Asset Allocation

Highlights Chart 1More Stimulus Required More Stimulus Required More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 3BCorporate Sector Risk Vs. Reward* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com 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. Performance Since March 23 Announcement Of Emergency Fed Facilities Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Recommended Allocation Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections The coronavirus pandemic is not over. Enormous fiscal and monetary stimulus will soften the blow to the global economy, but there remain significant risks to growth over the next 12 months. The P/E ratio for global equities is near a record high. This suggests that the market is pricing in a V-shaped recovery, and ignoring the risks. We can, therefore, recommend no more than a neutral position on global equities. But government bonds are even more expensive, with yields having largely hit their lower bound. Stay underweight government bonds, and hedge downside risk via cash. The US dollar is likely to depreciate further: It is expensive, US liquidity has risen faster than elsewhere, interest-rate differentials no longer favor it, and momentum has swung against it. A weakening dollar – plus accelerating Chinese credit growth – should help commodities. We raise the Materials equity sector to neutral, and put Emerging Market equities on watch to upgrade from neutral. Corporate credit selectively remains attractive where central banks are providing a backstop. We prefer A-, Baa-, and Ba-rated credits, especially in the Financials and Energy sectors. Defensive illiquid alternative assets, such as macro hedge funds, have done well this year. But investors should start to think about rotating into private equity and distressed debt, where allocations are best made mid-recession. Overview Cash Injections Vs. COVID Infections The key to where markets will move over the next six-to-nine months is (1) whether there will be a second wave of COVID-19 cases and how serious it will be, and (2) how much appetite there is among central banks and fiscal authorities to ramp up stimulus to offset the damage the global economy will suffer even without a new spike in cases. A new wave of COVID-19 in the northern hemisphere this fall and winter is probable. It is not surprising, after such a sudden stop in global activity between February and May, that economic data is beginning to return to some sort of normality. PMIs have generally recovered to around 50, and in some cases moved above it (Chart 1). Economic data has surprised enormously to the upside in the US, although it is lagging in the euro zone and Japan (Chart 2). Chart 1Data Is Rebounding Sharply Data Is Rebounding Sharply Data Is Rebounding Sharply Chart 2US Data Well Above Expectations US Data Well Above Expectations US Data Well Above Expectations     New COVID-19 cases continue to rise alarmingly in some emerging economies and in parts of the US, but in Europe and Asia the pandemic is largely over (for now) and lockdown regulations are being eased, allowing economic activity to resume (Chart 3). Nonetheless, consumers remain cautious. Even where economies have reopened, people remain reluctant to eat in restaurants, to go on vacation, or to visit shopping malls (Chart 4). While shopping and entertainment activities are now no longer 70-80% below their pre-pandemic levels, as they were in April and May, they remain down 20% or more (Chart 5). Chart 3Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Chart 4Consumers Still Reluctant To Go Out Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Chart 5Spending Well Below Pre-Pandemic Levels Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections So how big is the risk of further spikes in COVID-19 cases? Speaking on a recent BCA Research webcast, the conclusion of Professor Peter Doherty, a Nobel prize-winning immunologist connected to the University of Melbourne, was that, “It’s not unlikely we’ll see a second wave.”1 But experts can’t be sure. It seems that the virus spreads most easily when people group together indoors. That is why US states where it is hot at this time of the year, such as Arizona, have seen rising infections. This suggests that a new wave in the northern hemisphere this fall and winter is probable. Offsetting the economic damage caused by the coronavirus has been the staggering amount of liquidity injected by central banks, and huge extra fiscal spending. Major central bank balance-sheets have grown by around 5% of global GDP since March, causing a spike in broad money growth everywhere (Chart 6). Fiscal spending programs also add up to around 5% of global GDP (Chart 7), with a further 5% or so in the form of loans and guarantees. Chart 6Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Chart 7...And Unprecedented Fiscal Spending Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections   But is it enough? Considerable damage has been done by the collapse in activity. Bankruptcies are rising (Chart 8) and, with activity still down 20% in consuming-facing sectors, pressure on companies’ business models will not ease soon – particularly given evidence that banks are tightening lending conditions. Household income has been buoyed by government wage-replacement schemes, handout checks, and more generous unemployment benefits (Chart 9). But, when these run out, households will struggle if the programs are not topped up. Central banks are clearly willing to inject more liquidity if need be. But the US Congress is prevaricating on a second fiscal program, and the Merkel/Macron proposed EUR750 billion spending package in the EU is making little progress. It will probably take a wake-up call from a sinking stock market to push both to take action. Chart 8Companies Feeling The Pressure Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Considerable damage has been done by the collapse in activity. We lowered our recommendation for global equities to neutral from overweight in May. We are still comfortable with that position. Given the high degree of uncertainty, this is not a market in which to take bold positioning in a portfolio. When you have a high conviction, position your portfolio accordingly; but when you are unsure, stay close to benchmark. With stocks up by 36% since their bottom on March 23rd, the market is pricing in a V-shaped recovery and not, in our view, sufficiently taking into account the potential downside risks. P/E ratios for global stocks are at very stretched levels (Chart 10). Chart 9Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts Chart 10Global Equities Are Expensive... Global Equities Are Expensive... Global Equities Are Expensive...   Nonetheless, we would not bet against equities. Simply, there is no alternative. Most government bond yields are close to their effective lower bound. Gold looks overbought (in the absence of a significant spike in inflation which, while possible, is unlikely for at least 12 months). No sensible investor in, say, Germany would want to hold 10-year government bonds yielding -50 basis points. Assuming 1.5% average annual inflation over the next decade, that guarantees an 18% real loss over 10 years. The only investors who hold such positions have them because their regulators force them to. Chart 11...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds The Sharpe ratio on 10-year US Treasurys, which currently yield 70 BPs, will be 0.16 (assuming volatility of 4.5%) over the next 10 years. A simple calculation of the likely Sharpe ratio for US equities (earnings yield of 4.5% and volatility of 16%) comes to 0.28. One would need to assume a disastrous outlook for the global economy to believe that stocks will underperform bonds in the long run. Though equities are expensive, bonds are even more so. The equity risk premium in most markets is close to a record high (Chart 11). With such mathematics, it is hard for a long-term oriented investor to be underweight equities. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Premature Opening Of The Economy Is Risky Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections COVID-19: How Risky Is Reopening? Countries around the world are rushing to reopen their economies, claiming victory over the pandemic. It is hard to be sure whether a second wave of COVID-19 will hit. What is certain, however, is that a premature relaxation of measures is as risky as a tardy initial response. That was the lesson from our Special Report analyzing the Spanish Flu of 1918. The risk is certainly still there: Herd immunity will require around 70% of the population to get sick, and a drug or vaccine will (even in an optimistic scenario) not be available until early next year. China and South Korea, for example, after reporting only a handful of daily new cases in early May, were forced to impose new restrictions over the past few weeks as COVID-19 cases spiked again (Chart 12, panel 1). We await to see if other European countries, such as Italy, Spain, and France will be forced to follow. Some argue that even if a second wave hits, policy makers – to avoid a further hit to economic output – will favor the “Swedish model”: Relying on people’s awareness to limit the spread of the virus, without imposing additional lockdowns and restrictions. This logic, however, is risky since Sweden suffered a much higher number of infections and deaths than its neighboring countries (panel 2). The US faces a similar fate. States such as Florida, Arizona, and Texas are recording a sharp rise in new infections as lockdowns are eased. In panel 3, we show the daily number of new infections during the stay-at-home orders (the solid lines) and after they were lifted (dashed lines). To an extent, increases in infections are a function of mass testing. However, what is obvious is that the percentage of positive cases per tests conducted has started trending upwards as lockdown measures were eased (panel 4). Our base case remains that new clusters of infections will emerge. Eager citizens and rushed policy decisions will fuel further contagion. If the Swedish model is implemented, lives lost are likely to be larger than during the first wave. Chart 13W Or U, Says The OECD Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections What Shape Will The Recovery Be: U, V, W, Or Swoosh? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has already declared that the US recession began in March. The economists’ consensus is that Q2 US GDP shrank by 35% QoQ annualized. But, after such a momentous collapse and with a moderate move back towards normalcy, it is almost mathematically certain that Q3 GDP will show positive quarter-on-quarter growth. So does this mean that the recession lasted only one quarter, i.e. a sharp V-shape? And does this matter for risk assets? The latest OECD Economic Outlook has sensible forecasts, using two “equally probable” scenarios: One in which a second wave of coronavirus infections hits before year-end, requiring new lockdowns, and one in which another major outbreak is avoided.2 The second-wave scenario would trigger a renewed decline in activity around the turn of 2020-21: a W-shape. The second scenario looks more like a U-shape or swoosh, with an initial rebound but then only a slow drawn-out recovery, with OECD GDP not returning to its Q4 2019 level before the end of 2021 (Chart 13). Chart 14Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Why is it likely that, in even the absence of a renewed outbreak of the pandemic, recovery would be faltering? After an initial period in which many furloughed workers return to their jobs, and pent-up demand is fulfilled, the damage from the sudden stop to the global economy would kick in. Typically, unemployment rises rapidly in a recession, but recovers only over many years back to its previous low (Chart 14). This time, many firms, especially in hospitality and travel, will have gone bust. Capex plans are also likely to be delayed. Chart 15Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets However, a slow recovery is not necessarily bad for risk assets. Periods when the economy is recovering but remains well below potential (such as 2009-2015) are typically non-inflationary, which allows central banks to continue accommodation (Chart 15). Is This Sharp Equity Rebound A Retail Investor Frenzy? The answer to this question is both Yes and No. From a macro fundamental perspective, the answer is No, because coordinated global reflationary policies and medical developments to fight the coronavirus have been the key drivers underpinning this equity rebound. “COVID-on” and “COVID-off” have been the main determinants for equity rotations. Chart 16Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately But at the individual stock level, the answer is Yes. Some of the unusual action in beaten-down stocks over the past few weeks may have its origin in an upsurge of active retail participation (Chart 16). Retail investors on their own are not large enough to influence the market direction. Many online brokerages do not charge any commission for trades, but make money by selling order flows to hedge funds. As such, the momentum set in motion by retail investors may have been amplified by fast-money pools of capital. Retail participation in some beaten-down stocks has also provided an opportunity for institutions to exit. BCA’s US Investment Strategy examined the change in institutional ownership of 12 stocks in three stressed groups between February 23 and June 14, as shown in Table 1. In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. The redeployment of capital by institutions into large-cap and quality names may have pushed up the overall equity index level. Table 1Individuals Have Replaced Institutions Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections How Will Inflation Behave After COVID? Some clients have asked us about the behavior of inflation following the COVID epidemic. Over the very short term, inflation could have more downside. However, this trend is likely to reverse rapidly. Headline inflation is mainly driven by changes in the oil price and not by its level. Thus, even if oil prices were to stay at current low levels, the violent recovery of crude from its April lows could bring headline inflation near pre-COVID levels by the beginning of 2021 (Chart 17, top panel). This effect could become even larger if our Commodity strategist price target of 65$/barrel on average in 2021 comes to fruition. Chart 17Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation But will this change in inflation be transitory or will it prove to be sustainable? We believe it will be the latter. The COVID crisis may have dramatically accelerated the shift to the left in US fiscal policy. Specifically, programs such as universal basic income may now be within the Overton window3 of acceptable fiscal policy, thanks to the success of the CARES Act in propping up incomes amid Depression-like levels of unemployment (middle panel). Meanwhile there is evidence that this stimulus is helping demand to recover rapidly: Data on credit and debit card trends show that consumer spending in the US has staged a furious rally, particularly among low-income groups, where spending has almost completely recovered (bottom panel). With entire industries like travel, restaurants and lodging destroyed for the foreseeable future, the political will to unwind these programs completely is likely to be very low, given that most policymakers will be queasy about an economic relapse, even after the worst of the crisis has passed. Such aggressive fiscal stimulus, coupled with extremely easy monetary policy will likely keep inflation robust on a cyclical basis. Global Economy Overview: March-May 2020 will probably prove to be the worst period for the global economy since the 1930s, as a result of the sudden stop caused by the coronavirus pandemic and government-imposed restrictions on movement. As the world slowly emerges from the pandemic, data has started to improve. But there remain many risks, and global activity is unlikely to return to its end-2019 level for at least another two years. That means that further fiscal and monetary stimulus will be required. The speed of the recovery will be partly determined by how much more aggressively central banks can act, and by how much appetite there is among fiscal authorities to continue to bail out households and companies which have suffered a catastrophic loss of income. US: The economy has shown signs of a strong rebound from the coronavirus slump in March and April. Q2 GDP probably fell around 35% quarter-on-quarter annualized, but Q3 will almost certainly show positive growth. The Economic Surprise Index (Chart 18, panel 1) has bounced to a record high, after stronger-than expected May data, for example the 16% month-on-month growth in durable goods orders, and 18% in retail sales. But the next stage of the recovery will be harder: continuing unemployment claims in late June were still 19.5 million. Bankruptcies are rising, and banks are tightening lending conditions. One key will be whether Congress can pass a further fiscal program before the emergency spending runs out in July. Euro Area: Although pandemic lockdowns ended in Europe earlier than in the US, recovery has been somewhat slower. The euro zone PMI rebounded to close to 50 in June but, given that activity had collapsed in February-May, it is surprising (since the PMI measures month-on-month change) that it is not well above 50 (Chart 19, panel 1). Fiscal and monetary stimulus, while large, has not been as aggressive as in the US. The ECB remains circumscribed (as least psychologically) by the German constitutional court’s questioning the justification for previous QE. Germany and France have agreed a EUR750 billion additional package to help the periphery, but this has still to be finalized, due to the opposition of some smaller northern EU members. Chart 18Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Chart 19...But From Dramatically Low Levels ...But From Dramatically Low Levels ...But From Dramatically Low Levels   Japan: Although Japan escaped relatively easily from pandemic deaths and lockdowns, its economy remains notably weak. New machinery orders in April were still falling 18% YoY, and exports in May were down 28% YoY. The poor economic performance is due to its dependence on overseas demand, distrust in the government, the lingering effects of the ill-timed consumption tax rise last October, and limited room for manoeuvre by the Bank of Japan. The government has announced fiscal stimulus equal to a barely credible 40% of GDP, but much of this is double-counting, and less than half of the household and small-company income-replacement handouts announced in March have so far been paid out. Emerging Markets: India, Brazil, and other Latin American countries are now bearing the brunt of the coronavirus pandemic. Economies throughout Emerging Markets have weakened dramatically as a result. Two factors may come to their aid, though. China is again ramping up monetary stimulus, with a notable acceleration of credit growth over the past three months. Its economy has stabilized as a result, as PMIs show (panel 3). And the US dollar has begun to depreciate, which will take pressure off EM borrowers in foreign currencies, and boost commodities prices. The biggest risk is that many EM central banks have now resorted to printing money, which could result in currency weakness and inflation at a later stage. Interest Rates: Central banks in advanced economies have lowered policy rates to their effective lower bound. It is unlikely the Fed will cut into negative territory, having seen the nefarious effects of this on the banking systems in Japan and the euro zone, and particularly due to the large money-market fund industry in the US, which is unviable with negative rates. Reported inflation everywhere, both headline and core, has fallen sharply, but this is somewhat misleading since the price of items that households in lockdown have actually been buying has risen sharply. Markets have started to sniff out the possibility of inflation once the pandemic is over, and inflation expectations have begun to rise (panel 4). For now, deflation is likely to be the bigger worry and so we do not expect long-term rates to rise much this year. But a sharp pickup in inflation is a definite risk on the 18-24 month time horizon. Global Equities Chart 20Stretched Valuation Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Valuation Concern: Global equities staged an impressive rebound of 18% in Q2 after the violent selloff in Q1, thanks to the “whatever-it-takes” support from central banks, and massive fiscal stimulus packages around the globe. Within equities, our country allocation worked well, as the US outperformed both the euro Area and Japan. Our sector performance was mixed: The overweight in Info Tech and underweight in Utilities and Real Estate generated good profits, but the overweights in Industrials and Healthcare and the underweight in Materials suffered losses. As shown in Chart 20, even before the pandemic-induced profit contraction, forward earnings were already only flattish in 2019. The sharp selloff in Q1 brought the valuation multiple back down only to the same level as at the end of 2018. Currently, this valuation measure stands at the highest level since the Great Financial Crisis after a 37% increase in Q2 2020 alone. Such a rapid multiple expansion was one of the key reasons why we downgraded equities to Neutral in May at the asset-class level. Going forward, BCA’s house view is that easy monetary policies and stimulative fiscal policies globally will help to revive economic activity, and that a weakening US dollar will give an additional boost to the global economy, especially Emerging Markets. Consequently, we upgrade global Materials to neutral from underweight and put Emerging Market equities (currently neutral) on an upgrade watch (see next page). Warming To Reflation Plays Chart 21EM On Upgrade Watch EM On Upgrade Watch EM On Upgrade Watch Taking risk where risks will most likely be rewarded has been GAA’s philosophy in portfolio construction. As equity valuation reaches an extreme level, the natural thing to do is to rotate into less expensive areas within the equity portfolio. As shown in panel 2 of Chart 21, EM equities are trading at a 31% discount to DM equities based on forward P/E, which is 2 standard deviations below the average discount of past three years. Valuation is not a good timing tool in general, but when it reaches an extreme, it’s time to pay attention and check the fundamental and technical indicators. We are putting EM on upgrade watch (from our current neutral stance, and also closing the underweight in Materials given the close correlation of the two (Chart 21, panel 1). Three factors are on our radar screen: First, reflation efforts in China. The change in China’s total social financing as a % of GDP has been on the rise and BCA’s China Investment Strategy Team expects it to increase further. This bodes well for the momentum of the EM/DM performance, which is improving, albeit still in negative territory (panel 3). Second, a weakening USD is another key driver for EM/DM and the Materials sector relative performance as shown in panel 4. According to BCA’s Foreign Exchange Strategy, the US dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds.4 Last but not least, the recent surge in the number of the coronavirus infections in EM economies, especially Brazil and India, has increased the likelihood of a second wave of lockdowns. Government Bonds Chart 22Bottoming Bond Yields Bottoming Bond Yields Bottoming Bond Yields Maintain Neutral Duration. Global bond yields barely moved in Q2 as the global economy rebounded from the COVID-induced recession low (Chart 22, panel 1). The upside surprise in economic data releases implies that global bond yields will likely go up in the near term (panel 2). For the next 9-12 months, however, the upside in global bond yields might be limited given the increasing likelihood of a new set of COVID-19 lockdowns due to the recent surge in new infections globally, especially in the US, Brazil, and India. As such, a neutral duration stance is still appropriate (Chart 22). Chart 23Inflation Expectations On The Rise Inflation Expectations On The Rise Inflation Expectations On The Rise Favor Linkers Vs. Nominal Bonds. To fight off the risk of an extended recession, policymakers around the world are determined to continue to use aggressive monetary and fiscal stimulus to boost the global economy. The combined effect of extremely accommodative policy settings and the rebound in global commodity prices, especially oil prices, will push up inflation expectations (Chart 23). Higher inflation expectations will no doubt push up nominal bond yields somewhat, but according to BCA’s Global Fixed Income Strategy (GFIS), positioning for wider inflation breakevens remains the “cleaner” way to profit for the initial impact of policy reflation.5 According to GFIS valuation models, inflation-linked bonds in Canada, Italy, Germany, Australia, France, and Japan should be favored over their respective nominal bonds. Corporate Bonds Chart 24Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Investment-grade: Since we moved to overweight on investment-grade credit within the fixed-income category, it has produced 8.8% in excess returns over duration-matched government bonds. We remain overweight, given that the Federal Reserve has guaranteed to rollover debt for investment-grade issuers, essentially eliminating the left tail of returns. Moreover, the Fed has begun buying both ETFs and individual bond issues, in an effort to keep financial stress contained during the pandemic. However, there are some sectors within the investment-grade space that are more attractive than others. Specifically, our Global Fixed Income Strategy team has shown that A-rated and Baa-rated bonds are more attractive than higher-rated credits (Chart 24). Meanwhile, our fixed-income strategist are overweight Energy and Financials at the sector level.6 High-yield: High-yield bonds – where we have a neutral position - have delivered 11.5% of excess return since April. We are maintaining our neutral position. At current levels, spreads no longer offer enough value to justify an overweight position, specially if one considers that defaults in junk credits could be severe, since the Fed doesn’t offer the same level of support that it provides for investment-grade issuers. Within the high-yield space, we prefer Ba-rated credit. Fallen angels (i.e. bonds which fell to junk status) are particularly attractive given that most qualify for the Fed’s corporate buying program, since issuers which held at least a Baa3 rating as of March 22 are eligible for the Fed’s lending facilities.7  Commodities Chart 25Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Energy (Overweight): A near-complete lack of storage led WTI prices to go into freefall and trade at -$40 in mid-April: The largest drawdown in oil prices over the past 30 years (Chart 25, panel 1). Since then, oil prices have picked up, reaching their pre-“sudden stop” levels, as the OPEC 2.0 coalition slashed production. Nevertheless, excess supply remains a key issue. Crude inventories have been on the rise as global crude demand weakens. Year-to-date inventories have increased by over 100 million barrels, and current inventories cover over 40 days of supply (panel 2). As long as the OPEC supply cuts hold and demand picks up over the coming quarters, the excess inventories are likely to be worked off. BCA’s oil strategists expect Brent crude to rise back above $60 by year-end. Industrial Metals (Neutral): Last quarter, we flagged that industrial metals face tailwinds as fiscal packages get rolled out globally – particularly in China where infrastructure spending is expected to increase by 10% in the latter half of the year. Major industrial metals have yet to recover to their pre-pandemic levels but, as lockdown measures are lifted and activity is restored, prices are likely to start to rise strongly (panel 3). Precious Metals (Neutral): The merits of holding gold were not obvious during the first phase of the equity sell-off in February and March. Gold prices tumbled as much as 13%, along with the decline in risk assets. Since the beginning of March, however, there have been as many positive return days as there has been negative (panel 4). However, given the uncertainty regarding a second wave of the pandemic, and the rise in geopolitical tensions between the US and China, as well as between India and China, we continue to recommend holding gold as a hedge against tail risks. Currencies Chart 26Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative US Dollar: The DXY has depreciated by almost 3% since the beginning of April. Currently, there are multiple forces pushing the dollar lower: first, interest-rate differentials no longer favor the dollar Second, liquidity conditions have improved substantially thanks to the unprecedented fiscal and monetary stimulus, as well as coordinated swap lines between the Fed and other central banks to keep USD funding costs contained. Third, momentum in the DXY – one of the most reliable indicators for the dollar – has turned negative (Chart 26– top & middle panel). Taking all these factors into account, we are downgrading the USD from neutral to underweight. Euro: The euro should benefit in an environment where the dollar weakens, and global growth starts to rebound. Moreover, outperformance by cyclical sectors as well as concerns about over-valuation in US markets should bring portfolio flows to the Euro area. Therefore, we are upgrading the euro from neutral to overweight. Australian dollar: Last quarter we upgraded the Australian dollar to overweight due to its attractive valuations, as well as the effect of the monetary stimulus coming out of China. This proved to be the correct approach: AUD/USD has appreciated by a staggering 13% since our upgrade – the best performance of any G10 currency versus the dollar this quarter (bottom panel). Overall, while we believe that Chinese stimulus should continue to prop up the Aussie dollar, valuations are no longer attractive with AUD/USD hovering around PPP fair value. This means that the risk-reward profile of this currency no longer warrants an overweight position. Thus, we are downgrading the AUD to neutral. Alternatives Chart 27Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Return Enhancers: Over the past year, we have flagged that hedge funds, particularly macro funds, will outperform other risk assets during recessions and periods of high market stress. This played out as we expected: macro hedge funds’ drawdown from January to March 2020 was a mere 1.4%, whereas other hedge funds’ drawdown ranged between 9% and 19% and global equities fell as much as 35% from their February 2020 peak. (Chart 27, panel 1). However, unlike other recessions, the unprecedented sum of stimulus should place a floor under global growth. Given the time it takes to move allocations in the illiquid space, investors should prepare for new opportunities within private equity as global growth bottoms in the latter half of this year. In an earlier Special Report, we stressed that funds raised in late-cycle bull markets tend to underperform given their high entry valuations. If previous recessions are to provide any guidance, funds raised during recession years had a higher median net IRR than those raised in the latter year of the preceding bull market (panel 2). Inflation Hedges: Over the past few quarters, we have been highlighting commodity futures as a better inflation hedge relative to other assets (e.g. real estate). Within the asset class, assuming a moderate rise in inflation over the next 12-18 months as we expect, energy-related commodities should fare best (panel 3). This corroborates with our overweight stance on oil over the next 12 months (see commodities section). Volatility Dampeners: We have been favoring farmland and timberland since Q1 2016. While both have an excel track record of reducing volatility, farmland’s inelastic demand during slowdowns will be more beneficial. Investors should therefore allocate more to farmland over timberland (panel 4). Risks To Our View The risks are skewed to the downside. After such a big economic shock, damage could appear in unexpected places. Banking systems in Europe, Japan, and the Emerging Markets (but probably not the US) remain fragile. Defaults are growing in sub-investment grade debt; mortgage-backed securities are experiencing rising delinquencies; student debt and auto loans are at risk. Emerging Market borrowers, with $4 trn of foreign-currency debt, are particularly vulnerable. The length and depth of recessions and bear markets are determined by how serious are the second-round effects of a cyclical slowdown. If the current recession really lasted only from March to July, and the bear market from February to March, this will be very unusual by historical standards (Chart 28). Chart 28Can The Recession And Bear Market Really Be All Over Already? Can It Really Be Over Already? Can It Really Be Over Already? Upside surprises are not impossible. A vaccine could be developed earlier than the mid-2021 that most specialists predict. But this is unlikely since the US Food and Drug Administration will not fast-track approval given the need for proper safety testing. If economies continue to improve and newsflow generally remains positive over the coming months, more conservative investors could be sucked into the rally. Evidence suggests that the rebound in stocks since March was propelled largely by hedge funds and individual day-traders. More conservative institutions and most retail investors remain pessimistic and have so far missed the run-up (Chart 29). One key, as so often, is the direction of US dollar. Further weakness in the currency would be a positive indicator for risk assets, particularly Emerging Market equities and commodities. In this Quarterly, we have moved to bearish from neutral on the dollar (see Currency section for details). Momentum has turned negative, and both valuation and relative interest rates suggest further downside. But it should be remembered that the dollar is a safe-haven, counter-cyclical currency (Chart 30). Any rebound in the currency would not only signal that markets are entering a risk-off period, but would cause problems for Emerging Market borrowers that need to service debt in an appreciating currency. Chart 29Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Chart 30Dollar Direction Is Key Dollar Direction Is Key Dollar Direction Is Key     Footnotes 1  Please see BCA Webcast, "The Way Ahead For COVID-19: An Expert's Views," available at bcaresearch.com. 2  OECD Economic Outlook, June 2020, available at https://www.oecd-ilibrary.org/economics/oecd-economic-outlook/volume-2020/issue-1_0d1d1e2e-en 3  The Overton window, named after Joseph P. Overton, is the range of policies politically acceptable to the mainstream population at a given time. It frames the range of policies that a politician can espouse without appearing extreme. 4  Please see Foreign Exchange Strategy Weekly Report, “DXY: False Breakdown Or Cyclical Bear Market?” dated June 5, 2020 available at fes.bcaresearch.com 5  Please see Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations” dated June 23, 2020 available at gfis.bcaresearch.com 6 Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. 7  Fallen angels also outperform during economic recoveries. Please see Global Asset Allocation Special Report, "Even Fallen Angels Have A Place In Heaven," dated November 15, 2020, available at gaa.bcaresearch.com.   GAA Asset Allocation

Highlights Global Growth & Inflation: An increasing number of growth indicators worldwide are tracing out a “v”-shaped pattern from the COVID-19 recession. However, high unemployment and a lack of inflationary pressure will ensure that global monetary policies remain highly stimulative for some time. Duration:  Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield). Feature Today marks the midway point of what has already become one the most eventful years of our lifetimes. Investors have had to process multiple massive shocks: a global pandemic; a historically deep worldwide recession; and in the US, nationwide social unrest and a now politically vulnerable president.  Yet despite the severe economic shock and persistent uncertainties, financial market performance over the entire first six months of the year has not been terrible. The S&P 500 index is only down -5.5% year-to-date, while the NASDAQ index is up +10.5% over the same period. Meanwhile, the Barclays Global Aggregate benchmark fixed income index is up +3.9% so far in 2020 (in hedged US dollar terms).  In light of the magnitude of losses suffered by global equity and credit markets in February and March, those are impressive year-to-date returns. CHART OF THE WEEKA Tug Of War A Tug Of War A Tug Of War Falling government bond yields, driven lower by an aggressive easing of global monetary policies through rate cuts and quantitative easing (QE), have played a major role in driving the recovery in risk assets. With the number of global COVID-19 cases now accelerating rapidly once again, however, the odds are increasing that investors become more reluctant to drive equity and credit valuations even higher (Chart of the Week). At the halfway point of the calendar year, this is a good time to review our most trusted indicators, and current investment recommendations, for global government debt and corporate credit. Duration Allocation: A Non-Inflationary Growth Recovery – But With Higher Inflation Expectations Our current recommended overall global duration stance is NEUTRAL. Global growth has started to recover from the sharp COVID-19 recession.  Survey data like manufacturing and services purchasing managers indices (PMIs) have rapidly rebounded from the huge March/April drops, although most PMIs remain below the 50 level suggesting accelerating economic growth (Chart 2). While there is less timely “hard data” available due to reporting lags, there are signs of improvement in critical measures like US durable goods orders, which soared +15.8% in May after falling by similar amounts in both March and April.  Global realized inflation data remains very weak, however, with headline CPI flirting with deflation in most major develop economies.  Combined with still very high levels of unemployment, which will take years to return anywhere close to pre-COVID levels, the backdrop will keep central banks highly dovish for a long time. The US Federal Reserve has already signaled that the fed funds rate will remain near 0% until the end of 2022, while the Bank of Japan has said no rate hikes will happen before 2023 at the earliest. Our Global Duration Indicator, comprised of three elements - our global leading economic indicator and its diffusion index, along with the global ZEW measure of economic expectations - has already returned to pre-COVID levels (Chart 3).  This leading, directional indicator of bond yields suggests that the downward pressure on yields seen over the first half of 2020 is over.   Chart 2Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Growth, But Not Inflation, Is Recovering Chart 3Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 However, it is far too soon to expect a big bond selloff, with nominal government bond yields now pulled in opposing directions by their real yield and inflation expectations components. As we discussed in last week’s report, our models for market-based inflation expectations indicate that breakevens derived from inflation-linked bonds are too low.1 Hyper-easy monetary policies from the Fed, ECB and other major central banks will help lift inflation expectations, especially with oil prices likely to continue rising over the next 12-18 months according to BCA’s commodity strategists.  Chart 4Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves The rise in inflation breakevens already seen over the past three months in places like the US, Canada and Australia – combined with dovish forward guidance on future interest rates that has kept shorter-maturity bond yields anchored -  should have resulted in a bearish steepening of government bond yield curves.  Yet the differences between 10-year and 2-year yields across the major developed markets have gone sideways since the beginning of April, even as 10-year inflation breakevens have increased (Chart 4). This has also kept the overall level of nominal 10-year yields nearly unchanged over the same period; for example, the 10-year US Treasury yield is now at 0.64% compared to the 0.58% closing level seen back on April 1. An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.  That is exactly what has happened when looking at the actual real yield on 10-year inflation-linked bonds in the US, euro area, Canada, Japan, the UK and Australia. Using the US as an example, the 10-year inflation breakeven has increased +44bps since April 1, while the 10-year real yield has declined by -38bps. The decline in global real bond yields has coincided with the major central banks aggressively easing monetary policy, including large-scale purchases of government bonds.  This occurred even in countries that had not engaged in major QE programs before, like Australia and Canada. The sizes involved for the new QE purchases have been massive, given the significant increase in the size of central bank balance sheets in absolute terms and relative to GDP (Chart 5).  An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.   Chart 5Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower Global QE Is Helping Drive Real Bond Yields Lower It is possible that the decline in real yields is due to other factors besides QE purchases, like markets pricing in structurally slower economic growth (and lower neutral interest rates) following the severe COVID-19 recession.  Or perhaps it is more fundamentally economic in nature, reflecting a surge in domestic savings at a time of falling investment spending.  The key takeaway for investors is that rising inflation expectations do not necessarily have to translate into higher nominal bond yields if the markets do not expect central banks to signal a need to tighten monetary policy in the near future, which would push real bond yields higher. For this reason, we continue to prefer structural allocations to inflation-linked bonds out of nominal government debt, rather than maintaining below-benchmark duration exposure in fixed income portfolios.  That is a position that benefits from both higher inflation breakevens and lower real yields, while still having the benefit of maintaining a neutral level of safe-haven duration exposure given the lingering uncertainties over the accelerating global spread of COVID-19. At the specific country level, we recommend overweighting inflation-linked bonds over nominals in the US, Italy and Canada where breakevens appear most cheap on our models. Bottom Line: Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit Allocation: Keep Buying What The Central Banks Are Buying Our current recommended overall stance on global corporate credit is NEUTRAL. The same reflationary arguments underlying our recommended inflation-linked bond positions also help support our views on global corporate debt.  Aggressively easy monetary policies, combined with some recovery in global economic growth, will help minimize the risk premium on corporate debt.  Yield-starved investors will continue to have no choice but to look to corporate bond markets for income over the next 6-12 months. The same reflationary arguments under-lying our recommended inflation-linked bond positions also help support our views on global corporate debt.   The combined growth rate of the balance sheets for the major central banks (the Fed, ECB, Bank of Japan and Bank of England) has been a reliable leading indicator of excess returns for global investment grade and high-yield debt since the 2008 financial crisis (Chart 6). With that combined balance sheet now expanding at a 34% year-over-year pace after the ramp up of global QE, this suggests continued support for global corporate outperformance versus government bonds over the next year. Corporate debt is also benefitting from direct central bank purchases by the Fed, ECB and Bank of England. Unsurprisingly, the 2020 peak in US investment grade and high-yield corporate spreads occurred on March 20, literally the last trading day before the Fed announced its corporate bond purchase programs (Chart 7).  Chart 6Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Global QE Will Continue To Support Risk Assets Chart 7The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit The Fed Has Removed The 'Left Tail' Risk Of US Credit   The Fed’s announced plan for its corporate bond buying was to have it focused on shorter maturity (1-5 year) investment grade credit.  Later, the Fed allowed the programs to buy high-yield ETFs while also allowing “fallen angel” debt of investment grade credits downgrade to junk to be held within the programs.  Since that announcement in late March, risk premiums for US corporate debt across all credit tiers and maturities have narrowed.  However, the limits of that broad-based spread tightening may have now been reached, as some of the dislocations in US corporate bond markets created by the global market rout in February and early March have now been corrected.  Chart 8Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized Relative US Corporate Spread Relationships Have Normalized For example, the spread on the Bloomberg Barclays 1-5 year US investment grade index – a proxy for the universe of bonds the Fed is buying – has moved from a level 25bps above that of the 5-10 year US investment grade index, seen before the Fed announced its purchase programs, to 53bps below the longer maturity index (Chart 8, top panel). This is a more normal “slope” for that spread maturity curve relationship, in line with levels seen over the past decade. This suggests that additional spread tightening in US investment grade corporates may be more widespread across all maturities, even with the Fed still focusing its own purchases on shorter-maturity bonds. A similar dynamic is evident in the US high-yield universe.  The spread between the riskier B-rated and Caa-rated credit tiers to Ba-rated names has narrowed since late March to the lower bound of a rising trend channel in place since mid-2018 (bottom panel).  The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19. The implication going forward is that additional outperformance of lower-rated US junk bonds will be difficult to achieve. The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19.  European corporate debt has also been witnessing similar trends to those seen in the US.  Euro area investment grade corporate spreads have tightened alongside US spreads since the March 20 peak, but that trend has now stabilized given the recent uptick in market volatility measures like the VIX and VStoxx index (Chart 9).  The spread tightening in euro area high yield has also stalled, with spreads seeing a slight uptick alongside the recent increase in market volatility (Chart 10). Chart 9Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Global IG Spread Tightening Has Stalled Chart 10Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Have Global HY Spreads Bottomed? Given the renewed uncertainty over the accelerating number of global COVID-19 cases, hitting large US population areas in the US southern states and across the emerging economies, it will be difficult for global market volatility and credit spreads to return to even the recent lows, much less the pre-COVID levels. Thus, we continue to recommend a “selective” approach to global corporate bond allocations, based on valuations, while maintaining a neutral exposure to credit versus government bonds. Our preferred method for evaluating the attractiveness of credit spreads is to look at 12-month breakeven spreads, or the amount of spread widening that would make corporate bond returns equal to duration-matched government debt over a one-year horizon.  We compare those breakeven spreads to their own history to determine if the current level of credit spreads offer value, while adjusting for the underlying spread volatility backdrop. In the US, the 12-month breakeven spread for investment grade corporates is now less attractive than was the case back in March, now sitting at the long-run median level (Chart 11, top panel). The 12-month breakeven for US high-yield is much more attractive, sitting near the highest readings dating back to the mid-1990s (bottom panel).  Of course, this approach only looks at spreads relative to their volatility and does not incorporate credit risk, which is an obvious risk after the recent collapse in US economic growth. In other words, high-yield needs to offer very high 12-month breakeven spreads to be attractive in the current environment. In the euro area, 12-month breakevens for high-yield are only at long-run median levels, while the breakevens for investment grade are a bit more attractive sitting at the 65th percentile of its own history (Chart 12). Chart 11US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults Chart 12European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels European Corporate Breakeven Spreads: Now At Median Levels Importantly, 12-month breakeven spreads in both the US and euro area, for investment grade and high-yield, have not fallen into the lower quartile rankings, even after the sharp tightening of spreads since late March. This is a sign the current rally in global corporates has more room to run, strictly from a spread compression perspective.  For high-yield credit, however, the risk of default losses coming after a short, but intense, recession must be factored into any assessment of valuation. Chart 13Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Default-Adjusted HY Spreads In The US & Europe Are Unattractive Looking at default-adjusted spreads – spread in excess of realized and expected credit losses – shows that the current level of junk spreads on both sides of the Atlantic offers little-to-no compensation for credit losses (Chart 13).  Default-adjusted spreads are already well below long-run median levels, but if a typical 10-12% recessionary default rate is applied, expected credit losses over the next twelve months will exceed the current level of spreads, thus ensuring negative excess returns on allocations to junk bonds versus government bonds. Tying it all together, our valuation metrics for corporates suggest the following recommended allocations: Overweight US investment grade corporates, but focused on the 1-5 year maturity range that is supported by Fed purchases Overweight US Ba-rated high-yield (also eligible for Fed holdings), while underweighting lower-rated B- and Caa-rated junk Neutral allocation to euro area investment grade Underweight euro area high-yield across all credit tiers This allocation is in line with our current allocations within our model bond portfolio, which are on pages 13-14. Bottom Line: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1  Please see BCA Research Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations”, dated June 23, 2020, available at gfis.bcaresearch.com Recommendations Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Contagion Vs. Reflation: The Battle Of 2020 Rages On Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. Next week, please join me for a webcast on Thursday, July 9 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Markets will trade nervously over the coming weeks in response to the second wave of the pandemic and the looming US fiscal cliff. Nevertheless, we would “buy the dip” if global equities were to fall 5%-to-10% from current levels. While the pace of reopening will slow, there is little appetite for the sort of extreme lockdown measures that were implemented in March. The US Congress will ultimately extend fiscal support for households and firms. Around the world, both fiscal and monetary policy will remain highly accommodative, which should provide a supportive backdrop for stocks. Many institutional investors missed the rebound in stocks and are eager to get back in. High levels of “cash on the sidelines” will further buttress equities. Remain overweight stocks versus bonds on a 12-month horizon. Favor cyclical sectors over defensives and non-US stocks over their US peers. The US dollar has entered a bear market. A weaker greenback will boost commodity prices and EM assets. Global bond yields will rise modestly over the next few years. However, they will remain extremely low by historic standards. Bond yields will only surge once inflation reaches uncomfortably high levels. At that point, the equity bull market will end. Fortunately, this is unlikely to happen for at least three years. I. Macro And Markets Financial markets’ response to the pandemic has followed three distinct phases: Phase One: Hope and Denial. While equities did buckle on the news that a previously unknown coronavirus had emerged in China, they quickly recovered in the hope that the epidemic would be contained. Equities remained resilient even as the virus resurfaced in South Korea and Iran, prompting us to pen a report in February entitled “Markets Too Complacent About The Coronavirus.”1 Phase Two: The Wile E. Coyote Moment.2 The second phase began with the outbreak in Italy. Scenes of overflowing emergency rooms prompted governments to order all non-essential workers to stay home. The resulting decline in commerce caused equities to plummet. Credit spreads widened, while funding markets began to seize up (Chart 1). Phase Three: Recovery. With memories of the 2008 global financial crisis still fresh in their minds, policymakers sprung into action. The combination of massive monetary and fiscal easing helped stabilize financial markets. Risk assets received a further boost as the number of new cases in Italy, Spain, New York City and other hotspots began to decline rapidly in April (Chart 2). The hope that lockdown measures would be relaxed continued to power stocks in May and early June. Chart 1Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Chart 2Sharp Decline Of New COVID-19 Cases In April Allowed Equities To Recover Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Fast forward to the present and things do not seem as straightforward. Despite today’s rally, global equities are still down 4.7% from their June 8th high. The key immediate question for investors is whether the recent bout of volatility marks the end of Phase Three or just a temporary pause in a new cyclical bull market for stocks. On balance, we lean towards the latter scenario. As we discuss in greater detail below, while we do think that the next few months will be more treacherous for investors due to a resurgence in the number of Covid cases in some countries, as well as uncertainty over how the looming US fiscal cliff will be resolved, we expect global equities to be higher 12 months from now. Stocks And The Economy Pundits such as Paul Krugman often like to recite the mantra that “the stock market is not the economy.” While there is some truth to that, equities still tend to track the ups and downs of the business cycle. This can be observed simply by looking at the strong correlation between the US ISM manufacturing index and the S&P 500 (Chart 3).  Chart 3Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks As happened in 2009 and during prior downturns, stocks bottomed this year at roughly the same time as leading economic indicators such as initial unemployment insurance claims peaked (Chart 4). Chart 4Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Will the economic data continue to improve, allowing equities to move higher? In the past, recoveries following exogenous shocks have tended to be more rapid than those following recessions that arose from endogenous problems. The pandemic would seem to qualify as an exogenous shock. Temporarily furloughed workers have accounted for the vast majority of the increase in US unemployment this year (Chart 5). As lockdown measures are relaxed, the hope is that most of these workers will return to their jobs. Chart 5Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Bumps In The Road Nevertheless, the recovery will be a bumpy one. In the near term, the main barrier will be the virus itself. Globally, the number of new cases has been trending higher since early May. The number of deaths has also reaccelerated (Chart 6). In the US, the epicenter of the pandemic has shifted from the Northeastern tri-state corridor to the southern states. Florida, Texas, and Arizona have been particularly hard hit. Contrary to President Trump’s claims, more testing does not explain the rise in case counts. As Chart 7 shows, the fraction of tests coming back positive has actually been trending higher in all three states. Chart 6Globally, The Number Of New Cases Has Been Trending Higher Since Early May, While The Number Of Deaths Has Moved Off Its Recent Lows Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 7Fraction Of Tests Coming Back Positive Has Been Moving Higher In Certain States Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave It did not have to be this way. The evidence suggests that the widespread use of masks could have kept the virus at bay while still allowing most economic activities to resume (Chart 8). Unfortunately, the question of whether to wear a mask, like almost everything else in the US, has become another front in the culture war. Chart 8Masks On! Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Mask wearing is much more common in China and the rest of east Asia, which is one key reason why the region has suffered far fewer casualties than elsewhere. Hence, a second wave is likely to be much more muted there. Western Europe, Australia, and New Zealand should also remain largely unscathed going forward. Luckily, treatment options have improved over the past few months, as medical professionals have learned more about the virus. Hospitals have also built up capacity to deal with an influx of patients. Another less well recognized development is that protocols have been put in place to protect residents in long-term care facilities. In Canada, more than 80% of COVID deaths have occurred in nursing homes. All this suggests that while a second wave will weigh on global growth over the coming months, we are unlikely to see the sort of broad-based economic dislocations experienced in March. A Structural Break Even if a second wave does not turn out to be as disruptive as the first, it probably will be several years before spending in the sectors most affected by the virus returns to pre-pandemic levels. Indeed, there is a chance that some sectors may not ever fully recover. The technology to work from home was in place before the pandemic began. Many workers chose not to do so because they did not want to be the odd ones out. The pandemic may have nudged society to a new equilibrium where catching a red-eye flight to attend a business meeting becomes more the exception than the rule, while working from home is seen as perfectly acceptable (and safer) than going to the office. If that happens, there will be, among other things, less business travel going forward, as well as less demand for office space. Such a transformation could end up boosting productivity down the road by allowing companies to slash overhead costs and unnecessary expenses. However, it will impose considerable near-term dislocations, particularly for airlines, hotels, commercial real estate operators and developers, and associated lenders to these sectors. The Role Of Policy It would be unwise for policymakers to try to prevent the shift of capital and labor towards sectors of the economy where they can be more efficiently deployed. However, policy can and should smooth the transition. Chart 9Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Most of the suffering during recessions comes in the form of collateral damage. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 9). One does not have to fill a half-empty swimming pool through the same pipe from which the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs will likely find new jobs in other sectors. This is where the role of monetary and fiscal policy takes center stage. Central banks moved quickly to ease monetary policy as soon as the pandemic began. Unfortunately, with rates already quite low in most countries, there was only so much that conventional monetary policy could achieve. The Federal Reserve, which had more scope to cut rates than most, brought the fed funds rate down 150 bps to a range of 0%-to-0.25%. As helpful as this action was, it fell well short of the more than five percentage points in easing that the Fed has delivered, on average, during past recessions (Chart 10). Chart 10Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around With conventional monetary policy constrained by the zero lower bound, central banks turned to unconventional tools, the most important of which were asset purchases, lending backstops, and forward guidance. These tools blurred the line between fiscal and monetary policy. To some extent, this was by design. By offering to buy government debt in unlimited quantities and at extremely low rates, central banks incentivized governments to run larger budget deficits. Even if one excludes loan guarantees, governments have eased fiscal policy by an extraordinary degree this year (Chart 11). The G7 as a whole has delivered 11.7% of GDP in fiscal stimulus, compared to 4% of GDP in 2008-10. In China, we expect the credit impulse to reach the highest level since the Global Financial Crisis, and the budget deficit to hit the highest level on record (Chart 12).  Chart 11Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 12China Has Opened The Spigots China Has Opened The Spigots China Has Opened The Spigots   Fiscal Austerity? Don’t Bet On It The recovery following the Great Recession was hampered by the decision of many governments, including the US, Germany, and Japan, to tighten fiscal policy prematurely, despite a lack of pressure from bond markets to do so. While a repeat of such an outcome cannot be excluded, we think it is quite unlikely. Politically, stimulus remains very popular (Table 1). Unlike during the housing bust, there has been little moral handwringing about bailing out households and firms that “don’t deserve it.” Thus, while the US faces a daunting fiscal cliff over the next two months – including 3% of GDP in expiring Paycheck Protection Program funding and over 1% of GDP in expanded unemployment benefits and direct payments to individuals – we expect Congress to ultimately take action to avert most of the cliff. Table 1There Is Much Public Support For Fiscal Stimulus Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave This will probably involve rolling over some existing programs and supplanting others with new measures such as increased aid to state and local governments. The same pattern is likely to be repeated globally. II. Long-Term Focus: Inflation And The Fiscal Hangover The combination of large budget deficits and falling output has caused the ratio of government debt-to-GDP to explode. The IMF now expects net government debt to reach 132% of GDP in advanced economies in 2021, up from an earlier estimate of 104% made last October (Chart 13). What will happen to all that debt? The answer partly hinges on what happens to the neutral rate of interest, or more precisely, the difference between the neutral rate and the trend growth rate of the economy. The neutral rate of interest is the interest rate that is consistent with full employment and stable inflation. When policy rates are above the neutral rate, unemployment will tend to rise, and vice versa. Most estimates of the neutral rate, such as those produced by the widely used Laubach-Williams model, suggest that it is currently quite low — certainly lower than the potential growth rate of most economies (Chart 14). Theoretically, when GDP growth exceeds the interest rate the government pays on its borrowings, the debt-to-GDP ratios will eventually converge to a stable level, even if the government keeps running a huge budget deficit.3 Chart 13Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Chart 14The Neutral Rate Is Lower Than The Potential Growth Rate In Most Economies Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave   The catch is that this “stable” level of the debt-to-GDP ratio could turn out to be very high. This would leave the government extremely vulnerable to any future change in interest rates. Specifically, if at some point the neutral rate were to rise above the trend growth rate of the economy – and the central bank were to align policy rates with the new higher neutral rate – the government’s borrowing costs would soar. The government would then need to cut spending and/or increase in taxes to make room for additional interest payments.4  The Inflation Solution What if highly indebted governments refuse to tighten fiscal policy? At that point, they would either have to: 1) allow debt levels to spiral out of control; 2) default on the debt; or 3) lean on their central banks to keep rates low. The first two options are unlikely to be politically feasible, implying that the third one would be chosen. By definition, the third option would entail keeping policy rates below their neutral level, or in other words, keeping monetary policy more stimulative than is necessary to maintain full employment and stable inflation. Eventually, this would result in rising inflation. In theory, the increase in inflation can be temporary and limited. Rising consumer prices will lift nominal GDP, causing the ratio of debt-to-GDP to decline. Once the ratio shrinks by enough, central banks could raise interest rates to a suitably high level in order to bring inflation back down. Unfortunately, in practice, the whole process of driving inflation up in order to erode the real value of a government’s bond obligations could be quite destabilizing. This would be especially the case if, as is likely, a period of high inflation leads to a significant repricing of inflation expectations. Long-Term Inflation Risk Is Underpriced Chart 15Long-Term Inflation Expectations Remain Very Depressed Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Investors are not too worried that inflation will accelerate anytime soon. The CPI swap market expects inflation to remain subdued for decades to come (Chart 15). This could turn out to be an erroneous assumption. While central banks do not want inflation to get out of hand, they would be happy for it to increase from current levels. After all, they have been obsessing about the zero-lower bound constraint for the better part of two decades. If inflation is, say, 4% going into a downturn, central banks could cut nominal rates to zero, taking real rates to -4%. That would be quite stimulative. Such a deeply negative real rate would not be achievable if inflation were running at 1% going into a downturn.  As noted above, heavily indebted governments would also prefer higher inflation to higher interest rates. The former would erode the real value of debt, while the latter would require that tax dollars be diverted from social program to bondholders. The Neutral Rate May Rise The catch is that for inflation to rise, the neutral rate has to increase well above current policy rates. Will that happen? Our guess is that such an outcome is more likely than most investors believe. For one thing the neutral rate itself depends on the stance of fiscal policy. Looser fiscal policy will generate more demand in the economy. Since one can think of the neutral rate as the interest rate that equalizes aggregate demand with aggregate supply, this implies that larger budget deficits will increase the neutral rate. If, as seems likely, we are entering an era where political populism promotes big budget deficits, this makes it more likely that economies will, at some point, overheat. Savings Glut May Dissipate The structural forces that have depressed the neutral rate over the past few decades could also abate, and perhaps even reverse course. Take the example of demographics. Starting in the mid-1970s, the ratio of workers-to- consumers – the so-called “support ratio” – began to steadily increase as more women entered the labor force and the number of dependent children per household declined (Chart 16). An increase in the number of workers relative to consumers is equivalent to an increase in the amount of production relative to consumption. A rising support ratio is thus deflationary. More recently, however, the global support ratio has begun to decline as baby boomers leave the labor force in droves. Consumption actually increases in old age once health care spending is included in the tally (Chart 17). As populations continue to age, the global savings glut could dissipate, pushing up the neutral rate of interest in the process. Chart 16The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling Chart 17As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate Meanwhile, globalization, a historically deflationary force, remains on the backfoot. The ratio of global trade-to-output has been flat for over a decade (Chart 18). Globalization took a beating from last year‘s trade war, and is taking another bruising from the pandemic, as more companies relocate production back home in order to gain greater control over their supply chains. It is possible that newfangled technologies will allow companies to cut costs, thereby helping them to bring down prices. But, so far, this remains more a hope than reality. As Chart 19 shows, productivity growth in the major economies remains abysmal. Weak supply growth would slow income gains, potentially leading to a depletion of excess savings. Chart 18The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade Chart 19Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal   Social Unrest Continued social unrest could further disrupt the supply side of the economy. Violent crime has already spiked in a number of major US cities,5 just as it did five years ago in the aftermath of demonstrations in cities such as Baltimore and St. Louis (the US homicide rate rose 23% between 2014 and 2016, partly because police pulled out of many troubled neighbourhoods6). Markets generally ignored the social unrest back then, and they may do so again over the coming months. However, if recent developments herald the beginning of an extended crime wave, this could have momentous implications for asset markets. The number of people institutionalized in prisons and mental hospitals dropped dramatically during the 1960s. This corresponded with a sharp increase in the homicide rate (Chart 20). As violent crime soared, equity valuations dropped. Inflation also accelerated, hurting bondholders in the process (Chart 21). If a country cannot credibly commit to protecting its citizens, it is reasonable to wonder if it can credibly commit to maintaining price stability. Chart 20Dramatic Drop In Institutionalizations During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 21Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s As we discuss in greater detail below, the implication is that the long-term outlook for stocks and bonds is unlikely to be as rosy as the cyclical (3-to-12 month) outlook. III. Investment Implications For Now, Buy The Dip As anyone who has watched a horror movie knows, that scariest part of the film is the one before the monster is revealed. No matter how good the makeup or set design, our imaginations can always fathom something much more frightening than Hollywood can create. COVID-19 is a deadly disease, much deadlier than the common flu. But, at this point, it is a “known known.” The next few weeks will bring news reports of overflowing emergency rooms in some US states, delayed reopenings, and increased talk of renewed lockdowns. The knee-jerk reaction among investors will be to sell stocks. While that was the right trade in March, it may not be the right trade today, at least not for very long. Chart 22Betting Markets Now Expect Joe Biden To Become President Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave At this point, we know how the movie will end. As was the case during the first wave, the latest outbreak will be brought under control through a combination of increased voluntary social distancing and the cessation of activities that are known to significantly contribute to the spread of the disease (allowing bars and nightclubs to reopen was, as many predicted, a huge mistake). Likewise, while the next few weeks could see plenty of posturing among politicians in Washington, the end result will be a deal to avert most of the fiscal cliff. Investors who run for the hills now will end up making the same mistake as those who jettisoned stocks every time the debt-ceiling issue came to the fore in the past. Panicking about the outcome of November’s US presidential election would also be unwise. Yes, if Joe Biden wins and the Democrats take control of the Senate, then Trump’s corporate tax cuts would be in jeopardy. A full repeal would reduce S&P 500 EPS by about 12%. However, the betting markets are already expecting the Democrats to win the White House and Senate (Chart 22). Thus, some of this risk is presumably already priced in. Moreover, it is possible that the Democrats only partially reverse the corporate tax cuts, focusing more on closing some of the more egregious loopholes in the tax code. And even if corporate tax rates do rise, spending would likely rise even more, resulting in a net increase in fiscal stimulus. Lastly, a Biden presidency would result in less trade tension with China, which would be a welcome relief for equity investors. Are Stocks Already Pricing In A Benign Scenario? Chart 23Earnings Optimism Driven By Tech And Health Care Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Bottom-up estimates foresee S&P 500 earnings returning to 2019 levels next year. Does this mean that Wall Street analysts are banking on a V-shaped recovery? Not quite. Outside of the health care and technology sectors, EPS is still expected to be down 9% next year relative to 2019 (Chart 23). Globally, earnings estimates are still fairly downbeat. This suggests that analysts are expecting more of a U-shaped recovery. Of course, what matters to investors is not so much what analysts expect but what the market is pricing in. Given that the S&P 500 is down only 4% year-to-date, have investors gotten ahead of themselves? Again, it is not clear that they have. The value of the stock market does not simply depend on expected earnings growth. It also depends on the discount rate one uses to calculate the present value of future earnings. In a world of exceptionally low interest rates, the contribution from earnings far out into the future to this present value calculation is almost as important as the path of earnings over the next year or two. Provided that the pandemic does not permanently impair the supply-side of the economy, the impact on earnings should be transitory. In contrast, if long-term bond yields are any guide, the impact on the discount rate may be longer lasting. The 30-year US TIPS yield, a proxy for long-term real rate expectations, has fallen by 76 basis points since the start of the year, representing a significant decline in the risk-free component of the discount rate (Chart 24). If we put together analysts’ expectations of a temporary decline in earnings with the observed decline in real bond yields, what we get is an increase in the fair value of the S&P 500 of about 15% since the start of the year (Chart 25). Chart 24The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate Admittedly, the notion that there could be a temporary decline in corporate earnings but a permanent decline in bond yields sounds contradictory. However, it need not be. Imagine a situation where the pandemic does permanently reduce private demand, but that this is fully counteracted by looser monetary policy and increased fiscal stimulus. The result would be the same level of GDP but a lower interest rate.7 As odd as it sounds, this suggests that the pandemic might have increased the fair value of the stock market. Chart 25The Present Value Of Earnings: A Scenario Analysis Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Lots Of Cash On The Sidelines Chart 26Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around The combination of surging government transfers and subdued household spending has resulted in a jump in personal saving. Accumulated US personal savings totalled $1.25 trillion in the first five months of the year, up 123% from the same period last year. Much of that money has made its way into savings deposits and money market funds (Chart 26). As a share of stock market capitalization, US cash holdings currently stand at 51%, up nearly 12 percentage points from the start of the year. Looking at it differently, if the ratio of cash holdings-to-stock market capitalization were to return to January 1st levels, stocks would have to rise by about 30%. Retail Bros Versus The Suits Thanks to a steady flow of income from Uncle Sam, plenty of spare time, zero brokerage commissions, and a lack of opportunities for sports betting, the popularity of day trading has surged (Chart 27). It would be easy to dismiss the rise of the “retail bros” as another comical, and ultimately forgettable, chapter in financial history. That is what most have done. Not us. The late 1990s stock market bubble was as much a consequence of the boom in day trading as the cause of it. That boom lasted for more than four years, taking the S&P 500 to one record high after another. The current boom has lasted less than four months. It may have much further to run. Chart 27Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Keep in mind that every time an institutional investor sells what they regard as overpriced shares to a retail trader, the institutional investor is left with excess cash that must be deployed elsewhere in the stock market. Buying begets buying. Then there are the hedge funds. Brokerages like Robinhood make much of their money by selling order flow data to hedge funds, who then trade on this information. This activity probably lifts prices by enhancing liquidity and reinforcing the price momentum generated by retail trades.  