Fixed Income

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

Please note that there will be no US Bond Strategy report next week. We will publish December’s Portfolio Allocation Summary on December 8th, followed by our Key Views For 2021 on December 15th and a Special Report titled “The Fed In 2021” on December 22nd. Highlights Duration: Weaker Q4 economic growth could cause Treasury yields to fall in the near-term, but knowledge of a vaccine coming in 2021 will limit the downside. Investors should maintain below-benchmark portfolio duration on a 6-12 month horizon. Fed: The Treasury’s decision to let the Fed’s emergency lending facilities expire is unlikely to have a meaningful impact on credit spreads, and it may even increase the odds of getting another fiscal stimulus bill through Congress. Spread Product: Value is quickly disappearing from high-rated corporate bonds, and municipal bonds look like an attractive alternative. Stay overweight municipal bonds and corporate bonds rated Ba and higher. Avoid junk bonds rated B and lower. Feature Increasingly, financial markets look caught in a tug-of-war between two competing economic outlooks. On the one hand, the US sits on the precipice of what is likely to be a dark winter. COVID hospitalizations are breaking through prior peaks and deaths are following closely behind (Chart 1). On the other hand, excellent results from vaccine trials offer a ray of light in the not-too-distant future. Focusing on the next 1-to-2 months, economic activity is poised to slow. This is partly because many states will respond to the surging case count by enacting stricter lock-down measures (Chart 2). In fact, New York shuttered schools just last week. But even in the absence of stricter quarantine laws, consumers will certainly exercise greater caution this holiday season. Already, consumer sentiment looks to be waning at a time when more than 700 thousand people are filing new unemployment claims each week (Chart 2, bottom 2 panels). Chart 1A Dark Winter Chart 2Look For Slower Growth In Q4 With consumer sentiment souring at a time when the household income support from the CARES act has expired, it is only a matter of time before consumer spending dips. Added to that, last week’s decision by the Treasury Department to call in the funds used to back-stop the Fed’s emergency lending facilities demonstrates that Donald Trump’s administration will be increasingly erratic during the next two months.1 Chart 3Treasury & Corporate Excess Returns Heightened political uncertainty during a period of slowing economic growth should point to lower bond yields and wider credit spreads in the near term. But, at least so far, the market reaction has been muted (Chart 3). Treasuries have strengthened somewhat during the past week. Treasury returns in excess of cash are running at +735 bps, year-to-date. This is up from +617 bps on November 10th. However, year-to-date investment grade corporate returns in excess of duration-matched Treasuries just hit -121 bps, the highest since February. Year-to-date High-Yield excess returns have dipped to -72 bps, after peaking at -39 bps on November 9th. It’s possible that investors need more evidence of weakening economic growth before the market impact is really felt. Or, it could simply be that forward-looking markets are much more focused on news about the COVID vaccine, and that investors are willing to tolerate a couple months of poor growth if they are confident that better times lie ahead. It’s also conceivable that financial markets would look through a spate of poor economic data if investors believed that more fiscal stimulus is on the way. Given the protracted nature of fiscal negotiations so far, it’s fair to be skeptical that a deal can be struck. But with the election now over, the House Democrats and Senate Republicans may have a greater incentive to compromise on a small relief bill, on the order of $1 trillion or less. According to surveys, a compromise deal would curry favor with voters of all political stripes. Most Republicans, Democrats and Independents support further fiscal aid (Table 1). What’s more, having a timeline for vaccine distribution could make negotiations less contentious, since any stimulus can be sold as the final COVID relief bill before a vaccine is available. Finally, it’s possible that Treasury Secretary Steve Mnuchin’s gambit will pay off, and that policymakers will view the funds being returned by the Fed as “free money” that should be re-deployed in the form of fiscal support. All in all, we are optimistic that a moderately-sized relief bill will be passed, if not this year then early next year. Table 1The Public Supports Another Round Of Stimulus Investment Implications Chart 4Better Value In Munis Than IG Corporates With regards to our outlook for Treasury yields, we could see yields dip during the next month or two as the economic data weaken. However, we expect the knowledge that a vaccine is on the horizon will prevent yields from falling that much. We also could see progress made on a fiscal stimulus package, which would offset any downward pressure on yields. With that in mind, we advise investors to maintain below-benchmark portfolio duration on a 6-12 month horizon. On spread product, our investment conclusion is similarly colored by the tug of war between a negative near-term economic outlook and the positive news of a COVID vaccine. We recommend maintaining our current positioning: overweight investment grade corporates and Ba-rated junk, underweight junk bonds rated B and lower. If we do get some spread widening during the next month or two, driven by negative economic news or the expiry of the Fed’s emergency lending facilities, we would view that as an opportunity to get more aggressive by upgrading the lower-rated junk credit tiers. One caveat to our positive view on corporate credit is that value has deteriorated markedly in recent months, particularly for higher-rated investment grade corporates (Chart 4). At the same time, tax-exempt municipal bonds offer an exceptional spread pick-up relative to both Treasuries and equivalently-rated corporate bonds (Chart 4, bottom panel). We recommend that investors favor municipal bonds over corporate credit, particularly at the upper-end of the credit spectrum. The value in high-rated investment grade corporates has deteriorated markedly. Bottom Line: Maintain below-benchmark portfolio duration on a 6-12 month horizon. Stay overweight investment grade corporates and Ba-rated junk, while avoiding high-yield bonds rated B and below. Stand ready to upgrade low-rated junk bonds if spreads widen significantly during the next two months. Favor municipal bonds over equivalently-rated corporate credit, particularly at the upper-end of the credit spectrum. Treasury – Fed Disaccord As mentioned above, last week’s big news was that Treasury Secretary Steve Mnuchin sent a letter to the Federal Reserve saying that he would (a) not authorize an extension of some of the Fed’s emergency lending facilities beyond December 31st and (b) would like the Fed to return the unused funds that the Treasury Department had allocated to serve as the equity back-stop for those facilities. Though the Fed issued a statement saying that it would prefer to extend the facilities, Chair Powell eventually acceded to both requests. This means that the Secondary and Primary Market Corporate Credit Facilities (SMCCF & PMCCF), the Municipal Liquidity Facility (MLF), the Main Street Lending Facilities (MSLF) and the Term Asset-Backed Securities Loan Facility (TALF) will all cease operations at the end of the year.2 Gone For Good? Given the Fed’s stated desire for the facilities to continue and the fact that a new Treasury Secretary – presumably one that will show greater deference to the Fed – will take over in January. It’s conceivable that the facilities could be quickly re-started. If the Treasury had simply not authorized an extension of the facilities without taking its money back, this would be as simple as flicking a switch. The fact that the Fed will return the money makes the process slightly more complicated, but by no means impossible. The facilities in question are all structured as Special Purpose Vehicles (SPVs) to which the Treasury Department supplies some amount of equity financing. The Fed then loans money to the SPVs, levering them up dramatically in the process. Crucially, there is no statutory limit on the amount of leverage the Fed can provide to the SPVs. This means that the Fed could ramp them back up, even if it gets only a small injection of capital from the Treasury. A new Treasury Department could easily find enough money in the Exchange Stabilization Fund for the Fed to re-start the facilities in January, without seeking Congressional approval. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. While the Fed and Treasury will be able to re-start the facilities in January, we aren’t sure they will feel the need to do so. In our view, Secretary Mnuchin has a point when he writes that markets are functioning well enough on their own. Simply look at how little the emergency facilities have been used (Table 2). The Fed has purchased only $13 billion of corporate bonds in the SMCCF. TALF has only been tapped for $3.75 billion and both the MSLF and MLF are operating at less than 1% of their maximum capacities. The PMCCF, which the Fed can use to purchase new issuance in the corporate bond market, has never been accessed! Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Even the SMCCF, the facility through which the Fed buys corporate bonds and corporate bond ETFs in the secondary market, has significantly scaled back its purchases during the past few months. It also hasn’t purchased an ETF since August (Chart 5). Chart 5The Fed Is Not Very Active In The Corporate Bond Market At a certain point, if the facilities aren’t being used, it is entirely reasonable to ask whether they are still necessary. They would no doubt prove useful if we hit another crisis – like in March – where spreads widen sharply and primary markets shut down. But that seems like a relatively low-risk tail event at this stage of the recovery. Finally, Secretary Mnuchin made the case in his letter that the returned funds from the Fed could be re-deployed as fiscal stimulus by Congress. This argument doesn’t make a lot of sense economically. When it scored the CARES act, the Congressional Budget Office assumed that the Treasury would take no losses on the money used to finance the Fed’s emergency lending facilities, so clawing those funds back has no impact on the deficit. But this may not matter. What matters is whether Senate Republicans can use the Treasury’s maneuver as political cover to justify voting for more fiscal relief. We think they might be able to do so, and we therefore see the Treasury’s move as increasing the odds of getting another fiscal relief bill through Congress. Investment Implications Chart 6MLF And TALF Aren't Pushing Yields Lower This development does not immediately influence our recommended investment strategy. On corporate bonds, we can’t definitively rule out the possibility that the expiry of the facilities will cause spreads to widen in the near-term. But if that does occur, we will view it as an opportunity to quickly increase exposure. For municipal bonds, the MLF allows municipal governments to place new debt with the Fed at a rate that varies depending on the municipality’s credit rating. At present, that MLF rate is well above municipal bond yields for all credit ratings (Chart 6), meaning that it would only become important in the event of a crisis that caused municipal yields to rise sharply. Similarly, TALF allows participants to take out loans from the Fed using Aaa-rated securitizations as collateral. But the current yields on Aaa-rated consumer ABS and Aaa-rated non-agency CMBS are 91 bps and 33 bps below this rate, respectively (Chart 6, bottom panel). In other words, spreads would need to widen fairly sharply for TALF to be relevant for investors. The expiry of TALF is more concerning for CMBS than consumer ABS. Commercial real estate is structurally challenged by the current crisis, while consumer balance sheets are in good shape. We recommend overweighting consumer ABS across the entire credit spectrum but would limit non-agency CMBS exposure to the Aaa credit tier. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The second section of this report (titled “Treasury – Fed Disaccord”) examines the specific market implications of the Treasury Department’s decision to not authorize an extension of the Fed’s emergency lending facilities. 2  For details on how these facilities are structured and what they are designed to do please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020 and US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup Part 2: Shocked And Awed”, dated July 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

We are publishing the November issue of Charts That Matter. The key message from the charts on the following pages is that investor sentiment on global growth is elevated and the reflation trade is a bit overstretched. As a result, risk assets and commodities prices will likely correct, and the US dollar will rebound. Investors should keep dry powder to buy EM assets at a better entry point. A trigger for a selloff could be one or a combination of the following: the lack of a large US fiscal stimulus package, falling activity in Europe, peak stimulus in China or the recent jitter in the Chinese onshore corporate bond market. CHART OF THE WEEKThe Global Stock-To-Bond Ratio Is At A Critical Juncture US Equity Sentiment Is Elevated US equity sentiment is somewhat elevated and is consistent with a correction in share prices. Chart 1US Equity Sentiment Is Elevated Chart 2US Equity Sentiment Is Elevated   Peak Growth Sentiment Investors are quite optimistic on global growth. A record large net long positions in copper corroborate a very bullish investor stance on China/EM growth. From a contrarian perspective, this heralds a correction in commodities prices and EM as well as a rebound in the US dollar. Chart 3Peak Growth Sentiment Chart 4Peak Growth Sentiment   Defensive Versus Cyclical Equity Segments Defensive sectors/markets have been underperforming and are oversold. Their outperformance is likely in the near term. Chart 5Defensive Versus Cyclical Equity Segments Chart 6Defensive Versus Cyclical Equity Segments   Near-Term Risks To Industrial Metal Prices The Baltic Dry index is falling and iron ore prices have relapsed. This is consistent with diminishing Chinese imports of iron ore. However, iron ore inventories in China are not excessive, so odds are it is a correction and not a bear market in iron ore prices.  Chart 7Near-Term Risks To Industrial Metal Prices Chart 8Near-Term Risks To Industrial Metal Prices   Chart 9Near-Term Risks To Industrial Metal Prices Chinese Imports Of Commodities Are At Risk From Destocking  Starting April-May, Chinese imports of copper and other commodities was running at very high rates, exceeding any reasonable estimates of final demand. This suggests China has been accumulating commodities. Even as final demand continues recovering, China might diminish imports of commodities weighing on their prices in the near term. Chart 10Chinese Imports Of Commodities Are At Risk From Destocking Chart 11Chinese Imports Of Commodities Are At Risk From Destocking   Oil Prices, Energy Stocks And Glencore Share Price Oil prices and energy stocks are facing a technical resistance. Yet, the share price of the world’s largest global commodity trader – Glencore – seems to be breaking out. The coming weeks will reveal which way the commodities complex will trade. Our bias is that a near-term correction is overdue. The US dollar holds the key, please refer to the next page. Chart 12Oil Prices, Energy Stocks And Glencore Share Price Chart 13Oil Prices, Energy Stocks And Glencore Share Price   Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound US inflation expectations – which have risen sharply since March – are likely to retreat as the US Senate does not approve a large fiscal stimulus package. Falling US inflation expectations will translate into higher TIPS yields. The latter and very bearish sentiment/positioning on the US dollar will trigger a rebound in the greenback. Chart 14Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Chart 15Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar ReboundChart 16Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound   US Elections And The US Dollar: Is 2020 The Opposite Of 2016? After the 2016 US elections, the US dollar rallied strongly for several weeks and then it sold off considerably. It seems the broad trade-weighted dollar is following a reverse pattern now.  It was selling off before the 2020 US elections and has continued weakening afterwards. If the reverse of the 2016 pattern persists, it means the US dollar is about make a major bottom and stage a playable rebound. Chart 17US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 18US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 19US Elections And The US Dollar: Is 2020 The Opposite Of 2016?   More Reasons To Expect A US Dollar Rebound The periods when US share prices outperform their global peers in local currency terms often coincide with strength in the US dollar. Recently, this relationship has broken down. The greenback might soon recouple to the upside, re-establishing this relationship (Chart 21). Besides, the broad trade-weighted dollar is very oversold (Chart 22). Chart 20More Reasons To Expect A US Dollar Rebound Chart 21More Reasons To Expect A US Dollar Rebound   Rising Real US Yields And Growth Stocks Rising US TIPS yields could create headwinds for growth stocks. FAANG and Tencent share prices have risen about 20-fold since January 2010 – as much as the Nasdaq 100 did in the 1990s before topping out. Chart 22Rising Real US Yields And Growth Stocks Chart 23Rising Real US Yields And Growth Stocks   Drivers Of EM Corporate And Sovereign Credit Spreads EM corporate and sovereign credit spreads are driven by EM exchange rates and commodities prices. A potential US dollar rebound and a correction in commodities prices warrant near-term caution on EM credit markets. Chart 24Drivers Of EM Corporate And Sovereign Credit Spreads Chart 25Drivers Of EM Corporate And Sovereign Credit Spreads Messages From Indicators And Chart Patterns Various indicators and technical chart configurations send mixed signals. Our bias is to expect a correction in risk assets in the near term.  Chart 26Messages From Indicators And Chart Patterns Chart 27Messages From Indicators And Chart Patterns   Chart 28Messages From Indicators And Chart Patterns Chart 29Messages From Indicators And Chart Patterns   Peak Stimulus In China Fiscal stimulus is running out. In addition, the PBoC has been tightening liquidity in the interbank market and interest rates have risen. Banks’ loan approvals have rolled over. All these point to a peak in the credit and fiscal impulse as well as money impulses in Q4 2020. Does it mean China’s economy is about to decelerate? – refer to the next page. Chart 30Peak Stimulus In ChinaChart 31Peak Stimulus In China Chart 32Peak Stimulus In China   China: Business Cycle Expansion To Continue In H1 2021 Our credit and fiscal spending impulse points to a continuous expansion in the Chinese economy for now. If the credit and fiscal impulse rolls over in Q4 2020, as shown in the previous page, the business cycle in China will peak around middle of 2021 given the nine-month time lag between this impulse and economic data. Chart 33China: Business Cycle Expansion To Continue in H1 2021Chart 35China: Business Cycle Expansion To Continue in H1 2021 Chart 34China: Business Cycle Expansion To Continue in H1 2021   Stress In The Chinese Onshore Corporate Bond Market The recent defaults by several SOEs on their bond payments have led to a spike in corporate bond yields. However, there is no stable historical relationship between onshore corporate bond yields and the A-share market. Chart 36Stress In The Chinese Onshore Corporate Bond Market Chart 37Stress In The Chinese Onshore Corporate Bond Market   Chart 38Stress In The Chinese Onshore Corporate Bond Market China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? During periods of rising onshore corporate bond yields, the MSCI ex-TMT Investable equity index rallied if Chinese EPS expectations where improving. The latest rollover in EPS growth expectations amid rising corporate bond yields is a warning to share prices. Chart 39China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? Chinese And EM Equity Relative Performance Versus Global Stocks China’s outperformance versus global stocks has been due to its TMT stocks (Alibaba, Tencent and Meituan). In turn, excluding Chinese stocks, EM ex-China has not really outperformed the global equity index. Chart 40Chinese And EM Equity Relative Performance Versus Global Stocks Chart 41Chinese And EM Equity Relative Performance Versus Global Stocks Various EM Equity Indexes Till very recent (before the announcement of progress in vaccines), EM small caps, the equal-weighted index, EM ex-TMT stocks and the EM index ex-China, Korea and Taiwan had been lackluster. Will the latest spike persist? It depends on the S&P500 and global risk asset performance. Chart 42Various EM Equity Indexes Chart 43Various EM Equity Indexes   Chart 44Various EM Equity Indexes Chart 45Various EM Equity Indexes   Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia’s and overall EM relative performance versus global stocks is unlikely to break out now. We continue recommending a neutral allocation to EM equities in a global equity portfolio. Chart 46Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 47Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Chart 48Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 49Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Sell stocks and wait on the side lines if the 10-year T-bond yield rises by 0.3 percent. Go aggressively overweight T-bonds on any modest rise in yields. New recommendation: Go overweight healthcare versus technology on a 6-12-month investment horizon. New recommendation: Go overweight Europe versus Emerging Markets on a 6-12-month investment horizon. Fractal trade: Fractal analysis supports the decision to go overweight healthcare versus technology. Feature Since early 2018, a rise in the long bond yield has sent shudders through the stock market on four occasions: February 2018, October 2018, April 2019, and January 2020. On all four occasions, the tipping point was the earnings yield premium on tech stocks versus the 10-year T-bond yield falling towards its lower limit of 2.5 percent (Chart of the Week). Chart of the WeekSell Stocks If The Bond Yield Rises By 0.3 Percent Today, this all-important yield premium stands at 2.8 percent. Meaning that it would take the 10-year T-bond yield to rise by just 30 basis points to retest this four times tipping point. Alternatively, with the T-bond yield unchanged, the tipping point would be retested if tech stocks rallied by around 10 percent. The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Crucially, this means that the stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. We recommend selling stocks and waiting on the side lines if the earnings yield gap on tech stocks versus the T-bond yield approaches its lower limit of 2.5 percent – from any combination of moderately higher bond yields or higher stock prices over the coming weeks. Record Low Bond Yields Have Lifted The Stock Market To An All-Time High   ‘A once-in-a-century global pandemic lifts the world stock market to an all-time high’ sounds like an obscene headline. Yet this is the correct narrative for 2020. Yes, the European stock market is still languishing 10 percent below its mid-February peak. But the much larger and tech-heavy US stock market stands 10 percent higher, taking the world market to around 5 percent higher (Chart I-2). How can the aggregate market stand at an all-time high when a terrible plague continues to ravage the global economy? The simple answer: because of record low bond yields. Chart I-2Record Low Bond Yields Have Lifted The Stock Market To An All-Time High Back on February 27, we wrote: “for stock markets, the best inoculation against Covid-19 is ultra-low bond yields.” And so it proved. Though stock market profits are down by 15 percent this year, the multiple paid for those profits is up by 20 percent, resulting in a 5 percent uplift in the market price (Chart I-3). Chart I-3Valuations, Not Profits, Are Driving The Stock Market Specifically, tech sector valuations have become hyper-sensitive to any change in the long bond yield (Chart I-4). Meaning that for those stock markets with a high weighting to tech stocks, the valuation boost from a decline in bond yields has more than countered the profit slump from the pandemic. In fact, the pivotal role of bond yields precedes the pandemic. For the past three years, a good motto for investors has been: don’t focus on profits, focus on valuations. Chart I-4Valuations, Not Profits, Are Driving The Tech Sector The Biggest Threat To The Stock Market Is Higher Bond Yields   Through 2018-19, stock market profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018 then surged in 2019. In 2020, as the pandemic devastated profits, a further surge in the multiple immunised the stock market against the ravages of Covid-19. The dramatic swing in multiples was driven by the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing long-duration bonds. But at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. When bond yields approach their lower limit, bond prices approach their upper limit. This means that the scope for further price rises diminishes while the scope for price collapses increases. For proof, just look at Swiss 10-year bonds. Their prices can barely rise anymore! Yet they can fall precipitously (Chart I-5). In short, the lower that bond yields go, the riskier that bonds become as an investment. Chart I-5Swiss Bond Prices Can Barely Rise, But They Can Fall A Lot As bonds become a riskier investment, the excess return on equities versus bonds, the equity risk premium (ERP), collapses towards zero. After all, if the riskiness of equities and bonds converges, then any risk premium must disappear. The result is that the prospective return (discount rate) required on equities declines exponentially, because both of its components – the bond yield plus the ERP – decline in tandem. Given that valuation is just the inverse of the discount rate, the valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Conversely, the valuation of equities falls exponentially when the bond yield rises from an ultra-low level. The valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Yet doesn’t a higher bond yield also imply a higher nominal growth rate for profits, which should be good for the stock market? Yes, but understand that the increase in the discount rate (nominal bond yield plus ERP) will be much larger than the increase in the profit growth rate. The result is a plunge in the stock market’s net present value. Once you grasp this exponential relationship, the penny suddenly drops. The pandemic has proved that the biggest structural threat to the stock market does not come from a negative growth shock like a once-in-a-century global plague. The pandemic has been good for the aggregate stock market because it has forced bond yields to decline to ultra-low levels. Instead, the biggest threat to the stock market is higher bond yields. Please note that this disagrees with the BCA house view – which does not preclude stocks from rising even if yields rise by 0.3 percent, if this takes place against the backdrop of better growth prospects. Sell Stocks If The Bond Yield Rises By 0.3 Percent As the first chart powerfully illustrates, higher bond yields sent shudders through the stock market on four occasions in the past three years. We are close to a similar near-term valuation test. Of course, given enough time, a gradual rise in earnings can lift the tech earnings yield gap versus the bond yield to well above its danger level of 2.5 percent. However, over shorter periods, it would require stock prices and/or bond yields to stop rising. Or indeed, to reverse. For equities, the upshot is that the 60 percent rally since mid-March is reaching near-term exhaustion. We recommend selling stocks and waiting on the side lines if the 10-year T-bond yield was to rise by another 30 bps. For bonds, the upshot is that all else being equal, 10-year bond yields can rise by no more than 30 basis points before sending shudders through the stock market. Which would then cause bond yields to give back their gains, as they did on each of the four previous occasions that higher bond yields spooked the stock market. On this basis, it is not worth underweighting bonds. The much smarter strategy is to go aggressively overweight T-bonds on any modest rise in yields. Within equity sectors, there are three arguments in favour of healthcare. First, while the tech sector earnings yield gap versus the T-bond yield is approaching its lower limit of 2.5 percent, the healthcare sector earnings yield gap stands at a very comfortable and attractive 4.1 percent, well above its recent lower limit of 2.0 percent (Chart I-6). Second, unlike tech, the healthcare sector rally is being driven by profits, not by a valuation uplift (Chart I-7). Third, fractal analysis confirms that the massive underperformance of healthcare versus technology is reaching technical exhaustion (see last section). Chart I-6Healthcare's Earnings Yield Premium Looks Very Attractive Chart I-7Profits, Not Valuation, Are Driving The Healthcare Sector Hence, today we are recommending that on a 6-12-month horizon, equity investors should go overweight healthcare versus technology.  Go Overweight Europe Versus Emerging Markets Finally, sector strategy has huge implications for regional and country allocation. Given that the European stock market is overweight healthcare and emerging markets (EM) is overweight technology, the decision to overweight Europe versus EM is simply the decision to overweight healthcare versus technology. Nothing more, and nothing less (Chart I-8). Chart I-8Europe Versus EM = Healthcare Versus Tech Hence, today we are also recommending that on a 6-12-month horizon, equity investors go overweight Europe versus emerging markets. Fractal Trading System* Supporting the fundamental arguments for healthcare versus tech in the main body of this report, the 130-day fractal structure of relative performance is extremely fragile. This implies that the massive underperformance of healthcare versus tech is at a potential inflection point. Accordingly, this week’s recommenced trade is to go long healthcare versus technology. Set the profit target and symmetrical stop-loss at 6 percent. In other trades, we are pleased to report that long financials versus basic resources achieved its 3.5 percent profit target, and short MSCI India versus MSCI Czech Republic achieved its 8 percent profit target. The rolling 1-year win ratio now stands at 54 percent. Chart I-9 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 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    

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The vaccine promises an eventual return to “normal” life – just as Americans voted to “return to normalcy.” Markets are cheering and hinting at an eventual rotation into value stocks. The contested US election can still cause volatility even though Trump is highly unlikely to change the result. The fiscal stimulus cliff is still a risk to the normalcy rally in the short run. But gridlock is the best political outcome over the coming 12-24 months. Stay strategically long global stocks over bonds. Tactically maintain safe-haven positions, add risk gradually, and stay short China/Taiwan. Feature The news of Pfizer’s success in developing a COVID-19 vaccine galvanized financial markets this week. America’s leading public health official Anthony Fauci also predicted that Moderna’s vaccine candidate would be similarly effective. It will take time to distribute these vaccines but the world can look toward economic recovery next year. Stocks rallied, bonds sold off, and value outperformed growth on the back of the news (Charts 1A and 1B). Chart 1ABiden: Return To Normalcy Chart 1BVaccine: Return To Normalcy The vaccine announcement super-charged the “return to normalcy” rally that followed the US election. The election’s likeliest policy outcome is that President Elect Joe Biden will not raise sweeping tariffs while Republican senators will not raise taxes next year, the best-case scenario for markets. This is genuinely positive news. The benefits are very clear over the next 12 months. But the risks are also very clear over the next three months: the virus will remain a problem until the vaccine is widely distributed, the US is in the midst of a contested election that could still cause negative surprises, the Republican senators are less likely to agree to fiscal relief, and President Trump will take aggressive actions to cement his legacy during the “lame duck” period of his last 68 days in office. The takeaway is that the US dollar will see a near-term, counter-trend rally and developed markets will outperform emerging markets for a while longer. We are only gradually adding risk to our strategic portfolio as we keep dry powder and maintain tactical safe-haven trades. Is The Election Over Or Not? Yes, most likely the election is over. But our definitive guide to contested US elections will teach any reader to be sensitive to the tail risks. The counting of ballots is not finished and the Electoral College does not vote until December 14. First, it is still possible that President Trump could pull off a victory in Georgia, which will now recount ballots by hand. Biden’s margin of victory of 14,045 votes is not so large there as to make it impossible that Trump would come back with a win (though history suggests recounts only change hundreds, not thousands, of votes). Trump is also narrowing the gap in Arizona, where counting continues, though the latest reports suggest he is still falling short of the roughly 60% share of late ballots that he needs to close the 11,635 vote gap and win the state. Second, there is a 50/50 chance that the Supreme Court will rule that Pennsylvania must stick to the statutory November 3 deadline, i.e. not accept mail-in ballots that arrived in the three days after that date. While the high court would prefer to let Pennsylvania settle its own affairs, this case is of the sort that the court could feel compelled to weigh in. The constitution is crystal clear that legislatures, not courts, decide how a state’s electors are chosen. Such a ruling probably would not reverse Biden’s projected victory in Pennsylvania. Trump is currently trailing Biden by 53,980 votes in this state. State officials say that the ballots that arrived late amount to only 7,800 and would not be able to change the outcome.1 This may be understating the risk but it is probably accurate in the main. Table 1 shows the share of mail-in votes that arrived late in this year’s primary elections. The share was 1.07% in Pennsylvania and up to 3% in other states. Applying the high water mark of 3% to the November 3 general election mail-in ballots, it is possible that 77,187 votes arrived late and would be excluded by a Supreme Court ruling. However, 85% of those ballots would have to have gone to Biden in order for Trump to come out the winner. This is far-fetched. Table 1Share Of Ballots Arriving Late In Primary Election Extrapolated To General Election It is also unlikely that Republican legislatures will take matters into their own hands and defy the election boards of their state by nominating their own slate of Republican electors – a scenario we entertained in our definitive guide. If Biden leads the statewide vote, then a state legislature would be politically suicidal to appoint the state’s electors to vote for Trump. It would invite a popular backlash. In the case of Pennsylvania, Republican leaders of the lower and upper chambers have explicitly denied any willingness or ability to choose electors other than those entailed by the popular vote. Thus the 1876 “Stolen Election” scenario is extremely unlikely in this critical state. It is just as unlikely in Arizona, Nevada, or Georgia.2 Nevertheless, if President Trump wins in Georgia or gets a favorable Supreme Court verdict, investors will have to increase the probability that the election result will be overturned, which currently stands at 16% (Chart 2). This will cause a bout of volatility even if it changes nothing in the end. If somehow Trump pulls off a Rutherford B. Hayes and overturn the result, markets should sell off. Yes, Trump is an exclusively commercial and reflationary president, but his election on a constitutional technicality would create nearly unprecedented social and political instability in the United States and it would presage major instability globally. Chinese, European, and Canadian assets would be hardest hit (Chart 3). Chart 2Trump’s Tiny Chance Of Reversing Election Otherwise Trump and the Republicans are trying to do four things with their litigation: (1) probing for weaknesses that can delay or change the Electoral College math (2) conducting due diligence in case fraud really did tip over one of the states (3) saving face for President Trump and his allies, who otherwise would be exposed as failures (4) keeping their base motivated for the showdown in Georgia on January 5, which will determine control of the Senate. Chart 3Trump's Loss Favors Euro, Renminbi, Loonie In Georgia, opinion polls show Republican David Perdue slightly leading Democrat Jon Ossoff, in keeping with his superior showing on November 3. However, Republican Kelly Loeffler is trailing Democrat Raphael Warnock (Charts 4A and 4B). Last week we argued that the odds of Democrats winning both races stood around 20%. If anything this view is generous – given that Perdue already beat Ossoff, and Warnock will continue to suffer attacks for associating with Fidel Castro – but it is in line with online betting markets (Chart 5). Chart 4AVoters Split On Georgia Senate Runoffs Chart 4BVoters Split On Georgia Senate Runoffs Chart 5Democrats Have ~20% Chance To Win Senate Investors should plan on the US government being gridlocked unless something occurs that fundamentally changes the Georgia race. Gridlock is positive, so if Trump’s election disputes keep the Republican political base spirited for the Georgia runoffs, then Trump’s activities have an ironic upside for markets. That is, as long as he doesn’t succeed in overturning the election result and the flames of discontent do not break out into a significant violent incident. Other fears about the transition period are less concerning. Several clients have asked us what should happen if President Elect Biden came down with COVID-19 or were otherwise incapacitated. The answer is that Vice President Elect Kamala Harris would take his place, as she now has popular consent to do exactly that. Prior to the Electoral College voting on December 14, the Democratic National Committee would have to nominate a candidate to replace Biden, almost certainly Harris. After December 14, the regular succession would apply under the twentieth amendment and Harris would automatically fill Biden’s shoes. Harris is only slightly more negative for equities than Biden: her regulatory pen would be more anti-business, but like Biden her main policies depend entirely on control of the senate. Bottom Line: It ain’t over till it’s over. The big picture is positive for risk assets but a surprise from ongoing election disputes or the unusually rocky transition of power would trigger a new bout of volatility. Stay long Japanese yen and health stocks on a tactical time frame. Trump’s Lame Duck Risk An investor in the Wild West has often criticized us for arguing that Trump would become a “war president” as he became a political lame duck at home. This war president view did pay off with Iran in January 2020, but otherwise the criticism is valid (see Trump’s Abraham Accords). Now Trump is almost certainly a lame duck so we will find out what he intends to do when unshackled from election concerns. Stay long Japanese yen and health stocks on a tactical time frame.  Since losing the election, Trump has fired Defense Secretary Mark Esper, several defense officials have resigned, and CIA Director Gina Haspel is rumored to be next on the chopping block. Most of the officials to depart had broken with the president over the course of the election year, so he may just be dishing out punishment now that the campaign is over. But it is possible that Trump is planning a series of final actions to cement his legacy and that these officials were removed because they got in the way. Chart 6Trump's Lame Duck Risk To China And Taiwan Strait First, there is no doubt that Trump is already tightening sanctions on China and Iran. China was the origin of the coronavirus pandemic and Trump has called for reparations, which could mean more tariff hikes. His outstanding legacy in US history will be his insistence that the US confront China. We are fully prepared for this outcome and remain short the renminbi and Taiwanese equities, despite their strong performance year-to-date (Chart 6). Trump could also raise tariffs on Europe. However, investors should be used to tariffs and sanctions by now. The impact would be fleeting and the next administration could reverse it. In the case of the renminbi, or any tariffs that weigh on the euro, investors should buy on the dips. By contrast, there are some conceivable actions – we are speculating – that would be extremely destabilizing and possibly irreversible. These would include: Extending diplomatic recognition to Taiwan, potentially provoking a war with China. Sending aircraft carriers into the Taiwan Strait, like Bill Clinton did during the Third Taiwan Strait Crisis, to shore up US deterrence. Launching surgical strikes against Iran’s ballistic missile and nuclear facilities or critical infrastructure. A prominent official has already denied that Trump intends anything of the sort. Launching surgical strikes against North Korea’s ballistic missile and nuclear facilities. No sign of this, but Kim Jong Un did enhance his capabilities after his meetings with Trump, thus embarrassing the president on a major foreign policy initiative ahead of the election. Providing intelligence and assistance to US allies like Israel who may seek to sabotage or attack Iran now or in future to prevent it from acquiring nuclear weapons. Withdrawing US troops from Germany or South Korea – which is much more consequential than hasty withdrawals from Afghanistan or Syria, which Trump clearly intends. War actions are largely infeasible. The bureaucracy would refuse to implement them. Assuming the Department of Defense would slow-walk any attempts to reduce troops in important regions like Germany or Korea, it would almost certainly avoid instigating a war. Withdrawing troops from Afghanistan or Syria is manageable, and fitting with Trump’s legacy, but it would not be disruptive for financial markets. A diplomatic upgrade or a show of force to demonstrate the American commitment to defend Taiwan is possible and highly disruptive for global financial markets. The critical risk may come from US allies or partners that are threatened by the impending Biden administration and have a window of opportunity to act with full American support while Trump still inhabits the Oval Office. The likeliest candidate would be Israel and Saudi Arabia on the Iranian nuclear program. Trump’s onetime national security advisor, H. R. McMaster, has already warned that Israel could act on the “Begin Doctrine,” which calls for targeted preventive strikes against hostile nuclear capabilities.3 Even here, Israel is unlikely to jeopardize its critical security relationship with the United States, so any actions would be limited, but they could still bring a major increase in regional tensions. Saudi Arabia can do little on its own but President Trump could willingly or unwilling encourage provocative actions. Chart 7Big Tech Is Not Priced For Surprises Any number of incidents or provocations could occur in this risky interregnum between Trump and Biden. Some suggest Trump will release a treasure trove of documents to discredit Washington and the Deep State. If that is all that occurs, then investors will be able to give a sigh of relief, as revelations of government intrigue would have to be truly consequential for future events in order to cause a notable market impact. Last-minute executive orders on regulating domestic industries are just as likely to shock markets as any international moves. We speculate that Big Tech is in Trump’s sights for censoring his comments during the election. In the wake of the Supreme Court’s decision in Department of Homeland Security versus Regents of the University of California, the Trump administration is positively incentivized to issue a flurry of executive orders and write them in a way that makes them hard for the Biden administration to rescind them.4 Tech is priced for perfection, despite ruffles due to the vaccine this week, and investors expect Biden-Harris to maintain Obama’s alliance with Silicon Valley, not least because Biden has named executives from Facebook and Apple to his transition team and is considering putting former Google chief Eric Schmidt in charge of a Big Tech task force (Chart 7).5 Ultimately we have no idea what the Trump administration will do in its final two months. A lot of Trump’s attention will be focused on contesting the election. Drastic or reckless decisions will likely be obstructed by the bureaucracy. But the president still retains immense powers and there are executive orders that are legitimate and would benefit the US’s long-term interests even if disruptive for financial markets – and these would be harder for officials to disobey. Trump is an anti-establishment player who intends to shake up Washington, stay involved in politics, and cement his legacy. There is a reason for investors to take political risk seriously rather than to assume that the transition to a more market-friendly administration will be smooth. Bottom Line: Stay long gold on geopolitical risk, despite the potential for a counter-trend rise in the US dollar. We are neutral tech: polarization and fiscal risks are positive for tech shares but reopening and Trump lame duck risks are negative. Biden’s Cabinet Picks This “lame duck Trump” risk explains why we are not overly concerned about Biden’s cabinet picks. Insofar as Biden’s choices affect the market at all, they will confirm the “return to normalcy” theme and hence will be market-friendly. Take for example Biden’s just-announced chief of staff, Ronald Klain, who was chief of staff when Biden served as vice president from 2009- 16. The current transition is obstructed by election disputes, as occurred in November-December of 2000, but the cabinet picks are not likely to bring negative surprises. Already Biden has announced a coronavirus advisory board, a bipartisan transition team, and is pondering other picks, some of which will be known by Thanksgiving. None of the choices are in the least disruptive or radical – and most are acceptable to Wall Street. Biden will pick experts and technocrats who are known from his political career, the Obama administration, the Clinton administration, the Democratic Party, and academia. The market will invariably approve of establishment nominations after four years of anti-establishment picks and spontaneous firings. Since the Senate will remain in Republican hands, the cabinet members will have to be centrist enough to be confirmed. While Biden will inevitably nominate a few progressives, they will either fail in the Senate or take up marginal posts. Stay long gold on Trump “lame duck” geopolitical risks. Biden may have the opportunity to appoint three or even four members to the Federal Reserve’s board of governors. The Trump administration failed to fill two seats, while Fed Chair Jerome Powell’s term will expire in February 2022 (Diagram 1). If Biden appoints Lael Brainard to another post, such as Treasury Secretary, he will have a fourth space to fill. Diagram 1Biden Could Have Three-To-Four Fed Picks Chart 8Facing Gridlock, Biden Will Re-Regulate The implication will be a further entrenchment of dovish policy, with greater attention to new concerns that fall outside of traditional monetary policy such as climate change and racial inequality. The Fed has already committed to pursuing “maximum employment,” refraining from rate hikes till the end of 2023, and targeting average inflation – all a major boon to the Biden administration as it attempts to revive the economy. What is negative for markets is that Biden will re-regulate the economy – after Trump’s deregulatory shock – and that this will bring about political risks for small business and key industries like health, financials, and energy (Chart 8). Biden has little other option given that his legislative agenda will be largely stymied. Nevertheless, the sectors most likely to be heavily impacted are attractively valued and stand to benefit from economic normalization if not from Biden’s version of normalcy. Bottom Line: Stay long health and energy. Yes, Gridlock Is Best For Markets Some clients have asked us about our view that gridlocked government is truly the best for financial markets. Wouldn’t Democrats winning control of the Senate in Georgia be better, as it would usher in greater political certainty and larger fiscal spending? We have addressed this issue in previous reports so we will be brief. First, yes, gridlock has higher returns than single-party sweep governments on average over the past 120 years (Chart 9). Clearly the normalcy rally can go higher, but it is equally clear that it will get caught by surprise when the political reality hits home.  Second, however, the stock market’s annual returns are roughly average under single-party sweeps during this period (Chart 10). Chart 9Gridlock Best For Markets Chart 10Single-Party Sweeps Generate Average Annual Returns So while investors can cheer gridlock, it is not as if they should sell everything if Democrats do win control of the Senate on January 5. Chart 11Sweeps As Good As Gridlock Over 70 Years Indeed, looking at the period after World War II, sweep governments have witnessed average annual returns that are the same or slightly better than under gridlock (Chart 11). Whereas limiting the study to the post-Reagan era, gridlocks are clearly favored. If greater fiscal resources are needed then gridlock will quickly become a market risk rather than an opportunity. It is notable that over the past 120 years, there is not an example of a Democratic president presiding over a Republican senate and a Democratic House. There was only one case of the inverse – a Republican President, a Democratic senate, and a Republican House – which occurred in 2001-02 and coincided with a bear market. In fact, this episode should be classified as a Republican sweep, as in Table 2, since a sweep was the result of the 2000 election and the context of the key market-relevant legislation in 2001.6 Table 2Average Annual Equity Returns And Gridlock Government Chart 12Market Predicted Gridlock In 2020 In 2020 the stock market clearly anticipated a gridlocked outcome – the market’s performance matches with the historical profile of divided government (Chart 12). We argued that this was the best case for the market because it meant neither right-wing populism nor left-wing socialism. But we also highlighted that any relief rally on election results (reduced uncertainty) would be cut short by the major near-term implication of gridlock: a delay of fiscal support for the economy in the near term. This was the only deflationary scenario on offer in this election. Hence bad news in winter 2020-21 would precede the good news over the entire 2020-22 period. This is still largely our view, but we admit that the vaccine announcement erodes near-term risk aversion even further. There is little substance to the discussion of whether Americans will take the vaccine or not. Evidence shows that Americans are no less likely to take vaccines than other developed country citizens – assuming they are demonstrated to be safe and effective (Chart 13). Chart 13Yes, Americans Take Vaccines So gridlock looks even better now than it did previously. Yet we still think the near-term fiscal risks will hit markets sometime soon. Senate Republicans have been emboldened by the fact that their relative hawkishness paid off in the election on November 3. If they would not capitulate to House Speaker Nancy Pelosi prior to the election, they are even less likely to do so after gaining seats in the House, retaining the Senate, and crying foul over the presidential election. McConnell could agree to a $500 billion deal before Christmas – or not. There is no clear basis for optimism. A government shutdown is even possible if the continuing resolution expires on December 12. If the economic data turns sour and/or markets sell off dramatically then the Republicans will be forced to agree to a bigger deal, but as things stand they are not forced to do anything. And that presents a downside risk to the normalcy rally. Investment Takeaways Today’s post-election environment is comparable to the period after 2010, when a new business cycle was beginning and a new President Barack Obama had to face down Republican fiscal hawks in the House of Representatives. Today’s GOP senators may prove somewhat more cooperative with President Elect Biden, but that remains to be seen. Given how tight the election was, Republicans have an incentive to obstruct, slow down the economic recovery, and contest the 2022 midterms and 2024 election on the back of another slow-burn recovery. It worked last time. The debt ceiling crises of 2011 and 2012-13 were different than the fiscal stimulus cliff that Washington faces today but the market implications are similar. At the climax of brinkmanship between the president and the senate, treasuries will rally, the dollar will rally, stocks will fall, and emerging markets will underperform (Charts 14A and 14B). Today there is a greater limit on how far the dollar will rise and how far treasury yields will fall, but a fiscal impasse will still drive flows into these assets. Chart 14AObama’s Debt Ceiling Crises… Chart 14B… Presage Biden’s Fiscal Cliffs ​​​​​​​This is what we expect over the next three months. The fact that President Trump could bring negative surprises only enhances this expectation. Therefore we are only gradually adding risk to our strategic portfolio and maintaining tactically defensive positions. Clearly the normalcy rally can go higher, but it is equally clear to us that it will get caught by surprise when the political reality hits home. Since this could be anytime over the next two months, we are only gradually adding new risk. We would not deny that the outlook is brighter over the 12-24-month periods due to the vaccine and election results.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Chris Matthews, "Alleging fraud, GOP seeks to overturn election results in Michigan, Pennsylvania," MarketWatch, November 10, 2020, marketwatch.com. 2 See Senator Jake Corman and Representative Kerry Benninghoff, "Pennsylvania lawmakers have no role to play in deciding the presidential election," Centre Daily, October 19, 2020, centredailly.com. As for the 1876 “Stolen Election,” the initial election results suggested that Democrat Samuel Tilden had won 184 electoral votes while Republican Rutherford B. Hayes had won 165. The amount needed for a majority in the Electoral College at the time was 185, so Tilden fell one vote short while Hayes fell 20 votes short. After partisan litigation, actions by state legislatures, an intervention by the US House of Representatives, and a grand political compromise, Hayes won with 185 votes. 3 See Charles Creitz, "McMaster warns Biden on Iran deal: Don't resurrect 'political disaster masquerading as a diplomatic triumph,’" Fox News, November 12, 2020, foxnews.com. 4 In this ruling, which was decided on a 5-4 split with Chief Justice John Roberts siding with liberal justices, the Supreme Court denied the Trump administration’s effort to overturn the Obama administration’s policy known as Deferred Action on Childhood Arrivals (DACA), which stopped the US from deporting illegal immigrants who came to the US as children. The majority opinion argued that the Trump administration had merely asserted, not demonstrated, that the Obama administration’s executive orders were unconstitutional. In doing so, it established a precedent by which the court can determine whether one president’s executive orders should overrule another’s. While future administrations may follow better procedures in attempting to revoke their predecessors’ orders, this decision likely incentivizes the Trump administration to try to issue decrees that will be difficult to revoke. See John Yoo, "How the Supreme Court’s DACA decision harms the Constitution, the presidency, Congress, and the country," American Enterprise Institute, June 22, 2020, aei.org. 5 See Kiran Stacey, “What can Silicon Valley expect from Joe Biden?” Financial Times, November 8, 2020, ft.com. 6 The election produced a Republican sweep, with a 50-50 balance in the Senate, that led to the Bush tax cuts in May 2001. The business cycle was ending, however. In June, Democrats took the senate majority when Republican Senator Jim Jeffords of Vermont became an independent and began caucusing with Democrats. In September terrorists attacked the World Trade Center causing a market collapse.

Highlights US inflation expectations will moderate, and US real yields will rise. This will support the US dollar. The potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Rising US real yields are a risk to high-multiple global growth stocks. Maintain a neutral allocation to EM in global equity and credit portfolios. Feature In this week’s report we identify market-relevant issues and topics and then present the investment implications of these potential developments. Current key investment-relevant topics and issues are as follows: 1. Implications of the US elections Fiscal Stimulus: In the context of Biden’s victory and the Senate remaining Republican, the odds of a meaningful fiscal package in the next several months are quite low. The Republican Senate did not support a fiscal package going into the elections. Odds are low that it will now agree to a fiscal package larger than $750 billion. Chart 1Rising US Real Yields Are Positive For The US Dollar According to the US Congressional Budget Office’s calculations, without a new fiscal package, the fiscal thrust in 2021 will be -7.5% of GDP or $1.5 trillion. Hence, fiscal stimulus should be more than $1 trillion to avoid a slump in growth. Granted that the recovery in US consumer income and spending that has been underway since April has to a large extent been supported by US fiscal transfers, the lack of current government income support to households poses a risk to the economy.  Of course, if US economic activity tanks again and the stock market plunges, Republicans will support a much larger package. However, as things stand now, the probability of a substantial (more than $1 trillion) fiscal package is low. The lack of fiscal stimulus implies that US growth and inflation expectations will moderate. Chart 1 shows that US inflation expectations have probably reached an apex and will downshift for now. US nominal bond yields are capped on the upside (by the Fed’s purchases and its commitment not to raise interest rates for several years) and on the downside (by the Fed’s reluctance to reach negative interest rates). Consequently, swings in inflation expectations will drive fluctuations in real yields, as has been occurring in recent months. As inflation expectations decline, real yields will rise. Impact of rising US real yields on financial markets: A stronger US dollar and lower prices for Nasdaq stocks. Rising real rates will support the US dollar (Chart 1, bottom panel). Chart 5 on page 5 reveals that the real rates differential between the US and the euro area has recently been moving in favor of the greenback.  Chart 2Rising US Real Yields Are Negative For Growth Stocks Budding investor realization that the US might not pursue an aggressively expansionary fiscal policy, as has been expected since spring, could also support the greenback. Less issuance of Treasury securities might be interpreted as less public debt monetization and less money creation by the Federal Reserve. Such a viewpoint will also be marginally positive for the US dollar. As to the equity market, US real (TIPS) yields have been negatively correlated with the Nasdaq index (Chart 2). As US real yields continue to rise, odds are that global growth stocks will come under selling pressure. Geopolitical ramifications: The impact of the forthcoming change in the White House on US foreign policy has been widely anticipated and has already been priced in by financial markets. A Biden administration will have a positive impact on the euro area, Canada, Mexico and Asia Pacific countries with the exception of China – as was not the case under the Trump administration. On the other end, Russia, Turkey and Saudi Arabia will be under heat from Biden’s White House. In our view, the impact on China will be neutral, not better than during Trump’s administration. It might be mildly positive in the near term but negative in the long run. In the short run, the new US administration will be less likely to use global trade as a weapon. In the long run, however, Biden will likely mobilize Europe to join its geopolitical confrontation with China. This will be negative for the Middle Kingdom.   One country where the impact of Biden’s administration has not been fully priced in is Brazil. The US executive branch will take a tougher stance in its dealings with Brazil’s right-wing government because their social values are not aligned and policy priorities differ. We remain short the BRL and underweight Brazilian equity and fixed-income markets within their respective EM portfolios. 2. Vaccines We have no better expertise than the market’s judgement on the timing of vaccine availability and its effectiveness in containing the pandemic in EM ex-China countries. It is clear, however, that the process of vaccine acquisition and distribution might be slower in EM ex-China than in advanced countries. On all three fronts – the spread of the pandemic, policy stimulus and vaccine distribution – EM excluding China, Korea and Taiwan will continue lagging DM. Therefore, EM ex-China domestic demand will continue to underperform relative to expectations and versus those in DM. This argues for continuous underweight, or at best a neutral allocation, in EM ex-China, Korea and Taiwan equities versus their DM peers. Chart 3Chinese Onshore Equities Have Been In A Trading Range Since Early July 3. China: the business cycle and regulatory clampdown China’s business cycle recovery has further to go. The stimulus injected into the economy has been considerable and will continue to work its way into the economy. Even though we believe that China has reached peak stimulus, the latter works with a time lag of 6-12 months and economic growth will top only around mid-2021. That said, Chinese onshore share prices have been in a consolidation phase since early July and this is likely not over yet (Chart 3).  In turn, Chinese investable stocks have been surging in absolute terms and outperforming the global equity index (Chart 4, top panel). However, the entire Chinese equity outperformance has been due to growth stocks (TMT/new economy). Excluding these, the absolute and relative performance of Chinese investable stocks has been lackluster (Chart 4, top and bottom panels). Chart 4Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks In short, the spectacular performance of Chinese investable stocks this year has been attributed to three new economy stocks: Alibaba, Tencent and Meituan. These three stocks presently account for 40.5% of China’s MSCI Investable Index and 17.5% of the aggregate EM MSCI equity index. Concerns about regulatory clampdowns on new economy stocks have been, and remain, a major risk, not only in China but also in advanced economies. It is impossible to time regulatory actions. Nevertheless, investors should take into account the possibility that regulation may curb the profitability of new economy companies, especially if they are de-facto monopolies or oligopolies. Chinese authorities will not back down from imposing new regulation and scrutiny over the activities of giant new economy companies. Hence, risks of further de-rating remain elevated. In short, even though the mainland business cycle recovery is on a track, Chinese share prices remain at risk of correction due to overbought conditions and re-pricing of regulatory risks for new economy stocks. Will The US Dollar Capture Some Of Its Luster? US real yields are rising not only in absolute terms, but also relative to real yields in the euro area (Chart 5). Rising real yields in the US versus the euro area generally lead to a dollar rally against the euro.  Apart from rising US real bond yields, there are a number of other factors that will likely support the greenback: Investor sentiment on the US dollar is very low (Chart 6). From a contrarian perspective, this is positive. Chart 5The US Versus Euro Area: Real Yield Differentials And Exchange Rate Chart 6Investors Are Downbeat On The US Dollar   Consistently, investors are very short the US dollar, especially versus DM currencies (Charts 7and 8). Positioning is less short in the US dollar versus cyclical DM and high-beta EM currencies (Chart 8). That said, the fundamentals of EM high-beta currencies such as BRL, TRY, ZAR and IDR are poor. Chart 7Investors Are Very Long Safe-Haven Currencies… Chart 8...And Modestly Long Cyclical Currencies   The Republican Senate will block corporate tax increases and limit any regulatory initiatives by Democrats in Congress. Such business-friendly policies are currency bullish. In short, a Republican Senate is broadly positive for the US dollar, and markets have not priced it in. The fact that broad US equity averages – such as small caps and equal-weighted equity indexes – continue outperforming the rest of the world in local currency terms is also dollar bullish (Chart 9). The reasoning is that US equity outperformance versus the rest of the world suggests better profitability and return on capital in the US versus its peers. That favors a firmer US dollar. Finally, the broad-trade weighted US dollar is oversold and is sitting on a long-term technical resistance level (Chart 10). Chart 9US Relative Equity Outperformance Heralds A Stronger US Dollar Chart 10The US Dollar Is Very Oversold   Bottom Line: We have been highlighting downside risks to the US dollar since July 9. However, the conclusion of the US election raises the odds of a playable US dollar rebound. EM Strategy EM Equities We have been advocating for a neutral allocation toward EM in a global equity portfolio since July 30. If the US dollar rebounds, as we expect, EM stocks will not outperform the global equity index (Chart 11). Notably, excluding Chinese investable stocks, EM share prices have not outperformed the global benchmark (Chart 12). Besides, as shown in the top panel of Chart 4 on page 4, China’s outperformance against the global equity benchmark has been driven exclusively by new economy stocks. Chart 11EM Stocks Do Not Outperform When The Dollar Rallies Chart 12EM Versus Global Equity Performance: With And Without China   All in all, Charts 4 and 12 reveal that excluding three large Chinese new economy stocks – Alibaba, Tencent and Meituan – EM share prices have underperformed the global equity benchmark. Going forward, the potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Meanwhile, the correction in the NASDAQ and the increased scrutiny on the part of Chinese authorities over new economy stocks poses a risk to Chinese mega-cap TMT share prices. In absolute terms, we have been waiting for a pullback to buy EM equities, but they have surged following the US elections and the news on Pfizer’s vaccine. Chart 13EM Equity Index: No Breakout Yet The EM equity index could still advance and reach its 2011 or 2018 highs before rolling over (Chart 13). However, given our view on the US currency and risks to EM stemming from a rising US dollar, we refrain from playing such limited upside. EM currencies EM currencies will be at a risk if the US dollar stages a rebound. Since July 9, we have been shorting a basket of BRL, CLP, TRY, KRW, ZAR and IDR versus an equally-weighted basket of the euro, CHF and JPY. We are sticking with this strategy. Even if the US dollar rebounds, downsides in the euro, CHF and JPY against the greenback will be relatively limited. However, investors might consider adding the US dollar to the long side of this strategy. EM local bonds and EM credit markets We continue recommending long duration in EM local rates. However, we remain reluctant to take on currency risk. We maintain our recommendations from April 23 about receiving 10-year swap rates in Mexico, Colombia, Russia, India, China and Korea. We are also receiving 2-year rates in Malaysia and South Africa as a bet on rate cuts in these economies. In the EM credit space, we are also neutral. Our sovereign credit overweights are Mexico, Colombia, Peru, Russia, Thailand, Malaysia and the Philippines. Our underweights are South Africa, Turkey, Indonesia, Argentina and Brazil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations