Economy

I will be co-hosting a webcast with our Chief Geopolitical Strategist, Matt Gertken, in which we will discuss arguably the two biggest topics of the moment. The US Election Result, And The Pandemic: What Happens Next? on Friday November 6 at 8.00AM EST (1.00PM GMT, 2.00PM CET, 9.00PM HKT). Also, in lieu of the next strategy report, I will be presenting the quarterly webcast on Thursday November 12 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join both webcasts. Highlights Productivity growth will continue to outperform in the US versus Europe through 2021. Equity investors should tilt towards viable small companies and businesses with operations in the US rather than in Europe. Higher productivity growth in the US means that this cycle’s low in US versus euro area core CPI inflation is unlikely to be reached until deep into 2021, at the earliest. Remain structurally overweight long-dated US bonds versus long-dated core European bonds. Structurally favour European currencies versus the dollar. Investors who cannot tolerate volatility should own CHF/USD. Investors who can tolerate volatility should own the more undervalued SEK/USD. Fractal trade: Underweight Australian construction. Feature If the economic difference between the US and Europe could be encapsulated in one picture, then the Chart of the Week would be that picture. In the US, you can hire and fire workers very easily. In Europe, you cannot. This means that in good times, the US can create millions of jobs, Europe much less so. The flip side is that in bad times, the US can destroy millions of jobs, Europe much less so. Chart of the WeekThe US Can Hire And Fire Workers. Europe Much Less So After the dot com bust of 2000, employment fell by 2 percent in the US, but did not fall at all in France. After the global financial crisis of 2008, employment fell by 6 percent in the US, but by just 1.5 percent in France. After the pandemic recession of this year, US employment has rebounded strongly, yet is still down by 7 percent. In contrast, employment in France is down by just 3 percent.  After A Recession, Productivity Surges In The US, But Not In Europe If an economy can shed millions of jobs in a recession, then it is easier to restructure the economy with a new labour-saving technology or strategy that substitutes for the labour input permanently. In which case – to paraphrase Ernest Hemingway – the economy’s productivity growth comes gradually, and then suddenly. The suddenly tends to be immediately after a recession. In Europe, where the economy cannot easily shed workers in a recession, such a sudden post-recession productivity boom never happens. In the US, it always does. For example, at the start of the Great Depression a substantial part of the US automobile industry was still based on skilled craftsmanship. These smaller, less productive craft-production plants were the ones that shut down permanently, while plants that had adopted labour-saving mass production had the competitive advantage that enabled them to survive. The result was a major restructuring of the auto productive structure. Another simple example is the ‘typing pool’ which was a ubiquitous feature of the office environment until the late 1990s. Following the 2000 downturn, these typing jobs became extinct, to be replaced by the wholesale roll-out of Microsoft Word. Productivity growth will continue to outperform in the US versus Europe through 2021. After the 2000 downturn, productivity surged by 9 percent in the US, but rose by just 2 percent in France. After the 2008 recession, productivity increased by 5 percent in the US, but did not increase at all in France. And after this year’s recession, productivity is already up by 4 percent in the US, while it is down by 1 percent in France1 (Chart I-2). Chart I-2After Recessions, Productivity Surges In The US But Not In Europe If history is any guide, productivity growth will continue to outperform in the US versus Europe through 2021. One conclusion is that equity investors should tilt towards viable small companies and businesses with operations in the US rather than in Europe. A Surge In Productivity Means Lower Inflation Yet the flip side of the post-recession productivity boom is rising unemployment. After the 2000 downturn, the number of permanently unemployed US workers continued to rise until September 2003, two years after the trough in economic activity. After the 2008 recession, permanent unemployment continued to rise until February 2010, almost a year after the economy had bottomed (Chart I-3). Chart I-3US Permanent Unemployment Peaks Well After The Economy Bottoms Therefore, optimistically assuming the pandemic trough in the economy occurred in the second quarter of 2020, the rise in the number of permanently unemployed US workers is likely to continue through the winter. In fact, it could last much longer because, compared to the global financial crisis, the pandemic is wreaking much more structural havoc on the way that we live, work, and interact. This means that compared to a common-or-garden recession, many more jobs are now economically unviable. Worse, if a resurgent pandemic causes a double-dip recession, then the peak in structural unemployment will be pushed back even further. Higher structural unemployment depresses rent inflation. Higher structural unemployment hurts the security and growth of wages. Therefore, as we pointed out in last week’s Special Report, The Real Risk Is Real Estate, one major consequence is that it depresses housing rent inflation (Chart I-4). It also depresses owner equivalent rent (OER) inflation – the imputed costs that homeowners notionally pay ‘to consume’ their home – because OER inflation closely tracks actual rent inflation (Chart I-5). Chart I-4Higher US Permanent Unemployment Depresses Rent Inflation Chart I-5Owner Equivalent Rent Inflation Tracks Actual Rent Inflation This is important for European investors, because another big difference between the US and Europe is the treatment of owner-occupied housing costs in the consumer price index (CPI). The US includes OER in its inflation rate, whereas Europe does not. The result is that shelter – the sum of OER and actual rents – carries a 42 percent weighting in the US core CPI, compared with just a 13 percent weighting in the euro area core CPI. Hence, US core CPI inflation closely tracks rent inflation (Chart I-6). Meaning that US core CPI inflation reaches its cycle low only after the number of permanently unemployed workers reaches its peak. This holds true both in absolute terms, and in relative terms versus euro area core CPI inflation. After the 2000 downturn, both the absolute and relative inflation cycle lows were not reached until late 2003. After the 2008 recession, the inflation lows were not reached until late 2010 (Chart I-7 and Chart I-8). Chart I-6US Core CPI Inflation Tracks ##br##Rent Inflation Chart I-7Only After Permanent Unemployment Peaks Does US Core Inflation Bottom, Both In Absolute Terms... Chart I-8...And Relative To Euro Area Core CPI Inflation On this basis, this cycle’s low in US versus euro area core CPI inflation is unlikely to be reached until deep into 2021, even on the most optimistic assumptions. Some Investment Conclusions From an investment perspective, US versus euro area core CPI inflation is important because it drives relative bond yields. As the spread between relative inflation rates compresses, the spread between long-dated bond yields also compresses (Chart I-9). Chart I-9When US And Euro Area Core CPI Inflation Rates Converge, So Do US And Euro Area Bond Yields One conclusion is to remain overweight long-dated US bonds versus long-dated core European bonds. Our preferred expression is to stay overweight a 50:50 portfolio of higher yielding US T-bonds and Spanish Bonos versus a 50:50 portfolio of near-zero yielding German Bunds and French OATs. In this strategic position, any price moves in the aftermath of the US election result are just short-term noise. A second conclusion is that the likely yield spread compression between US and European long-dated bond yields will structurally favour European currencies versus the dollar. Though an important caveat is that the dollar will retain its haven qualities during periods of market stress, because many haven assets and markets are denominated in the greenback.  Remain overweight long-dated US bonds versus long-dated core European bonds. Therefore, investors who cannot tolerate volatility should own Europe’s haven currency, the Swiss franc versus the dollar. Investors who can tolerate volatility should own the more undervalued Swedish krona versus the dollar. Fractal Trading System* This week’s recommended trade is to underweight the Australian construction sector versus the market. One way to implement this is to short an equally-weighted basket of James Hardie, Lendlease, and Boral versus the market. Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short MSCI Finland versus MSCI Switzerland achieved its 7 percent profit target. But long 30-year T-bond versus French 30-year OAT reached its 3.2 percent stop-loss just before the T-bond’s strong post-election rally. The rolling 1-year win ratio now stands at 53 percent. Chart I-10Australia: Construction Materials Vs. Market When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Productivity is defined here as real GDP per employed person, and productivity growth is quoted for the periods q1 2002 through q4 2003, q2 2008 through q4 2010, and q4 2019 through q3 2020. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

The 14th Five-Year Plan has more strategic importance than in the past decade. Spending on national defense, technological self-sufficiency, public welfare and green energy will likely see substantial increases under the guidelines of a strong central government. The Proposal from the Five-Year Plan does not change our cyclical view on Chinese assets. Beyond mid-2021, the differences in sectoral performance will widen. We will likely begin to trim our position in China’s “old economy” stocks in the first half of 2021.