One would also be remiss not to point out that the mockery levelled at retail traders has an aura of hypocrisy to it. The average mutual fund underperforms its benchmark, even before fees are included. As we discussed before, this is not because active managers cannot outperform the market.8 It is because most don’t even bother to try. In contrast to retail traders, a large fraction of institutional investors did not participate in the stock market recovery that began in late March. According to the latest BoA Merrill Lynch Survey, fund managers were still more than one sigma underweight stocks and nearly one sigma overweight cash in June. Along the same vein, speculators increased short positions in S&P 500 futures contracts soon after stocks rallied, paring them back only recently (Chart 28). As of last week, bears exceeded bulls by 25 percentage points in the AAII survey (Chart 29). When positioning is underweight equities and sentiment is bearish, as it is today, stocks are more likely to go up than down.   Chart 28Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Chart 29Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks The bottom line is that stocks could fall another 5%-to-10% from current levels to about 2850 on the S&P 500 and 68 on the ACWI ETF but are unlikely to go much lower, as investors start to anticipate a peak in the number of new cases and a deal to maintain adequate levels of fiscal support. Start Of The Dollar Bear Market A weaker dollar should also help global equities (Chart 30). After peaking in March, the broad trade-weighted US dollar has fallen by 4.4%. Unlike last year, the dollar no longer benefits from higher US interest rates. Indeed, US real rates are below those of many partner countries due to the fact that US inflation expectations are generally higher than elsewhere (Chart 31). Chart 30A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities Chart 31The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 32). If global growth recovers over the coming quarters, the dollar should weaken. The negative pressure on the dollar may be amplified by the fact that the second wave of the pandemic seems likely to affect the US more than most other large economies. Chart 32The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Commodities And Commodity Currencies To Benefit Once fears of a second wave abate, the combination of stronger global growth, infrastructure-intense Chinese stimulus, and a weaker dollar will also boost commodity prices (Chart 33). BCA’s commodity strategists remain particularly fond of oil. They expect demand to pick up gradually this year, with supply continuing to be curtailed by shut-ins among US producers and production discipline from OPEC and Russia. Their latest projections foresee WTI and Brent prices rising more than 50% above current market expectations in 2021 (Chart 34). Chart 33Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 34Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Higher oil prices will be particularly beneficial to currencies such as the Norwegian krone, Canadian dollar, Mexican peso, Colombian peso, and Malaysian ringgit. A Weaker Dollar Will Support Non-US Stocks Stronger global growth, a weaker dollar, and higher commodity prices will disproportionately help the more cyclical sectors of the stock market (Chart 35). Since cyclical stocks tends to be overrepresented outside the US, non-US equities should outperform their US peers over the next 12 months. A weaker dollar will also reduce the local-currency value of dollar-denominated debt. This will be especially helpful for emerging markets. Despite the recent rally, the cyclically-adjusted PE ratio for EM stocks remains near historic lows (Chart 36). EM equities should fare well over the next 12 months. Chart 35Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Chart 36EM Stocks Are Cheap Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 37Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Chart 38Expected Earnings Recovery: US Lags Slightly Behind Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave More broadly, non-US stocks look quite attractive in both absolute terms and in relation to bonds compared to their US peers (Chart 37). They are also unloved. In the BofA Merrill Lynch survey mentioned above, equity managers are heavily overweight the US, despite the fact that consensus earnings estimates point to a slightly faster recovery in EPS outside the United States (Chart 38). Thus, earnings trends, valuations, and sentiment all currently favor non-US stocks. Bond Yields To Stay Subdued… For Now It will probably take a couple of years for the unemployment rate in the G7 to fall to pre-pandemic levels. It will likely be another year or two before labor markets tighten to the point where inflation takes off. And, as discussed above, even if inflation does rise, central banks will be slow to raise rates both because they want higher inflation and because governments will pressure them to keep rates low in order to avoid having to redirect tax revenue from social programs to bondholders. All this suggests that short-term rates could remain depressed across much of the world until the middle of the decade. Chart 39Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Yield curves will steepen marginally over the next few years as global growth recovers and long-term bond yields rise in relation to short-term rates. In absolute terms, however, long-term yields will remain low. An initial bout of higher inflation will not be enough to lift long-term yields to a significant degree given the ability of central banks to cap yields via the threat of unlimited bond purchases – something that Japan and Australia are already doing. Yields will only rise substantially when central banks start feeling uneasy about accelerating inflation. As noted above, that point is probably still 3-to-5 years away. But, when it does come, it will be very painful for bondholders and equity holders alike. Not Much Scope For Further Spread Compression Spreads are unlikely to widen much in a low-rate, higher growth environment. Nevertheless, one should acknowledge that spreads are already low and corporate debt levels were quite elevated going into the recession, especially among companies with publicly-traded bonds (Chart 39). As such, while we generally favor a pro-risk stance over the next 12 months, we would recommend only benchmark exposure to high-yield credit. Within that category, we would favor consumer credit or corporate credit. We would especially shy away from credit linked to urban office and brick-and-mortar retail shopping, given the unfavorable structural shifts in those sectors.  Gold Is Still Worth Owning Chart 40Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Lastly, a few words on gold. We upgraded our view on gold in late March. A weaker dollar will boost gold prices over the next 12 months, while higher inflation down the road makes gold an attractive hedge. Yes, the real price of gold is elevated relative to its long-term history (Chart 40). However, gold prices were distorted during most of the 20th century as one country after another abandoned the gold standard. The move to fiat money eliminated the need for central banks to hold large amounts of gold, which reduced underlying demand for the commodity. Had this move not happened, the real price of gold – just like the price of other real assets such as property and art – would have risen substantially. Thus, far from being above their long-term trend, gold prices could still be well below it. Our full suite of tactical, cyclical, and structural market views are depicted in the matrix below. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020. 2  For those unfamiliar with Saturday morning cartoons, Wile E. Coyote is a devious and scheming Looney Tunes cartoon character usually depicted unsuccessfully attempting to catch his prey, the Road Runner. Wile E. Coyote is outwitted each time by the fast-running bird, but fails to learn his lesson and tries anew. One popular gag involves the coyote running off a cliff, stopping mid-air to look down, only to realize that there is no more road beneath him. 3 This is a tricky point to grasp, so it might be helpful to think through an example. Suppose that government debt is 100 and GDP is also 100. Let us assume that the interest rate is 1%, trend growth is 3%, and the government wishes to run a primary budget deficit of 5% of GDP (the primary deficit is the deficit excluding interest payments). It does not matter if the interest rate and growth are expressed in nominal terms or real terms, as long as we consistently use one or the other. Initially, the debt-to-GDP ratio is 100%. The following year, debt increases to 100+5+100*0.01=106, while GDP rises to 103. Hence, the debt-to-GDP ratio jumps to 106/103=102.9%. The debt-to-GDP ratio will keep rising until it reaches 250%. At that point, debt-to-GDP will stabilize. To see why, go back to the original example but now assume that debt is 250 while GDP is still 100. The following year, debt increases to 250+5+250*0.01=257.5, while GDP, as in the first example, rises to 103. 257.5 divided by 103 is exactly 250%. 4 The standard equation of debt sustainability, which we derived in Box 1 of the Global Investment Strategy Weekly Report titled “Is There Really Too Much Government Debt In The World?”, says that the ratio of government debt-to-GDP will be stable if the primary budget balance (expressed as a share of GDP), p, is equal to the debt-to-GDP ratio (D/Y) multiplied by the difference between the interest rate and the growth rate of the economy, that is, p=D/Y (r-g). When p>D/Y (r-g), debt-to-GDP will fall. When, p<D/Y (r-g), debt-to-GDP will rise. Note that the higher the debt-to-GDP ratio is at the outset, the more the primary budget surplus would need to increase in response to a rise in interest rates.  5 Please see Ashley Southall and Neil MacFarquhar, “Gun Violence Spikes in N.Y.C., Intensifying Debate Over Policing,” The Wall Street Journal, dated June 23, 2020; “Gun Violence Soars in Minneapolis,” WCCO/CBS Minnesota, dated June 22, 2020;  and Tommy Beer, “18 People Were Murdered In Chicago On May 31, Making It The City’s Single Deadliest Day In 60 Years,” Forbes, dated June 8, 2020. 6 Please see “Baltimore Residents Blame Record-High Murder Rate On Lower Police Presence,” npr.org, dated December 31, 2017. 7 For economics aficionados, one can model this as a permanent inward shift of the IS curve and permanent outward shift of the LM curve which leaves the level of GDP unchanged but results in lower equilibrium interest rate. 8 Please see Global Investment Strategy Special Report, “Quant-Based Approaches To Stock Selection And Market Timing,” dated November 9, 2018. Global Investment Strategy View Matrix Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Current MacroQuant Model Scores Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave

Dear Client, There will be no US Equity Insights from July 1-3 inclusive, as the US Equity team will be on vacation for the week. Our regular publication schedule will resume on Monday July 13, 2020 with our Weekly Report. Happy Independence Day.  Kind Regards, Anastasios Highlights Portfolio Strategy Odds are high that stocks will move laterally in Q3, digesting the massive gains since the March 23 lows. Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. On all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress. Tack on the potential dividend cuts/suspensions and we were compelled to downgrade exposure to neutral. A dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions enticed us to trim exposure in the S&P investment banks & brokers index to neutral. Recent Changes Last Tuesday we downgraded the S&P banks and S&P investment banks & brokers indexes to neutral. These two moves also pushed the S&P financials sector weighting to neutral.1 Feature The SPX remains in churning mode, consolidating the massive gains since the March 23 lows. Easy fiscal and monetary policies are still the dominant macro themes underpinning markets, and thus any letdown in either loose policies poses a threat to the 1000 point three-month SPX run-up (bottom panel, Chart 1). Importantly, correlations have gone vertical of late with the CBOE’s implied correlation index – gauging the S&P 500 constituents’ pairwise correlations – surging to 70% (implied correlation index shown inverted, second panel, Chart 1). This is cause for concern as it has historically been a precursor to SPX pullbacks. Typically, stocks move in tandem, especially during risk off phases when everything becomes one big macro trade. Similarly, two Fridays ago we highlighted that the VIX and the S&P 500 were becoming positively correlated.2 The 20-day moving correlation between these two assets is shooting higher, approaching positive territory. Since late-2017 every time this correlation has hit the inflection point near the zero line, stocks has subsequently suffered a sizable setback (Chart 2). Chart 1Short-Term Downdraft Risks Are Rising Short-Term Downdraft Risks Are Rising Short-Term Downdraft Risks Are Rising Chart 2Watch SPX/VIX Correlation Watch SPX/VIX Correlation Watch SPX/VIX Correlation Tack on the public’s renewed interest in COVID-19 according to Google trends search results, and the odds are high that stocks will be range bound this summer (top panel, Chart 1). Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. Turning over to profits on the eve of earnings season, our four-factor macro EPS growth model for the SPX has tentatively troughed at an extremely depressed level (Chart 3). Our SPX EPS estimate for next calendar year remains near $162/share which we consider trend EPS and was last hit both in 2018 and 2019.3 Chart 3Our EPS Growth Model Has Troughed Our EPS Growth Model Has Troughed Our EPS Growth Model Has Troughed Moreover, drilling beneath the surface, this week Table 1 updates the sector and subgroup EPS growth expectations. First we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 1). The third columns in Table 1 show the sector growth rate relative to the SPX. Table 1Identifying S&P 500 Sector EPS Growth Leaders And Laggards Drilling Deeper Into Earnings Drilling Deeper Into Earnings The final columns highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Tech, health care and communication services occupy the top ranks with positive EPS growth expectations, while financials, real estate and energy are forecast to contract in the coming 12 months and have fallen at the bottom of the table. Table 2Sector EPS And Market Cap Weights Drilling Deeper Into Earnings Drilling Deeper Into Earnings Given that the tech sector has the highest profit weight in the SPX roughly 23% projected for next year (Table 2) it has really helped the broad market’s profit growth recovery (Chart 4). As a reminder, we continue to employ a barbell portfolio approach and prefer defensive (software and services) to aggressive tech (hardware and equipment). On the flip side, financials have the third largest profit weight roughly 16% in the S&P 500, trailing tech and health care, and pose a big threat to overall SPX profits next year, especially if there are any hiccups with the reopening of the economy (Table 2). Worrisomely, investors are not voting with their feet and are doubting that financials profits will deliver as the market cap weight relative to the profit weight stands at negative 540bps.  Last Tuesday we downgraded the S&P financials sector to a benchmark allocation via trimming the S&P banks and S&P investment banks & brokers indexes to neutral and this week we delve into more details on these two early cyclical subgroups. Chart 4Earnings Finding Their Footing Earnings Finding Their Footing Earnings Finding Their Footing Downgrade Banks To Neutral… We were compelled to downgrade the S&P banks index to neutral last Tuesday in advance of the Fed’s stress test results. There are high odds that a number of banks will cut/suspend dividend payments in coming quarters in line with the Fed’s guidance in the latest round of stress test, especially if profits take a big hit as we expect. As a reminder, dividends are paid out below-the-line. Beyond the Fed’s stress tests and rising political risks,4 yellow flags are waving on all three key bank profit drivers, namely the price of credit, loan growth and credit quality. First, it is disconcerting that bank relative performance has really not taken the yield curve’s steepening cue and has negatively diverged as we showed last week.5 The year-to-date plummeting 10-year yield is weighing heavily on relative share prices (top panel, Chart 5). The transmission mechanism to bank profits of this lower price of credit is via the net interest margin (NIM) avenue (third panel, Chart 5). NIMs will remain under downward pressure as long at the 10-year Treasury yield stays suppressed owing to the Fed’s immense b/s expansion. The rising likelihood of yield curve control could keep interest rates on the long end of the curve depressed for a number of years similar to what happened between 1942 and 1951. Second, on the credit growth front news is equally worrisome. The widening in the junk spread signals loan growth blues in the quarters ahead (second panel, Chart 6). Despite the initial knee jerk reaction, primarily by corporations, of tapping existing C&I credit lines and causing a surge in bank credit growth, bankers are not willing to extend credit according to the latest Fed Senior Loan Officer survey (third panel, Chart 6). The same survey revealed that banks are reporting lower demand for credit across the board, warning that future loan growth will be anemic at best, especially given the collapse in our economic impulse indicator (bottom panel, Chart 6). Chart 5Bank Yellow Flags Waving Bank Yellow Flags Waving Bank Yellow Flags Waving Chart 6Loan Growth Will Suffer Loan Growth Will Suffer Loan Growth Will Suffer Finally, with regard to credit quality, delinquency and charge-off rates are all but certain to spike in the coming months. The third panel of Chart 7 highlights that historically all these credit quality gauges are lagging. However, the near vertical climb in the unemployment rate recently and persistently high continuing unemployment benefit claims near 20mn signal that non-performing loans (NPLs) are slated to soar in the back half of 2020 (bottom panel, Chart 7). True, the recent $2tn+ fiscal package is acting as a Band-Aid solution by putting money in unemployed consumers’ pockets, but when the money runs out on July 31, the going will get tough especially if Congress does not pass a new fiscal package. In addition, there are “extend and pretend” clauses in the existing relief package especially on the residential mortgage front that aim to help homeowners make ends meet. But, the longer workers stay out of the labor force the higher the chances that their skills atrophy making it difficult for them to return to work. As a result, foreclosure risk is on the rise. While residential real estate loans are no longer the largest category in bank loan books they still comprise a respectable 21% of total loans or $2.3tn, a souring housing market could spell trouble for banks (Chart 8). Chart 7Deteriorating Credit Quality Will Sink Profits Deteriorating Credit Quality Will Sink Profits Deteriorating Credit Quality Will Sink Profits Chart 8Housing Arrears Are A Risk Housing Arrears Are A Risk Housing Arrears Are A Risk Already, residential mortgage delinquencies are rising and in May surged to the highest level since November 2011 according to Bloomberg. 4.3mn residential real estate borrowers are in arrears (this delinquency count includes borrowers with forbearance agreements who missed payments) and “more than 8% of all US mortgages were past due or in foreclosure” according to Black Night Inc., a property information service. Tack on the shattering consumer confidence and the consumer loan category (credit card, auto and student debt) is also under risk of severe credit quality deterioration (fourth panel, Chart 7). The commercial real estate (CRE) side of loan books is also likely to bleed. Anecdotes where landlords are demanding past due rent payment from tenants are mushrooming, at a time when the same landlords refuse to service their loan obligations. According to TREPP, CMBS delinquencies are skyrocketing across different REIT lines of business. Importantly, CRE loans add up to $2.4tn on commercial bank balance sheets or roughly 22% of total loans. Encouragingly, in Q1 banks started to aggressively provision for steep credit losses with commercial bank loan loss reserves now climbing just shy of $180bn according to the latest FDIC Quarterly Banking Profile (second panel, Chart 7). This figure is almost twice as high as noncurrent loans and represents a healthy reserve coverage ratio. However, our fear is that if history at least rhymes NPLs will sling shot higher (bottom panel, Chart 7) rendering loan loss reserves insufficient. Putting this provisioning number in context, according to the Fed’s most adverse stress test scenarios banks’ losses could spring to $700bn: “In aggregate, loan losses for the 34 banks ranged from $560bn to $700bn”.6 As a result, banks will have to further provision for futures losses and thus take an additional hit to profitability. Our bank earnings growth model does an excellent job in capturing all these moving parts and warns of a contraction in profit in the back half of the year (bottom panel, Chart 9). Nevertheless, before getting too bearish on banks, there two key offsetting factors. Relative valuations are bombed out, signaling that most of the bad news is likely reflected in prices (bottom panel, Chart 5). Finally, technicals are also extremely oversold. The second panel of Chart 5 shows that relative momentum is as bad as it gets. Netting it all out, on all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress and compel us to downgrade exposure to neutral. Chart 9Dividend Cuts Are Looming Dividend Cuts Are Looming Dividend Cuts Are Looming …And Move To The Sidelines On Investment Banks & Brokers The S&P investment banks & brokers (IBB) group has a similar investment profile to the S&P banks index. But, given its more cyclical nature it typically oscillates violently around banks’ relative performance. Thus last Tuesday, we were also compelled to move to the sidelines on this higher beta financials subgroup.7 The COVID-19 accelerated recession has not only mothballed potential M&A deals that were in the works, but also a number of previously announced deals have been canceled. In addition, the outlook for M&A is grim, at least until the dust really settles from the coronavirus pandemic (second panel, Chart 10), weighing heavily on the sector’s profit prospects. While “Robinhood” (retail investor) trading stories abound, margin debt remains moribund and continues to contract, despite the V-shaped recovery in all major US stock markets since the March 23 lows (third panel, Chart 10). This coincident indicator speaks volumes in the near term direction of the broad market and any sustained contraction in trading related debt uptake will likely dent IBB profitability. According to the American Association of Individual Investors bullish retail investors have been absent from this quarter’s massive stock market rally and equity mutual fund and exchange traded fund flows corroborate this message (fourth panel, Chart 10). With regard to cyclicality, IBB are extremely quick to prune labor in times of duress and aggressively add to headcount during expansions. Recent trimming of IBB input costs signal that this industry is retrenching as it is trying to adjust cost structures to lower revenue run rates (bottom panel, Chart 10). Chart 10Diminishing Activities Are Profit Sapping Diminishing Activities Are Profit Sapping Diminishing Activities Are Profit Sapping Related to the cyclical nature of the IBB industry, an accelerating stock-to-bond ratio has been synonymous with relative share outperformance and vice versa. In early June we turned cautious on the broad market’s near-term return prospects primarily on the back of rising (geo)political risks. The implication is that a lateral move in the broad market would push down the S/B ratio and weigh on relative share prices (Chart 11). However, there are some offsets that prevent us from turning outright bearish on this niche early-cyclical group. First relative valuations are extremely alluring. On a price-to-book basis IBB traded recently at 0.8x in absolute terms and at a steep 68% discount to the broad market (bottom panel, Chart 12). Chart 11Move To The Sidelines On This Highly Cyclical Industry Move To The Sidelines On This Highly Cyclical Industry Move To The Sidelines On This Highly Cyclical Industry Chart 12Some Positive Offsets Some Positive Offsets Some Positive Offsets Second, volatility has gone haywire since late-February and it remains elevated with a VIX reading still north of 30. This is a fertile environment for IBB trading desks and should translate into higher profits (second panel, Chart 12). Third, equity trading volumes have exploded. True, volumes spike on downdrafts, but they have remained at an historically high level recently underscoring that IBB trading desk should be minting money (third panel, Chart 12). Adding it all up, a dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions compelled us to trim exposure in the S&P investment banks & brokers index to neutral. Bottom Line: Downgrade the S&P banks index to neutral for a loss of 32.4% since inception. Trim the S&P investment banks & brokers index to neutral for a loss of 24% since inception. These moves also push the S&P financials sector to a benchmark allocation. 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, and BLBG S5INBK – GS, MS, SCHW, ETFC, RJF, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Insight Report, “Tales Of The Tape” dated June 19, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value ” dated April 27, 2020, and BCA US Equity Strategy Special Report, “Debunking Earnings” dated May 19, 2020, both available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 5    Ibid. 6    https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200625c.htm 7    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).

Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections ...But Led To Many More Infections ...But Led To Many More Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark.  As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Chart I-5…And More ##br##Deaths Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare ...Like Healthcare ...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania  Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF AUD/CHF AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights We test the out-of-sample performance of Mean-Variance Optimization (MVO) portfolios. We find that MVO portfolios based on historical estimates have historically underperformed static-weight portfolios. However, MVO portfolios using momentum-based return estimates and a “shrunk” correlation matrix dramatically improved performance, allowing them to outperform our benchmarks. Additionally, MVO portfolios where the asset weights could not deviate more than 10% from the benchmark still added value, making them a more attractive option for benchmarked investors. Feature “Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve” – Rabbi Isaac bar Aha, Babylonian Talmud, 200 C.E.   Diversification is the main pillar of asset allocation. Its advantages are clear: By spreading out funds to different assets, a portfolio can remain resilient to the failings of individual investments, provided they do not occur at the same time. But, while it is universally accepted that “you should not put all your eggs in one basket”,1 putting this concept into practice remains challenging: After all, how exactly do you diversify? The first attempt to answer this question dates back to the Babylonian Talmud, which suggested that an equally weighted portfolio between a growth asset, a real asset, and a safe asset was the best way to allocate one’s funds. After that, it took almost 2000 years for the first formal theory on portfolio construction to emerge, with the derivation of the mean-variance solution by Harry Markowitz in the 1950s. Today, while other methods such as risk parity, factor-based diversification, and the Kelly criterion have also emerged, mean-variance optimization remains the standard theoretical framework for portfolio construction. However, mean-variance optimization (MVO) has not proven to be the final solution to the asset allocation puzzle. Far from it. With time, investors have realized that, while MVO might provide the optimal allocation in theory, it has several drawbacks when used to construct real world portfolios. Specifically, MVO portfolios have become notorious due to their inability to deal with estimation error, as well as for their large concentrated positions on a single asset. In this report we examine the strengths and weaknesses of MVO portfolios from an empirical standpoint, and we suggest three practical solutions to solve some of the problems described above. The report is structured as follows: We first describe our data and methodology in our Methodology section. We then provide a summary of our main findings in the Summary Of Results section. For readers who wish to read a more detailed description of our analysis, please refer the Results In Full section. Methodology Data In order to build optimized portfolios, we use monthly returns for seven assets from the perspective of a US-based investor: US equities, international equities (developed markets ex-US), US Treasurys, US investment-grade corporate bonds, commodity futures, US REITs, and US cash. We use a sample starting in 1973 and ending in April 2020.2 Optimization We build three types of mean-variance optimized portfolios: A conservative portfolio, with a target volatility of 6%, a moderate portfolio, with a target volatility of 9%, and an aggressive portfolio, with a target volatility of 12%.3 In the optimization procedure, each portfolio seeks to maximize returns subject to the risk constraint. In addition to this risk constraint, we also do not allow for leverage or short positions. The optimization and rebalancing are done on a monthly basis. Benchmarking As a benchmark we build three portfolios (an aggressive benchmark, a moderate benchmark, and a conservative benchmark) with constant weights. The portfolios are rebalanced on a monthly basis. Be advised that this is not a completely fair comparison, as these benchmarks are constructed ex-post, which means that in contrast to the MVO portfolios, these benchmark portfolios have the benefit of hindsight to achieve their target volatility. However, they will prove useful to evaluate whether MVO portfolios are doing a good job at maximizing returns. Table 1 describes the benchmark portfolios. Table 1Benchmark Portfolio Weights The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization Turnover limits In order to get a better picture of how MVO performs under realistic conditions, we assess the performance of MVO portfolios with turnover limits. These turnover limits are put in place to take into account that changing portfolio weights by large amounts from month to month is not feasible for most asset managers. We limit the month-to-month change in the weight of each asset to 5%. As an example, if the current weight in US Treasurys is 20%, and the MVO finds that the optimal weight for the following month is 40%, the new weight will only be 25%. In a few months this results in buying and selling not being equal. In those cases, turnover for certain assets might be limited further to ensure that all of the weights add up to 100%. Transaction costs Table 2One-Way Transaction Costs The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization To calculate transaction costs, we multiply the absolute value of the month-on-month change in the weight of each asset by the transaction costs shown in Table 2. Note that this approach does not take into account drift. However, this will not be important when comparing portfolios, given that drift will also not be considered for the benchmarks (since weights stay static from month to month, transaction costs for the benchmarks are zero in our analysis).   Summary Of Results After conducting our analysis, our main findings were the following (please see full details below in the following sections): Historical performance MVO portfolios using historical estimates as inputs have historically underperformed static-weight benchmarks in both raw return and risk-adjusted terms (Table 3). The realized volatility of MVO portfolios was relatively close to their target risk over the sample. However, this was not true when looking at shorter periods. Table 3Summary Of Results The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization Solution #1: Momentum-based return estimates Expected return estimates can be improved by taking into account that prices usually trend (price momentum). These momentum-based return estimates improve both the return and the Sharpe ratio. Additionally, the volatility of MVO portfolios using momentum-based return estimates remains below the target risk more consistently. Solution #2: Shrinking correlation matrix  Historical correlation estimates are often too noisy and lead to estimation error.  “Shrinking” cross-asset correlations to a pre-specified value often results in improvements in both raw returns and risk-adjusted returns.   Very high shrink factors had the best performance. Solution #3: Constraining weights MVO portfolios result in large concentrations in one or two assets. Such an allocation is not practical for most asset managers, particularly if they are benchmarked. However, MVO can improve performance even when asset weights are constrained. Specifically, the information ratio can be improved when using the two solutions described above. We remind clients that MVO should be used prudently. Specifically, even though many of the measurements we have suggested here concentrate in making MVO more robust to noisy estimates, MVO is always vulnerable to the risk of estimation error. Other inputs should be considered when making final asset allocation decisions. Results In Full Historical performance The theory underpinning mean-variance optimizations assumes perfect knowledge of expected returns, volatility, and correlation. In practice, however, this is never the case. Instead, these inputs need to be estimated – a process which unavoidably carries error with it. This error in the estimated inputs can lead to significant deviations from the optimal weights, resulting in lower performance. But to what extent does performance suffer when using imperfect inputs? To answer this question, we construct MVO portfolios as they are often built in practice: using historical estimates. The portfolios are built as follows: Each month we use the historical mean return, historical volatility, and historical correlation matrix up to that point in time, as inputs for every asset with the exception of cash.4 To ensure that the historical inputs are robust enough, we start building the portfolios when we have at least 10 years of historical data (since our data begins in 1973, we start building the portfolios in 1983). Table 4 shows several key metrics for these MVO portfolios with the different risk targets as well as for their benchmarks. Overall, MVO portfolios underperformed their respective benchmarks in every single category regardless of the risk level. This result is in line with previous research, which has shown that MVO usually underperforms equally weighted or static-weight portfolios.5 Table 4MVO Versus Benchmarks The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization The one positive trait of the MVO portfolios was that the volatility of returns over the entire sample stayed relatively close to the risk target. This happened because, over the very long term, volatility remains fairly stable within assets, in stark contrast to returns or correlations, which can undergo dramatic changes even over very long horizons. (Chart 1). However, it is important to point out that, while the volatility of the MVO portfolios stayed relatively close to the risk target throughout the almost 40-year sample, the same was not true if we look at subperiods. Volatility of MVO portfolios was often significantly higher than the risk constraint in the medium term (Chart 2). This is a problem, given that asset managers are usually evaluated in these shorter time frames. Chart 1Volatility Is Relatively Stable Over The Long-Term Volatility Is Relatively Stable Over The Long-Term Volatility Is Relatively Stable Over The Long-Term Chart 2MVO Volatility Can Stray Well Above Target MVO Volatility Can Stray Well Above Target MVO Volatility Can Stray Well Above Target   Solution #1: Momentum-based return estimates Expected returns are the most important input for mean-variance optimization. In general, there are many ways to improve on the dismal track record of historical estimates. However, in this report we will focus on a simple way to improve them. Specifically, we take into account the fact that prices usually trend. As we discussed in our July 2019 report, momentum in asset prices has been one of the most persistent forces in the history of financial markets.6 The propensity of returns to trend, was first discussed by the academic literature in the 1990s but has possibly been known amongst practitioners since the primitive financial markets of the 17th century. We use this simple stylized fact about returns for a couple of reasons: First, there is extensive literature arguing that there are structural forces which causes prices to trend. This gives us some assurance that this tendency is not a random trait of the data, but rather a result of an internal mechanism in the market. Second, the existence of price momentum has been known for a very long time, which means that any sophisticated investor could have realistically used this fact during our sample to improve his or her estimate of expected returns. To take price momentum into account, we estimate expected returns as follows for each asset except for cash: Each month we compute the average return of the asset up to that point, following periods when price was above the 12-month moving average (uptrend average). We also compute the average return of the asset up to that point, following periods when price was below the 12-month moving average (downtrend average). If the asset’s price is above its 12-month moving average, we use the uptrend average as our expected return estimate. If the asset’s price is below its 12-month moving average, we use the downtrend average as our expected return estimate. Much like with our historical estimates, we wait until we have 10 years of data to begin constructing the portfolios. Table 5 shows the result of the MVO portfolios using these momentum-based expected return inputs, as well as the MVO portfolios using historical estimates and the benchmarks. Overall, using momentum-based expected returns significantly improved the performance of all of the MVO portfolios. Additionally, the volatility of the enhanced MVO portfolios was much better behaved, staying much closer to the risk target than the volatility of the MVO that used historical return estimates (Chart 3). Table 5Momentum-Based Return Estimates Enhance Performance The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization Chart 3Momentum-Based Return Estimates Lead To Better Behaved Volatility Momentum-Based Return Estimates Lead To Better Behaved Volatility Momentum-Based Return Estimates Lead To Better Behaved Volatility Solution #2: Shrinking correlation matrix What about improving correlation estimates? Correlations are notoriously noisy and difficult to forecast since they often change depending on the regime. Moreover, while the number of estimates necessary for expected returns and volatility increases linearly with the number of assets in consideration, the number of estimates necessary for the correlation matrix increases at a much higher rate.7 One alternative solution proposed by practitioners to deal with this noise and limit the amount of estimation error is to anchor correlations to some pre-specified value (also known as “shrinking” the correlation matrix). This reduces the noise of the correlation estimate, making for a much more robust input. Shrinking the correlation matrix can be done as follows: Choose shrinkage target: The anchor value or the shrinkage target, is the number to which cross-asset correlations are anchored. Often the average cross-asset correlation between all assets is chosen as the shrinkage target.8 Choose a shrinkage factor: The shrinkage factor is the weight we put on the anchor versus our estimate. The weighting is done with the formula below: Shrunk correlation = (Shrinkage factor) * (Shrinkage target) + (1-Shrinkage factor)* (Correlation estimate) But what exactly should the shrinkage factor be? To answer this question, we test the performance of MVO portfolios that use historical estimates for expected returns and variance, but where the correlation matrix is shrunk. Additionally, we examine how varying the shrinkage factor affected historical performance for different types of investors. Our results indicate that correlation matrices with high levels of shrinkage (70%+ shrink factor) have invariably improved Sharpe ratios and reduced volatility, while also improving returns in almost all cases (Table 6). Table 6High Shrinkage Factors Lead To Better Risk-Adjusted Returns The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization This result was also robust to using other types of expected return estimates. Table 7 shows that shrinking the correlation continued to either maintain or improve performance when using the momentum-based expected return inputs from the section above. Importantly, MVO portfolios using momentum-based returns and shrunk correlation with high shrinkage factors were able to beat the benchmarks at various metrics regardless of the type of portfolio. Table 7Momentum-Based Return Estimates Enhance Performance The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization Solution #3: Constraining weights MVO often results in portfolios that have highly concentrated positions in one or two assets (Chart 4). Additionally, asset weights can experience dramatic changes, even when turnover limits are imposed. For several reasons this is not a desirable trait for most asset managers. Benchmarked managers in particular are often constrained in how much they can deviate from their benchmarks. Moreover, even if they do not have explicit deviation limits, benchmarked managers are often limited implicitly since they are evaluated on their tracking error. Chart 4MVO Weights Are Highly Concentrated The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization One solution to the extreme weights problem is to limit the amount by which the weights can deviate from the benchmark. To test this hypothesis, we perform the optimization as described previously, using momentum-based return estimates and a shrunk correlation matrix, but we limit the amount by which weights can deviate from the benchmark weights by 10%. Table 8A shows the result of MVO portfolios with weight limits, as well the benchmark. Overall, constraining the amount of deviation from the benchmark weights resulted in significant performance improvements across every metric we tested on. Additionally, while the limited MVO portfolios did not always outperform the unconstrained MVO portfolios in terms of return, they were able to have much lower tracking risk and better information ratios, making them a better option for benchmarked investors (Table 8B). Finally, the constrained portfolios had much better-behaved asset weights than the unconstrained ones9 (Chart 5). Table 8APortfolios With Shrunk Correlation (80% Shrinkage Factor) & Momentum-Based Return Estimates The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization Table 8BPortfolios With Shrunk Correlation (80% Shrinkage Factor) & Momentum-Based Return Estimates The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization Chart 5Limited MVO Leads To More Realistic Assets Weights For Benchmarked Investors The User Manual On Portfolio Construction: Mean-Variance Optimization The User Manual On Portfolio Construction: Mean-Variance Optimization   Juan Correa Ossa, CFA  Associate Editor juanc@bcaresearch.com Footnotes 1  The origin of this phrase is often attributed to Don Quijote, the main character of the famous 17th century Spanish novel of the same name by Miguel de Cervantes. 2 Our sources are MSCI Inc (Please see copyright declaration), Bloomberg /Barclays Indices, National Association Of Real Estate Investment Trusts and Goldman Sachs via Datastream. 3 Our approach is loosely based on the work from Bessler, Opfer and Wolff. For more details, please see Wolfgang Bessler, Heiko Opfer, and Dominik Woff, “Multi-Asset Portfolio Optimization and Out-of-Sample Performance: An Evaluation of Black-Litterman, Mean-Variance, and Naïve Diversification Approaches”, European Journal of Finance, Vol. 23, no.1, 2017. 4 For the expected return of cash we just use the current cash yield, since this will be the return of cash with certainty. Volatility and correlation are calculated using historical estimates. 5 Please see De Miguel, Garlappi, Uppal, “Optimal Versus Naïve Diversification: How Inefficient is the 1/N Portfolio Strategy?”, The Review of Financial Studies, Vol. 22, no. 5, May 2009. 6 Please see Global Asset Allocation Report “Swimming With The Tide: Momentum Strategies In Financial Markets,” dated July 23 2019, available at gaa.bcaresearch.com 7 Specifically, if you need to build a portfolio of n assets, you need n estimates of expected returns, n estimates of variances but (n*(n-1))/2 estimates of asset correlations. 8 We use this method to compute the shrinkage target in our analysis since we have a balanced variety of assets (two risk assets, two fixed income assets, two real assets and cash). However, be advised that this shrinkage target might not always be appropriate. In general, judgement should be used to choose an appropriate shrinkage target. 9 In general, there might be other benefits to constraining asset weights. A recent paper by Pedersen et al showed that MVO tends to suffer due to taking large exposure in problematic portfolios that arise due to noise. Constraining MVO weights is a solution to control for this noise and keep the optimization from overweighting this problem portfolios. For more details please see Pedersen, Lasse Heje and Babu, Abhilash and Levine, Ari, “Enhanced Portfolio Optimization”, NYU Stern School of Business, 2020.

Highlights Treasuries: Keep portfolio duration close to benchmark on a 6-12 month horizon, but continue to hold tactical overlay positions that will profit from modestly higher bond yields: Overweight TIPS versus nominal Treasuries, hold duration-neutral nominal curve steepeners, hold real yield curve steepeners. IG Tech: Given our positive outlook for investment grade corporate bond spreads, the Technology sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech spreads are attractive compared to other A-rated corporate bonds. HY Tech: We want to focus our high-yield allocation on defensive sectors where a large proportion of issuers are able to benefit from Fed support. The high-yield Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Feature Chart 1Three Treasury Trades Three Treasury Trades Three Treasury Trades As we have previously written, bond yields should move modestly higher over the course of the summer as the US economy re-opens.1 However, there are enough potential medium-term pitfalls related to US politics and COVID transmission that we aren’t yet comfortable with below-benchmark portfolio duration. Instead, we recommend that investors keep portfolio duration close to benchmark on a 6-12 month horizon, but add three tactical overlay positions that will profit from higher bond yields: Overweight TIPS versus nominal Treasuries Duration-neutral nominal Treasury curve steepeners Real yield curve steepeners All three of these positions have performed well during the past couple of months (Chart 1), and in the first section of this report we assess whether they have further to run. The remaining two sections of this week’s report consider the outlooks for investment grade and high-yield Technology bonds, respectively. Three Trades To Profit From Higher Yields 1) Overweight TIPS Versus Nominals Chart 2Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model TIPS breakeven inflation rates have moved up considerably since mid-March. Back then, the 10-year TIPS breakeven rate troughed at 0.50%. It currently sits at 1.31%. Despite the large move, TIPS breakeven inflation rates still have a considerable amount of upside. One way to assess how much is through the lens of our Adaptive Expectations Model (Chart 2).2 This model considers several different measures of inflation expectations (based on realized CPI inflation and surveys) and uses the difference between those measures of inflation expectations and the 10-year TIPS breakeven inflation rate to forecast the future 12-month change in the 10-year TIPS breakeven. At present, the model forecasts that the 10-year TIPS breakeven inflation rate will rise 23 bps during the next 12 months, bringing it to 1.54%. It’s important to note that our model is biased towards measures of longer-run inflation expectations. As a result, it can be surprised from time to time by large fluctuations in drivers of short-term inflation expectations, like the oil price. This year’s massive drop in oil – and concurrent decline in headline inflation – were the main factors that caused the 10-year TIPS breakeven inflation rate to fall so far below our model’s fair value. However, as we discussed in last week’s report, the oil price looks to have troughed and there is preliminary evidence that we might also be past the lowest point for headline CPI.3 Profit from rising bond yields by entering a duration-neutral yield curve steepener. We see TIPS continuing to outperform nominal Treasuries over both short- and long-run horizons. 2) Duration-Neutral Yield Curve Steepeners Chart 3Stick With Steepeners Stick With Steepeners Stick With Steepeners Another way to profit from rising bond yields without taking a large duration bet is via a duration-neutral yield curve steepener. One example would be a long position in the 5-year note and a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. Alternatively, you could use the 2-year note and 30-year bond as the two legs of the barbell. These sorts of duration-matched trades where you take a long position in a bullet maturity near the middle of the curve and go short the wings are designed to perform well in periods of yield curve steepening.4  In the current environment, where dovish Fed guidance has dampened volatility at the front-end of the yield curve, any bond sell-off will be felt disproportionately at the long-end, leading to a steeper curve. The only problem with this proposed trade is that it is no longer cheap. The spread between the 5-year bullet and 2/10 barbell is -6 bps and the spread relative to the 2/30 barbell is -3 bps (Chart 3). What’s more, the 5-year bullet trades expensive relative to the 2/10 and 2/30 barbells, according to our fair value models (Chart 3, bottom panel). However, for the time being we are inclined to overlook stretched valuations. The 5-year bullet does appear expensive but it has been more expensive in the past, most notably during the last zero-lower-bound episode from 2010 to 2013. Similar to then, the market is now priced for an extended period of a zero fed funds rate. We would not be surprised to see bullets become much more expensive in that sort of environment, and possibly even return to extended 2010-2013 valuations.   We recommend holding onto duration-neutral yield curve steepeners, despite unattractive valuations. Specifically, we favor going long the 5-year bullet and short a duration-matched 2/10 barbell. 3) Real Yield Curve Steepeners Chart 4Higher Inflation Means Steeper Real Yield Curve Higher Inflation Means Steeper Real Yield Curve Higher Inflation Means Steeper Real Yield Curve The final position we recommend is a steepener along the real yield curve. We first recommended this trade on April 28 when a plunge in oil (and spike in deflationary sentiment) caused the real 2-year yield to jump to 0.28% compared to a real 10-year yield of -0.70%.5 Since then, the real 2-year yield has collapsed to -1% compared to a real 10-year yield of -0.87%. Although the real 2-year/10-year slope is once again positive, it has typically been higher during the past few years (Chart 4). We therefore expect further steepening as long as the oil price and headline inflation continue to recover from April’s lows. Much like during the 2008/09 financial crisis, the combination of the Fed’s zero-lower-bound forward guidance and a massive drop in both oil and headline inflation caused short-dated real yields to jump. Subsequently, this led to a massive steepening of the real yield curve, once the oil price and headline inflation started to recover. We believe that same dynamic is playing out today. Investors should continue to hold real yield curve steepeners, at least until rebounding oil and headline CPI return short-dated inflation expectations to more reasonable levels. Investment Grade Tech Risk Profile Technology accounts for 9% of the overall Bloomberg Barclays investment grade corporate index, which makes it the second biggest industry group, after Banking. Its large index weight is due to the presence of three tech giants: Microsoft (Aaa-rated), Apple (Aa-rated) and Oracle (A-rated) which, combined, constitute 38% of the Tech sector.  Investment grade Technology is a highly defensive corporate bond sector. In sharp contrast with the equity market, Technology is a highly defensive corporate bond sector. That is, it tends to outperform the overall corporate bond index during periods of spread widening and underperform during periods of spread tightening. This largely comes down to the fact that Tech has a higher credit rating than the overall corporate index. Twenty five percent of the Tech sector’s market cap carries a Aaa or Aa rating compared to just 9% for the overall index (Chart 5). Further, of the high-flying FAANG stocks that garner a lot of attention from equity analysts, only Apple is a significant presence in the Technology bond index.6 Chart 5Investment Grade Credit Rating Distributions* Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Chart 6IG Technology Risk ##br##Profile IG Technology Risk Profile IG Technology Risk Profile The Tech sector’s defensive nature is confirmed by looking at its duration-times-spread (DTS) ratio and historical excess returns (Chart 6).7 The sector’s DTS ratio is consistently below 1.0, and its excess returns show a clear pattern of outperformance during periods of spread widening and underperformance during periods of spread tightening. Valuation In terms of valuation, although the Tech sector does not offer a spread advantage over the corporate index – which should be expected given its higher credit rating – we find that it trades cheap relative to its comparable credit tier (Table 1). Tech offers an option-adjusted spread of 115 bps versus 111 bps for the A-rated corporate index, and the sector still appears attractive after controlling for duration differences by looking at the 12-month breakeven spread. In absolute terms, Tech sector spreads are just above their median since 2010. The A-rated corporate index spread currently sits right on top of its post-2010 median. Table 1IG Technology Valuation Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Balance Sheet Health Chart 7IG Technology Debt Growth IG Technology Debt Growth IG Technology Debt Growth The Technology sector added a large amount of debt during the last recovery. The par value of the Tech index’s outstanding debt has grown 5.2 times since 2010 compared to 2.4 times for the benchmark. As a result, Tech’s weight in the corporate index has more than doubled, from 4% to 9% (Chart 7). However, earnings have done a pretty good job of keeping pace with the large increase in debt. The market cap-weighted net debt-to-EBITDA ratio for the investment grade Tech index is only 2.4, and the sector’s average credit rating has been stable since 2010. At the individual issuer level, there are 58 issuers in the Tech index and only 4 currently have a negative ratings outlook from Moody’s (Appendix B). What’s more, of the 16 Tech sector ratings that Moody’s has reviewed this year, 12 have been affirmed with a stable outlook, 1 was assigned a positive outlook and only 3 were assigned negative outlooks. Macro Considerations Chart 8Technology Sector Macro Drivers Technology Sector Macro Drivers Technology Sector Macro Drivers The Tech sector can be split into three major segments that have distinct macro drivers: Software (26% of Tech index market cap, includes Microsoft and Oracle) Hardware (29% of Tech index market cap, includes Apple, IBM and Dell) Semiconductors (24% of Tech index market cap, includes Intel and Avago Technologies) Software investment has been in a structural bull market for many years, and should remain resilient during the COVID recession as demand for remote working solutions increases. While we only have data through the end of March, software investment did not see the same collapse as other sectors during the first quarter (Chart 8). The Hardware and Semiconductor segments are more cyclical and geared toward manufacturing. As such, their macro outlooks were already challenged pre-COVID, due to the US/China trade war and manufacturing downturn of 2019. Both US computer exports and global semiconductor sales were showing signs of life near the end of last year, but were decimated when the pandemic struck in 2020 (Chart 8, panels 3 & 4). A revival in this space is contingent upon continued gradual re-opening and a return to economic growth. More optimistically, US consumer spending on personal computers and peripheral equipment has not fallen as much as broad consumer spending during the past few months (Chart 8, bottom panel). In the long-run, the 5G smartphone rollout is a significant structural tailwind for both semiconductor issuers and Apple. Meanwhile, the threat of significant regulatory crackdown on Tech firms remains a long-run risk. Our sense is that any push toward stricter regulations won’t have that much impact on Technology bond returns. This is because the subjects of most lawmaker scrutiny – Facebook, Amazon and Google – are largely absent from the Bloomberg Barclays Tech index. Investment Conclusions We expect that investment grade corporate bond spreads will tighten during the next 6-12 months. Against this positive back-drop, investors should focus exposure on cyclical (lower-rated) sectors that offer greater expected returns. With that in mind, the Tech sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech does offer a slight spread advantage compared to other A-rated bonds and the macro back-drop is reasonably supportive. We would therefore recommend Tech bonds to investors looking for some A-rated corporate bond exposure. But in general, we prefer the greater spreads on offer from sectors that occupy the high-quality Baa space, such as subordinate bank debt.8 High-Yield Tech Risk Profile High-Yield Technology’s credit rating profile is similar to that of the overall benchmark, but with a slightly larger presence of low-rated (Caa & below) issuers (Chart 9). The largest issuers in the space are Dell (5.7% of Tech index market cap, Ba-rated), MSCI Inc. (5.1% of Tech index market cap, Ba-rated, see copyright declaration) and CommScope (8.1% of Tech index market cap, B-rated). High-yield Tech recently transitioned from being a cyclical sector to a defensive one. Interestingly, the high-yield Tech sector recently transitioned from being a cyclical sector to a defensive one. The sector behaved cyclically during the 2008 recession, underperforming the index when spreads widened and outperforming when they tightened. But Tech then outperformed the High-Yield index during the spread widening episodes of 2015 and 2020. Based on the sector’s low DTS ratio, this defensive behavior should persist for the next 12 months (Chart 10). Chart 9High-Yield Credit Rating Distributions* Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Chart 10HY Technology Risk Profile HY Technology Risk Profile HY Technology Risk Profile Valuation The High-Yield Technology option-adjusted spread (OAS) is significantly lower than the average OAS for the benchmark High-Yield index. However, it offers a spread premium compared to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes high-yield Tech look significantly more attractive. The high-yield Tech spread would have to widen by 146 bps for the sector to underperform duration-matched Treasuries during the next 12 months. This compares to 96 bps for other Ba-rated issuers and 152 bps for the overall junk index. Table 2HY Technology Valuation Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds It is apparent that the Tech sector’s low average duration (Chart 10, bottom panel) is a major reason for its relatively tight OAS. On a risk-adjusted basis, high-yield Tech valuation actually appears quite compelling, with a 12-month breakeven spread only 6 bps below that of the overall index. Balance Sheet Health Chart 11HY Technology Debt Growth HY Technology Debt Growth HY Technology Debt Growth The amount of outstanding high-yield Technology debt has grown a bit more rapidly than overall junk index debt since 2010 (Chart 11). As a result, Technology’s weight in the index has increased from 5% in 2010 to 6% today. At the issuer level, the Tech sector should benefit from having a large number of issuers that will be able to take advantage of the Fed’s Main Street Lending facilities. To be eligible for the Main Street facilities, issuers must have less than 15000 employees or less than $5 billion in 2019 revenue. Also, the issuers must be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. Of the 43 high-yield Tech issuers with available data, we estimate that 30 are eligible to receive support from the Main Street facilities (Appendix C). This even includes 11 out of the 16 B-rated issuers. Typically, we don’t expect that many B-rated issuers will be eligible for the Main Street facilities, which makes this result encouraging for Tech sector spreads. Investment Conclusions We recommend an overweight allocation to high-yield Technology bonds. As we wrote last week, high-yield spreads appear too tight if we ignore the impact of the Fed’s emergency lending facilities and consider only the fundamental credit back-drop.9 With that in mind, we want to focus our high-yield allocation on defensive sectors where a large proportion of issuers able to benefit from Fed support. The Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. 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 3Performance Since March 23 Announcement Of Emergency Fed Facilities Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Appendix B Table 4Investment Grade Technology Issuers Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds Appendix C Table 5High-Yield Technology Issuers Take A Look At High-Yield Technology Bonds Take A Look At High-Yield Technology Bonds   Ryan Swift US Bond Strategist rswift@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 4 For an explanation of why this works please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 6 Of the other FAANG stocks: Google accounts for just 0.5% of Tech bond sector market cap, Facebook has close to no debt, Amazon is included in the Consumer Cyclical corporate bond index and Netflix is included in the Media: Entertainment sector of the High-Yield index. 7 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 8 For more details on our recommendation to overweight subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Credit Impulses Are Large, But The Hole In Output Is Much Larger Credit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent A Full Shutdown Collapses Output By 30 Percent A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2  But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion.  Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China ...And In China ...And In China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers.  To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... $10-15 Trillion Of QE Is Chicken Feed... $10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates ...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates ...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Bond Yields That Can Decline Will Decline Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. MSCI: Germany Vs. UK MSCI: Germany Vs. UK In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 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 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion.   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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear client, It was my pleasure to join Dhaval Joshi, BCA’s Chief European Investment Strategist, this past Friday June 12, 2020 on a webcast he hosted titled: “Sectors To Own, And Sectors To Avoid In The Post-Covid World”. You can access the replay of the lively webcast here, where Dhaval and I debate how investors should be positioned in different time horizons. I hope you will find it both insightful and informative. Kind Regards, Anastasios Highlights Portfolio Strategy While we cannot time the exact equity market top, our sense is that we are more than fairly valued at the current juncture and the equity market has entered a speculative phase; thus the risk/reward tradeoff is poor in the near-term. We are compelled to put the S&P home improvement retailers index (HIR) on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year. Recent Changes Our rolling 10% stop got hit last Tuesday and we monetized 32% gains since the reinstatement of the long S&P oil & gas exploration & production / short global gold miners pair trade.1 Feature Equities briefly erased all losses for the year early last week, but the Fed’s June meeting lacked any additional easing measures and served as a catalyst for a much needed breather – the fifth 5.3-7.3% pullback since the March 23 bottom – as the week drew to a close. While extremely easy monetary and fiscal policies remain the key macro drivers for the SPX, any hiccups in passing a new fiscal spending bill once the money runs out on July 31, carry enough risk to short circuit the equity market’s momentum and result in a shakeout phase. Importantly, given the recent speculative overshoot in equities, the cyclical return potential has diminished, and that is cause for concern. The ongoing COVID-19 catalyzed recession that the NBER last week confirmed commenced in February, the “second wave” risk, a flare up in the US/Sino trade war and more recently, civil unrest have dominated the news flow. However in all this chaos, the November election has slowly moved into the background, especially the SPX return implications during the 4th year of a Presidency. Chart 1 shows the profile of the S&P 500 during Presidential Election calendar years, going back to the 1950s. The solid green line shows the historical mean, and shaded areas denote the 10th and 90th percentiles of SPX performance. If history rhymes, the average profile of these 17 iterations suggests that more cyclical gains are in store for the S&P 500. Chart 1Do Not Ignore… Do Not Ignore… Do Not Ignore… Nevertheless, before getting carried away, a word of caution is in order. As we highlighted last week, a Biden win represents a risk to the SPX’s euphoric rise from the March lows, and could serve as a catalyst for a much needed pullback (Chart 2).2 Thus, according to our analysis if the 90th percentile proves accurate, then the SPX could trace this lower bound and fall 640 points or 20% (Chart 1). This is a key tail risk to our cyclically sanguine equity market view. Chart 2…(Geo)Political Risks Exit Stage Right Exit Stage Right Turning over to the reopening of the economy, while the SPX has now discounted a near fully functioning economy for the rest of the year and beyond (bottom panel, Chart 3), fixed income investors are not in total agreement. In fact, the missing ingredient in giving the green light for equities is a selloff in the bond market, which financials/banks are currently sniffing out on the back of the reopening of the economy. Until fixed income investors get on the same page as equity investors, the SPX will remain on shaky ground (top panel, Chart 3). We first turned positive on the cyclical prospects of the equity market in mid-March3 and cemented our conviction in our March 23 report presenting 20 reasons to buy stocks.4 Since then, the SPX has rocketed higher by 1000 points and overshot our 3,000 SPX target that we recently derived from three methods.5 While we cannot time the exact top and equities may have a bit more upside, our sense is that today, stocks are more than fairly valued and they have entered a speculative phase (Chart 4). Thus the risk/reward tradeoff in the near-term has shifted to the downside. Once these (geo)political risks get appropriately repriced via a higher risk premium, then the broad equity market will resume its cyclical upside march. Chart 3Bond Market Is Not Buying Stock Market’s Euphoria Bond Market Is Not Buying Stock Market’s Euphoria Bond Market Is Not Buying Stock Market’s Euphoria Chart 4Lots Of Good News Is Priced In Lots Of Good News Is Priced In Lots Of Good News Is Priced In This week we update one consumer discretionary subgroup and put it on our downgrade watch list. Put Home Improvement Retailers On Downgrade Alert We are putting the S&P home improvement retailers index (HIR) on downgrade alert and setting a stop at the 10% return mark in order to protect handsome gains for our portfolio since the mid-April overweight inception. HIR have catapulted to all-time highs both in absolute terms and relative to the broad market. Granted, this has been an earnings-led propulsion (top panel, Chart 5), however, we are uneasy that HD is a top ten holding in the S&P growth index (middle panel, Chart 5).6 Importantly, the first print in the real GDP release for Q1/2020 in late-April made for grim reading, with one notable exception: real residential investment. Business capex took it to the chin, but housing related outlays spiked over 20% on a quarter-over-quarter annualized basis, and signal that DIY same-store retail sales will likely prove resilient this summer (bottom panel, Chart 6). Chart 5An Earnings-Led Advance… An Earnings-Led Advance… An Earnings-Led Advance… Chart 6…Buttressed By Resilient Residential Investment… …Buttressed By Resilient Residential Investment… …Buttressed By Resilient Residential Investment… As a reminder, these Big Box retailers are highly levered to the ebbs and flows of residential investment and the latest GDP print should sustain the recent bid under S&P HIR prices (top & middle panels, Chart 6). Tack on the roughly $75/tbf jump in lumber prices since the early-April trough (not shown), and profits benefit from a dual lift: rising volumes and firming selling prices. The DIY avalanche is real and not likely to dissipate any time soon as a consequence of the coronavirus-induced working from home pervasiveness. Yet, HIR has run too far too fast and is due for a consolidation phase. One yellow flag is the recent fall in existing home sales, despite the all-time lows in mortgage rates brought back by the Fed’s ZIRP. The middle panel of Chart 7 shows that if the home sales decline continues in the summer months, then HIR sales will face stiff headwinds as remodeling activity suffers a setback. In addition, in previous recessions the inventory of homes for sale has surged, but at the current juncture only a small jump in inventories is visible (inventories shown inverted, top panel, Chart 7). Were that trend to gain steam, it could put downward pressure to high-flying HIR equities. Chart 7…But Soft Home Sales Are An Issue… …But Soft Home Sales Are An Issue… …But Soft Home Sales Are An Issue… Chart 8…And The Tick Down In Our HIR Model Is A Yellow Flag …And The Tick Down In Our HIR Model Is A Yellow Flag …And The Tick Down In Our HIR Model Is A Yellow Flag The industry’s net earnings revision ratio has climbed to multi-year highs and warns that analyst optimism is excessive, which is contrarily negative (bottom panel, Chart 7). Our macro driven HIR model does an excellent job in encapsulating all the moving parts and its recent tick down is worrisome (Chart 8). Nevertheless, given that this has been a profit-led advance, HIR have a large valuation cushion. The relative forward P/E is trading near a market multiple and below the historical mean (bottom panel, Chart 5). Netting it all out, we are compelled to put the S&P HIR index on our downgrade watch list and institute a stop at the 10% return mark in order to reflect softness in our HIR macro model, a hook down in existing home sales and a high profit growth bar that sell-side analysts have set for the coming year (middle panel, Chart 5). Bottom Line: While we remain overweight the S&P HIR index it is now on downgrade alert. We also set a stop at the 10% return mark in order to protect profits for our portfolio. Stay tuned. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     Please see BCA US Equity Strategy Insight Report, “Pocketing Gains In Oil/Gold Pair Trade” dated June 10, 2020, available at uses.bcaresearch.com. 2     Please see BCA US Equity Strategy Weekly Report, “Don’t Turn A Blind Eye To Geopolitical Risks” dated June 8, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Inflection Point” dated March 16, 2020, available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Weekly Report, “The Darkest Hour Is Just Before The Dawn” dated March 23, 2020, available at uses.bcaresearch.com 5    Please see BCA US Equity Strategy Weekly Report, “New SPX Target” dated April 20, 2020, and “Gauging Fair Value” dated April 27, 2020, available at uses.bcaresearch.com. 6    https://us.spindices.com/indices/equity/sp-500-growth#data-constituents   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Exit Stage Right Exit Stage Right Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).