Economy

Highlights Monetary Policy: The Fed will keep rates at the zero bound at least until inflation is above 2% and it will maintain an accommodative policy stance until long-dated TIPS breakeven inflation rates move above 2.3%. Remain overweight spread product versus Treasuries and stay in nominal yield curve steepeners. Bond Yields & The Dollar: US dollar weakness will be bearish for bonds during the next 6-12 months. As long as the global economic recovery is maintained, the dollar will weaken further and bond yields have room to rise. EM Sovereigns: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio, with the exception of Mexico. Economy: August’s poor retail sales figures strengthen our conviction that further fiscal stimulus is required to sustain the economic recovery. Our base case outlook is that Congress will deliver that stimulus in the coming weeks, and that yields will be higher in 6-12 months. But the risk of no deal is too great to ignore. Keep portfolio duration close to benchmark for now. Fed Adopts Explicit Forward Guidance, But Leaves Many Questions Unanswered Chart 1Fed And Markets Agree: No Rate Hike Until 2024 Following last month’s adoption of an average inflation targeting regime, the next logical step was for the Fed to translate its new policy framework into more explicit forward rate guidance.1 The Fed took that step at last week’s FOMC meeting by adding the following language to its post-meeting statement: The Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.2 Chart 2A Long Way From 2% The new guidance says that the funds rate will not rise off the zero bound until three criteria are met: The labor market must be at “maximum employment” Inflation must be at or above 2% Inflation must be “on track to moderately exceed 2%” Notice that the criteria of “maximum employment” and inflation that “moderately exceeds 2%” are quite vague. In fact, Fed Chair Powell stated in his post-meeting press conference that “maximum employment” refers to a range of different labor market indicators, not just the unemployment rate. He also refused to provide more detail on how much of an inflation overshoot would qualify as “moderate”. This means that, practically, the only actionable information that the Fed gave investors is the promise that the funds rate won’t rise at least until inflation is at or above 2%. This is important info that can be easily visualized on a chart (Chart 2). We can plainly see that core inflation has a long way to go before it reaches the Fed’s target, and also that the Fed will not be making the same hawkish policy mistake it made in 2015, when it lifted rates with year-over-year core PCE inflation at 1.2%. Monetary policy will remain accommodative and supportive for risk assets until TIPS breakeven inflation rates return to well-anchored levels. For their part, FOMC participants don’t expect inflation to reach the 2% target for quite a while. The median participant doesn’t see core inflation reaching 2% until sometime in 2023, and only 4 out of 17 participants expect to lift rates before 2024. This is consistent with market pricing. The overnight index swap curve doesn’t price-in a full 25 basis point rate hike until September 2024 (Chart 1). Investment Implications We know that the Fed wants inflation to overshoot 2% for some period of time. Now, based on last week’s new guidance, we also know that no rate hikes will occur until inflation is above 2%. However, we still don’t know how much or how long of an inflation overshoot the Fed is targeting. For this reason, we think investors would be wise to keep in mind that the goal of the Fed’s new framework is to ensure that inflation expectations return to well-anchored levels. Our sense is that “well anchored” can be defined as a range of 2.3% to 2.5% for long-maturity TIPS breakeven inflation rates (Chart 3). Chart 3Inflation Expectations: The Fed's Real Target We see monetary policy staying accommodative and supportive for risk assets until TIPS breakeven inflation rates reach those levels. This argues for maintaining an overweight 6-12 month allocation to spread product versus Treasuries. This also argues for staying overweight TIPS versus nominal Treasuries, and for positioning in nominal yield curve steepeners. The Fed will maintain its firm grip on the front-end of the curve for a long time yet, but the market will eventually start to price-in liftoff at the long end. A Weaker Dollar Will Be Bearish For Bonds, Bullish For EM Sovereign Spreads The broad trade-weighted US dollar is 8% off its 2020 peak, and the BCA house view is that the dollar will weaken further during the next 12 months. This section explores what that will mean for Treasury yields and for USD-denominated Emerging Market Sovereign debt. The Dollar And Treasury Yields Bond yields and the dollar are intimately related, but the relationship is more complex than a simple coincident correlation. We like to think of the relationship as a feedback loop between the exchange rate, bond yields and global economic growth (Chart 4). Chart 4The Dollar/Bond Feedback Loop Since the dollar is currently falling, let’s start at the left-hand side of the feedback loop shown in Chart 4. The dollar’s current weakness is both a reflection of improving global economic growth and a catalyst for even stronger global economic growth. It is reflective because, compared to the rest of the world, the US is a large and stable economy. Firms and investors will respond to a positive global growth environment by sending capital overseas in search of higher returns. This puts downward pressure on the dollar. Dollar weakness also boosts global economic growth by making US dollars cheaper to acquire in global markets. This is particularly important for emerging markets, where a weaker dollar gives policymakers leeway to boost domestic growth via easier monetary and fiscal policies, without sacrificing the purchasing power of their currencies. Higher yielding countries tend to have less economic slack than low yielders. Moving to the top of the loop, stronger global economic growth (aka global reflation) will obviously impart upward pressure to bond yields. What’s less obvious is that US yields will rise by more than yields in the rest of the world. Chart 5 shows 3-year trailing yield betas for several major developed bond markets. Notice that the highest-yielding countries (US and Canada) also have the highest yield betas. This means that their yields rise the most when global bond yields are rising and fall the most when global bond yields are falling. This pattern holds because higher yielding countries tend to have less economic slack than low yielders. In other words, the high yielders will be quicker to price-in eventual monetary tightening when global growth is on the upswing. The high yielders also have more room to fall when growth ebbs. Chart 5High Yielding Bond Markets Are The Most Cyclical Initially, global reflation sends US bond yields higher. But eventually, US yields will become too high relative to the rest of the world. At that point, the US dollar will respond to wide interest rate differentials and start to appreciate. This dollar appreciation will eventually lead to slower economic growth (“global deflation”), which will cause bond yields to decline. Finally, just as US bond yields rise more than non-US yields during the global growth upswing, they also fall more during the downswing. Eventually, the tightening rate differentials lead to US dollar depreciation and the cycle repeats. Where are we situated in the cycle right now? As of today, we contend that rate differentials between the US and the rest of the world have fallen a lot, and we are at the stage of the loop where the dollar is weakening in response (Chart 6). This means that dollar weakness has further to run, and we should expect that it will eventually lead to global reflation and higher US bond yields. In fact, Chart 7 shows that sentiment toward the dollar has already soured considerably, and that increasingly bearish dollar sentiment has a habit of leading to higher bond yields. Chart 6Rate Differentials Signal More Downside For Dollar Chart 7Bearish Dollar Sentiment Leads To Higher Bond Yields Eventually, US yields will rise too much compared to the rest of the world and the dollar’s depreciation will stop. But for now, dollar weakness is bearish for bonds. The Dollar And USD-Denominated EM Sovereign Spreads USD-denominated Emerging Market Sovereigns are an obvious sector that benefits from a weaker US dollar. Since the debt is denominated in US dollars but the country collects tax revenues in its local currency, any dollar weakness makes the issuer’s debt easier to service, and presumably leads to tighter sovereign spreads. Most of the dollar’s weakness this year has come against other developed market currencies, not against EMs. Despite this relationship, we are reluctant to advocate an overweight allocation to EM Sovereigns. First, most of the dollar’s weakness this year has come against other developed market currencies, not against EMs (Chart 8). Chart 8EM Currencies Have Lagged Second, an environment of US dollar depreciation and global reflation is also a good environment for US corporate bonds and, with a couple exceptions, US corporate spreads are more attractive than EM Sovereign spreads. The vertical axis of Chart 9 shows the spread differential between the USD-denominated bonds of several EMs relative to a position in US corporate bonds with identical duration and credit rating. After differences in duration and credit rating are considered, only Turkey, Colombia, South Africa, Mexico and Russia offer a spread advantage over US corporate credit. The horizontal axis of Chart 9 shows each country’s export coverage of its foreign debt obligations. Greater coverage should make that country’s currency less vulnerable to depreciation, and vice-versa. In our view, the Turkish, Colombian and South African currencies are simply too risky. But Mexico and Russia present more interesting opportunities. Chart 9EM Sovereign Spread Over US Credit Versus Currency Vulnerability We recommend an overweight allocation to Mexican Sovereigns because they offer a spread advantage relative to US corporates, and because the currency has been on an appreciating trend versus the dollar that still has further to run to get back to pre-COVID levels (Chart 8, panel 3). Despite the small spread pick-up, we would avoid Russian Sovereigns, at least until after the US election. The Ruble has been depreciating versus the dollar since mid-year (Chart 8, bottom panel) and a Democratic sweep in November will likely lead to the imposition of fresh US sanctions on Russia.3 Bottom Line: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio. Despite the outlook for US dollar weakness, US corporate bonds offer more value and will deliver better returns. Mexican debt is the sole exception. Mexican spreads are attractive and the peso has room to appreciate. Economic Update: Signs Of Weakness In Consumer Spending  Chart 10A Warning From Retail Sales In last week’s report, we warned that without a fresh round of fiscal stimulus, the 12-month outlook for US consumer spending is dire.4 Then, last Wednesday, we received August’s retail sales figures – the first month of spending data since the expiry of the CARES act’s income support provisions – and learned that spending contracted on the month, after having rebounded sharply in May, June and July when the CARES act was in full force (Chart 10). There had been some hope that US consumers might be able to compensate for the lack of income by deploying some of the savings they had built up in the spring, thus keeping spending at decent levels for at least a few months. But August’s weak retail sales report challenges that narrative, as does the fact that consumer sentiment surveys have not improved very much since April (Chart 10, panel 3). Still low consumer sentiment suggests that households remain cautious and that they will be reluctant to spend with the same abandon they showed prior to COVID. We also note that, while weekly initial jobless claims continue to fall, the pace of improvement has significantly tapered off during the past few weeks and initial claims are still coming in about 4 times higher than they were last year (Chart 10, bottom panel). Bottom Line: While significant strides have been made, the US economy is not out of the woods. Our base case view is that Congress will deliver sufficient household income support in the coming weeks, allowing the economic recovery to continue. But the risk that they won’t is too great to ignore. Keep portfolio duration close to benchmark for now, and position for higher yields on a 6-12 month horizon via less risky duration-neutral yield curve steepeners. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed examination of the Fed’s new average inflation targeting regime please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 3 Please see Geopolitical Strategy / Emerging Markets Strategy Special Report, “US-Russia: No Reverse Kissinger (Yet)”, dated July 3, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Feature In last week’s US Bond Strategy report, we presented the results of a scenario analysis on consumer spending.1 The goal of that analysis was to assess how much additional federal government income support is required to achieve consumer spending growth targets that won’t disappoint markets. The calculations regarding the amount of additional stimulus required to hit different spending targets are correct. However, a typo in our code (in fact, a missing letter “c”) caused us to specify the wrong targets. Last week, we targeted -3% 12-month over 12-month consumer spending growth for the period between March 2020 and February 2021. The rationale being that -3% was the worst spending growth seen during the 2008 Great Recession and would likely be the minimum that markets could tolerate this time around. As shown in the second panel of Chart 1, this number should have been -1.9%. Chart 1Consumer Spending Driven By Income & The Savings Rate We also considered spending growth targets for the 12-month period between August 2020 and July 2021. Last week we set our target range for that period at between 2% and 6%, the growth rates seen during the recovery years that followed the Great Recession. That range should have been set at 2.5% to 5%. We present revised results from our scenario analysis in Table 1 and Table 2. These tables are identical to the ones presented last week, except that they now have the correct consumer spending targets. Table 1Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Table 2At Least $600 Billion More Government Income Support Is Needed Our conclusion remains similar, though our corrected numbers suggest that more income support from the federal government will be required to hit reasonable spending targets. Last week, we concluded that extra income support on the order of $500 - $800 billion is the minimum that will be required. Our corrected numbers suggest that more stimulus will be necessary, on the order of $600 billion to $1 trillion.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com

Highlights Consumers are the beating heart of the US economy, … : By showering cash on the newly unemployed, and issuing checks to more than half of all taxpayers, the CARES Act arrested April’s free fall in consumption and helped households meet their financial obligations. … and if they’re waylaid by the pandemic, only a forceful fiscal response stands in the way of reduced future growth: Bankruptcies and widespread displacement of workers would turn a nasty cyclical shock into lower trend growth. How big does the next round need to be?: Applying a framework developed by our US Bond Strategy colleagues, we estimate that consumption growth will get back to trend if Congress provides $800 billion of aid to households through the first half of next year. Is it likely something that size can get through Capitol Hill?: Assistance for reeling states is a potential sticking point, but we continue to believe that a major aid package will pass. If it doesn’t, the election outcome will loom large over the 2021 outlook. Feature Over BCA’s 70-plus years, our research teams have developed hundreds if not thousands of proprietary indicators to project where financial markets and the major economies are headed. They are central to our process and we are continuously engaged in trying to improve them. Sometimes, though, it helps to take a step back and look at the landscape from the broadest and simplest perspective. When we do, we remind ourselves of what we have come to think of as macroeconomics’ fundamental lesson: My spending is your income and your spending is my income. Consumption isn't just four times as large as each of the other two main components of US GDP, it also exerts a gravitational pull on them. The truth of this simple formulation is especially easy to see in the United States, where consumption accounts for two-thirds of GDP (investment and government spending each contribute one-sixth, ignoring net exports’ modest drag). The US economy would shrivel if household spending were to fall sharply, and the second-order effects on investment and government receipts would prolong the agony. The former is a function of consumption; businesses only invest once it’s clear that demand has overtaken existing capacity or will soon do so. Reduced consumption would pressure employment and profits, squeezing federal revenues that are almost entirely composed of individual income taxes, payroll taxes and corporate income taxes (Chart 1). Transfers from the federal government account for one-third of the states’ total revenues (Chart 2); since most of them are forbidden to run budget deficits, they would face immediate cutbacks if the flows from Washington were to slow. Chart 1Consumption Exerts An Outsized Impact On Federal ... Chart 2... And State Government Revenues Plugging The Gap Recognizing that a wobbling consumer has the potential to topple several economic dominos, Congress undertook extraordinary measures to keep a vicious short-term shock from impairing growth into the intermediate and long term.1 The CARES Act included provisions to support ailing industries and small businesses, but its efforts at shoring up vulnerable households have been the most effective by far. Direct payments of $1,200 to every adult and $500 to every child in households earning less than $99,000 ($198,000 for married filing jointly taxpayers) and weekly $600 supplemental unemployment benefits helped push personal income well above February’s pre-pandemic level (Chart 3). Chart 3The CARES Act Gave Lower-Income Households An Enormous Boost With income rising, especially for those at the lower end of the income distribution, households were able to stay current on their rent (Table 1), their mortgage and all their other obligations (Table 2). They were even able to pay down their credit card balances, an unusual occurrence at the start of a recession (Chart 4). Residential landlords and personal lenders breathed a sigh of relief, along with the entities that have lent to them, though they must be wondering how their obligors will fare now that the CARES Act’s supplemental unemployment benefit has expired. Households built up $325 billion of savings from March through July, which helped tide them over in August and is presumably doing so in September, but we expect that cracks may be beginning to show and that they will emerge in force in October if another round of aid is not forthcoming. Emergency CARES Act fiscal transfers were so large that they more than offset the drag from declining compensation as employees were laid off or worked less than full time during the lockdowns. Table 1September Slowdown? Table 2Credit Performance Across Personal Loan Categories Was Solid Through July Chart 4Strapped Households Usually Run Up Their Credit Card Balances When Recessions Hit How Much Will It Take? Deficit spending is a charged issue, especially among those at the upper end of the income distribution who will ultimately be taxed to repay the debt to fund today’s deficits. However, we agree with the mainstream economic consensus that issuing another two or three trillion dollars of debt at negative real yields is preferable to suffering the hysteresis effects of an uncontained surge of bankruptcies. From a short-term perspective, vigorous fiscal support is the only thing that can preserve the seeming dichotomy between the real economy’s struggles and the equity and credit markets’ bliss.2 The key practical question is how big the next round needs to be to allow policymakers to extend the bridge over the gap opened by the pandemic. Our US Bond Strategy colleagues addressed that question head on last week.3 They proceeded from the assumption that a certain minimum level of consumer spending growth is necessary to meet market participants’ generally sanguine recovery expectations. They then focused on how household income (what comes in) and the savings rate (how much is held back) might evolve under pessimistic and optimistic scenarios and a base-case scenario that splits the difference between the two. Their estimates of required support from a new round of fiscal transfers are simply the difference between the spending that would occur without the transfers and the minimum required spending. Looking at the 12-month moving average of consumer spending to smooth out single-month swings, and comparing it to its year-ago level (a 12-month-over-12-month basis), we map out three nominal growth targets for the August 2020 to July 2021 period: 3%, 4% and 5%, consistent with the range that prevailed once the economy found its footing after the global financial crisis (Chart 5). Instead of performing the analysis under all three of our colleagues’ scenarios, we simply use the split-the-difference base case that has household income ex-CARES Act transfers (Chart 6, top panel) and the savings rate (Chart 6, bottom panel) returning to their pre-pandemic level by September 2021. Chart 5Outside Of Recessions, Consumer Spending Growth Typically Occupies A Tight Range Chart 6Recovery Scenarios For Consumption's Drivers The results are shown in Table 3. The 4% nominal rate of consumption matches the economy’s trend growth since the GFC (2-to-2.25% real plus 1.75-to-2% inflation), 3% allows for a sluggish recovery in which the virus only slowly loosens its grip and 5% covers the possibility of a burst of above-trend growth that might follow a better-than-expected virus outcome. We project that households will require an average of $70-to-94 billion of monthly income support to grow 12-month-on-12-month consumption by 3-to-5%. A repeat round of stimulus checks would chip in $23 billion, leaving supplemental unemployment insurance benefits and the extension of benefits to workers that would not otherwise be covered by their state unemployment insurance program to pick up much of the rest of the $50-to-70 billion tab. Once those programs were fully up and running in May, June and July, they distributed an average of $92 billion per month ($77 billion supplemental benefits and $15 billion expanded eligibility). Those numbers suggest that unemployment-related transfers amounting to 55-to-75% of the CARES Act transfers would suffice, which is encouraging because the Senate and the White House now view its $600 weekly supplement as too generous. The unemployment rate has fallen since the spring, however, with fewer households in line to receive payments, so lawmakers will have to devise other ways to get money into the hands of consumers. Given that states and municipalities face an acute cash crunch and Democrats have insisted on addressing it, there is a good chance that states will receive a healthy allocation and some of the state funds will eventually find their way to households. Table 3Another Round, Please The bottom line for investors assessing the adequacy of a stimulus bill is that we think it should allocate at least $800 billion to support household income. A bill in the mid-to-high $1 trillion range that would split the difference between Republican and Democratic proposals should suffice and it would leave ample room for desperately needed support for state and local governments. Public transit systems like the gasping New York city subway, which suffered ridership declines of as much as 80-90% at the height of the lockdown while incurring significant new cleaning costs, may otherwise have to impose draconian service cutbacks that undermine their local economies’ efforts to reopen. The Fundamental Theorem Of Microeconomics At the University of Chicago’s Booth School of Business, Introductory Microeconomics is called Price Theory to keep the central lesson of the course in every student’s mind: people respond to incentives. We have come to think of this as the fundamental rule of microeconomics. It is the foundation of public policy’s attempts to shape behavior: If you want more of something, subsidize it; if you want less of something, tax it. When mulling the prospects for the passage of a significant new aid bill, we begin and end with a consideration of the key players’ incentives. The Democrats want a bill to demonstrate that government can be the solution and to push back against the anti-government narrative that has taken root over the last 40 years. The administration should be doing its utmost to obtain a robust spending package since recessions have reliably sunk incumbent presidents’ re-election prospects. Republican senators, even those who are not up for election this year, should want a bill because control of the Senate is likely to go to the party that wins the White House and individual senators’ power and influence are magnified when they are in the majority. Despite months of posturing and foot-dragging, we second our geopolitical strategists’ view that an aid package aligning with all the major players’ interests will pass soon. Investment Implications Much of our constructive take on markets and the economy proceeds from our view that another significant round of fiscal aid is forthcoming. If it is not, we would revisit our bullish 12-month asset allocation recommendations and we would close out our overweight on the SIFI banks’ stocks. An assumption that humankind will find a way to tame COVID-19 on a timetable in line with market expectations is also embedded in our 12-month equity overweight. If a second wave of infections takes hold, the mortality rate moves significantly higher and treatment and/or vaccine progress unexpectedly reverses, our recommendations will get more cautious. If it is in the interests of all of Washington's key players to pass a bill, there's an awfully good chance that bill will get passed. Although those in the know have lately become more optimistic that the first installment(s) of an effective vaccine(s) will become available in the next two quarters (Chart 7), such an outcome is not assured. A client asked us last week what would ensue if a vaccine is not available until the third or fourth quarter of 2021. As we talked through it with her, we could not escape the idea that the election could be hugely consequential for markets if the lack of a vaccine coincides with a failure to pass a stimulus package before the election, or with a stimulus package that does not extend beyond the end of March. Chart 7Rising Odds Of A Vaccine Within The Next Six Months If the next round of stimulus is not passed before the election, or if it is set to expire two or three quarters before an effective vaccine will be available in sufficient quantities to turn the public health tide, fiscal policy would become the single most important driver of the near-term market and economic outlook, given our view that the Fed has already done nearly all it can do. Congress would then take center stage, with the White House playing a secondary role based on its veto power and the influence of the bully pulpit. In that case, we would expect equity and credit markets to fare much better under a Blue Wave outcome in which the Democrats sweep the election than they would in any outcome that leaves Republicans in control of the Senate. Think of it like this: if the economy needed fiscal aid to counter six-to-twelve more months of pandemic disruptions two years before Congress again had to face voters, would you rather appeal to Pelosi, Schumer and Biden, champing at the bit to demonstrate how government can alleviate suffering, or Mitch McConnell, itching to teach profligate cities and states a lesson?   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The Fed leaped into the breach as well, but we have already discussed its efforts in detail. This report focuses on fiscal policy. 2 Please see the September 18, 2020 BCA Research Special Report, "The US Economy vs. The Stock Market: Is There A Disconnect?" available at www.bcaresearch.com. 3 Please see the September 15, 2020 US Bond Strategy Weekly Report, "More Stimulus Needed," available at usb.bcaresearch.com.

Highlights While the bull market in the Australian dollar might pause temporarily, it will advance further this cycle. The key catalyst for the AUD is an improving balance-of-payments backdrop. Despite its explosive rise, the majority of our models still show the Aussie as relatively cheap. At the crosses, AUD/NZD, AUD/CAD, and AUD/CHF are attractive. Buy AUD/NZD if it drops to 1.05. Feature Chart I-1A V-Shaped Recovery The bounce in the Australian dollar has been remarkable. From a low of 55 cents, the Aussie is up over 30% from the March 19 lows, making it the best performing G10 currency over the period. In technical parlance, the Aussie has entered a bull market. More importantly, the performance of the AUD has been a mirror image of broad stock market indices, suggesting investors have been using both vehicles to reprice a global recovery (Chart I-1). The rise in the Aussie dollar raises a few questions. First, do conditions remain in place for continued appreciation in the exchange rate? Second, at what AUD levels does currency strength tighten domestic financial conditions significantly? Finally, what are the opportunities at the crosses that investors could leverage on? A Terms-Of-Trade Boom For over four decades, one of the key primary drivers of the AUD exchange rate has been the basic balance. For simplicity, our definition of basic balance is just the sum of the current account and long-term capital flows, such as foreign direct investment. Remarkably, Australia’s basic balance is making new secular highs, despite the fact that the commodity boom peaked almost a decade ago (Chart I-2). The big divergence between an improving basic balance and a relatively soft trade-weighted currency suggests room for mean reversion is substantive. Australia’s basic balance is making new secular highs, despite the fact that the commodity boom peaked almost a decade ago. There are three key drivers behind the improvement of Australia’s balance-of-payment dynamics. First, in terms of economic recovery, China has led the pack vis-à-vis other countries by simple virtue of the fact that the authorities started injecting stimulus much earlier on, which helped ease domestic financing conditions. Chart I-3 shows that Chinese domestic imports are tracking the easing in financial conditions we saw earlier this year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil have been exploding higher. These have benefited Australian export volumes Chart I-2Improving Balance Of Payments Chart I-3Chinese Imports To Improve Further Remarkably, there have been notable improvements in recent months that suggest economic velocity in China may be picking up: Production of electricity and steel, which are inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. If these leading indicators continue to advance, as we believe they will, it will suggest further upside in the Chinese industrial cycle (Chart I-4). Chart I-4Chinese End-Use Is Improving The second reason behind Australia’s improving balance-of-payment dynamics has been increasing relative competitiveness in the types of raw materials that China needs and wants. In recent months, both steel and iron ore prices have been soaring. Part of the reason is because Australian exporters produce higher-grade ore, which is more expensive, pollutes less and is in high demand in China. Going forward, Australia’s terms-of-trade improvement is likely to continue. This is because of another tectonic shift in China: an energy policy shift away from coal and towards natural gas (Chart I-5). Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-6). Given that reducing, if not outright eliminating, pollution is a long-term strategic goal in China, this will provide a multi-year tailwind. Already, Australian oil and gas stocks have been outperforming global bourses on the back of this tectonic shift. Such outperformance could help drive portfolio flows into Australia, further buffeting the currency (Chart I-7). Chart I-5A Tectonic Shift In Chinese Energy Policy Chart I-6Australia Is Becoming A Big LNG Player Chart I-7A Bull Market In Aussie Energy? Will Domestic Factors Derail The Aussie? The jobs report out of Australia yesterday was stellar. The economy added 111,000 jobs, pushing the unemployment rate down from 7.5% to 6.8%. This was within the context of a rise in the participation rate to 64.8%. This is an impressive feat given that Melbourne was effectively in complete lockdown in August (Chart I-8). The key takeaway is that as a manufacturing-oriented economy, the impact of social distancing and lockdowns in Australia are less severe than for service-oriented economies. This could be the story over the next year, allowing the AUD to outperform not just the USD but also other currencies with a higher share of services in their economies. Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix.  Monetary and fiscal policy have obviously played a big role as well. The Reserve Bank of Australia has cut interest rates to 0.25% and is doing yield-curve control on three-year maturities at 0.25%. The Liberal-National coalition government has also been very proactive, especially with the “Job Seeker” and “Job Keeper” scheme, which has provided a valuable cushion for domestic economic conditions (Chart I-9). With a very low government debt burden, there is obviously scope to expand the scheme further. Chart I-8The Employment Market Is Recovering Chart I-9A Big Fiscal Thrust The boost in confidence has helped engineer a meaningful recovery in Australian house prices (Chart I-10). More importantly, this recovery is driven by domestic concerns rather than by foreigners (Chart I-11). This suggests that at least at the margin, house prices are being driven by domestic demand/supply fundamentals. The key takeaway is that relative to its commodity-currency peers, Australia is well along its house-price adjustment path. This should favor Australian real estate and bank stocks relative to those in Canada (Chart I-12). Chart I-10A Housing Market Recovery Chart I-11Credit Is Flowing To Households, Not Foreigners/Investors Chart I-12Aussie Real Estate Relative To Canadia The economic recovery is already being priced in by the long end of the Australian bond curve. Long-term rates have collapsed in the US, relative to Australia, the latter offering a 40 basis point premium. Should US real rates move further into negative territory, this could continue to provide an interest-rate cushion for the AUD (Chart I-13). A further steepening in the Australian yield curve will be positive for banks, which have lagged the index, and could play catch up (Chart I-14). Chart I-13AUD Follows Long-Term Rates Chart I-14Australian Banks And The Yield Curve   How High Can The AUD Bounce? Usually, a rise in the AUD over a cycle goes uninterrupted until the cross becomes expensive. On this basis, the Australian dollar remains accommodative. Our purchasing power parity (PPP) models point to an 8% undervaluation in the Australian dollar. One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 10% (Chart I-15). Our fundamental intermediate-term timing model, which uses real bond yield differentials and commodity prices, shows the Australian dollar as 5% cheap, or one standard deviation below the mean (Chart I-16). Chart I-15The AUD Is Cheap Chart I-16Our Timing Model Is Buying AUD Importantly, while our momentum indicators are stretched in the short term, speculators are still neutral the currency. Like the US dollar, the Aussie tends to be a momentum currency, with speculators that typically remain long over the cycle driving it to overvalued levels (Chart I-17). In terms of currency performance, the Australian dollar remains 10% below its 2018 peak and almost 35% below its 2011 peak, suggesting there is much scope for mean reversion. Chart I-17Speculators Are Not Yet Bullish Opportunities At The Crosses Long AUD/NZD and long AUD/JPY remain attractive bets. While our momentum indicators are stretched in the short term, speculators are still neutral the currency. As for AUD/NZD, our bias is that terms of trade in Australia will continue to outperform that in New Zealand. AUD/NZD and relative terms of trade tend to move together (Chart I-18). Meanwhile, the exchange rate is cheap on a historical basis. Furthermore, the Reserve Bank of New Zealand is likely to continue with more dovish forward guidance, relative to the RBA, which will favor AUD/NZD (Chart I-19). As a percentage of GDP, the RBNZ is more aggressive in terms of asset purchases. Buy the cross if it touches 1.05. Chart I-18AUD/NZD And Terms Of Trade Chart I-19AUD/NZD And Balance Sheet Policy AUD/JPY is a bet on a continued global economic recovery, and any drop below 74 is a buying opportunity. Interestingly, speculators remain short the cross despite a nice run-up from the March lows.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data from the US have been positive: Headline inflation increased from 1% to 1.3% year-on-year in August. Core inflation also edged up from 1.6% to 1.7% year-on-year. The NY Empire State Manufacturing Index jumped from 3.7 to 17 in September. Retail sales increased by 0.6% month-on-month in August. Initial jobless claims increased by 860K for the week ending on September 11. The DXY index increased by 0.3% this week. On Wednesday, the Fed kept interest rates unchanged and made a bold statement that they would keep rates low until inflation comes back to the 2% target. New economic projections show that most policymakers see interest rates on hold through at least 2023. Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have been positive: The ZEW Economic Sentiment Index surged from 64 to 73.9 in September. The trade surplus widened from €16 billion to €20.3 billion in July, led by a faster decline in imports. Industrial production fell by 7.7% year-on-year in July, following a 12% contraction in June. Both headline inflation and core inflation remained flat at -0.2% and 0.4% year-on-year, respectively. The euro fell by 0.4% against the US dollar this week. While downside risk still looms for the euro area growth, we believe that the euro will continue to appreciate, as the structural growth rate of the euro area should improve relative to the US amid global economy recovery. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan have been negative:  Industrial production plunged by 15.5% year-on-year in July. The total trade balance increased from ¥10.9 billion to ¥248.3 billion in August due to a steeper decline in imports. Exports fell by 14.8% year-on-year, while imports slumped by 20.8%. The Japanese yen appreciated by 1.5% against the US dollar this week. The BoJ kept interest rates steady this Thursday and upgraded its view on the economy outlook. Moreover, the governor Haruhiko Kuroda said that the Bank will not only monitor inflation trends but also the overall economy, including job growth, for future guidance. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data from the UK have been mixed: The total trade surplus narrowed from £3.9 billion to £1.1 billion in July. The unemployment rate rose to 4.1% from 3.9% in July. Average earnings improved by 0.2% quarter-on-quarter for the three months to July. Headline inflation declined from 1% to 0.2% year-on-year in August. Core inflation slipped from 1.8% to 0.9% in August. The British pound appreciated by 0.8% against the US dollar this week. On Thursday, the BoE kept interest rates on hold at 0.1%. While recent data have been stronger than expected, multiple threats still loom, including a second wave of COVID-19, a no-deal Brexit, and the possibility of persistent high unemployment. The Bank is now considering all options, including negative interest rates, to support the economy. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data from Australia have been positive: House prices fell by 1.8% quarter-on-quarter in Q2. However, this is a 6.2% increase compared with the same quarter last year. The Westpac Leading Index increased from 0.05% to 0.48% in August. On the labor market front, the unemployment rate fell from 7.5% to 6.8% in August. 111K jobs were added in August, including 74.8K part-time positions and 36.2K full-time positions. The Australian dollar has been flat this week. The RBA minutes released this week stated that the Bank will maintain its “highly accommodative settings” as long as required to further support the economy. Please refer to our front section this week for a more detailed analysis of the Aussie dollar. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data from New Zealand have been negative: GDP slumped by 12.2% quarter-on-quarter in Q2, or 12.4% year-on-year, the largest decline on record. The current account balance shifted to a surplus of NZ$1.8 billion in Q2 from a deficit of NZ$1.47 billion the same quarter last year, led by the sharp decline in domestic demand. The New Zealand dollar appreciated by 0.5% against the US dollar this week. The latest GDP release, while negative, was better than expectations. Goods industries, which make up 20% of the total economy, declined by 16.3% quarter-on-quarter in Q2. Services industries, which make up more than 50% of the economy, also fell by 10.9%. The path of the recovery will be highly contingent on COVID-19 developments. 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 II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have been mixed: Manufacturing sales increased by 7% month-on-month in July, following a 20.7% surge the previous month. Headline inflation was flat at 0.1% year-on-year in August, below market expectations of 0.4%. Core inflation edged up from 0.7% to 0.8% year-on-year in August. ADP employment recorded a loss of 205.4K jobs in the month of August. The Canadian dollar fell by 0.4% against the US dollar this week. The latest inflation report shows that gasoline prices were down 11.1% year-on-year in August, which has been a drag on inflation. On the other hand, prices of personal care services, including haircuts, have been increasing, as the cost to implement COVID-19 safety measures are being passed on to customers. With extremely low inflation, the BoC would most likely maintain interest rates low to support the economy recovery. 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 II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been positive: Total sight deposits increased from CHF 702.9 billion to CHF 704.1 billion for the week ending on September 11. Real exports increased by 2.9% month-on-month in August, while real imports fell by 1.3%. The trade surplus widened from CHF 3.3 billion to CHF 3.6 billion in August. PPI fell by 3.5% year-on-year in August. The Swiss franc depreciated by 0.3% against the US dollar this week, as the SNB continues to intervene in the currency market. Our bias is that the franc will fall against the euro but not so much against the US dollar. Moreover, holding the Swiss franc remains a good hedge, as Switzerland still sports the highest real rate in the G10 universe. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data from Norway have been mixed: The trade deficit widened from NOK 1.8 billion to NOK 2.9 billion in August. Exports continued to fall by 13% year-on-year to NOK 57 billion in August due to lower sales of mineral fuels and related materials (-20.1%), chemical and related products (-9.3%), and food and live animals (-13.1%). Imports, on the other hand, remained unchanged at NOK 59.9 billion in August from a year earlier. The Norwegian krone fell by 0.5% against the US dollar this week. While the widening of the trade deficit seems to be bad news for the economy, the resilience of imports reflects a strong domestic demand, which bodes well for the Norwegian economy and the krone. 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 II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been positive: The seasonally-adjusted unemployment rate dropped from 9.2% to 9.1% in August. The Swedish krona depreciated by 0.3% against the US dollar this week. The better-than-expected data from the labor market suggests that the economic recovery is underway, which is bullish for the Swedish krona. 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   Kelly Zhong Research Analyst Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Special Report

“Based on a broad set of indicators, it is hard not to see a certain amount of daylight between risky asset prices and economic prospects” – Claudio Borio, Head of Monetary and Economic Department, BIS, September 14, 2020 A pandemic, the resulting sharpest downturn in modern times and soaring government debt have made 2020 an annus horribilis for the US and world economy. Growth has rebounded strongly as economic lockdowns have ended, but most forecasts suggest that the level of activity will not return to its pre-virus level before the end of next year. That implies a lingering problem of high unemployment and there will be ongoing concerns about the eventual consequences of policymakers’ extreme monetary and fiscal actions. The long-run outlook for the US economy was already challenging before Covid-19 appeared on the scene. And this year’s events cannot have improved prospects relative to pre-crisis expectations. Thus, it is reasonable to wonder why the S&P500 hit a new all-time high in early September and currently is only slightly below that level. Is it a classic case of irrational exuberance or a sign that the economic outlook is much better than generally assumed? If we cannot come up with a convincing case for the latter then irrationality is left as a likely explanation. The sharp decline in interest rates certainly supports higher equity valuations, but a bull market that depends largely on stimulative monetary policy is problematic. The Stock Market Is Not The Economy, But… Finance theory states that equity prices should reflect the discounted long-run stream of expected dividend payments. In turn, those payments should be correlated with earnings growth which one would expect to have a close relation to underlying economic conditions. While prices often deviate significantly from so-called fundamentals, it is perfectly reasonable to assume a long-run correlation between the stock market and the performance of the economy. In practice, there is a loose relationship with occasional large deviations. Chart 1The US Economy vs. The Market Chart 1 shows the five-year annualized growth in US real GDP versus both real total returns from the S&P500 and real earnings.1 In making these comparisons, there are a few issues to consider. The stock market only represents quoted companies while GDP also includes the economic contribution of unincorporated businesses and the government. The sectoral composition of the S&P 500 is different from that of businesses at large. Many large US companies earn a significant share of their earnings from overseas operations that may be uncorrelated with domestic economic conditions. The price performance of stocks can reflect large swings in valuations driven by investor sentiment rather than fundamentals. Starting with the first point, corporate sector GDP accounts for only slightly more than half of total GDP, moving within a range of around 55% to 60% for the past 50 years (Chart 2). Yet the real growth in corporate GDP has moved in lockstep with that of total GDP. And aggregate sales of S&P500 companies have broadly tracked the swings in GDP. Thus, it cannot be argued that quoted companies can somehow miraculously avoid the ups and downs of the overall business cycle. The economy is based on a complex set of interconnected relationships and it would be remarkable if the performance of the country’s major corporations could deviate significantly from the economy at large for any length of time. Chart 2The Corporate Sector And Total GDP There certainly is an issue with the second point because the sectoral breakdown of the S&P500 does not exactly match that of the overall economy. While that does not always protect the stock market from general economic trends, it can help explain occasional large equity price moves. Table 1 shows the sector composition of the S&P500, weighted by market capitalization, sales and earnings, versus the composition of GDP. It is difficult to break down GDP exactly in line with the sector classifications of the market, but we have done as close a job as the data allows. Notable differences between the structure of the market and GDP are the relative weightings of the health care, industrials and information technology sectors. The following explanations seem plausible. Table 1Sector Composition: A Comparison For health care, the GDP weighting shown in the table is understated because it also is a significant part of the government sector’s contribution via Medicare and Medicaid. Other data show that total spending on health care accounts for around 18% of US GDP, broadly in line with the S&P index weighting. The large weighting of industrials in GDP compared with its share of the equity index probably reflects the fact that this broadly-defined group has a very large number of small and unquoted companies. On that point, it should be noted that unincorporated businesses account for 21% of national income – a non-trivial share. Last, but not least, there is the huge discrepancy in the weightings of information technology. This is a bit harder to explain, but two reasons come to mind. First, the S&P index market cap weighting has been boosted by the strong share price performance of these companies and high valuations thus flatter their index importance relative to underlying business activity. The IT weights based on sales and earnings are much lower, but still significantly exceed that in GDP. Secondly, some of these companies (Apple being a prime example) produce very little in the US relative to what they sell in the country. As GDP measures domestic output, this affects the relative weightings. Chart 3Growth In Overseas vs. Domestic Profits Let’s explore the issue about overseas earnings more closely. According to national income data, 45% of the corporate sector’s after-tax profits come from overseas earnings. And that is broadly consistent with the overseas share of sales for S&P500 companies. While the relationship is not perfect, the growth of overseas profits roughly tracks that of domestic profits (Chart 3). And where there have been large divergences, such as in 2009, that often has reflected large swings in oil prices. Overall, it hard to make the claim that the large share of earnings coming from overseas has been a factor supporting the strong performance of stocks relative to the underlying economy. This is especially true given that the US has performed better than most other economies in recent years and the dollar has been a strong currency. In sum, our analysis does not give compelling support to the idea that the fundamental performance of large quoted companies can sustainably diverge from that of the underlying economy. But that does not mean that share prices cannot deviate because of large swings in valuation. Is The US Equity Market Overvalued? This should be a simple question to answer, but often is not. Alternative approaches to valuation are sometimes in conflict and that is the current situation. Various valuation measures are shown in Chart 4 with the following observations. Chart 4AMeasures Of US Equity Valuation Chart 4BMeasures Of US Equity Valuation All the measures based on earnings (trailing, forward and cyclically-adjusted) suggest that the market is very expensive. While current earnings are affected by the economy’s second-quarter collapse, there remains considerable uncertainty about the speed of recovery. The current forward price-earnings ratio (PER) assumes that earnings will increase by around 30% over the next 12 months and that could prove to be optimistic. The market also looks significantly overvalued based on the ratios of price-to-book, price-to-sales and total market capitalization to GDP. While the valuation of the aggregate index has been boosted by the exceptional performance of the technology sector, it is important to note that the ratios of price to trailing earnings and to sales also are very elevated using the medians of 58 sub-groups, as calculated by BCA’s US Equity Strategy Service (Chart 5). In other words, this is not a story about overvaluation simply reflecting the hot technology sector. Chart 5Overvaluation Is Not Just About Technology The market looks much more attractive when comparing dividend and earnings yields with the returns available on cash and bonds. This is the so-called TINA argument (there is no alternative). It is hard not to prefer stocks when the dividend yield is above the yield on long-term government bonds. During the market overshoot of the late 1990s, the dividend yield was 500 basis points below the 30-year Treasury yield, highlighting that stocks were in a very risky phase. Moreover, the current environment of unusually low interest rates is unlikely to end any time soon. The Federal Reserve’s newly-released projections indicate that interest rates are expected to remain at current levels at least through the end of 2023. The Fed has made it abundantly clear that it is prepared to take risks with inflation in order to support a revival in economic activity. It is relatively straightforward when the different valuation metrics are all giving the same message, as was the case in the late 1990s. Even then, the market overshoot lasted longer and became more extreme than generally expected. Our composite valuation indicator takes account of 10 different measures and currently supports the idea that the market is indeed very expensive (Chart 6). Chart 6BCA Equity Valuation Indicator It currently is very difficult for institutional investors to favor fixed-income instruments over a higher-yielding equity market. However, there is no free lunch here. We cannot ignore the argument that low interest rates reflect a very bleak long-run outlook for economic growth and thus for earnings and stock prices. The secular stagnation view put forward by Larry Summers looks even more apposite today than when he outlined it several years ago. We are fortunate to have Larry as the opening speaker for our virtual Investment Conference on October 6th and it will be extremely interesting to hear his latest thinking. Some Thoughts On The Economic Outlook Equities are a long-duration asset so it makes sense to consider valuations in the context of the long-run economic outlook rather than the near-term ups and downs of activity. Of course, short-run economic moves do affect investor sentiment so cannot be ignored. The near-term outlook is extremely cloudy because of uncertainty about the future path of the pandemic. While the virus appears to have become less virulent, infection rates could climb sharply over the winter months as schools re-open and people spend more time indoors. In addition, there are doubts about the scale and timing of much-needed additional government stimulus. Chart 7Mixed Data On The US Economy Some recent data have been impressively strong. The value of retail sales has surpassed pre-virus peaks as have new and existing home sales (Chart 7). On the other hand, manufacturing and construction output and overall employment remain far below previous peaks. And we have yet to see the impact of the ending of the $600 a week income support. There are legitimate concerns that early 2021 will see a surge in home evictions and a marked increase in small business bankruptcies. Most likely, the economy will experience a bumpy and moderate recovery after its post-lockdown strong third-quarter growth. The Fed forecasts US growth of 4% in 2021 after a 3.7% drop this year and the OECD’s latest projections are similar. That still means that it will take until the end of 2021 before real GDP gets back to its end-2019 level. And there are downside risks to that forecast if the virus remains a lingering problem. Our conference on October 6th will have what is sure to be a lively debate about the US economic outlook between Ed Yardeni and Dave Rosenberg. These two very smart economists have a very different take on how things are likely to play out and what it means for the markets. This debate will follow the presentation by Larry Summers and after that, Peter Berezin, our Chief Global Strategist, and myself will discuss our views and will be open for audience questions. Should be very interesting! Let’s talk about the longer-run economic outlook. As noted at the outset, it was less than inspiring even before the virus arrived on the scene. The two drivers of long-run economic performance are demographics and productivity and the growth in both has been trending lower. Chart 8Demographics Are A Problem The demographics story is straightforward and essentially locked in place. A falling birth rate means that the working-age population will rise at a meager 0.2% a year over the next ten years compared with more than 1% a year in the 1980s, 1990s and 2000s. Moreover, growth is projected to remain low in subsequent decades (Chart 8). And even these forecasts may be optimistic if the current antipathy toward immigration leads to a more closed-door stance. Demographic trends not only imply a slow-growing workforce (impacting potential GDP) but also create a worsening picture for government finances. An aging population boosts spending on health care and pensions when the number of taxpayers is growing very slowly. This shows up in a dramatic drop in the ratio of the working-age population (i.e. potential taxpayers) to those aged 65 and above.2 This is happening when government finances are already in dire straits and implies that future tax rates can only go higher, regardless of which political party is in power. The issue of productivity is more contentious because it is hard to measure, and future trends are less predictable than for demographics.3 Nevertheless, the data present a relatively clear picture: the growth of output per hour in the non-financial corporate sector has slowed markedly after a tech-driven spurt in the second half of the 1990s (Chart 9). We show the trend as a five-year growth rate to smooth out the short-term noise in the series. Chart 9Productivity Growth Has Slowed We discussed the outlook for productivity in a recent Special Report and highlighted some worrying trends.4 These include weak growth in business investment, a retreat from globalization, increased government involvement in the economy and friction caused by new pandemic-related protocols to protect the safety of customers and workers in several industries. On a more positive note, the virus has forced many businesses to streamline their operations and the move to remote working should boost productivity in some cases. What about the issue of technological advances such as artificial intelligence (AI) and autonomous vehicles? These clearly have the potential to boost productivity in many areas but with a caveat. Previous major technological breakthroughs (often called general purpose technologies or GPTs) such as steam power, the internal combustion engine, electricity, and the internet had major impacts on both supply and demand. Generally, they were associated with creating completely new activities. For example, steam power led to the locomotive which in turn allowed the opening of the country and the movement of goods to distant markets. Similarly, the automobile led to the development of the suburbs and the associated demand for housing and related services. More recently, the internet boosted the demand for a wide range of tech goods and services. While that is still ongoing, its peak effect has passed, helping to explain the decline in productivity growth from late-1990s level. In contrast, a lot of current ‘new’ technologies simply are associated with doing existing tasks more efficiently (3-D printing would be an example). That is still important but not on the same scale as GPTs. There is no doubt that AI will be a big disruptor in many sectors but its impact on demand is less clear. Maybe one day all households will have a domestic robot but that is still far enough away to be in the realm of science fiction. The bigger near-term impact will be job displacement. And the same can be said for autonomous vehicles. The demand for new self-driving cars will rise, but these will simply replace gas-powered ones and perhaps the overall number of vehicles on the road will decline. In sum, there will be both positive and negative forces acting on future productivity growth and any predictions need to be treated with caution. Nonetheless, a base case should probably assume any improvements will be relatively modest. Finally, any discussion of long-run economic prospects cannot ignore the alarming rise in government debt. The US was already running $1 trillion federal deficits before this year’s crisis led to a further extraordinary explosion of red ink (Chart 10). Chart 10Soaring Government Debt Current large deficits are not fazing investors. In the past, the spread between 30-year and 10-year Treasurys widened as the deficit rose, but this relationship has weakened recently (second panel Chart 10). Fed buying of bonds may have had some impact, but it also reflects the weak economy and low inflation. It is hard to know at what point investors will take fright at US fiscal trends. The experience of other countries that faced sovereign debt crises suggests problems can arrive with little advance notice. One day investors seem complacent and the next they are running scared. The dollar’s status as the world’s main reserve currency gives the US more protection than other countries had when facing debt problems. And central banks’ willingness to be the bond buyers of first and last resort gives debt burdens more room to grow than in the past. However, debt arithmetic is relentless and will turn very ugly when bond yields eventually rise. It is futile to try and pin a date on when bond vigilantes might reassert themselves in the US. But it will happen at some point. Moreover, even before that happens, there will be political pressure to do something about soaring debt levels. Even without a market revolt, the burden of increased spending on entitlements and debt servicing will force the government to pursue austerity. Taxes will rise and spending growth will be curtailed. That is a further reason to be cautious about economic prospects. Increased debt is a way to bring spending forward but unless the money is used to invest in productive assets, the process eventually goes into reverse. Unfortunately, the surge in US government borrowing has been used to prop up consumption rather than to finance capital spending. The short- and long-run economic outlook would have been worse if there had not been a powerful fiscal response. Consumption would have suffered an even sharper decline with a catastrophic impact on employment, profits and capital spending. In that sense, the government really had no choice: the health of government finances becomes irrelevant in the midst of a pandemic-related economic collapse. Market Implications There are several explanations for the remarkable strength of the US equity market. Prime place goes to the Fed’s hyper-easy monetary stance. A policy of zero interest rates with a stated intention to keep them there for a long time has the desired effect of boosting risk-taking. A second factor has been excitement about technology that has created a bubble in that sector. And then there is the view that novice retail investors have been seduced into the market by online applications such as Robinhood that make day trading very easy. Missing from the above list is the suggestion that investors expect the economy to be strong enough to validate the market’s current level. That just does not seem plausible because it is not credible that earnings could grow strongly enough to lower valuations to more reasonable levels over the next five to ten years. If the bull case for stocks rests simply on the TINA argument, then it implies equities will remain in a bubble over the medium term. That certainly is possible but not the foundation for a sound investment strategy. It is not easy to come up with an investment strategy when no asset is cheap. BCA’s House View is still to prefer equities on a cyclical basis and the challenge will be timing when to jump off the train. In conclusion, my answer is that there is indeed a disconnect between the economy and equity market. This may persist for quite a while but does not appear sustainable. I am reminded of the late 1990s when the bull market lasted much longer and moved far higher than I and many others expected. Yet, fundamentals eventually did matter with the S&P500 dropping by almost 50% over the space of 30 months. I am not suggesting that a similar decline is imminent and if the 1990s example is relevant, then the market can continue to rise for quite a while, and I am sure the BCA view will prove to be correct. However, ever the skeptic, my bias is to err on the side of caution rather than try to maximize returns. Let me end by giving our upcoming conference another plug. The outlook for US equities will be discussed by Liz Ann Sonders and Ned Davis, two highly-respected market analysts and we will have a separate important session on coming up with the ideal investment strategy from three different perspectives: the buy side, the sell side and independent research In addition, over the four days of the event, we will have high-level discussions of all the other key issues that will drive markets including China, geopolitics, the US election, currencies, and policy challenges. Find out more at https://www.bcaresearch.com/conference2020.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com   Footnotes 1Total returns and earnings were deflated using the corporate price deflator. 2Obviously, not everyone of working age pays much in the way of taxes and there are many aged 65 above who pay lots of taxes. But that does not abstract from the dramatic change in the ratio.  3If you want to know how many 70-year old people there will be in 10 years’ time, simply count the number of 60-year olds today and apply an appropriate mortality rate. 4Please see BCA Special Report "Beyond the Virus," dated May 22, 2020, available at bca.bcaresearch.com