Bank Credit Analyst

Highlights Our base case of a Biden win with a GOP Senate may come to pass. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until just before December 14 (or even January). Risk-off sentiment will prevail in the interim, given the importance of the executive-legislative configuration for the pandemic response and the fiscal policy outlook. What we know is that Republicans kept the Senate, in line with our final forecast last week. This means gridlock is assured – which is positive for US stocks beyond near-term fiscal risks. Stay long JPY-USD, short CNY-USD, long stocks over bonds, long health care equipment, and long infrastructure plays. Keep dry powder for the presidential outcome, as global trade hangs in the balance. Feature The US presidential election is unsettled as we go to press, but we know that Republicans will keep control of the Senate and hence that American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans – which is one seat better than our final 51-49 forecast in their favor (Chart 1).1 Chart 1Our Senate Election Model Correctly Predicted Republican Control Table 1Gridlock Is Inevitable Regardless Of Presidential Outcome Gridlock is the inevitable consequence. If President Trump pulls off a victory in any two of the upper Midwestern states (Michigan, Pennsylvania, Wisconsin), then he will still face a Democrat-controlled House of Representatives. If former Vice President Joe Biden pulls off a victory in two of these states, then he will face a Republican controlled Senate (Table 1). Chart 2Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Historically gridlock offers more upside for the S&P 500 than a single-party sweep (Chart 2), and we agree with this expectation when it comes to the long-run impact of this election. However, we have also warned against the fiscal risks of a Biden win with a Republican Senate in the short run. The status quo Trump gridlock is reflationary at first but later problematic due to trade war. The Biden gridlock is deflationary at first but the best outcome for investors over the long run. Consider the following: Trump with Senate Republicans: Trump is a spendthrift and he and his party joined the House Democrats in blowing out the budget deficit from 2018-20. Trump’s victory will force House Speaker Nancy Pelosi to concede to a Republican-drafted ~$1-$1.5 trillion new COVID-19 fiscal relief bill right away. For the second term, Trump will push an infrastructure bill, border security, and make his tax cuts permanent. The fiscal thrust in 2021 will be flat-to-up. The budget deficit will probably end up somewhere between the Republican “high spending” scenario and the Democratic “low spending” scenario in our budget deficit projections (Chart 3). This is positive for US growth and especially corporate earnings, but it comes with a catch: Trump will be emboldened in his trade wars, which could expand beyond China to Europe or others. Tariffs and currency depreciation will weigh on global growth. Still, Trump’s second term will occur in the early stages of the business cycle and the Fed is committed not to hike rates until 2023, so the overall picture is reflationary.   Chart 3Trump Gridlock Reflationary, Biden Gridlock Deflationary Over Short Run Biden with Senate Republicans: Since Senate Republicans did not capitulate to large Democratic spending demands prior to the election, when their seats were at risk, they will have less incentive to do so afterwards when the president hails from the opposing party. The only way they will agree to a new fiscal stimulus in the “lame duck” session (November-December) is if the Democrats concede to their skinny proposals for the time being. But Democrats will probably insist on their demands having made electoral gains. In this case, either financial markets will sell off, forcing Republicans to capitulate, or investors will have to wait until early 2021 to receive a new fiscal bill that is uncertain in size and timing. The first battle of Biden’s presidency will be with the GOP Senate. The Republican “low spending” scenario in Chart 3 is most likely. It is not realistic that Congress will allow the baseline scenario, in which the budget deficit contracts by ~7.4% of GDP. Republican senators today are not the Tea Party House Republicans of 2010, who were rabid fiscal hawks. Still, uncertainty will weigh heavily and markets will have to fall before GOP senators wake up to the underlying risk to the economic recovery. The consolation is that beyond this 3-6 month period of negative sentiment and deflationary fiscal risk, the outlook will be fairly positive. Biden will not use broad-based unilateral tariffs the way Trump did, with the possible exception of China later in his term. And the Republican Senate will not agree to tax hikes at any point, making taxes a concern for 2023 or thereafter. This is the best of both worlds for US business sentiment and the corporate earnings outlook over the two-year period. Risk-off sentiment will prevail until the election is decided. This could be in a couple of days if the vote count is clear in Michigan, Pennsylvania, and Wisconsin. Or it could extend until just before December 14, when the Electoral College votes, if the litigation and court rulings in these critical states drag on, which we discuss below. The reason risk-off sentiment will prevail is that the US economy is burning through its remaining stimulus funds rapidly, the fiscal trajectory is unclear until the presidency is decided, Europe is going into partial lockdowns over the pandemic, and a Biden victory would imply more US lockdowns. Diagram 1 outlines the macro and market implications as we see them, depending on the presidential outcome. We never took the view that a Democratic sweep of White House and Senate would be the best outcome for the overall investment outlook, though we conceded that it was the most reflationary and bullish in the short term. But now this point is moot. Investors will have to wait another two years at minimum for the full smorgasbord of Democratic spending proposals to have a chance at passage. Diagram 1Gridlock Rules Out Massive Fiscal Boost Bottom Line: The presidency is indeterminate as we go to press. What is clear is that Republicans retained the Senate. Therefore gridlock will prevail. This is generally market positive, though a Biden win would weigh on risk assets in the near term until financial markets force Republican senators to capitulate to a new fiscal bill. A Controversial Election Or A Contested Election? The critical battleground states are undecided as we go to press. Trump needs to win any two of Michigan, Pennsylvania, and Wisconsin to retain the White House. The vote count will last through Wednesday and possibly beyond. The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible. For example, Wisconsin is within a percentage point. Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted). Thus Pennsylvania poses the biggest risk of a contested result – and this was anticipated. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.2 We will not pretend to predict the final court verdict on Pennsylvania, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges has little bearing on their decisions because they serve lifetime appointments. Once election disputes rise above state vote-counting to the federal level, Trump gets a lifeline. First, the two-seat conservative leaning on the Supreme Court should produce strict readings of the law that could favor his bid. Second, the GOP’s victory in the Senate means that Democrats cannot unilaterally settle disputed electoral votes in their own favor at the joint session of Congress on January 6, which they could have done with a united Congress. Third, the Republicans are likely to have maintained a one or two-state majority of state delegations in the House of Representatives (based on results as we go to press), which means that Trump would win if the candidates failed to reach a 270-vote majority on the Electoral College or tied at 269. Note that an Electoral College tie is a distinct possibility in this election. Right now, if Trump loses in Michigan and Wisconsin, but wins Pennsylvania, and nothing else changes, then an Electoral College tie could result at 269-269 electoral votes.3 Polls … And Exit Polls Before condemning the entire profession of opinion pollsters to death it will be important to receive the verified results of the election and compare them with the final polling averages. It is clear that Trump was widely underrated yet again, but it is not yet clear that this was primarily or exclusively the fault of pollsters. Right now Trump is down by 1.8% in the nationwide popular vote, whereas he lagged by 7.2% in the average of the national polls and 2.3% in the battleground average on election day. This is a big 5.4% gap in the national poll, but in the battleground poll it is a minor 0.5% polling gap and as such merely confirms what many observers knew, that the battleground polls were the ones that really mattered due to the Electoral College. Trump’s battleground support average was 46.6% and his approval rating was 45.9% on election day, which respectively is 1.8% and 2.5% below his tentative share of the national vote at 48.4%. These gaps are within the average 3% margin of error – and normally sitting presidents outperform their polling by around 1%. State opinion polling had huge errors like the national poll. Charts 4 and 4B shows the final election polling in the critical swing states along with a “T” or “B” to mark Trump’s and Biden’s tentative vote share as we go to press. Swing state polls showed Trump staging a major rally in the final weeks of the campaign, which is what prompted us to upgrade his odds to 45%. Neither major pundits nor the mainstream media paid enough attention to this shift. Several prominent outlets denied that there was any real tightening in the polls even in late October. Chart 4APundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Chart 4BPundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks What this demonstrates to us is the power of momentum in opinion polling, especially in the final week before an election when people’s attitudes harden and they bare more of their true opinions. It does not tell us that opinion polling is dead. What about the exit polls? Biden cut into Trump’s lead in key demographic groups just as the Democratic Party machinery anticipated, but it is not clear if it was enough to win the election. Trump lost ground and Democrats gained ground, relative to 2016, with white voters, old folks, and non-college-educated voters. But Trump improved his support among blacks and Hispanics, a signal point that gives the lie to much of this year’s media hype (Charts 5A and 5B). Chart 5ADemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Chart 5BDemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics By far voters cared most about the issues, not personalities, and the biggest issue was the economy (35% of voters versus 20% on racial inequality and 17% on the coronavirus, which was apparently overrated as an issue by Democrats). The economic focus is the only explanation for Trump’s outperformance – the law and order narrative was less popular. Trump’s vote share may end up exactly equal to the number of respondents who said the economy was “good” or “excellent” (48%). Otherwise Trump’s base is well known: it consists predominantly of white people, rural people, those in the Midwest and South, those who have been fairly successful in income, and those who think America needs a “strong leader” more than a unifier with good judgment who seems to care about the average person. If Trump is defeated, the clear implication is that he failed to expand his base. If he wins, the clear implication is that Democrats suffered in the key regions for their aggressive approach to COVID lockdowns, their condoning of lawlessness, and their divisive handling of racial inequality and police brutality. With such a close vote for the White House, sweeping narratives are questionable. It is not clear yet whether liberalism or nationalism won, and at any rate the margin was thin. What is clear is that Democrats substantially disappointed in the Senate and they might even have failed to gain the White House. Given that this year witnessed a recession, pandemic, and widespread social unrest – well-attested historical signs that point to the failure of the incumbent party and recession – Democrats apparently failed to capitalize. National exit polls suggest the fault lay in their relative neglect of bread and butter in favor of the coronavirus or left-wing social theory. This is true not so much in the House of Representatives but in the presidential and senate races. If Trump wins – especially through a contested election – then US political polarization will rise due to the continued divergence of popular opinion and the constitutional system. “Peak polarization” will last another four years at least. But if Trump loses, given that Republicans held the Senate, there is room for compromise that would reduce polarization. But it is too early to say. Investment Takeaways Trade and foreign policy hinge on the presidency. Trump is favored in several of the key states at the moment and he is especially favored in a contested election process, but it is too soon to make investment recommendations on the executive branch other than that US equity outperformance is likely to continue on both of the scenarios at hand. Table 2Earnings Shock From Partial Repeal Of Trump Tax Cuts Has Been Averted For now we recommend investors stay long JPY-USD, short CNY-USD, long health care equipment, and overweight stocks relative to bonds. On the Senate, the key takeaway is that Biden and the Democrats will not be able to raise taxes. This is a big benefit to the sectors that faced the greatest earnings shock from a partial repeal of Trump’s Tax Cuts and Jobs Act – namely real estate, tech, health care, utilities, consumer discretionary, and financials (Table 2). A simple play on these sectoral benefits courtesy of Anastasios Avgeriou, our US equity strategist, would be to go long small caps versus large caps, i.e. S&P 600 relative to the S&P 500, but wait till the fiscal hurdle is cleared. The BCA infrastructure basket should benefit regardless, as infrastructure is one of the few areas of bipartisan agreement, especially amid a large output gap.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We upgraded the Republicans to favored status last week based on our quantitative Senate election model, which showed a 51% chance that Republicans would maintain control, with 51-49 votes. Our presidential model also showed Trump winning with a 51% chance, but we subjectively capped his odds at 45% due to our doubts about his ability to win Michigan given Biden’s 4% lead in head-to-head public opinion polls there. 2 It is possible that Nevada’s November 10 deadline or North Carolina’s November 12 deadline could become relevant, but we doubt it. 3 Precise Electoral College outcomes cannot be predicted due to faithless electors, i.e. electoral college members who vote differently than required based on their state’s popular vote. In 2016 there were seven faithless electors and in 2020 there could be several and they could make the difference. Material punishments may not prevent an elector from making a conscientious decision to stray from his or her state’s results in an election viewed as having historic importance.

Highlights COVID-19 In Europe: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. ECB: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. European Bond Strategy: Stay overweight core European government debt, particularly versus US Treasuries. Remain overweight Italian and Spanish government bonds, as well, which remain supported by both ECB asset purchases and perceptions of increases European fiscal integration. Stay cautious on euro area corporate debt, however, as the renewed recession risk comes at a time when yields and spreads offer poor protection from future credit downgrades and defaults. Feature Chart of the WeekA Bad Time For A Second Wave Today’s long anticipated US election will be the focus for investors in the coming days (and, potentially, weeks) as all votes are counted. We have discussed our views on the potential bond market impact of the election - bearish for US Treasuries with both Joe Biden and Donald Trump promising big fiscal stimulus in 2021 – in our previous two reports. We will provide an update of those views as soon as we get clarity on the election result. This week, we discuss a new concern for jittery markets - the explosion of new COVID-19 cases in Europe that has already led to governments imposing aggressive lockdown measures. The timing of the new viral surge could not be worse for the euro area economy, which had recovered smartly from the massive lockdown-related demand shock this past spring. Real GDP for the entire euro area exploded higher at a 12.7% rate in Q3/2020, a big rebound from the 11.8% drop in Q2. Yet the second wave of coronavirus is starting to weigh on the more domestically focused service sectors most vulnerable to lockdowns and declining consumer confidence (Chart of the Week). From the perspective of European fixed income strategy, the imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. This will support the performance of euro area government bond markets, both in absolute terms and especially versus US Treasuries where yields are drifting higher and should continue to do so after the US election. Another Deflationary Shock To Europe From The Virus The surge in COVID-19 cases has hit the euro area hard and fast. France has seen the most stunning increase, with a population-adjusted daily increase of 596 new cases per million, a nearly six-fold increase in just two months (Chart 2). Importantly, this second wave has so far been nowhere near as lethal as the first wave. The “case fatality ratio” – confirmed deaths as a percentage of confirmed cases – is down in the low single digits for the largest euro area countries (bottom panel). The imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. Even with this second wave being less deadly, governments are taking no chances. France and Germany announced national lockdowns last week for at least the month of November, and Italy and Spain have put new restrictions on activity as well. The new lockdowns are already denting consumer confidence across the euro area and this trend will continue as people choose to spend less time outside of their homes to avoid infection. If the case numbers do not begin to stabilize and the lockdown measures extend into December or beyond, governments will likely be forced to consider new fiscal stimulus measures. According to the latest IMF Fiscal Monitor, the largest euro area economies are projected to have a negative “fiscal thrust” – the change in the cyclically-adjusted primary budget balance as a share of potential GDP – in 2021 of at least -3% of GDP (Chart 3). Chart 22nd Wave Of European Coronavirus Is Far Less Lethal Chart 3A Big European Fiscal Drag Coming Next Year In the case of Italy, the fiscal thrust is expected to be a whopping -6.6% of GDP. The main cause is reduced government spending as the massive temporary stimulus measures to fight the 2020 COVID-19 recessions roll off. Chart 4The ECB Has A Deflation Problem A fresh set of lockdowns will result in a need for more government support measures for unemployed workers, especially those in service-related industries like hospitality and tourism most exposed to lost business as consumers stay home. This poses a serious problem in countries like Spain and Italy that saw a rise in unemployment during the first lockdown but have seen no reversal since (Chart 4). More elevated unemployment rates suggest a lack of inflationary pressure, a point confirmed by recent inflation data. Overall headline HICP inflation fell to -0.3% in September, while core inflation is now a mere +0.4%. Headline HICP inflation rates are now below 0% in the largest euro area economies (Germany, France, Italy and Spain), while core HICP inflation in Italy fell to -0.3% in September. The collapse in oil prices earlier in 2020 has been the main cause of the negative headline inflation prints in the euro area, but is not the only source of weak inflation. According to a decomposition of inflation presented in the Bank of Italy’s October 2020 Economic Bulletin, a falling contribution from services inflation was responsible for about one-third of the entire decline in euro area headline HICP inflation since January (Chart 5). This comes from the part of the euro area economy most exposed to COVID-19 restrictions, highlighting the deflationary risk of the second wave. Chart 5Euro Area Deflation Is Mostly, But Not Only, Driven By Oil Simply put, the second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Policymakers need to spring into action to help provide support for the euro area economy during this time, starting with the ECB. The second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Bottom Line: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. The ECB Will Deliver New Stimulus In December At last week’s policy meeting, ECB President Christine Lagarde announced that the Governing Council would reassess its monetary policy stance at the December meeting, when a new set of economic projections would be presented that factored in the negative impact of the second COVID-19 wave. Lagarde was very candid about the expected outcome of that next meeting, when she stated that the ECB would “recalibrate its instruments” based on the new economic forecasts. Chart 6European Banks Are Tigthening Lending Standards In our view, the ECB’s next policy options can only realistically focus on three options: Cutting policy rates deeper into negative territory Increasing the size, or altering the composition of its bond-buying programs Altering the terms of its current Targeted Long-Term Refinancing Operations (TLTROs) We view a rate cut as a low probability outcome. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. According to the ECB’s latest Bank Lending Survey, euro area banks tightened credit conditions in Q3/2020 (Chart 6). Worsening perceptions of risk and a deteriorating economic outlook were cited as the main reasons for tightening lending standards. The tightening was most severe in Spain, but Italy also saw a big swing away from the easing standards seen in the Q2/2020 survey. Within the details of the Q3/2020 survey, the demand for loans from companies was expected to improve in Q4/2020. The demand for housing and consumer credit increased due to favorable borrowing conditions and a softening in negative contribution from consumer sentiment. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. The ECB’s bond buying programs – the Asset Purchase Program (APP) and the Pandemic Emergency Purchase Program (PEPP) – were deemed to have a positive impact on bank liquidity and financing but a negative impact on profitability. Chart 7Low Interest Rates Are Crushing European Bank Stocks Therein lies the problem of the ECB’s negative interest rate policy and large-scale bond buying – it has lowered borrowing costs for euro area governments, consumers and businesses, but has crushed the profits of Europe’s banks. That can be seen when looking at the ongoing miserable performance of euro area bank stocks, which continue to plumb new lows. The relative performance of euro area banks versus the broad equity market benchmark index tracks the slope of government bond yield curves quite closely in the major euro area economies (Chart 7), highlighting the link between the level of euro area interest rates and bank profits. In Chart 8A, we show the Tier 1 capital ratio, as well as the non-performing loan (NPL) ratio for the five largest banks in Germany, France, Italy, Spain and the Netherlands. The message from the chart is clear – European banks remain well capitalized, with double-digit Tier 1 capital ratios well in excess of regulatory minimums, and have a relatively low share of assets that are non-performing. This is especially true in Italy, where the NPL ratio has collapsed from a high of 20% to 7% over the past five years. In Chart 8B, we present the return on equity and return on asset ratios for the same banks presented in the previous chart. Most large euro area banks suffer from a very low return on assets, not materially above 0%, reflecting the non-existent interest rates banks earn on their government bond holdings as well as the low rates on their loan books. Chart 8AEuropean Banks: The Good News Chart 8BEuropean Banks: The Bad News So given the fragile state of euro area bank health, and with banks already tightening lending standards in anticipation of slower economic activity because of second wave lockdowns, we can rule out a policy interest rate cut as an option to ease policy in December. This leaves only two other easing options, both associated with an expansion of the ECB’s balance sheet – more asset purchases of sovereign bonds and encouraging bank lending through cheap funding via TLTROs (Chart 9). The impact of either policy in offsetting slowing growth is debatable. Government bond yields are already miniscule, if not outright negative, across the euro area and do not represent a hindrance to increased government spending. The ECB can tweak some of the terms of the existing TLTRO programs, like maturity or the price of funding, but that may not encourage new lending if both borrowers and lenders fear a double-dip recession because of the second wave. The pressure is on the ECB to do something to stem the decline in euro area inflation. Nonetheless, the pressure is on the ECB to do something to stem the decline in euro area inflation. While real interest rates are still negative, they are increasingly becoming less so as inflation expectations continue to drift lower. The 5-year/5-year forward EUR CPI swap rate is now down to 1.1%, and was last trading near the ECB’s inflation target of just under 2% in 2013-14 (Chart 10). Unsurprisingly, the rising real rate backdrop has helped boost the value of the euro, especially versus the US dollar, which has suffered under the weight of falling real US interest rates this year. Chart 9The ECB Can Only Expand Its Balance Sheet In the end, greater fiscal stimulus will be the only option available to get Europe through the second wave. All the ECB can do is provide a backdrop of loose monetary policy that supports easy financial conditions, so that any stimulus will have the maximum effect on growth. Chart 10Deflation Is Pushing Up Real Rates In Europe Bottom Line: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. Stay Overweight European Government Bonds, But Stay Cautious On Euro Area Credit With the ECB set to deliver some form of easing in December, core European bond yields are likely to remain stable over at least the next six months. The ECB has shown no reservations about expanding its balance sheet via bond purchases when needed. A surge of buying similar in size to that of the first COVID-19 wave is not out of the question if Europe faces a double-dip second wave recession (Chart 11). Chart 11Stay Overweight Core European Government Bonds Chart 12Italian BTPs Are Preferable To Euro Area Corporate Credit In an environment where we see US Treasury yields having more upside on the back of post-election fiscal stimulus, this makes the likes of German bunds and French OATs good “defensive” lower-beta plays to replace high-beta US Treasury exposure in global USD-hedged bond portfolios. We also like core Europe as a pure spread trade versus Treasuries, as we see scope for the UST-Bund spread to widen further – a tactical trade we initiated last week (see our Tactical Overlay table on page 15). We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying.  We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying (Chart 12). The ECB has already been purchasing a greater share of Italy in the PEPP, allowing significant deviations from the Capital Key weights that limit purchases in the older APP. ECB President Lagarde noted last week that those deviations will continue over the life of the PEPP, which should help support further declines in Italian bond yields over at least the next six months. We are maintaining a relatively cautious stance on European credit, however, even with the ECB likely to make a move in December. The renewed recession risk from the second wave comes at a time when low yields and spreads for euro area corporate bonds offer poor protection from future credit downgrades and defaults. We continue to prefer owning US corporate credit, both investment grade and high-yield, versus US equivalents in USD-hedged bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns