Developed Countries

Underweight We remain bearish on the prospects of the S&P real estate sector as the pandemic will continue to severely bruise REITs. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25%. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel). A fresh stimulus bill could come to the rescue, but recent news of President Trump halting negotiations jeopardizes chances for near-term relief. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels). Bottom Line: We remain underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO. For more details, please refer to this Monday’s Weekly Report.

Highlights Long-term investors who can tolerate volatility should buy SEK/USD for a potential 20 percent upside. Short-term investors who cannot tolerate volatility should buy CHF/USD. The dollar’s short-term moves are a perfect mirror-image of the global stock market. US and euro area long-duration bond yields will ultimately converge… …and the euro area’s huge trade surplus with the US will vanish. Fractal trade: Underweight European retailers versus market. Feature Chart of the WeekSEK/USD Is 20 Percent Undervalued Relative To The Sweden/US Bond Yield Differential The demand for a foreign currency serves one of four purposes: To buy goods and services denominated in the foreign currency. To buy long-term investments denominated in the foreign currency, also known as foreign direct investment (FDI). To buy shorter-term financial investments like bonds and equities denominated in the foreign currency, also known as portfolio flows.1 To buy currency reserves denominated in the foreign currency. What Sets The Broad Level Of EUR/USD? Looking at the euro, three of the four components of demand tend to change relatively slowly. The net foreign demand for euro area goods and services is not particularly volatile. Neither is FDI. Demand for euro reserves also tends not to suffer wild gyrations, except at the rare moment that a currency peg starts or ends.  All of which means that the usual driver of demand for euros are portfolio flows (Chart I-2). Chart I-2Euro Area Portfolio Flows Have A High Amplitude Portfolio flows are of two main types: fixed income and equity. However, in the euro area, fixed income portfolio flows usually have the much higher amplitude (Chart I-3). The reason is that most savings are invested in fixed income assets. For example, German households hold 80 percent of their assets in fixed income, cash, or close proxies. This explains why the stock of government fixed income securities in the euro area is almost twice as large as the market capitalisation of all the euro area’s stock markets (Chart I-4). Chart I-3Euro Area Fixed Income Portfolio Flows Have A Higher Amplitude Than Equity Flows... Chart I-4...Because Euro Area Fixed Income Is The Dominant Asset-Class What causes fixed income flows to flood out of the euro area one moment and back in the next? The answer is the expected change in interest rates. The main issue is not the exact timing of short-term interest rate changes. Instead, it is the so-called terminal rate: the average interest rate over the very long term, proxied by the long-duration bond yield. Fixed income investors gravitate to the bonds with the highest potential returns adjusted for currency hedging costs or likely currency moves. In the euro area, fixed income portfolio flows have a higher amplitude than equity flows. When the expected interest rate in the euro area declines relative to that in the US, it diminishes any further price upside of euro area bonds compared with that of US T-bonds. Hence, fixed income investors shift out of the less attractive euro area bonds into US T-bonds. The outflow continues until it has depressed EUR/USD to a level where the potential upside to the exchange rate becomes symmetrically more attractive. At this new lower level for EUR/USD, the fixed income portfolio outflow stops because a new equilibrium has been established. International fixed income investors have less upside from the euro area bond price, but they now have symmetrically more upside from the cheaper EUR/USD – and the two factors cancel out. Chart I-5 provides powerful evidence of this dynamic. For the past 15 years, the broad territory in which EUR/USD trades has been a close function of the euro area/US long-duration bond yield spread.3 A zero yield spread equates to EUR/USD in the broad territory of 1.35 with every +/-100 bps equal to +/- 15 cents. Hence, the current yield spread of -100 bps equates to EUR/USD trading in the broad territory of 1.20. Chart I-5The Euro Area/US Bond Yield Differential Sets EUR/USD... Interestingly, the euro area/US trade imbalance is also a close function of the bond yield spread. This confirms that the euro area’s massive trade surplus with the US is the direct result of the massive imbalance in relative monetary policy – which depressed EUR/USD and boosted the euro area’s relative competitiveness. Put simply, at a narrower (and more normal) bond yield spread, the euro area’s trade surplus with the US would largely vanish (Chart I-6). Chart I-6...And Thereby It Sets The Euro Area/US Trade Imbalance The Euro Area/US Yield Spread Is Likely To Narrow Further The long-term evolution of EUR/USD – as well as the associated trade imbalance – hinges on the long-term evolution of the euro area/US long-duration bond yield spread. Will this spread widen or narrow? At a narrower bond yield spread, the euro area’s trade surplus with the US would largely vanish. From the euro area side, the answer is easy. The spread cannot widen, it can only narrow. With the ECB policy interest rate already expected to be stuck at its lower bound indefinitely, down is not an option. From the US side, the spread could go either way, at least mathematically. However, it is our high conviction view that in the long term it will narrow. The Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric. The central bank has told us that it will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. Hence, when the slightest further deflationary shock comes – and sooner or later it will – US long-duration bond yields will converge with those in the UK and Japan in one of two ways. Either the Fed will follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or the Fed will follow the Bank of Japan in formally implementing yield curve control (Chart I-7).   