Developed Countries

In this Monday’s Strategy Report we upgraded the S&P hotels, resorts & cruise lines index to an above benchmark allocation in light of the improving macro backdrop. Consumer sentiment has staged a W-shaped recovery and while still flimsy, the brightening vaccine efficacy news should catapult it higher in the coming quarters. The implication is that the wide gulf between consumer confidence and relative hotels share prices will narrow via a catch-up phase in the latter (top panel). Closely linked to the budding recovery in confidence are discretionary versus non-discretionary retail sales. The latter have been correlated with the oscillations in relative share prices, and the current message is positive (bottom panel). Finally, the ISM non-manufacturing survey is on a sling shot recovery following the depths of the spring readings. This rebound also suggests that the path of least resistance is higher for lodging stocks (middle panel). Bottom Line: Upgrade the S&P hotels, resorts & cruise lines index to overweight. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH.  

Our macro view assumes a lower US dollar in the New Year. Our sister BCA Foreign Exchange service published a Strategy Report last week exploring a possible 1.50 print on EUR/USD. The bottom panel of the chart shows that China is firing on all cylinders and is pulling all the levers in reflating global growth. Keep in mind that increasing global trade is synonymous with a declining USD. As the supply/circulation of US dollars increases with rising global exports, a virtuous cycle takes root where a lower USD begets increasing trade in a positive feedback loop. This sparked a thought experiment on our end: what are the US equity sectors implications of EUR/USD at 1.50? First, deep cyclical and high operating leverage sectors will accelerate their outperformance phase as they are responsible for the lion’s share of SPX foreign sourced revenues. In contrast and in a relative sense, landlocked domestic sectors with little if any international sales will underperform in a steeply declining USD backdrop. Taken together our cyclicals over defensives portfolio bent will catch on fire (middle panel). Bottom Line: Rising prospects of a virtuous cycle where the revival in global trade pushes the US dollar lower and ignites a positive feedback loop will further boost deep cyclical sectors at the expense of defensives. ​​​​​​​

Please note that there will be no US Bond Strategy report next week. We will publish December’s Portfolio Allocation Summary on December 8th, followed by our Key Views For 2021 on December 15th and a Special Report titled “The Fed In 2021” on December 22nd. Highlights Duration: Weaker Q4 economic growth could cause Treasury yields to fall in the near-term, but knowledge of a vaccine coming in 2021 will limit the downside. Investors should maintain below-benchmark portfolio duration on a 6-12 month horizon. Fed: The Treasury’s decision to let the Fed’s emergency lending facilities expire is unlikely to have a meaningful impact on credit spreads, and it may even increase the odds of getting another fiscal stimulus bill through Congress. Spread Product: Value is quickly disappearing from high-rated corporate bonds, and municipal bonds look like an attractive alternative. Stay overweight municipal bonds and corporate bonds rated Ba and higher. Avoid junk bonds rated B and lower. Feature Increasingly, financial markets look caught in a tug-of-war between two competing economic outlooks. On the one hand, the US sits on the precipice of what is likely to be a dark winter. COVID hospitalizations are breaking through prior peaks and deaths are following closely behind (Chart 1). On the other hand, excellent results from vaccine trials offer a ray of light in the not-too-distant future. Focusing on the next 1-to-2 months, economic activity is poised to slow. This is partly because many states will respond to the surging case count by enacting stricter lock-down measures (Chart 2). In fact, New York shuttered schools just last week. But even in the absence of stricter quarantine laws, consumers will certainly exercise greater caution this holiday season. Already, consumer sentiment looks to be waning at a time when more than 700 thousand people are filing new unemployment claims each week (Chart 2, bottom 2 panels). Chart 1A Dark Winter Chart 2Look For Slower Growth In Q4 With consumer sentiment souring at a time when the household income support from the CARES act has expired, it is only a matter of time before consumer spending dips. Added to that, last week’s decision by the Treasury Department to call in the funds used to back-stop the Fed’s emergency lending facilities demonstrates that Donald Trump’s administration will be increasingly erratic during the next two months.1 Chart 3Treasury & Corporate Excess Returns Heightened political uncertainty during a period of slowing economic growth should point to lower bond yields and wider credit spreads in the near term. But, at least so far, the market reaction has been muted (Chart 3). Treasuries have strengthened somewhat during the past week. Treasury returns in excess of cash are running at +735 bps, year-to-date. This is up from +617 bps on November 10th. However, year-to-date investment grade corporate returns in excess of duration-matched Treasuries just hit -121 bps, the highest since February. Year-to-date High-Yield excess returns have dipped to -72 bps, after peaking at -39 bps on November 9th. It’s possible that investors need more evidence of weakening economic growth before the market impact is really felt. Or, it could simply be that forward-looking markets are much more focused on news about the COVID vaccine, and that investors are willing to tolerate a couple months of poor growth if they are confident that better times lie ahead. It’s also conceivable that financial markets would look through a spate of poor economic data if investors believed that more fiscal stimulus is on the way. Given the protracted nature of fiscal negotiations so far, it’s fair to be skeptical that a deal can be struck. But with the election now over, the House Democrats and Senate Republicans may have a greater incentive to compromise on a small relief bill, on the order of $1 trillion or less. According to surveys, a compromise deal would curry favor with voters of all political stripes. Most Republicans, Democrats and Independents support further fiscal aid (Table 1). What’s more, having a timeline for vaccine distribution could make negotiations less contentious, since any stimulus can be sold as the final COVID relief bill before a vaccine is available. Finally, it’s possible that Treasury Secretary Steve Mnuchin’s gambit will pay off, and that policymakers will view the funds being returned by the Fed as “free money” that should be re-deployed in the form of fiscal support. All in all, we are optimistic that a moderately-sized relief bill will be passed, if not this year then early next year. Table 1The Public Supports Another Round Of Stimulus Investment Implications Chart 4Better Value In Munis Than IG Corporates With regards to our outlook for Treasury yields, we could see yields dip during the next month or two as the economic data weaken. However, we expect the knowledge that a vaccine is on the horizon will prevent yields from falling that much. We also could see progress made on a fiscal stimulus package, which would offset any downward pressure on yields. With that in mind, we advise investors to maintain below-benchmark portfolio duration on a 6-12 month horizon. On spread product, our investment conclusion is similarly colored by the tug of war between a negative near-term economic outlook and the positive news of a COVID vaccine. We recommend maintaining our current positioning: overweight investment grade corporates and Ba-rated junk, underweight junk bonds rated B and lower. If we do get some spread widening during the next month or two, driven by negative economic news or the expiry of the Fed’s emergency lending facilities, we would view that as an opportunity to get more aggressive by upgrading the lower-rated junk credit tiers. One caveat to our positive view on corporate credit is that value has deteriorated markedly in recent months, particularly for higher-rated investment grade corporates (Chart 4). At the same time, tax-exempt municipal bonds offer an exceptional spread pick-up relative to both Treasuries and equivalently-rated corporate bonds (Chart 4, bottom panel). We recommend that investors favor municipal bonds over corporate credit, particularly at the upper-end of the credit spectrum. The value in high-rated investment grade corporates has deteriorated markedly. Bottom Line: Maintain below-benchmark portfolio duration on a 6-12 month horizon. Stay overweight investment grade corporates and Ba-rated junk, while avoiding high-yield bonds rated B and below. Stand ready to upgrade low-rated junk bonds if spreads widen significantly during the next two months. Favor municipal bonds over equivalently-rated corporate credit, particularly at the upper-end of the credit spectrum. Treasury – Fed Disaccord As mentioned above, last week’s big news was that Treasury Secretary Steve Mnuchin sent a letter to the Federal Reserve saying that he would (a) not authorize an extension of some of the Fed’s emergency lending facilities beyond December 31st and (b) would like the Fed to return the unused funds that the Treasury Department had allocated to serve as the equity back-stop for those facilities. Though the Fed issued a statement saying that it would prefer to extend the facilities, Chair Powell eventually acceded to both requests. This means that the Secondary and Primary Market Corporate Credit Facilities (SMCCF & PMCCF), the Municipal Liquidity Facility (MLF), the Main Street Lending Facilities (MSLF) and the Term Asset-Backed Securities Loan Facility (TALF) will all cease operations at the end of the year.2 Gone For Good? Given the Fed’s stated desire for the facilities to continue and the fact that a new Treasury Secretary – presumably one that will show greater deference to the Fed – will take over in January. It’s conceivable that the facilities could be quickly re-started. If the Treasury had simply not authorized an extension of the facilities without taking its money back, this would be as simple as flicking a switch. The fact that the Fed will return the money makes the process slightly more complicated, but by no means impossible. The facilities in question are all structured as Special Purpose Vehicles (SPVs) to which the Treasury Department supplies some amount of equity financing. The Fed then loans money to the SPVs, levering them up dramatically in the process. Crucially, there is no statutory limit on the amount of leverage the Fed can provide to the SPVs. This means that the Fed could ramp them back up, even if it gets only a small injection of capital from the Treasury. A new Treasury Department could easily find enough money in the Exchange Stabilization Fund for the Fed to re-start the facilities in January, without seeking Congressional approval. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. In our view, Secretary Mnuchin has a point when he writes that markets are functioning well enough on their own. Simply look at how little the emergency facilities have been used (Table 2). The Fed has purchased only $13 billion of corporate bonds in the SMCCF. TALF has only been tapped for $3.75 billion and both the MSLF and MLF are operating at less than 1% of their maximum capacities. The PMCCF, which the Fed can use to purchase new issuance in the corporate bond market, has never been accessed! Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Even the SMCCF, the facility through which the Fed buys corporate bonds and corporate bond ETFs in the secondary market, has significantly scaled back its purchases during the past few months. It also hasn’t purchased an ETF since August (Chart 5). Chart 5The Fed Is Not Very Active In The Corporate Bond Market At a certain point, if the facilities aren’t being used, it is entirely reasonable to ask whether they are still necessary. They would no doubt prove useful if we hit another crisis – like in March – where spreads widen sharply and primary markets shut down. But that seems like a relatively low-risk tail event at this stage of the recovery. Finally, Secretary Mnuchin made the case in his letter that the returned funds from the Fed could be re-deployed as fiscal stimulus by Congress. This argument doesn’t make a lot of sense economically. When it scored the CARES act, the Congressional Budget Office assumed that the Treasury would take no losses on the money used to finance the Fed’s emergency lending facilities, so clawing those funds back has no impact on the deficit. But this may not matter. What matters is whether Senate Republicans can use the Treasury’s maneuver as political cover to justify voting for more fiscal relief. We think they might be able to do so, and we therefore see the Treasury’s move as increasing the odds of getting another fiscal relief bill through Congress. Investment Implications Chart 6MLF And TALF Aren't Pushing Yields Lower This development does not immediately influence our recommended investment strategy. On corporate bonds, we can’t definitively rule out the possibility that the expiry of the facilities will cause spreads to widen in the near-term. But if that does occur, we will view it as an opportunity to quickly increase exposure. For municipal bonds, the MLF allows municipal governments to place new debt with the Fed at a rate that varies depending on the municipality’s credit rating. At present, that MLF rate is well above municipal bond yields for all credit ratings (Chart 6), meaning that it would only become important in the event of a crisis that caused municipal yields to rise sharply. Similarly, TALF allows participants to take out loans from the Fed using Aaa-rated securitizations as collateral. But the current yields on Aaa-rated consumer ABS and Aaa-rated non-agency CMBS are 91 bps and 33 bps below this rate, respectively (Chart 6, bottom panel). In other words, spreads would need to widen fairly sharply for TALF to be relevant for investors. The expiry of TALF is more concerning for CMBS than consumer ABS. Commercial real estate is structurally challenged by the current crisis, while consumer balance sheets are in good shape. We recommend overweighting consumer ABS across the entire credit spectrum but would limit non-agency CMBS exposure to the Aaa credit tier. Appendix: 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. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The second section of this report (titled “Treasury – Fed Disaccord”) examines the specific market implications of the Treasury Department’s decision to not authorize an extension of the Fed’s emergency lending facilities. 2  For details on how these facilities are structured and what they are designed to do 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 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification