Economy

Dear Client, Instead of our regular report next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. We will be back the week after with the GIS quarterly Strategy Outlook, where we will explore the major investment themes and views we see playing out in 2021. Best regards, Peter Berezin, Chief Global Strategist Highlights While a vaccine, ironically, could dampen economic activity in the near term, it will pave the way for faster growth in the medium-to-long term. Inflation is unlikely to rise much over the next two-to-three years. However, it could gallop higher later this decade as unemployment falls below pre-pandemic levels and policymakers keep both monetary and fiscal policy accommodative. Many of the structural factors that have depressed inflation are going into reverse: Baby boomers are leaving the labor force, globalization is on the back foot, and social cohesion is fraying. The lackluster pace of productivity growth suggests that innovation is not occurring as fast as many people think. Rather, what seems to be happening is that the nature of innovation is changing in ways that are a lot more favorable to Wall Street than Main Street. Monopoly power has grown, especially in the tech sector. This has had a deflationary effect in the past but could take a more inflationary tone in the future. Investors should remain overweight stocks for the next 12 months, while shifting equity allocation away from growth companies towards value companies and away from the US towards the rest of the world. The Waiting Game This week brought some further good news on the pandemic front. The number of reported daily cases continues to trend lower in Europe. The 7-day average has now fallen by 30% from its November 8th peak (Chart 1). In the US, there are faint indications that the number of new cases is stabilizing, especially in the hard-hit Midwest (Chart 2). Chart 1Covid Cases In Europe: Past The Worst Chart 2Covid Cases In The US: Approaching The Peak Of The Third Wave? Nevertheless, it is too early to breathe a sigh of relief. As with other coronaviruses, SARS-CoV-2 spreads more easily in colder temperatures. Moreover, this week is Thanksgiving in the US, and with the holiday season approaching in the wider world, there will be more opportunities for the virus to propagate. Chart 3The US May Have To Follow Europe In Tightening Lockdown Measures Despite the cresting in new cases, the absolute number of confirmed daily infections remains extremely high. The 7-day average currently stands at about 175,000 in the US. Adjusting for the typical three-week lag between new cases and deaths, the case-fatality rate is approximately 1.8%. The CDC estimates the “true” fatality rate is 0.7%.1 This implies that for every one person who tests positive for Covid-19, 1.5 people go undetected. Thus, around 450,000 Americans are catching Covid every day. That is 3.2 million per week or about 1% of the US population. Other estimates from the CDC suggest that the true number of new infections may now be even greater, perhaps as high as 11 million per week.2 Unlike in Europe, where governments have implemented a series of stringent lockdown measures, the US has taken a more relaxed approach (Chart 3). If the number of new infections fails to fall much from current levels, more US states will have to tighten social distancing rules. The availability of vaccines will pave the way for stronger growth in the medium-to-long term. Ironically however, as we pointed out two weeks ago, vaccine optimism could dampen economic activity in the near term. With the light clearly visible at the end of the tunnel, more people may choose to hunker down to avoid being infected. After all, how frustrating would it be to contract the virus just a few months before one can be vaccinated? It is like being the last guy shot on the battlefield in a war that is drawing to an end. The Outlook For Inflation Could inflation make a comeback once a vaccine is widely available? The pandemic put significant downward pressure on prices in a number of areas, particularly air transport, accommodation, apparel, and gasoline. While prices in some categories, such as used cars, meats and eggs, and certain toiletries did rise briskly, the net effect was still a substantial decline in overall inflation (Chart 4). Chart 4The Impact Of Covid On US Inflation Core PCE inflation stood at 1.4% in October, well below the Fed’s target. As Chart 5 illustrates, core inflation is below central bank targets in most other economies as well. A bounce back in prices in the most pandemic-afflicted sectors should lift inflation over the next six months. Our US bond strategists expect core PCE inflation to peak at 2¼% in the second quarter of next year, before falling back below 2% by the end of 2021. Chart 5Core Inflation Below Central Bank Targets Chart 6Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Ignoring the temporary oscillations in inflation due to base effects, a more sustained increase in inflation would require that labor market slack be fully absorbed. In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the major economies would fall back to its full employment level by around 2025 (Chart 6). While a vaccine will expedite the healing of labor markets, it is probable that unemployment will remain too high to generate an overheated economy for the next three years. What about beyond then? The fact that long-term bond yields are so low today implies that most investors think that inflation will remain subdued for many years to come (Chart 7). This is confirmed by CPI swaps, which in some countries go out as far as 50 years. For the most part, they are all trading at levels below official central bank inflation targets (Chart 8). Chart 7Long-Term Bond Yields Are Depressed... Chart 8… As Are Long-Term Inflation Expectations Heading Towards The Kink Is inflation really dead, or is it just dormant? We think it is the latter. Contrary to the claim that the Phillips curve has become defunct, Chart 9 shows that the wage version of the Phillips curve – which compares wage growth with the unemployment rate – is very much alive and well. What is true is that rising wage growth has failed to translate into higher price inflation in most economies since the early 1980s. However, this may have simply been due to happenstance: Every time the global economy was starting to heat up to the point that a price-wage spiral could develop, something would happen to break it. In 2019, the unemployment rate in the G7 hit a 46-year low. Perhaps inflation would have accelerated this year had it not been for the pandemic? Likewise, inflation might have risen in 2008 had it not been for the financial crisis, and in 2001 had it not been for the dotcom bust. Chart 9Is The Phillips Curve Really Dead? Chart 10Inflation Reached The ''Kink'' In 1966 Rather than being defunct, the price-version of the Phillips curve may turn out to be kinked at a very low level of the unemployment rate. Such was the case during the 1960s (Chart 10). US core inflation remained steady at around 1.5% in the first half of that decade, even as the unemployment rate drifted lower and lower. In 1966, with the unemployment rate nearly two percentage points below NAIRU, inflation blasted off, doubling to more than 3% within a span of six months. Core inflation would go on to increase to 6% by 1969, setting the stage for the stagflationary 1970s. A Less Deflationary Structural Backdrop Many pundits argue that the structural backdrop for inflation is vastly different today than it was during the 1960s, making any comparison with that decade next to worthless. They point out that unions had a lot more power back then, global supply chains were underdeveloped, and rapid population growth was creating more demand for goods and services than the economy could supply. We have addressed these arguments in the past and will not belabor the point this week other than to note that all three of these structural forces are now in retreat.3 Chart 11The Heyday Of Globalization Is Behind Us Granted, unions are not as powerful as they were in the 1960s. However, public policy is still moving in a more worker-friendly direction. Witness the fact that Florida voters, despite handing the state to President Trump, voted 61%-to-39% to raise the state minimum wage in increments from $8.56 an hour to $15 by 2026. Joe Biden has also pledged to hike the federal minimum wage to $15 from its current level of $7.25. Meanwhile, globalization is on the back foot, with the ratio of trade-to-output moving sideways for more than a decade (Chart 11). At the same time, baby boomers are departing the labor force en masse. Rather than remaining net savers, these retiring workers will become dissavers. This means that the global savings glut, which has suppressed interest rates and inflation, could begin to dry up. Perhaps most ominously, social stability is at risk of breaking down. Homicides in the US have risen by nearly 30% so far this year compared to the same period a year ago.4 Historically, the institutionalization rate has tracked the homicide rate quite closely (Chart 12). As was the case in the 1960s, a lot of the well-meaning discussion about criminal justice reform today could turn out to be counterproductive. Perhaps it was just a coincidence, but it is worth remembering that inflation exploded in the 1960s at exactly the same time that the murder rate shot up (Chart 13). Chart 12Dramatic Drop In Institutionalization Rate During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Chart 13Social Unrest Can Fuel Inflation The Role Of Innovation Technological innovation has been routinely cited as a driver of falling inflation. In many ways, this is rather odd. Economic theory states that faster innovation should lead to higher real income. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Moreover, the fixation on technology as a deflationary force is a bit strange considering that measured productivity growth has been exceptionally weak in most advanced economies over the past 15 years – weaker, in fact, than it was in the 1970s (Chart 14). Chart 14US Productivity Has Been Exceptionally Weak Over The Past Ten Years How, then, does one explain why tech stocks have fared so well? One often-heard answer is that productivity growth is mismeasured. We examined this argument carefully in our report entitled Weak Productivity Growth: Don't Blame The Statisticians, concluding that this does not appear to be the case. A more plausible answer is that while the pace of innovation has not sped up, the nature of innovation has changed dramatically in ways that have helped Wall Street a lot more than Main Street. The True Nature Of Corporate Profits Standard economics textbooks regard profit as a return on capital. This implies that if the price of capital goes down, firms should respond by increasing investment spending in order to further boost profits. In practice, that has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. While business investment did rise in 2018, this was all due to a rebound in energy spending. Outside of the oil and mining sector, business investment grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 15). Likewise, neither falling interest rates nor rising stock prices – two factors that should produce a lower cost of capital – have done much to buoy investment spending in recent years. Chart 15Overall Capex In 2017-2019 Was Boosted By The Oil And Mining Sector Chart 16A Winner-Takes-All Economy   Why did the standard economic relationship between investment and the cost of capital break down? The answer is that the traditional approach does not take into account what has become an increasingly important driver of corporate profits: monopoly power. A recent study by Grullon, Larkin, and Michaely found that market concentration has increased in 75% of all US industries since 1997.5 Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times that of the median firm, a massive increase from the historic average of two times (Chart 16). The dispersion in performance has been particularly stark within the tech sector. According to BCA Research’s proprietary Equity Analyzer, the shares of “value tech” companies – that is, companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales – have not only lagged the shares of other tech companies, but they have also lagged the shares of similarly valued financial companies (Chart 17). This underscores the point that the outperformance of growth stocks over the past 12 years has not just been a story about technology. Rather, it has primarily been a story about some tech companies doing much better than other tech companies. Chart 17Value Tech Lagged Value Financials The Winner-Take-All Economy What explains the bifurcation in performance within the tech sector? Two reasons come to mind. First, tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. The role played by winner-take-all markets explains how a handful of companies were able to become mega-cap tech titans. Chart 18 and Chart 19 show that increased monopoly power, as reflected in rising profit margins and higher relative P/E ratios, has played a greater role in driving tech share outperformance since the mid-1990s than faster revenue growth. Chart 18Decomposing Tech Outperformance (I) Chart 19Decomposing Tech Outperformance (II) Reaching Adulthood History suggests that monopolists tend to experience an initial rapid growth phase in which they capture ever-more market share, followed by a mature phase where they effectively function as utilities – cranking out stable cash flows to shareholders without experiencing much further growth. While it is impossible to say how far along most of today’s tech leaders are in this cycle, it does appear that the period of rapid growth for many of them may be drawing to a close. As it is, close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. The shift away from “growth status” towards “utility status” for some tech monopolists could prompt investors to trim the valuation premium they assign to these stocks. In addition, it could lead to increased regulation by governments to ensure that monopoly power is not abused. This could further depress valuations. Monopolies And Inflation What about the implications for inflation? Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output could depress selling prices, thus leading to lower profit margins. As my colleague Mathieu Savary has emphasized,6 this implies that rising market power could simultaneously increase profits while reducing investment in new capacity. At least initially, this could be deflationary in two ways: First, lower investment spending will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. This helps explain why falling real interest rates and rising profits have failed to trigger an investment boom. Further down the road, the impact of monopoly power on inflation could turn on its head. Less investment spending will curb potential GDP growth, making it easier for economies to run up against capacity constraints. Low real interest rates could also induce governments to run larger budget deficits, boosting aggregate demand in the process. Finally, an economy where monopoly power runs unchecked will eventually spur a populist backlash, leading to reflationary policies that favor workers over business oligarchs. Investment Conclusions Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 20). Given the likelihood that economic growth could surprise on the downside in the near term, equities are vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Chart 20A Lot Of Bullishness Chart 21European Banks: A Low Bar For Success   Equity investors should shift their allocation away from growth stocks towards value stocks and away from the US towards the rest of the world. We like European banks in particular. They currently trade at 0.6-times tangible book value and 7.2-times 2019 earnings. Earnings estimates for 2021 have been slashed but should rebound on the expectation of a vaccine-driven growth recovery later next year (Chart 21). Faster growth should produce a modest steepening in yield curves, boosting net interest margins in the process. Faster growth should also lead to stronger credit demand while reducing bad loans. Looking further out, this week’s report argues that inflation could accelerate meaningfully once unemployment returns to pre-pandemic levels in about two-to-three years. The departure of baby boomers from the labor market, sluggish productivity growth, fraying social cohesion, and a backlash against monopoly power could all push up inflation. These forces could also create a more challenging environment for stocks, particularly today’s mega-cap tech names.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. 2 Please see “Covid live updates: CDC estimates only eighth of infections counted,” NBC News Live Blog, November 25, 2020; and “The Latest: South Korea has most daily cases in 8 months,” Associated Press, November 26, 2020. 3 Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” October 25, 2019; Special Reports “1970s-Style Inflation: Could It Happen Again? (Part 1),” and “1970s-Style Inflation: Could It Happen Again? (Part 2),”dated August 10 and 24, 2018; and Weekly Report, “Is The Phillips Curve Dead Or Dormant?” dated September 22, 2017. 4 Please see this Twitter thread on the latest data from the 100 largest US cities by Patrick Sharkey, Professor of Sociology and Public Affairs at Princeton University. 5 Gustavo Grullon, Yelena Larkin, and Roni Michaely, “Are US Industries Becoming More Concentrated?” Oxford Academic, Review of Finance (23:4), July 2019. 6 Please see The Bank Credit Analyst Special Report, “The Productivity Puzzle: Competition Is The Missing Ingredient,” dated June 27, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights US Corporates: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. Global Corporate Strategy: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak. Feature When looking at the 2020 year-to-date total returns from global corporate credit, the performance at first blush has not been terrible. The Bloomberg Barclays Global Investment Grade Corporate index has returned 8.2% since the start of the year, while the benchmark global high-yield index has returned 3.6%. While the bulk of those returns have come from duration exposure as global bond yields have fallen sharply, a passive allocation to corporate bonds on January 1 has been a money-making investment in 2020. Chart of the WeekUS Credit Markets Need Less Policymaker Support Of course, a lot has happened since the beginning of the year. A global pandemic, a historically severe global recession, a massive selloff of risk assets in February and March and an equally robust recovery of equity and credit markets on the back of huge monetary and fiscal stimulus. It should come as no surprise that the 2020 peak in US corporate bond spreads occurred on March 23 – the day that the Fed and US Treasury introduced asset purchase vehicles designed to support stricken US credit markets. This is why the announcement last week that outgoing US Treasury Secretary Steve Mnuchin has decided to let those emergency lending facilities expire on December 31, with the Fed returning the US Treasury’s capital invested in those programs, is potentially of major significance for credit investors. It is reasonable to think that credit markets could suffer without the Fed’s involvement. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. The US economy remains surprisingly resilient, with the November flash estimate for the Markit composite PMI index reaching the highest level since 2015. This occurred even in the midst of a huge surge of global COVID-19 cases that has weighed heavily on European economies (Chart of the Week). Add to that signs that corporate bond markets are functioning smoothly - investors are willing to commit capital to credit markets, and borrowers are having no problem placing large volumes of debt at low yields and spreads – and it is easy to conclude that Fed’s explicit support is no longer required. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. From the point of view of corporate bond investment strategy, we continue to recommend a moderate overweight stance on global corporate debt versus government bonds over the next 6-12 months, favoring US investment grade and high-yield over European equivalents, even with the Fed pulling away its bid. Steve Mnuchin May Have A Good Point Even though Fed Chair Jerome Powell publicly disagreed with Treasury Secretary Mnuchin’s decision, the Fed will shut down the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility, the Term Asset-Backed Loan Facility, the Municipal Liquidity Facility and the Main Street Lending Program on December 31. Those facilities are part of the US government support programs under the Coronavirus Aid, Relief and Economic Security (CARES) Act. The US Treasury seeded the facilities with $195 billion in capital, which the Fed levered up to create as much as $2 trillion in buying power (Table 1). Yet the actual usage of that spending capacity has been quite low, with only $13.3 billion spent in the Fed’s secondary market facility. Not a single dollar was spent in the primary market facility, as companies had no problems issuing debt directly to markets rather than selling new bonds to the Fed. Table 1US CARES Act Programs: Little-Used, But Highly Successful According to data from the Securities Industry and Financial Markets Association (SIFMA), the pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years (Chart 2). This occurred after a surge of issuance activity in Q2 as issuers took advantage of the vastly improved trading conditions in corporate bond markets after the initiation of the Fed’s liquidity backstop. Treasury Secretary Mnuchin noted these trends in his letter to Fed Chair Powell that was essentially an order to shut down the Fed’s emergency lending facilities.1 Chart 2US Credit Markets Are Functioning Normally Chart 3No Stomach For Nation-Wide Lockdowns In The US US credit markets are not only functioning well, so is the US economy. The Markit US services PMI rose in November to 57.7 (from 56.9 in October), while the same index fell to 41.3 (from 46.9) in the euro area and 45.8 (from 51.4) in the UK (Chart 3). As services industries like dining, travel and retail spending are most directly impacted by lockdowns related to COVID-19, it should not be a surprise that the data underperformed massively in Europe, where severe economic restrictions have been imposed to slow the spread of the virus. This compares to the US where the restrictions have been far more modest and varying across cities and regions. The pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years. Some slowing of US domestic economic activity should be expected over the next month or two, with more parts of the country putting greater restrictions on activities like indoor dining and in-person schooling. However, the political will to impose the sort of harsh nation-wide “shelter at home” type lockdowns currently in place in Europe is simply not there in the US after the shock of the Q2 lockdown-induced economic slump. US growth should thus continue to outperform – to the benefit of US corporate bond market performance relative to US Treasuries and European corporate equivalents. US corporate bond yields, both for investment grade and high-yield credit, have already declined massively in 2020, as have yields for European credit and even emerging market bonds (Chart 4). Given our view that US Treasury yields have bottomed and will likely drift higher over the next 6-12 months, it will be difficult to see further declines in corporate bond yields that are already near record lows. Chart 4Corporate Yields Falling To New Lows Chart 5Corporate Spreads Approaching 2020 Lows Corporate bond spreads, on the other hand, do have room to compress even just to levels seen before the February/March credit market rout – especially for US high-yield. The option-adjusted spread (OAS) for the Bloomberg Barclays US investment grade index is now 17bps away from the 2020 low, while the OAS for the euro area and UK are 7bps and 8bps away, respectively. For high-yield, the US index OAS is 107bps above the 2020 low, compared to 95bps for euro area high-yield and 81bps for UK high-yield (Chart 5). The near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns.  Given the severity of the lockdown-induced economic slump in the euro area and UK, which is likely to linger over the holiday season and into the early part of 2021, the near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns. Bottom Line: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. A Quick Look At Corporate Bond Spread Valuations In The US & Europe The tremendous rally in global corporate bond markets since late March has pushed credit spreads down to levels that raise concerns about valuations. Thus, it is now a good time to revisit some of our favorite spread valuation metrics. One simple way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX index. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. Chart 6US Corporate Spreads Look Tight Vs Equity Vol Chart 7Euro Area Corporate Spreads Look Tight Vs Equity Vol We show the ratio of the US investment grade and high-yield index OAS to the VIX index in Chart 6. For both higher-quality and lower-rated corporate credit, the spread-to-VIX ratio is now close to the lowest level seen since 2000 – both around 1.7 standard deviations below the long-run mean – suggesting that spreads are tight relative to overall macro volatility We show similar ratios for euro area corporates versus the VStoxx European equity volatility index in Chart 7, and UK corporates versus the IVI UK equity volatility index in Chart 8. The conclusions are similar to US credit, with spread-to-volatility ratios for both investment grade and high-yield now at low levels, one standard deviation below the mean since 2000. Chart 8UK Corporate Spreads Look Tight Vs Equity Vol Chart 9Notable Duration Differences Between Corporates It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight. Thus, we need to look at other valuation tools. Our more preferred metric to assess credit spreads is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that must occur for a credit product to have a return equal to a duration-matched, risk-free government bond over a one-year horizon. We look at the historical percentile ranking of the 12-month breakeven spreads to determine how current levels compare with the past. It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight.  To calculate the 12-month breakeven spreads for corporate bonds, we take the ratio of the index OAS to the index duration for the specific bond market in question. This allows a comparison of breakeven spreads across different markets with varying risks, with duration being a main source of price risk (Chart 9). The 12-month breakeven spreads for the investment grade and high-yield corporate debt for the US, euro area and UK are shown in Charts 10, 11 and 12, respectively. For the US, the breakeven spread for investment grade corporates is currently in the bottom decile of its history, suggesting that the spread does not look particularly attractive on a risk-adjusted basis. Chart 10US Corporate Bond Breakeven Spread Percentile Rankings Chart 11Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 12UK Corporate Bond Breakeven Spread Percentile Rankings Euro area and UK investment grade breakeven spread percentile rankings are a bit higher than in the US, right on the cusp of the bottom quartile for both. Although for euro area corporates, the breakeven spread is boosted by the much lower duration of the euro area investment grade index and does not necessarily suggest that spreads there are currently more attractive than in the US and UK. Turning to junk bonds, the US high-yield 12-month breakeven spread is currently in the 67th percentile of its own history, suggesting that spreads are relatively attractive. The UK high-yield breakeven spread is also above average, with the latest reading in the 55th percentile. Euro area high-yield is the least attractive, with the latest 12-month breakeven spread in the 33rd percentile of its own history. Taking the 12-month breakeven spread as a measure of value (and, hence, a gauge of prospective future returns), we can compare it to a measure of spread volatility to evaluate the risk/return tradeoff for various credit markets. To measure spread risk, our preferred metric is duration times spread (DTS). We show a scatter chart of the latest 12-month breakeven percentile ranking for the overall US, UK and euro area corporate bond markets – for investment grade and high-yield, and including all the major credit rating tiers – in Chart 13. The most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Chart 14A Lingering Positive Impact On Credit Markets From Global QE What stands out in the chart is that the most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). At the other end of the spectrum, US investment grade offers one of the least attractive risk/reward tradeoffs. This suggests a potential attractive opportunity to move down in quality within US corporate debt, particularly with ultra-accommodative global monetary policies providing a lingering tailwind for global corporate bond performance over the next 6-12 months (Chart 14). We prefer scaling into that trade on any bouts of US high-yield weakness, however. There are still near-term risks associated with the rapid spread of COVID-19 in the US and the lack of momentum on US fiscal stimulus negotiations during the transition period to the new Biden administration. Turning across the Atlantic, euro area high-yield looks far less attractive than US high-yield on a risk/reward basis. This fits with our current recommendation to underweight euro area junk bonds versus US equivalents (see our strategic recommendation tables on page 14). We also continue to recommend an overweight stance on UK investment grade corporates, which still offer a slightly more attractive risk/return tradeoff versus US equivalents. Bottom Line: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Mnuchin’s letter to Powell can be found here: https://home.treasury.gov/system/files/136/letter11192020.pd Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Prices of global major commodities such as copper and iron ore have rallied significantly this year. It seems that strong Chinese imports once again became the major driving force for both commodities. Is the rally in commodity prices sustainable in 2021? This is the first of three reports focusing on copper, iron ore, and energy. In this week’s report, our views on copper are highlighted below: Chinese imports of copper have substantially outpaced Chinese underlying copper consumption this year, resulting in considerable inventory accumulation. Destocking and underlying demand weakness in 2021 suggest that China’s copper imports are likely to decline next year.  In the meantime, the global refined copper supply will grow at 1.5-2.5% in 2021 from 2020. Copper prices are vulnerable to the downside next year. Short December 2021 LME copper futures.  Feature China’s total demand and imports have surged by 23% and 62% year on year, respectively, in the last six months (Charts 1A and 1B). Both growth rates were the fastest they have been since 2010 (Chart 2). Chart 1AWill Chinese Total Copper Demand Surge Into 2021? Chart 1BWill Chinese Copper Imports Surge Into 2021? Please note throughout of this report, total demand is defined as the formula below: Total demand = underlying consumption1 + change in inventories Solely due to the surging total demand from China, global copper demand rose by 5% year on year so far this year (Chart 3). China’s total copper demand accounted for 58.4% of global copper demand for the first nine months of this year, increasing from a 53.6% share last year. Chart 2Unusual Strong Growth In Chinese Total Copper Demand And Imports Chart 3China Alone Has Pushed Up Global Copper Demand This Year In the meantime, global copper ore and refined copper outputs were curbed by the pandemic. As a result, the global copper market balance2 swung from a small surplus in March to a record high deficit in September (Chart 4). However, based on our estimates, China’s total demand for copper this year has meaningfully outpaced its underlying consumption, implying there has been substantial inventory buildup in the country. As a result, China’s strong copper imports will not continue into 2021. Moreover, global copper output is set to increase in 2021, adding further downward pressure on copper prices next year. Chart 4Global Copper Market Balance Has Swung From A Small Surplus To A High Deficit Chart 5China's Total Copper Demand: A Big Deviation From Its Long-Term Underlying Consumption Growth Understanding Strong Chinese Copper Demand In 2020 For the past five years, the annual increase in China’s total copper demand grew at a compound annual growth rate (CAGR) of only 2.5%, reflecting the country’s long-term underlying copper usage growth (Chart 5). However, China’s total copper demand (consumption plus change in inventories) has increased by 18.4% year on year for the first nine months of this year. This surge in total demand has significantly outpaced its long-term underlying consumption growth. Our research shows that slightly more than half of China’s total copper demand growth so far this year can be attributable to a solid underlying consumption rebound boosted by the stimulus. The government’s strategic purchases and commercial restocking may have contributed to the other half of the country’s total copper demand growth. Copper Consumption By Real Economy Chart 6The Structure Of China’s Underlying Copper Consumption In 2019 The structure of China’s underlying copper consumption in 2019 stemmed from the following industries and sectors: power (about 49% of Chinese copper usage); refrigeration and air conditioning (15%); transportation (10%); electronic communication (9%); buildings and construction (8%); and others (Chart 6). Table 1 shows our rough estimations of the copper consumption growth in each sector in 2020, respectively. Based on this, we concluded that China’s underlying copper consumption might grow by approximately 10% this year. Table 1Chinese Underlying Copper Consumption Year-On-Year Growth Estimates For 2020 Chart 7Copper Consumption In The Power Industry Has Been Strong The power sector is the largest copper user as copper is among the best conductors of electricity and heat. The metal is used in high, medium and low voltage power networks. Following the pandemic, China significantly boosted investment in the power sector by 17% (year to date, January - October) from the same period last year (Chart 7). The power generation equipment output has surged by 28.7% year on year during the same period, while the electrical cable output increased only slightly. All together, we estimated that the copper consumption from the power sector grew by approximately 16% from last year. While air conditioner output declined moderately from 2019, freezer and refrigerator production has gone up significantly this year (Chart 8). The global “stay-at-home” economy due to the pandemic boosted Chinese exports of freezers and refrigerators.  Considering air conditioner copper usage per unit is generally higher than that in freezers/refrigerators, we assumed this year’s copper consumption in the home appliance sector to be up by 6% from the previous year. Despite a recent sharp rebound in transportation investment and automobile output, in the first ten months of this year the transportation investment grew by only 2% year on year while automobile output still contracted by 4% from the previous year (Chart 9). Hence, we assumed a 2% year-on-year contraction of copper usage in this sector this year.3 Chart 8Moderate Growth In Copper Usage In The Home Appliance Sector Chart 9Contracted Automobile Output May Have Reduced Copper Consumption In The Transportation Sector Copper or copper-base alloys are used in printed circuit boards, in electronic connectors, as well as in many semiconductor products. This year, China had set a strategic goal to develop the tech-related new infrastructure, which includes information transmission, software and information technology services, such as 5G networks, industrial internet, and data centers. The tech-related new infrastructure investment has increased by 20% year on year during January - October (Chart 10). We expect the year-on-year copper usage growth in this sector to be 20% this year as well.   The buildings and construction sector accounts for 8% of China’s copper usage. During the first nine months of this year, our broad measure of China’s building construction activity—specifically building area starts and completions—have contracted 3.2% and 9.6% year on year, respectively (Chart 11). Assuming half of this sector’s usage is in building area starts and the other half in completions, we expect the copper consumption in this sector to contract by 6% year on year this year. Chart 10Copper Usage Rising Due To Strong Tech-Related New Infrastructure Investment Chart 11Weak Property Market May Have Also Cut Copper Consumption In The Construction Sector Altogether, our calculation shows that the Chinese underlying copper consumption growth for the full 2020 year is likely to be up 10% from last year. Copper Restocking Although the most tracked official data does not show a significant pileup in copper inventories in China, our research indicates that the Chinese government’s strategic and enterprises’ speculative restocking might have accounted for nearly half of China’s total copper demand growth this year. Chinese total copper demand (consumption plus change in inventories) was approximately 9,120 thousand metric tons (kt) during last January - September.4 A 10% growth from this number will equal an increase of 912 kt, still 770 kt (or 46%) short of the total increased amount of 1,678 kt year on year in Chinese total copper demand. First, of the 770-kt gap between China’s total demand and our estimated underlying consumption, we believe that about 200-400 kt of copper—about 4%-8% of Chinese copper imports in the first nine months of this year—were purchased by the Chinese government.5 Many market analysts have been suspecting that China’s State Reserve Board (SRB) has been buying copper this year, as there was no way Chinese underlying consumption could grow as strong as what its total demand and imports suggested. Historically, the SRB bought copper whenever prices declined significantly, and stopped or reduced its purchases when prices had a significant rally. For example, many believe that the SRB bought 200-400 kt in 2008,6 200-500 kt in 2014,7 and 200 kt in 2015,8 when prices dropped considerably. Copper prices have been trading well below US$3 per pound for most of the year, and the Chinese currency has been strengthening. Thus, it is reasonable to assume that the SRB purchased at least a similar amount as in previous cycles to strategically stock up on cheap commodities. Second, Chinese enterprises may have bought 370-570 kt of copper this year.9 Easy money and abundant credit with lower borrowing costs have probably allowed some Chinese enterprises to accumulate copper inventories, representing financial speculative demand (with a motive of selling at higher prices) and/or inventories to be used in future. Chart 12The SHFE Copper Warehouse: No Inventory Accumulation Based On This Measure The most often tracked China copper inventory data by market analysts is the copper inventory at Shanghai Futures Exchange (SHFE), which has been highly volatile this year. Its current level is near its level at the end of last year (Chart 12). This means no inventory accumulation in the SHFE copper warehouse. This also implies that Chinese companies may have restocked their copper inventories in their own warehouses, for which no official data can be tracked.  Bottom Line: Chinese underlying consumption accounts for slightly more than half of the increase in the country’s total copper demand this year, whereas the government’s strategic purchases and commercial restocking have most likely contributed to the other half. China’s Copper Demand Boom Is Unsustainable This year’s surging total demand for copper in China was due to the stimulus as a result of the pandemic, as well as government and commercial copper restocking. Looking forward in 2021, these driving forces will either diminish or disappear. First, China’s copper restocking will be followed by destocking. With copper prices having risen by 57% from their trough in March, and now well above US$3 per pound, odds are that the SRB and commercial buyers that have been accumulating copper inventories will considerably reduce their copper purchases next year. Moreover, as China’s financial regulations have become stricter and the monetary stance more hawkish of late, we expect Chinese enterprises will largely refrain from speculative activities in the commodity market next year.  Second, the country’s underlying copper consumption growth will likely drop considerably to the range of -3% to zero next year (Table 2). Table 2Chinese Underlying Copper Consumption Year-on-Year Growth Estimates For 2021 As government stimulus will likely be scaled back substantially next year, infrastructure investment in the power sector will fall from the current level. In 2019, the year-on-year growth of power investment, power generation equipment, and electrical cable output was -0.2%, -15% and 3.3%, respectively. We expect the level of Chinese investment in the power sector to normalize to its long-term trend next year from this year’s substantial increase. Therefore, we estimate a 5%-8% contraction in this sector’s copper consumption next year. Next year’s government-targeted stimulus in the consumption segment may provide a boost in output of home appliances, albeit a modest one. In addition, global demand for freezers and refrigerators due to the pandemic may diminish, as global supply chains as well as production from pandemic-struck countries will likely recover next year. Hence, we expect the copper usage growth in the “refrigeration and air conditioning” sector will drop to a 0-2% year-on-year growth in 2021 from this year’s 6% growth. For copper usage in the transportation sector, we expect a 3%-5% growth next year as the automobile sector will likely continue to recover, and transportation infrastructure investment may also increase slightly due to the government’s effort to expand its electric car charging infrastructure. We expect the investment in the tech-related new infrastructure to increase by 12%-15%, which will be a drop from this year’s sharp growth of 20%.  The copper usage in the buildings and construction sector is likely to continue until the fall of next year. However, as property developers need to complete their existing projects, copper consumption in this sector may decline by 2%-4%, smaller than this year’s 6% contraction. All together, we conclude that the underlying Chinese copper consumption will likely contract by 0-3% next year from 2020. Bottom Line: China’s underlying copper consumption is likely to contract slightly next year, which will weigh on the country’s copper imports. Additionally, as China had accumulated considerable copper inventories this year, the country’s destocking will also depress its copper imports next year. More Global Copper Supply In 2021 Chart 13Global Copper Ore And Refined Copper Supply Are Set To Increase In 2021 Global supply of both copper ore and refined copper outside China will go up next year, by about 3-5% in 2021, a sharp contrast with the declines of 2.2% and 3.2% year on year, respectively, for the first nine months of this year (Chart 13). Table 3 shows the world’s top 10 copper producing companies’ capex this year and in 2021. Most of these companies slashed their capex this year due to the pandemic. However, the capex of all these companies will likely be much higher in 2021, which will facilitate copper output growth. The companies that will increase their capex in 2021 are largely outside China. The aggregate capex for the world’s top 10 copper producing companies will increase by nearly 20% year on year in 2021. Some mining giants such as BHP and Rio Tinto produce many other commodities rather than copper, so only part of their investment will go to copper-related assets/operations. For companies with a significant amount of revenue coming from copper, such as Codelco, Glencore, Southern Copper, KGHM, and Antofagasta, all will have more than 20% growth in their 2021 capex. Table 3The World’s Top 10 Copper Producing Companies’ Capex Investment In 2020 & 2021 As these companies account for about half of the global copper production, we believe the 20% increase in their aggregate capex will likely result in a 3%-5% increase in their copper ore and refined copper outputs. China’s copper production growth rate is expected to accelerate within the next few years, mainly driven by the construction of Tibet's Qulong copper mine, the second phase expansion of Duobaoshan, the second phase of the Jiama copper mine, and the Chifeng Fubo project. China is currently the world’s third-largest copper ore producer, accounting for 9% of the global copper ore supply. The country is also the world’s largest refined copper producer, contributing 43% of global refined copper production. After having managed to add a 430-kt smelting capacity and a 640-kt refining capacity this year, the country plans to increase its new smelting capacity of 525 kt and new refinery capacity of 110 kt in 2021, most of which will need copper ore and concentrates. If the 110-kt new refinery capacity is fully utilized, it will increase global refined copper output by about 0.5% next year. Chart 14China: Rising Imports Of Copper Ore Will Likely Reduce Its Refined Copper Imports This year, due to constrained copper ore supply outside China, Chinese copper ore imports only increased 2% year on year during January - September. This has also prompted Chinese refined copper imports. In 2021, rising imports of copper ore by China will likely boost the country’s domestic production of refined copper and reduce imports (Chart 14). In addition, the significant increase in Chinese refined copper imports this year was partially due to the substitution effect of the shortage in global copper scrap supply. This is likely to change. We expect global secondary copper production—refined copper produced from scrap copper—to rise next year from the current level. Global secondary copper output accounts for 17% of global total refined copper supply. The pandemic-triggered lockdowns disrupted the global scrap copper supply chains, including collection, processing, and transportation. According to the International Copper Study Group (ICSG), global secondary refined copper production is expected to decline by 5.5% year on year this year due to a shortage of scrap metal in many regions. This is likely to reverse next year, as fewer countries will force complete lockdowns. Chart 15China: Rising Imports Of Scrap Copper Will Also Likely Reduce Its Refined Copper Imports Also, in order to reduce domestic pollution, starting from the second half of 2019, China has moved the metal scraps10 from the non-restricted category to the restricted category. As a result, importing copper scrap into China requires approval, and the number of approvals is strictly controlled. This had resulted in a sharp drop in the amount of imported copper scrap (Chart 15). China’s imported volumes of copper scrap plunged 38% year on year in 2019 and will likely fall further this year.  Next year, the newly implemented "Solid Waste Pollution Prevention and Control Law" will allow China to import high-quality copper scrap. This will also reduce the country’s need to import refined copper from overseas. Bottom Line: Both rising global ore output and recovering global secondary copper supply will increase the global refined copper supply next year. China will likely boost its imports of ore and high-quality scrap copper while considerably reducing its imports of refined copper. This will be negative to global refined copper prices. Investment Implications Chart 16Net Speculative Positions Of Copper Are At A Multi-Year High Fundamentally, China’s contracting underlying copper consumption and destocking, as well as the rising global refined copper supply, are all set to create a bearish backdrop for copper prices in 2021. Meanwhile, net speculative positions of copper in the US as a share of total open interest have risen to a multi-year high (Chart 16). This is a bearish technical signal for copper prices. In addition, LME warehouse copper inventories rebounded recently, which may also be a sign of easing supply bottlenecks and slower market demand (Chart 17). To conclude, copper prices are vulnerable to the downside next year. Short December 2021 LME copper futures outright (Chart 18). We expect a 10%-15% downside in copper prices next year from the current level. Chart 17Rebounding LME Copper Inventories: A Sign Of Easing Supply Bottlenecks And Slower Demand? Chart 18Short December 2021 LME Copper Futures Outright   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1 Underlying consumption is defined as the usage of copper in the real economy and excludes changes in inventories. 2Market balance measured as refined copper total demand minus refined copper production. The market balance is in deficit if total demand exceeds production and it is in surplus if total demand falls short of production. 3Transportation investment is for the transportation infrastructure sector. Here we assumed the copper usage in the transportation sector is evenly divided between transportation infrastructure and automobile production in China. 4According to WBMS data, China’s total demand during last January - September 2019 was 9,120 kt. Since China’s total demand for copper last year was within the range of its long-term underlying consumption, our estimates for China’s real economy driven consumption in 2020 are based on this number. 5Precise numbers are not available, and these data represent our estimates. 6Please refer https://news.smm.cn/news/66571 7Please refer https://www.reuters.com/article/copper-reserve-source-buy-idCNCNEA3N02F20140424 8Please refer https://news.cnpowder.com.cn/31981.html 9We derived this estimate by deducting SRB’s 200-400 kt from the 770-kt gap. 10In early 2019, China announced plans to restrict imports of eight different scrap categories – including aluminum, steel and copper – starting July 1, 2019. Cyclical Investment Stance Equity Sector Recommendations