Economy

Highlights Duration: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. Employment: The US employment boom is just getting started. Total employment is still 8.4 million below pre-pandemic levels, but 37% of missing jobs are from the Leisure & Hospitality sector where demand is about to surge. Fed: The US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year. Feature Chart 1Price Pressures Building The past two weeks brought us a couple of interesting developments directly related to the Treasury market. First, long-dated Treasury yields declined somewhat, presumably because many investors concluded that the yield curve is already priced for the full extent of future Fed rate hikes. Second, we received further evidence – from March’s +916k employment report, the 12% year-over-year increase in producer prices and continued elevated readings from PMI Prices Paid indexes – that economic activity is recovering more quickly than even the most optimistic forecasters anticipated (Chart 1). These two opposing forces highlight a tension in the current outlook for US Treasury yields. Yields now look fairly valued on several different valuation metrics, a fact that justifies keeping bond portfolio duration close to benchmark. However, cyclical economic indicators are surging, a fact that suggests yields will keep rising in the near-term, causing them to overshoot fair value for a time. This week’s report looks at this tension between valuation indicators and cyclical economic indicators through the lens of our Checklist To Increase Portfolio Duration. While we think there are convincing arguments in favor of both “At Benchmark” and “Below Benchmark” portfolio duration stances on a 6-12 month investment horizon, we are deciding to stick with our recommended “Below Benchmark” stance for now, until the economic data are more in line with market expectations. Checking In With Our Checklist Back in February, following the big jump in bond yields, we unveiled a Checklist of several criteria that would cause us to increase our recommended portfolio duration stance from “Below Benchmark” to “At Benchmark”.1 As is shown in Table 1, the Checklist contains seven items that can be grouped into two categories: Valuation Indicators that compare the level of Treasury yields to some estimate of fair value Cyclical Indicators that look at whether trends in the economic data are consistent with rising or falling bond yields Table 1Checklist For Increasing Duration Valuation Indicators Chart 2Valuation Indicators As mentioned above, valuation indicators show that Treasury yields are roughly consistent with fair value, suggesting that a neutral duration stance is appropriate. First, consider the 5-year/5-year forward Treasury yield relative to survey estimates of the long-run neutral fed funds rate (Chart 2). Last week, survey estimates from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers were updated to March, and while there was some upward movement in the estimated long-run neutral rate ranges, the median estimates in both surveys were unchanged from January. The result is that the 5-year/5-year forward Treasury yield remains near the top-end of its survey-derived fair value band (Chart 2, top 2 panels). Second, the same two surveys also ask respondents to forecast what the average fed funds rate will be over the next 10 years. We can derive an estimate of the 10-year term premium by subtracting those forecasts from the 10-year spot Treasury yield (Chart 2, bottom 2 panels). In this case, respondents did raise their average fed funds rate forecasts and our term premium estimates were revised down as a result. While both term premium estimates are now below their 2018 peaks, they remain elevated compared to recent historical averages. Third, we turn to the front-end of the yield curve to look at what sort of Fed rate hike path is priced into the market (Chart 3). We see that the market is currently priced for Fed liftoff in December 2022 and for a total of four 25 basis point rate hikes by the end of 2023. Only a handful of FOMC participants forecasted a similar path at the March Fed meeting. Chart 3Market Priced For December 2022 Liftoff We discussed the wide divergence between market expectations and the Fed’s “dot plot” in a recent report.2 Essentially, the divergence boils down to the Fed focusing more on actual economic outcomes while the market takes its cues from economic forecasts. We think there’s good reason for optimism about the economy, and therefore expect that the Fed will revise its interest rate forecasts higher in the coming months as the “hard” economic data improve. However, we should point out that respondents to the New York Fed’s Survey of Primary Dealers and Survey of Market Participants also have much more benign interest rate forecasts than the market, and respondents to those surveys do not share the Fed’s bias toward actual economic outcomes. Table 2 shows that the average respondent to the Survey of Market Participants only sees a 35% chance that the Fed will lift rates before the end of 2022 and the Survey of Primary Dealers displays a similar result. Table 2Odds Of A Fed Rate Hike By End Of Year The wide gap between rate hike expectations embedded in the yield curve and forecasts from both the FOMC and the New York Fed’s surveys suggests that Treasury yields are at least fairly valued, and perhaps too high. However, the most important question is whether the market’s rate hike expectations look lofty compared to our own forecast. As is explained in the below section (titled “The Employment Boom Is Just Getting Started”), we think that the jobs market will be strong enough for the Fed to lift rates before the end of 2022 and that the market’s anticipated rate hike path looks reasonable. However, even this view is only consistent with a neutral stance toward portfolio duration. Chart 4Higher Inflation Is Priced In For our final valuation indicator we focus specifically on the outlook for inflation compared to what is already priced into the forward CPI swap curve (Chart 4). The forward CPI swap curve is priced for headline CPI inflation to rise to 2.7% by May 2022 before falling back down only slightly. In reality, year-over-year headline CPI will probably spike to even higher levels during the next two months but will then recede more quickly. We think it’s reasonable to expect headline CPI inflation to be between 2.4% and 2.5% in 2022, a range consistent with the Fed’s 2% PCE target, but the forward CPI swap curve reveals that this outcome is already priced. All in all, the message from the valuation indicators in our Checklist is that a robust economic recovery is already reflected in market prices. Thus, even with our optimistic economic outlook, Treasury yields look fairly valued, consistent with an “At Benchmark” portfolio duration stance.  Cyclical Indicators While valuation indicators perform well over longer time horizons, they are notoriously bad at pinpointing market turning points. It’s for this reason that we augment our Checklist with cyclical economic indicators, specifically high-frequency cyclical economic indicators that correlate tightly with bond yields. First, we look at the ratio between the CRB Raw Industrials commodity price index and gold (Chart 5). The CRB index is a good proxy for global economic growth and gold is inversely correlated with the stance of Federal Reserve policy – gold falls when policy is perceived to be getting more restrictive and rises when policy is perceived to be easing. This ratio has shown little evidence of rolling over and further gains are likely as the economy emerges from the pandemic. We also look at other high-frequency global growth indicators like the relative performance between cyclical and defensive equities and the performance of Emerging Market currencies (Chart 5, panels 2 & 3). The trend of cyclical equity sector outperformance continues while EM currencies have shown some tentative signs of weakness. The US dollar is one particularly important indicator for bond yields. As US yields rise relative to yields in the rest of the world it makes the US bond market a more attractive destination for foreign investors. When US yields are attractive enough, these foreign inflows can stop them from rising. One good indication that US yields are sufficiently high to attract a large amount of foreign interest is when investor sentiment toward the dollar turns bullish. For now, the survey of dollar sentiment we track shows that investors are still bearish on the US dollar (Chart 5, bottom panel). Bearish dollar sentiment supports further increases in bond yields. Chart 5Cyclical Indicators Chart 6Data Surprises Still Positive Finally, we track the US Economic Surprise Index as an excellent summary indicator of the US data flow relative to market expectations. The index also correlates tightly with changes in bond yields (Chart 6). Though the index has fallen significantly from the absurd highs seen late last year, it is still elevated compared to typical historical levels. In general, bond yields tend to rise when the economic data are beating expectations, as indicated by a positive Surprise Index. All in all, we see that the cyclical indicators in our Checklist are sending a very different signal than the valuation indicators. This suggests a high probability that yields could overshoot fair value in the near term. Bottom Line: Treasury yields look fairly valued on several different valuation metrics and the yield curve discounts a much quicker pace of rate hikes than is currently signaled by the Fed’s “dot plot”. However, the economic data continue to beat expectations by a wide margin. This suggests that bond yields could overshoot their fair value in the near term. Maintain below-benchmark portfolio duration. The Employment Boom Is Just Getting Started Chart 7Defining "Maximum Employment" The Fed has conditioned the first rate hike of the cycle on both (i) 12-month PCE inflation being at or above 2% and (ii) the labor market being at “maximum employment”. As we’ve previously written, we see strong odds that the inflation trigger will be met in time for a 2022 rate hike.3 This week, we assess the likelihood that “maximum employment” will be reached in time for the Fed to lift rates next year. Fed communications have made it clear that the FOMC’s definition of “maximum employment” is equivalent to an environment where the unemployment rate is between 3.5% and 4.5% - the range of FOMC participants’ NAIRU estimates – and the labor force participation rate has made a more-or-less complete recovery to pre-pandemic levels (Chart 7). Following March’s blockbuster employment report, we update our calculations of the average monthly nonfarm payroll growth that must occur to hit “maximum employment” by different future dates (Tables 3A-3C). Table 3AAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% By The Given Date Table 3BAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4% By The Given Date Table 3CAverage Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 3.5% By The Given Date For example, to reach the Fed’s definition of “maximum employment” by December 2022, nonfarm payroll growth must average between +410k and +487k per month between now and then. To reach “maximum employment” by the end of this year, payroll growth must average between +701k and +833k over the remaining nine months of 2021. It’s probably unrealistic to expect a return to “maximum employment” by the end of this year, but we do expect at least a couple more monthly payroll reports that are even stronger than last month’s +916k. Our optimism stems from the industry breakdown of the current jobs shortfall. Table 4 shows the change in overall nonfarm payrolls between February 2020 and March 2021. In total, we see that the US economy is missing 8.4 million jobs compared to pre-pandemic. We also see that 3.1 million (or 37%) of those jobs come from the Leisure & Hospitality sector. That sector is predominantly made up of restaurants and bars, two services where demand is about to ramp up significantly as COVID vaccination spreads across the US. A few months in a row of 1 million or more jobs added is highly likely in the near future. Table 4Employment By Industry Bottom Line: We see the boom in employment as just getting started and we expect that the US economy will reach the Fed’s definition of “maximum employment” in 2022. This will cause the Fed to lift rates before the end of 2022, an event that will be preceded by an announcement of asset purchase tapering either late this year or early next year.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 https://www.bcaresearch.com/webcasts/detail/387 2 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The latest major economic releases have been solidly positive, … : The manufacturing ISM hit a 37-year high and the services ISM made a new all-time high in its 24-year history, while the March employment report was quite strong. … but they have fallen within the wide distribution of Goldilocks economic and market outcomes, … : The pace of vaccinations is limiting the potential of a negative pandemic surprise and the Fed continues to stick to its easier-for-longer messaging. … though we are watching the potential to drift into the too-hot right tail: Although the labor market is awash in excess capacity, both ISM surveys are telling a pro-inflation story replete with bottlenecks, shortages and suppliers willing to exploit their advantages. Earnings season will shed some light on how long the good times can be sustained: First quarter earnings releases begin this week with the SIFI banks. We will look to management commentary for insight into how corporate earnings are likely to stack up against expectations and how long we might be able to stick with our risk-friendly positioning. Feature When the COVID-19 pandemic reached the US last spring, our view turned on the outcome of the battle between policy makers and the virus. We were optimistic that the economy could escape long-term damage and that risk assets would be able to come back from their vicious February-March declines because we expected that policy makers would do what it took to build a bridge across the pandemic crater. Once the Democrats captured the White House and a majority in both houses of Congress, the policymakers-versus-the-virus outcome was settled, as the Biden-Pelosi-Schumer triumvirate ensured that fiscal policy would join monetary policy in erring to the side of providing too much support to the economy. The investment narrative now has shifted to whether or not policy makers have overdone it. It is possible to have too much of a good thing and excessive stimulus could cause the economy to overheat, hastening the end of the just-right Goldilocks combination of strong growth and easy monetary policy. It is also possible that the pandemic could still spring a nasty surprise on the United States, bringing about a growth disappointment despite indulgent policy, but the probability of a bad public-health outcome appears to shrink every week that the rapid vaccination clip is maintained. Our new framework is Goldilocks and the two tails (Figure 1), in which the probability of a just-right outcome that keeps the strong-growth, easy-policy beat going is considerably larger than unanticipated slowing (the too-cold left tail) or overheating (the too-hot right tail). This week, we review vaccine progress, consumer loan delinquencies and key economic releases to assess where in our stylized distribution the economy is likely to fall. Figure 1Goldilocks And The Two Tails The Left Tail We have viewed widespread vaccinations as the best way to inoculate the economy against a left-tail outcome. The more quickly herd immunity can be achieved via vaccinations, the less likely that growth will fall short of market expectations. We are impressed with the ground the US has made up after stumbling out of the gate; vaccine production has ramped up well beyond expectations and a mix of public and private injection sites are getting doses delivered. Assuming that new virus-resistant variants do not emerge, it looks as if the US is sure to meet the goal of inoculating a critical mass of the adult population well before September 30th (Chart 1). Chart 1Off And Running A self-reinforcing wave of defaults and bankruptcies would have been at the center of any worst-case economic and market scenarios. The Fed was keenly aware of the threat and preventing avoidable bankruptcies was an explicit monetary policy aim. Zero interest rates, massive asset purchases and new emergency measures like the Primary and Secondary Corporate Credit Facilities paved the way for record corporate bond issuance, eradicating the threat of bankruptcy for many viable businesses that were severely strained by the pandemic. Generous fiscal policy more directly buoyed household borrowers, but Powell and company had an eye out for them as well, highlighting the goal of : “just … keeping people solvent, keeping them in their homes, keeping them paying their bills just for maybe a few more months.”1 Personal loan performance has therefore been an important indicator for tracking the course of the recovery and policy makers’ success in promoting it. We have been monitoring 60-day delinquency rates across the four main consumer loan categories (90-day rates for credit cards) ever since TransUnion began publishing them on a monthly basis last spring. They have been a good barometer (with a lag) of the flow of transfer payments from the federal government to households. The $1,200 economic impact payments for adults with annual earnings below $75,000 were distributed in March and April, while the $600 weekly federal unemployment insurance (UI) benefit supplement was available from late March until the end of July, and delinquency rates steadily declined from March through August in every category but autos (Chart 2, top panel). Chart 260-Day Delinquency Rates Had Stopped Falling … Chart 3… But The Leading 30-Day Delinquencies Are Headed Lower After the UI supplements stopped flowing in the second half of the year, 60-day delinquencies began creeping up in every category but mortgages (Chart 2, third panel). A new round of $600 checks that were distributed in January, along with the resumption of federal UI benefit supplement payments at a rate of $300 per week, helped the February numbers and March’s $1,400 checks will extend the positive turn. The 30-day delinquency rates show the same pattern, but with bigger declines in February (Chart 3). 30-day delinquency rates lead 60- and 90-day rates and their positive trend will surely be enhanced by the latest round of direct payments and the gathering hiring momentum on display in the March employment report. Along with the success of the vaccination rollout, consumer loan performance suggests that the probability of left-hand tail outcomes is narrowing. Robust ISM Surveys And The Specter Of Cost-Push Inflation The ISM manufacturing and services PMI surveys stand out amid the welter of economic data that researchers and investors have to navigate. They are issued monthly with virtually no lag and provide a reliable read on the economy’s direction. Given that stocks tend to perform well when the economy performs well, they also provide information about the future direction of the stock market (Chart 4) and offer a first-cut guide to asset allocation. Chart 4A Strong Economy Is Good For Equity Returns The March composite releases were quite strong, with the manufacturing survey hitting a 37-year high and the services survey reaching the highest level in its 24-year history. The manufacturing survey was strong across the board, with new orders and order backlogs at or near extended highs (Chart 5, fourth panel) and the production and employment indexes (Chart 5, second and third panels) pointing to broad pickups. Unfortunately, the prices paid and supplier performance indexes (Chart 5, bottom panel) hinted that upward price pressures and supply bottlenecks have taken hold across broad swaths of the economy. Those components, and the accompanying comments from survey respondents, suggest that upward inflation pressures are building. The ISM services PMI survey closely resembled its manufacturing counterpart. New orders (Chart 6, fourth panel) and business activity (Chart 6, second panel) were very strong, though not as large a share of services employers are looking to hire (Chart 6, third panel). The share of respondents facing higher prices has broken out (Chart 6, fifth panel) and lengthening supplier delivery times are prevalent. The services sector has more slack than the manufacturing sector, but it is not immune from inflation pressure. Chart 5The Manufacturing PMI Looks A Lot Like ... Chart 6... Its Services Counterpart It is important to remember that the PMI surveys are diffusion indexes that capture share rather than magnitude. The record and near-record readings don’t mean that respondents’ businesses are growing at their most rapid rate in decades; they mean that the share of respondents who report quickening growth is at record/near-record levels. The same goes for the near-record prices paid readings; they don’t reflect that prices are rising at close-to-record rates, they reflect that an unusually large proportion of companies report increasing prices. The diffusion of upward price pressures as reported in the surveys has had a solid record of leading year-on-year core CPI increases and testifies to the economy’s potential to overheat (Chart 7). Cost-push inflation pressures could derail the strong-growth/easy-policy backdrop. Chart 7Inflation Pressures Have Begun To Stir Bottom Line: The ISM PMI surveys reinforce the idea that the probability of a left-hand tail outcome is modest and shrinking, but they suggest that right-tail overheating is a valid concern. Labor Market Firmly In Goldilocks Territory Chart 8The Labor Market Still Has A Lot Of Slack Net payroll gains in the March employment report comfortably surpassed expectations, while January’s and February’s estimates were also revised higher. The employment figures added to the run of positive surprises in key economic data series that suggest that growth in 2021 and 2022 will run well above its long-term potential. Despite the gains, however, employment remains far below its pre-pandemic peak (Chart 8, top panel) and the spaces that were hardest hit by the pandemic, like restaurants and hospitality, are not operating at anything close to full capacity. With labor force participation sharply reduced from its pre-pandemic level (Chart 8, bottom panel), the labor market is a long way from being tight. With all the excess capacity in the labor market, wage growth has been well behaved. Neither of the main wage series is growing at a rate that would give rise to inflation concerns. Average hourly earnings are up a lot year-over-year (Chart 9, top panel) because of a 5% month-over-month surge last April, but they have been running in place for the last three months and face much tougher comparisons beginning next month. The employment cost index has been rising at a rate well below its 2019 peak (Chart 9, bottom panel) that accompanied half-century lows in the unemployment rate. Chart 9Wage Growth Is Not Yet A Reason For Concern With considerable ground to make up to get back to its pre-pandemic state, the labor market appears to have plenty of room to run before it pulls the overall economy into overheating territory. The combination of ample slack and a strong backlog of labor demand (Chart 10) hints at a best-of-both-worlds/Goldilocks scenario. As long as it remains in place, the labor market is likely to be a positive economic catalyst, promoting robust hiring activity without setting off a self-reinforcing wage-price dynamic that would prod the Fed to cut off monetary accommodation in an abrupt way that would disrupt financial markets. Chart 10There's Still A Lot Of Demand For Workers Investment Implications We stand by our base case that the Goldilocks backdrop of solid growth and ample monetary accommodation will remain in place at least into early 2022. That backdrop precludes the possibility of a recession and therefore argues for risk-friendly investment strategy. Stocks rarely experience significant reversals outside of recessions and spread product reliably generates positive excess returns over Treasuries and cash. Multi-asset investors should remain at least equal weight equity and credit while holding fixed income duration below benchmark levels. We have a high degree of conviction that the economy will avoid a downside surprise in the next twelve months, thanks to the success of the vaccination effort and measures undertaken to limit defaults by households and businesses. We are less sure that the economy will be able to avoid overheating. A rapid rise in consumer prices to levels that would unsettle markets and force the Fed into tightening monetary policy sooner than expected is not our base case but it cannot be ruled out. We will be perusing the data for any advance indications that inflation could be gaining a foothold while also carefully observing what we see in our day-to-day experience. We will also be listening eagerly to what corporate management teams have to say over the next three to four weeks when they report their first-quarter earnings and offer their impressions of the second quarter and the full year.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Interview conducted May 13, 2020 and broadcast May 17. Full Transcript: Fed Chair Jerome Powell's 60 Minutes interview on economic recovery from the coronavirus pandemic - CBS New.

Highlights Private-sector savings exploded during the pandemic, swelling the already large global savings glut. Reluctant to sit on excess cash, households shifted some of their funds into the stock market. With corporate buybacks outpacing new share issuance, stock prices had nowhere to go but up. Falling bond yields further supercharged equity valuations. Despite the run-up in stocks, the global equity risk premium – measured as the forward equity earnings yield minus the real bond yield – still stands at about 6%, similar to where it was in late-2009. Using a simple example, we show why investors should hold more stock than the standard 60/40 rule suggests when bond yields are still this low. While bond yields will rise further over the coming years, it is likely to be a slow process. Investors should remain bullish on stocks over a 12-month horizon, favouring non-US equities over their US peers. Did A Surfeit Of Savings Lead To A Shortage Of Assets? Real interest rates have fallen dramatically since the early 1980s (Chart 1). Economic theory posits that lower real rates discourage savings while encouraging spending. Yet, as Chart 2 shows, with the exception of the late-1990s and the mid-2000s – two periods when spending was buoyed first by the dotcom bubble and then by the housing bubble – the US private sector has run a large financial surplus; that is to say, it has consistently spent less than it earned. Private-sector financial balances in most other economies have followed a similar trend. Chart 1Real Bond Yields Have Been Trending Lower Since The 1980s Chart 2The Private Sector Has Been Mostly Running Surpluses Ben Bernanke famously cited chronic private-sector financial surpluses as evidence of a “global savings glut.” The concept of a savings glut is closely related to the concept of demand-side secular stagnation, an idea popularized by Larry Summers prior to his heel-turn towards stimulus skeptic. When the private sector is unable to find enough worthy investment projects to make use of all available savings, the economy will struggle to attain full employment, even in the presence of very low interest rates. The concept of a savings glut is also related to another, less well known, concept: a safe asset shortage. If the private sector earns more than it spends, it must, by definition, accumulate assets. In principle, governments can satiate the demand for safe assets by issuing more bonds. In practice, governments have often been reluctant to run persistently large budget deficits for fear that this could undermine their credibility. Faced with a shortage of safe assets, the private sector has stepped in to fill the void, often with disastrous consequences. Most notably, in the lead-up to the Global Financial Crisis, banks sliced and diced portfolios of risky mortgages with the goal of creating safe assets that could be sold into the market. Most financial crashes occur when investors conclude that the assets they once thought were safe are not so safe after all. This was precisely what happened to mortgage-backed securities during the 2008 mortgage meltdown. The exact same pattern repeated itself two years later when investors finally came around to the seemingly obvious conclusion that Greek government bonds were not as safe as say, German bunds. The Safe Asset Shortage In A Post-Pandemic World This brings us to the present day. After falling from 7% of GDP in 2009 to 3% of GDP in the lead-up to the pandemic, the global private-sector financial balance surged to 11% of GDP in 2020. The IMF expects the global private-sector balance to average 9% of GDP in 2021 before trending lower over the coming years. Arithmetically, the private-sector financial balance must equal the sum of the fiscal deficit and the current account balance.1 By running large budget deficits during the pandemic, governments endowed the private sector with income they otherwise would not have had. This income consisted of transfers (stimulus checks, expanded unemployment benefits, business subsidies, etc.) as well as income generated from direct government spending on goods and services. As of the end of March, we estimate that US households had accumulated about $2.2 trillion (10.5% of GDP) in savings over and above what they would have had in the absence of the pandemic. About 40% of those “excess savings” stemmed from fiscal policy with the remainder reflecting decreased consumption (Chart 3). Chart 3Lower Spending And Higher Income Have Led To Mounting Savings Chart 4Government Largesse Boosted Savings And Fattened Bank Deposits As the private sector’s financial balance increased, so did its asset holdings. Unlike in normal fiscal expansions where governments fund budget deficits by selling debt to the public, this time around, governments largely sold the debt to central banks. The money that governments received from central banks in return was then pumped into the economy, leading to a surge in bank deposits (Chart 4).   The Nature Of Stock Market “Flows” What happened to the money after it reached people’s bank accounts? A popular narrative is that some of it flowed into the stock market. While this description is technically true, it is somewhat misleading in that it conveys the false impression that there was a net inflow of money into stocks. The reality is more nuanced. When I buy some stock, I gain some shares but lose some cash. Conversely, whoever sold me the stock gains some cash and loses some shares. In aggregate, there is no change in either the number of shares or the amount of cash that investors hold. What does change is the value of the shares in relation to the cash that investors hold. My purchase must lift the share price by enough to persuade someone else to part with their shares. If the seller does not want to hold the additional cash, he or she may try to place an order to purchase a different stock that appears more attractively priced. This game of hot potato will only end when the value of the stock market rises by enough that all investors are happy with how much stock they own in relation to how much cash they hold. Rethinking The 60/40 Split The standard investment mantra is that investors should hold 60% of their portfolios in stock and the rest in cash, bonds, and other financial assets. The discussion above casts doubt on this simple rule of thumb. Suppose that Melanie holds $600 in stock and $400 in cash, and that cash earns a real interest rate of 2%. Let us also assume that Melanie requires a 4% equity risk premium. Hence, the equity earnings yield must be 6% (i.e., her $600 in stock must correspond to $36 in earnings).2 Now let us suppose that the central bank cuts the policy rate, so that the real interest rate falls to zero. In order to maintain a 4% equity risk premium, the earnings yield must decline to 4%, which implies that the value of the stock must rise to $900 ($36/0.04=$900). Thus, we have gone from a position where Melanie holds 60% of her portfolio in stock to one where she holds about 69% ($900/$1300) in stock. In other words, even though the equity risk premium did not change at all, the desired ratio of stock-to-cash rose from $600/$400=1.5 to $900/$400=2.25. Let us continue the thought experiment and imagine a scenario where the government sends Melanie and everyone else a stimulus check of $100. Now she has $500 in cash and $900 in stock. If she wants to maintain a stock-to-cash ratio of 2.25, she would need to use some of her cash to buy stock. However, since everyone else is also looking to purchase stock with their stimulus checks, before Melanie has a chance to enter a buy order, she finds that the stock in her portfolio has appreciated to $1125. Since $1125/$500 is equal to 2.25, Melanie cancels her buy order, content with the knowledge that she holds as much stock as she wants. Notice that in this simple example, neither interest rate cuts nor stimulus checks did anything to boost corporate profits. All that happened is that stock prices rose, causing the equity earnings yield to first fall from 6% to 4% after the central bank cut rates, and then fall again from 4% to 3.2% ($36/$1125) after the stimulus checks were sent out. If all of this sounds a bit familiar, it should. The sequence of events described above is precisely what has happened over the past 12 months. And not just to stock prices. As interest rates fell and cash balances swelled, other risky assets such as cryptocurrencies went to the proverbial moon. Is The Party Over? Given that fiscal stimulus has peaked and interest rates cannot be cut any further in the major economies, are stocks set to fall? Not necessarily! The amount of stock that investors choose to hold in relation to their cash balances is a function of animal spirits. While US consumer confidence rebounded in March to the highest level in a year, it still remains well below pre-pandemic levels (Chart 5). The percentage of households in The Conference Board’s survey who expect stock prices to rise over the next 12 months is still around its long-term average (Chart 6). Chart 5Stocks Could Rise Further As Confidence Recovers Chart 6The Percentage Of Households Who Expect Stock Prices To Rise Over The Next 12 Months Is Still Around Its Long-Term Average Fortunately, the US is on target to provide a vaccine shot to everyone who wants one by the end of April.3 As the economy continues to reopen, confidence will rise further. Rising confidence, in turn, may prompt investors to increase their equity holdings. Our US equity strategists expect share buybacks to exceed share issuance over the next 12 months. Thus, the value of equity portfolios will only be able to rise if share prices go up. Outside the US and the UK and a few other smaller economies, the vaccination campaign has gotten off to a rocky start. However, the pace of inoculations is set to accelerate rapidly in the second quarter, which should pave the way to faster global growth. Global equities usually outperform bonds when growth is on the upswing (Chart 7). Chart 7Stocks Usually Outperform Bonds When Economic Growth Is Strong While equity allocations have risen, they are below the level reached in 2000 (Chart 8). Back then, the global equity earnings yield was on par with the real bond yield. Today, the earnings yield is about six percentage points above the bond yield, a similar gap to what prevailed in late-2009 (Chart 9). Chart 8Stock Allocations Have Rebounded, But Remain Below Their 2000 Peak Chart 9The Equity Risk Premium Is At Levels Similar To Late-2009 Granted, today’s high equity risk premium largely reflects the exceptionally low level of bond yields. If bond yields were to move up, the equity risk premium would shrink. While we do think that bond yields will rise by more than expected in the long run, the path to higher yields is likely to be a slow one. Rate expectations 2-to-3 years out tend to move closely in line with the 10-year yield (Chart 10). Already, there is a large gap between market expectations and the Fed dots. Whereas the market expects the Fed to start lifting rates late next year, the median Fed “dot” continues to signal no rate hike at least until 2024 (Chart 11). It is unlikely that market expectations will shift towards an even more aggressive path of rate tightening unless the Fed’s dovish rhetoric turns hawkish. As we discussed in our recently published Second Quarter Strategy Outlook, we do not expect this to happen anytime soon. Thus, with monetary policy still very loose, stocks can continue to grind higher. Chart 10Bond Yields Are Unlikely To Rise Much Unless The Market Lifts Its Estimate Of Where The Fed Funds Rate Will Be 2-To-3 Years Out   Chart 11A Wide Gap Has Opened Up Between Market Expectations And The Fed Dots Regionally, we favour stock markets outside the US. Not only will overseas markets benefit from a rotation in growth from the US to the rest of the world in the second half of this year, but US corporate tax rates are almost certain to rise. We will be exploring the tax issue over the coming weeks.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com Footnotes 1 Just as the private-sector financial balance is the difference between what the private sector earns and spends, the fiscal balance is the difference between what the government earns and spends. If the fiscal balance is negative, the government runs a deficit. If the fiscal balance is positive, the government runs a surplus. Thus, added together, the private-sector financial balance and the fiscal balance simply equals the difference between what the country as a whole earns and spends which, by definition, is equal to the current account balance. One can also see this point by rewriting the equation Y=C+I+G+X-M as (Y-T)-(C+I)=(G-T)+(X-M) where T is tax revenue, Y-T is private-sector earnings, C+I is what the private sector spends on consumption and capital goods, G-T is the fiscal deficit, and X-M is the current account balance, broadly defined to include not only the trade balance but also net income from abroad. 2 The relative attractiveness of stocks can also be inferred by subtracting the real bond yield from the earnings yield on stocks in order to get an implied equity risk premium (ERP). It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3 Mia Sato, “The US is about to reach a surprise milestone: too many vaccines, not enough takers,” MIT Technology Review, March 22, 2021. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores