Developed Countries

Highlights Structural reform is coming to the US in the wake of the riotous 2020 election cycle. Extreme levels of political polarization will subside, albeit remaining relatively elevated. This will smooth the way to a more proactive fiscal policy that secures the economic recovery. The Biden administration has enough political capital to pass large fiscal stimulus, an expansion of Obamacare, and an increase of taxes, regulations, and the minimum wage. The Republican Party will go into the political wilderness – and it may not recover from its internal struggle in time for the 2022-24 elections. Moderate Republicans will assist in passing legislation. Stay cyclically long stocks over bonds, cyclicals over defensives, and value over growth, but introduce tactical hedges. Go long VIX.  Feature Structural reform is coming to the United States in the wake of the riotous 2020 election cycle. The incoming administration of President-elect Joe Biden will usher in a stabilization of US politics by means of a substantial increase in fiscal support for the economy. This provides a backstop for the recovery that, combined with the ultra-accommodative Federal Reserve, suggests investors should keep an optimistic attitude toward risk assets over the coming 12 months, despite the inevitable ups and downs (Chart 1). Biden and the establishment politicians of both parties are beset by rising forces of populism on the right and left. They likely recognize that their political survival, as well as the country’s stability, depends on maintaining the recovery. The soon-to-be ruling Democratic Party narrowly obtained the majorities necessary to pass at least a few major laws. Chart 1Biden's First 100 Days Triggers Brief Pullback The change in political leadership will be beneficial for the middle class household but  less so for Big Business and corporate earnings. The US faces a rocky historical transition toward larger government involvement in the economy, more restrictions on private enterprise, and more redistribution of wealth. Labor is taking up a larger share of national income, as opposed to capital – a big shift away from the trend of the past 40 years (Chart 2). That period was extremely friendly to equity investors. The future will be trickier, though for the time being the market is pricing the good news. Chart 2Labor Makes A Comeback Versus Capital In this report we lay down our three key views for 2021: Peak Polarization – US political polarization is at extreme levels and though it will subside in the wake of the feverish 2020 cycle, it will remain elevated in the coming years. There will be aftershocks from the past year’s crises. Extremism and political violence will continue to flare up with the possibility of domestic terrorist incidents. The market impact of this trend is inherent in the Democratic victory in the White House and Congress, but the Biden administration’s political capital will increase upon any major shocks stemming from extreme polarization. Bipartisan Structural Reform – Investors should expect a flurry of legislation. The Democrats will be anxious to reward their base and consolidate power. Moderate Republicans will assist on some votes. New taxes and spending, a higher federal minimum wage, a larger safety net (e.g. healthcare), and administrative reforms will all ensue. Republicans In The Wilderness – The Republican Party is hereby exiled into the political wilderness to settle its internal struggle over Trumpism. The Party of Lincoln will somehow survive but it may not recover by 2024. Below we explain these views, what would undermine them, and what they mean for investors over the next 12 months and beyond. View #1: Peak Polarization US political polarization hit extreme levels over the past year according to various measures (Chart 3). Polarization will retreat as a result of Biden’s victory over Trump – Biden will have a higher approval rating, both generally and among the opposite party, than Trump did. But it will remain elevated relative to history. Structural drivers of polarization, such as wealth and racial inequality, congressional gerrymandering, and regional disparities, remain unaddressed. It will take time to reduce them. Hence, US social and political instability will continue in 2021. Most of this will be noise but some of it will not. Chart 3Polarization At Extremes Chart 4Terrorism On The Rise In The USThere will be aftershocks in the wake of the Trump rebellion on January 6 and the House Democrats’ decision to impeach him for a second time. A massive show of force will attend Biden’s inauguration, but extremism and political violence of various kinds have been flaring in recent years and will persist for some time (Chart 4). Both the FBI and the Department of Homeland Security have warned of a rise in domestic extremism and terrorism. Increased political instability creates fertile ground for malign actors of all stripes to operate, including domestic or foreign saboteurs. At a critical juncture in the nation’s politics like today, a major attack could wreak more panic and uncertainty than otherwise would be the case. The past year of unrest shows that the bar is high for markets to respond to passing political events. But a major crisis event that has systemic importance cannot be ruled out in today’s precarious environment. In the event of a major domestic terrorist incident, such as the 1995 Oklahoma City bombing, the vast majority of the public would react with utter revulsion and rally around the flag (Chart 5), while the federal counterterrorism response would be overwhelming, just as it was in the 1990s. Chart 5OKC Bombing Spurred Rally Round The Flag The market impact of such an attack would be fleeting. Other domestic incidents bear this out, such as the Waco siege (1993), the Olympic Park bombing in Atlanta (1996), the Charleston church massacre (2015), and the shooting of Republican lawmakers in 2017 (Chart 6). This point is intuitive given the extensive rioting and unrest in 2020 yet the fall of market volatility throughout the year. Yet the past year’s social and political instability does have major investment implications. It has led to full Democratic control of Congress and the White House on an agenda of fiscal expansion and wealth redistribution. Chart 6Market Largely Ignores Domestic Terrorism What About Long-Term Effects? With the government supporting the economy, it is less likely that the US will experience a drastic backslide into even greater social instability in the coming years. On the contrary, a more proactive fiscal policy, with more robust social safety nets in terms of health, unemployment, child care, and old age, means that social stability should improve (Chart 7). If the material wellbeing of the country fails to improve, or if exogenous events further destabilize the US, then the social and political environment will deteriorate further. But we would expect that 2021 will see the US secure the recovery and begin to restore order, at least temporarily. Longer term stabilization will require a succession of improvements that span administrations.  Chart 7Better Social Safety Net Could Reduce Deaths Of Despair Bottom Line: The Biden administration’s political support will increase if there are any major attacks and that support will be used to restore order. The market ramifications of any such response are already known: expansive, proactive fiscal policy to stabilize the economy and society and thus reduce the odds of greater division and radicalization. This kind of stabilization is positive for risk assets over a 12-month horizon. View #2: Bipartisan Structural Reform Investors should bet on a flurry of legislation from the Democrats (Table 1). They will be anxious to reward their base, consolidate power, and restore the political establishment to a position of primacy. They will be determined to act quickly, remembering how the 2010 midterms stymied their agenda after winning a blue sweep in the wake of the last major national crisis. Table 1Biden’s Priority? Stimulus … And More Stimulus Not only do Democrats control Congress but also Republicans are divided – by their loss of the Senate and by Trump’s rebellion. Over the coming year, moderate Republicans will be much more likely to vote with Democrats than the latter will be to defect from their party, especially on popular legislation such as economic stimulus (Chart 8). Chart 8Biden’s Priority? Stimulus … And More Stimulus If Republicans prove obstructionist then we would not rule out the Democrats mustering the votes to remove the Senate filibuster. But in the current climate, several moderate Republicans, such as Alaska Senator Lisa Murkowski, Pennsylvania Senator Pat Toomey, and Utah Senator Mitt Romney, are looking to distance themselves from Trump and Trumpism. Opposition to government spending has lost a lot of steam in US politics. The populist Republicans are increasingly willing to accept large spending to ease burdens on their voter base. Trump was a big spender, and the Republicans passed large spending bills during his term. Republicans have supported large household rebates as a COVID relief measure, as our Global Investment Strategy points out. These include prominent Senators like Lindsey Graham of South Carolina as well as presidential hopefuls like Marco Rubio of Florida and Josh Hawley of Missouri. Granted, desperate times call for desperate measures – Republican fiscal hawkishness will return now that the party is in the opposition. But there can be little doubt that Republican fiscal discipline has eroded given that both populists and moderates have loosened their standards. Austerity will not have as much support in the 2020s as it did after 2008. There is no chance that Democrats and Republicans will agree on a 2011-style Budget Control Act in the near future. The budget deficit will normalize albeit at a higher level than before the crisis (Chart 9). Chart 9Budget Deficit: Larger For Longer Democrats are guaranteed to drive a big spending agenda through Congress. They have the votes, the popular support, and the lingering COVID crisis as added impetus. The voting record of the Obama administration reinforces the high likelihood of Democratic unity as well as moderate GOP support (Chart 10). Chart 10Obama Era Shows Democrats Will Pass Legislation What About Tax Hikes? Congress will also raise taxes sooner or later. The party is united on the need to tackle economic inequality. There is no clear relationship between marginal tax rates and economic growth, capital spending, or productivity, according to our US Investment Strategist Doug Peta. If anything a positive correlation exists between corporate tax rates and economic growth, suggesting the right time to increase taxes is when the economy has recovered from recession or is otherwise in full stride (Chart 11). Nevertheless it is intuitive that a big tax hike could weigh on growth when it is first rolled out. Chart 11A Growing Economy Enables Tax Hikes So there is a good basis for the Biden administration to delay raising taxes until the recovery is secure. However, taxes will go up sooner or later (Chart 12). Chart 12Corporate Tax Rate Will Rise Sooner Or Later But The Economy Can Power Through It Taxes must rise to pay for new spending and, in the Democratic Party’s view, redress inequality. The use of the budget reconciliation procedure to pass laws with a simple majority in the Senate will necessarily require revenue offsets over a ten-year window to pay for new spending. The Trump tax cuts were never very popular to begin with, so the political blowback is manageable (Chart 13). Any delay would be temporary and thus its positive effects would be counteracted by the expectations of firms and investors. Passing tax hikes in 2021 enables COVID to serve as a pretext for a larger round of spending increases than would otherwise be possible to offset the new tax burden. Taxes can be passed in 2021 but not take effect until 2022. That might prevent the full impact from hitting ahead of midterm elections that year. Democrats hope to pick up two seats in the Senate, bringing their majority to 52-48 and bringing the more controversial parts of their agenda within reach. Chart 13Trump Tax Cuts Were Never Very Popular Note also that the Biden administration aims only partially to repeal the Trump tax cuts. The new corporate tax rate will rise to no more than 28%, which is still seven percentage points lower than Trump found it in 2016. Nor is Biden projecting a higher top marginal individual rate than the 39.6% that prevailed before Trump. The minimum corporate tax rate of 15% will bring a bigger negative impact for firms but it will be politically popular. There could also be a financial transactions tax, which Biden has said he supports. All of this is achievable with Senate control (Table 2). Table 2Biden’s Fiscal Agenda Investors should expect an early hit to earnings expectations. There will be an earnings hit from the simultaneous increase in taxes, regulations, and the doubling of the minimum wage to $15 per hour. Moreover investors need to price in more than Biden’s agenda. They need to price in a broader shift in US policy to redistribute wealth from capital to labor. Firms will face a new paradigm that is less corporate-friendly and laissez faire, at least until the Republican Party recovers and offers a viable alternative. And as discussed below, that could take a while. Bottom Line: The Biden administration will pass big new increases in spending and taxation as well as minimum wages and a slew of new regulations on labor and the environment. The shift to a fiscally proactive US government, at a time when the Fed is ultra-dovish, will ensure that the positive market reaction continues for the most part of the coming 12 months. But sooner or later markets will have to discount a generally more intrusive government that will reduce profit margins. View #3: Republicans In The Wilderness The Republican Party will go into the political wilderness in 2021, where it faces an internal struggle over how to deal with Trump and Trumpism. In the short run this means Republicans will not be well organized to oppose the Biden administration. In the long run, the outcome of this internal struggle will have a historic impact on the overall US policy outlook. Trump has become the first president to be impeached twice. There are eight days until Biden’s inauguration at noon on January 20. The Senate, still led by Republicans, has scheduled the trial to take place after that time, but it may still be relevant. If Trump is tried and convicted, which requires a two-thirds vote, then he could be disqualified from holding any future office on a simple majority vote. Otherwise, Congress could censure him, which would be merely symbolic. The Democrats hope to force Republicans to go on the record after Trump’s interference with the peaceful transfer of power to force them either to break with their party or wear the Trump albatross forevermore. Republican senators are not as reliable for Trump in any new impeachment as in the first one. A vote to remove, disqualify, or censure him would enable them to wash their hands of his actions. This could be useful for swing state moderates. The problem for the GOP is that it is still beholden to Trump, who generated large voter turnout and won 47% of the national vote, despite a pandemic and recession. Trump has left the party in better condition, in terms of seats, than his predecessor George Bush did (Chart 14). If he leaves the GOP and starts his own party, he could bring anywhere from one-third to half of Republican voters with him and thus hobble the party semi-permanently (Chart 15). It has happened before in US history.1 Chart 14GOP Still Fairly Strong In Congress, State Capitol Chart 15If Trump Leaves, He Could Take One-Third To Half Of GOP Voters A high-stakes negotiation will have to be held in a smoke-filled back room. Trump wants the 2024 nomination; the GOP wants his base. A solution would involve the GOP exculpating Trump yet again while he shepherds his base over to a successor within the party. But there is deep distrust. Trump was never a normal Republican and now he is even at odds with Vice President Mike Pence, Senate Leader Mitch McConnell, and his former chief of staff Mick Mulvaney. The party is losing donors over Trump’s actions, as companies withdraw support in the name of democracy. Moderate lawmakers and high-profile Republicans are trying to sever ties with Trump and considering leaving the party. If Republicans convince Trump to put away his 2024 aspirations and support the party, they may recuperate fairly quickly, on a populist basis. If they cannot, then the party may split, whether formally or informally, and hand the Democrats a decade-long ascendancy in US politics. Trump has shown that his base is too small to win against a fully mobilized Democratic-led political establishment. But without his base the Republicans definitely cannot win. The Republican Party will thus experience varying degrees of fracture in 2021. So far, Trump says he will run in 2024 and there is no reason to doubt him. But this is moot if the Senate agrees to impeach. This means the party is almost guaranteed to suffer a lasting split that will undermine its prospects in 2022, which would normally be fairly strong, and set up a bloody primary election in 2024. If this is the path the party embarks on in 2021, then investors should expect the Biden administration to be more effective than its narrow majorities suggest in passing legislation. Bottom Line: The Republican Party will suffer a deep fissure, or split entirely apart, depending on President Trump’s actions in the coming years. The implication is that the GOP opposition will be mostly ineffective in Washington in 2021. Moderate senators will be liable to vote with the Democratic majority on major bills. This is especially true of bills relating to COVID relief, economic stimulus, health care, or administrative reform to prevent 2020 election debacles from happening again. Investment Takeaways US equity markets and risk assets will eventually suffer a correction when the market comes to grips with the Biden administration’s capabilities and the looming rise in taxes, regulations, and wages. A stock market drop around Biden’s inauguration and first 100 days would fit the pattern of new “sweep” governments with single-party control. Timing is always tricky especially because the market is exuberant about the combination of larger fiscal and monetary stimulus. Stock prices are technically extended, expensive, and vulnerable to a negative growth surprise, but we would be buyers amid an equity pullback as the policy and macro fundamentals remain supportive. We are bullish over the 12-month horizon, especially in the first half. We are long stocks, the stock-to-bond ratio, value over growth, infrastructure plays, and reflation plays. Fiscal spending will go up quickly with new legislation, whereas tax hikes could be delayed. The implication is that the deficit will get larger and the yield curve will steepen, which is beneficial for cyclical and value plays. When tax hikes come into focus – which we expect to be soon – the tech sector will be the first casualty. We are long materials relative to Big Tech and would also be constructive toward energy relative to tech. The sectors that face the greatest policy risks under the Biden administration – health care, energy, financials – are also the ones best positioned to capitalize on the fresh burst of policy reflation, especially the latter two.   Big Pharma and the health insurers clearly face higher policy and regulatory risks. We recommend going tactically short S&P managed health care relative to the broad market. Consumers stand to benefit from stimulus measures that add to their already formidable pile of savings and provide more robust safety nets. Consumer discretionary stocks will also benefit from the normalization of the economy. Thus we view consumer plays favorably in general and recommend going long consumer staples as a tactical hedge.     As another tactical hedge we recommend going long volatility (VIX).   Several clients have asked about the drop in Twitter’s share prices upon its announcement that President Trump would be permanently removed from the platform. In general, we expect a drop in polarization to coincide with a drop in tech outperformance (Chart 16). The reason is that a slight increase in bipartisanship will result in fewer fiscal cliffs and policy-induced shocks, thus helping inflation expectations recover. This will benefit value stocks more so than growth. The Biden administration is allied with Big Tech but the threats to this sector are sprouting up in both political parties and from every direction – from anti-trust authorities, state-level governments, privacy advocates, free speech advocates, foreign tax authorities and regulators, and unions. We will discuss the latest controversies regarding Big Tech and free speech/press in future reports but for now suffice it to say that the macro and policy landscape is shifting against Big Tech. The big five tech firms may still see their stock prices rise but they will underperform the other 495 companies on the S&P. Chart 16Polarization And Tech Go Hand-In-Hand   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com     Appendix Table A1Biden’s Cabinet Position Appointments   Footnotes 1     Namely in the 1912 election when Theodore Roosevelt left the Republican Party and started the progressive “Bull Moose” party, costing incumbent President William Howard Taft the election versus Democratic challenger Woodrow Wilson. One could loosely interpret Texan Ross Perot’s presidential runs in 1992 and 1996 in a similar vein, and perhaps that would be more applicable to any future independent run by President Trump.  

Overconcentration of returns in a handful of stocks has been an overarching theme in a number of our 2020 publications. For instance, we separated the SPX in the S&P 5 vs. the S&P 495 in late-July, and showed how a handful of tech titan stocks dominated S&P 500 returns, especially since 2015. Roughly a month later these tech stocks peaked, and the normalization process began (top panel). It is remarkable that the S&P 5 are down in absolute terms since their September 2 crest, whereas the S&P 495 are up over 15%. The recent surge in the 10-year Treasury yield exacerbated the nosedive in relative share prices as it deals a blow to the bubbly valuation of the longest duration sector in the SPX: the tech sector. Crudely put, the steeper the selloff in the bond market the greater the fall in relative market capitalization (10-year Treasury yield shown inverted, middle & bottom panels). Bottom Line: Stick with a barbell tech sub-group positioning, preferring software and services to hardware and equipment, but stay tuned.  

Highlights US Reflation: The Georgia senate victories for the Democratic Party have returned the bond-bearish “Blue Sweep” scenarios to the forefront. More fiscal stimulus and an easy Fed will extend the policy-driven reflation of the US economy and financial markets. US Treasury Strategy: Stay underweight US Treasuries, with below-benchmark duration exposure, in global bond portfolios. Stay overweight TIPS versus nominal US Treasuries and continue to position for more bear-steepening of the Treasury curve. Global Corporate Sector Valuation: Developed market investment grade corporate spread valuations look stretched. Maintain only neutral levels of spread risk for higher-quality corporates while targeting sectors that look undervalued across the majority of regions, such as Energy and Financials. Avoid universally expensive consumer sectors such as Retailers, Restaurants, and Food & Beverages. Feature Chart of the WeekUS Policy Reflation Is Negative For USTs In a week of stunning US political events, the most important one for financial markets was not the mob invasion of the US Capitol. The Georgia senate runoff votes completed the unfinished business of the 2020 US elections, with Democratic Party candidates winning both seats. This effectively delivered a change in party control of the US Senate to the Democrats, with a 50/50 seat split that would give incoming Vice-President Kamala Harris the potential tiebreaking vote. With the Democratic Party now in control of the US House of Representatives, the Senate and the White House, the bond-bearish “Blue Sweep” scenario that we discussed in our pre-election Special Report last October – with greater odds that the highly expansionary Biden policy agenda can be more fully implemented - is now coming to fruition.1 The benchmark 10-year US Treasury yield broke above 1% after the election results, continuing to climb to 1.13% yesterday. The overall US Treasury market action has continued the reflationary trends seen in the latter half of 2020, with a bear-steepening of the Treasury curve and wider inflation breakevens in the TIPS market (Chart of the Week). Treasuries continue to underperform other developed economy government bond markets (in USD-hedged terms), continuing a move that started back in the spring of 2020. We expect these trends to remain in place over the next several months, given the current and likely future monetary and fiscal policy mix in D.C. The Biden Boost To US Treasury Yields BCA Research’s newest service, US Political Strategy, launched last week with a discussion of the US fiscal policy outlook after the Georgia senate elections.2 The conclusion was that the most radical parts of the Democratic Party agenda will be difficult to pass given their narrow majorities in the House and Senate, but some sizeable fiscal stimulus is still likely. In the near term, an expansion of the COVID relief passed in the December stimulus bill, such as boosting monthly checks to individuals from $600 to $2000, is likely to come relatively quickly after Biden is inaugurated via a “reconciliation bill”. Additional stimulus measures could also be enacted, partially funded by some rollback of the Trump tax cuts. Beyond that, the Biden administration will attempt to push through some of the more expansionary parts of incoming president’s campaign platform related to items like infrastructure spending. In the end, the expectation is that the US fiscal drag (a reduction in the deficit) that was set to occur in 2021 after the massive stimulus measures enacted in 2020 will be much smaller with full Democratic control in D.C. This will help boost US GDP growth this year. A greater implementation of the Biden agenda would have a more lasting impact on US economic growth in the following years. Last September, Moody’s published a report that compared the policy platforms of Candidate Biden and President Trump, running the details of the agendas into the Moody’s US economic model.3 The analysts concluded that under realistic assumptions about how much of the Biden platform would be implemented under a “Blue Sweep” scenario, US real GDP growth would average 6% in 2021 and 2022 under President Biden, a full two percentage points higher than the baseline scenario (Chart 2). This would also drive the US unemployment rate back toward pre-pandemic levels more quickly. Moody’s concluded that the Fed would start hiking rates in 2023 under the Democratic sweep scenario, similar to the current pricing in the US overnight index swap (OIS) curve, but with a more aggressive pace of tightening expected over the subsequent two years (bottom panel) – a bond bearish outcome that would push the 10-year Treasury yield back to 2% by the end of 2022 and 3% by the end of 2023. We expect the Fed to normalize US monetary policy at a slower pace than Moody’s, but we do agree on there is still plenty of upside potential for Treasury yields over the next 1-2 years. This will initially come more from rising inflation breakevens than real yields. Currently, US TIPS breakevens are drifting steadily higher, even as realized US inflation is starting to cool off a bit (Chart 3). The 10-year breakeven is now up to 2.1%, a level last seen in 2018 but still below the 2.3-2.5% level we deem consistent with the market expecting that the Fed’s 2% inflation target will be sustainably achieved. The idea that inflation breakevens can widen without higher realized inflation may seem odd on the surface, but it is not unprecedented. In the years immediately after the 2008 financial crisis, when the Fed kept rates at 0% while the economy recovered from the Great Recession, TIPS breakevens rose alongside very weak US inflation. Chart 2How 'Bidenomics' Can Be Bond-Bearish Chart 3Fed Policy Stance Favors Wider TIPS Breakevens With the Fed having shifted to an Average Inflation Targeting framework last year, we don’t expect the Fed to turn more hawkish too quickly. We expect the Fed to keep the funds rate well below US realized inflation for at least the next couple of years and likely longer, keeping real US interest rates negative and preventing an unwanted flattening of the Treasury curve (Chart 4). The Fed’s low interest rate policies will also make it easier to service the growing stock of US government debt during the Biden Administration (Chart 5). Net-net, we continue to see additional upside for US Treasury yields in the aftermath of the “Blue Sweep”.  Chart 4US Policy Mix Favors UST Curve Steepening Net-net, we continue to see additional upside for US Treasury yields in the aftermath of the “Blue Sweep”. We expect the benchmark 10-year Treasury yield to rise to the 1.25-1.5% range over the next six months, with higher yields possible if the market begins to question the Fed’s commitment to keeping the funds rate anchored at 0% - an outcome that could occur by year-end if the Fed starts to consider a slower pace of Treasury purchases via quantitative easing (Chart 6). Chart 5Low Interest Rates Help Service Rising Debt Chart 6More Upside Room For UST Yields We continue to recommend an overall US Treasury investment strategy that will perform well as yields rise. Stay underweight US Treasuries, with below-benchmark duration exposure, in global bond portfolios. Stay overweight TIPS versus nominal US Treasuries and continue to position for more bear-steepening of the Treasury curve. Bottom Line: The odds of a major US fiscal spending boost from the incoming Biden Administration, both in the short-run and over the medium term, are now much higher after the Georgia senate elections. More fiscal stimulus and an easy Fed will extend the policy-driven reflation of the US economy and financial markets. Maintain positions that will benefit from higher Treasury yields. Finding Value In Global Investment Grade Corporate Bond Sectors As we discussed in our 2021 Model Bond Portfolio Update published last week,4 the strong performance of global spread product in H2/2020 has led to an across-the-board narrowing of credit spreads, with investment grade spreads hovering close to, or below, pre-COVID levels in developed markets (Chart 7). Predictably, this has stretched valuations to historically expensive levels across developed economy investment grade corporate bond markets. Our preferred measure of spread valuation, the 12-month breakeven spread, measures how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. These breakeven spread percentile rankings for investment grade corporates are now at the bottom percentile in the US and below the 25th percentile level in the euro area, UK, Australia, and Canada, indicating that there is limited potential for additional spread tightening from current levels (Chart 8). Chart 7Investment Grade Spreads At Or Below Pre-Covid Lows As the gains from the “beta” of owning corporate credit have been largely exhausted, it now makes sense to pay more attention to the “alpha” in corporate debt markets by looking at relative valuations across sectors. To accomplish this, we return to our cross-sectional relative value framework, which we last discussed in the summer of 2020.5 Readers should refer to that report for details on our framework methodology. In this report, we apply our relative value framework to investment grade corporate bond markets in the US, euro area, UK, Canada and Australia. Chart 8Valuations Look Stretched On A Breakeven Spread Basis US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. As the gains from the “beta” of owning corporate credit have been largely exhausted, it now makes sense to pay more attention to the “alpha” in corporate debt markets by looking at relative valuations across sectors. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk, which we measure as duration-times-spread (DTS), to target. With valuations for US investment grade looking stretched, we are looking to target only a neutral DTS at or around that of the benchmark index. Investors willing to take on a greater amount of spread risk should look at the beaten-up Airlines sector, which offers the most attractive risk-adjusted valuation in US investment grade within our model. The sweet spot, therefore, is the upper half of Chart 9, around the dotted horizontal line denoting the benchmark DTS. Given the large amount of spread narrowing seen since we last published these models, there are fewer obvious overweight candidates, with most sectors priced close to our model-implied fair value. However, Finance Companies, Lodging, and REITs are interesting opportunities that fit our “risk budget”. Investors willing to take on a greater amount of spread risk should look at the beaten-up Airlines sector, which offers the most attractive risk-adjusted valuation in US investment grade within our model. Sectors to avoid, meanwhile, are Restaurants, Environmental, and Other Utilities. Chart 9US Investment Grade Corporate Sectors: Risk Vs. Reward Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation In keeping with our neutral stance on euro area investment grade, we will be targeting an overall level of spread risk at or around the benchmark. Therefore, we are interested in overweighting sectors in the upper half of Chart 10 that are close to the overall index DTS. Chart 10Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward On that basis, Subordinated Debt, Brokerage Asset Managers, and Integrated Energy seem appealing overweight candidates while Airlines, Independent Energy, and Building Materials are ones to avoid. UK In Table 3, we present the latest output from our UK relative value spread model. We are currently overweight UK investment grade, one of the best performers in our model bond portfolio universe last year. Although investment grade spreads are below pre-pandemic lows, the major factor to watch is how the economy adjusts to the Brexit trade deal. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation As with other regions, our ideal overweight candidates here are those with positive risk-adjusted residuals and a relatively neutral DTS—represented in the upper half of Chart 11 near the dotted line. The best overweight candidates are concentrated within Financials, with Brokerage Asset Managers, REITs and Insurance appearing attractive. Tobacco and Railroads also fit our criteria. Meanwhile, Metals and Mining, Aerospace, and Restaurants are sectors to avoid. Chart 11UK Investment Grade Corporate Sectors: Risk Vs. Reward Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. While we do not have an allocation to Canadian corporate debt in our model bond portfolio, our key insight regarding other markets also applies here—historically expensive valuations for the overall market mean that we recommend keeping exposure to spread risk neutral while finding pockets of value where available. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation On that basis, some of the most appealing overweight candidates, shown in the top half of Chart 12, are Finance Companies, Office and Healthcare REITs, Brokerage Asset Managers, Life Insurance, and Other Industrials. Meanwhile, we are staying away from Cable Satellite, Media Entertainment, and Environmental sectors. Chart 12Canada Investment Grade Corporate Sectors: Risk Vs. Reward Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation As with Canada, we have no exposure to this market in our model bond portfolio but are looking to maintain a neutral level of recommended overall spread risk while looking at sectors in Chart 13 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. On that basis, Finance Companies and Insurance appear attractive while Energy, Technology, and REITs should be avoided. Chart 13Australia Investment Grade Corporate Sectors: Risk Vs. Reward Comparing Sector Valuations Across Regions The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Table 6 allows us to highlight some clear trends: Table 6Valuations Across Major Corporate Bond Markets Industrials such as Chemicals, Capital Goods, and Diversified Manufacturing look overvalued across the board. These cyclicals, which are deeply sensitive to the health of business investment and confidence, rallied strongly on vaccine optimism but now look overbought. On the consumer side, there is weakness in cyclicals such as retailers and restaurants, and non-cyclicals like consumer products and food & beverages. The new round of lockdowns instituted in Europe and the UK are a major risk for these sectors as we head into the final stretch before mass vaccination. Energy looks undervalued in all three regions. This result is supported by the outlook from our BCA Research Commodity & Energy strategists, who are bullish on oil and believe that Brent prices will average at $63/bbl in 2021 as demand continues to grow and OPEC 2.0 keeps a tight grip on supply. Financials look to be a bastion of value, with finance companies/institutions and insurance looking cheap across the board. These sectors have obviously benefited from the steepening in yield curves we have already seen but there is still remaining upside as inflation expectations continue to rise and push up nominal yields at the long-end of the curve. Financials look to be a bastion of value, with finance companies/institutions and insurance looking cheap across the board. Bottom Line: Developed market investment grade corporate spread valuations look stretched. Maintain only neutral levels of spread risk for higher-quality corporates while targeting sectors that look undervalued across the majority of regions, such as Energy and Financials. Avoid universally expensive consumer sectors such as Retailers, Restaurants, and Food & Beverages.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Political Strategy Report, "Buy Reflation Plays On Georgia’s Blue Sweep", dated January 6, 2021, available at usps.bcaresearch.com. 3 The full report can be found here: https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 4 Please see BCA Research Global Fixed Income Strategy Report, "Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation", dated January 6, 2021, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Report, "Hunting For Alpha In The Global Corporate Bond Jungle", dated May 27, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

​​​​​​​Consistent with the previous Insight’s cautionary tone, we recommend investors book gains of 16% on the small size bias that we have been exploring since the October 26, 2020 inception (top panel) and 6% since the high-conviction calls report on December 7, 2020. Small caps have gone parabolic since late October and the small/large 13-week rate of change annualized momentum is at the highest print since the dotcom bubble era breaching 100%/annum recently (second panel), and second largest ever in the history of our data set (not shown). The top 10 constituents of small cap indexes are now populated by highly speculative names (see here and here) and in the Russell 2000 specifically the weights of some of the top 10 constituents have jumped to more than 10 fold from the 0.05% median weight to over 0.5% weight. In other words, elements of frothiness are also evident in small cap indexes. At least a pause for breath is likely in the next three months and we opt to move to the sidelines and downgrade the size bias back down to neutral. Finally, we are also shifting the 10% stop in our long “Back-To Work”/short “COVID-19 Winners” pair trade baskets to a 5% rolling stop in order to protect gains of over 25% since the September 8, 2020 inception (bottom panel). Bottom Line: The easy money has been made in the small/large ratio, lock in gains and step aside. Today we also switch our trailing 10% stop to a rolling 5% stop in the long “Back-To Work”/short “COVID-19 Winners” pair trade baskets. Stay tuned.

The previous Insight highlighted the similarities between the 2009/10 episode and today, when the SPX troughed in March 2009 similar to the recent recessionary trough in March 2020. Our biggest worry is the reflex rebound in the dollar. Everyone is short dollars and this one-sided bet is at risk of capsizing the ship. Importantly, interest rate differentials will likely start to push the greenback higher. The bottom panel of the chart shows that since the August trough, 10-year US Treasury yields have more than doubled to over 1.1%, whereas the 10-year bund yield has stayed muted at -0.5%. Additional US fiscal easing along with the sustained rebound in the US economy should continue to weigh on bond prices and further push interest rates higher and eventually stock valuations lower. This accumulated interest rate pressure will at the margin start to weigh on EUR / USD. As a result, the near parabolic move in cyclicals versus defensives will at least go on hiatus. We are putting the S&P utilities sector on upgrade alert and the S&P materials sector on downgrade alert and once we execute these moves our portfolio will hopefully monetize double digit gains since the July 27, 2020 inception, and will push our cyclicals/defensives portfolio bent back to even keel. Bottom Line: Prepare to lock in gains in the cyclicals versus defensives portfolio bent (via downgrading materials and upgrading utilities), this ratio is now on our downgrade watch list (please see the next Insight).  

Last autumn during the 10% SPX correction, we started to reposition the portfolio to benefit from the reopening trade and initiated our long “Back-To-Work”/short “COVID-19 Winners” trade, implemented a small cap size bias, reiterated our cyclicals / defensives portfolio bent by downgrading the S&P pharma index to underweight (which pushed the S&P health care to neutral) and crystalized handsome gains in our VIX futures trade. We were arguing that stocks would glide lower into the election and then take off as geopolitical in general and election in particular uncertainty would subside and also seasonality would switch from a headwind to a powerful tailwind for stocks. One week following the election we updated our three EPS scenarios for 2021 and also upped our calendar 2021 EPS estimate to $168, from $162 previously, and lifted our SPX target for end-2021 to 4,000. Since then, the SPX is up nearly 600 points and we are now compelled to turn wary. Keep in mind that the S&P 500 has fully discounted the 24% EPS growth for calendar 2021 and now that we are in early 2021 and the market will soon look into calendar 2022 EPS, we doubt that the sell side’s $196 EPS level which translates into 17% EPS growth rate is attainable, especially given the specter of rising corporate taxes.     The higher the SPX will rise in the near-term the more it will eat into future returns and thus push down the expected return. Equity flows are very powerful both from sidelined cash coffers, which are getting replenished from fiscal easing packages and from investors fleeing bonds. The implication is that timing the exact turn is difficult. The chart (on the previous page) shows that 2009/10 is an interesting parallel to draw, which we used recently when we initiated a VIX futures hedge to our high-conviction calls for the June 2021 expiry, as a number of asset classes signal that it is prudent to be cautious especially on the prospects of the broad equity market. Applying the SPX return from the 2009 trough to the 2010 peak, implies that the SPX can rise to 4,010 if history at least rhymes. Given recent bubble talk in the media, using the October 1998 to March 2000 parallel and applying that SPX return would imply an SPX level of 3,687 (see table). Our sense is that the further we rise the bigger the snapback will be and a retest of the October 2020 lows is a high probability event. Thus, from a tactical perspective we are not willing to risk 100-200 points of upside for a potential 800-point drawdown. One enticing synthetic long trade recommendation we are initiating is to buy a $390/$410 call spread on the SPY ETF and sell a $340 put for March 19 expiry for a modest cost of $0.67 per contract. The June expiry is a good alternative for more conservative investors with an actual $2.85 per contract cash inflow. This is not a speculative trade; it is a way to deploy fresh capital (i.e. covered position) at a much lower S&P 500 level given our still sanguine broad equity market view on a cyclical 9-12 month time horizon. This way we can partially participate (as we cap our gains) in the unfolding mania, and if markets turn around, as we expect on a near-term tactical basis, this trade goes long the SPY at a much lower level. Bottom Line: The board equity market risk/reward tradeoff is to the downside for the next three months on a tactical basis (please see the next Insight).