Corporate Bonds

Highlights Energy Bond Model: This report presents models for both investment grade and high-yield Energy bond excess returns. The models are based on overall corporate bond index spreads and the oil price. They can be used to generate Energy bond excess return forecasts for investment horizons up to 12 months. IG Energy Bonds: Our model suggests that investment grade Energy bond excess returns will be strong during the next 12 months under likely economic scenarios. We recommend an overweight allocation to investment grade Energy bonds.  HY Energy Bonds: Our models imply positive excess return outcomes for high-yield Energy bonds, but we remain concerned about near-term default risk for lower-rated issuers. We advise a cautious (neutral) allocation for now. Part 2 of this Special Report, to be published next week, will dig further into the high-yield Energy index on an issuer-by-issuer basis. Feature Table 1Energy Bond Excess Return* Scenarios (12-Month Investment Horizon) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns During the past couple of months we’ve published several reports that take more detailed looks at specific industry groups within both the investment grade and high-yield corporate bond markets. So far, we’ve published reports on: Banks1 Healthcare & Pharmaceuticals2 Technology3 This week and next week, we continue our series with a deep dive into Energy bonds that is split between two Special Reports. This week’s report develops a model for Energy bond excess returns based on overall corporate bond index excess returns and the oil price. In next week’s report, we look more deeply into the characteristics of the investment grade and high-yield Energy indexes. We also consider the outlooks for the five sub-categories of Energy debt: Independent, Integrated, Oil Field Services, Refining and Midstream. A Model Of Energy Bond Excess Returns A good starting point for modeling the excess returns of any corporate bond sector is to combine the sector’s Duration-Times-Spread (DTS) ratio with the excess returns of the overall corporate bond index.4 Please note that “excess returns” refers to returns relative to a duration-matched position in Treasury securities. The DTS-only model explains 86% of the variance in monthly investment grade Energy excess returns. Considering only a sector’s DTS ratio, we can define the following model for monthly investment grade Energy excess returns: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP Where: EXSENRG = Monthly investment grade Energy excess returns versus duration-matched Treasuries (DTSENRG / DTSCORP) = The investment grade Energy sector’s DTS ratio EXSCORP = Monthly investment grade corporate index excess returns versus duration-matched Treasuries For example, the current DTS for the investment grade Energy sector is 18. The DTS for the overall corporate index is 12. This means that the DTS ratio for the Energy sector is 18/12 = 1.5. According to our simple model, we would expect Energy sector excess returns to be 1.5 times corporate index excess returns in any given month. It turns out that our simple model performs quite well. Chart 1 shows monthly investment grade Energy sector excess returns versus our model’s prediction. Our sample period spans from 1997 to the present. Specifically, we find that our model explains 86% of the variance in monthly investment grade Energy excess returns. Chart 1Investment Grade Energy Monthly Excess Returns*: DTS-Only Model** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The simple (DTS-only) model’s performance is admirable, but we can do slightly better if we also incorporate the oil price. Chart 2 shows a statistically significant relationship between the residual from the DTS-only model and the monthly change in the Brent crude oil price. Chart 2Residual From DTS-Only Model* Versus Oil Price The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Combining the models shown in Charts 1 and 2, we get a model for investment grade Energy monthly excess returns based on both corporate index excess returns and the oil price: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP + (376.84 * ∆ ln Oil) – 1.0587 Where excess returns are measured in basis points and (∆ ln Oil) = the monthly change in the natural logarithm of the Brent crude oil price. Chart 3 shows the historical performance of this complete model. Note that the model now explains 91% of the historical variance of investment grade Energy excess returns, 5% more than the initial DTS-only model. Chart 3Investment Grade Energy Monthly Excess Returns*: Complete Model (DTS & Oil)** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Robustness Checks We performed the same analysis for 3-month, 6-month and 12-month excess returns and found very consistent results (Table 2). The oil price adds significant explanatory power to the model in each case, but the bulk of variation in investment grade Energy excess returns is determined by trends in the overall corporate index spread. Table 2Investment Grade Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns We also find consistent results when looking at high-yield Energy returns (Table 3). Once again, the bulk of excess return variation is explained by multiplying the DTS ratio and the benchmark index’s excess returns. The oil price also adds a statistically significant amount of extra explanatory power. Table 3High-Yield Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns One final observation is that oil explains a greater proportion of the variation in Energy sector excess returns if we limit our sample period to the past few years. Specifically, we re-ran the monthly iterations of both the investment grade and high-yield models from July 2014 to present. We found that the DTS component of the model explains the same amount of excess return variation as it did for the full sample. However, we also found that the oil price has a much greater impact if the sample is limited to the past six years (Table 4). Table 41-Month Excess Return* Models: Full Sample (1997 - Present) Versus Recent Sample (2014 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Energy Excess Return Scenarios Finally, using our 12-month excess return models for investment grade and high-yield Energy, we can project likely outcomes for Energy excess returns versus Treasuries for the next 12 months. All we have to do is assume different outcomes for the overall benchmark index spread (either the investment grade or High-Yield index, depending on the model) and the oil price.5 The results of this scenario analysis are shown in Table 1. Starting with investment grade Energy, we see that all scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. This is true even in a scenario where the oil price falls by $20 during the next year. Our model also suggests that a $10-$20 increase in the oil price during the next 12 months will keep Energy excess returns positive, even in a modest “risk off” scenario where the corporate index spread widens by 25 bps. All scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. The story is similar in high-yield, though returns are much more variable. For example, high-yield Energy is projected to lose money relative to Treasuries in a scenario where the junk index spread tightens 50 bps and the oil price falls by $20. There are no scenarios where benchmark index spread tightening coincides with negative Energy excess returns in the investment grade model. Chart 4Watch For Falling Inventories Watch For Falling Inventories Watch For Falling Inventories In terms of likely scenarios for the next 12 months, we anticipate further spread tightening for corporate bonds rated Ba & above. But we also view B-rated and lower spreads as too tight given the default outlook for the next 12 months and the fact that these lower-rated issuers usually can’t access the Fed’s emergency lending facilities.6 With that in mind, we would confidently bet on investment grade index spread tightening during the next 12 months, but can envision high-yield spread widening driven by the lower credit tiers. On oil, our Commodity & Energy Strategy service forecasts an average Brent crude oil price of $65 in 2021, a sizeable increase relative to the current price of $43.27.7 Our strategists expect a significant supply contraction in the second quarter of this year that will cause the oil market to enter a physical deficit in the second half of 2020. Investors can look for falling storage levels in the coming months to confirm whether that forecast is playing out (Chart 4). Escalating tensions between the US and Iran pose an additional near-term upside risk to oil prices. This risk increased during the past few weeks as a string of mysterious explosions struck several Iranian military and economic facilities.8 However, with major oil producers now operating significantly below capacity, any net impact on oil prices from a supply disruption in the Persian Gulf would likely be short-lived. Investment Conclusions All in all, our bullish outlook for both investment grade corporate bond spreads and the oil price makes us inclined to overweight investment grade Energy bonds on a 12-month horizon. Within high-yield, our model also suggests that we should have a bullish bias toward Energy, but we remain concerned about default risk for lower-rated (B & below) Energy issuers during the next few months. We will dig into the high-yield Energy index on an issuer-by-issuer basis in Part 2 of this report, to be published next week. For now, we advise a more cautious stance toward high-yield Energy.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 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 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 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. 5 We translate changes in benchmark index spread into 12-month excess returns using the formula: excess return = option-adjusted spread – (duration * change in option-adjusted spread) 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, “Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks”, dated June 18, 2020, available at ces.bcaresearch.com 8 Please see Geopolitical Strategy Special Alert, “Cyber-Rattling In The Middle East”, dated July 10, 2020, available at gps.bcaresearch.com

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

Highlights Money Supply Drivers: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. Money Supply Impact: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Bank Bonds: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. Feature The COVID-19 recession and associated policy response have led to unprecedented moves in a number of economic indicators. In this week’s report we focus on one such move that is particularly difficult to square with the rest of the economic landscape, at least judging by the large volume of client questions we’ve received on the topic. The move in question: Broad money supply growth (M1 & M2) is faster today than at any time since the mid-1940s (Chart 1). This week, we look at what has driven money growth to such heights and consider what it might mean for bond investors. We also update our call to overweight subordinate bank bonds based on last week’s release of the Fed’s bank stress tests. Chart 1Massive Money Growth! Massive Money Growth! Massive Money Growth! Money Supply Drivers The US economy’s broad money supply is more or less the sum total of all the money sitting in bank deposits at any point in time. More specifically, the M1 measure includes currency in circulation, demand deposits and traveler’s checks. The M2 measure includes all of M1 plus savings accounts, time deposits and retail money market funds. Fed asset purchases and bank lending are the two drivers of money supply growth. There are two ways for these broad money supply measures to grow. First, the Fed can purchase securities from the private market. Second, banks can lend money to the private sector. We consider both of these drivers in turn. The Federal Reserve’s Contribution To Money Growth The Fed influences the money supply by changing the amount of reserves in the banking system. To see how this works, Table 1 shows recent balance sheets for both the Fed and the aggregate US banking system. Table 1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System The Case Against The Money Supply The Case Against The Money Supply The largest line items on the Fed’s balance sheet are the securities it owns (on the asset side) and the reserves it supplies to the banking system (on the liability side). The Treasury Department’s General Account has also become a sizeable liability for the Fed during the past couple of months (see Box). Box 1: The Large Treasury General Account Is Not Stimulus Waiting To Be Deployed The Treasury General Account (TGA), aka the Treasury Department’s cash account at the Fed, has skyrocketed during the past couple of months and now totals $1.6 trillion (Chart 3). This has prompted more than a few client questions, mostly asking whether this large amount of money represents fiscal stimulus that is waiting to be deployed. Chart 3Treasury Holds A Huge Cash Buffer Treasury Holds A Huge Cash Buffer Treasury Holds A Huge Cash Buffer It does not. Any new fiscal stimulus must be authorized by Congress and with most of the funds from the CARES act having already been paid out, any further fiscal stimulus is contingent upon Congress passing a follow-up bill. So why is the TGA balance so large? The Treasury Department’s job is to finance the federal government’s deficit by issuing bonds. To do this, it must make estimates about what tax revenues and government spending will be in the future. To avoid a situation where it has not issued enough bonds to finance the deficit, it will typically err on the side of caution and issue some extra bonds, holding the proceeds in cash in its account at the Fed. Due to the heightened uncertainty of the current macro environment, it recently decided to target a larger-than-usual cash balance of $800 billion. It even overshot that target during the past couple of months, likely because tax revenues came in higher than expected. Going forward, heightened uncertainty about federal deficit projections will ensure that the Treasury continues to hold an elevated cash balance. However, it will probably try to bring the TGA balance down a bit in the second half of the year, closer to its stated $800 billion target. It will accomplish this by simply issuing fewer T-bills in the second half of the year. This will have the result of increasing the broad money supply through the same mechanism as Fed asset purchases. That is, any drawdown in the TGA increases the amount of reserves supplied on the liability side of the Fed’s balance sheet. When the Fed buys a Treasury security it removes that security from the private market and replaces it with cash in the form of a bank reserve. Those bank reserves are a liability for the Fed, but appear on the asset side of the banking sector’s aggregate balance sheet. Please note that the amount of reserves supplied on the Fed’s balance sheet in Table 1 doesn’t exactly match the amount of reserves shown on the banking sector’s balance sheet. This is only because the numbers were recorded on different days. Turning to the banking sector’s balance sheet, we see that when the amount of reserves increases there are only a few different things that can occur to keep the balance sheet in balance. Banks can accommodate the increase in reserves by reducing the amount of loans or securities they hold. Alternatively, banks can raise capital, borrow in private debt markets or show an increase in deposits. When banks accommodate the increase in reserves by raising deposits, the money supply rises. Charts 2A and 2B show the change in the main items on the aggregate banking system balance sheet since the end of February. First, we see that banks did not reduce their other asset holdings in response to the sharp increase in reserves. Neither did they raise capital or debt. Rather, deposit growth accommodated the entire increase in bank reserves. Chart 2AChange In Commercial Bank Assets: February 26 To June 17, 2020 The Case Against The Money Supply The Case Against The Money Supply Chart 2BChange In Commercial Bank Liabilities & Capital: February 26 To June 17, 2020 The Case Against The Money Supply The Case Against The Money Supply In fact, deposits have grown by about $2 trillion since February compared to reserve growth of $1.4 trillion. Roughly, we can say that Fed asset purchases are responsible for 70% of the growth in the money supply since then. The remaining 30% is attributable to the second driver of the money supply: bank lending. Bank Lending’s Contribution To Money Growth Looking again at Table 1, we see that an increase in bank loans must also lead to an increase in deposits, unless the bank raises debt and/or capital instead. Further, Chart 2A shows that increased bank lending since February accounts for about 30% of the growth in deposits. However, we expect bank loan growth to moderate in the coming months, easing some of the upward pressure on the money supply. This year's increase in bank loan growth has been driven entirely by C&I loans. A look at bank loan growth by category shows that this year’s increase has been driven entirely by Commercial & Industrial (C&I) loans (Chart 4). Growth in other major loan categories – commercial real estate, residential real estate and consumer – has flagged. Further, the increase in C&I lending has been mostly due to firms drawing on existing credit lines. Chart 4A Spike In C&I Lending A Spike In C&I Lending A Spike In C&I Lending The Fed’s Senior Loan Officer Survey for the first quarter of 2020 showed a small increase in C&I loan demand. But the survey also asked about potential reasons for the demand uptick (Chart 5). When faced with that question, 95% of respondents reported that “precautionary demand for cash” was a “very important” reason for increased C&I loan demand in Q1. 71% of respondents also pointed to a lack of internally generated funds as a “very important” reason. Importantly, no respondents reported increased C&I loan demand due to investment needs or M&A activity. Chart 5Possible Reasons For Greater C&I Loan Demand In Q1 2020 The Case Against The Money Supply The Case Against The Money Supply The distinction is important. Greater investment needs and M&A activity would suggest an improving economic back-drop, and would imply a more sustainable increase in bank lending. In contrast, there is a limit to how much firms can tap existing credit lines for immediate cash needs, and this activity should taper off during the next few months. Bottom Line: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. The Implications Of Rapid Money Growth According to some theory and popular thought, there are three possible channels through which rapid money growth could impact the economy and financial markets: Fast money growth could lead to stronger economic growth in the future. Fast money growth could lead to rising inflationary pressures. A larger money supply could suggest that there are more funds available to deploy in financial markets. As such, it could lead to price appreciation in risky financial assets. We are inclined to downplay the importance of M1 and M2 as indicators in all three of these areas, for reasons discussed below. The Money Supply’s Impact On Economic Growth In the past, measures of the broad money supply (M1 and M2) did a good job of forecasting economic growth and were tracked closely (and at times targeted) by the Federal Reserve. But as the banking and monetary systems evolved, M1 and M2 became less important. As Fed Chairman Alan Greenspan explained in 1996:1 At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. […] Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Chairman Greenspan’s insight is backed up by the empirical data (Chart 6). Real M2 growth was an excellent leading indicator of economic growth until the early 1990s. The relationship has broken down since then, and in fact, the only reliable trend in Real M2 since the 1990s is that it tends to spike during recessions. Chart 6Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s The Conference Board also noticed this trend and removed Real M2 from its Leading Economic Indicator in 2012. According to the Conference Board, Real M2 ceased to function as a leading economic indicator because (i) the Fed began targeting interest rates instead of monetary aggregates and (ii) the creation of interest-bearing checking accounts and money market funds increased safe haven demand for M2. The latter helps explain why money growth has surged during the last three recessions. All in all, broad money growth is now a poor indicator for GDP. The Money Supply’s Impact On Inflation Another popular theory is that money growth is a leading indicator of inflation. This stems from the following identity, aka the Equation of Exchange: MV = PY Where: M = money supply, V = velocity of money, P = price level and Y = real output The identity holds, but is of little practical value, mainly because there is no good way to measure (or model) velocity (V) without relying on money growth and nominal GDP (P*Y). This means that an increase in the money supply doesn’t necessarily tell us anything about inflation, because we have no idea how velocity will respond. In fact, many commentators have observed that the stronger empirical correlation is actually between money velocity (PY/M) and core inflation (Chart 7). When nominal GDP growth exceeds money growth, core inflation tends to rise 18 months later. However, this relationship also holds if we remove money supply from the equation entirely (Chart 7, bottom panel). What we’re actually observing is that core inflation tends to lag economic growth by about 18 months. Chart 7Inflation Lags Economic Growth, Not Broad Money Growth Inflation Lags Economic Growth, Not Broad Money Growth Inflation Lags Economic Growth, Not Broad Money Growth Since we’ve already seen that money supply does a poor job forecasting economic growth, it’s clear that indicators such as M1 and M2 don’t improve our ability to forecast inflation, and in fact probably only confuse the picture. The Money Supply’s Impact On Financial Markets BCA’s US Bond Strategy definitely subscribes to the notion that the stance of monetary policy is one of the most important drivers of financial market performance. If the Fed keeps interest rates low and signals to the market that rates will stay low for a long time, then we would expect investors to chase greater returns in riskier assets, driving up the prices of corporate bonds and equities. That being said, the appropriate way to measure the stance of monetary policy is with interest rates. Money supply measures like M1 and M2 are not helpful guides for risk asset performance. We have already seen that an increase in the money supply can only arise via (i) greater bank lending or (ii) the Fed’s purchase of securities and injection of reserves into the banking system. Both of these things are likely to occur when interest rates are low and monetary policy is accommodative. Low interest rates boost loan demand, and large-scale Fed asset purchases are more likely to occur when interest rates are already at the zero-lower-bound. We would argue that it is, in fact, low interest rates that influence both money growth and financial asset prices. The drivers of money supply growth – bank lending and Fed asset purchases – don’t offer any new information beyond what the interest rate already tells us. On loan growth, both loan demand and risk asset price appreciation are functions of low interest rates. In fact, financial markets will respond more quickly to changes in interest rates than will bank lending: Stock prices are included in the Conference Board’s Leading Economic Indicator, while C&I bank lending is included in the Lagging Economic Indicator.2 This means that, practically, any money supply growth that is driven by bank lending is not useful as an indicator for financial asset prices. What about money growth that is driven by Fed asset purchases? Here, we need to distinguish between the signaling impact of Fed asset purchases and any other potential impact that purchases might have on asset prices. In the first half of 2019, financial markets responded to the Fed's dovish interest rate policy, not to its shrinking balance sheet. Though the data are difficult to parse, our reading is that the only meaningful impact of Fed purchases on financial asset prices is through what the purchase announcements signal to markets about the future path of interest rates. To test this theory, we need to search for periods when the Fed’s signaling about its future interest rate policy diverges from its balance sheet policy. That is, we need to find periods when the balance sheet is shrinking and Fed rate guidance is becoming more dovish, or periods when the balance sheet is growing and rate policy is becoming more hawkish. Unfortunately, we can only identify one such period and that is the first half of 2019 when the Fed was simultaneously shrinking its balance sheet and signaling to markets that interest rate policy was becoming more dovish (Chart 8A). During that period, financial markets responded to the more dovish interest rate policy and not to the shrinking of the Fed’s balance sheet (Chart 8B). Bond yields fell, the dollar weakened and both corporate bonds and equities delivered strong returns. Chart 8ARates Policy Trumps Balance Sheet Part I Rates Policy Trumps Balance Sheet Part I Rates Policy Trumps Balance Sheet Part I Chart 8BRates Policy Trumps Balance Sheet Part II Rates Policy Trumps Balance Sheet Part II Rates Policy Trumps Balance Sheet Part II Bottom Line: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Subordinate Bank Bonds: Still In The Sweet Spot Chart 9Still In The Sweet Spot Still In The Sweet Spot Still In The Sweet Spot Two months ago we made the case for owning subordinate bank bonds.3 The premise for this call is that subordinate bank bonds are a high-quality cyclical sector, exactly the sweet spot of the investment grade corporate bond market that we want to own in the current environment. We expect that extraordinary Fed support for the market will cause investment grade corporate bond spreads to tighten during the next 6-12 months. In that environment we want to focus on cyclical (or “high beta”) bond sectors, ones that outperform the index during periods of spread tightening. However, we also recognize that the Fed’s emergency lending facilities will not prevent a surge in ratings downgrades. Therefore, the sweet spot we want to own is cyclical bonds that are unlikely to be downgraded. High-quality Baa-rated securities, like subordinate bank bonds, fit the bill nicely. Chart 9 shows that the subordinate bank bond index has a duration-times-spread ratio above 1.0.4 This confirms that the sector will trade cyclically relative to the corporate benchmark. We also see that subordinate bank bonds have outperformed both the overall corporate index and other Baa-rated bonds since the start of the year (Chart 9, panel 2). Further, subordinate bank bonds offer a spread pick-up versus the corporate index in both option-adjusted spread terms (Chart 9, panel 3) and 12-month breakeven spread terms (Chart 9, bottom panel).   What Did We Learn From The Stress Tests? Last week the Fed released the results of its 2020 bank stress tests. Results for individual banks were released for a “severely adverse scenario”, the details of which had been publicly available since February. However, because of concern that the “severely adverse scenario” wasn’t dire enough to capture the potential fallout from the pandemic, the Fed also stress tested three COVID-specific scenarios and released results only for the banking system in aggregate. The three scenarios are: A ‘V’-shaped recovery, where economic growth recovers in Q3 and Q4 of this year after contracting significantly in the first half. A ‘U’-shaped recovery, where the growth pick-up in the second half of 2020 is much milder. A ‘W’-shaped recovery, where economic growth recovers in Q3 but then dips again near the end of the year. Table 2 shows a few key assumptions of the three scenarios along with how the actual economy is tracking. It seems that, absent the re-imposition of lock-down measures, the economy is tracking to be in a slightly better place than in any of the three scenarios. Note that the unemployment rate has already peaked below 15%, lower than assumed by any of the three scenarios. Table 2Three Stress Test Scenarios* The Case Against The Money Supply The Case Against The Money Supply Chart 10Banks Have Huge Capital Buffers Banks Have Huge Capital Buffers Banks Have Huge Capital Buffers Chart 10 shows the Common Equity Tier 1 Capital Ratio for the aggregate banking sector, and the dashed horizontal lines show how far it would fall in the three different COVID scenarios. The results show that the ‘V’-shaped scenario is manageable for the banking system, but a significant number of banks would run into trouble in the ‘U’ and ‘W’ shaped scenarios.   The good news for bank credit quality is that, based on how the economy is tracking and the prospects for further fiscal stimulus, the worst ‘U’ and ‘W’ shaped scenarios will probably be avoided. Further, the Fed has already suspended share buybacks and capped dividend payouts. It will also re-run the stress tests later this year. Another round of stress tests this year is credit positive, as it will encourage banks to strengthen their capital buffers during the next few months. Bottom Line: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. 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 The Case Against The Money Supply The Case Against The Money Supply Footnotes 1 https://www.federalreserve.gov/BOARDDOCS/SPEECHES/19961205.htm 2 https://www.conference-board.org/data/bci/index.cfm?id=2160 3 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 4 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. Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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 High-Yield: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. Fed/Treasuries: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitizations: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Feature In case it wasn’t already obvious that the Fed will continue to act as a tailwind behind risky asset prices, Chair Powell made it abundantly clear at last week’s FOMC press conference. When asked about the risk of bubbles in financial markets, Powell’s response was to focus on the millions of unemployed workers and imply that it would be a dereliction of the Fed’s duties if it were to hold back on monetary stimulus because it thought asset prices were too high. Ironically, this strong statement of market support came the day before the S&P 500 fell 6% in a single session. Nonetheless, with the Fed providing such aggressive forward guidance on top of direct intervention in certain segments of the fixed income market, it behooves us to consider whether our recommended portfolio allocation is insufficiently aggressive. The Strong Performance Of Low-Rated Junk Chart 1Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Lower-Rated Junk Bonds Playing Catch-Up Within the high-yield corporate bond market we have been advising an overweight allocation to Ba-rated bonds but an underweight allocation to bonds rated B and below. The reasoning is that Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold.1 This positioning worked well throughout April and the first half of May, but lower-rated junk bonds have started to play catch-up during the past month (Chart 1). High-Yield Index Fundamentals To get a sense of whether we should extend our overweight recommendation to the B and below credit tiers, let’s first perform a valuation exercise on the entire high-yield index. In this exercise we consider current spread levels relative to likely economic outcomes. We set aside any impact from direct Fed intervention for the time being. Our analysis revolves around the High-Yield Default-Adjusted Spread (Chart 2). This valuation measure takes the junk index spread and subtracts default losses realized during the subsequent 12 month period. The spread’s historical average is around 250 bps, but it has occasionally dipped below zero during periods when default losses swamp the compensation offered by the index. Chart 2High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread High-Yield Index Assessment: Default-Adjusted Spread The Default-Adjusted Spread also lines up very closely with 12-month excess returns (Chart 2, panel 2). A simple linear regression model of 12-month excess returns versus the Default-Adjusted Spread gives an R2 of 53% and tells us that the threshold between positive and negative excess returns is a Default-Adjusted Spread of 187 bps. That is, if the Default-Adjusted Spread is above 187 bps we should expect high-yield to outperform Treasuries, if it is below 187 bps we should expect high-yield to underperform. With that in mind, we can apply some quick figures to the current context. The High-Yield index option-adjusted spread is 611 bps. If we assume a default rate of 10% and recovery rate of 25% for the next 12 months, we get expected default losses of 750 bps and a Default-Adjusted Spread of -139 bps. We should expect Treasuries to outperform junk bonds in that scenario. Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold. We can also perform the same sort of analysis in reverse. If we target a Default-Adjusted Spread of 187 bps – the spread that is consistent with high-yield performing in line with Treasuries – and we also assume a recovery rate of 25%, then the current index spread gives us an implied 12-month default rate of 5.7% (Chart 2, bottom panel). That is, we should expect high-yield to outperform Treasuries during the next 12 months if the default rate comes in below 5.7%, and underperform if it is above 5.7%. There are a couple assumptions used in the above analysis that require clarification. First, we relied on a simple linear regression model to get the result that a Default-Adjusted Spread of 187 bps is consistent with junk bonds breaking even with Treasuries. This is not an entirely accurate depiction of the historical record. Table 1 shows a more complete picture of the historical linkage between the Default-Adjusted Spread and 12-month high-yield excess returns. Here, we see that junk bonds have actually outperformed duration-matched Treasuries 81% of the time when the Default-Adjusted Spread is between 150 bps and 200 bps, and 72% of the time when it is between 100 bps and 150 bps. Relative junk bond losses only become more likely than gains when the Default-Adjusted Spread is below 100 bps. Table 1The Default-Adjusted Spread & High-Yield Excess Returns No Holding Back No Holding Back Second, we assumed a 25% recovery rate when we calculated our implied default rate of 5.7%. This is low compared to the historical average, but we would argue that a low recovery rate assumption is appropriate in the current environment. We analyzed the main economic drivers of default and recovery rates in a recent Special Report and found that the recovery rate observed during an economic downturn is primarily driven by corporate balance sheet leverage heading into that downturn.2 Corporate balance sheets were carrying a lot of debt heading into the current recession, meaning that we should expect a lower-than-normal recovery rate. In fact, the current trailing 12-month recovery rate is 22%, below our assumed level. Table 2 shows what the Default-Adjusted Spread will be for the next 12 months under different default and recovery rate assumptions. We think that 25% is a reasonable recovery rate assumption and expect that the default rate will be somewhere between 9% and 12% during the next 12 months. At present, Moody’s baseline 12-month default rate forecast is 11.6%. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates No Holding Back No Holding Back Clearly, junk spreads do not offer adequate compensation for default losses in the economic environment we anticipate. This logic also extends to the individual B and Caa/C credit tiers when we look at them in isolation. A Focus On B-Rated & Below Junk Bonds Charts 3A and 3B show the historical linkage between Default-Adjusted Spreads and excess returns for those specific credit tiers, with forecasts plugged in for “mild”, “moderate” and “severe” default scenarios. All three scenarios use a recovery rate of 25%. The assumed default rate is 6% in the “mild” scenario, 9% in the “moderate” scenario and 12% in the “severe” scenario. Default-adjusted compensation is unattractive in all three cases. Chart 3AB-Rated Default-Adjusted Spread No Holding Back No Holding Back Chart 3BCaa/C-Rated Default-Adjusted Spread No Holding Back No Holding Back Bottom Line: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. The Fed’s support for the Ba credit tier will significantly limit default losses for those bonds, making current spread levels attractive. However, absent Fed intervention, junk spreads are already far too tight. Investors should avoid bonds rated B & below where issuers generally don’t benefit from the Fed’s emergency programs. No Rush For More Explicit Forward Guidance In addition to Chair Powell’s strong statement of support for risky assets, last week’s FOMC meeting brought us the committee’s updated interest rate projections. With only two exceptions, those projections revealed that all Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. There had been some expectation that the Fed might provide more explicit forward guidance for the funds rate. Something along the lines of the “Evans Rule” that was used during the last zero-lower-bound episode. For example, the Fed could pledge to not increase rates until the unemployment rate is below some specified threshold or inflation is above some specified threshold. Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. This sort of forward guidance would be useful if the Fed needed to convince markets about its commitment to keeping rates pinned near zero, but the market has already internalized that message. Notice in Chart 4 that expectations priced into the overnight index swap curve show no rate hikes through the end of 2022. The same goes for the median estimate from the New York Fed’s April 2020 Survey of Market Participants. Chart 4Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 Fed Policymakers And Market Participants Agree: No Hikes Until 2023 More explicit forward rate guidance will likely be required in the future, when the market starts to price-in the eventual return of rate hikes. But for the time being, the Fed will probably be content to stay the course. Treasury Positioning The combination of the Fed’s strong commitment to zero interest rates and the risks to the 6-12 month economic outlook that we detailed in last week’s report make us inclined to maintain our recommended “At Benchmark” portfolio duration stance.3 However, we also recognize that yields are more likely to rise than fall in the coming months as the US economy re-opens and the economic data trend higher. For this reason, we advise holding several tactical overlay trades that will profit from rising bond yields: overweight TIPS versus nominal Treasuries, duration-neutral nominal curve steepeners, real yield curve steepeners. On TIPS, May’s CPI report showed a third consecutive month-over-month decline but the drop was far less severe than what was seen in March and April (Chart 5). This is a preliminary indication that we could already be passed the trough in inflation. The fact that trimmed mean CPI has not followed the core measure lower during the past few months is further evidence that inflation may not fall much more from its current level (Chart 5, bottom panel). If inflation has indeed bottomed, then our recommendation to favor TIPS over nominal Treasuries looks very good. We calculate that the current 1-year TIPS breakeven inflation rate is 0.1%, slightly below trailing 12-month headline CPI inflation (Chart 5, panel 2). Along the nominal Treasury curve, we continue to recommend favoring the 5-year bullet over a duration-matched 2/10 barbell. This position will profit from continued 2/10 yield curve steepening (Chart 6). We also recommend steepeners along the real yield curve. The real 2/10 slope has already steepened a lot (Chart 6, bottom panel), but has more room to run given that the 2-year cost of inflation compensation remains well below the 10-year cost (Chart 6, panel 3). Chart 5Is The Trough In Inflation Already##br## Behind Us? Is The Trough In Inflation Already Behind Us? Is The Trough In Inflation Already Behind Us? Chart 6Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Keep Steepeners Along Both The Nominal And Real Yield Curves Bottom Line: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitized Products Update Take Some Non-Aaa Risk In Consumer ABS, But Not In CMBS Since the Fed rolled out its emergency lending facilities in late-March, our spread product strategy has been to favor sectors that offer attractive spreads and that benefit from Fed support. This has meant owning Aaa-rated consumer ABS and CMBS, which are eligible for the Fed’s Term Asset-Backed Securities Loan Facility (TALF), and avoiding non-Aaa securitizations, which don’t qualify for Fed support. How has this worked out? Aaa-rated ABS and CMBS have both performed well since spreads peaked on March 23 (Chart 7). Within ABS, Aaa issues have beaten Treasuries by 390 bps since March 23 compared to 290 bps for non-Aaa securities. In CMBS, non-Aaa securities have lagged, losing 470 bps versus Treasuries since March 23 compared to gains of 810 bps for Aaa CMBS. As Chart 7 makes plain, no segments of either market have regained all of the ground that was lost during March’s blow-up. Chart 7Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Going forward, we think it is wise to re-consider our strategy when it comes to consumer ABS. Specifically, we think investors should dip into non-Aaa ABS where we see potential for strong returns, even in the absence of Fed support. The reason for our optimism is that consumer credit losses will probably turn out to be significantly lower than many had feared in March. During the past two months, we learned that federal government stimulus actually caused real personal income to rise by 9% since February. Also, consumers have generally been able to keep up with their debt payments.4  According to data from TransUnion, the percentage of credit card and mortgage loans that are more than 30 days past due actually declined in April compared to March. For auto loans it only increased by 7 bps (Table 3). Further, the data show that households paid off significantly more of their credit card balances than usual in April, presumably because they received an influx of cash from the government but had fewer spending opportunities due to the quarantine. Table 3No Spike In Consumer Credit Delinquencies No Holding Back No Holding Back There remains a risk that Congress will delay passing further stimulus measures to keep consumers flush during the next few months. But we think enough stimulus will be delivered to prevent a significant default spike in credit cards and auto loans. Investors should add some exposure to non-Aaa consumer ABS. CMBS is a different story. The commercial real estate market is particularly challenged by the current environment. The office and retail sectors in particular were already facing structural headwinds from remote working and online shopping, respectively. The pandemic has accelerated the adoption of those trends. Not surprisingly, May’s CMBS delinquency rate saw its largest jump since 2017 and more delinquencies are certainly on the way (Chart 8). Chart 8Challenging Environment For CMBS Challenging Environment For CMBS Challenging Environment For CMBS Investors should continue to avoid non-Aaa CMBS. Continue To Avoid Agency MBS We have been advising an underweight allocation to Agency MBS because, even though the securities benefit from support through the Fed’s direct MBS purchases, value has been insufficiently attractive. That is starting to change. Agency MBS spreads widened considerably during the past month and are now very close to Aa-rated corporate bond spreads. They are also greater than Agency CMBS and Aaa ABS spreads (Chart 9). However, despite improving valuations, we remain concerned about risks in the MBS sector. Notice in the top 2 panels of Chart 9 that the MBS option-adjusted spread (OAS) has returned to 2012 levels, but the nominal spread (which is not adjusted for expected prepayment losses) remains quite low. This means that the prepayment loss assumption embedded in the current index OAS is much lower than it was in 2012. Is this reasonable? We estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. In part, yes it is. Even with mortgage rates at all-time lows, we estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. This is lower than what was seen in 2012 (Chart 10). However, we would also argue that mortgage rates have room to fall further Chart 9Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Agency MBS Spreads Have Widened Chart 10Prepayment Risk Is Elevated Prepayment Risk Is Elevated Prepayment Risk Is Elevated Despite having fallen to all-time lows, this year’s decline in the 30-year mortgage rate has been much smaller than what was seen in Treasury or MBS yields (Chart 10, bottom 3 panels). The 30-year mortgage rate could drop by another 50 bps and it would only restore typical primary and secondary mortgage spread levels. We estimate that a further 50 bps drop in the mortgage rate would increase the refinanceable share of the MBS index from 63% to 74% (horizontal dashed line in the second panel of Chart 10). This is below 2012 levels, but still leads us to the conclusion that the current index OAS understates the risk of prepayment losses. In summary, the Agency MBS OAS is starting to look more attractive but we are concerned that it embeds an overly optimistic prepayment loss assumption. Investors should maintain underweight allocations to Agency MBS. Bottom Line: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. 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 4Performance Since March 23 Announcement Of Emergency Fed Facilities No Holding Back No Holding Back Footnotes 1 For more details on the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 4 For more details on the outlook for the US consumer please see US Investment Strategy Weekly Report, “So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)”, dated June 8, 2020, available at usis.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Duration: Investors should keep portfolio duration close to benchmark, but continue to hold yield curve steepeners (on both the nominal and real yield curves) as well as overweight TIPS positions versus nominal Treasuries. These tactical trades will profit from higher Treasury yields in the near-term. Healthcare: We recommend an overweight allocation to investment grade Healthcare bonds relative to the overall investment grade corporate index. But we also recommend an underweight allocation to high-yield Healthcare relative to the high-yield corporate index.  Pharmaceuticals: Investors should underweight Pharmaceutical bonds in both the investment grade and high-yield credit universes. How Much Higher For Bond Yields? Two weeks ago, we warned that bonds would struggle in the near-term as the re-opening of the US economy led to an improvement in economic data.1 However, we definitely didn’t anticipate the magnitude of the positive data surprise that has occurred since then. The US Economic Surprise Index was -55 one week ago and today it sits at +66 (Chart 1)! The bulk of that jump occurred after Friday’s employment report revealed that 2.5 million jobs were added in May when Bloomberg’s consensus estimate had called for a contraction of 7.5 million. Against this back-drop, it shouldn’t be too surprising that bond yields jumped sharply. The 30-year Treasury yield rose 27 bps last week to 1.68% and the 10-year yield rose 26 bps to 0.91% (Chart 2). The 2-year yield rose a more modest 6 bps to 0.22%, as the Fed maintains its tight grip on the front-end of the curve. Chart 1Back In Business Back In Business Back In Business Chart 2Yields Have Room To Move Higher Yields Have Room To Move Higher Yields Have Room To Move Higher For investors, the first relevant question is: How high can yields go? Our view is that if last week does indeed represent the cyclical economic trough, then forward rates at the long-end of the curve will revert to levels consistent with market expectations for the long-run neutral fed funds rate. The median estimate of that rate from the New York Fed’s most recent Survey of Market Participants is 2%, but with an unusually wide interquartile range of 1.3% to 2.5% (Chart 2, bottom panel). At the very least, we’d expect the 10-year and 30-year Treasury yields to re-test their respective 200-day moving averages of 1.38% and 1.91%, respectively. However, we are not ready to declare last week the economic trough for three reasons: First, we cannot rule out a re-acceleration in the number of confirmed COVID cases as the economy re-opens. This could lead to the re-imposition of lockdown measures come fall. Second, last week’s positive economic data might cause some members of Congress to question the need for further fiscal stimulus. This would be a mistake. In last week’s report we showed that fiscal measures have done a good job propping up household income so far, but these measures are temporary and will need to be renewed.2  Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak (Chart 1, bottom panel). This is by no means a fully healed economy that can withstand policymakers taking their feet off the gas. Even after last week’s large drop, the unemployment rate is still 3.3% above its Great Recession peak. Finally, US political risks are heightened with anti-police protests occurring daily in most major cities. Added to that, President Trump is now the underdog heading into November’s election and he will need to develop a reelection bid that doesn’t hinge on the economy. Our geopolitical strategists think a doubling down on “America First” foreign and trade policies makes the most sense.3 A significant move in that direction would certainly send a flight to quality into US bonds. Investment Strategy As we advised two weeks ago, nimble investors should tactically reduce duration as yields still have more upside in the next month or two. However, we are not yet sufficiently confident in the sustainability of the economic rebound to recommend reducing portfolio duration on a 6-12 month horizon. Rather, we continue to recommend keeping portfolio duration close to benchmark while holding several less risky positions that will profit from higher yields. Specifically, investors should hold duration-neutral curve steepeners along the nominal Treasury curve. We advise going long the 5-year note and short a 2/10 barbell.4 We also like holding TIPS over nominal Treasuries and positioning for a steeper real Treasury curve.5 In terms of spread product, we also recommend staying the course. This entails overweighting corporate bonds rated Ba and higher, Aaa consumer ABS, Aaa CMBS (both agency and non-agency) and municipal bonds, while avoiding corporate bonds rated B and below and residential mortgage-backed securities. Appendix A at the end of this report shows how these positions have performed since the March 23 peak in spreads. The remainder of this report focuses on the Healthcare and Pharmaceutical sectors of both the investment grade and high-yield corporate bond markets. Investment Grade Healthcare & Pharma Risk Profile When assessing the risk profiles for investment grade-rated Healthcare and Pharmaceutical bonds, we first consider the credit rating distributions of both sectors relative to the overall Bloomberg Barclays corporate index (Chart 3). Chart 3Investment Grade Credit Rating Distribution* Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Immediately, we see that the Healthcare sector has a lower credit rating than the benchmark: 71% of the Healthcare index is rated Baa, compared to 48% for the corporate index. Meanwhile, the Pharmaceuticals sector has slightly higher credit quality than the corporate benchmark: 12% of the Pharmaceuticals index is rated Aa or Aaa, compared to 8% for the corporate index. Credit rating alone suggests that Healthcare should trade cyclically relative to the corporate index. That is, it should outperform during periods of spread tightening and underperform during periods of spread widening. However, this turns out to not be the case. Chart 4 shows that healthcare has outperformed the corporate benchmark during each of the last five major bouts of spread widening and underperformed during periods of spread tightening. Clearly, despite its low credit rating, Healthcare trades like a defensive corporate bond sector. Healthcare’s historically defensive nature is confirmed by its duration-times-spread (DTS) ratio, which has tended to be below 1.0 (Chart 4, top panel).6 Though recently, the DTS ratio climbed above 1.0 due to a lengthening of the sector’s duration (Chart 4, bottom panel). This suggests that Healthcare, while historically defensive, might trade more cyclically during the next 12 months. Neither the Healthcare nor Pharmaceuticals sectors offer a spread advantage over the corporate index. Pharmaceuticals, on the other hand, are a much more cut and dry defensive sector (Chart 5). The DTS ratio is almost always below 1.0 and the sector has a strong track record of outperforming the corporate index during periods of spread widening (Chart 5, panels 2 & 3) Chart 4IG Healthcare Risk Profile IG Healthcare Risk Profile IG Healthcare Risk Profile Chart 5IG Pharma Risk Profile IG Pharma Risk Profile IG Pharma Risk Profile   Valuation Turning to valuation, we find that neither sector offers a spread advantage compared to the corporate index or its comparable credit tier (Table 1). This is true whether we look at the raw option-adjusted spread or if we control for duration differences by looking at the 12-month breakeven spread.7  It is interesting to note that the Healthcare index offers a spread advantage compared to the A-rated corporate index. On the one hand, this is not surprising because the Healthcare index carries an average Baa rating. On the other hand, we have seen that Healthcare tends to trade more defensively than its average credit rating implies. This arguably makes its spread advantage over A-rated debt somewhat compelling. Table 1IG Healthcare & Pharma Valuation Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Balance Sheet Health Both the Healthcare and Pharmaceuticals sectors loaded up on debt during the last recovery. The amount of Healthcare debt in the corporate index grew 8.8 times since 2010. Meanwhile, total debt in the corporate index grew 2.4 times. The result is that Healthcare’s weight in the corporate index increased from 1.1% in 2010 to 4.3% today (Chart 6). The Pharma sector also increased its debt load at a faster pace than the overall corporate universe since 2010 (3.2 times versus 2.4 times), but the boom in Pharma debt has been much milder than in Healthcare. The weight of Pharmaceuticals in the corporate index increased from 4.1% in 2010 to 5.5% today (Chart 7). Chart 6IG Healthcare Debt Growth IG Healthcare Debt Growth IG Healthcare Debt Growth Chart 7IG Pharma Debt Growth IG Pharma Debt Growth IG Pharma Debt Growth Despite rapid debt growth during the past few years, credit quality in both the Healthcare and Pharma sectors appears quite solid. Appendix B lists the issuers in the Healthcare index, grouping them by credit tier and indicating whether they carry a positive, stable or negative ratings outlook from Moody’s. Of the 56 issuers in the Healthcare index, only six currently have a negative ratings outlook. The two largest issuers in the Healthcare index are Cigna and CVS Health. Both carry Baa ratings, but Moody’s just confirmed Cigna’s ratings outlook at stable in mid-May. CVS Health, on the other hand, has carried a negative ratings outlook since 2018. Appendix C lists issuers in the Pharmaceuticals index. Of the 17 issuers, only four carry a negative ratings outlook. None of the Baa-rated Pharmaceutical issuers currently has a negative ratings outlook. The two biggest issuers in the index are Bristol-Myers Squibb and Abbvie. Bristol-Myers Squibb is A-rated with a negative outlook, while Abbvie is Baa-rated with a stable outlook. Macro Considerations In a typical demand-driven recession, consumers tend to prioritize healthcare spending while they cut back on more discretionary outlays. This dynamic is probably what causes healthcare bonds to trade defensively relative to the overall corporate index. However, the unique nature of the COVID recession has thrown this traditional pattern into reverse. Consumer spending on health care services is down 40% since February while overall consumer spending is 19% lower (Chart 8). Oddly, healthcare bonds shrugged off this year’s massive drop in spending and continued to behave defensively – outperforming the corporate index when spreads widened and underperforming since the March 23 peak in spreads. Despite the plunge in spending, pricing power in the health care industry remains strong. Health care services prices continue to accelerate even as overall inflation has dropped sharply (Chart 8, bottom panel). Unlike healthcare, pharmaceutical spending has held firm during the past couple of months (Chart 9). Consumer spending on pharmaceuticals is only down 4% since February, while overall consumer spending is down 19%. But despite firm spending, medicinal drug prices have decelerated in concert with the overall headline CPI (Chart 9, bottom panel). Chart 8Healthcare Demand & Pricing Power Healthcare Demand & Pricing Power Healthcare Demand & Pricing Power Chart 9Pharmaceutical Demand & Pricing Power Pharmaceutical Demand & Pricing Power Pharmaceutical Demand & Pricing Power Investment Conclusions Putting everything together, we are inclined to recommend an underweight allocation to Pharmaceuticals and an overweight allocation to investment grade Healthcare. Pharmaceuticals are simply too expensive and too defensive for the current environment. Given our positive outlook on investment grade corporate bonds, we should target cyclical sectors with elevated spreads that have more room to compress. Healthcare is slightly more interesting. It has behaved like a typical defensive sector so far this year, but there are some indications that it is becoming more cyclical. The DTS ratio recently shot above 1.0 and consumer spending on healthcare services is poised for a rapid snapback. In terms of valuation, healthcare is expensive relative to other Baa-rated bonds but cheap versus the A-rated universe. This would seem to make healthcare a good risk-adjusted bet. Even if the sector continues to behave defensively, its spread advantage over A-rated bonds makes it an attractively priced defensive sector. High-Yield Healthcare & Pharma Risk Profile Considering the risk profile of high-yield Healthcare and Pharmaceuticals, we first notice that both sectors have significantly lower credit ratings than the overall junk index (Chart 10). Ba-rated credits account for 29% and 24% of the Healthcare and Pharma indexes, respectively, compared to 54% for the High-Yield index as a whole. Chart 10High-Yield Credit Rating Distribution* Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic The fact that significant portions of the Healthcare and Pharmaceutical indexes are rated B and lower immediately raises alarm bells. This is because we do not expect that many B-rated or lower issuers will be able to take advantage of the Fed’s Main Street Lending Program. This lack of Fed support for the lower-rated junk tiers has led us to recommend underweighting junk bonds rated B & below.8 High-yield Healthcare and Pharmaceuticals sectors have significantly lower credit ratings than the overall junk index. Interestingly, despite low credit ratings, a look at both sectors’ DTS ratios and historical excess returns reveals that they tend to trade defensively relative to the high-yield benchmark index. Healthcare outperformed the high-yield index by 473 bps from the beginning of the year until the March 23 peak in spreads and has underperformed the index by 123 bps since (Chart 11). Similarly, Pharmaceuticals outperformed the junk index by 670 bps from the beginning of the year until March 23 and have since underperformed by 136 bps (Chart 12). Chart 11HY Healthcare Risk Profile HY Healthcare Risk Profile HY Healthcare Risk Profile Chart 12HY Pharma Risk Profile HY Pharma Risk Profile HY Pharma Risk Profile Valuation Turning to spreads, we would characterize both high-yield Healthcare and Pharmaceuticals as expensive (Table 2). Despite both sectors carrying average credit ratings of B, they offer spreads that are below both the overall junk index average and the average for other B-rated credits. Tight option-adjusted spreads are at least partially attributable to low average duration for both sectors. If we adjust for duration differences by looking at 12-month breakeven spreads, we see that Pharmaceuticals look somewhat cheap versus other B-rated credits while Healthcare remains expensive. Table 2HY Healthcare & Pharma Valuation Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Balance Sheet Health Healthcare debt has grown less quickly than overall high-yield index debt since 2010 (Chart 13). Healthcare debt has grown 1.7 times since 2010 while the overall index has grown 1.8 times. This has caused Healthcare’s weight in the index to fall from 6.2% to 5.7%. In contrast, the high-yield Pharmaceuticals sector has grown rapidly during the past decade (Chart 14). Pharma debt has increased 10.3 times since 2010 compared to 1.8 times for the overall index. This has brought the sector’s weight in the index up to 2.3% from 0.4% Chart 13HY Healthcare Debt Growth HY Healthcare Debt Growth HY Healthcare Debt Growth Chart 14HY Pharma Debt Growth HY Pharma Debt Growth HY Pharma Debt Growth Looking beyond debt growth, in the current environment we are mostly concerned with the number of issuers in each index that will be able to access Fed support through the Main Street Lending facilities. In this regard, neither sector fares particularly well. Appendix D lists all high-yield Healthcare issuers along with their ratings outlooks, number of employees, 2019 revenues and total debt-to-EBITDA ratios. To qualify for the Fed’s Main Street Lending facilities, issuers must have either less than 15000 employees or less than $5 billion in 2019 revenues. Additionally, they must be able to keep their Debt-to-EBITDA ratios below 6.0. We estimate that all but three of the Ba-rated Healthcare issuers are eligible for the Main Street program, but only one of the B-rated issuers is eligible. High-yield Pharmaceuticals issuers are listed in Appendix E. Here, we once again find that only one of the B-rated issuers is likely to qualify for the Main Street lending facilities. Of the two Ba-rated issuers, one is likely to qualify. The other is Bausch Health, a Canadian firm that is by far the largest issuer in the Pharma index. It would need to turn to the Canadian authorities for help in an emergency lending situation. Investment Conclusions We recommend underweight allocations to both the high-yield Healthcare and Pharmaceuticals sectors. In the current environment we prefer to focus our high-yield credit exposure on the Ba-rated credit tier where issuers are more likely to have access to Fed support. The large concentration of B-rated and lower issuers in both the Healthcare and Pharma sectors, along with their generally expensive valuations, makes us wary about both sectors. 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 Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix B Table 4Investment Grade Healthcare Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix C Table 5Investment Grade Pharmaceuticals Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix D Table 6High-Yield Healthcare Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic Appendix E Table 7High-Yield Pharmaceuticals Issuers Assessing Healthcare & Pharma Bonds In A Pandemic Assessing Healthcare & Pharma Bonds In A Pandemic   Ryan Swift US Bond Strategist rswift@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 Please see US Bond Strategy Portfolio Allocation Summary, “Filling The Income Gap”, dated June 2, 2020, available at usbs.bcaresearch.com 3 Please see Geopolitical Strategy Weekly Report, “Spheres Of Influence (GeoRisk Update)”, dated May 29, 2020, available at gps.bcaresearch.com 4 For more details on this recommended yield curve position please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on these recommendations 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 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. 7 The 12-month breakeven spread represents the spread widening that must occur for a sector to underperform a duration-matched position in Treasury securities during the next 12 months. It can be proxied by option-adjusted spread divided by duration. 8 For more details please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The Chinese economy continues to recover, albeit less quickly than the first two months following a re-opening of the economy. The demand side of the Chinese economic recovery in May marginally outpaced the supply side, with a notable improvement concentrated in the construction sector. We are initiating two new trades: long material sector stocks versus the broad indices, in both onshore and offshore equity markets. Feature The recovery in China’s economy and asset prices has entered a “tapering phase”, in which the speed of the recovery is normalizing from a rapid rebound two months after the economy re-opened. The direction of the ultra-accommodative monetary and fiscal stance has not changed, but the aggressiveness in the stimulus impulse is abating as the recovery continues. As we highlighted in last week’s report, the announced stimulus at this year's NPC was less than meets the eye of investors.1 Chart 1A Quick Reversal In The Outperformance Of Chinese Stocks A Quick Reversal In The Outperformance Of Chinese Stocks A Quick Reversal In The Outperformance Of Chinese Stocks Near-term downside risks in Chinese stocks were highlighted by last week’s quick reversal in the outperformance of Chinese equities relative to global benchmarks (Chart 1). As the US and European economies re-open and the stimulus impulse in major developed markets (DMs) is at peak intensity, Chinese stocks will underperform those in DMs, particularly US stocks. The re-escalation in Sino-US tensions will also add to the near-term volatility in Chinese equities. Therefore, we maintain our tactical (0-3 months) neutral view on aggregate Chinese equity indexes, in both domestic and offshore markets. Beyond Q2, however, our baseline view still supports an outperformance in Chinese stocks. The stepped-up stimulus measures since March should start to trickle down into the broader economy. Global business activities and demand will slowly normalize in the summer, helping to revive China’s exports. Moreover, an intensified pressure on employment, indicated in this month’s employment subcomponents in manufacturing and non-manufacturing PMIs, should prompt policymakers to roll out more growth-supporting measures in Q3. Tables 1 and 2 below highlight key developments in China’s economic and financial market performance in the past month. Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Chart 2ASpeed Of Manufacturing Activity Recovery Has Moderated Speed Of Manufacturing Activity Recovery Has Moderated Speed Of Manufacturing Activity Recovery Has Moderated China’s official manufacturing PMI slipped to 50.6 in May from 50.8 a month earlier (Chart 2A). While the reading suggests that manufacturing activities are still in an expansionary mode, the speed of the expansion has moderated compared with April and March. The supply side of manufacturing activities and employment were the biggest drags on May’s official PMI. The production subcomponent in the PMI decelerated whereas new orders increased from April (Chart 2A, bottom panel). The net result is an improved supply-demand balance in the manufacturing sector, however, the improvement is marginal. It also differs from the V-shaped recovery in 2008/09, when both new orders and production subcomponents grew simultaneously (Chart 2B). The demand side of the economy is still concentrated in the policy-driven construction sector. The rebound in construction PMI continues to significantly outpace that in manufacturing and non-manufacturing PMIs (Chart 2C, top panel). The construction employment sub-index ticked up by 1.7 percentage points in May, compared with a slowdown of 0.8 percentage points in manufacturing and 0.1 percentage points in non-manufacturing employment PMIs (Chart 2C, bottom panel). Chart 2BDemand Struggles To Outpace Supply Demand Struggles To Outpace Supply Demand Struggles To Outpace Supply Chart 2CDemand Recovery Is Concentrated In Construction Demand Recovery Is Concentrated In Construction Demand Recovery Is Concentrated In Construction While a buoyant construction sector should provide a strong tailwind to raw material prices and related machinery sales, a laggard recovery from other sectors means the upside potential in aggregate producer prices (PPI) will be limited in the current quarter. In May, there was a rebound in the PMI sub-indices measuring raw material purchase prices and ex-factory prices, which heralds easing in the contraction of PPI in Q2 (Chart 3). However, neither of the PMI price sub-indices has returned to levels reached in January, when PPI growth was last positive. Moreover, weaker readings in the purchases and raw material inventory subcomponents suggest that manufacturers may be reluctant to restock due to sluggish global trade and a lagging rebound in domestic demand (Chart 3, bottom panel).  This month’s PMI shows that the employment subcomponents in both the manufacturing and non-manufacturing PMIs are contracting (Chart 4). Because demand for Chinese export goods remains sluggish, we expect unemployment in China’s labor-intensive export manufacturing sector to rise in Q2 and even into Q3. The intensified pressure on employment will likely prompt Chinese policymakers to roll out more demand-supporting measures. Chart 3PPI Contraction Will Ease But Upside Limited In Q2/Q3 PPI Contraction Will Ease But Upside Limited In Q2/Q3 PPI Contraction Will Ease But Upside Limited In Q2/Q3 Chart 4Employment In Trouble, A Catalyst For More Easing Employment In Trouble, A Catalyst For More Easing Employment In Trouble, A Catalyst For More Easing The BCA Li Keqiang Leading Indicator rose moderately in April. A plunge in the Monetary Conditions Index (MCI) limited the magnitude of the indicator's increase, offsetting an uptick in money supply and credit growth (Chart 5). A rapid disinflation in headline consumer prices (CPI) since the beginning of this year has pushed up the real savings deposit rate, which contributed to the MCI’s nose-dive. In our view, the MCI’s sharp drop is idiosyncratic and does not signify a tightening in the PBoC’s monetary stance or overall monetary conditions. Huge fluctuations in food prices have been driving the headline CPI since March 2019, while the core CPI remains stable. While food prices historically have very little correlation with the PBoC's monetary policy actions, a disinflationary environment will provide the central bank more room for easing. Odds are high that the PBoC will cut the savings deposit rate for the first time since 2015.  Chart 5Monetary Conditions Are Not As Tight As The Indicator Suggests Monetary Conditions Are Not As Tight As The Indicator Suggests Monetary Conditions Are Not As Tight As The Indicator Suggests The yield curve in Chinese government bonds quickly flattened around the time of the National People’s Congress (NPC), with the short end of the curve rising faster than the long end (Chart 6). This is in keeping with our assessment that while the market is expecting the recovery to continue in China, it is unimpressed with the intensity of upcoming stimulus and monetary easing. Monetary easing seems to be taking a pause, but we do not think this indicates a change in the PBoC’s policy stance (Chart 7). Instead, weak global demand, slow recovery in the domestic economy and intensified pressure on domestic employment, all will incentivize policymakers to up their game by mid-year. As such, we expect the yield curve to steepen again in H2, with the short-end of the curve fluctuating at a low level and the 10-year government bond yield picking up when the economy gains traction. Chart 6The Bond Market May Be Incorrectly Pricing In A Monetary Tightening The Bond Market May Be Incorrectly Pricing In A Monetary Tightening The Bond Market May Be Incorrectly Pricing In A Monetary Tightening Chart 7A Pause Before More Easing In June A Pause Before More Easing In June A Pause Before More Easing In June The spread in Chinese corporate bond yields has dropped by more than 30bps from its peak in April. This is in line with that of major DM countries and a reflection of the easier liquidity conditions globally (Chart 8). We anticipate that the yield spreads in Chinese corporate bonds will continue to normalize. However, a flare in US-China tensions will put upward pressure on the financing costs of lower-rated corporations (Chart 8, bottom panel). The default rate among Chinese corporate bonds is unlikely to rise meaningfully this year, in light of ultra-accommodative monetary conditions and the Chinese government’s bailout programs to backstop corporate defaults. Chinese corporate bond defaults and non-performing loans historically have correlated with periods of financial sector de-leveraging and de-risking, other than during economic downturns. We continue to recommend investors hold China’s corporate bonds in the coming 6-12 months in a USD-CNH hedged term. Chart 8Financing Costs May Rise For Lower-Rated Corporations Financing Costs May Rise For Lower-Rated Corporations Financing Costs May Rise For Lower-Rated Corporations Chart 9Cyclicals Are Struggling To Break Out Cyclicals Are Struggling To Break Out Cyclicals Are Struggling To Break Out Among Chinese equities, cyclical sectors have struggled to outperform defensives in both onshore and offshore markets (Chart 9). This reflects investors’ concerns over the slow recovery in domestic demand and heightened geopolitical risk between the US and China. As such, we continue to favor domestic, demand-driven sectors among the cyclical stocks, such as consumer discretionary and construction-related materials. We upgraded consumer discretionary stocks from neutral to overweight on May 20, and we are now initiating two trades to long material sector stocks versus the broad markets in both the domestic and investable markets. The constituents of both China’s investable and domestic material sectors are highly concentrated in the metal and mining subsectors, which roughly account for half of the material sectors’ weight in the MSCI and MSCI A Onshore Indexes, respectively. Chart 10 highlights that the material sectors’ relative performance is highly correlated with CRB raw materials in both domestic and investable markets. Given that China’s credit cycles historically lead the CRB material index by about six months, China’s massive credit stimulus will boost CRB raw materials by end-Q2 and thus, the outperformance of the material sectors.  The RMB has depreciated by almost 3% in the wake of a re-escalation in US-China frictions. The CNY/USD spot rate is approaching its weakest point reached in September 2019 (Chart 11). Furthermore, on May 29, the PBoC set the CNY/USD reference rate at its lowest level since 2008, a move that suggests defending the RMB is no longer in China’s interest. Downward pressure on the RMB will persist in the months leading up to the November US presidential election. The US economy is in a much more fragile state than in 2018/19, which may hinder President Trump’s willingness to resort to tariffs between now and November. However, we cannot completely roll out the probability that Trump will impose further tariffs on Chinese exports, if he is losing the election through weak public support and is removed from his financial and economic constraints.  In any case, in the coming months CNY/USD exchange rate will likely continue to decouple from the economic fundamentals such as interest rate differentials (Chart 11, bottom panel). Instead, the exchange rate will be largely driven by market sentiment surrounding the US-China frictions.  Volatility in CNY/USD will increase, but the overall trend in the CNY/USD will continue downwards as long as the escalation in US-China tensions persists. On a 6- to 12-month horizon, however, we expect that the depreciation trend in the RMB to moderately reverse as the Chinese economy continues to strengthen. Chart 10Material Sectors Should Benefit From The Stimulus And Construction Boom Material Sectors Should Benefit From The Stimulus And Construction Boom Material Sectors Should Benefit From The Stimulus And Construction Boom Chart 11The CNY/USD Will Continue To Decouple From Interest Rate Differentials The CNY/USD Will Continue To Decouple From Interest Rate Differentials The CNY/USD Will Continue To Decouple From Interest Rate Differentials Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1    Please see China Investment Strategy Weekly Report "Taking The Pulse Of The People’s Congress," dated May 28, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations