to deal with post-recession. 3) Central bank liquidity is booming The other main reason for the boom in risk asset performance that has started to put upward pressure on bond yields is the extremely accommodative stance of global monetary policy. This is occurring through 0% policy rates in the developed economies but, even more importantly, the aggressive expansion of central bank balance sheets through quantitative easing (QE). The Fed has its foot firmly on the monetary accelerator, with year-over-year growth in its balance sheet of 87% (Chart 5). The European Central Bank (ECB) is no slouch, though, with its balance sheet up 19% from a year ago and having expanded its Pandemic Emergency Purchase Program (PEPP) by another €600 billion last week. Chart 4Signs Of Life In The Global Economy Chart 5'QE Forever' Driving Money From Bonds To Risk Assets The combined annual growth of the central bank balance sheets for the “G4” (the Fed, ECB, Bank of Japan and Bank of England) is now up to 26%. The rate of G4 balance sheet expansion has been a reliable leading indicator of global risk asset performance since the 2008 financial crisis (with about a 12-month lead), and the current boom in “liquidity” suggests that the current rise in global equity and corporate bond markets can continue over the next year. Easing global financial conditions are now returning to levels that should support economic growth in the coming months, helping to mitigate (but not eliminate) the potential credit stresses from companies that have suffered during the COVID-19 recession. This recovery remains fragile, however, and policymakers will continue to maintain an extremely dovish policy bias – even with significant fiscal stimulus measures also in place to help economies climb out of recession. This suggests that the current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. The current rise in global bond yields is not the start of a new bond bear market driven by expectations of tighter monetary policies. Chart 6Global Bond Sentiment Is Still Very Bullish 4) Bullish sentiment for bonds is at extremes From a contrarian perspective, another factor helping put a floor underneath bond yields is investor sentiment towards fixed income, which remains bullish. The widely followed ZEW survey of economic forecasters also contains a question on the expected change in bond yields over the next year. The latest read on the surveys shows a net balance still expecting lower bond yields in the US, Germany, the UK and Japan, nearing levels seen prior to the end of the recessionary bond bull markets in the early 2000s and after the 2008 financial crisis (Chart 6). In addition, the Market Vane survey of bullish sentiment on US Treasuries is nearing past cyclical peaks, suggesting limited scope for new bond buyers that could drive US yields to new lows. 5) Inflation expectations are moving higher Finally, global yields are rising because the inflation expectations component of yields has started to move higher. The hyper-easy stance of monetary policy is playing a role here. Market-based inflation expectations measures like the breakevens on inflation-linked bonds (or CPI swap rates) are a vote of confidence by investors in the “appropriateness” of policy settings. The fact that inflation expectations are now drifting higher suggests that bond markets now believe that central banks are now "easy" enough to give inflation a shot at rising sustainably as growth recovers. Global yields are rising because the inflation expectations component of yields has started to move higher. Chart 7Oil Prices & Breakeven Inflation Rates Are Both Recovering This move higher in inflation expectations can continue in the coming months, particularly with global oil prices likely to move even higher. Our colleagues at BCA Research Commodity & Energy Strategy are quite bullish on oil prices, forecasting the benchmark Brent oil price to rise to around $50/bbl by the end of 2020 and continuing up to $78/bbl by the end of 2021. Such an outcome would push up market-based inflation expectations, and likely put more upward pressure on nominal bond yields, given the strong correlation between oil and inflation breakevens in the developed economies that has existed over the past decade (Chart 7). Bottom Line: Global risk assets are discounting a V-shaped economic recovery. With economic data starting to revive as more economies emerge from virus-related shutdowns, bond yields are showing signs of following suit. Duration Strategy For The Next Few Months The trends in growth, inflation and financial conditions all suggest bond yields can continue to drift higher over at least the next 3-6 months. Yet given the potential for a negative shock from a second wave of coronavirus infection, or geopolitical uncertainties in a volatile US election year, a below-benchmark global duration stance is not yet warranted. This is especially true with unemployment rates in most countries remaining elevated even as growth rebounds from recession, forcing central banks to maintain a very dovish policy posture. Our “Risk Checklist” that we have been monitoring to move to a more aggressive recommended investment stance on global spread product – the US dollar, the VIX and the number of new COVID-19 cases - can also be helpful in helping us determine when to shift to a more defensive bias on global duration. On that note, the Checklist still argues for a neutral duration stance, rather than positioning for a big move higher in yields. The US dollar has started to soften, but remains at a very high level relative to interest rate differentials (Chart 8). A weaker greenback is a source of global monetary reflation, primarily through changes in the prices of commodities and other traded goods that are denominated in dollars, but also by helping alleviate funding pressures for companies that have borrowed heavily in US dollars (especially in the emerging world). The dollar is also an “anti-growth” currency that appreciates during periods of slowing global growth, and vice versa, so some depreciation should unfold as more of the world economy emerges from lockdown (middle panel). The VIX index – a measure of investor uncertainty - continues to climb down from the massive surge in February and March, now sitting at 26 after peaking around 80. This is the one part of our Risk Checklist that argues for reducing duration exposure now. We prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. The daily number of new reported cases of COVID-19 (using data from the World Health Organization) has come down dramatically in Europe, but in the US the decline in new cases has stalled over the past month – a worrisome sign as the country continues to reopen amid mass protests in major cities (Chart 9). New cases outside the US and Europe are rapidly moving higher, however, primarily in major Latin American countries like Brazil and Mexico. This suggests that while there is a concern about a “second wave” of coronavirus later in the year, the risks from the first wave are far from over. Chart 8Still Not Much Reflationary Push From A Weaker USD Chart 9The COVID-19 Threat Has Not Gone Away Instead of shifting to a below-benchmark recommended stance on overall portfolio duration too soon in the cycle, we prefer trades that will benefit from the combination of continued global policy reflation and growing investor risk appetite. We call these “duration-lite” trades. Specifically, we like owning inflation-linked government bonds versus nominal debt, while also positioning for steeper government yield curves (on a duration-neutral basis). Longer-dated breakeven inflation rates within the major developed markets are becoming increasingly correlated to both the level of 10-year government bond yields (Chart 10) and the slope of the 2-year/10-year yield curve (Chart 11). Chart 10Rising Inflation Expectations Will Lead To Higher Bond Yields ... Chart 11... And Steeper Yield Curves In terms of country selection for these trades, we look to the valuations on inflation-linked bond breakevens from our modeling framework that we introduced back in late April.1 In that framework, we model 10-year breakevens as a function of oil prices, exchange rates and the long-run trend in realized inflation. Chart 12Global Inflation Breakevens Look Cheap On Our Models In Chart 12, we show the deviation of 10-year inflation breakevens from the model-implied fair value, shown both terms of standard deviations and basis points. The “cheapest” breakevens from our models are for inflation-linked bonds in Italy and Canada, although almost all counties (outside of the UK) have breakevens to look far too low. This suggests that global bond investors should consider a multi-country portfolio of inflation-linked bonds versus nominal paying equivalents – or in countries where the inflation-linked bond markets are small and illiquid, duration-neutral yield curve steepeners - as a more efficient way to play for a continuation of the current reflationary global backdrop without taking duration risk. Bottom Line: Even with global yields showing signs of a cyclical bottom, we continue to recommend a neutral duration stance. Given the lingering uncertainties about a second wave of coronavirus, and the rising political and social tensions in the US only five months before the presidential election, we prefer to focus on “duration-lite” trades in the developed economies - like overweighting inflation-linked government bonds versus nominals as inflation expectations will drift higher over the next 6-12 months.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns