Developed Countries

Recommended Allocation Chart 1Only Internet Stocks Have Kept On Rising It has been a very strange bull market. Although global equities are up 52% since their bottom on March 23rd, the rally has been limited largely to internet-related stocks. Excluding the three sectors (IT, Consumer Discretionary, and Communications) which house the internet names, equities have moved only sideways since May (Chart 1). Moreover, the rally comes amid sporadic serious new outbreaks of COVID-19 cases, most recently in Europe (Chart 2). Fears of the pandemic and much-reduced business activity in leisure-related industries have caused consumer confidence to diverge from the stock market in an unprecedented way (Chart 3).  Chart 2New Outbreaks Of COVID-19 In Europe Chart 3Why Are Stocks Rising When Consumers Are So Wary? The only explanation for these phenomena is the unprecedented amount of monetary stimulus, which is causing excess liquidity to flow into risk assets. Since March, the balance-sheets of major central banks have increased by $7 trillion (Chart 4), and M2 money supply growth has soared (Chart 5). Chart 4Central Banks Have Grown Their Balance-Sheets... Chart 5...Leading To A Big Rise in Money Growth Moreover, the Fed’s new strategic framework announced in late August represents a commitment to keep monetary policy loose even when the economy begins to overheat. The Fed will (1) target 2% inflation on average over time which means that, after a period of low inflation, it will “aim to achieve inflation moderately above 2 percent for some time”; and (2) treat its employment mandate as asymmetrical, so that when employment is below potential the Fed will be accommodative, but that a rise in employment above its “maximum level” will not necessarily trigger tightening. Historically the Fed has raised rates when unemployment approached its natural rate (Chart 6). The new policy implies it will no longer do so. The aim of the policy is to raise inflation expectations which have become unanchored, with headline PCE inflation above the Fed’s 2% target for only 14 out of 102 months since the target was introduced in February 2012 (Chart 6, panel 3).  Chart 6The Fed's Behavior Will Be Different In Future Chart 7More Permanent Job Losses To Come This commitment to easier monetary policy for longer will certainly help risk assets. But will it be enough? The global economic environment remains weak. Permanent job losses continue to increase, as workers initially put on furlough or dismissed temporarily, are fired (Chart 7). A second wave of COVID-19 cases in the Northern Hemisphere winter would worsen the situation. While central banks everywhere remain committed to aggressive policy, fiscal policy decision-makers are getting cold feet, with the UK’s wage-replacement scheme due to end in October, and government support in the US set to decline absent a big new fiscal package agreed by Congress (Chart 8). Credit risks are beginning to emerge, with bankruptcies surging (Chart 9), and mortgage delinquencies starting to rise (Chart 10). As a result, banks are becoming significantly more reluctant to lend (Chart 11). Chart 8Fiscal Support Is Starting To Slide   Chart 9Bankruptcies Are Surging…   Chart 10...Along With Mortgage Delinquencies Chart 11Banks Turning Increasingly Cautious To those concerns, we should add political risk ahead of the US presidential election. President Trump is probably not as far behind as the 7-percentage point gap in opinion polls suggests: After the Republican National Convention, online betting sites give him a 46% probability of being reelected (Chart 12). Over the next two months, he could be aggressive in foreign policy, particularly towards China. A disputed election is not unlikely. Investors might be wise to hedge against that possibility: BCA Research’s Geopolitical service recommends buying December VIX futures, which are still cheaply priced, and selling January VIX futures (Chart 13). 1 Chart 12Trump Could Still Pull It Off   Chart 13Hedge Against A Disputed Election Result Given the power of monetary stimulus, we are reluctant to bet against equities – not least since the yield on fixed-incomes assets is so low. Nonetheless, we see the risk of a sharp correction over the coming six months, driven by a second pandemic wave, a renewed downturn in the global economy, or political events. We continue to recommend, therefore, only a neutral position on global equities. We would hold a large overweight in cash, to keep powder dry for when a better buying opportunity for risk assets arises. But a warning: The long-run return from all asset classes will be poor. The global bond index is unlikely to produce a nominal return much above zero over the coming decade. While equities look more attractive, our valuation indicator points to a nominal annual return of only around 3% (Chart 14). For the US, valuation suggests a return of zero. Investors will need to become more realistic about their return assumptions. The 7% annual return still assumed by the average US pension fund might have made sense when the yield on BBB-rated corporate bonds was 8%, but it no longer does when it has fallen to 2.3% (Chart 15). Chart 14Long-Term Equity Returns Will Be Poor Chart 15Investors' Return Assumptions Are Unrealistic   Chart 16Value Sectors' Profits Have Been Terrible Equities: The most vigorous debate among BCA Research strategists currently is over whether growth stocks will continue to outperform, or whether value will take over leadership. The Global Asset Allocation service is on the side of growth. The poor performance of value stocks (concentrated in Financials, Energy, and Materials) is explained by the structural decline in their profits for the past 12 years (Chart 16). With the yield curve unlikely to steepen and non-performing loans set to rise, we do not see Financials’ earnings recovering. China’s economic shifts represent a long-term headwind for Materials. Internet stocks are expensively valued, but we do not see them underperforming until (1) their earnings’ growth slows sharply, (2) regulation on them is significantly tightened, or (3) long-term bond yields rise, lowering the NPV of their future earnings. This view drives our Overweight on US equities versus Europe and Japan. US stocks have continued to outperform even in the risk-on rally since March (Chart 17). We are a little more enthusiastic (with a Neutral recommendation) about Emerging Market stocks, which are very cheaply valued (Chart 18). Chart 17US Stocks Have Outperformed Even In A Risk-On Market   Chart 18EM Stocks Are Cheap   Chart 19Short USD Is Now A Consensus Trade Currencies: The US dollar has depreciated by 10% since mid-March. Over the next 12 months, the trend for the USD is likely to continue to be down. The new Fed policy emphasizes that real rates will stay low, and US inflation will probably be higher than in other developed economies. Nonetheless, short-USD/long-euro positions have become consensus (Chart 19) and, given the safe-haven nature of the dollar, a period of risk-off could push the dollar back up temporarily. Chart 20IG Spreads Are No Longer Attractive Fixed Income: We don’t expect to see a sustained rise in nominal US Treasury yields, despite the Fed’s new monetary policy framework. The Fed has an implicit yield curve control policy, and would react if yields showed signs of rising significantly. TIPS breakevens should eventually rise further to reflect the likelihood of higher inflation in the longer term, though the recent sharp rise in inflation (core CPI rose by 0.6% month-on-month in July, the largest increase since 1991) will likely subside and so the upside for breakeven yields might be limited over the next six months. We are becoming a little more cautious on credit. Investment-grade spreads are now close to historic lows and so returns are likely to be limited (Chart 20). We lower our recommendation to Neutral. Ba-rated bonds still offer attractive yields and are supported by Fed purchases. But we would not go further down the credit curve, and so stay Neutral on high yield. This by definition means that we must also be Neutral within fixed income on government bonds, which is compatible with our view that rates will not rise much. Note, though, that we remain Underweight the fixed-income asset class overall, but no longer have a preference for spread product within it. One exception is EM dollar-denominated debt, both sovereign and corporate, which offers spreads that are attractive in a world of low returns from fixed income. Chart 21Crude Prices Can Rise Further As Demand Recovers Commodities: Industrial metals prices have further to run up, as China continues its credit stimulus, which should lead to a rise in infrastructure investment and increased imports of commodities. The outlook for crude oil will be dominated by the demand side: OPEC forecasts demand destruction this year of 9 million barrels per day (compared to consensus expectations of 8 million) and so will be cautious about loosening its supply constraints. Demand should be boosted by increased driving, as people avoid using public transport for commuting and airlines for vacations. Based on a robust demand forecast (Chart 21), BCA Research’s energy strategists see Brent crude stable at around current levels through to the end of 2020 but averaging $65 a barrel next year. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1  Please see Geopolitical Strategy Special Report, “What Is The Risk Of A Contested US Election?” dated July 27, 2020. GAA Asset Allocation  

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 31, 2020.  The country allocation model still favors the US as its largest overweight. Despite Japan’s outstanding performance in August, the model still maintains its large underweight in Japanese equities, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model slightly underperformed the MSCI World benchmark by 7 bps in August. The Level 1 model outperformed by 19 bps because of the overweight in the US, while the Level 2 model underperformed its benchmark by 104 bps partly because of its large underweight in Japan. August was a very strange month in the sense that only the US and Japan outperformed while the rest underperformed the MSCI World benchmark.  As such, except for the US and Japan bets, all other six underweight choices made positive contributions to the overall performance of the model, while all other four overweight bets made negative contributions. Since going live, the overall model has outperformed its MSCI World benchmark by 404 bps, with 604 bps of outperformance from the Level 2 model, and 111 bps of outperformance from the Level 1 model. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1)   Chart 3GAA Non US Model (Level 2)For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of August 31, 2020. Chart 4Overall Model Performance The model continues to maintain its pro-cyclical stance driven by an improvement in its global growth proxy, and remains exposed to cyclical sectors. Over the past month, the model outperformed its benchmark by 58 basis points. Year-to-date, the model has outperformed its benchmark by 212 basis points, and 227 basis points since going live. The model’s global growth proxy continues to signal a bullish stance – driven by its three components: Appreciating EM currencies, rising metal prices, and an improvement in broad business climate. The model therefore continues to remain positive on cyclical sectors. Global monetary easing for the coming years and low rates should keep the liquidity component favoring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, several sectors continue to be near the expensive and cheap zones – mainly Info Tech and Consumer Discretionary (expensive), and Real Estate and Consumer Staples (cheap). The model awaits confirming momentum signals to change recommendations for those sectors. The model upgraded Industrials this month based on an improvement in its momentum component. Table 3Overall Model Performance Table 4Current Model Allocations     The model is now overweight five cyclical sectors in total. These are Information Technology, Consumer Discretionary, Communication Services, Materials, and Industrials. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com.   Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Senior Analyst amrh@bcaresearch.com

Special Report

Highlights Fed Policy Changes: The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past. The main takeaway for investors should be that inflation expectations will carry more weight than ever in the Fed’s thinking, with far less emphasis on estimated measures like the output gap. Investment Implications: The Fed’s new policy framework supports our current US fixed income recommendations: a neutral duration stance; overweighting TIPS versus nominal US Treasuries; positioning for real yield curve steepeners; and overweighting US spread product most directly supported by the Fed’s balance sheet (i.e. investment grade corporates and Ba-rated high-yield). Feature The pandemic forced the Federal Reserve to move its annual Jackson Hole Economic Policy Symposium online this year.  That change deprived policymakers of a late-August vacation in the mountains of Wyoming, but offered the public a rare glimpse at the full proceedings live on YouTube.1 Federal Reserve Chairman Jerome Powell took advantage of that larger audience to announce significant changes to the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy. Though many of the basic elements of the new strategy were well telegraphed in advance, the adjustments are hugely significant and will shape the conduct of US – and, potentially, global - monetary policy for years to come. This Special Report presents the most important takeaways – and fixed income investment implications - from the Fed’s new approach to setting monetary policy. Say Hello To Average Inflation Targeting The most significant change has to do with how the Fed defines its price stability mandate. In its old Statement, the Fed defined its 2% inflation target as “symmetrical”, meaning that the Fed would be equally concerned if inflation were running persistently above or below the target. In the Fed’s words, communicating this symmetry was enough to “keep longer-term inflation expectations firmly anchored.” The Fed now believes that a more aggressive approach is required to keep inflation expectations anchored. The new Statement reads: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.2 In other words, the Fed’s 2% inflation target is no longer purely forward-looking. It is now dependent on the history of realized US inflation, and thus is now much more like a price level target than an inflation target. We will know that the Fed has seen enough inflation overshooting when long-term expectations are anchored at levels consistent with its 2% inflation target. For example, Chart 1 shows how the headline PCE price index would have evolved since the end of 2007 had it averaged 2% growth per year, exactly equal to the Fed’s target. Starting from today, PCE inflation would need to average 3% for the next seven years, or 2.5% for the next fourteen years, for the index to converge with this target. In other words, if the Fed seeks to achieve average 2% inflation since 2007, we are in for a prolonged period of overshooting the old 2% target. Chart 1An Illustration Of Average Inflation Targeting Notice that we had to make several assumptions in our above example. First, we had to assume that the Fed will seek to achieve average 2% inflation since the end of 2007. The Fed could just as easily choose a different start date for calculating the 2% average. We also assumed that the year-over-year PCE inflation rate never breaks above 3% during the overshooting phase. As of now, we have no sense of whether the Fed would act to make sure that inflation only overshoots 2% by a small amount (say, between 0.5 and 1 percentage point) or whether it would tolerate a larger overshoot. A larger overshoot would potentially be more de-stabilizing, but it would allow the Fed to catch up to its price level target more quickly. We will probably get some more information about these missing details when the Fed translates its new framework into more explicit forward rate guidance (see section titled "Are There Any Additional Changes Coming?" below), but the Fed will still want to retain some flexibility. That is, we shouldn’t expect the Fed to tie its hands with a strict policy rule. This means that the question of how much inflation would prompt any future Fed tightening could linger for some time. Faced with this ambiguity, investors are advised to focus more keenly than ever on inflation expectations (Chart 2). Note that in the above excerpt from the revised Statement on Longer-Run Goals and Monetary Policy Strategy, the explicit goal of average inflation targeting is to “anchor long-term inflation expectations at [2 percent]”. This means that we will know that the Fed has seen enough inflation overshooting when long-term expectations are anchored at levels consistent with its 2% inflation target. We view this “well anchored” level as a range between 2.3% and 2.5% for long-dated TIPS breakeven inflation rates (top two panels). When TIPS breakevens reach those levels, we should expect the Fed to shift toward a more restrictive policy stance. Chart 2The Fed Wants Higher Inflation Expectations How long will it take for TIPS breakevens to reach our target range? We expect it will take quite some time because Fed communications alone cannot drive long-term TIPS breakevens back to target. Rather, inflation expectations tend to follow trends in the actual inflation data, so expectations will only return to well-anchored levels once inflation has risen significantly. Further, long-dated inflation expectations tend to adapt slowly to changes in the actual inflation data. Notice in Chart 3 that the 5-year/5-year forward CPI swap rate correlates much more strongly with the 8-year rate of change in CPI inflation than it does with the 1-year rate of change. This suggests that, most likely, 12-month inflation will have to run above 2% for some time before long-term TIPS breakevens sustainably return to our target range. One way to understand the link between actual inflation and inflation expectations is to look at the distribution of individual inflation forecasts. Chart 4 shows the distribution of 10-year headline CPI inflation forecasts from the Survey of Professional Forecasters from 2004 – a year when inflation expectations were well anchored around 2% – and from August 2020. Notice that a similar proportion of respondents at both points in time expect inflation to be near the Fed’s target, in a range of 2% to 2.5%. The difference is that, in 2004, a large minority of respondents anticipated a significant overshoot of the inflation target. Today, hardly anyone anticipates a significant overshoot, and many expect a significant undershoot. Chart 3Inflation Expectations Adapt Slowly To The Actual Data Chart 4Distribution Of Inflation Forecasts ##br##(2004 & Today) Since market prices can be thought of as a weighted average of the entire distribution of inflation forecasts, it follows that to drive TIPS breakevens higher we need to see investors shift their forecasts from the left tail of the distribution to the right tail. This will only happen if actual inflation rises, and probably only if it stays durably above 2% for a prolonged period. Chart 5shows that the percentage of respondents that expect inflation to average above 3% for the next ten years tends to follow both the long-run inflation rate and the median inflation forecast. Chart 5Few Expect Inflation To Be Above 3% Bottom Line:  The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past. The main takeaway for investors should be that inflation expectations carry more weight than ever in the Fed’s thinking. In particular, we should expect the Fed to move to a more restrictive policy stance only when long-maturity TIPS breakeven inflation rates return to a well-anchored range of 2.3% to 2.5%. Some Key Questions Following The Fed’s Big Shift Does The Phillips Curve Still Matter? The second big change that the Fed made to its official Statement on Longer-Run Goals and Monetary Policy Strategy is in how it views the unemployment rate relative to its “natural” level. Specifically, the change has to do with making estimates of the natural rate of unemployment (NAIRU) less important in the Fed’s reaction function. In its old Statement, the Fed talked about minimizing “deviations of employment from the Committee’s assessments of its maximum level”. The revised Statement talks about mitigating “shortfalls of employment from the Committee’s assessment of its maximum level.” This one word change says a lot about the Fed’s faith in the Phillips curve. In the past, the Fed viewed an unemployment rate below its estimate of NAIRU as a signal that inflation was poised to accelerate. This often led to premature tightening, and over time, a pattern of missing the inflation target to the downside. Now, the Fed is explicitly saying that it only cares about shortfalls of employment from its estimated maximum level. If the labor market appears overheated, the Fed will not take this as a sign that inflation is about to accelerate. Rather, it will wait for the evidence to show up in the actual inflation data. The percentage of respondents that expect inflation to average above 3% for the next ten years tends to follow both the long run inflation rate and the median inflation forecast. This change sends a very clear signal that the Fed will put much less emphasis on expected “Phillips curve effects” in the future than it has in the past. In addition to long-term implications, this change will likely also impact the type of forward rate guidance the Fed provides this year. What’s Missing? It is also interesting to touch on the things that Powell did not mention in his Jackson Hole speech. First, as noted above, Powell provided few details on the length of time over which the Fed will seek to hit average 2% inflation and did not specify any upper limit to the amount of inflation the Fed would tolerate during the overshooting phase. Perhaps more importantly, Powell also did not say much about how the Fed will seek to drive inflation higher, and whether there are additional tools at his disposal that have not yet been rolled out. We think there is good reason for this. In effect, we think the Fed is more or less tapped out in terms of the amount of additional monetary easing it can provide. Negative interest rates have already been ruled out. A Yield Curve Control policy of capping intermediate-maturity bond yields has been discussed, but this policy doesn’t accomplish much beyond what the Fed is already doing with its forward rate guidance. For example, a policy of capping the 2-year Treasury yield at the current level of 0.13% has essentially the same impact on bond prices as convincing the market that the fed funds rate will stay in a range between 0% and 0.25% for the next two years or more. The notion that the Fed is “out of bullets” was hammered home during the final Jackson Hole panel on Friday. The speakers for the panel titled “Post-Pandemic Monetary Policy and the Effective Lower Bound” shifted much of the onus for boosting growth, with policy interest rates at the effective lower bound, toward fiscal policymakers. Given the limitations on the amount of additional easing that the Fed can deliver, the potent impact of the changes announced last week will not really be felt until the economic recovery is further underway. Only once inflation starts to rise will we get a test of the Fed’s resolve to stay on the sidelines. Now that the changes have been enshrined in an official Fed document, we have no doubt that they will follow through. What About The Role Of QE? Chart 6The Future Of QE: Go Big & Go Fast Not every speaker at Jackson Hole, however, felt that central banks had run out of policy options.  Bank of England (BoE) Governor Andrew Bailey gave a speech on Day Two of the conference that focused on the use of central bank balance sheets as a more regular part of policymakers’ toolkits over the next decade with policy rates at the effective lower bound. Bailey noted that the use of quantitative easing (QE) in the future would be less about signaling future central bank intentions on interest rates, or forcing changes to the composition of assets held by the private sector, and would be more about “going big and going fast” to calm financial markets during periods of instability.3 Some past examples of such use of QE include the 2008 Global Financial Crisis, the 2011/12 European Debt Crisis and the 2016 UK Brexit shock (Chart 6). In Bailey’s view, QE will now have to be “state contingent”, based on the nature of the financial market shock and where liquidity (cash) needs are greatest at that time.  In 2008, it was the banking system that needed liquidity, so central banks expanded their balance sheets in ways that got cash directly to the banks – like repos and government bond purchases.  In 2020, the demand for liquidity from the COVID-19 shock came more from non-bank entities, like investment funds or the corporate sector itself.  Therefore, central bank balance sheets had to be used to support loans to the private sector or even buying private assets like corporate debt, on top of the usual QE buying of sovereign debt to help drive down risk-free bond yields. What does that mean for the new policy regime of the Fed?  It means that the type of market intervention we saw earlier this year – with the Fed announcing a variety of measures to support liquidity like corporate bond purchases when markets were not functioning – will become more commonplace during periods of severe market stress.  This is because there cannot be any “emergency” Fed rate cuts to calm markets if the Fed is keeping rates at very low levels to try and make up for past undershoots of its inflation target. Chart 7The Fed Has Room To Do More QE In The Future This also means that the balance sheets of the Fed, and other major global central banks, will likely continue to get larger over time.  Tapering of balance sheets, as the Fed engineered during 2014-19, will become very rare events before inflation expectations are stabilized at policymaker targets.  That does raise issues of capacity constraints for QE programs, as Bailey mentioned in his speech, where the central bank footprint in financial markets becomes so large as to impair market functionality.  That is the case today where the Bank of Japan now owns nearly 50% of all outstanding Japanese government bonds (JGB) and the day-to-day liquidity in the JGB market is extremely challenging for market participants that need to buy and trade JGBs, like Japanese banks and investment funds.  Bailey noted that there was still ample capacity for the BoE to ramp up its buying of UK Gilts (and even UK corporate debt) before the sheer size of its presence became a BoJ-like problem for the UK bond market (Chart 7). The same can be argued in the US, where the Fed only owns a little over 20% of outstanding US Treasuries – the supply of which is growing rapidly thanks to large US budget deficits. Are There Any Additional Changes Coming? As we outlined in a recent US Bond Strategy Webcast, after revising the Statement on Longer-Run Goals and Monetary Policy Strategy, the Fed’s next step will be to provide more explicit guidance about the economic conditions that will have to be in place before it considers lifting the fed funds rate.4 We speculate that this next announcement will occur before the end of the year, possibly at this month’s FOMC meeting, and that the guidance will be similar to the Evans Rule employed in 2012. The Evans Rule was a promise that the Fed would not lift rates at least until the unemployment rate was below 6.5% or inflation was above 2.5%. For the 2020 version of the Evans Rule, policymakers had been debating whether to specify both an unemployment target and an inflation target, as was done in 2012, or whether to specify only an inflation target. With the Fed’s new Statement putting much less emphasis on Phillips curve effects and estimates of NAIRU, it now appears much more likely that the 2020 version of the Evans Rule will have only an inflation trigger, or perhaps an inflation trigger and an inflation expectations trigger. Bottom Line: There are still many lingering unanswered questions about the new Fed strategy, but what we do know is that the Fed will focus more on inflation, rather than forecasts of inflation, when making future interest rate decisions.  The Fed will also likely use its balance sheet more as a market stability tool during times of crisis. Investment Implications Chart 8Financial Conditions The first implication of the Fed’s big shift has to do with the long-run outlook for risk asset prices (corporate bonds, equities and other fixed income spread product). With the Fed committing to give the economic recovery more runway before choking it off, risk asset valuations have been provided with a massive tailwind. In fact, the longer it takes for inflation to move up, the longer the Fed will stay on hold and the more expensive risk asset valuations will become. It is even possible that, if inflation remains subdued for a few more years, risk asset valuations will become so stretched that the Fed might have to exercise its financial stability “out clause”. That is, if the Fed viewed a growing asset bubble as a threat to the economic recovery and/or financial system, it could abandon its inflation target and lift interest rates to deflate that bubble. This out clause is specifically enshrined in the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy: Moreover, sustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals. We should stress that US financial asset valuations are currently nowhere near expensive enough to prompt this sort of move (Chart 8). However, that picture could change after a few more years of low inflation and zero interest rates. We have been saying since March 2019 that the two most important indicators to watch for gauging the eventual pace of Fed tightening are inflation expectations and financial conditions.5 Last week’s announcement serves to reinforce that view. The Fed could abandon its inflation target and lift interest rates to combat a growing asset bubble. A second investment implication of the Fed’s announcement is that TIPS will continue to outperform nominal US Treasuries until there is an eventual re-anchoring of long-run TIPS breakeven inflation rates in a range between 2.3% and 2.5%. As noted above, this structural investment position could take some time to pan out, and we may even get an opportunity to tactically position for periods of TIPS underperformance if breakevens start to look too high compared to the actual inflation data.6 For now, our models suggest that TIPS breakevens are fairly valued relative to the actual inflation data, and we recommend staying overweight TIPS versus nominal Treasuries as a core allocation in fixed income portfolios. We would also advise investors to enter flatteners along the inflation protection curve (TIPS breakevens or CPI swaps). This recommendation flows directly from the Fed’s announcement. If the Fed is eventually successful at achieving a temporary overshoot of its 2% inflation target, then the cost of short-maturity inflation protection should rise above the cost of long-maturity inflation protection. That is, the inflation protection curve should invert (Chart 9). This would be a stark dislocation compared to the past, but it is a logical one if the Fed is to be attacking its inflation target from above instead of from below. As for nominal Treasury yields, our baseline view is that yields will be flat-to-higher over the next 12 months, with the amount of upside dictated by the pace of economic recovery. The Fed’s extraordinarily dovish monetary policy will keep some downward pressure on nominal yields, but expectations of Fed tightening will eventually infiltrate the long end of the curve. Given that the Fed’s grip is much firmer at the short end of the curve than at the long end, we prefer to play the nominal Treasury curve through yield curve steepeners rather than through outright duration bets (Chart 10). Chart 9Position For Inflation Curve Inversion Chart 10Enter Nominal Curve Steepeners Finally, the level of real yields is perhaps the trickiest to get right in the current environment. The Fed’s dovish policies are clearly meant to push real yields down, but now that those policies have been announced, it may signal that we are near the trough. In fact, real yields actually rose somewhat on Thursday after the Fed’s announcement. As with nominal yields, we prefer to play the real Treasury (TIPS) curve via steepeners (Chart 11). Whether or not the Fed is able to apply further downward pressure on real yields, as long as its policies are viewed as reflationary and the economic recovery is maintained, then the real yield curve has ample room to steepen. Chart 11Enter Real Curve Steepeners Bottom Line: The Fed’s new policy framework supports our current US fixed income recommendations: a neutral duration stance; overweighting TIPS versus nominal US Treasuries; positioning for real yield curve (TIPS) steepeners; and overweighting US spread product most directly supported by the Fed’s balance sheet (i.e. investment grade corporates and Ba-rated high-yield).   Ryan Swift US Bond Strategist rswift@bcaresearch.com   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 https://www.youtube.com/user/KansasCityFed 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 The full text of BoE Governor Bailey’s speech can be found here: https://www.bankofengland.co.uk/speech/2020/andrew-bailey-federal-reserve-bank-of-kansas-citys-economic-policy-symposium-2020 4 https://www.bcaresearch.com/webcasts/detail/338 5 Please see US Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 This possibility is discussed in US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com

Special Report

Highlights President Trump is making a comeback in our quantitative election model. An upgrade from our 35% odds of a Trump win is on the horizon, pending a fiscal relief bill.  The Fed’s pursuit of “maximum employment,” the necessities of the pandemic response, fiscal largesse, a US shift toward protectionism, and the strategic need to counter China will pervade either candidate’s presidency. A Democratic “clean sweep” would add insult to injury for value stocks, but these stocks don’t have much more downside relative to growth stocks. Trump’s tariffs, or Biden’s taxes, will hit the outperformance of Big Tech, as will the recovery of inflation expectations. Feature More than at any time in recent US history, voters believe that the 2020 election is definitive in charting two distinct courses for the country (Chart 1). No doubt 2020 is an epic election with far-reaching implications. However, from an investment point of view, a Trump and a Biden administration have more in common than consensus holds. Chart 1An Epic Choice About The US’s Future The US political parties have finalized their policy platforms, giving investors greater clarity about what policies the parties will try to implement over the next four years.1 While the presidential pick is critical for American foreign and trade policy, the Senate is just as important as the president for US equity sectors. The only dramatic changes would come if the Democrats achieved a clean sweep of government – yet this result is likely as things stand today (Chart 2). Investors should prepare. It would prolong the suffering of value stocks relative to growth stocks by hitting the US health care and energy sectors hard. Chart 2“Blue Wave” Still The Likeliest Scenario The State Of Play A “Blue Wave” is still the likeliest outcome – and that’s where the stark policy differences emerge. The race is tightening. Our quantitative election model looks at state leading indicators, margins of victory in 2016, the range of the president’s approval rating, and a “time for change” variable that gives the incumbent party an advantage if it has not been in the White House for eight years. The model now shows Florida as a toss-up state with a 50% chance of flipping back into the Republican fold (Chart 3). Chart 3Florida Now 50/50 In Our Election Quant Model – 45% Chance Of Trump Win As long as the economy continues recovering between now and November 3, Florida should flip and Trump should go from 230 Electoral College votes to 259. One other state – plus one of the stray electoral votes from either Nebraska or Maine, which Trump is like to get – would deliver him the Oval Office again. The model says that Trump has a 45% chance of victory, up from 42% last month. Subjectively, we are more pessimistic than the model. Pandemic, recession, and social unrest have taken a toll on voters and unemployment is nearly three times as high as when Trump’s approval rating peaked in March. Consumer confidence is weak, albeit making an effort to trough. Voters take their cue from the jobs market more than the stock market, although the stock rally is certainly helpful for the incumbent. We await the completion of a new fiscal relief bill in Congress before upgrading Trump to closer to our model’s odds and the market consensus of 45%. Another Social Lockdown? COVID-19 subsiding in the US a boon for Trump in final two months of campaign. The first concern for the next president is COVID-19. On the surface Trump and Biden are diametrically opposed. President Trump is obviously disinclined to impose a new round of lockdowns and the Republican platform calls for normalizing the economy in 2021. By contrast, the Democrats claim they will contain the virus even at a high economic cost. Biden says he will be willing to shut down the entire US economy again if scientists deem it necessary.2 There is apparently political will for new draconian lockdowns – but it is not likely to be sustained after the election unless the next wave of the virus is overwhelming (Chart 4). Biden will need to be cognizant of the economy if he is to succeed. Chart 4Biden Has Some Support For Another Lockdown However, it is doubtful that Trump would refuse to lock down the economy in his second term if his advisers told him it was necessary. After all, it is Trump, not Biden, who implemented the lockdowns this year. Arguably he reopened the economy too soon with the election in mind. But if that is true, then it isn’t an issue for his second term, since he can’t run for president a third time. This is a theme we often come back to: reelection removes a critical impediment to Trump’s policies in a second term as opposed to his first. Bottom Line: The coronavirus outbreak and the country’s top experts will decide if new lockdowns are warranted, regardless of president, but the bar for a complete shutdown is high. COVID-19 is subsiding in both the US and in countries like Sweden that never imposed draconian lockdowns (Chart 5). Still, given that the equity market has recovered to pre-COVID highs, investors would be wise to hedge against a bad outcome this winter. Chart 5Pandemic Subsiding In US And ‘Laissez-Faire’ Sweden Maximum Employment The monetary policy backdrop will be ultra-dovish regardless of the presidency. The Fed is now pursuing average inflation targeting and “maximum employment,” according to Fed Chairman Jay Powell, speaking virtually on August 27 at the Kansas City Fed’s annual Jackson Hole summit. This means that if Trump wins, he will not have to fight running battles with Powell over rate hikes. The monetary backdrop for either president will be more reminiscent of that faced by President Obama from 2009-12 – extremely accommodative. It is possible that Trump’s “growth at all costs” attitude could lead to speculative bubbles that the Fed would need to prick. Already the NASDAQ 100 is off the charts. Elements of froth reminiscent of the dotcom bubble era are mushrooming (Chart 6). Nobody has any idea yet how the Fed will square its maximum employment mission with the need to prevent financial instability, but it will err on the side of low rates. Chart 6Frothy NDX Chart 7The Mother Of All V-ShapesBiden will be more likely to tamp down financial excesses through executive orders – or to deter excesses through taxes if he controls the Senate. But there is no reason the executive branch would be more vigilant than the Fed itself. Higher inflation will push real rates down and weaken the dollar almost regardless of who wins the presidency. Trump’s trade wars – and any major conflict with China – would tend to prop up the greenback relative to Biden’s less hawkish, more multilateral, approach. But either way the combination of debt monetization, twin deficits, and global economic recovery spells downside for the dollar. This in turn spells upside for the S&P500 and inflation-friendly (or deflation-unfriendly) equity sectors in the longer run (Chart 7). Fiscal Largesse The next president will struggle with a massive fiscal hangover resembling late 1940s. The Fed’s new strategy ensures that fiscal policy will prove the driving factor in the US macro outlook. Regardless of who wins the election, the budget deficit will fall from its extreme heights amid the COVID-19 crisis over the next four years (Chart 8). If government spending falls faster than private activity recovers, overall demand will shrink and the economy will be foisted back into recession. Chart 8Budget Deficit Will Decrease As Economy Normalizes The deep 1948-49 recession occurred because of the government’s climbing down from wartime levels of spending (Chart 9). Premature fiscal tightening would jeopardize the 2021 recovery. Yet neither candidate is a fiscal hawk. Trump is a big spender; Biden is a Democrat. The House Democrats will control the purse strings. Republican senators, the only hawkish actors left, are not all that hawkish in practice. They agreed with Trump and the Democrats in passing bipartisan spending blowouts from 2017-20. They will likely conclude another such deal just before the election. Chart 9Sharp Deficit Correction Would Jeopardize Recovery So Trump would maintain high levels of spending without raising taxes; Biden would spend even more, albeit with higher taxes. Table 1Biden Would Raise $4 Trillion In Revenue Over Ten Years On paper, Biden would add a net ~$2 trillion to the US budget deficit over ten years, as shown in Tables 1 and 2. But these are loose costings. Nobody knows anything until actual legislation is produced. The risk to spending levels lies to the upside until the employment-to-population ratio improves (Chart 10). Trump’s net effect on the deficit is even harder to estimate because the Republican Party platform is so vague. What we know is that Trump couldn’t care less about deficits. Back of the envelope, if Congress permanently cut the employee side of the payroll tax for workers who earn less than $8,000 per month, as Trump has suggested, the deficit would increase by roughly $4.8 trillion over ten years.3 Table 2Biden Would Spend $6 Trillion In Programs Over Ten Years   Chart 10Massive Labor Slack Will Encourage Government Spending House Democrats will hardly agree to any major new tax cuts – and certainly not gigantic ones that would “raid Social Security.” This accusation will be popular and Trump will want to avoid it during the campaign as well – his 2020 platform does not explicitly mention the payroll tax. Many of Trump’s other proposals would focus on extending the Tax Cut and Jobs Act. For example, it is possible that Trump could extend the full expensing of companies’ depreciation costs for capital purchases, set to expire in 2022 and 2026, to the tune of $419 billion over ten years.4 Thus the overall contribution of government spending to GDP growth will be higher than in the recent past. This trend was established prior to COVID (Chart 11). The rise of populism supports this prediction, as Trump has always insisted he will never cut mandatory (entitlement) spending – a major change to Republican orthodoxy now enshrined in its policy platform. Chart 11Government Role To Increase In America Chart 12No Cuts To Defense Likely Either Meanwhile Biden is not only rejecting spending cuts but also coopting the profligate spending agenda of the left wing of his party. Practically speaking, social spending cannot be cut by Trump – and yet Biden cannot cut defense spending much either, since competition with Russia and China is growing (Chart 12). The common thread in both party platforms is fiscal largesse at a time of monetary dovishness, i.e. reflation. Other Common Denominators Market is overrating Biden’s China friendliness. Both Trump and Biden promise to build infrastructure, energize domestic manufacturing, and lower pharmaceutical prices. The two candidates are competing vociferously over who will bring more American manufacturing jobs home. President Trump won the Republican nomination in 2016 partly because he stole the Democrats’ thunder on “fair trade” over “free trade.” Biden’s agenda is effusive on these Trump (and Bernie Sanders) themes – his party sees an existential risk in the Rust Belt if it cannot steal that thunder back. The manufacturing agenda centers on China-bashing. China runs the largest trade surplus with the US, it has a negative image in the public eye, and it has alarmed the military-industrial complex by rising to the status of a peer strategic competitor over the technologies of tomorrow. Where Trump once spoke of a “border adjustment tax,” or a Reciprocal Trade Act, Biden speaks openly of a carbon border tax: “the Biden Administration will impose carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”5 China’s coal-guzzling economy would obviously be the prime target. It is true that Biden will seek to engage China and reset the relationship. He will probably maintain Trump’s tariff levels or even slap a token new tariff, but he will then settle down for a two-track policy of dialogue with China and coalition-building with the democracies. The result may be a reprieve from strategic tensions for a year or so. Investors are exaggerating Biden’s positive impact on China relations, judging by the correlation of China-exposed US equities with the Democrats’ odds of winning. The truth is that Biden will maintain the Obama administration’s “Pivot to Asia,” which was about countering China. The secular power struggle will persist and China-exposed stocks, especially tech, will be the victims (Chart 13). Chart 13Market Over-Optimistic About Biden Vis-à-Vis China Senate election will likely tip with White House – but checks and balances are best for equities. Control of the Senate will determine whether the big differences between the two candidates materialize. Biden can’t raise taxes without the Senate; Trump can’t wage trade wars of choice as Congress is supreme over commerce and could take his magic tariff wand away from him. Trump can use executive orders to pare back immigration, but he cannot force the House Democrats to approve a southern border wall. In fact, he dropped “the Wall” from his agenda this time around. (It didn’t help that former Trump adviser Steve Bannon has been arrested for allegedly scamming people out of their money to pay for a wall.) Biden will be far looser on immigration than Trump and the reviving economy will attract foreign workers. But the Obama administration showed that during times of high unemployment, even Democrats have a limit to the influx they will allow (Chart 14). Meanwhile Biden can use executive orders to impose aspects of his version of the Green New Deal, but he cannot pass carbon pricing laws or other sweeping climate policy if Republican Senators are there to stop him. For this reason, a divided government is likely to produce three cheers from the markets. The single most market-positive scenario is Biden plus a Republican Senate, which suggests a moderation of the trade war and yet no new taxes. Second best would be Trump with a Democratic Congress that would clip his wings on tariffs, but enable him to veto any anti-market laws. The stock market’s performance to date is more reminiscent of a “gridlock” election outcome, in which the two parties split the executive and legislative branches of government in some way, as opposed to a unified single-party government (Chart 15). Chart 14Immigration Faces Limits Even Under Democrats Chart 15Stock Market Expects Gridlock? Investors should not be complacent, however, because the political polling so far suggests that the Senate race is on a knife’s edge. The balance of power will tilt whichever way the heavily nationalized, heavily polarized White House race tilts (Chart 16). A “blue sweep” is still a fairly high probability. Indeed a Biden win will most likely produce a Democratic sweep while a Trump win will produce the status quo. Chart 16Tight Senate Races Will Turn On White House Race Biden’s Agenda After A Blue Sweep Democrats would remove the filibuster – another big difference in outcomes. Biden is more likely to benefit from Democratic control of Congress if he wins. He is also more likely to rely on his top advisers and the party apparatus. Hence the Democratic platform matters more than the Republican platform in this cycle. Investors should set as their base case that a new president will largely succeed in passing his top one or two priorities. Less conviction is warranted after the initial rush of policymaking, as political capital will fall and the economic context will change. But in the honeymoon period, a president can get a lot done, especially if his party controls Congress. Investors would have been wrong to bet against George W. Bush’s Economic Growth and Tax Relief Act (2001), Barack Obama’s Affordable Care Act (2009), or Trump’s Tax Cut and Jobs Act (2017). Yet they could never have known that COVID-19 would strike in Trump’s fourth year and overturn the very best macroeconomic forecasts. Critically, if Democrats take the Senate, our base case is that they will remove the filibuster, i.e. the use of debate to block legislation. Biden has suggested that he would look at doing so. President Obama recently linked it to racist Jim Crow laws of the late nineteenth and early twentieth centuries, making it hard for party members to defend keeping the filibuster. Senate minority leader Charles Schumer (D, NY) has signaled a willingness to change the Senate rules if he becomes majority leader. Removing the filibuster would change the game of US lawmaking, enabling the Senate to pass laws with a simple majority of 51 votes – i.e. 50 plus a Democratic vice president. This is entirely within reach. While a handful of moderate Democratic senators may oppose such a dramatic move at first, the Democratic Party leadership will corral its members once it faces the reality of the 60-vote requirement blocking its agenda. The party will remember the last time it took power after a national crisis, in 2009, and the frustrations that the filibuster caused despite having at that time a much stronger Senate majority than it can possibly have in 2021. Populism is rife in the US and it is all about shattering norms. Moreover, the filibuster has already been eroding over the past two administrations (vide judicial appointments). Revoking it would enable Democrats to pass a lot more ambitious legislation, and many more laws, than in previous administrations. This is important because Biden’s agenda is more left-wing than some investors realize given his history as a traditional Democrat. In order to solidify the increasingly powerful progressive faction of his party, symbolized by Vermont Senator Bernie Sanders, Biden created task forces to merge his agenda with that of Sanders. Sanders and his fellow progressive Senator Elizabeth Warren of Massachusetts have much more influence in the party than their 35% share of the Democratic primary vote implies. The youth wing of the party shares their enthusiasm for Big Government. Here are the key structural changes that matter to investors: Offering public health insurance – A public health option will benefit from government subsidies and thus outcompete private options, reducing their pricing power. The lowest income earners will be enrolled in the program automatically, rapidly boosting its size (Chart 17). Enabling Medicare to negotiate drug prices – Medicare’s drug spending is equivalent to almost 45% of Big Pharma’s total sales. Enabling this government program to bargain with companies over prices will push down prices substantially. However, the sector’s performance is not really tied to election dynamics because President Trump is also pledging to cap drug prices – it is an effect of populism (Chart 18). Doubling the federal minimum wage – The wage will rise from $7.25 to $15 per hour, hitting low margin franchises and small businesses alike. Chart 17Health Care Gives Back Gains After Biden Nomination Chart 18Big Pharma Faces Onslaught From Both Parties Eliminating carbon emissions from power generation by 2035 – Countries are already rapidly shifting from coal to natural gas, but the Biden agenda would attempt to move rapidly away from fossil fuels completely (Chart 19). If legislation passes it will revolutionize the energy sector. Prohibiting “right to work” laws – This is only one example of a sweeping pro-labor agenda that would involve an extensive regulatory push and possibly new laws. New laws would prevent states from passing “right to work” laws that give workers more freedoms to eschew labor unions. The removal of the filibuster makes this possible. Moreover Biden will be aggressive in using executive orders to implement a pro-labor agenda, going further than Bill Clinton or Barack Obama attempted to do in recognition of the party’s shift to the left of the political spectrum. Chart 19Blue Sweep Would Bring Climate Policy Onslaught Subsidizing college tuition and low-income housing. US housing subsidies currently make up 25% of domestic private investment in housing and Biden’s government would roll out a significant expansion of these programs. Granting Washington, DC statehood – This is unlikely to happen as two-thirds of Americans are against it. But without the filibuster, Democrats could conceivably railroad it through. Trump’s Agenda Trump’s signature is tariffs – and globally exposed stocks know it. If Trump wins, his domestic legislative agenda will be stymied, other than laws directly aimed at fighting the pandemic and reviving the economy. As mentioned, Trump is unlikely to pass a law building a wall on the southern border. It is conceivable that Trump could pass a comprehensive immigration reform bill with House Democrats, but that is not a priority on the platform and Trump would have to pivot toward compromise. That would depend on Democrats winning the Senate or forcing him to negotiate with the House. Hence a Trump second term will mostly focus on foreign and trade policy. The Republican platform is aggressive on economic decoupling from China, which is ranked third behind tax cuts and pandemic stockpiles.6 Trump, vindicated on protectionism, would likely go after other trade surplus nations. The Chinese could offer some concessions, producing a Phase Two deal early in his second term to avoid sweeping tariffs and encourage him to wage trade war against Europe (Chart 20). Chart 20Trump = Global Trade War Trump’s foreign policy would consist of reducing US commitments abroad. Withdrawing from Afghanistan and other scattered conflicts is hardly a game changer. Shifting some forces back from Germany and especially South Korea is far more consequential. It will create power vacuums. But the US is not likely to abandon the allies wholesale. Chart 21Defense Stocks Will Get Wind In Sails Trump has moderated his positions on NATO and other defense priorities over his first term. It is possible he could revert back to his original preferences in a second term, however, so global power vacuums and geopolitical multipolarity will remain a major source of risk for global investors. He will probably also succeed in maintaining large defense spending, despite a Democratic House, given the reality of great power struggle with China and Russia. Geopolitical multipolarity means that defense stocks will continue to enjoy a tailwind from demand both at home and abroad (Chart 21). Investment Takeaways Energy sector struggles most under Democrats. Biden and Trump are both offering reflationary agendas. Where the two agendas diverge most notably, the impacts are largely market-negative – Trump via tariffs, Biden via taxes. The current signals from the market suggest that growth stocks benefit more from a Democratic clean sweep than value stocks (bottom panel, Chart 22). However, the general collapse in value stocks versus growth suggests that there is not much more downside even if the Democrats win (top panel, Chart 22), especially if the 10-year yield rises, as we have been writing in recent research: a selloff in the bond market is the last QE5 puzzle-piece to fall into place. Fed policy, fiscal largess, and the dollar’s decline will support a global cyclical recovery and downtrodden value stocks regardless of the president. The difference is that Biden would slow their relative recovery by piling regulatory burdens on energy as well as health care, which in the US context are a value play. As a reminder, and contrary to popular belief, health care stocks are the largest constituent of the S&P value index with a market cap weight of 21%.7 Trump’s populist “growth at any cost” and deregulatory agenda would persist in a second term and clearly favor value. Yet, if his trade wars get out of hand, they would also weigh on the recovery of these stocks. The difference is that tech stocks are not priced for a Phase Two trade war. If Trump wins it will be a rude awakening. Not to mention that Trump and populist Republicans will seek to target the tech sector for what is increasingly flagrant favoritism in political and cultural debates. Democrats are much more clearly aligned with tech. While they have ambitions of reining in the tech giants as part of the progressive drive against corporate power writ large, Joe Biden will struggle to take on Big O&G, Big Pharma, Big Insurance, and Big Tech at the same time in a single four-year term. The logical conclusion is that he will spare Silicon Valley, which maintained a powerful alliance with the Obama administration. He cannot afford to betray his progressive base when it comes to climate policy, so the Obama alliance with domestic O&G producers will suffer. Tech will face regulatory risks but they will not be existential. Chart 22Not Much Downside Left For Value Stocks The fact that the final version of the Democratic Party platform did not contain a section on removing federal subsidies for fossil fuels is merely rhetorical.8 The one clear market reaction from this election cycle is the energy sector’s abhorrence of Democratic policies (Chart 23). The difference is that energy is priced for it whereas tech is priced for perfection. Chart 23Energy Sector Loses From Blue Sweep     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     In this report we work from the latest policy platforms available. See “Trump Campaign Announces President Trump’s 2nd Term Agenda: Fighting For You!” Trump Campaign, donaldjtrump.com  ; and the draft “2020 Democratic Party Platform” Democratic National Committee, demconvention.com. 2     Bill Barrow, “Biden Says he’d shut down economy if scientists recommended,” Associated Press, August 23, 2020, abcnews.go.com. 3    See Seth Hanlon and Christian E. Weller, “Trump’s Plan To Defund Social Security,” Center for American Progress, August 12, 2020, americanprogress.org; “The 2020 Annual Report Of The Board Of Trustrees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds,” Social Security Administration, April 22, 2020, ssa.gov. 4    Erica York, “Details And Analysis Of The CREATE JOBS Act,” Tax Foundation, July 30, 2020, taxfoundation.org. 5    See “The Biden Plan For A Clean Energy Revolution And Environmental Justice,” Biden Campaign, joebiden.com. 6    A Democratic Congress could take back the constitutional power over commerce that it delegated to the president back in the 1960s-70s, limiting Trump’s ability to wage trade war. If Republicans hold the Senate, they still might restrain Trump’s protectionism, as they did with his threatened Mexico tariffs in early 2019, but they would not do so until he has already taken a major disruptive action.    7     See “S&P 500 Value,” S&P Dow Jones Indices, spglobal.com. 8    Andrew Prokop, “The Democratic Platform, Explained,” Vox, August 18, 2020, vox.com.  

Special Report

Highlights Several malls are likely to fail in 2020 and 2021, but the overall economy will emerge unscathed … : Although lenders will recover a good bit less than par and equity holders will be wiped out, the losses will not create an observable macroeconomic drag. … because no critical element of the financial system has concentrated exposure to them: The amounts involved are not that large and the banking system’s stake is negligible. Malls disrupted the existing retailing footprint during their rise, and now it’s their turn to be disrupted: Creative destruction is natural and healthy. It will be a net positive for the economy if obsolete malls make way for more productive uses of their space. Feature As detailed in the first part of our Mallpocalypse Special Report, enclosed shopping malls are under pressure from a variety of forces. Department stores, which have typically anchored malls, are in the throes of a protracted structural decline; the apparel retailers that fill most of the leasable area between the anchors are in disarray; and e-commerce continues to take share from brick-and-mortar retailers. The pandemic, which forced many malls to close for an extended period and will likely undermine foot traffic until an effective vaccine is available, intensified the pressure. It pushed several national store chains into bankruptcy, emboldened many of their peers to stop paying rent and stymied malls’ pivot to gyms, movie theaters, restaurants and entertainment centers to fill their vacant spaces. Property analysts and investors estimate that the weakest 25% of malls face the possibility of extinction. Their owners’ equity stakes are likely to be wiped out and their lenders will recover considerably less than par. This installment examines the macroeconomic consequences of mall investors’ losses and the obsolescence of a formerly important aspect of the capital stock. Our view is that the malls’ demise does not constitute a macro threat; the mallpocalypse is not the commercial real estate analogue of the subprime crisis. Mall Exposures Are Diffused The sparks generated by the subprime mortgage collapse helped fuel the conflagration of the global financial crisis because they eroded commercial banks’ capital base; hobbled two major investment banks such that counterparties refused to deal with them; brought about declines in the prices of homes, which constitute a meaningful share of the collateral of the US banking system; and crippled the massive multi-line insurer that had been the biggest seller of the credit default swaps that the major banks and broker-dealers were using to hedge some of their residential mortgage exposures. With so many of the biggest players circling the wagons, liquidity dried up, credit spreads blew out and a major financial crisis ensued. No bank or major bank counterparty is sitting on a pile of mall mortgages. Mall failures will not have anything close to the same impact. Retail properties do not undergird the banking system like single-family homes and exposure to them is diffused across owners and creditors that can sustain losses without setting off broad ripple effects. More than half of US malls1 are owned by publicly traded REITs with the remaining ownership scattered among several privately held specialist investors. Developing and owning real estate is a leveraged pursuit and mall owners aren’t shy about borrowing, especially Simon Property Group (SPG), the largest player in the space (Table 1). Like some of its mall REIT peers, and nearly all its shopping center/strip mall counterparts, however, it does the bulk of its borrowing via bond issues. The effect is to reduce the concentration of creditor exposures; instead of borrowing from a bank or a syndicate of banks, SPG and many other publicly traded REITs sell bonds to a range of institutional investors. The mortgages it does take out predominantly wind up being securitized and dispersed across the institutional investor community. Table 1Large US Mall Owners Creditor exposures to mall owners are thereby atomized, making losses a micro issue rather than a macro one. Distributing credit losses across a wide swath of investors neutralizes the systemic risk posed by any given borrower or common group of borrowers. Alan Greenspan was compelled to recant his spectacularly ill-timed praise for securitization’s risk-mitigating properties, but it was conceptually sound. Residential mortgage securitization wasn’t the problem per se, it was that the private-label mortgage market had become a largely closed system in which the banks swapped positions with one another, amplifying counterparty exposures within the banking system without anyone seeming to care, if indeed they were aware. Table 2Top 15 Holders Of SPG Debt The primary owners of SPG’s bonds are the dominant index ETF sponsors, insurers and active mutual fund managers (Table 2). They are unlevered investors whose involvement diversifies exposure to credit losses away from the banks, thereby dissipating systemic risk. Although their losses cause financial conditions to tighten at the margin as spreads widen in response, they don’t disrupt financial intermediation in the way that sizable bank losses do. The worst outcome is a barely observable decline in funds available for consumption or investment and marginal employment declines as defaulting borrowers and their chastened creditors tighten their belts. Institutional investors are agents for the wealthier households that own a disproportionate share of financial instruments. They have a low marginal propensity to consume, which is to say that their consumption patterns are relatively insensitive to one-off income reversals and their investment losses don’t therefore perturb the broad economy. Equity holders in ailing mall REITs may have their stakes wiped out (Chart 1, bottom panel), adding insult to the injuries retail REIT investors have already sustained so far this year (Chart 1, top panel), but no critical intermediaries are shareholders and the overall market cap of retail REITs is not meaningful. Chart 1Trees Falling In Abandoned Mall Courtyards Do Not Make A Sound The Big Short 2.0 Investors who foresaw a future in which e-commerce wipes out department stores and other national chains with sizable mall footprints have sought out ways to bet against malls. Many of them have gravitated to selling the CMBX 6 Index (Box 1). The trade has been talked about so much in credit circles over the last few years that the financial media have labeled it The New Big Short, after the book and movie about investors who anticipated the wreckage of the subprime crisis. The New York Times devoted an article to it last week, and Bloomberg, The Wall Street Journal and countless credit market blogs have been following it for a while. Box 1: The CMBS Insurance Marketplace Credit default swaps (CDS), developed in the mid-nineties as a tool for hedging lending exposures, have become a wildly popular way for investors to bet on the fate of a given bond issue or security. Bonds can be quite illiquid relative to equities, and CDS vastly ease the process of obtaining exposure to them. They are effectively an insurance contract in which the protection buyer pays the protection seller a flat annual fee to indemnify the buyer against missed or partial interest or principal payments. The CMBX indices provide a reference point for buying and selling protection on a large basket of commercial mortgage backed securities (CMBS). They are composed of 25 equally weighted CMBS of common vintage, each of which contains at least 40 loans, and they are divided into quality tranches from AAA to BB, based on the level of credit enhancement provided to each tranche. The BB tranche absorbs losses first, then the BBB- tranche, and so on, up to the AAA tranche. The protection seller is said to go long the index while the buyer shorts it. CMBX trades between counterparties are zero-sum. They produce no aggregate increase or decrease in wealth because the longs’ and the shorts’ return profiles are perfect inverses. The weakest mall REITs aren't long for this world, but their ultimate demise will not trigger any broader repercussions. The CMBX 6, consisting of whole loans issued in 2012, became the darling of the retail bears because a comparatively large 44% of the face value of its mortgages backed retail properties (27% non-mall retail, 17% malls). As of late 2019, the index contained loans on 37 malls (Table 3). Publicly traded REITs have a stake in 26 of the 37 malls in the index and account for 70% of the outstanding principal balance. Table 3Mall Mortgages In The CMBX 6 Index Live By Disruption, Die By Disruption Obsolete malls are not likely to hurt the macroeconomy. Their disappearance will reslice the pie, creating micro winners and losers, but it shouldn’t cause it to shrink. Unwanted malls are a drag on the capital stock, because they’re not worth the cost of maintaining them, and converting the sites to better uses should act to boost productivity. Creative destruction is a positive feature of capitalism and a sign of economic health. The macro-economy didn't suffer when malls disrupted traditional downtown shopping districts and there's no reason to think it will now that the malls themselves are being disrupted. To those inclined to think we’re being cavalier about economic shifts and the near-term disruptions they provoke, we would point to the decades when the malls themselves were the disruptors. Mall construction – and branch department stores – thrived amidst the city-to-suburb migration that unfolded across the ‘50s, ‘60s and ‘70s. Population and wealth flooded out of the cities and into the suburbs, leaving some nasty micro-level scars as once-thriving retail quarters in the urban core became derelict. That outmigration did not produce a wave of bank failures, however. Citing Detroit’s experience in the ‘50s through the ‘70s in its Special Report examining the potential commercial real estate impact of a sizable uptake in work-from-home arrangements, our Global Investment Strategy service found no evidence that urban flight imposed undue stress on the financial system.2 Outmigration was also pervasive along the mid-Atlantic I-95 corridor in those decades. Suburbs of New York, Philadelphia and Washington, DC all experienced phenomenal growth while their core metropolitan areas shrank (Chart 2, top three panels). Even a growing city like Atlanta (Chart 2, bottom panel) saw its surrounding suburban counties welcome six times as many net new residents over the period. Chart 2City And Suburb Net Population Change By Decade Despite inevitable home price declines in several city neighborhoods and reduced demand for retail and office space, aggregate residential (Chart 3) and commercial mortgage performance (Chart 4) held up quite well and there was no uptick in bank failures (Chart 5). Inflation helped to hold down defaults then in a way it won’t now, but the bottom line is that the shift in consumer preferences toward shopping malls did not feed broader disruptions, even though credit exposures were nearly entirely concentrated within the banking system. With exposure to mall operators’ equity, mortgages and unsecured loans widely dispersed away from the banking system, and retail accounting for only a modest share of commercial property value (Chart 6), the shift away from shopping malls will not have broader macro consequences. Chart 3Urban Flight Didn't Undermine Residential ... Chart 4... Or Commercial Mortgage Performance Chart 5Urban Flight Didn't Promote Bank Stress Of Diamonds And Malls The forces behind the rise and fall of malls closely resemble the forces that drove the postwar waves of stadium construction: population shifts, increased reliance on automobiles and fashion’s impermanence. For the first half of the twentieth century, professional baseball’s sixteen franchises were spread across just ten cities. Its geographic footprint stretched from Boston to Washington on the Atlantic seaboard and along the Ohio River, the Great Lakes and the Mississippi to Chicago and St. Louis. The spread of franchises beyond the northeast and industrial midwest has tracked and foreshadowed the southern and westward movement of the population. Franchise moves, expansion and the mothballing of old city-center stadiums without parking led to a multi-decade boom in stadium construction that roughly coincided with the boom in mall construction. On undeveloped parcels on their outskirts, one city after another erected bland, utilitarian stadiums that were as uniform as the malls that had begun to dot suburban highway interchanges. They were hulking concrete structures with synthetic Astro-turf surfaces that could host baseball in the spring and summer and football in the winter, with capacity for between 50,000 and 70,000 fans and their cars. The early ‘90s witnessed a new stadium construction boom, motivated by franchises’ desire to reconfigure their seating to maximize revenues from businesses who used the games as a vehicle for entertaining clients. Stadiums without luxury boxes and enclosed suites were swiftly seen as obsolete. The popularity of Baltimore’s new park (1992), showcasing a retro design that hearkened back to the days of center city stadiums with brick facades and asymmetric quirks, made the stadiums of the sixties and seventies look hopelessly passé. The stock of dual-sport, artificial turf stadiums with concrete facades was eradicated over the next decade-plus, including Houston’s iconic Astrodome. The first fully enclosed stadium, billed as “the eighth wonder of the world” upon its 1965 opening, was the subject of rapturous national media coverage akin to the attention lavished on Southdale, the first mall, a decade before. The conversion of the stadiums did not bring ruin for any franchise, its municipal host,3 or the syndicate of banks and muni bond buyers that financed it. In cities where the new stadiums have been built closer to the center of town, the new ballparks have been a catalyst for a range of commercial and residential development. The broadly positive impact of scrapping faded stadiums for newer, better designed replacement stock looks like what we might expect from the scrapping of obsolete malls to make way for properties able to make better use of the space. Investment Implications Investors should not fear negative economic or market consequences from the retirement of underperforming malls. Their exit will not produce investment losses on a scale that slows the economy or interrupts banks’ intermediation function. Specialist real estate investors may find several opportunities in an industry in which the three most important factors are location, location and location. Credit and equity analysts and PMs may well find ways to profit from micro distinctions, but the lack of macro impacts means the demise of a meaningful share of the country’s malls does not have asset allocation implications. Investors in US assets will continue to be best served by taking their asset allocation cues from the fiscal and monetary policy backdrop. Mallpocalypse may be a clever phrase, but culling the nation’s underperforming malls from the capital stock won’t have adverse impacts on financial markets or the broad economy. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 There are around 1,300 malls in the US, including outlet malls and lifestyle centers. 2 Please see the August 28, 2020 Global Investment Strategy Special Report, "Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?" available at gis.bcaresearch.com. 3 The merits of using public funds to subsidize stadium construction for private concerns are hotly contested. Taking the existing level of public subsidies as a given, however, successful facilities upgrades confer an overall economic benefit, even if it involves a transfer of wealth from taxpayers to private entities.

Software stocks have been on a tear. This defensive-tech index has bested the SPX by 34% year-to-date, and in absolute terms is up a whopping 45%. While such a breakneck pace is clearly unsustainable, and a short-term breather is in order, software stocks have been high-flying as they are trying to satisfy investors’ insatiable appetite for cloud exposure. True, some recent IPO activity is reminiscent of the dotcom bubble excesses (re:BIGC doubled in a mere 5 trading days) as investors are scrambling to gain any cloud exposure at any price. Circling back to the S&P software index, encouragingly this has been a capex-led advance, as software outlays now capture a larger slice of corporate budgets (top panel). As a result, software stocks have rallied along side swelling profits (second panel). Granted, valuations are trading at a large premium versus the broad market, however, the 12-month forward P/E is hovering near the historical average and way below the 1990s peak (middle panel). When corrected for the long-term growth rate, the relative P/E/G ratio is near parity and below the historical mean (bottom & fourth panels).   Bottom Line: While software stocks have run too far too fast, appear expensive to the naked eye and a near-term breather is needed, the earnings-led advance keeps us on the cyclically bullish side. The ticker symbols for the stocks in the S&P software index are: BLBG: S5SOFT – MSFT, ADBE, CRM, ORCL, INTU, NOW, ADSK, ANSS, SNPS, CDNS, FTNT, PAYC, CTXS, NLOK, TYL. ​​​​​​​