Chart I-7The US Bond Yield Will Converge With The Others Buy SEK/USD For The Long Term, Buy CHF/USD For The Short Term Other European economies also exhibit the same strong link between their exchange rates with the dollar and their bond yield spreads with the US. In the case of Sweden, there is an attractive opportunity. SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread. Hence, the long-term case for owning SEK/USD does not even require the yield spread to narrow from where it stands today. Of course, if the spread did narrow by a further 50 bps, the potential upside would approach 30 percent (Chart of the Week). SEK/USD is still about 20 percent undervalued relative to the long-term relationship with the Sweden/US bond yield spread.  Nevertheless, for short-term investors, there is an important caveat. While fixed income portfolio flows drive the long-term values of European currencies versus the dollar, equity portfolio flows become dominant in periods of market stress. During such dislocations, equity flows tend to flee to perceived haven assets and markets, many of which are denominated in dollars. As a result, the dollar rallies. The compelling proof is that over the past year, the dollar has traded as a perfect mirror-image of the global stock market (Chart I-8). Chart I-8The Dollar In 2020 = A Perfect Mirror-Image Of The Stock Market In Europe, the haven currency is the Swiss franc. Hence, while SEK/USD fell by 10 percent during this year’s market turbulence, CHF/USD remained unperturbed. Furthermore, CHF/USD is also undervalued relative to its relationship with the Switzerland/US bond yield spread.4 Albeit, the undervaluation is more modest, at around 6 percent (Chart I-9). Chart I-9CHF/USD Is Modestly Undervalued Relative To The Switzerland/US Bond Yield Differential The conclusion is that long-term investors who can tolerate volatility should buy SEK/USD for its greater upside. Whereas short-term investors who cannot tolerate volatility should buy CHF/USD for its greater safety. Fractal Trading System* This week we note that the recent strong outperformance of European retailers is vulnerable to a trend reversal, and especially so if the pandemic resurges. Accordingly, the recommended trade is underweight European retailers versus the market (which can be implemented as EXH8 versus Euro Stoxx 600). The profit target and symmetrical stop-loss is set at 4.2 percent. Chart I-10European Retailers Vs. Market The rolling 1-year win ratio now stands at 56 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Footnotes 1 In this discussion, portfolio flows include short-term speculative flows. 2 For example, when the Swiss National Bank broke the franc’s peg with the euro in early 2015, it abruptly stopped buying euro reserves. 3 The euro area bond yield is the issue-weighted average of the euro area’s constituent sovereign bond yields. A good approximation of the euro area’s issue-weighted average is the French bond yield.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart I-1Indicators To Watch - Bond Yields Chart I-2Indicators To Watch - Bond Yields Chart I-3Indicators To Watch - Bond Yields Chart I-4Indicators To Watch - Bond Yields   Interest Rate Chart I-5Indicators To Watch - Interest Rate Expectations Chart I-6Indicators To Watch - Interest Rate Expectations Chart I-7Indicators To Watch - Interest Rate Expectations Chart I-8Indicators To Watch - Interest Rate Expectations  

Neutral - Downgrade Alert Absent another fiscal package, banks risk digesting a new wave of credit defaults, further increasing their loan loss provisions as pandemic wounds remain open. Importantly, according to the latest Fed data, small banks1 are at the forefront of sloppy lending activity, warning that those weaker banks have higher exposure to defaults than large banks.2 Small bank C&I loan growth reached a whopping 50% per annum growth rate (second panel). Commercial real estate (CRE) loans are also expanding at a higher rate in small banks compared with large banks (third panel). With regard to concentration, small banks have been making inroads in feverishly doling out loans versus large banks. The former now comprise 40% of total C&I loan books (the largest credit category, bottom panel) and 2/3 of CRE loans – the second largest loan category with $2.4tn outstanding. Inevitably, some loans will sour because of the pandemic and the longer it takes Congress to pass a fresh stimulus bill the higher the pain for banks. One way out of this mess will likely be via much needed industry consolidation. As a reminder the US still has 4,400 banks. Bottom Line: We remain neutral the S&P banks index, which is also on our downgrade watchlist since early September. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT.    Footnotes 1 Small banks are defined as all commercial banks excluding top 25 banks ranked by domestic assets. 2 Large banks are defined as top 25 commercial banks ranked by domestic assets.

Highlights Q3/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +19bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +10bps, led by overweights in US (+13bps), Canada (+2bps) and Italy (+4bps) that favored allocations to inflation-linked government bonds out of nominals. Spread product generated a similar-sized outperformance (+9bps), led by overweights to US investment grade corporates (+8bps). Portfolio Positioning For The Next Six Months: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar. Feature As we enter the final quarter of 2020, global financial markets are dealing with many near-term uncertainties related to the upcoming US presidential election, potential next moves in global policy stimulus and, perhaps most worrying, a second wave of coronavirus infections in Europe and the US. That means the “easy money” has been made in global fixed income from the unwind of the blowout in credit spreads, and collapse of government bond yields, seen following the COVID-19 related market turbulence of February and March. Investors should expect substantially lower fixed income returns in the coming months. Relative performance between countries and sectors will be the more dominant influence on bond portfolio returns in the absence of big directional moves in yields or spreads. Alternatively put, expect alpha to win out over beta. This week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2020 Model Portfolio Performance Breakdown: Another Positive Quarter, Led By Linkers & Corporates Chart of the WeekQ3/2020 Performance: Gains From Both Sides Of The Portfolio The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was 3.14%, modestly outperforming the custom benchmark index by +19bps (Chart of the Week).1 This is the second consecutive positive quarter, lifting the year-to-date outperformance into positive territory (+12bps) – an impressive accomplishment given the sharp drawdown that occurred during the market volatility of February and March. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +10bps of outperformance versus our custom benchmark index while the latter outperformed by +9bps. That government bond return includes a substantial gain (+17bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework back on June 23.2 In a world of very low bond yields (Table 2), our preference for the relatively higher-yielding government bond markets in the US, Canada and Italy was an important source of outperformance, delivering a combined excess return of +19bps (including inflation-linked bonds). This was only partially offset by the negative active returns from underweights in low-yielding countries such as Germany, France, and Japan (a combined drag of -9bps). Table 2GFIS Model Bond Portfolio Q3/2020 Overall Return Attribution In spread product, our overweights in US investment grade corporates (+8bps), UK investment grade corporates (+3bps) and US Agency CMBS (+4bps) were the main sources of outperformance, while the negative active return from underweighting Euro Area high yield (-2bps) was minimal. Our preference to favor higher-rated US high-yield relative to lower-rated US junk bonds, even as riskier credit rallied, did little damage to portfolio performance, with a combined excess return across all three US junk credit tiers of just -2bps. The moderate outperformance of the model bond portfolio versus the benchmark in Q3 is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors – particularly in sectors most strongly supported by central bank easing actions, like US investment grade corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q3/2020 Spread Product Performance Attribution By Sector Biggest Outperformers: Long US TIPS (+12bps) Overweight US investment grade industrials (+5bps) Overweight US Agency CMBS (+4bps) Overweight UK investment grade corporates (+3bps) Overweight US high-yield Ba-rated corporates (+3bps) Biggest Underperformers: Underweight French government bonds with maturity greater than 10 years (-4bps) Underweight US high-yield B-rated corporates (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2020. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3/2020 (red for underweight, dark green for overweight, gray for neutral).3 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q3/2020 The top performing sectors within our model bond portfolio universe in Q3 were well distributed among government bonds and spread products: Italian government bonds (relative index return of +3.8), New Zealand government bonds (+3.0%), EM USD-denominated sovereign (+2.6%), US high-yield corporates (2.4%), Spanish government bonds (+2.3%), and investment grade corporates in the UK (+2%) and US (1.9%). Importantly, we were overweight or neutral all of those markets during the quarter, driven by our main investment themes of “buying what the central banks are buying” and “yield chasing.”4 On the other side, we had limited exposure to the worst performing sectors during Q3, with underweights to government bonds in Germany and Japan, US Agency MBS and euro area high-yield. Cutting our long-standing overweight on UK Gilts to neutral in early August also benefitted the portfolio performance, with Gilts being the worst performer in our model bond universe by far in Q3. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +19bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. This is in line with the current strategic investment recommendations of the BCA Research fixed income services. Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. The overall duration of the portfolio is in line with that of the custom benchmark index (Chart 5), consistent with our strategic investment recommendation to be neutral on exposure to changes in interest rates. With central banks actively seeking to keep policy rates as low as possible until inflation returns – i.e. aiming to push real rates even lower - we expect the negative correlation seen between global inflation breakevens and real bond yields to persist over at least the next 6-12 months. Offsetting moves in both will continue to dampen the volatility of nominal bond yields, as has been the case over the past six months (Chart 6). Chart 5Overall Portfolio Duration Exposure: At Benchmark Central banks aiming for an inflation overshoot and negative real rates will also continue to boost the relative performance of inflation-linked bonds versus nominal equivalents. Chart 6Within Governments, Continue Overweighting Linkers Vs Nominals We see this as a similar environment to the years following the 2008 financial crisis, with central banks keeping rates at 0% while rapidly expanding their balance sheets via quantitative easing and cheap liquidity provision for banks. The result was a multi-year period where linkers outperformed nominal government bonds (Chart 7). Thus, we are maintaining a large core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy and Canada. Chart 7The Strategic Case For Inflation-Linked Bond Outperformance Chart 8Overall Portfolio Allocation: Moderately Overweight Credit Vs Governments In terms of country allocations on the government bond side of the portfolio, we continue to favor overweights in higher-yielding markets with overall global yield volatility likely to remain subdued. Chart 9Global QE Continues To Support Credit Markets That means overweighting the US, Canada, Australia, Italy and Spain, while underweighting Germany, France and Japan. The UK belongs in that latter list, but we are maintaining a neutral stance on the UK, for now, given the near-term uncertainty surrounding final Brexit negotiations and the surge in new UK COVID-19 cases. Turning to spread product, we are maintaining only a moderate aggregate overweight allocation versus government bonds, equal to 4% of the portfolio (Chart 8). The same aggressive easing of global monetary policy and expansion of central bank balance sheets that is good for relative inflation-linked bond performance also benefits global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has proven to be an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 9). With the combined balance sheet now expanding at a 40% pace, corporate bonds are likely to continue to outperform government debt over the next 6-12 months. Thus, our allocation to inflation-linked bonds and corporate credit, both out of nominal government bonds, are both motivated by the same factor – monetary policy reflation. The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. At the same time, we continue to maintain a cautious stance on allocations to countries and sectors within that overall overweight tilt towards spread product in the model bond portfolio. We prefer to stay relatively up-in-quality within global corporate debt, even with high-yield bonds in the US and Europe offering relatively high spreads using our 12-month breakeven spread metric (Chart 10).5 Chart 10US & European HY Offer Relatively Wide Breakeven Spreads Chart 11US & European HY Offer No Spread Cushion Against Rising Defaults The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. Our measure of the default-adjusted spread, calculated by taking the option-adjusted spread of the Bloomberg Barclays high-yield index and subtracting default losses, shows that high-yield spreads on both sides of the Atlantic will be dwarfed by expected default losses over the next year, assuming a typical pattern of defaults after recessions (Chart 11). We continue to prefer staying up-in-quality within our recommended corporate allocations, favoring Ba-rated US high-yield over B-rated and Caa-rated credit while also underweighting euro area high-yield relative to euro area investment grade corporates. This strategy lowers the yield of the model portfolio, which is currently in line with that of the custom benchmark index (Chart 12), at the expense of stretching for yields in riskier credit that may not be sustainable over the medium-term. Chart 12Overall Portfolio Yield: At Benchmark Chart 13Overall Portfolio Risk: Moderate At the same time, our measured stance on relative corporate exposure also acts to reduce portfolio risk – a useful outcome as we are targeting a relatively moderate tracking error (relative portfolio volatility versus that of the benchmark) within the model portfolio (Chart 13). Given the near-term uncertainties over the US elections and the potential second wave of COVID-19 in the US and Europe, staying relatively cautious on the usage of the “risk budget” of the portfolio seems prudent. Scenario Analysis & Return Forecasts In past quarterly reviews of our model bond portfolio, we have presented forecasts for the performance of the overall portfolio based off scenario analysis and some simple quantitative model-based predictions of various fixed income sectors. Given the unprecedented nature of the COVID-19 shock, we chose to avoid such model driven forecasts based on historical coefficients and correlations that may not be applicable. As it turns out, we may have been too cautious in that decision. The “risk-factor” models that we have used to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A) - have actually done a reasonable job of predicting yield changes over the past year. This can be seen in the charts shown in the Appendix on pages 18-20. Only in the case of US Caa-rated high-yield and EM USD-denominated corporates – two sectors where we are underweight given our concerns about valuation - have yields fallen by a far greater amount than implied by our models. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. For the government bond side, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those into changes in non-US bond yields by applying a historical yield beta (Table 2B). Table 2BEstimated Government Bond Yield Betas To US Treasuries Chart 14Risk Factor Assumptions For The Scenario Analysis For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs (Chart 14): Base Case: The US election result is initially uncertain, but a clear winner is determined within a few days. COVID cases continue to increase, but with less severe economic restrictions than during the first wave. Global growth continues to show steady improvement. There will be some additional global fiscal stimulus, with central banks keeping foot on monetary accelerator. There is mild bear steepening of the US Treasury curve with moderate widening of US inflation breakevens. The VIX reaches 25, the USD dollar depreciates by -5%, oil prices climb 10% and the fed funds rate remains at 0%. Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. Optimistic Scenario: The US election goes smoothly and a clear winner is declared on election night. The current uptick in global COVID cases does not turn into a full-blown second wave requiring severe economic restrictions. Global growth continues to steadily improve, with additional global fiscal stimulus and central banks staying highly dovish. The US Treasury curve bear steepens as US inflation expectations steadily increase. The VIX falls to 20, the USD dollar depreciates by -7%, oil prices climb 20%, and the fed funds rate stays at 0%. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15US Treasury Yield Assumptions For The Scenario Analysis Pessimistic Scenario: There is a contested US election result taking weeks to resolve, leading to major US social unrest. A full-blown second COVID-19 wave hits the world and severe economic restrictions are implemented. Governments become more worried about debt/deficits and deliver underwhelming stimulus. Central banks do not provide enough additional stimulus to offset the shocks. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX soars to 35, the USD dollar rise by 5%, oil prices fall -20%, while the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B and Chart 15). The model bond portfolio is expected to deliver an excess return over the next six months of +17bps in the base case and +27bps in the optimistic scenario, but is only projected to underperform by -1bp in the pessimistic scenario. Bottom Line: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of lobal Inflation Expectations", dated June 23 2020, available at gfis.bcaresearch.com. 3 Note that sectors where we made changes to our recommended weightings during Q3/2020 will have multiple colors in the respective bars in Chart 4. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 The 12-month breakeven spread measures the amount of spread widening that must take place for a credit product to have the same return over a one-year horizon as a duration-matched position in government bonds. We compare those breakeven spreads to their own history in a percentile ranking to determine the relative attractiveness of a credit product strictly from a spread and spread volatility perspective. Appen dix Appendix Chart 1US Investment Grade Sectors Appendix Chart 2US High-Yield Credit Tiers Appendix Chart 3US MBS & CMBS Appendix Chart 4Euro Area And UK Credit Appendix Chart 5Emerging Markets USD-Denominated Debt Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns