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Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 19 at 10:00 AM EDT, 3:00 PM BST, 4:00 PM CEST, 11:00 PM HKT). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist

Highlights A slower money and credit growth in China will eventually generate disinflationary pressures by weighing on demand for commodities. The PBoC has shifted its inflation anchor and policy framework to target core CPI and the PPI rather than headline CPI. Beijing is scaling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. In the next six to nine months we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. We are long CSI500 relative to China’s A shares. The CSI500 has a larger exposure to the global economy and lower valuation relative to China’s broad onshore market.  Feature As a follow up to last week’s report, we look at another topic raised in recent client meetings: whether rapidly rising producer prices in China will morph into a broad-based inflationary risk and how macroeconomic policies will evolve to counter such a risk. Clients who believe that the ongoing producer price inflation is transitory cited China’s low consumer price inflation, and slowing money and credit growth, as leading indicators of budding disinflationary pressures. Advocates of sustained inflation pointed to robust recoveries and demand among advanced economies, extremely accommodative monetary conditions worldwide, massive fiscal stimulus in the US, a weak US dollar, and supply constraints. It remains to be seen what the worldwide pandemic’s impact will be on the balance between global production capacity and aggregate demand. In this report we analyze the PBoC’s inflation target and policy framework, and conclude that while China’s monetary policy has not become more hawkish, policy tightening seems to be taking place on the fiscal front. Is Inflation In China A Risk? It is debatable whether the strong rebound in GDP growth in Q4 last year and in Q1 this year has closed China’s output gap and will lead to widespread inflation. Given data distortions due to low-base effects from the previous year and uncertainty about China’s productivity and labor force growth, any calculation of the output gap will be unreliable. In addition, China’s employment statistics lack cyclicality and cannot be used to gauge inflationary pressure stemming from wage growth and unit labor costs.     Chart 1A Rollover In Credit Growth Will Weigh On Chinese Demand For Commodities Our cyclical view of inflation is therefore based on the framework that the ongoing moderation in China's money and credit growth will eventually generate disinflationary pressures by weighing on the country’s demand for and price of commodities (Chart 1).  Furthermore, behind a resilient PPI, there are suggestions that the strength in China’s economy is still bifurcated. A narrow-based uptrend in the PPI lacks the ground for sustained inflation, and is unlikely to trigger a general tightening in monetary policy.  While mounting global prices for raw materials propelled strong upstream PPI, producer prices for consumer goods and core consumer price inflation remain very subdued (Chart 2).  The inconsistency in producer prices among various industries highlight the unevenness of the economic recovery and, importantly, persistently muted household consumption (Chart 3). Chart 2A Bifurcated Economic Recovery Chart 3A Muted Recovery In Household Consumption Chart 4Weak Price Transmission From Upstream To Downstream Industries The transmission from upstream industrial PPI to the middle and downstream sectors has also been weak (Chart 4). It is evidenced in the faster growth of manufacturing output volume compared with price increases (Chart 5). This contrasts with the previous inflationary cycles, as well as mining and ferrous metals where surging prices for raw materials have way surpassed recovery in output volume (Chart 6). Given that price changes are more important to corporate profits than volume changes, Chinese middle-to-downstream industries face downward pressure on their profit margins and will likely deliver disappointing profits, despite a strong rebound in production. Chart 5China's Manufacturing Recovery: Stronger Volume Than Prices Chart 6China's Upstream Industries: Prices Surged Faster Than Production Furthermore, PMI input prices, which lead core CPI by about nine months, rolled over in April (Chart 7). While it is too soon to conclude that input prices have peaked, it is implied that upward pressure on core CPI from input prices may start to ease in 2H21. Bottom Line: So far there is no sign that elevated upstream producer prices will create sustainable inflationary pressure on consumer prices. Hence our view is that the PBoC will not respond to a rising PPI by further tightening monetary policy. Chart 7PMI Input Prices Have Rolled Over Chart 8Core CPI And PPI Have Been The PBoC's Inflation Targets Since 2015 The PBoC’s Inflation Target Since 2015, China’s monetary tightening cycles have closely correlated with a combination of the core CPI and PPI instead of headline CPI (Chart 8). The shift to targeting core CPI and PPI occurred despite the central bank’s frequent mention of headline CPI as its inflation target. The reasons for the shift are twofold. First, swings in food and fuel prices have become much larger since 2014, often dominating fluctuations in headline CPI (Chart 9).  Secondly, the price swings were often driven by supply-side factors and did not reflect changes in demand. Therefore, monetary policies could do little to mitigate inflationary or deflationary pressures. Furthermore, the PPI seems to play a greater role in the PBoC’s monetary policymaking than the headline and core CPI (Chart 10).  The tighter relationship between the de facto policy rate and the PPI is not surprising, given that China’s ex-factory price inflation reflects changes in corporate pricing, profit, and inventory cycles – all are driven by the country’s money supply and credit cycles.  Chart 9Large Swings In Food And Energy Prices Distorted Headline CPI In Recent Years Chart 10PPI Plays A Greater Role In The PBoC's Monetary Policymaking The relationship between the 7-day repo rate - the de jure policy rate - and the PPI has broken down since 2015 (Chart 11). Meanwhile, the 3-month repo rate has maintained a close relationship with the PPI (Chart 10, bottom panel). The change in the relationship is because the PBoC shifted its policy to target interest rates instead of the quantity of money supply since 2015 (Chart 12). Moreover, since 2016 the PBoC has generated monetary policy tightening measures through changes in its Macro Prudential Assessment Framework (MPA) rather than directly through interest rate hikes.  Chart 11Relationship Between The 7-Day Repo Rate And The PPI Has Broken Down Since 2015... Chart 12...Due To Monetary Policy Regime Shifted Bottom Line:  The PBoC has shifted its inflation anchor and policy framework since 2015. Core CPI and the PPI are now the main inflation targets. A Quiet Fiscal Tightening? Despite a jump in the PPI, the 3-month repo rate fell sharply in the past two months (Chart 10 on page 6, bottom panel).  It is possible that the PBoC considers escalating producer prices as transitory and, therefore, intends to keep its overall policy stance unchanged. However, the PBoC’s relaxed policy response towards inflation risk may be explained by Beijing’s quiet tightening on the fiscal front. Chart 13The Central Bank Has Made Little Interbank Liquidity Injections Lately The PBoC can hold its policy rates steady by supplying adequate liquidity to the interbank system through open market operations or by reducing the demand for liquidity. On a net basis, the PBoC has recently injected very little liquidity into the interbank system, implying that banks’ liquidity demand has likely softened (Chart 13).  This might be a sign of weakening credit origination. In a previous report we discussed how fiscal stimulus has become a more relevant driver of China’s credit origination since the onset of the 2014/15 economic downcycle. A rising 3-month SHIBOR can be the result of rapid fiscal and quasi-fiscal expansions, which occurred in Q3 last year. A flood of local government bond issuance drained liquidity from commercial banks, which boosted the banks’ needs to borrow money from the interbank system and pushed up interbank rates. Despite higher interest rates, credit growth soared in Q3 as fiscal multiplier provided an imminent and powerful reflationary force to the economy. In contrast, local government bond issuance was down sharply in the first four months of this year, compared with 2019 and 2020. Local governments sold 222.7 billion yuan of special-purpose bonds (SPBs) from January to April, a plunge from 730 billion yuan of debt sold in the same period in 2019 and 1.15 trillion yuan in 2020. The total local government bond issuance in Q1 this year has also been 36% and 44% lower than in Q1 2019 and 2020, respectively. A lack of local governments’ appetite to borrow coupled with a shortage in profitable infrastructure projects might have contributed to the sharp drop in bond issuance this year. Local government financing and spending have been under increased scrutiny this year. Following the State Council Executive Meeting in late March, in which Premier Li Keqiang pledged to reduce government leverage ratio and raise regulatory standards on infrastructure investment, Beijing suspended two high-speed rail projects that were initiated by provincial governments. Messages from Politburo’s meeting last week reinforced our view that policymakers may be scaling back fiscal support while further tightening regulations in the property sector. Both aspects have the potential to cool China’s demand for industrial metals and global industrial material prices (Chart 14 and Chart 15). Chart 14A Slowdown In Chinese Manufacturing Demand Will Have A Greater Impact On Global Industrial Material Prices Chart 15Lower Housing Demand In China Will Help To Cool Industrial Metal Prices We expect the intensity of policy tightening to reach its peak between mid-year to third-quarter 2021. It is unclear at this point whether policymakers are willing to allow local governments to significantly undershoot their SPB quota for this year. Local governments reportedly experienced a shortage in profitable investment projects towards the end of last year, and thus, parked more than 10% of proceeds from 2020 SPB issuance at the central bank. The central government may be taking a wait-and-see attitude this year, and saving more fiscal dry powder for later this year when the economic slowdown becomes more meaningful. Bottom Line: Beijing is pulling back its fiscal supports and cooling the property sector to tackle local government and housing sector debt issues. The deleveraging efforts will curb China’s demand for commodities, and may work to ease inflationary pressure on prices for raw materials. Investment Conclusions The outlook for China’s risk asset prices remains bearish, at least in the next six months. If the credit and fiscal impulse slow enough to depress corporate pricing power, inflation will not be a problem because disinflationary pressures will resurface. However, the growth of corporate profits will disappoint (Chart 16). Beijing may be saving more fiscal dry powder for later this year. Still, SPBs are only a small part of local governments’ financing source for infrastructure projects. Given the central government’s renewed focus on reducing public debt, policymakers are unlikely to unleash fiscal power to significantly boost infrastructure spending or economic growth. In the next six to nine months, we favor companies and sectors that will benefit from global economic recovery rather than China’s domestic demand. With this week's report, we initiate a long position on the CSI500 index, which has a larger exposure to the global market and lower valuation relative to China’s broad onshore market (Chart 17).  Chart 16Aggregate Corporate Profit Growth Will Slow Even Though Inflation Is No Longer An Issue Chart 17Long CSI500/Broad Market   Jing Sima China Strategist jings@bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

ハイライト もし完全に実施されれば、バイデン大統領の メイド・イン・アメリカ税制プラン はS&P 500の利益を約8%押し下げることになります。私たちはいくつかの提案された税制措置が弱められると予想しており、実際の影響は利益が5%減少する程度になると見ています。 強い経済成長と緩和的な金融政策からの継続的な支援を考えれば、投資家は短期的な増税の影響をやすやすと受け流す可能性が高いです。 しかし長期を見渡すと、米国の税率が引き上げられ続け、最終的に株価に悪影響を及ぼす水準に達するだろうと考える理由が四つあります。第一に、実効の米国法人税率は依然として非常に低いこと。第二に、トランプ政権の減税が投資支出を押し上げなかったことにより、最終的に減税を完全に元に戻しやすくなっていること。第三に、債券利回りの上昇は借入の増加よりも増税で歳出を賄う方が得策にしてしまうこと。第四に、そして最も重要なのは、企業と富裕層への増税に有利に働く政治的な風向きが変わりつつあることです。 民主党はしばらくの間、経済問題で左傾化してきました。一方で保守的な共和党員は、いまや自分たちを嫌うように見える“ウォーク（woke）”な企業群に対する減税をなぜ支持すべきか自問し始めています。 米国の企業部門は自らの利益を擁護してくれる政党を失うリスクに直面しています。したがって、短期的な株式の見通しは依然として明るいものの、長期的見通しは次第に暗くなっています。 バイデンの税制プラン 3月31日、バイデン大統領は アメリカン・ジョブズ・プラン を発表しました。本プランは公共インフラ等に対し、8年間にわたって合計2.25兆ドルの新たな連邦支出を提案しています。メイド・イン・アメリカ税制プラン に概説されているように、バイデン政権はこの新たな支出パッケージの財源として今後15年間で2兆ドルの税収を確保しようとしています。 税制プランの最も重要な三つの条項は次の通りです： 米国内の法人税率を21%から28%に引き上げること。これにより税率はトランプ減税前の水準（35%）の中間点に戻ることになります。法人利益の世界的配分やその他の要因を考慮すると、こうした増税はS&P 500の利益を約4%押し下げることになります。 米企業の海外利益に対する最低税率の引き上げ。バイデン政権はGlobal Intangible Low-Taxed Income（GILTI）の最低税率を10.5%から21%へ倍増することを提案しています。また、Foreign-Derived Intangible Income控除（FDII）を廃止する計画です。これら二つの措置はS&P 500の利益をさらに約3.5%押し下げることになります。 「ブック・インカム」（すなわち企業が株主に報告する利益）に対する15%の最低税。年間利益が20億ドルを超える法人に適用されます。財務省はこの税の対象となる企業は45社になると見積もっています。これはS&P 500の利益をさらに0.5%押し下げます。 これらを合わせると、S&P 500の利益は約8%減少します。実際には、影響は5%前後に近いと考えています。バイデン案にはクリーン・エネルギーや研究開発（R&D）などを対象とした各種税額控除が含まれており、これが一部の増税を相殺するはずです。また最終的な法人税率は28%に達しない可能性が高いです。重要なスイング票であるウェストバージニア州の上院議員ジョー・マンチンは既に25%で抑えることを好むと述べています。 何が既に織り込まれているか？ チャート 1 増税で最も打撃を受ける可能性のある企業群は好調に推移している 増税で最も損失を被る可能性のある企業は好調に推移している 増税で最も損失を被る可能性のある企業は好調に推移している 私たちのデータの読み取りでは、増税の影響はアナリストの利益予想や市場の期待のいずれにもほとんど織り込まれていないようです。 チャート 1 はゴールドマンの「Formerly High Tax（以前は高税）」と「Formerly Low Tax（以前は低税）」の株式バスケットのパフォーマンスを示しています。以前高税だった企業はトランプの減税で最も恩恵を受け、減税が巻き戻された場合には最も損をすることが想定されます。それにもかかわらず、これらはジョージア州の決選投票で上院が民主党に渡って以来、低税の同業者をアウトパフォームしています。 同様に、利益見通しも増税の見込みに反応していません。これは驚くべきことではありません。チャート 2 は、アナリストが利益見積りを調整したのはドナルド・トランプ大統領がTax Cuts and Jobs Actに署名して法制化した2017年12月22日を過ぎてからであったことを示しています。当時と同様に、アナリストは最終的な税制パッケージの詳細を待ってから推計を変えるように見えます。 チャート 2 アナリストは増税の可能性を反映して利益見積りを調整していない アナリストは、税金の増加の可能性を織り込んで利益予想を修正していない アナリストは、税金の増加の可能性を織り込んで利益予想を修正していない 当面は景気循環のダイナミクスが税制より重要 投資コミュニティが増税を織り込んでいないことは株式への逆風ではありますが、控えめな逆風と表現するのが適切でしょう。IBESの推計は依然として2022年のS&P 500企業の利益成長を15%と示しています。来年に企業利益の上昇を阻むには非現実的に大きな税負担が必要になります。 国際通貨基金（IMF）が数週間前に発表した最新の経済見通しは、2022年の米実質GDPが3.5%成長すると予想しており、これはファンドが1月に想定していた水準より1ポイント高い数字です（表 1）。株式リターンと経済成長には強い相関があるため、株式の強気相場は増税があっても生き残る可能性が高いです（チャート 3）。 表 1 成長は依然として堅調 ウォーク資本への課税 ウォーク資本への課税 チャート 3 経済成長が強いときに株は通常債券をアウトパフォームする 景気が強いとき、エクイティは通常、ボンドを上回る 景気が強いとき、エクイティは通常、ボンドを上回る   もちろん、いくつかの銘柄は増税によって打撃を受ける可能性があります。テクノロジーセクターは特に脆弱で、現在S&P 500の中でも最も低い実効税率の一つを享受しているためです（チャート 4）。テック企業は特許のような無形資産からの所得をオフショアの税制回避地に振り向けることにも非常に長けており、まもなく強化されるであろう内国歳入庁（IRS）の標的になる可能性があります。1 現在、私たちはグロース株よりバリュー株を支持しています。増税がテックのような成長セクターに不均衡にマイナスの影響を与える可能性があるという事実は、この見解を強化します。 チャート 4 テックは増税に脆弱である ウォーク・キャピタルへの課税 ウォーク・キャピタルへの課税   増税：長期トレンドの始まりか？ 増税が株価に与える短期的影響についてはそれほど心配していませんが、より長期的な結果については懸念しています。以下で論じるように、バイデンは今後の支出イニシアティブ（例えば今後提示される アメリカン・ファミリーズ・プラン）を賄うために所得税やキャピタルゲイン税を引き上げる可能性が高いだけでなく、法人税を引き上げ続けようという圧力は彼の政権を超えて持続するでしょう。その理由は四つあります： 理由 #1：実効の米国法人税率はいまだ非常に低い チャート 5 法人税収は低い 法人税収は低い 法人税収は低い 2018年4月、Tax Cuts and Jobs Act が施行されて4か月後、議会予算局（CBO）は2019年に米国企業が支払う法人税を2760億ドルと予測しました。しかし最終的に企業が支払ったのは2300億ドルに過ぎませんでした。2 米国の法人所得税収は2018–19年にGDP比でわずか1%にとどまり、2013–17年の半分でした（チャート 5）。ロナルド・レーガンの2期目には、米国企業は約30%の実効税率に直面していました。今日ではそれが15%未満です（チャート 6）。GDP比で見ると、米国政府が徴収する法人税収はほとんどの他のOECD諸国より低くなっています（チャート 7）。   チャート 6 経済全体の実効法人税率は30年以上にわたり縮小してきた 経済全体の実効法人税率は30年以上にわたり縮小し続けている 経済全体の実効法人税率は30年以上にわたり縮小し続けている チャート 7 米国の法人課税は高くない ウォーク資本への課税 ウォーク資本への課税 チャート 8 トランプ氏はIRSに狙われる不運に見舞われた ウォーク資本への課税 ウォーク資本への課税 さらに、米国政府は時に支払われるべき金を集めようとすらしません。資産200億ドル超の法人に対する監査は2011年以降で50%減少しています。年収100万ドル超の個人に対する監査は80%減少しています（チャート 8）。今週上院で証言したチャック・レッティグ内国歳入庁長官は、税の脱漏が政府に年間1兆ドルの損失をもたらしていると推定しました。 理由 #2：トランプの減税が投資支出を押し上げられなかったことが、最終的に減税を完全に逆転しやすくする もしトランプの減税が投資支出を押し上げていたなら、これらが財政赤字に与えるマイナスの影響を見過ごしやすくなったでしょう。しかし証拠は、法人税率の引き下げが資本支出を促進する効果はほとんどなかったことを示しています。 チャート 9 は、Tax Cuts and Jobs Act 可決後の2年間で資本支出がGDP比でほとんど増加していないことを示しています。国際通貨基金によれば、減税のうちわずか5分の1だけが資本投資や研究開発支出の資金に使われました。3 同様に、Hanlon、Hoopes、Slemrodの研究では、S&P 500企業のカンファレンスコールで減税を受けて資本支出を増やす計画について言及した企業は4分の1未満であったと報告されています。4 チャート 9 トランプの減税は投資をほとんど押し上げなかった トランプの減税は投資を促す効果がほとんどなかった トランプの減税は投資を促す効果がほとんどなかった チャート 10 設備投資と知的財産は長持ちしない 事業用設備と知的財産は長持ちしない 事業用設備と知的財産は長持ちしない   なぜ企業投資はあまり上昇しなかったのでしょうか。一つの答えは、利益への課税は資本投資への課税とは同じではないということです。付録1が説明するように、利息費用が税控除の対象である場合、低い法人税は借入を通じて賄われる資本支出に大きな影響を与えない可能性があります。 住宅のような長寿命資産とは異なり、企業の資本ストックの多くは比較的寿命が短い（チャート 10）。事業用機器やソフトウェアの需要は、資本コストよりも総需要の見通しに依存します。 最後に、私たちが 「不平等が量的緩和をもたらした、逆ではない」 と題した報告書で説明したように、今日の企業利益の大部分は何らかの形の独占的な力に帰せられます。標準的な経済理論は、独占的な超過利潤に課税しても生産や投資が減るとは限らないことを示唆しています。 理由 #3：債券利回りの上昇は、借入増加より増税で歳出を賄うことをより合理的にする 金利が依然として極めて低い水準にある間は、増税で政府支出を賄う必要性は差し迫っていません。これは特に、長期的に経済成長（したがって税収）を押し上げると合理的に期待されるインフラ支出に当てはまります。 チャート 11 現状のままだと米国の利払いは急増する 米国の利払いは現状のままでは急増する 米国の利払いは現状のままでは急増する しかし金利が上昇すれば、政府は利払い費の急増に直面するよりも増税を選ぶ方が有利と考えるでしょう。米国を含む多くの経済で公的債務水準は非常に高いため、金利上昇は社会保障プログラムから債券保有者への資金移転を引き起こします。これは有権者に人気がありません。 議会予算局は、歳出削減などの措置が講じられない場合、今後数十年で連邦政府の利払いが急速に膨らむと見積もっています（チャート 11）。次に論じるように、これらの措置は支出削減よりも増税の形を取る可能性が高いでしょう。   理由 #4：企業や富裕層への増税に有利な政治的風向きが強まっている 民主党はしばらくの間左へ移動しています。2001年には「政府が我が国の問題を解決するためにもっと役割を果たすべきだ」と答えた民主党支持者は50%でした。今日ではその割合は83%です（チャート 12）。 チャート 12 民主党支持者はより大きな政府を望んでいる ウォーク資本への課税 ウォーク資本への課税 チャート 13 社会保障・医療関係の大型歳出は今後も増え続ける 社会保障と医療の高額支出は今後も増え続ける 社会保障と医療の高額支出は今後も増え続ける 共和党は小さな政府を好む傾向を示し続けていますが、これは長続きしないかもしれません。メディケアと社会保障は連邦の非利子支出の40%以上を消費しています。両プログラム（特にメディケア）への支出は今後急速に増加する見込みです（チャート 13）。高齢者の政治的志向が共和党寄りである程度あるなら、これは高齢者向け給付を維持するために共和党が増税を支持する傾向を強める可能性があります。 企業や富裕層が社会的にリベラルな政策を支持する傾向が強まっていることは、保守的な共和党員が、なぜ自分たちを嫌うように見える人々や企業への減税を支持し続けるべきかを自問する原因になっています。昨年11月、ジョー・バイデンは米国で最も裕福な郡で20ポイントの差をつけて勝利しましたが、トランプの支持は最も貧しい郡で上昇しました（チャート 14）。この傾向を反映して、「コーポレート・アメリカにほとんど信頼を置いていない」と答えた共和党員の割合は2018年2月の19%から2021年3月には30%に上昇しました（チャート 15）。   チャート 14 民主党は富裕層層で着実に支持を拡大している ウォーク・キャピタルへの課税 ウォーク・キャピタルへの課税 チャート 15 共和党支持者は企業CEOに対してより懐疑的に ウォーク資本への課税 ウォーク資本への課税 共和党支持者の中で、法人税を引き上げることを支持する人の割合は引き下げを支持する人の2倍以上になっています（チャート 16）。全国的には、73%のアメリカ人が企業の影響力に不満を抱いており、これは2001年から25ポイントの上昇です（チャート 17）。 チャート 16 より多くのアメリカ人が富裕層に課税することを望んでいる ウォーク資本への課税 ウォーク資本への課税 チャート 17 大企業に対する態度の悪化 ウォーク資本への課税 ウォーク資本への課税 世論の変化を踏まえれば、バイデンの税制案に対する共和党の反応がいかに「元気がない」ものだったかはさほど驚くべきことではありません。党の指導者たちはプランを形式的に非難した後、迅速に「ウォーク」企業を攻撃する立場に転じました。 ジョージア州の新しい選挙法に対する企業の反応について述べる中で、上院共和党院内総務ミッチ・マコーネルは「我々は権力と富を持つ人々による国民を誤導し脅すための組織的なキャンペーンを目撃している」 と述べました。さらに彼は続けて、「選挙法から環境問題、過激な社会政策、第二改正に至るまで、民間セクターの一部はウォークな並行政府のように振る舞うことに手を出し続けている。企業が憲法秩序の外から我が国を極左の群衆に乗っ取られる手段となれば、重大な結果を招くことになるだろう」と述べました。 私たちが予想するようにこの傾向が続けば、米国の企業部門は自らの利益を守る政党を失うでしょう。したがって短期的な株式の見通しは依然として明るいものの、長期的な見通しはますます暗くなっています。   Peter Berezin チーフ・グローバル・ストラテジスト pberezin@bcaresearch.com   付録1：法人利益への増税が投資を減らすのはどんなときか？ ある企業が機械を1,000ドルで購入するかどうかを検討しているとします。企業は外部の貸出・借入の利回り、すなわち外部金利 r を8%と直面していると仮定します。 付随する表は、機械が生み出す内部収益率（その機械が生成する投資収益）によって企業の利益がどのように変わるかを示しています。 まず、企業が機械の購入を新たな負債の発行で賄う場合を考えます。ここでは内部収益率が10%で機械が永久に使える（すなわち減価償却しない）と仮定します。この場合、機械は年間100ドルの営業収入を生みます。80ドルの利息費用を差し引いた後、企業の税引前利益は20ドルになります（例A）。 企業の所得税率が20%で利息が完全に税控除されるとすると、企業は20*0.2＝4ドルの税金を支払い、税後利益は16ドルになります（例B）。 税金が企業の税後利益を減らしたことに注意してください。とはいえ、それは機械を購入するインセンティブを消滅させるものではありません。20ドルが16ドルになっても、16ドルはゼロより良いのです。 したがって、この単純な例では、資本設備の購入が借入で賄われ、利息支払が完全に税控除される場合、利益課税の導入は投資するか否かの最終判断に影響を与えません。 利息が税控除されない場合は状況が変わります。この場合、企業が機械を買うか否かで無差別になるためには内部収益率が r/(1-t) まで上昇する必要があります。上の例では、内部収益率は8%/(1-0.2)=10%に上がらなければなりません。このとき企業は100ドルの営業利益を得て、その利益に20ドルの税を支払い、80ドルの利息を支払った後にトントンになります（例C）。 利息支払が税控除されない場合、株式による資金調達で新しい資本設備に投資するか否かの計算は、借入の場合と似ています。株式による資金調達を考える最良の方法は、企業が機械を購入した後にその機械の市場価格がいくらになるかを考えることです。税がなく内部収益率が10%であれば、市場価格は100/0.08＝1,250ドルになります（例D）。企業は1,000ドルで買えるので購入するのが合理的です。 もし機械のオーナーがその機械が生み出す所得の流れに対して20%の利益税を支払わなければならないなら、市場価値は80/0.08＝1,000ドルになります（例E）。この時点で企業は機械を購入するかどうかに無差別になります。 機械が永久に持たないという仮定を放棄した場合はどうでしょうか。主な違いは、機械を購入するかどうかの決定が資本コストの変化に対して鈍感になることです。例えば、機械が1年しか持たないとすると、その1年で得られる収益が著しく高くなければ企業にとって購入する価値が出ません（例F）。これにより、機械購入の決定は金利よりも景気循環、特に総需要の見通しにより依存するようになります。   付録 表 1 ウォーク・キャピタルへの課税 ウォーク・キャピタルへの課税 脚注 1 Jed Graham, “バイデンの税制案：Amazon、Google、Facebook、Apple、Microsoftへの影響,” インベスターズ・ビジネス・デイリー (2021年4月8日). 2 “議会予算局の2019会計年度ベースライン見積りの正確性,” 議会予算局（Congressional Budget Office） (2019年12月). 3 Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, “2017年のTax Cuts and Jobs Act以降の米国投資,” 国際通貨基金（IMF）ワーキングペーパー (2019年5月31日). 4 Michelle Hanlon, Jeffrey L. Hoopes, and Joel Slemrod, “Tax Reform Made Me Do It!” NBER ワーキングペーパー 25283 (2018年11月). グローバル・インベストメント・ストラテジー ビュー・マトリックス ウォーク資本への課税 ウォーク資本への課税 特別トレードの推奨 ウォーク資本への課税 ウォーク資本への課税 現在のマクロクアント・モデル・スコア ウォーク資本への課税 ウォーク資本への課税

Highlights Chart 1How Long Until Full Employment? It’s official. The vaccination roll-out is successfully suppressing the spread of COVID-19 throughout the United States and the associated economic re-opening is leading to a surge in activity. Not only did March’s ISM Manufacturing PMI come in at 64.7, its highest reading since 1983, but the economy also added 916 thousand jobs during the month. Interestingly, the 10-year Treasury yield was relatively stable last week despite the eye-catching economic data. This is likely because the Treasury curve already discounted a significant rebound in economic activity and last week’s data merely confirmed the market’s expectations. At present, the Treasury curve is priced for Fed liftoff in September 2022 and a total of five rate hikes by the end of 2023. By our calculations, the Fed will be ready to lift rates by the end of 2022 if monthly employment growth averages at least 410k between now and then (Chart 1). If payroll growth can somehow stay above 701k per month, then the Fed will hit its “maximum employment” target by the end of this year. While a lot of good news is already priced in the Treasury curve, the greatest near-term risk is that the data continue to beat expectations. Maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 29 basis points in March, bringing year-to-date excess returns up to +98 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen, this does not yet pose a risk for credit spreads. The 5-year/5-year forward TIPS breakeven inflation rate remains below the Fed’s target range of 2.3% to 2.5%. We won’t be concerned about restrictive monetary policy pushing spreads wider until inflation expectations are well-anchored around the Fed’s target. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 83 basis points in March, bringing year-to-date excess returns up to +263 bps. In last week’s report we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.4% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth.  The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4% for the next 12 months, exactly matching what is priced into junk spreads. Given that the Fed’s 6.5% real GDP growth forecast looks conservative given the large amount of fiscal stimulus coming down the pike, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in March, bringing year-to-date excess returns up to +15 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 12 bps in March. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) currently sits at 19 bps. This is considerably below the 52 bps offered by Aa-rated corporate bonds, the 38 bps offered by Agency CMBS and the 27 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates, meaning that mortgage refinancings have probably peaked. The coming drop in refi activity will be positive for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, as mentioned above, value is poor compared to other similarly risky sectors. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) and we could still see spreads adjust higher. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 45 basis points in March, bringing year-to-date excess returns up to +66 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 157 bps in March, bringing year-to-date excess returns up to +40 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +33 bps. Local Authority bonds outperformed by 81 bps in March, bringing year-to-date excess returns up to +286 bps. Domestic Agency bonds underperformed by 2 bps, dragging year-to-date excess returns down to +14 bps. Supranationals outperformed by 7 bps, bringing year-to-date excess returns up to +13 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Mexico, Russia and Colombia We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over Ba-rated EM Sovereigns and the lower EM credit tiers are dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 187 basis points in March, bringing year-to-date excess returns up to +291 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit, with the possible exception of some short-maturity GO bonds. Revenue Munis offer a before-tax yield pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 13% (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 24%. GO Munis with 17+ years to maturity offer an after-tax yield pick-up relative to Credit for investors with an effective tax rate above 1%. This breakeven effective tax rate rises to 6% for the 12-17 year maturity bucket, 23% for the 8-12 year maturity bucket (panel 3) and 32% for the 6-8 year maturity bucket. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury yields moved up dramatically in March, with the curve steepening out to the 10-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 28 bps to end the month at 158 bps. The 5/30 slope steepened 7 bps to end the month at 149 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.4 Beyond 10 years, the curve has transitioned into a bear flattening/bull steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position for a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 155 basis points in March, bringing year-to-date excess returns up to +341 bps. The 10-year TIPS breakeven inflation rate rose 22 bps on the month and it currently sits at 2.38%. The 5-year/5-year forward TIPS breakeven inflation rate rose 30 bps in March and it currently sits at 2.15%. Despite last month’s sharp move higher, the 5-year/5-year forward breakeven rate is still below the Fed’s target range of 2.3% to 2.5% (Chart 8). This means that the rising cost of inflation protection is not yet a concern for the Fed, and in fact, the Fed would like to encourage it to rise further still. Our recommended positions in inflation curve flatteners and real curve steepeners continued to perform well last month. The 5/10 TIPS breakeven inflation slope was relatively stable, but the 2/10 CPI swap slope flattened 8 bps (panel 4). The 2/10 real yield curve steepened 31 bps in March to reach 169 bps (bottom panel). An inverted inflation curve has been an unusual occurrence during the past few years, but we think it will be the normal state of affairs going forward. The Fed’s new strategy involves allowing inflation to rise above 2% so that it can attack its inflation target from above rather than from below. This new monetary environment is much more consistent with an inverted inflation curve than an upward sloping one, and we would resist the temptation to put on an inflation curve steepener. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in March, dragging year-to-date excess returns down to +16 bps. Aaa-rated ABS underperformed by 5 bps on the month, dragging year-to-date excess returns down to +8 bps. Non-Aaa ABS underperformed by 2 bps, dragging year-to-date excess returns down to +56 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and now another round of checks is poised to push the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 10 basis points in March, dragging year-to-date excess returns down to +77 bps. Aaa Non-Agency CMBS underperformed Treasuries by 23 bps in March, dragging year-to-date excess returns down to +14 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 30 bps, bringing year-to-date excess returns up to +293 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 10 basis points in March, bringing year-to-date excess returns up to +49 bps. The average index option-adjusted spread tightened 5 bps on the month and it currently sits at 38 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of March 31ST, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of March 31ST, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 43 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 43 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of March 31st, 2021) Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance

Highlights Duration: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration. Corporate Bonds: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Disposable personal income fell in February compared to January, but it has risen massively since last year’s passage of the CARES act. The large pool of accumulated household savings will help drive economic growth as the pandemic recedes. Feature There is widespread anticipation that the economic recovery is about to kick into high gear. To us, this anticipation seems rather well founded. The United States’ vaccination roll-out is proceeding quickly and the federal government is pitching in with a tsunami of fiscal support. But it’s important to acknowledge that this positive outlook is still a forecast, one that has not yet been validated by hard economic data. The risk for investors is obvious. Market prices have already moved to price-in a significant amount of economic optimism and they are vulnerable in a situation where that optimism doesn’t pan out. In this week’s report we look at how much economic optimism is already discounted in both the Treasury and corporate bond markets. We conclude that the most likely scenario is one where the economic data are strong enough to validate current pricing in both markets. Investors should keep portfolio duration below-benchmark and continue to favor spread product over Treasuries, with a down-in-quality bias. Optimism In The Treasury Market The most obvious way to illustrate the economic optimism currently embedded in Treasury securities is to look at the rate hike expectations priced into the yield curve relative to the Fed’s own projections (Chart 1). The market is currently looking for four 25 basis point rate hikes by the end of 2023 while only seven out of 18 FOMC participants expect any hikes at all by then. Chart 1Market More Hawkish Than Fed We addressed the wide divergence between market and FOMC expectations in last week’s report.1 We noted that the main reason for the divergence is that while the market is focused on expectations for rapid economic growth the Fed is making a concerted effort to rely only on hard economic data. This sentiment was echoed by Fed Governor Lael Brainard in a speech last week:2 The focus on achieved outcomes rather than the anticipated outlook is central to the Committee’s guidance regarding both asset purchases and the policy rate. The emphasis on outcomes rather than the outlook corresponds to the shift in our monetary policy approach that suggests policy should be patient rather than preemptive at this stage in the recovery. The upshot of the Fed’s excessively cautious approach is that its interest rate projections will move toward the market’s as the hard economic data strengthen during the next 6-12 months, keeping the bond bear market intact. As evidence for this view, consider that the US Economic Surprise Index remains at an extremely high level, consistent with a rising 10-year Treasury yield (Chart 2). Further, 12-month core inflation rates are poised to jump significantly during the next two months as the weak monthly prints from March and April 2020 fall out of the 12-month sample (Chart 3). Then, pipeline pressures in both the goods and service sectors will ensure that inflation remains relatively high for the balance of the year (Chart 3, bottom panel).3   Chart 2Data Surprises Remain Positive Chart 3Inflation About To Jump Finally, the hard economic data still do not reflect the truly massive amount of fiscal stimulus that is about to hit the US economy. Chart 4 illustrates how large last year’s fiscal stimulus was compared to what was seen during recent recessions, and this chart does not yet incorporate the recently passed $1.9 trillion American Rescue Plan (~8.7% of GDP) or the second infrastructure focused reconciliation bill that is likely to pass this fall. Our political strategists expect 2021’s second budget bill to be similar in size to the American Rescue Plan though tax hikes will also be included and, due to the infrastructure-focused nature of the bill, the spending will be more spread out over a number of years.4  Chart 4The Era Of Big Government Is Back Bottom Line: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration.  Optimism In The Corporate Bond Market Chart 5What's Priced In Junk Spreads? The way we assess the amount of economic optimism baked into the corporate bond market is to calculate the 12-month default rate that is implied by the current High-Yield Index spread (Chart 5). We need to make a few assumptions to do this. First, we assume that investors require an excess spread of at least 100 bps from the index after subtracting 12-month default losses. In past research, we’ve noted that High-Yield has a strong track record of outperforming duration-matched Treasuries when the realized excess spread is above 100 bps. High-Yield underperforms Treasuries more often than it outperforms when the realized excess spread is below 100 bps.5 Second, we must assume a recovery rate for defaulted bonds. The 12-month recovery rate tends to fluctuate between 20% and 60%, with higher levels seen when the default rate is low and lower levels when the default rate is high (Chart 5, bottom panel). For this week’s analysis, we assume a range of recovery rates, from 20% to 50%, though we expect the recovery rate to be closer to the top-end of that range during the next 12 months, given our expectations for a rapid economic recovery. With these assumptions in mind, we calculate that the High-Yield Index is fairly priced for a default rate between 2.8% and 4.5% for the next 12 months (Chart 5, panel 2). If the default rate falls into that range, or below, then we would expect High-Yield bonds (and corporate credit more generally) to outperform a duration-matched position in Treasuries. If the default rate comes in above 4.5%, then we would expect Treasuries to beat High-Yield. To figure out whether the default rate will meet the market’s expectations, we turn to a simple model of the 12-month speculative grade default rate that is based on nonfinancial corporate sector gross leverage (aka total debt over pre-tax profits) and C&I lending standards (Chart 6). If we make forecasts for nonfinancial corporate 12-month debt growth and pre-tax profit growth, we can let the model tell us what default rate to anticipate. Chart 6Default Rate Model Debt Growth Expectations We expect corporate debt growth to be quite weak during the next 12 months (Chart 7). This is mainly because firms raised a huge amount of debt last spring when the Fed and federal government made it very attractive to do so. Now, we are emerging from a recession and the nonfinancial corporate sector already holds an elevated cash balance (Chart 7, bottom panel). Debt growth was also essentially zero during the past six months, and very low (or even negative) debt growth is a common occurrence right after a peak in the default rate (Chart 7, top 2 panels). It is true that the nonfinancial corporate sector’s Financing Gap – the difference between capital expenditures and retained earnings – is no longer negative (Chart 7, panel 3). But it is also not high enough to suggest that firms need to significantly add debt. Chart 7Debt Growth Will Be Slow For our default rate calculations, we assume that corporate debt growth will be between 0% and 8% during the next 12 months. However, our sense is that it will be closer to 0% than to 8%. Profit Growth Expectations Chart 8Profit Growth Will Surge Our expectation is that profit growth will surge during the next 12 months, as is the typical pattern when the economy emerges from recession. Year-over-year profit growth peaked at 62% in 2002 following the 2001 recession, and it peaked at 51% in 2010 coming out of the Global Financial Crisis (Chart 8). More specifically, if we model nonfinancial corporate sector pre-tax profit growth on real GDP and then assume 6.5% real GDP growth in 2021, in line with the Fed’s median forecast, then we get a forecast for 31% profit growth in 2021. If we use a higher real GDP growth forecast of 10%, in line with our US Political Strategy service's "maximum impact" scenario, then our model forecasts pre-tax profit growth of 40% for 2021.6 Default Rate Expectations Table 1 puts together different estimates for profit growth and debt growth and maps them to a range of 12-month default rate outcomes, as implied by our Default Rate Model. For example, profit growth of 30% and debt growth between 0% and 8% in 2021 maps to a 12-month default rate of between 3.2% and 3.8%. This falls comfortably within the range of 2.8% to 4.5% that is consistent with current market pricing. Table 1Default Rate Scenarios In fact, for our model to output a default rate range that is higher than what is priced into junk spreads, we need to assume 2021 profit growth of 20% or less. This is quite far below the estimates we made above based on reasonable forecasts for real GDP. Bottom Line: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Household Income Update Last week’s personal income and spending report showed that disposable household income was lower in February than in January, a decline that is entirely attributable to the fact that the $600 checks to individuals that were part of the December stimulus bill were mostly delivered in January. These “Economic Impact Payments” totaled $138 billion in January and only $8 billion in February. This drop-off of $130 billion almost exactly matches the $128 billion monthly decline seen in disposable personal income. Consumer spending also fell in February compared to January, a result that likely owes a lot to February’s bad weather conditions, particularly the winter storm that caused much of Texas to lose power. Though spending has recovered a lot from last year’s lows, it remains significantly below its pre-COVID trend (Chart 9). In contrast to spending, disposable income has skyrocketed since the pandemic started last March. Chart 10 shows that disposable personal income has increased 8% in the 12 months since COVID struck compared to the 12 months prior. Moreover, it shows that the increase is entirely attributable to fiscal relief. Chart 9Households Have Excess ##br##Savings Chart 10Disposable Personal Income Growth And Its Drivers The result of below-trend spending and a surge in income is a big jump in the savings rate. The personal savings rate was 13.6% in February, well above its average pre-COVID level (Chart 9, panel 3), as it has been since the pandemic began. This consistently elevated savings rate has led to US households building up a $1.9 trillion buffer of excess savings compared to a pre-pandemic baseline (Chart 9, bottom panel). Perhaps the biggest question for economic growth is whether households will deploy this large pool of savings as the economy re-opens or whether they will continue to hoard it. In this regard, the individual checks that were part of last year’s CARES act are the most likely to be hoarded, as these checks were distributed to all Americans making less than $99,000. The income support provisions in this month’s American Rescue Plan are much more targeted. Only individuals making below $75,000 will receive a $1,400 check and the bill also includes expanded unemployment benefits and a large amount of aid for state & local governments. All in all, we anticipate that a substantial amount of household excess savings will be spent once the vaccination effort has made enough progress that people feel safe venturing out. This will lead to strong economic growth and higher inflation in the second half of 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20210323b.htm 3 For more details on our outlook for core inflation in 2021 please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 4 Please see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com 5 For more details on this excess spread analysis please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6 The "maximum impact" scenario assumes that the full amount of authorized outlays from the American Rescue Plan will be spent, with 60% of the outlays spent in FY2021. For more details see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Even though bonds have cheapened relative to stocks, the equity risk premium remains elevated. The end of the pandemic and supportive fiscal and monetary policies should buoy economic activity in the second half of the year, lifting corporate earnings in the process. Some critics charge that low interest rates and QE have exacerbated wealth and income inequality. The evidence suggests the opposite: Rising inequality since the early 1980s has depressed aggregate demand, forcing central banks to loosen monetary policy. The tide of inequality may be turning, however. Ongoing fiscal and monetary stimulus, increasingly aggressive income distribution policies, heightened anti-trust enforcement, and waning globalization could all shift the balance of power from capital back to labor. Investors should overweight global equities for now but prepare for a more stagflationary environment later this decade. Market Overview We continue to favor global equities over bonds on a 12-month horizon. While bonds have cheapened relative to stocks, the global equity risk premium is still quite wide by historic standards (Chart 1). The distribution of vaccines over the coming months should pave the way for a strong rebound in economic activity in the second half of 2021. This will lift corporate earnings. The macro policy mix will also remain supportive. Thanks to the combination of increased fiscal transfers and subdued spending last year, US households have accumulated $1.5 trillion in savings – equivalent to 10% of annual consumption – over and above the pre-pandemic trend (Chart 2). Chart 1Equity Risk Premia Remain Elevated Chart 2Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending   US household balance sheets are set to improve further. Congress passed a $900 billion stimulus bill in December, which provides direct support to households, unemployed workers, and small businesses. On Thursday, President-elect Joe Biden unveiled an additional $1.9 trillion relief package. Biden’s plan calls for making direct payments of $1400 to most Americans, bringing the total to $2000 after the $600 in direct payments in December’s deal is included. President Trump had earlier called for stimulus payments of $2000 per person, a number the Democrats quickly seized on. Biden’s plan would also extend emergency unemployment benefits to the end of September, boost funding for schools, raise the child tax credit, and increase spending on Covid testing and the vaccine rollout. Unlike the December deal, it would also provide $350 billion in assistance to state and local governments. We expect at least $1 trillion of Biden’s proposal to be enacted into law. A trillion here, a trillion there, and pretty soon you are talking big money. Admittedly, taxes are also likely to rise. During the election campaign, Joe Biden pledged to lift the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He also promised to introduce a minimum 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and boost payroll taxes on households with annual earnings in excess of $400,000. If carried out, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. Given the slim majority that Democrats maintain in the Senate, it is unlikely that taxes will rise as much as Joe Biden’s tax plan calls for. Nevertheless, a tax hit to EPS of around 5% starting in 2022 looks probable. On the positive side, the additional spending will goose the economy, so that the net effect of the tax increase on corporate profits should be fairly small. Meanwhile, monetary policy will remain exceptionally accommodative. The Fed is unlikely to hike rates until late 2023 or early 2024. It will take even longer for policy rates to rise in the other major economies. Our bond strategists think that the Fed will start tapering QE only about six months before the first rate hike. Hence, for the time being, ongoing bond buying will limit the upside to yields. We see the US 10-year Treasury yield rising to 1.5% by the end of this year, only modestly higher than market expectations of 1.36%. Rising Inequality: The Dark Side Of QE? Chart 3Inequality Has Risen Across Major Developed Economies One often-heard objection to QE is that it has exacerbated inequality by pushing up equity prices without doing much to help the real economy. Some even contend that QE has hurt the middle class by depriving savers of a critical source of interest income. It is certainly true that inequality has risen sharply over the past 40 years, especially in the US (Chart 3). It is also true that the bulk of equity wealth is held by the very rich. According to Fed data, the wealthiest top 1% own half of all stocks (Chart 4). However, QE has pushed up not only equity prices. Falling bond yields have also pushed up home prices. Unlike stocks, housing wealth is broadly held across the population. Moreover, monetary policy operates through other channels. Lower interest rates tend to weaken a country’s currency, boosting competitiveness in the process. Lower rates also encourage investment. Again, real estate figures heavily here. Chart 5 shows that there is a very strong correlation between mortgage yields and housing starts. And while lower interest rates do penalize savers, the middle class is not the main victim. Interest receipts represent a much larger share of total income for ultra-wealthy individuals than for everyone else (Chart 6).   Chart 4The Rich Hold The Bulk Of Equities Chart 5Strong Correlation Between Mortgage Rates And Housing Activity Chart 6Interest Represents A Bigger Share Of Overall Income At The Top Of The Income Distribution Far from exacerbating income inequality, a recent IMF research paper argued that easier monetary policy may dampen inequality by boosting employment and wage growth. Chart 7 shows that labor’s share of GDP has tended to rise whenever the labor market tightened.   Chart 7Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Inequality Paved The Way To QE Chart 8The Rich Save More Than The Poor Rather than QE exacerbating inequality, a more plausible story is that rising inequality led to QE. The rich tend to save more than the poor (Chart 8). Consistent with estimates by the IMF, we find that the shift in income towards the rich has depressed US aggregate demand by about 3% of GDP since the late 1970s (Chart 9). A standard Taylor Rule equation suggests that real interest rates would need to be 1.5-to-3 percentage points lower to offset a 3% loss in demand.1 That’s a lot! Thus, not only have the rich benefited directly from receiving a bigger share of the economic pie, they have also benefited indirectly from the fact that falling interest rates have pushed up the value of their assets.   Chart 9Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s For a while, lower rates allowed poorer households to take on more debt, thus masking the impact of rising income inequality on consumption. However, after the housing bubble burst, households were forced to retrench and start living within their means. The resulting collapse in spending pushed interest rates towards zero and forced the Fed to undertake one QE program after another. It Is Not About Education Many of the popular explanations for rising inequality have focused on the widening gap between well-educated and less well-educated workers. While there is evidence that the demand for skilled workers increased in the 1980s and 1990s, Beaudry, Green, and Sand have shown that it has declined since then. Together with a rising supply of college-educated workers, softer demand for skilled workers compressed the so-called “skill premium.” So why has inequality increased? One can get a sense of the answer by looking at Chart 10. It shows that almost all the increase in US real incomes has occurred not just near the top of the income distribution, but at the very very top – people in the highest 0.1% of income earners. These are not university professors. These are hedge fund managers and corporate chieftains, with a sprinkling of celebrities (Chart 11). Chart 10The (Really) Rich Got Richer Chart 11Who Are The Top Income Earners? Superstars In his seminal paper entitled “The Economics of Superstars,” Sherwin Rosen argued that technological trends have facilitated the rise of winner-take-all markets. The classic example is that of stage actors. A century ago, tens of thousands of actors could eke out a living performing at the local theater. Today, a small number of superstars dominate the entertainment industry, while countless others work odd jobs, waiting in vain for their chance for stardom. A similar argument applies to professional athletes. The applicability of the superstar model to other classes of workers is more debatable. How much of the income of star hedge fund managers reflects their unique skills and how much of it reflects a “heads I win, tails you lose” approach to investing client money? Similarly, do CEOs get paid what they do because there is no one else who can do the same job with less pay? Or is it because CEOs can effectively set their own compensation, subject to an “outrage constraint” from shareholders and the broader public — a constraint that has loosened in recent decades due to rising stock prices and a shift in public attention away from class issues towards the debilitating distraction of identity politics? The Rise Of Monopoly Capitalism Where the superstar model may be more relevant is at the firm level. Standard economics textbooks treat profit as a return on capital. This implies that when the after-tax rate of return on capital goes up, firms should respond by increasing investment spending in order to further boost profits. In practice, this has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. Yet, outside of the energy sector – which benefited from an unrelated recovery in crude oil prices – US corporate capex grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 12). Why did the textbook economic relationship between investment and the rate of return on capital break down? The answer is that the textbook approach ignores what has become an increasingly important source of corporate profits: monopoly power. Chart 12No Evidence That Trump Corporate Tax Cuts Boosted Investment   Chart 13A Winner-Take-All Economy A recent study by Grullon, Larkin, and Michaely finds that market concentration has increased in 75% of all US industries since 1997. Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times higher than the median firm, a massive increase from the historic average of two times (Chart 13).   The rise of monopoly power has been most evident in the tech sector. Over the past 25 years, rising tech profit margins have contributed more to tech share outperformance than rising sales (Chart 14). Chart 14Decomposing Tech Outperformance Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Tech companies also benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner-take-all environment where success begets further success. Monopolies And The Neutral Rate Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output tends to depress selling prices, thus leading to lower profit margins. As such, rising market power may simultaneously increase profits while reducing investment spending. This may be deflationary in two ways: First, lower investment will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. An increase in savings relative to investment, in turn, will depress the neutral rate of interest. An Inflection Point For Inequality? After rising for the past four decades, inequality may be set to decline. Central banks are keen to allow economies to overheat. A feedback loop could emerge where overheated economies push up labor’s share of income, leading to more spending and even higher wages. Fiscal policy is likely to amplify this feedback loop. As we discussed last week, loose monetary policy is allowing governments to pursue expansionary fiscal policies. Fiscal stimulus raises the neutral rate of interest, making it easier for central banks to keep policy rates below their equilibrium level. Government policy is also moving in a more redistributive direction. Tax rates on high-income earnings will rise over the next few years, which will support new spending initiatives. Minimum wages are also heading higher. It is worth noting that Florida voters, despite handing the state to President Trump in November, voted 61%-to-39% to raise the state minimum wage from $8.56 an hour to $15 by 2026. Joe Biden also reaffirmed today his pledge to hike the federal minimum wage to $15 from its current level of $7.25. In addition, there is bipartisan support for strengthening anti-trust policies. On the left, Senator Elizabeth Warren has stated that “Today’s big tech companies have too much power – too much power over our economy, our society, and our democracy.” Increasingly, Republicans agree with this sentiment. According to a Pew Research study conducted last June, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). This number has probably gone up following last week’s coordinated effort by the largest tech companies to banish Parler, a Twitter-style app popular with conservatives, from the internet. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies Meanwhile, globalization is on the back foot. After rising significantly, the ratio of global trade-to-output has been flat for over a decade (Chart 16). As competition from foreign workers abates, working-class wages in advanced economies could rise. Chart 16Globalization Plateaued More Than A Decade Ago Long-Term Investment Implications What is good for Main Street is usually good for Wall Street. For the past 70 years, the S&P 500 has generally moved in sync with the ISM manufacturing index (Chart 17). The same pattern holds globally. Chart 18 shows that the stock-to-bond ratio has correlated closely with the global manufacturing PMI. Chart 17Strong Correlation Between Economic Growth And Stocks Cyclical fluctuations can disguise important structural trends, however. US productivity has doubled since 1980, but real median wages have increased by only 20% (Chart 19). The bulk of productivity gains have flowed to upper-income earners and owners of capital. Hence, corporate profits rose, while inflation and interest rates declined. Chart 18Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 19Real Median Wages Failed To Keep Up With Productivity   If we are approaching an inflection point for inequality, we may also be approaching an inflection point for profit margins and bond yields. To be sure, with unemployment still elevated, wage growth and inflation are not about to take off anytime soon. However, investors should prepare for a more inflationary – and ultimately, stagflationary – environment in the second half of the decade. This calls for reducing duration risk in fixed-income portfolios, favoring TIPS over nominal bonds, and owning inflation hedges such as gold and farmland. It also calls for maintaining a bias towards value over growth stocks, as the former usually outperform when inflation and commodity prices are on the upswing (Chart 20). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 20Value Stocks Usually Outperform When Commodity Prices Are On The Upswing   Footnotes 1 One can specify different parameters to weight the inflation and capacity utilization segments of a Taylor rule equation so that they are equally-weighted, meaning there is a coefficient of 0.5 on the gap between the year-over-year percent change in headline PCE and the Fed's 2% target and a coefficient of 0.5 on the output gap term. Previous Fed Chair and incoming Treasury Secretary Janet Yellen preferred an alternative specification where there was a coefficient of 1 on the output gap term so that the equation is as follows: RT= 2 + PT + 0.5(PT- 2) + 1.0YT, where R is the federal funds rate; P is headline PCE as expressed as a year-over-year percent change; and Y is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook and Monetary Policy," April 11, 2012. Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Chart 5Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments   Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9).  Chart 7Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession     Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023.  The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating   Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future.   The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21).   Chart 21The Present Value Of Earnings: A Scenario Analysis Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield   Imagine having to decide whether to place your money either in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50% (Chart 24). Chart 24 (I)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 24 (II)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves   Chart 27USD Remains Overvalued Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks   BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge   Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth   Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul.   Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa.  Chart 37High-Yielding Bond Markets Are The Most Cyclical In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020.  2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020.  3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020.     Global Investment Strategy View Matrix Current MacroQuant Model Scores

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Dear Client, There will be no Weekly Report on August 10, as the US Equity Strategy team will be on vacation for the week. Our regular publication schedule will resume on Monday August 17, 2020 with a Special Report by my colleague Chester Ntonifor, BCA’s Chief FX Strategist on the interplay of the style bias and the US Dollar. We trust that you will find this Report both informative and insightful. Kind Regards, Anastasios Feature Before getting to our analysis on why cyclicals will best defensives, we want to address our definition of cyclicals and defensives, where we think tech stands and why, discuss what our current positioning is and what time horizon we are targeting for this portfolio bent. Cyclicals And Defensives Definition Table 1 is a stripped down version of our current recommendations table and shows that our cyclicals definition is one of deep cyclicals including industrials, materials, energy and the information technology sector. Utilities, consumer staples, health care and telecom services (which is currently categorized as a GICS2) comprise our defensives universe. Table 1US Equity Strategy's Cyclicals Vs. Defensives Current Recommendations Tech Is Still Cyclical Importantly, we still consider the tech sector a deep cyclical and not a safe haven sector. While the COVID-19 fallout has acted as an accelerant especially to a faster absorption of goods and services of the tech titans, that is not a de facto change in the behavior of these still cyclical stocks.  As a reminder tech stocks have 60% export exposure or 20 percentage points higher than the broad market. The implication is that US tech trends should follow the ebbs and flows of the global economy. Contrary to popular belief that technology equities behaved defensively recently, empirical evidence gives credence to our hypothesis that technology stocks remain cyclical: from the Feb 19 SPX peak until the March trough the IT sector underperformed all four defensive sectors (Chart of the Week). In marked contrast, tech has left in the dust defensive sectors since the March bottom, cementing its cyclical status. Chart of the WeekTech Remains A Cyclical Sector Current Positioning With regard to our broader technology positioning, we are currently neutral the S&P tech sector, overweight the S&P internet retail index (which Amazon dominates) that sits under the S&P consumer discretionary sector and underweight the S&P interactive media & services index (which includes Alphabet and Facebook) that falls under the newly formed S&P communications services sector. Thus, our broadly defined tech sector exposure remains neutral. Meanwhile, last week we boosted the S&P materials sector to overweight and that move pushed our cyclicals/defensives bent marginally to preferring deep cyclicals to defensives (please see market cap weights in Table 1). Timing Is Key This portfolio bent may run into some near-term trouble as we expect a flare up of (geo)political risks (please see here and here), but once the election uncertainty lifts, hopefully in late-November/early-December, from that point onward and on a 9-12 month time horizon cyclicals should really start to flex their muscles versus defensives.  The purpose of this Special Report is to identify the top ten drivers of the looming cyclicals versus defensives outperformance phase on a cyclical time horizon. What follows is one page one chart per key reason, in no particular order of importance. 1.)    Dollar The Reflator Time and again we have highlighted the boost that internationally exposed sectors get from a weakening greenback. Cyclicals are the primary beneficiaries of such a backdrop as a lot of these deep cyclical companies garner over 50% of their sales from abroad. We recently updated in a Special Report the breakdown of GICS1 sectors’ foreign sourced revenues and more importantly their performance during US dollar bear markets. Cyclicals clearly have the upper hand. Chart 1 shows this tight inverse correlation, irrespective of what USD index we use. Finally, looking ahead a falling greenback will act as a relative profit reflator (US dollar shown inverted, bottom panel, Chart 1), especially given that most of the defensive sectors are landlocked in the US and do not get a P&L fillip from positive translation gains. Chart 1CHART 1 2.)    Global Growth Recovery Not only does the debasing of the US dollar bode well for Income Statement (I/S) relative translation gains, but also serves as a tonic to global growth. In other words, a final demand recovery is in the works on the back of a pending virtuous cycle: a depreciating dollar lifts global growth, and an increase in trade brings more US dollars in circulation further weakening the greenback (top panel, Chart 2). Our Global Trade Activity Indicator also corroborates the USD message and underscores a global growth recovery into 2021 (second panel, Chart 2). Tack on the meteoric rise in the G10 economic surprise index (third panel, Chart 2) and factors are falling into place for a synchronized global economic recovery including a V-shaped US rebound from the depths of the recession in Q2 (ISM manufacturing survey shown advanced, bottom panel, Chart 2). Chart 2CHART 2 3.)    US Capex To The Rescue The latest GDP report made for grim reading. US capex collapsed 27% last quarter in line with the fall it suffered in Q1/2009. Not even bulletproof software investment escaped unscathed and contracted for the first time in seven years, albeit modestly. However, if the looming recovery resembles the GFC episode when real non-residential investment soared 40 percentage points from that nadir in the subsequent five quarters, then a slingshot rebound will ensue by the end of 2021. Importantly, our US capex indicator has an excellent track record in leading the relative share price ratio and confirms that a capex trough is already in store, tracing out the bottom hit during the Great Recession (top panel, Chart 3). Regional Fed surveys also signal that a capex boom looms in the coming quarters (middle panel, Chart 3). And, so do cheery CEOs that expect a sizable investment recovery in the next six months, according to the Conference Board survey (bottom panel, Chart 3). All of this is a harbinger of a cyclicals outperformance phase at the expense of defensives. Chart 3CHART 3 4.)   Chinese Capex On The Upswing (Fiscal Easing) Across the pacific, Chinese excavator sales have gone vertical. While we take Chinese data with a grain of salt, Komatsu hydraulic excavator demand growth in China has averaged 45% on a year-over-year basis in the quarter ending in June. This Japanese company’s data, which has been unaffected by the US/Sino trade war, corroborates the Chinese official statistics (top panel, Chart 4). Infrastructure spending is also on the rise in China following an abrupt halt in projects started early in 2020. This revving of the investment spending engine is bullish for the broad commodity complex including US cyclicals (bottom panel, Chart 4). Chart 4CHART 4 5.) Chinese Monetary Easing None of the above investment recovery would have been possible had the Chinese authorities not opened up the liquidity spigots. Monetary easing via the sinking reserve-requirement-ratio (RRR) has been instrumental in engineering an economic rebound (RRR shown inverted, third panel, Chart 5). The credit-easing channel has been also important in funneling cash toward investment, and the climbing Li Keqiang index is evidence that sloshing liquidity is being put to good use (bottom & second panels, Chart 5). Finally, Chinese loan demand data also confirms that an economic recovery is in the offing and heralds a US cyclicals versus defensives portfolio tilt (top panel, Chart 5).  Chart 5CHART 5 6.)   Firming Financial Market Data (Chinese And EM Equity Market Outperformance) Typically, financial market data are early in sniffing out a turn in economic data. This anticipatory nature of financial markets is currently signaling that EM in general and Chinese economic growth in particular will make a significant comeback in the coming quarters. Importantly, Chinese bourses and the MSCI EM equity index (in USD) have recently started to outperform the ACWI and the SPX (Chart 6). Both of these equity markets are more cyclically exposed than the defensive US and global indexes because of the respective sector composition and have paved the way for a sustainable rise in the US cyclicals/defensives share price ratio (Chart 6).   Chart 6CHART 6 7.)    Transition From Deflation To Inflation Similarly to the EM and Chinese equity market outperformance of their DM peers, commodity prices are putting in a bottom and forecasting a brighter global trade backdrop for the rest of the year (top panel, Chart 7). The depreciating US dollar is also underpinning the commodity complex and this should serve as a catalyst for an exit from the recent global disinflationary backdrop, especially corporate wholesale price deflation. Domestically, the prices paid subcomponent of the ISM manufacturing survey is firming and projecting that relative pricing power will favor cyclicals versus defensives (bottom panel, Chart 7). Chart 7CHART 7 8.)   Profit Expectations Have Turned The Corner Sell-side extreme pessimism has given way to mild optimism as depicted by the now positive relative Net Earnings Revisions (NER) ratio (third panel, Chart 8).  Importantly, despite the spike in the relative NER ratio, the bar has not risen enough both on a relative profit growth and revenue growth basis in order to short circuit the recovery in the relative share price ratio (second & bottom panels, Chart 8).  Chart 8CHART 8 9.)   Alluring Valuations The relative Valuation Indicator remains below the neutral zone offering a cushion to investors that are contending to execute a cyclicals versus defensives portfolio bent (Chart 9).   Chart 9CHART 9 10.) Enticing Technicals Lastly, cyclicals are still unloved compared with defensives as our relative Technical Indicator (TI) highlights in Chart 10.  In fact, our relative TI also hovers below the neutral zone, near a level that has marked previous playable recovery rallies (bottom panel, Chart 10). Chart 10CHART 10     But Monitor Three Key Risks Over the coming 12 to 18 months, investors should prepare their portfolios for an outperformance phase of cyclical sectors relative to defensives. Nonetheless, we are closely monitoring a number of key risks that can put our view offside. First, the relentless rise of ex-Vice President Biden in the polls on PREDICTIT, the rapidly increasing probability of a “Blue Sweep” in the upcoming elections, and the non-negligible risk of a contested election (as discussed in a joined Special Report with our sister Geopolitical Strategy service last week), all pose a short-term threat to the benign election backdrop priced into stocks. Were a risk-off phase to materialize in the next three months, as we expect, then cyclicals would take the back seat versus defensives, at least temporarily (bottom panel, Chart 11). Second, what worries us most is that Dr. Copper and crude oil (another global growth barometer), especially compared with gold, have yet to confirm the global growth recovery. In other words, the fleeting oil-to-gold and copper-to-gold ratios underscore that the liquidity-to-growth handoff has gone on hiatus. While we are not ready to throw in the towel yet, these relative commodity signals are disconcerting, and were they to deteriorate further, they would definitely undermine our optimistic view on global growth (top and second panels, Chart 11). Finally, it is disquieting that our relative profit growth models have no pulse. They represent a significant risk to the relative earnings-led rebound which the rest of the indicators we track are anticipating (third panel, Chart 11). Chart 11Three Key Risks We Are Monitoring Bottom Line: On balance, a looming global growth recovery and pending global capex upcycle, a softening US dollar, commodity price inflation and Chinese monetary easing will more than offset the trifecta of rising election-related risks, the current unresponsiveness of our relative profit growth models and the lack of confirmation of a liquidity-to-growth transition. This will pave the way for a cyclicals outperformance phase at the expense of defensives.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com  

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Dear Client, Next Monday, July 20, we will be hosting our quarterly webcast, one at 10am EST for our US and EMEA clients and one at 9pm for our Asia Pacific, Australia and New Zealand clients; our regular weekly publication will resume on Monday July 27, 2020. Kind Regards, Anastasios Highlights A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. A Biden presidency would lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. Democrats would remove the Senate filibuster. Yet the macro agenda is reflationary. A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps. While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Feature Online political betting markets are still not fully pricing our “Blue Wave” scenario for the US election this year. The odds are closer to 50%-55% than 35%. Hence the equity market, especially the NASDAQ, is complacent about rising political risks to US equity sectors (Chart 1). The immediate risk to the rally is not politics but the pandemic, namely the COVID-19 resurgence in the United States, which is causing governors of major states like Texas, California, and Florida to slow down the economic reopening. The US’s failure to limit the spread of the virus has not yet led to a spike in deaths in aggregate, but it is leading to a spike in major states like Texas and Florida (Chart 2). Deaths are ultimately what matter to politicians and financial markets, since governments will not shut down all of society for less-than-lethal ailments. Fear will weigh on consumer and business confidence, including fear of a deadly second wave this winter. Near-term risks to the equity rally are elevated. Chart 1Blue Wave Expected, Equities Unconcerned Chart 2COVID-19 Outbreak Still A Risk Beyond this risk, the driver of the cyclical rally is the gargantuan monetary and fiscal stimulus – and more is on the way. President Trump wants another $2 trillion coronavirus relief package, while House Democrats already passed a $3 trillion package to demonstrate their election platform that government should take a greater role in American life. Senate Republicans (and reportedly Vice President Mike Pence) want a smaller $1 trillion bill but will capitulate in the face of a growing outbreak and any financial turmoil. Congress is highly likely to pass a new relief bill before going on recess on August 10. If COVID-19 causes another swoon in financial markets and the economy, then this congressional timeline will accelerate. America’s total fiscal stimulus for 2020 is rapidly approaching 20% of GDP, or 7% of global GDP (Chart 3). Thus it is understandable that the market has not reacted negatively to an impending blue wave election. Bipartisan reflation is overwhelming the Democratic Party’s market-negative agenda of re-regulation, tax hikes, minimum wage hikes, energy curbs, price caps, and anti-trust probes. Moreover the Democrats’ agenda also includes social and infrastructure spending, cheap immigrant labor, and less hawkish trade policy ex-China, which are all reflationary. Chart 3US Stimulus Greater Than Global – And Rising In short, over the next year, the US is not lurching from massive stimulus to a mid-term election that imposes budget controls and “austerity,” as occurred in 2010, but rather from massive stimulus to a likely Democratic sweep that will be fiscally profligate (Charts 4A & 4B). After all, Democrats are openly flirting with modern monetary theory. Chart 4ADeficits Would Soar Under Democrats Chart 4BDemocrats Would Be Ultra-Dovish On Fiscal Debt monetization is the big change, regardless of the election, which makes investors cyclically bullish. China is also bound to provide massive fiscal-and-credit stimulus because its first recession since the 1970s is threatening the Communist Party’s source of legitimacy (Chart 5). The European Union is uniting under a banner of joint debt issuance to fend off deflation. Bottom Line: Near-term risks to the exuberant post-lockdown rally abound, but the cyclical view remains constructive due to the ultimate policymaker stimulus put. Chart 5China Loosens Credit And Fiscal Taps Pre-Election Volatility And Post-Election Equity Returns Volatility normally rises ahead of US elections and it could linger in the aftermath given extreme polarization and the risk of vote recounts, contested results, Supreme Court interventions, and refusals by either candidate to concede. This is a concern in the short run but not the long run. US equities will grind higher over the long run regardless of the election outcome. Stocks normally rise by 10% in the 12 months after a presidential election that yields single-party control, though the upside is smaller and the initial downside is bigger than is the case with a gridlocked government (Chart 6, top panel). In cases of gridlock – which is virtually assured if Trump wins – the equity pullback after the election is just as deep but tends to be later in coming. On average stocks rise by the same amount after 12 months in either case (Chart 6, bottom panel). Thus political risks are primarily relevant in their regional or sectoral effects, though investors should take note that a Democratic sweep probably limits next year’s upside. Chart 6Equities Have Less Upside Under Democratic Sweep There are two likely scenarios. The first is the risk that President Trump makes a historic comeback and wins re-election, with Republicans retaining the Senate. Subjectively we put Trump’s odds at 35% though our quantitative model suggests they could be as high as 44%. The second scenario is our base case that the Democratic Party wins the Senate as well as the White House. In this scenario, the Democrats will prove more left-wing and anti-corporate than the market currently expects. Bottom Line: A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. However, history shows that a clean sweep limits the market’s upside risk. And full Democratic rule entails major political risks that have a regional and sectoral character. Biden And The Blue Wave Our expectation of a blue sweep is not based only in polling – which is uniformly disastrous for Trump as we go to press – but in the surge in unemployment. The basis for investors to view Biden as a risk-on candidate is driven by the macro and market views outlined above, not political fundamentals. From the political point of view, Biden may prefer to govern as a centrist, but victory in the Senate would remove constraints on his party’s domestic agenda. He would move to the left. Indeed, a Democratic sweep would mark a paradigm shift in domestic economic policy that is negative for corporate profits and the capital share of national income. It would unleash pent-up ideological and generational forces in favor of redistributing wealth and restructuring the economy. Progressivism would have the tendency to overshoot and create negative surprises for investors (Chart 7). Unlike 2008-10, when Republicans were last out of power, Republicans this time would be divided over Trump and populism and would be unlikely to recuperate as quickly. Chart 7Democratic Party Would Focus On Inequality Biden would end up governing to the left of the Obama administration, promoting Big Government while restricting Big Business and re-regulating Wall Street banks. A sharp leftward turn would be in keeping with the trend in the Democratic Party and the generational shift in the electorate (Chart 8). Only if Republicans pull off a surprise and keep the Senate despite losing the White House (~10% chance) would Biden be forced to govern as a true centrist. Even then Biden would oversee a large re-regulation of the economy through executive powers alone (Chart 9).1 Chart 8Generational Shift Favors Wealth Redistribution Chart 9Biden Would Re-Regulate The Economy Additional reasons to expect a left-wing policy overshoot:  · Presidents tend to succeed in passing their initial legislative priority after an election. This is incontrovertible when they control both chambers of Congress, as Obama showed in 2009 and Trump showed in 2017.2 · Biden will have huge tailwinds. He will not be launching a new agenda so much as restoring a policy status quo in most cases (laws and agreements that Trump either revoked or refused to enforce). He will also benefit from majority popular opinion and support of the bureaucracy and media (Chart 10). · Biden and the Democrats will be even more determined not to “let a good crisis go to waste” after having witnessed the Obama administration’s frustrations the last time the party took over in a sweeping victory on the back of a national disaster. · Democrats will not hesitate to use the budget reconciliation process to pass their first priority legislation with a mere 51 votes in the Senate. This is how Trump passed the Tax Cut and Jobs Act (TCJA). This is also how progressive stalwart Howard Dean believed the party should have passed a public health insurance option in 2009. This means Biden will be capable of increasing the corporate tax rate higher than 28%, pass a minimum 15% tax rate for corporations, and raise the capital gains tax and individual taxes. Chart 10Popular Opinion Would Boost Biden Administration · Contrary to consensus, Democrats are likely to remove the filibuster in the Senate – enabling bills to pass with a simple majority rather than the 60/100 votes required to close off debate. Yes, some moderate Democrats have already spoken out against “going nuclear” and changing such a critical norm. But populism and polarization are the driving forces in US politics today and we would advise investors not to bet heavily on “norms.” If Republicans prove capable of obstructing major legislative initiatives in the Senate, then Democrats, remembering obstructionism in the Obama years, will go nuclear to enact their progressive agenda. This would mark a massive increase in uncertainty for investors on everything from taxes to wages to anti-trust laws. Bottom Line: Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. If Republicans are obstructionist, Democrats will remove the filibuster. Biden’s Legislative Priorities First, Biden would seek to restore and expand the Affordable Care Act (Obamacare). The party has fixated on health care since 1992. Investors are complacent about Biden’s plan. A public health insurance option will be a major new progressive initiative that would undercut private health insurers over time (Chart 11). The bill will also impose caps on pharmaceutical prices and allow imports, reducing Big Pharma’s pricing power (Chart 12). Chart 11Health Insurers Will Be Undercut By Biden Public Option Investors are also complacent about taxation. Biden will pay for health care reform by partially repealing the Tax Cut and Jobs Act. He has proposed raising the corporate rate from 21% to 28%, but this could go higher and still fall well below the 35% that Trump inherited in 2017. Chart 12Big Pharma Faces Price Caps A rate above 28% would be a major negative surprise for financial markets and yet it is an obvious way for Democrats to raise much-needed revenue. Biden also intends to pass a 15% minimum tax that would hit large firms adept at paying lower effective taxes. Capital gains taxes and individual income taxes for high-earners could also rise by more than is expected (Table A1 in Appendix). Second, Biden will seek to offset the negative growth impact of falling stimulus and rising taxes by enacting large “Great Society” fiscal spending on infrastructure, the Green New Deal, education, and other non-defense discretionary spending (Table A2 in Appendix). Even defense spending will be largely kept flat due to rising geopolitical conflicts. As mentioned, this part of the agenda is reflationary, especially relative to a scenario in which fiscal largesse is normalized more rapidly by a Republican Senate. The redistribution effects would be marginally positive for household consumption, but marginally negative for corporate investment. On immigration, Biden will follow the Obama administration in pursuing a path to citizenship for “Dreamers” (illegal immigrants brought to the US as children) and taking executive action to allow more high-skilled workers and refugees, defer deportation of children and families, and reduce border security enforcement. There will be some constraints due to the risk of provoking another populist backlash, but comprehensive immigration reform is possible. This would be positive for potential GDP, agriculture, construction, and housing demand on the margin (Chart 13). On trade, Biden will have to steal some thunder back from Trump if he is to win the election and maintain the Rust Belt. He will concentrate his protectionist policy on China, while removing virtually all risk of a trade war with Europe, Mexico, or other partners. China may get a reprieve at first but Biden will ultimately prove hawkish (Chart 14). Investors are underrating the use of import duties to punish countries like China for carbon-intensive production. Chart 13Biden Lax Immigration Policy A Boon For Housing Biden will take a multilateral approach and restore international agreements that Trump revoked. Joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) is not a massive change given that even Trump agreed to trade deals with Canada, Mexico, and Japan. But it is marginally positive for the US-friendly trade bloc while contributing to the US economic decoupling from China (Chart 15). Chart 14Watch Out, Biden Won’t Be Too Dovish On China In Office! Chart 15Biden Eliminates Risk Of Global Trade War Ex-China On foreign policy, Biden will face the ongoing US-China cold war. He will also seek to restore the Iranian nuclear deal of 2015. The removal of Iran risk is positive for European companies with a beachhead in Iran as well as for the euro more generally, since regional instability ultimately threatens the EMU with waves of refugees (Chart 16). Chart 16Biden Removes Tail-Risk Of Iran War Bottom Line: A Biden presidency will lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. But Biden’s agenda is mostly reflationary in other respects. Blue Wave Equity Market And Sector Implications The most profound implication of a blue sweep of government is an SPX profit margin squeeze that will weigh heavily on EPS. Importantly, there are two clear avenues through which net profit margins will suffer: An increase in the corporate tax rate. A rise in labor’s share of national income. As a reminder these are two of the four primary profit margin drivers we discussed in detail in our “Peak Margins” Special Report last October (Chart 17). The other two are selling price inflation and generationally low interest rates. Odds are high that all four drivers are slated to dent S&P 500 margins. With regard to corporate tax rates, the mirror image of the one time fillip that SPX EPS enjoyed in 2018, owing to Trump’s 1.2% increase in fiscal thrust that year, is a drop in S&P 500 profits given that a Biden presidency will boost the corporate tax rate from 21% to 28% or higher. In early-December 2017 we posited that SPX EPS would jump 14% on the back of that fiscal easing package, which is very close to what actually materialized. Chart 18 compares S&P 500 EBIT growth with S&P 500 net profit growth. The 2018 delta hit a zenith of 16%. Chart 17Profit Margin Drivers Chart 18Spot Trump's Tax Cut Assuming a blue wave, the opposite would happen, i.e. net profit growth would suffer an 11% one-time contraction according to our calculations (Table 1). The bill would pass in 2021 and take effect in 2022. Importantly, Table 1 reveals that the hardest hit GICS1 sectors are real estate, tech and health care, and the ones faring the best are consumer staples, industrials and energy. Table 1What EPS Hit To Expect? Table 2S&P 600/S&P 500 Sector Comparison Table The second way SPX margins undergo a squeeze is via climbing labor costs. Labor costs have been increasing since 2008/09 (labor’s share of income shown inverted, second panel, Chart 17), coinciding with the apex of globalization (third panel, Chart 17). A Biden presidency would also more than double the federal minimum wage to $15 per hour for all workers over six years. These policies would take a bite out of corporate profits by knocking down profit margins. While S&P 500 EPS maybe recover back to trend near $162 in 2021, they would gap lower in 2022 which is not at all priced in sell side analysts’ EPS expectations of $186. A blue sweep would produce some other US equity sore spots. Small caps would suffer disproportionately compared with their large cap brethren as would banks, health care, and parts of tech (see below). Chart 19 shows that according to the National Federation of Independent Business (NFIB) survey, small and medium enterprise (SME) owners grew extremely concerned about higher taxes and red tape by the end of the Obama presidency. When President Trump got elected, he cut back these fears drastically. Today concerns about taxes and regulation are probing multi-decade lows, which implies that SMEs are not prepared for the regulatory shock that a Biden administration has in store for them (Chart 19). These small business concerns will resurface with a vengeance if there is a blue sweep this November. The implication is that at the margin small caps would underperform their large cap peers, especially given that small cap indexes sport 1.5x the financials sector market cap weight compared with the SPX (Table 2). Bottom Line: A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps as they will have to vehemently contend with rising red tape and taxes. Chart 19Re-Regulation Will Weigh On Small Business Sentiment Historical Parallel Of Blue Sweeps And Select Sector Performance A more detailed discussion on banks, health care, and technology sectors is in order, as they are the likeliest candidates to be at the forefront of Biden’s regulatory, wage, and tax policies. There are two recent episodes when US presidential elections resulted in a blue sweep, namely in 1992 and 2008. Both times, Democrats took control of both chambers of Congress and the White House but eventually surrendered this trifecta two years later during the 1994 and 2010 mid-term elections.3 Charts 20 & 21highlight the S&P banks, S&P health care, and S&P IT sectors’ performance during the last two blue waves. In both cases, banks remained flat to down; health care equities went down sharply; while tech stocks had mixed results. Tech took off in 1993-1994, but remained flat in 2009-2010 (excluding the recovery rally off the recessionary trough). Armed with this general roadmap, we now dive deeper into each of these three sectors for a more detailed discussion. Chart 20Not Everyone Is A Fan... Chart 21...Of The Blue Sweeps Banks Face High Risk Of Re-Regulation There is little doubt that Biden will re-regulate Wall Street, especially after the recent COVID-19-related watering down of the Dodd-Frank Act. Big banks are popular scapegoats. In fact, Biden already moved to the left on bankruptcy reform by adopting Massachusetts Senator Elizabeth Warren’s progressive proposal after a long drawn-out battle over this issue between them. Both of the earlier blue wave elections proved challenging for the banking sector. In addition, banks are already under pressure from the recent Fed stress tests. There are high odds that a number of banks will further cut or suspend dividend payments in coming quarters in line with the Fed’s guidance, especially if profits take a big hit, as we expect. Currently, the market is underestimating the Biden threat to the banking sector as a substantial divergence has materialized between the banks’ relative performance and the blue sweep probability series (Chart 22). As the election draws closer, a repricing in the banking sector is likely looming. Chart 22Mind The Divergence Health Care Stands To Lose The Most From A Blue Sweep The health care sector was the only sector we analyzed that clearly underperformed in both 1992 and 2008 blue waves. Health care reform will be Biden’s top priority, as outlined above. Biden will also go after pharma manufacturers. As a reminder, while Medicare has substantial bargaining power with hospitals and other drug providers due to the number of Americans enrolled, it has no leverage when it comes to pharma manufacturers leaving them free to set prices at will. Biden intends to end such practices, enabling Medicare to bargain for prices. He also wants to link the rise in drug prices to inflation and allow foreign imports. These actions will put a cap on pharma manufacturers’ pricing power. Importantly, the S&P pharmaceuticals index is the dominant player within the S&P health care universe comprising 29% of the entire health care sector. A direct hit to pharma earnings will be a hard pill to swallow, especially if the S&P biotech index (comprising 17% of the S&P health care market cap weight) is included that are similar to Big Pharma as they manufacture blockbuster drugs. In fact, as the American electorate is getting more interested in Biden’s campaign, the market is pricing in a tougher environment for US pharmaceuticals (Chart 23). Markets can rely on the fact that Biden has rejected a single-payer government health system (“Medicare For All”) – this policy position helped him beat Vermont Senator Bernie Sanders for the Democratic nomination. However, he is proposing a public insurance option, which will have the ability to absorb losses indefinitely and will have the insurance regulators at its side. Thus private health insurers will be undercut. Chart 23Beginning Of The End A public option is also seen even by promoters as a “Trojan Horse” that will increase the odds that Democrats will move toward a single-payer system in 2024 or thereafter. Thus the risk/reward ratio skews further to the downside for the S&P health care sector. Will Technology Escape Unscathed? In the wake of COVID-19, and facing geopolitical competition in cyber space, a Biden administration will also seek a much stronger regulatory handle on Big Tech. Social media companies are already buttering up to the Democrats to ensure that Biden maintains the Obama administration’s alliance with Silicon Valley and does not pursue extensive anti-monopoly and anti-trust investigations. Yet the tech sector cannot avoid heightened scrutiny due to its conspicuous gains in the midst of an economic bust – this is what normally prompts anti-trust actions (Chart 24). The Democrats will pursue probes into data privacy and excessive market concentration and will demand stricter patrolling of the ideological space in battles that will be adjudicated by the courts. Chart 24How Much Is Too Much? Should the monopolistic tech stocks – including FB and GOOGL, which are now classified under the GICS1 S&P communication services index – be forced to sell their crown jewel assets, then a hit to earnings is a given. The S&P technology sector plus FB & GOOGL commands more than one third on the SPX index, meaning that a dent in tech earnings will have negative ramifications for the entire market. In previous research, we drew a parallel with the chemicals industry and the regulatory shock that came in 1976 when the Toxic Substance Control Act (TSCA) was introduced.The bill pushed chemical stocks off the cliff as investments in the index became dead money for a whole decade – until 1985 when chemicals finally troughed (Chart 25) In the near future, a similar shock might come as a result of privacy-related regulation. A series of anti-monopoly or anti-trust probes, whether by the US or the EU, would make investors cautious about their tech exposure. While the probes may not result in a break-up, the heightened uncertainty would dampen the allure of tech stocks. The pattern of anti-trust probes in US history is that a probe first causes a selloff in the stock of the company investigated; then another selloff occurs when it is clear that a break-up is a real option under consideration; then a buying opportunity emerges either when the company is cleared or when the long dissolution process is completed. Bottom Line: While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Chart 25Will History Rhyme?     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Appendix Table A1Biden Would Raise $4 Trillion In Revenue Over Ten YearsTable A2Biden Would Spend $6 Trillion In Programs Over Ten Years   Footnotes 1     Republicans have 13 Senate seats at risk this cycle while Democrats have only four. More conservatively, Republicans have nine at risk while Democrats have two. Opinion polling has Democrats leading in seven out of nine top races, and tied in the other two – including states like Kansas where Democrats should have zero chance. Most of these races are tight enough that they will hinge on whether the election is a referendum on Trump. If so, Democrats will likely win the net three seats they need to control the chamber. Most likely they will have a 51-49 majority if Biden wins, though a 52-48 balance is possible.   2     The Republican failure to repeal and replace Obamacare in 2017 but success in passing the Tax Cuts and Jobs Act reflects the fact that political constraints are higher on taking away an entitlement than they are on giving benefits (tax cuts). 3    As noted above, however, investors today cannot be assured that Republicans will come roaring back in 2022 to impose constraints. Trump’s populism threatens to divide the party if he loses and delay its ability to regroup and recover.  

Dear Client, There will be no US Equity Insights from July 1-3 inclusive, as the US Equity team will be on vacation for the week. Our regular publication schedule will resume on Monday July 13, 2020 with our Weekly Report. Happy Independence Day.  Kind Regards, Anastasios Highlights Portfolio Strategy Odds are high that stocks will move laterally in Q3, digesting the massive gains since the March 23 lows. Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. On all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress. Tack on the potential dividend cuts/suspensions and we were compelled to downgrade exposure to neutral. A dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions enticed us to trim exposure in the S&P investment banks & brokers index to neutral. Recent Changes Last Tuesday we downgraded the S&P banks and S&P investment banks & brokers indexes to neutral. These two moves also pushed the S&P financials sector weighting to neutral.1 Feature The SPX remains in churning mode, consolidating the massive gains since the March 23 lows. Easy fiscal and monetary policies are still the dominant macro themes underpinning markets, and thus any letdown in either loose policies poses a threat to the 1000 point three-month SPX run-up (bottom panel, Chart 1). Importantly, correlations have gone vertical of late with the CBOE’s implied correlation index – gauging the S&P 500 constituents’ pairwise correlations – surging to 70% (implied correlation index shown inverted, second panel, Chart 1). This is cause for concern as it has historically been a precursor to SPX pullbacks. Typically, stocks move in tandem, especially during risk off phases when everything becomes one big macro trade. Similarly, two Fridays ago we highlighted that the VIX and the S&P 500 were becoming positively correlated.2 The 20-day moving correlation between these two assets is shooting higher, approaching positive territory. Since late-2017 every time this correlation has hit the inflection point near the zero line, stocks has subsequently suffered a sizable setback (Chart 2). Chart 1Short-Term Downdraft Risks Are Rising Chart 2Watch SPX/VIX Correlation Tack on the public’s renewed interest in COVID-19 according to Google trends search results, and the odds are high that stocks will be range bound this summer (top panel, Chart 1). Beyond that, on a cyclical 9-12 month time horizon we remain constructive on the return prospects of the broad market. Turning over to profits on the eve of earnings season, our four-factor macro EPS growth model for the SPX has tentatively troughed at an extremely depressed level (Chart 3). Our SPX EPS estimate for next calendar year remains near $162/share which we consider trend EPS and was last hit both in 2018 and 2019.3 Chart 3Our EPS Growth Model Has Troughed Moreover, drilling beneath the surface, this week Table 1 updates the sector and subgroup EPS growth expectations. First we rank the GICS1 sectors and then within each sector we rank the subsectors, both times by absolute 12-month forward EPS growth using I/B/E/S/ data (see second columns, Table 1). The third columns in Table 1 show the sector growth rate relative to the SPX. Table 1Identifying S&P 500 Sector EPS Growth Leaders And Laggards The final columns highlight the trend in relative growth. In more detail, they compare the current relative growth rate to that of three months ago: a positive sign indicates an upgrade in analysts’ relative estimates and a negative sign a downgrade in analysts’ relative estimates. Tech, health care and communication services occupy the top ranks with positive EPS growth expectations, while financials, real estate and energy are forecast to contract in the coming 12 months and have fallen at the bottom of the table. Table 2Sector EPS And Market Cap Weights Given that the tech sector has the highest profit weight in the SPX roughly 23% projected for next year (Table 2) it has really helped the broad market’s profit growth recovery (Chart 4). As a reminder, we continue to employ a barbell portfolio approach and prefer defensive (software and services) to aggressive tech (hardware and equipment). On the flip side, financials have the third largest profit weight roughly 16% in the S&P 500, trailing tech and health care, and pose a big threat to overall SPX profits next year, especially if there are any hiccups with the reopening of the economy (Table 2). Worrisomely, investors are not voting with their feet and are doubting that financials profits will deliver as the market cap weight relative to the profit weight stands at negative 540bps.  Last Tuesday we downgraded the S&P financials sector to a benchmark allocation via trimming the S&P banks and S&P investment banks & brokers indexes to neutral and this week we delve into more details on these two early cyclical subgroups. Chart 4Earnings Finding Their Footing Downgrade Banks To Neutral… We were compelled to downgrade the S&P banks index to neutral last Tuesday in advance of the Fed’s stress test results. There are high odds that a number of banks will cut/suspend dividend payments in coming quarters in line with the Fed’s guidance in the latest round of stress test, especially if profits take a big hit as we expect. As a reminder, dividends are paid out below-the-line. Beyond the Fed’s stress tests and rising political risks,4 yellow flags are waving on all three key bank profit drivers, namely the price of credit, loan growth and credit quality. First, it is disconcerting that bank relative performance has really not taken the yield curve’s steepening cue and has negatively diverged as we showed last week.5 The year-to-date plummeting 10-year yield is weighing heavily on relative share prices (top panel, Chart 5). The transmission mechanism to bank profits of this lower price of credit is via the net interest margin (NIM) avenue (third panel, Chart 5). NIMs will remain under downward pressure as long at the 10-year Treasury yield stays suppressed owing to the Fed’s immense b/s expansion. The rising likelihood of yield curve control could keep interest rates on the long end of the curve depressed for a number of years similar to what happened between 1942 and 1951. Second, on the credit growth front news is equally worrisome. The widening in the junk spread signals loan growth blues in the quarters ahead (second panel, Chart 6). Despite the initial knee jerk reaction, primarily by corporations, of tapping existing C&I credit lines and causing a surge in bank credit growth, bankers are not willing to extend credit according to the latest Fed Senior Loan Officer survey (third panel, Chart 6). The same survey revealed that banks are reporting lower demand for credit across the board, warning that future loan growth will be anemic at best, especially given the collapse in our economic impulse indicator (bottom panel, Chart 6). Chart 5Bank Yellow Flags Waving Chart 6Loan Growth Will Suffer Finally, with regard to credit quality, delinquency and charge-off rates are all but certain to spike in the coming months. The third panel of Chart 7 highlights that historically all these credit quality gauges are lagging. However, the near vertical climb in the unemployment rate recently and persistently high continuing unemployment benefit claims near 20mn signal that non-performing loans (NPLs) are slated to soar in the back half of 2020 (bottom panel, Chart 7). True, the recent $2tn+ fiscal package is acting as a Band-Aid solution by putting money in unemployed consumers’ pockets, but when the money runs out on July 31, the going will get tough especially if Congress does not pass a new fiscal package. In addition, there are “extend and pretend” clauses in the existing relief package especially on the residential mortgage front that aim to help homeowners make ends meet. But, the longer workers stay out of the labor force the higher the chances that their skills atrophy making it difficult for them to return to work. As a result, foreclosure risk is on the rise. While residential real estate loans are no longer the largest category in bank loan books they still comprise a respectable 21% of total loans or $2.3tn, a souring housing market could spell trouble for banks (Chart 8). Chart 7Deteriorating Credit Quality Will Sink Profits Chart 8Housing Arrears Are A Risk Already, residential mortgage delinquencies are rising and in May surged to the highest level since November 2011 according to Bloomberg. 4.3mn residential real estate borrowers are in arrears (this delinquency count includes borrowers with forbearance agreements who missed payments) and “more than 8% of all US mortgages were past due or in foreclosure” according to Black Night Inc., a property information service. Tack on the shattering consumer confidence and the consumer loan category (credit card, auto and student debt) is also under risk of severe credit quality deterioration (fourth panel, Chart 7). The commercial real estate (CRE) side of loan books is also likely to bleed. Anecdotes where landlords are demanding past due rent payment from tenants are mushrooming, at a time when the same landlords refuse to service their loan obligations. According to TREPP, CMBS delinquencies are skyrocketing across different REIT lines of business. Importantly, CRE loans add up to $2.4tn on commercial bank balance sheets or roughly 22% of total loans. Encouragingly, in Q1 banks started to aggressively provision for steep credit losses with commercial bank loan loss reserves now climbing just shy of $180bn according to the latest FDIC Quarterly Banking Profile (second panel, Chart 7). This figure is almost twice as high as noncurrent loans and represents a healthy reserve coverage ratio. However, our fear is that if history at least rhymes NPLs will sling shot higher (bottom panel, Chart 7) rendering loan loss reserves insufficient. Putting this provisioning number in context, according to the Fed’s most adverse stress test scenarios banks’ losses could spring to $700bn: “In aggregate, loan losses for the 34 banks ranged from $560bn to $700bn”.6 As a result, banks will have to further provision for futures losses and thus take an additional hit to profitability. Our bank earnings growth model does an excellent job in capturing all these moving parts and warns of a contraction in profit in the back half of the year (bottom panel, Chart 9). Nevertheless, before getting too bearish on banks, there two key offsetting factors. Relative valuations are bombed out, signaling that most of the bad news is likely reflected in prices (bottom panel, Chart 5). Finally, technicals are also extremely oversold. The second panel of Chart 5 shows that relative momentum is as bad as it gets. Netting it all out, on all three key profit fronts – price of credit, loan growth and credit quality – banks are starting to show signs of stress and compel us to downgrade exposure to neutral. Chart 9Dividend Cuts Are Looming …And Move To The Sidelines On Investment Banks & Brokers The S&P investment banks & brokers (IBB) group has a similar investment profile to the S&P banks index. But, given its more cyclical nature it typically oscillates violently around banks’ relative performance. Thus last Tuesday, we were also compelled to move to the sidelines on this higher beta financials subgroup.7 The COVID-19 accelerated recession has not only mothballed potential M&A deals that were in the works, but also a number of previously announced deals have been canceled. In addition, the outlook for M&A is grim, at least until the dust really settles from the coronavirus pandemic (second panel, Chart 10), weighing heavily on the sector’s profit prospects. While “Robinhood” (retail investor) trading stories abound, margin debt remains moribund and continues to contract, despite the V-shaped recovery in all major US stock markets since the March 23 lows (third panel, Chart 10). This coincident indicator speaks volumes in the near term direction of the broad market and any sustained contraction in trading related debt uptake will likely dent IBB profitability. According to the American Association of Individual Investors bullish retail investors have been absent from this quarter’s massive stock market rally and equity mutual fund and exchange traded fund flows corroborate this message (fourth panel, Chart 10). With regard to cyclicality, IBB are extremely quick to prune labor in times of duress and aggressively add to headcount during expansions. Recent trimming of IBB input costs signal that this industry is retrenching as it is trying to adjust cost structures to lower revenue run rates (bottom panel, Chart 10). Chart 10Diminishing Activities Are Profit Sapping Related to the cyclical nature of the IBB industry, an accelerating stock-to-bond ratio has been synonymous with relative share outperformance and vice versa. In early June we turned cautious on the broad market’s near-term return prospects primarily on the back of rising (geo)political risks. The implication is that a lateral move in the broad market would push down the S/B ratio and weigh on relative share prices (Chart 11). However, there are some offsets that prevent us from turning outright bearish on this niche early-cyclical group. First relative valuations are extremely alluring. On a price-to-book basis IBB traded recently at 0.8x in absolute terms and at a steep 68% discount to the broad market (bottom panel, Chart 12). Chart 11Move To The Sidelines On This Highly Cyclical Industry Chart 12Some Positive Offsets Second, volatility has gone haywire since late-February and it remains elevated with a VIX reading still north of 30. This is a fertile environment for IBB trading desks and should translate into higher profits (second panel, Chart 12). Third, equity trading volumes have exploded. True, volumes spike on downdrafts, but they have remained at an historically high level recently underscoring that IBB trading desk should be minting money (third panel, Chart 12). Adding it all up, a dearth of M&A deals, a steep fall in margin debt and declining equity flows into mutual funds and exchange traded funds and potential dividend cuts/suspensions compelled us to trim exposure in the S&P investment banks & brokers index to neutral. Bottom Line: Downgrade the S&P banks index to neutral for a loss of 32.4% since inception. Trim the S&P investment banks & brokers index to neutral for a loss of 24% since inception. These moves also push the S&P financials sector to a benchmark allocation. The ticker symbols for the stocks in these indexes are: BLBG S5BANKX – JPM, BAC, C, WFC, USB, TFC, PNC, FRC, FITB, MTB, KEY, SIVB, RF, CFG, HBAN, ZION, CMA, PBCT, and BLBG S5INBK – GS, MS, SCHW, ETFC, RJF, respectively.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Insight Report, “Tales Of The Tape” dated June 19, 2020, available at uses.bcaresearch.com. 3    Please see BCA US Equity Strategy Weekly Report, “Gauging Fair Value ” dated April 27, 2020, and BCA US Equity Strategy Special Report, “Debunking Earnings” dated May 19, 2020, both available at uses.bcaresearch.com. 4    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com. 5    Ibid. 6    https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200625c.htm 7    Please see BCA US Equity Strategy Insight Report, “Unresponsive” dated June 23, 2020, available at uses.bcaresearch.com.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views June 3, 2019 Stay neutral cyclicals over defensives (downgrade alert)  January 22, 2018 Favor value over growth April 28, 2020  Stay neutral large over small caps  June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V).