Currencies

Highlights The dollar bounce has further to run. The DXY index could touch 94 before working off oversold conditions. In this environment, yen long positions also provide an attractive hedge. Meanwhile, Japan has stepped back into deflation, with the resurgence in Covid-19 cases constraining activity and consumption spending. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. Remain strategically short USD/JPY. Tactical investors can also short EUR/JPY as a trade. Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. We were stopped out of our long silver/short gold position last week. Reinstate. Feature The powerful bounce in global markets from the March lows is morphing into a speculative frenzy. The highlight this week centered on a few stocks, such as GameStop, Blackberry, and AMC Entertainment holdings, that have entered a manic phase. While liquidity conditions remain extremely favorable for risk assets, only a small shift in market sentiment may be required to trigger a reversal. The big risk from a technical perspective is that this reversal might be deeper and longer than most expect, given extremely overbought conditions. The dollar has tended to strengthen as market volatility rises. 2020 saw the rapid accumulation of dollar shorts, as low interest rates squeezed investors into more speculative assets, such as cryptocurrencies (Chart I-1). With these assets now having  jumped high into the stratosphere, and dollar-short positioning at a bearish nadir, the nascent bounce in the USD could morph into something bigger. In our report a fortnight ago,1 we argued for a 2%-4% rise, putting 94 on the DXY index within striking distance. Chart I-1Some Signs Of Speculative Froth Chart I-2The Yen Benefits From A Rise In Volatility The yen also generally benefits from rising volatility (Chart I-2). Should a market correction develop, it will provide the necessary catalyst for established long yen positions. Meanwhile, as we argue below, the backdrop in Japan is becoming more deflationary, which is also yen bullish. We are already short USD/JPY in our portfolio and recommend going short EUR/JPY for a trade. The Yen And Global Markets The AUD/JPY rate is extremely sensitive to equity market conditions (Chart I-3). Therefore, one of the ways to play a potential reversal in equity markets and a rise in volatility is to short the AUD/JPY cross. While we certainly recommend this trade tactically, we prefer to express this view via a short EUR/JPY position. There are three main reasons for this.  First, despite a significant rally in AUD/JPY, speculators are still very short the cross, as we showed two weeks ago. This is because short USD positions have been expressed in a concentrated number of currencies, including the euro. In a nutshell, speculators are very long EUR/USD and just neutral EUR/JPY (Chart I-4). This favors EUR short positions from a contrarian perspective, compared to AUD. Chart I-3The Yen And Equity Markets Chart I-4Go Short EUR/JPY For A Trade Second, Australia is doing much better in terms of containing the spread of Covid-19, compared to Europe as we argued last week.2 Australian export volumes and prices continue to recover smartly, and the basic balance remains in a healthy surplus. Meanwhile, there is a rising risk that the Covid-19 crisis will hit Europe particularly hard in Q1 this year. Interest rate markets are already beginning to discount this view. Real interest rates in the euro area are collapsing relative to Japan (Chart I-5). This will limit any fixed-income flows into the euro area from Japanese investors. At the margin, this is negative EUR/JPY. Third, given the most recent stimulus out of Europe, the European Central Bank’s (ECB) balance sheet is expanding faster than that of the Bank of Japan (BoJ). This has historically been negative for the EUR/JPY (Chart I-6). Chart I-5EUR/JPY And Real Interest Rates Chart I-6EUR/JPY And Relative Balance Sheets In a nutshell, equity markets are due for a healthy reset. In a similar fashion, a washing out of stale euro long positions will ensure the bull market for 2021 unfolds with higher conviction. Tactical investors can also short EUR/JPY as a trade. Outright short EUR/USD positions also make sense in the near term.  The Yen And Japanese Growth Japan has re-entered a debt-deflation spiral, and it is unclear how it will exit this predicament, other than via a rebound in external demand. While it remains our base case that external demand will recover, the yen will be held hostage in the interim to short-term safe-haven inflows, as real rates remain well bid. Like most other economies, Japan is seeing the worst private-sector contraction in decades. For an economy that has held interest rates near zero since the better part of the 90s, this is not good news. Whenever the structural growth rate of the Japanese economy has fallen below interest rates, the trade-weighted yen has staged a powerful rally (Chart I-7). A strong yen, on the back of deficient domestic demand, then leads to a self-fulfilling deflationary spiral. Chart I-7The Story Of Japan In One Chart The latest Bank of Japan (BoJ) meeting was a clear indication that the central bank was out of policy bullets (the central bank left policy largely unchanged). The BoJ began to acknowledge this problem with the end of the Heisei era3 two years ago. A policy review is due in March of this year, but with aggressive stimulus in place since governor Haruhiko Kuroda took helm almost a decade ago, it is difficult to see how any changes could steer Japan out of deflation and towards a 2% inflation target anytime soon.  For example, with the BoJ owning 47% of outstanding JGBs, about 80% of ETFs and almost 5% of JREITs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. As a result, the impulse of the BoJ’s balance sheet could soon begin to fade, especially relative to that of other central banks (Chart I-8). Chart I-8The BoJ's Balance Sheet Could Peak Soon 2% Inflation = Mission Impossible? Most developed economies have not been able to meet their inflation targets over the last decade. While this might change going forward with unprecedented monetary and fiscal stimulus, it will not happen anytime soon. For example, the US is a much more closed economy than Japan and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream in the near future. Strictly looking at the data, the situation is even worse, with Japan having categorically stepped back into deflation (Chart I-9). The three key variables the authorities pay attention to for inflation – Core CPI, the GDP deflator, and the output gap – are all negative or rolling over. In fact, since the financial crisis, prices in Japan have only been able to really rise after a tax hike. Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and aging) population, leading to deficient demand (Chart I-10). Chart I-9Japan Is Back In Deflation Chart I-10Japan Prices And Demographics This view is corroborated in the inflation swap market. 5, 10, and 20-year inflation swaps in Japan are all depressed (Chart I-11). More importantly, with almost 50% of the Japanese consumption basket in tradeable goods, domestic inflation is as much driven by the influence of the BoJ or demographics, as it is by globalization. Chart I-11Is 2 Percent Inflation Mission Impossible? Fiscal Policy To The Rescue? Chart I-12Falling Consumer Confidence In Japan Most governments have carte blanche on fiscal stimulus. While it is certainly the case that the Japanese government could boost spending via transfer payments, much of this income is more likely to be saved than spent by the private sector. In other words, the savings ratio for workers continues to surge. If consumers were not willing to spend prior to COVID-19,4 they are unlikely to do so under much more uncertain future conditions (Chart I-12). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity, or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. The first is a potential postponement of the Olympics once again for 2021. This will continue to be a drag on Japanese construction activity. Second, the Covid-19 pandemic has severely curtailed tourism in Japan, especially as Niseko and Hakuba, important ski destinations for foreigners, lose inbound momentum. Tourism makes up a non-negligible component of Japanese income. Finally, the labor (and income) dividend from immigration has practically vanished. The Yen Beyond The Near Term Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. Real interest rates are already higher in Japan, and the above factors could meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-13). Chart I-13The Yen And Relative Interest Rates Chart I-14DXY And USD/JPY Usually Move Together A continued rise in global equity markets is a key risk to our scenario. This will especially favor short dollar positions. However, as a low-beta currency, our contention is that the yen will surely weaken at its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-14). While short EUR/JPY positions will suffer, short USD/JPY bets should still fare well. As such, we remain strategically short USD/JPY. It is rare to find such a “heads I win, tails I do not lose too much” proposition. Housekeeping We were stopped out of our long silver/short gold position for a modest profit of 6%. We have profitably traded silver for almost two years now, and could see a speculative breakout in the metal over the next few months. We recommend reinstating this trade today with the ratio at 71, while maintaining our target at 65 and setting the stop loss at 72.5. We were also stopped out of our long petrocurrency basket versus the euro. With heightened volatility in oil prices, we will be looking to re-establish this trade from lower levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange and Global Fixed Income Strategy report, "Australia: Regime Change For Bond Yields And Currency," dated January 20, 2021. 3 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito, from January 8, 1989 until his abdication on April 30, 2019. 4 Ricardian equivalence suggests in simple terms that public-sector dissaving will encourage private-sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart I-2USD Technicals 2 Recent data in the US have been resilient: US manufacturing activity continues to outperform its peers, with a solid 59.1 print on the Markit PMI for January. The S&P CoreLogic house price index grew by 9.5% year-on-year in November. Consumer confidence remains resilient, with the expectations component surging for the month of January. 4Q GDP came in at an annualized 4% quarter-on-quarter, in line with expectations. The DXY index was flat this week. The latest FOMC meeting reinforced the view that there will be no rush to tighten US monetary policy. Two preconditions for tightening is inflation well above 2% and tight labor market conditions. This suggests the path for least resistance for the US dollar is down, albeit with some near-term consolidation. Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart I-3EUR Technicals 1 Chart I-4EUR Technicals 2 Recent data from the euro area are softening: Manufacturing PMIs are rolling over, with the aggregate index down to 54.7 in January from 55.2. The German IFO Business climate index also softened from 92.1 to 90.1 in January. GfK consumer confidence slipped from -7.3 to -15.6 in February. The euro fell by 0.3% against the US dollar this week. As the broad dollar continues to work off oversold conditions, the euro remains a potent valve to allow for this reset. We are shorting EUR/JPY this week to profit from any setback in risk assets.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart I-5JPY Technicals 1 Chart I-6JPY Technicals 2 Recent data from Japan has been disappointing: Departmental store sales fell by 13.7% year-on-year in December. Retail sales are softening overall in Japan. Tokyo CPI will be released overnight and is expected to stay weak. The Japanese yen fell by 0.7% against the US dollar this week. Our highest conviction call over the next one to three months is to be long the yen both versus the dollar and versus the euro. As we discuss in the front section of this report, short USD/JPY is an attractive “heads I win, tails I do not lose too much” bet. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart I-7GBP Technicals 1 Chart I-8GBP Technicals 2 Recent data out of the UK have been softening: The Markit manufacturing PMI fell from 57.5 to 52.9 in January. 88K jobs were lost in the three months ending November. This pushed up the ILO unemployment rate to 5%. Average weekly earnings rose by 3.6% year-on-year in November. The British pound was flat against the US dollar this week. Post-Brexit relations and Covid-19 vaccinations continue to dominate the news flow in Britain. The latter is progressing, but a difficult adjustment remains for Britain’s exporters. This will add volatility to the pound. We remain short EUR/GBP on valuation grounds.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart I-9AUD Technicals 1 Chart I-10AUD Technicals 2 Recent data from Australia have been improving: CPI went up a notch in the fourth quarter, to 0.9% from 0.7%. The weighted median number was more encouraging at 1.4% NAB Business conditions improved from 9 to 14 in December. However, the expectations component deteriorated from 12 to 4. 4Q export prices rose by 5.5% quarter-on-quarter. The Australian dollar fell by 0.9% against the US dollar this week. The Aussie has been consolidating gains for most of January. The dominant feature driving the Aussie in the near term will continue to be terms of trade. We expect the AUD to resume its uptrend after a brief consolidation phase. We shied from implementing a short AUD/JPY trade today, preferring to express this view via short EUR/JPY. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart I-11NZD Technicals 1 Chart I-12NZD Technicals 2 There was scant data out of New Zealand this week:  The trade surplus in 2020 was NZ$2.9bn, compared to a deficit of NZ$4.5bn in 2019.  The New Zealand dollar fell by 0.4% against the US dollar this week. Agricultural prices are consolidating after a rebounding from the lows of last year. Poor weather continues to be a worry on the supply side, but this is already reflected in very long Ag positioning. More should continue to deflate air off the high-flying kiwi. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart I-13CAD Technicals 1 Chart I-14CAD Technicals 2 Recent data from Canada continues to disappoint: Building permits fell by 4.1% month-on-month in December. The Canadian dollar plunged by 1.3% against the US dollar this week. Oil prices are consolidating this year’s gains, which has weighed on the loonie. There is also the issue of the cancelled keystone XL pipeline, which is adding a risk premium for Canadian crude. We are short CAD/NOK as a trade, to capitalize on the latter headwind. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart I-15CHF Technicals 1 Chart I-16CHF Technicals 2 There was scant data out of Switzerland this week: The Swiss franc fell by 0.3% against the US dollar this week. The Swiss national bank (SNB) has two headaches to contend with in the coming weeks: a potential correction in the euro, which encourages safe-haven flows into the franc, and the lagged effects on a strong currency on domestic prices. This will force the hand of the SNB to continue being foreign exchange reserves at an aggressive pace. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart I-17NOK Technicals 1 Chart I-18NOK Technicals 2 The data out of Norway has been robust: The unemployment rate came down in November to 5% from 5.2%. The Norwegian krone fell by 2% this week on oil-related losses. Despite this, good management of the COVID-19 situation remains a positive catalyst relative to US or European peers. We expect the krone to keep outperforming for the rest of the year. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart I-19SEK Technicals 1 Chart I-20SEK Technicals 2 Recent data from Sweden has been mixed: The unemployment rate ticked up in December from 8.3% to 8.7%. Retail sales fell by 0.6% year-on-year in December, after rising by 5.7% the previous month. The trade balance improved from SEK1.4bn to SEK2.7bn in December. The Swedish krona fell by 0.8% against the US dollar this week. As a high beta currency, the Swedish krona typically bears the brunt of a US dollar rally. However, this time around, valuations provide a sufficient margin of safety for investors that are long. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. That was followed by a lost decade for EM. The US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Due to recurring stimulus, the US will experience asset bubbles and inflation in the real economy. The Fed will fall behind the inflation curve. The resulting downward pressure on the US dollar in the coming years favors EM stocks and fixed-income markets over their US counterparts. Feature Policymakers worldwide and in the US in particular “are riding a tiger”. Congress is authorizing unlimited spending and the government is on a borrowing and spending spree. So far there are no constraints on the ballooning budget deficit. Government bond yields are well behaved. In turn, the Fed is printing limitless money to finance the Treasury and there have been no market or economic constrictions. Share prices are at a record high and credit spreads are very tight. The US dollar is depreciating but it is a benign adjustment for the US because the greenback had been too strong for too long. Chart 1EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover In brief, the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. At the BCA annual conference in New York in 2016, one of the invited speakers – a hedge fund manager – recounted that in 2010, in a private conversation with an investor, Brazilian President Lula da Silva likened ruling Brazil to driving a sports car at high speed in the city with no police around. These were prescient words to describe the situation in Brazil’s economy and financial markets in 2009-10. In 2009-10, Brazil – like many other developing countries – benefited from both the impact of China’s enormous stimulus on commodities prices as well as from foreign capital inflows in part triggered by the Fed’s QE program. In addition, its own government provided sizeable monetary and fiscal stimulus. This stimulus trifecta – emanating from China, the US and local authorities – produced a one-off economic boom and a cyclical bull market in Brazil and other EM countries. Yet, the exuberance was followed by a stagflationary period in Brazil, and later a depression and associated rolling bear markets. Brazil was a poster child for that EM era. The experience of other EM economies was similar and the performance of their financial markets was equally underwhelming. These economies, their leaders, and financial markets wholly enjoyed the stimulus of that period. What followed, however, was a drawn-out hangover that lasted many years: EM ex-China, Korea and Taiwan share prices have been flat for the past 10 years and their currencies were depreciating till last spring (Chart 1). China, the epicenter of epic stimulus in 2009-10, had a similar experience. Its investable ex-TMT stocks, i.e., excluding Alibaba, Tencent and Meituan, are presently at the same level as they were in 2010 (Chart 2). The underlying cause has been a collapse in listed companies’ return on assets (Chart 2, bottom panel). It is essential to emphasize that such poor Chinese equity market performance occurred despite recurring fiscal and credit stimulus from Chinese authorities since 2009 (Chart 2, top panel). As we discussed in detail in a previous report, soft-budget constraints – unlimited stimulus and liquidity overflow – led to complacency, inefficiencies and falling return on capital in EM/China. Chart 3 demonstrates that EM EPS (including China, Korea and Taiwan and their TMT companies) has been flat for 10 years and non-financial companies’ return on assets plunged during the past decade. Chart 2China: "Free Money" Undermined Corporate Efficiency And Profitability Chart 3EM EPS And Return On Assets: The Lost Decade   Can The US Dismount The Tiger? The US is currently experiencing no budget constraints. US broad money (M2) growth is at a record high both in nominal and real terms (Chart 4). In turn, the fiscal thrust was 11.4% of GDP last year and will remain substantial this year as most of Biden’s stimulus plan is likely to gain approval from Congress.  Chart 4Helicopter Money In The US Chart 5China Has Not Been Able To Wean Off Stimulus Such an explosive boom in US money supply and fiscal largess will continue. Even after the pandemic is under control, it will be hard for policymakers to withdraw stimulus. China is a case in point. In the past 10 years, any time Beijing attempted to reduce the stimulus, China’s economic growth downshifted considerably and financial markets sold off (Chart 5, top panel). This forced Chinese policymakers to continuously enact new rounds of stimulus measures. As a result, they have not been able to achieve their goal of stabilizing the credit-to-GDP ratio (Chart 5, bottom panel). Similar dynamics will likely transpire in the US. Having been inflated enormously, US equity and corporate credit markets will be exceptionally sensitive to any policy shifts. US financial markets will riot at any attempt to withdraw monetary or fiscal stimulus. Given how sensitive US policymakers are to selloffs in financial markets, authorities will be extremely reluctant to exit these stimulative policies. Overall, the US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Bottom Line: Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount. Inflation, Asset Bubbles Or Capital Misallocation? In any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation. Charts 6 and 7 illustrate that rampant money/credit growth in Japan and Korea in the second half of the 1980s produced property and equity market bubbles. Chart 6Japan: Money And Asset Prices Chart 7Korea: Money And Asset Prices   Chart 8Deploying Credit To Capital Spending Could Lead To Deflation In China’s case, the 2009-10 stimulus resulted in a property bubble as well as capital misallocation. Over the years, we have discussed these outcomes in China in detail and will not elaborate on them in this report. The pertinent question is why inflation has remained depressed in China. In fact, bouts of deflation occurred in various industries in China in the past 10 years. One usually associates a money/credit boom with demand exceeding supply resulting in higher inflation. That is correct if money/credit origination finances consumption with little capital expenditures taking place. However, the credit outburst in China enabled a capital spending boom. This led to a greater supply of goods and services, which in many cases exceeded underlying demand. The upshot has been deflation in various goods prices (Chart 8). History does not repeat but it rhymes. Open-ended stimulus in the US will eventually lead to years of economic and financial malaise. The nature of the challenges that the US will face matters not only to US financial markets but also to EM. Odds are that the US will experience asset bubbles and inflation in the real economy. We will not debate whether the US equity market is already in a bubble or not. Suffice it to say that in our opinion, parts of the market are already in a bubble. The main observation we will make in that regard is as follows: the sole way to justify the current broad US equity valuations is to assume that US Treasurys yields will not rise from the current levels. If US bond yields do not rise much, equity prices could hover at a high altitude. However, any mean reversion in US bond yields will deflate American share prices considerably. In turn, the outlook for US bond yields is contingent on the Fed’s willingness to continue with QE. We do not doubt the Fed will continue buying government securities until it faces a significant inflationary threat. Hence, the primary threat to US and global equity prices is inflation. Fertile Grounds For Inflation In The US Odds of inflation rising meaningfully above 2% in the US economy in the next 12-24 months have increased substantially:1 1. A combination of surging money supply and a potential revival in the velocity of money herald higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 4.  In the Special Report from October 22 we discussed in depth why US money growth is currently substantially stronger than the post-GFC period. With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed, the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 9). Chart 9The US: The Velocity Of Money Correlates With Inflation Momentum 2. Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will shrink (Chart 10).  Businesses will attempt to raise prices to restore their profit margins. Provided income and spending will be strong, companies could succeed in raising their prices. In the US, a modest wage-inflation spiral is probable in the coming years. Chart 10The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins Chart 11US Core Goods Price Inflation Is Accelerating 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has produced shortages of manufacturing goods. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia and China are rising (Chart 11). In the service sector, lockdowns will permanently curtail capacity in some sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services, leading to shortages in certain segments. 4. De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. 5. Higher industry concentration and less competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed – it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulation, large companies have acquired smaller competitors. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases when the macro backdrop permits. In sum, US inflation will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main and overarching risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite cost pressures. Conclusions And Investment Strategy As America’s economy normalizes in the second half of this year, US inflationary pressures will begin rising. However, the Fed will fall behind the inflation curve – it will be late to acknowledge the potency of the inflationary pressures and act on it. It is typical for policymakers to downplay a budding new economic or financial tendency when they have long been pre-occupied with the opposite. Policymakers often fight past wars and are slow to calibrate their policy when the setting changes. The Fed falling behind the inflation curve is bearish for the US dollar in the medium and long-term. Share prices will be caught between rising inflationary pressures and the Fed’s continuous dovishness. This could create large swings in share prices: the market will sell off in response to evidence of rising inflation but will rebound after being calmed by the Fed. Eventually, fundamentals will prevail and the next US equity bear market will be due to higher inflation and rising bond yields. Over the coming several years, US share prices and bond yields will be negatively correlated as they were in the second half of the 1960s (Chart 12). Chart 12The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated Chart 13Will Gold Outperform Global Equities? This is not imminent, but it is not several years away either. Inflation could become the market’s focus later this year. Such a backdrop of heightening inflation risks and the Fed falling behind the curve will favor gold over equities – this ratio might be making a major bottom (Chart 13). In this context, we reiterate our trade of being long gold/short EM stocks. For now, global risk assets are extremely overbought and many of them are expensive. In short, they are overdue for a correction. During this setback, EM equities and credit markets will suffer and in the near term could even underperform their respective global benchmarks. In anticipation of such a setback, we have not upgraded EM to overweight. We continue to recommend maintaining a neutral allocation to EM in global equity and credit portfolios. Consistently, the US dollar will rebound because it is very oversold. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. High-risk currencies will underperform low-beta currencies. The EM/China backdrop remains disinflationary. Therefore, fixed-income investors should continue receiving 10-year swap rates in the following EM countries: Mexico, Colombia, Russia, China, Korea, India, and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1  This is the view of BCA’s Emerging Markets team and is different from BCA’s house view. The latter is more benign on the US inflation outlook in the coming years.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Pandemic uncertainty is keeping the USD well bid by raising global economic policy uncertainty. When this breaks – i.e., as higher vaccination rates push contagion rates down – the USD will resume its bear market. Renewable-energy output surpassed fossil-fuel generation in Europe for the first time in 2020. With the Biden administration re-committing to renewables, and China and Europe continuing their build-outs, copper demand will rise to meet grid-expansion needs. Copper mine output fell 0.5% in Jan-Oct 2020. Treatment and refining charges – already at 10-year lows – will remain depressed as supplies tighten. Major exchanges’ refined copper inventories were down 17% y/y in December, suggesting weak mine output continued into end-2020. Stocks will continue to fall this year, backwardating the COMEX's copper forward curve (Chart of the Week). Based on the World Bank’s forecast for real global GDP growth of 4% this year, and our expectation for a weaker USD, COMEX copper prices will likely breach $4.00/lb by 2H21. COVID-19 uncertainty drives metals: If infection and hospitalization rates outpace vaccinations, additional lockdowns in the US and Europe will stymie the recovery. Success in expanding vaccinations will push economic activity higher. We expect the latter outcome. Feature Pandemic uncertainty is driving global economic policy uncertainty, which is keeping a safe-haven bid under the USD (Chart 2). Chart of the WeekPhysical Copper Deficit Signals Continued Inventory Draws This continues to stymie the recovery in industrial commodity prices, particularly oil and base metals.1 The uncertainty caused by the COVID-19 pandemic feeds directly into global economic policy uncertainty, which drives USD safe-haven demand. Chart 2USD Remains In The Thrall Of Pandemic Uncertainty Pandemic uncertainty will not abate until vaccination distribution is sufficient to put infection, hospitalization and death rates on a clear downward trajectory, and remove the threat of widespread lockdowns, which once again are required to deal with rampant contagion rates and the possible spread of vaccine-resistant COVID-19 mutations locally and globally. As markets see empirical evidence of falling COVID-19-related infection, hospitalization and mortality, safe-haven demand for USD will weaken. Massive fiscal and monetary support will continue to support GDP globally, until organic growth takes off after sufficient populations are vaccinated, per the World Bank’s assumptions (Chart 3).2 Fiscal stimulus in the US exceeds 25% of GDP, and will continue to expand as the Biden administration rolls out additional spending measures. With the Fed remaining willing and able to accommodate this massive fiscal profligacy in the US, the USD will face increasing pressure on the downside as normalcy returns. Chart 3Massive Fiscal Support Globally Will Be Replaced By Organic Growth A weaker USD and stronger economic growth would boost copper prices this year and the next. A 5% decline in the broad trade-weighted USD this year would push spot COMEX copper prices above $4.30/lb, all else equal, while a 4% boost in world GDP – in line with the World Bank’s forecast for real growth this year – would lift prices to just under $4.05/lb, based on our modeling (Chart 4).3 Chart 4Lower USD, Stronger GDP Bullish For Copper Prices Renewable Generation Will Boost Copper Demand In addition to these stronger fundamentals, base metals demand – particularly for copper – will continue to benefit from the build-out of renewable-energy electricity generation globally, particularly in Europe and China. The return of the US to the Paris Agreement to combat climate change, and a renewed effort by the Biden administration to fund expanded renewable-energy resources will add to the increase in base-metals demand accompanying this global build-out (Chart 5).4 Europe is moving out ahead of the US in its deployment of renewable electricity generation, which, for the first time ever, surpassed fossil-fuel generation in 2020.5 S&P Global Market Intelligence this week reported renewable energy sources accounted for 38% of electricity generation in the EU vs 37% for fossil fuels. Renewables also surpassed fossil-fuel generation in the UK last year. Wind, solar and hydro all saw strong gains. Chart 5Copper Is Indispensible For A Low-Carbon Future Copper Supply Continues To Tighten It is important to once again note that all of these, and other renewable technologies, will require higher base metals output, none moreso than copper, which spans all renewable technologies. With copper-mining capex still weak and ore qualities falling in the mines that are producing, the supply side remains challenged (Chart 6). Over the past two years, p.a. supply growth on the mining side has been close to flat. The International Copper Study Group (ICSG) this week reported copper mine output fell 0.5% in the first 10 months of 2020. Refined copper output was up 1.5% over the same interval. Treatment and refining charges – already at 10-year lows – will remain depressed as supplies tighten. We expect full-year mined and refined output to fall on either side of zero growth for 2020, and 2021 (Chart 7).6 Major exchanges’ refined copper inventories were down 17% y/y in December, according to the ICSG, suggesting weak mine output continued into end-2020. An apparent increase in refined copper consumption of 2% noted by the ICSG also contributed to lower inventories. The Group estimates global refined copper balances adjusted for changes in Chinese bonded stocks, which are believed to have increased 105k tons y/y in the Jan-Dec 2020 interval, posted a physical deficit of ~ 380k tons. Chart 6Weak Capex, Lower Copper Ore Quality Remain Chief Supply-Side Challenges Chart 7Mined, Refined Copper Supply Growth Remains WeakWe expect inventories will continue to fall this year – as seen in the Chart of the Week – as demand strengthens and supply growth remains weak, which will backwardate the COMEX copper forward curve. Metal Ox Year Brings Short-Term Uncertainties The approach of the Chinese New Year beginning 12 February 2021 normally would herald massive travel and celebration, which, all else equal, would dampen economic growth until festivities ended. This year, however, reports of a re-emergence of COVID-19 infections is casting doubt on this year’s celebrations. In addition, winter industrial curtailments to reduce pollution also should reduce short-term demand for metals generally. These transitory factors should show up in lower levels of economic activity on the industrial side. For this reason, we expect seasonal weakness to show up in 1Q21 activity, to be followed in 2Q21 by higher growth y/y. Bottom Line: Copper fundamentals continue to paint a bullish price picture, particularly on the supply side. Although risks abound on both sides of the market, we expect the massive support being provided by fiscal and monetary policy globally to transition to organic growth in 2H21, in line with the World Bank’s expectations. The enormous fiscal stimulus being unleashed by the US – coupled with an ultra-accommodative Fed – will result in a weakening of the USD that will provide a tailwind to copper prices in 2H21 and next year. We remain long the PICK ETF, expecting copper miners and traders to benefit from this bullish backdrop, which we expect to persist for the next decade. The recommendation is up 6.4% since inception December 10, 2020. We also remain long December 2021 copper, which is up 19.6% since it was recommended on September 10, 2020.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish After falling 11% in 2020 due to COVID-19-induced demand destruction, US energy-related CO2 emissions will rebound this year and next, according to the Energy Information Administration (Chart 8).  The EIA forecasts US energy-related CO2 emissions this year and next will be 4.8 and 4.9 billion MT, which would amount to a 4.7% and 3.2% gains, respectively.  The EIA tracks emissions from coal, petroleum and natural gas usage in the US in its estimates.  Petroleum accounts for ~ 46% of total emissions in 2021 and 2022, while natgas contributes ~ 33% of all energy-related emissions in both years, on average.  Reflecting its market-share loss in the power-generation market, coal accounts for ~ 21% of total US energy-related CO2 emissions in 2021 and 2022. Base Metals: Bullish Globally, crude steel production was down 0.9% y/y at 1.864 billion MT, the World Steel Association reported this week.  China’s steel production was up 5.2% last year, to 1.053 billion MT, the country a market share of 56.5%, up from 2019’s level of 53.3%.  Output in all of Asia totalled 1.375 billion MT, up 1.5% y/y, with India’s production falling close to 11% to 99.6 billion MT.  China’s iron-ore imports set a record last year on the back of its strong steel-making performance, reaching 1.2 billion tonnes, a 9.5% increase y/y.  Higher infrastructure spending was the primary driver of increased steel demand last year.  Iron ore delivered to the Chinese port of Tianjin (62% Fe) closed just above $169/MT on Tuesday, up ~ 9% YTD. Precious Metals: Bullish Gold continues to trade ~ $1,850/oz, down more than $100/oz from its highs earlier this month on the back of persistent USD strength (Chart 9).  The pandemic uncertainty feeding into global economic policy uncertainty is the proximate cause of dollar strength.  COVID-19 vaccine rates are increasing, and governments remain committed to widespread distribution, which likely will be visible to markets during 1H21.  Once this occurs, we expect gold to rally along with other commodities, as the safe-have bid is priced out of the USD. Ags/Softs: Neutral US corn prices rallied on the back of stronger China purchases of the grain on Tuesday.  Farm Futures reported a 53.5mm-bushel order out of China on Tuesday was responsible for the gain earlier this week.  Farmers continue to expect Chinese buying to remain strong, given falling corn stocks in China. Chart 8 Chart 9   Footnotes 1     At the margin, this increases the cost of purchasing commodities and lowers the cost of producing them ex-US in local-currency terms, both of which depress prices. Pandemic uncertainty and global economic policy uncertainty (GEPU) are cointegrated; the USD and GEPU also are cointegrated. We discussed the effects of pandemic uncertainty on the USD and its impact on oil prices in last week’s balances and price forecast update entitled Brent Forecast: $63 This Year, $71 Next Year. This report is available at ces.bcaresearch.com. 2     Please see the Bank's Global Economic Prospects released 5 January 2021 entitled Subdued Global Economic Recovery. The IMF upgraded its global growth outlook to 5.5% this year and 4.2% next year, in its World Economic Outlook Update released this week. We continue to use the more conservative World Bank forecasts. The Israeli economy is providing something of a natural experiment vis-à-vis the rate of COVID-19 vaccination and economic growth. According to reuters.com, the country got an early start on vaccinations, and has one of the highest rates in the world. If maintained, this will result in GDP growth of 6.3% in 2021 and 5.8% next year. Without these early and intensive vaccination rates, 2021 growth likely would be 3.5%. 3    The models in Chart 4 use the broad trade-weighted USD and global copper stocks as common regressors, and estimate copper prices given the World Bank estimates for World, EM ex-China, China and DM real GDPs. In the discussion above, we use elasticities from the World GDP model to highlight the impact of changes in copper prices from the different variables. 4    Please see Renewables, China's FYP Underpin Metals Demand, which we published 26 November 2020. We discuss the implications of essentially rebuilding the global electric-generation grid to accommodate more renewable energy resources vis-à-vis base metals demand. Copper, in particular, spans all technologies that will be deployed to achieve a low-carbon generation pool globally, as Chart 5 illustrates. 5    Please see For 1st time, renewables surpass fossil fuels in EU power mix published by S&P Global Market Intelligence 25 January 2021. 6    Benchmark treatment and refining fees charged by smelters to refine raw ore fell to 5.9 cent/lb this year, down from 6.2 cent/lb last year, according to reuters.com. This 10-year low reflects an abundance of smelting capacity relative to concentrates on the supply side needing to be refined.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades

Highlights Biden’s initial political capital is moderate-to-strong according to our Political Capital Matrix. He will pass his American Rescue Plan and one or two budget reconciliation bills over the next 18 months. Investors will need to discount the impact of tax hikes eventually.  The Democrats’ second impeachment of President Trump is a distraction but the party will not let it derail their legislative agenda. The bipartisan power-sharing agreement in the Senate will keep the filibuster in place for now (though not permanently). This does not affect the most market-relevant aspects of Biden’s policies, at least not in 2021, but beyond that it is an open question.  The stock rally is stretched, so prepare for volatility in the near term. But over the long run continue to prefer stocks over bonds, cyclicals over defensives, and value over growth stocks. Feature The US equity rally is getting frothy even as President Joe Biden kicks off his administration with a flurry of executive orders. Financial exuberance stems from combined monetary and fiscal stimulus that will provide a positive backdrop for risk assets for most of this year. Still, most of the good news is priced so we expect volatility to revive in the short run. The BCA Equity Capitulation Indicator is nearing the highest points of its historic range, which is typically a signal for a 10% equity correction or more (Chart 1). Not all indicators point decisively to a bubble that will pop imminently but several suggest that a bubble is being formed.1 The policy backdrop of fiscal largesse combined with an ultra-dovish Fed makes it easy to see why some parts of the market are getting manic. In this context, the Biden administration’s regulatory and tax agenda will become a negative catalyst in the short run even though its big spending will secure the economic recovery, which is positive in the long run. Chart 1Mania Unfolding Biden’s First Executive Orders Biden’s initial decrees brought zero surprises so far. He rejoined the Paris climate agreement, canceled the Keystone XL pipeline, suspended new oil and gas leasing on federal land, reversed President Trump’s border emergency and immigration curbs, ordered federal workers to wear masks, and directed the federal government to “Buy American.” The energy sector suffered the brunt of Biden’s initial regulatory salvo but the relative performance of energy stocks did not drop as much as financials, where Biden’s regulatory risks are less immediate. Biden’s policies are negative for health care stocks but they suffered least from what was a general setback for value plays in the context of a small bounce in the dollar and fears about global growth weakness stemming from the pandemic which has not yet been quelled. Large caps in all three of these sectors are underperforming small caps, suggesting that Biden’s new regulations and looming tax hikes are not driving the markets – at least not yet (Chart 2). Rather these cyclical small caps stand to benefit from the administration’s large spending plans, which include the $1.9 trillion American Rescue Plan currently being negotiated (Table 1). These plans are highly likely to pass as explained below.    Chart 2Biden's Executive Orders: No Surprises So Far Table 1Biden’s American Rescue Plan (With Previous COVID Relief) Going forward, Biden’s regulatory onslaught will bring negative surprises eventually as it expands and deepens but these will not counteract the stronger tailwinds of the vaccine and fiscal spending. Democrats have yet to invoke the Congressional Review Act, which enables them rapidly to reverse the regulations that the Trump administration ordered just before leaving office.2 The regulatory risk is greater for health care and energy than it is for financials and tech, though the latter two are not void of risk. Health care is the Democrats’ top priority outside of pandemic relief and economic recovery. (See Appendix for our updated political risk matrix by sector.) While the market can look through Biden’s regulatory threat, at least for now, it cannot look through the impact of higher taxes on corporate earnings forever. Over the next two months House Democrats will start revealing details of their budget proposals, which could serve as a negative catalyst for the overstretched equity rally. Other negative catalysts from an ambitious new administration are also possible with a market at such dizzy heights. Secretary of Treasury Janet Yellen has discouraged raising taxes initially but investors know that taxes will go up sooner or later. Moreover the specific legislative vehicle for Biden to push his agenda – “budget reconciliation” – requires tax hikes to offset spending increases. Thus if Democrats initiate a reconciliation bill in February or March then it will imply at least some revenue offsets, even if the biggest tax increases are saved for the second reconciliation bill for FY2022. Bottom Line: Value stocks have taken a breather but will continue to outperform over the cyclical 12-month time horizon. Looming Democratic tax proposals are more likely to serve as a near-term negative catalyst for the overstretched equity rally than Biden’s regulatory onslaught, which will take time to be felt. We are sticking with value over growth stocks due to the extremely accommodative fiscal and monetary policy setting. The Filibuster Preserved (For Now) A critical check on lawmaking in the Senate, the filibuster, has been preserved – at least for the moment. This is positive news for markets as it lowers the odds of major legislative surprises this year. The filibuster enables senators to block normal legislation through endless debate. Sixty senators are needed to invoke “cloture” and bring debate to a close. Otherwise the bill goes nowhere. With the Senate divided evenly at 50-50 seats between the two parties, Biden’s agenda will now depend on any bills that can garner 10 Republican senators, plus two “budget reconciliation” bills for fiscal 2021-22. Reconciliation bills only require a simple 51-seat majority in the Senate. Eliminating the filibuster will remain a risk over the long run. It was only preserved because two centrist Democratic senators, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, declared that they would not vote to abolish it. This prompted Republican Senate Minority Leader Mitch McConnell to drop his chief demand, that the filibuster be kept, in his negotiations with Democratic Majority Leader Chuck Schumer toward an agreement for the two evenly divided parties in the Senate to share power. Now a power-sharing agreement is in place so the legislative process can begin, albeit within the filibuster’s guardrails. Notice that Schumer never conceded to McConnell that the filibuster would be preserved. And two Democrats is not very many. Later these centrists may succumb to party pressure, say amid Republican obstructionism of a voting rights bill, to eliminate the filibuster. The last time the Senate was evenly divided, after the 2000 election, the power-sharing agreement only lasted six months, from January to June 2001. A single retirement or death could turn the balance. Moreover since Democrats have the option of two reconciliation bills first, the filibuster is not a substantial check on them until 2022 or beyond, at which point the centrists could fall under sustained pressure.3 Bottom Line: Preserving the filibuster provides a source of stability – it reduces policy uncertainty and polarization. It restricts Biden’s agenda largely to his major initiatives: entrenching the Affordable Care Act, expanding infrastructure spending, partially repealing Trump tax cuts, and various other tax-and-spend measures known to investors. It lowers the chance that financial markets will be blindsided in 2021 by a sweeping new legislative initiative – for example, the Green New Deal – or radical redistributive schemes. While markets will need to discount the tax hikes they will be able to recover more quickly than if they also expected a stream of unpredictable legislation from a Senate unshackled from the filibuster. Stimulus And The Tax Hike Timeline The American Rescue Plan could pass in February at the earliest or April at the latest. If at least 10 Republican senators cooperate then it will fly through Congress. The advantage of this bipartisan route is that it would achieve an early Biden objective while still leaving Democrats with two full chances to pass reconciliation bills covering fiscal 2021-22. The economic recovery would be on sure footing thereafter, giving Biden more room to maneuver (Charts 3 and 4). Chart 3Is More Stimulus Necessary? Bipartisan talks are under way. Senator Joe Manchin of West Virginia set up talks with about 15 other senators and three White House aides, including National Economic Council director Brian Deese, toward revising and passing the rescue plan.4 Winning over ten Republicans is a tall order but GOP senators are aware that the pandemic is still going and even Republican voter opinion favors more relief. So far Democrats have not allowed any compromise in the size of the deal but that could change to get 60 votes, since they can always make up the difference through reconciliation later. The rescue plan is unlikely to be passed before Trump’s second impeachment trial begins on February 8, however. If 10 Republicans cannot be found, the Senate will be slowed down by juggling reconciliation and impeachment. Trump’s first impeachment took 49 days, leaving the average at 65 days (Table 2). It will keep the Senate busy at least through mid-March. Chart 4More Checks Coming For Households? Table 2Impeachment Takes At Least A Month Since Democrats are highly unlikely to win over 17 Republicans to convict Trump of inciting insurrection, the impeachment could be a policy mistake. Democrats are determined not to let slide the opportunity to position themselves as the arch defenders of democracy. Acquitting Trump would put several prominent Republicans on record endorsing him even after his alleged interference with the peaceful transition of power. However, impeachment will not be allowed to derail Biden’s agenda. The Democratic Party controls both processes. The Senate can wrap up the trial if it becomes an obstacle. Diagram 1 presents the timeline for these events to occur. The implication is that March 14, when the latest expansion of unemployment benefits starts to expire, will serve as a deadline for Biden’s rescue plan. Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Budget reconciliation takes seven months on average but it only took three months in 2017, which is the proper analogy for today. Even if tax hikes are passed in Q2 there is an open question as to when they would take effect (Diagram 2). Prudent investors should be prepared for a retroactive January 1, 2021 effective date, even if it is more likely that they will kick in on January 1, 2022 to give the economy more time to recover. Again, taxes pose a risk to the rally. Diagram 2How Long Does It Take To Pass A Budget Reconciliation Bill? If Republicans do not cooperate on Biden’s rescue plan then Democrats will cite it as obstructionism from the beginning, despite Biden’s call to unity, and it will play into any future efforts to eliminate the filibuster. But those will likely center on the period after the two reconciliation bills. Bottom Line: As the House Democrats begin to draft their first budget resolution, to initiate the reconciliation process, tax hikes will come more into focus. The near-term upside risk is that Democrats skip taxes in the first bill and save it for later. But there will have to be at least some revenue raisers in any reconciliation bill. So a near-term pullback is entirely reasonable to expect. We would be buyers on the dip given the extremely accommodative fiscal and monetary backdrop. Introducing Our Political Capital Index To assess any government’s capability – namely its ability to alter the policy setting that affects the economy and financial markets – we need to measure its political capital or grounds of support. To this end we have constructed a Political Capital Index to measure the strength and capability of US ruling parties and presidencies (Table 3). Table 3Political Capital Index The Political Capital Index shows a series of political and economic indicators, as of the latest available data (December or January), as well as the change since Biden’s election in November.5 Below we describe the political and economic categories of political capital that we chose and the data we use to represent them: Political Strength: The most basic measure of political capital is President Biden’s margin of victory in the popular vote (4.4%) and Electoral College vote (306/538), the number of days he has been in power, his party’s Congressional majorities, and the Supreme Court’s ideological leaning. These components will last for two-to-four years and can only be changed by new elections or deaths (Table 4). Even a president elected in a landslide would see his political capital decay over time. The sooner the next election, the less political capital the ruling party has. The president and Congress will have more trouble passing legislation just before the election and will be more careful about what they do pass to avoid punishment at the ballot box. Any difficult economic policies or reforms will tend to be done at the beginning of the term, as political capital is still abundant and the next election is not a clear and present danger. President Biden has moderate political capital. His popular victory was solid, his electoral victory was the same as President Trump’s, but his congressional majorities are weak. His initial legislative efforts should be assumed to pass but aside from his rescue plan and one or two reconciliation bills he will not be able to get much else done. Table 4Political Capital: White House And Congress Household Sentiment: Household sentiment is the origin of political capital since households are voters. We measure it through presidential net approval ratings, both in general and in handling the economy, as well as through consumer confidence (Chart 5). Household sentiment changes easily – it can drive policies and react to them. Even if the economy is objectively improving, sentiment can remain downbeat if politicians fail to communicate their policies, which could cost them the election. Measures that improve household pocketbooks or welfare are more popular than those that impose structural changes like taxes and regulation. But reforms are possible when a politician has sufficient political capital, or when a worse outcome would follow from doing nothing. Biden will start with a higher approval rating than President Trump but his average approval is not much higher at present and consumer confidence has ticked down as a result of the pandemic. His economic stimulus should create an improvement in household sentiment in the coming year. Chart 5US Households: Still Downbeat Business Sentiment: Business sentiment is another important element of political capital. Businesses that are confident about the economy’s prospects will spend on capex, new orders, and new hires, and they will also deplete their inventories (Table 5). Animal spirits respond to spending, taxation, regulation, and trade – all areas where politicians have some control. Table 5Political Capital: Household And Business Sentiment Policymakers can run down business sentiment by enacting painful policies for business, in favor of government or households or personal whim – or they can pass business-friendly policies to boost animal spirits. Businesses cannot vote like households but they have a powerful influence over politicians through lobbyists and political donations and a powerful influence on voters through employment. Higher animal spirits encourage new employment, which improves household welfare, thus boosting political capital. Biden is starting out fairly strong with respect to business sentiment, with the exception of the service sector, which is still beaten down by the pandemic. This is an area where his political capital could decay over time. Big business was happy to get rid of Trump’s trade war but now it faces larger government encroachment. This risk is flagged by small businesses, which are already highly distrustful of new taxes and regulation (Chart 6). Chart 6US Business Sentiment Chart 7Measures Of Polarization Political Polarization: Starkly divided populations and governments are often gridlocked or obstructionist, preventing policies from getting approved or implemented (Chart 7). Our polarization proxy measures the difference in approval of the sitting president according to party, while our economic polarization measure does the same for economic sentiment. Structural polarization is a low-frequency data series from political science literature that measures whether House members and senators tend to vote with the “party line” or “reach across the aisle.”6 The Philly Fed Partisan Index also measures the degree of political disagreement among politicians at the federal level. A highly polarized environment ensures that there will be strong opposition to any policy put forward by lawmakers and a higher likelihood of reversal by the next governing party. This leads to erratic policymaking and policy uncertainty among households and businesses. Lower polarization increases the durability of policies. Fiscal Policy: The government sector contributes to political capital through fiscal policy, especially fiscal thrust (the change in the cyclically adjusted primary budget deficit) (Table 6). An expansionary fiscal policy affords policymakers greater latitude – especially in times and places where inflation is not a public concern. It can also be an effort by the ruling party to boost its political capital when it is low, or when an election looms. The Biden administration is lucky to start off with a new business cycle, as Obama did in 2009, but the large dose of fiscal support today will become a fiscal drag by 2024 so the long-term effectiveness of today’s “pump priming” will be essential. Table 6Political Capital: The Economy And Markets Economic Conditions: Economic conditions are arguably the most important component of political capital. We included several objective measures of household wellbeing such as unemployment, inflation, gasoline prices at the pump, and wage growth. If voters have seen their quality of life improve under the current set of leaders then they are more likely to vote to continue their windfall. To judge whether a party will be re-elected, it is critical to know whether household wellbeing has changed since the last election. High unemployment, high inflation, high economic uncertainty, and high bankruptcy levels point to struggling voters who are more likely to take their grievances to the ballot box. By the same token, leaders will struggle to get anything done if voters are beset with these ills. Asset Markets: Asset markets play at least some role in determining political capital. Most voters are not highly exposed to the stock market, though they care about their pension fund. Most voters are highly exposed to the property market. A euphoric stock market will not necessarily buoy the political capital of a president or ruling party, as demonstrated by the recent election: President Trump’s approval was closely linked to the stock market, which also restrained his actions, yet a rallying market did not get him re-elected. A market crash will always hurt policymakers, especially if it happens just before an election. We watch the stock market primarily as a downside risk to the ruling party’s political capital rather than upside. Bottom Line: Our Political Capital Index is how we will monitor President Biden’s and the Democratic Party’s capability in the coming months and years. The administration begins with moderate political capital but it is likely to improve on economic recovery, which will be secured through control of Congress and the purse strings. Our confidence that Biden’s American Rescue Plan and one or two reconciliation bills will pass stems from this assessment. This means a large spending program and tax hikes are highly probable and investors should prepare for them. Investment Takeaways Signs of mania – from Bitcoin to TESLA to GameStop – have gripped the market as the combined effect of ultra-dovish monetary and fiscal policy is priced. This process can continue beyond reasonable expectations. Nevertheless we are prepared for near-term volatility and a correction at any time. The rollout of the COVID-19 vaccine faces inevitable bumps and the pandemic is still triggering government lockdown measures and consumer caution – though these will improve over time. Biden’s regulatory agenda and especially looming tax hikes will also spur some risk aversion in the near term as the House Democrats begin preparing a reconciliation bill. Overcoming the hurdle of Trump’s impeachment will free up the Senate to move forward on reconciliation as well, which means tax hikes will fall under the market’s radar sooner or later. A regular bill could be passed in February without new taxes but otherwise a reconciliation bill will pass as early as April and include at least some new taxes, even if they take effect next year. We would still use the opportunity to buy into any further weakness in value plays relative to growth plays (Chart 8). Fundamentally the economy is set to improve this year, the pandemic is set to subside, and the policy support will be reinforced and expanded as necessary. Chart 8A Setback For Growth Versus Value Chart 9Equity Correction Looms The reflation trade is technically over-extended, investors are complacent, and some profit-taking is due. The extremely depressed put-to-call ratio tracks well with the US dollar index, both of which are showing signs of life (Chart 9). We would fade a rebound in the dollar, however, as the Democratic Party’s policies will ensure widening twin deficits (budget and trade deficits) even as the Fed demonstrates its commitment to its new goal of allowing an inflation overshoot to make up for past undershoots.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1Political Risk Matrix Table A2Biden’s Cabinet Position Appointments   Footnotes 1     See BCA Research US Equity Strategy, “Overdose?” January 25, 2021, bcaresearch.com. 2     The Congressional Review Act of 1996 enables Congress to speed up the removal of regulations that were adopted recently, in this case since August 21, 2020. The process requires both houses of Congress to repeal a regulation but the Senate cannot prevent repeal via filibuster. The Trump administration used the law aggressively to remove several of President Barack Obama’s outgoing regulations. See Jonathan H. Adler, “Will Democrats Learn To Love The Congressional Review Act?” Reason, January 23, 2021, reason.com.  3    Democrats are explicitly interested in repealing the filibuster, as Biden and Senate Majority Leader Chuck Schumer have indicated (not to mention former President Obama who characterized it as a relic of the racist Jim Crowe era). 4    See Ed O’Keefe et al, “16 senators from both parties meet with White House on COVID-19 relief plan,” CBS News, January 25, 2021, cbsnews.com; Aamer Madhani and Lisa Mascaro, “White House Begins Talks With Lawmakers On COVID-19 Relief,” Associated Press, January 25, 2021, apnews.com.  5    Biden’s term technically began on January 20 but voters in 2024 will judge the president and ruling party based on whether they are better off than they were four years ago, i.e. when they last made a major judgment. 6    See Jeffrey Lewis, Keith Poole, Howard Rosenthal, et al, at voteview.org.  

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, 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