先進国

Highlights 2021 Model Bond Portfolio Broad Allocations: Translating our 2021 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions: target a relatively aggressive level of overall portfolio risk, while maintaining a moderately below-benchmark duration exposure alongside overweight allocations to lower-quality global corporate credit, and inflation-linked debt, versus nominal government bonds. Specific Allocation Changes: We are increasing credit spread risk in the US by upgrading our recommended overall US high-yield allocation to overweight, focused on B- and Caa-rated credit tiers, while downgrading US investment grade corporates to neutral. We are also reducing the size of our underweights in euro area corporates and shifting the overall allocation to emerging market USD-denominated credit to overweight. Feature Happy New Year! Just before our holiday break last month, we published our 2021 “Key Views” report, outlining the thematic implications of the BCA 2021 Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations and changes to the allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. The main takeaways are that the expected global backdrop of improving economic growth momentum, a reduction in coronavirus uncertainty as vaccines are distributed, highly accommodative monetary policy and a weakening US dollar will all provide an additional reflationary lift to global financial markets after a strong H2/2020. That means moderately higher global government bond yields (led by US Treasuries) along with outperformance of growth-related spread product like corporate bonds – specifically in the riskier credit segments like US high-yield and emerging markets (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The 2020 Model Bond Portfolio Performance Before we look ahead to discuss the details of the changes to our model bond portfolio for 2021, we need to take a final look back at the performance of the portfolio in 2020. Chart 12020 Performance: A Positive Year After A Volatile Start Last year, the model bond portfolio delivered a total return (hedged into US dollars) of 5.9%, which outperformed its custom benchmark index by +20bps (Chart 1).2 That moderately solid return was not delivered without some volatility over the course of the year, particularly during the global market tumult last February and March. Over the full year, the government bond portion of the portfolio underperformed the custom benchmark index by -70bps while the spread product segment outperformed by +90bps. The government bond underperformance occurred entirely in the first quarter of the year, as we began 2020 with a recommended below-benchmark global duration stance and an underweight overall allocation to government bonds versus spread product. For a portfolio that is intended to reflect our strategic investment recommendations, the COVID-19 market volatility in Q1/2020 forced us to change our allocations more frequently and aggressively than usual. In early March, we moved to an overweight recommendation on government bonds and underweight on spread product (particular corporate debt) while also shifting the portfolio duration to above-benchmark. That was a large flip from a pro-risk portfolio construction to a defensive one, but which helped claw back some of the severe underperformance in the month of February as government bonds yields plunged and corporate credit spreads surged higher. After the dramatic easing of monetary policy by the major global central banks in March, most notably the US Federal Reserve’s decision to begin buying corporate bonds, we reverted back to a pro-risk stance by upgrading US investment grade credit and Ba-rated high-yield to overweight – positions that were maintained for the rest of 2021. Those US corporate bond exposures alone accounted for essentially all of the spread product outperformance of our model bond portfolio in 2020 (Table 2). Table 2GFIS Model Bond Portfolio Full Year 2020 Overall Return Attribution In terms of specific country exposures (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) early in 2020 severely hurt the government bond portion of the portfolio (-76bps of underperformance versus the benchmark). This dwarfed the 2020 outperformance from other countries like Italy (+11bps), Japan (+17bps), and the UK (+5bps). Importantly, our move to allocate out of nominal government bonds to inflation-linked debt in the US, Italy and Canada back in June was a positive contributor on the year, boosting the overall portfolio outperformance by a combined +25bps. Chart 2GFIS Model Bond Portfolio Full Year 2020 Government Bond Performance Attribution Within spread product (Chart 3), the biggest gains outside of US investment grade came from UK investment grade (+18bps), euro area investment grade (+12bps) and US CMBS (+11bps). The biggest drags on performance came from underweights in euro area high-yield (-23bps) and US B-rated high-yield (-17bps), as we maintained a relatively cautious stance on those sectors even during the sharp rally in the latter half of 2020 given the lingering risks from COVID-19 and US election year uncertainty. In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt. Chart 3GFIS Model Bond Portfolio Full Year 2020 Spread Product Performance Attribution By Sector In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt (Chart 4). Given our overweight stance toward credit, the year ended on a strong note, with the portfolio delivering +16bps of outperformance in Q4/2020 – the details of which can be found in the Appendix on pages 19-23. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In 2020 Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from our 2021 Key Views report were the following: Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global nominal bond yields should see some upward pressure as growth picks up, with US Treasury yields rising the most. Global real bond yields will stay deeply negative with on-hold central banks actively seeking an inflation overshoot. The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: MODERATELY BELOW BENCHMARK Our Global Duration Indicator, comprised of leading economic growth variables, is already signaling that the direction of global bond yields will be higher in 2021 (Chart 5). Successful distribution of COVID-19 vaccines should eventually add additional upward momentum to global growth as confidence improves later in the year. Even if the vaccine rollout does not go as smoothly as expected, that would put pressure for fiscal stimulus policy responses – especially in the US - that can help sustain economic recoveries. Chart 5Global Bond Yields Will Drift Higher In 2021 Chart 6Stay Below-Benchmark On Overall Duration Exposure However, with major central banks like the Fed and ECB likely to keep policy rates unchanged in 2021, so as not to impede a recovery in inflation, any upward lift to bond yields will be moderate and driven overwhelmingly by rising longer-term inflation expectations and not a repricing of future monetary policy tightening. That means developed market yield curves should bearishly steepen, in general, as front-end yields remain anchored. We shifted to a below-benchmark overall portfolio duration stance back at the end of last October, equal to just over 0.5 years of duration versus the custom benchmark index (Chart 6). We are comfortable maintaining that position, in that size, while maintaining a bearish steepening bias to yield curve exposure across all countries in the model portfolio. Government Bond Country Allocation: OVERWEIGHT LOW YIELD BETA MARKETS, OVERWEIGHT PERIPHERAL EUROPE, UNDERWEIGHT THE US In more normal times, we would let our expectations of monetary policy changes guide our recommended government bond country allocations. Yet in 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. Thus, we continue to rely on a “yield beta” framework for making fixed income country allocation decisions in our model bond portfolio. In 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. We expect the largest increase in developed market bond yields in 2021 to occur in the US, thus we recommend favoring countries that have a lower sensitivity to changes in US Treasury yields (i.e. the “yield beta”). The obvious candidates are government bonds in Japan and core Europe, where inflation expectations are likely to see less upward pressure than in the US – especially if the US dollar weakens further (Chart 7). Thus, we begin 2021 by maintaining our existing overweight positions in Germany and France. Chart 7Favor Government Bond Markets Less Correlated To UST Yields In 2021 The UK has been transitioning from a high-beta to low-beta bond market in recent years and we do not see that trend turning in 2021. The Bank of England (BoE) will maintain a dovish policy bias this year as the UK economy begins adjusting to the post-Brexit world and a stronger pound will dampen inflation pressures. We also begin 2021 by staying overweight UK gilts in our model portfolio. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021. Chart 8Stay Overweight Italian Government Bonds Australia and Canada are two countries where a high yield beta to US Treasuries would make them ideal underweight candidates in a global bond portfolio this year. However, the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) have instituted aggressive quantitative easing (QE) programs that are designed to dampen increases in government bond yields. As a result of these opposing forces on Australian and Canadian bond yields, we begin 2021 with a neutral allocation to both countries. However, we may shift either or both to an underweight stance if we sense any wavering of the commitment of the RBA or BoC to their QE programs amid improving economic growth.  We also expect further declines in the risk premia for Italian government bond yields in 2021. The combination of aggressive ECB government bond purchases, which includes greater buying of BTPs than in years past, and signs of a somewhat more supportive backdrop of fiscal unity within the European Union (the €750bn Recovery Fund) reduce both the sovereign credit risk and “redenomination risk” of a potential euro breakup. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021 – an outcome that last occurred in 2016 (Chart 8). We are not only maintaining our long-held overweight stance on Italy in our model portfolio, we are increasing the size of the allocation to begin 2021. Inflation-Linked Bond Allocations: MAINTAIN EXPOSURE IN THE US, ITALY AND CANADA; ADD A NEW ALLOCATION TO FRANCE Chart 9Stay Overweight Global Inflation-Linked Bonds Inflation-linked bonds had a strong relative performance versus nominal government debt across the developed markets during the second half of 2020, with breakevens widening even in countries with low realized inflation like France and Australia. Dovish central banks, the reflationary impacts of rising commodity prices (also fueled by US dollar weakness), and the V-shaped recovery in global economic growth from the 2020 COVID-19 recession have all played a role in helping lift breakevens from the depressed levels seen last spring. None of those factors is expected to change during at least the first half of 2021, thus allocations to inflation-linked bonds are still justified in several countries. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Our fair value models for 10-year inflation breakevens show that valuations are no longer unequivocally cheap in most countries, but only in Australia do breakevens look much too high relative to underlying fundamental drivers (Chart 9). US TIPS breakevens are approaching levels that would appear “expensive”, defined as at least one standard deviation above fair value, but we still see additional upside as the model implied fair value is also rising. We currently have recommended allocations to inflation-linked bonds in the US, Italy and Canada in our model portfolio, and we are maintaining those positions as we begin 2021. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Spread Product Allocation: OVERWEIGHT GLOBAL CORPORATES VERSUS GOVERNMENT BONDS, FOCUSED ON US HIGH-YIELD AND EM Our expectation of a combination of improving global economic growth and persistent reflationary monetary policies is a very positive backdrop for global spread product, most notably corporate bonds. However, valuations across the global corporate debt spectrum are not universally cheap after the strong H2/2020 performance. Thus, we are maintaining only a moderate overall overweight stance on spread product versus government bonds in our model bond portfolio, equal to 5% of the portfolio (Chart 10). At the same time, we recommend taking more relative spread risk within that moderate overweight allocation. This is the way we are balancing the competing forces of a pro-risk backdrop and increasingly stretched valuations in many sectors. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. As we discussed in our 2021 Key Views report, spread valuation measures are more stretched for higher-rated US investment grade corporate debt compared to junk bonds. Chart 10A Moderate Recommended Overweight To Global Spread Product In 2021 Combined with a monetary liquidity backdrop that supports the performance of riskier assets like high-yield (Chart 11), we anticipate that US high-yield will be a relatively strong performer within the US credit markets in 2021. Chart 11Upgrade Lower Rated US High-Yield To Overweight When looking at the relationship between spread valuation (using our preferred metric of 12-month breakeven spreads) and risk (using a standard measure like duration-times-spread), the lower rated credit tiers of US high-yield stand out as having the most attractive risk/valuation tradeoff (Chart 12). Thus, we are focusing our shift to an overweight stance on US high-yield in our model bond portfolio by increasing the allocations to the B-rated and Caa-rated tiers. Chart 12Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Outside the US, we are also adding additional spread product exposure by increasing the weightings to euro area high-yield and emerging market USD-denominated sovereign debt. However, we are still maintaining a relatively higher allocation to US high-yield over euro area equivalents, and emerging market USD-denominated corporate debt over sovereigns. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. Finally, we are entering 2021 with the same relative tilt within US mortgage-backed securities (MBS) we maintained during the latter half of 2020, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Overall Portfolio Risk: AGGRESSIVE The net impact of all the changes made to our portfolio allocations is to boost the estimated tracking error – the relative portfolio volatility versus that of the benchmark – from 31bps to 73bps (Chart 13). This is a significant increase in the usage of our portfolio “risk budget”, but the tracking error is still below our self-imposed limit of 100bps. Chart 13Taking A More Aggressive Posture On Overall Portfolio Risk Chart 14Boosting Portfolio Yield Through Selective Overweights After maintaining a cautious stance on overall portfolio risk levels in the latter half of 2020, given the persistent uncertainties over the spread of COVID-19 and the US presidential election, we now deem it appropriate to be more aggressive within our model bond portfolio allocations. The pro-risk positioning changes will also boost the overall yield of the model bond portfolio. The greater allocations to riskier spread product sectors leave the portfolio with a yield that begins 2021 modestly higher than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making the shifts to our model bond portfolio allocations, which can all be seen in the tables on pages 24-25, we now turn to scenario analysis to determine the return expectations for the portfolio for the first half of 2021. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case The current surge of global COVID-19 cases gives way to increased distribution of vaccines. The result is a steady improvement in global growth. Some additional fiscal stimulus is delivered in the US and the larger countries of Europe. Central banks keep their foot on the monetary accelerator with realized inflation moving only modestly higher. The US Treasury curve bear steepens as US inflation expectations continue drifting higher. The VIX index reaches 23, the US dollar depreciates by -5%, oil prices climb +10% and the fed funds rate remains at 0%. Optimistic Scenario The global distribution of COVID-19 vaccines goes smoothly and rapidly, while the current surge in COVID-19 cases fades in the early weeks of 2021. Global growth quickly accelerates on the back of soaring consumer & business confidence. Global fiscal stimulus surprises to upside, while central banks remain super-dovish even as inflation perks up. The US Treasury curve bear-steepens substantially as US inflation expectations steadily increase. The VIX index falls to 18, the US dollar depreciates by -10% in a pro-risk/pro-growth move, oil prices climb +20% and the fed funds rate remains at 0%. Pessimistic Scenario The vaccine rollout is slower than expected, with COVID-19 restrictions remaining in place for longer. Policymakers deliver inadequate new fiscal and monetary stimulus measures to support underwhelming growth. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX index soars to 35, the US dollar appreciates by +5%, oil prices plunge -20% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15Risk Factor Assumptions For The Scenario Analysis Chart 16US Treasury Yield Assumptions For The Scenario Analysis The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +50bps in the base case and +78bps in the optimistic scenario, but is projected to underperform by -37bps in the pessimistic scenario. These are larger expected relative returns than witnessed during the latter half of 2020, consistent with the larger tracking error we are taking entering 2021.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2021 Key Views: Vaccination, Reflation, Rotation," dated December 17, 2020, available at gfis.bcarsearch.com. 2 Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Appendix Appendix Chart 1Q4/2020 GFIS Model Bond Portfolio Performance Appendix Table 1GFIS Model Bond Portfolio Q4/2020 Overall Return Attribution Appendix Chart 2GFIS Model Bond Portfolio Q4/2020 Government Bond Performance Attribution Appendix Chart 3GFIS Model Bond Portfolio Q4/2020 Spread Product Performance Attribution By Sector Appendix Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q4/2020 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 12020 Returns After a tumultuous start to the year, corporate bonds rallied in 2020 H2, managing to eke out small annual gains versus Treasuries. Specifically, investment grade corporates outperformed duration-equivalent Treasuries by 4 basis points in 2020 and high-yield outperformed by 185 bps (Chart 1). Treasuries, for their part, bested cash by 7% on the year but returns have been trending down since August. As we look forward to 2021, the economic cycle is in what we call a sweet spot for spread product returns. Economic growth is above trend, but inflation is low and monetary conditions are highly accommodative. This macro back-drop will lead to positive spread product returns versus Treasuries and a moderate bear-steepening of the Treasury curve in 2021. However, stretched valuations for investment grade corporates mean that investors must be selective within spread product. We think the Ba credit tier offers the best risk-adjusted opportunity in the corporate bond space, and also recommend favoring tax-exempt municipal bonds over equivalent-quality investment grade corporates. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-matched Treasury index by 79 basis points in December and by 4 bps in 2020. The investment grade corporate index eked out a small gain relative to the duration-matched Treasury index in 2020. Corporates underperformed Treasuries by 18% from the beginning of the year until March 23, the day that the Fed stopped the bleeding in credit markets by unveiling its suite of emergency lending facilities. With the Fed’s backstops in place, the corporate index went on to outperform Treasuries by 22% between March 23 and the end of the year (Appendix A). As we noted in our 2021 Key Views Special Report, the corporate bond index option-adjusted spread is not quite back to its pre-COVID low.1 However, valuation is close to all-time expensive after adjusting for changes in the index’s average credit rating and duration. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. As noted, the macro environment of above-trend growth and accommodative Fed policy is very positive for spread product returns. However, better value exists outside of the investment grade corporate space. In particular, we advise investors to look at Ba-rated high-yield corporates and tax-exempt municipal bonds. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 190 basis points in December and by 185 basis points in 2020. Ba-rated junk bonds outperformed duration-matched Treasuries by 431 bps in 2020, while B-rated and Caa-rated bonds lagged by 13 bps and 238 bps, respectively. Since the March 23 peak in spreads, Ba-rated bonds outperformed Treasuries by 33%, B-rated bonds outperformed by 30% and Caa-rated bonds outperformed by 36% (Appendix A). We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is in line with historical averages.2   Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only seven defaults occurred in November, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms.    Table 3ACorporate Sector Relative Valuation And Recommended Allocation*Table 3BCorporate Sector Risk Vs. Reward*  MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in December but underperformed by 17 bps in 2020. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 10 bps on the month to reach 61 bps (Chart 4). This is higher than the 58 bps offered by Aa-rated corporate bonds, the 49 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a material risk for MBS investors. The elevated spread suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). Our view is that expected prepayment losses embedded in MBS spreads (aka the option cost) are too low relative to this pace of refinancing. Last year’s spike in the mortgage delinquency rate was driven by households that were granted forbearance by the federal government’s CARES act (panel 4). The risk for MBS holders is that these households will not be able to resume their regular mortgage payments when the forbearance period ends this spring. While the situation bears close monitoring, our sense is that excess savings built up during the past nine months will be sufficient to prevent a surge of bankruptcies when the forbearance period ends. The recent stimulus package provides households with even more assistance. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 62 basis points in December but underperformed by 161 bps in 2020. Sovereign debt outperformed duration-equivalent Treasuries by 176 bps in December but underperformed by 98 bps in 2020. Foreign Agencies outperformed the Treasury benchmark by 7 bps in December but underperformed by 640 bps in 2020. Local Authority debt outperformed Treasuries by 146 bps in December but underperformed by 86 bps in 2020. Domestic Agency bonds outperformed by 14 bps in December but underperformed by 9 bps in 2020. Supranationals outperformed by 2 bps in December and by 3 bps in 2020. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, 2020’s dollar weakness was mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia, South Africa and Indonesia are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 56 basis points in December but underperformed by 286 bps in 2020 (before adjusting for the tax advantage). We upgraded municipal bonds to “maximum overweight” in our recent 2021 Key Views Special Report.3 Attractive valuations are the main reason for this move. First, spreads between Aaa-rated municipal bonds and equivalent-maturity Treasuries are elevated compared to history across the entire yield curve (Chart 6). Second, municipal bonds look even more attractive relative to duration and quality-matched credit. The Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage). The same is true for the Bloomberg Barclays General Obligation index beyond the 12-year maturity point (panel 3). While the failure to include state & local government aid in the recent relief bill is a big blow to municipal budgets that are already stretched, we think municipal bond spreads offer more-than-adequate compensation for default/downgrade risk. State & local governments are already engaging in austerity measures that will help protect bondholders (bottom panel) and State Rainy Day Fund balances were at all-time highs heading into the COVID downturn. Both of these things should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in December. The 2/10 Treasury slope steepened 13 bps to 81 bps. The 5/30 Treasury slope steepened 7 bps to 129 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and the recently passed fiscal relief bill will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels.        TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 141 basis points in December and by 117 bps in 2020. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 22 bps and 18 bps on the month. They currently sit at 2.01% and 2.07%, respectively. Core CPI rose 0.22% in November, pushing the year-over-year rate from 1.63% to 1.65%. Meanwhile, 12-month trimmed mean CPI fell from 2.22% to 2.09%, narrowing the gap between trimmed mean and core (Chart 8). We anticipate further narrowing in 2021 Q1 and therefore expect core CPI to print relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven inflation rate looks somewhat elevated on our Adaptive Expectations Model (panel 2).4 Inflation pressures may moderate once the core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure in the first half of this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel).   ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in December and by 98 bps in 2020. Aaa-rated ABS outperformed the Treasury benchmark by 12 bps in December and by 81 bps in 2020. Non-Aaa ABS outperformed by 33 bps in December and by 207 bps in 2020 (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 is quite negative for ABS. However, as we explained in a recent report, we don’t anticipate a material impact on spreads.5 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality is strong. As we first explained last June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).6 Faced with an income boost and few spending opportunities, many households paid down consumer debt. Given the recently passed additional fiscal support and the substantial savings that have already accrued, we see household balance sheets as being in a good place. As such, we advise moving down-in-quality to pick up extra spread in non-Aaa ABS.   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 113 basis points in December but underperformed by 57 bps in 2020. Aaa Non-Agency CMBS outperformed Treasuries by 58 bps in December and by 56 bps in 2020. Non-Aaa Non-Agency CMBS outperformed Treasuries by 277 bps in December but underperformed by 360 bps in 2020 (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 will not be negatively impacted.7 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 50 basis points in December and by 105 bps in 2020. The average index spread tightened 7 bps in December to reach 49 bps (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, will only purchase what is “needed to sustain smooth market functioning”. This is nonetheless a backstop of the market, and it does not change our overweight recommendation.   Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: 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 December 31ST, 2020) 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 December 31ST, 2020) 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 85 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 85 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 C: 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 December 31ST, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 4 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

特別レポート

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 5th with our Portfolio Allocation Summary for January 2021. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to “well-anchored” levels. We don’t expect Fed liftoff in 2021. Balance Sheet Policy: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities: The Fed will not undertake efforts to subvert Congress and re-establish its emergency lending facilities in 2021. However, the absence of the facilities will not have a negative impact on financial markets. Fiscal/Monetary Coordination: Looking beyond 2021, we see the lines between fiscal and monetary policy continuing to blur. The Fed will be increasingly incentivized to dip its toes into the fiscal arena and fiscal policymakers will let it. Feature Chart 1An Eventful Year It would be an understatement to say that 2020 was a busy year for the Federal Reserve. The Fed cut rates to the zero bound when the recession struck in March. It also exploded its balance sheet to fresh all-time highs and rolled out brand-new emergency lending facilities to support flagging credit markets (Chart 1). Then, to top it all off, the Fed concluded a Strategic Review of its monetary policy strategy in August and officially adopted an Average Inflation Target. This report touches on the market implications of 2020’s big Fed moves, but its focus is on what the Fed is likely to do in 2021. The first three sections discuss how we see the Fed’s interest rate policy, balance sheet policy and emergency lending facilities evolving next year. The final section considers a longer time horizon as it discusses what might be the next frontier for monetary policy: increased cooperation between monetary and fiscal authorities. Interest Rate Policy With the fed funds rate at its effective lower bound, bond investors will spend 2021 trying to determine the eventual start date and magnitude of the next tightening cycle. This will be especially complicated because the Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. We discussed the implications of the move toward Average Inflation Targeting in a September Special Report.1 To quickly recap, the Fed made three main changes that will influence our outlook for interest rate policy in 2021. First, the Fed edited its Statement on Longer-Run Goals and Monetary Policy Strategy to include a new interpretation of its price stability mandate. The new Statement reads: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.2 Second, the Fed modified its Statement on Longer-Run Goals and Monetary Policy Strategy to signal that it will rely less on labor market indicators to forecast future inflation. In its old Statement, the Fed talked about minimizing “deviations of employment from the Committee’s assessments of its maximum level.” The revised Statement talks about mitigating “shortfalls of employment from the Committee’s assessment of its maximum level.” In other words, the Fed is saying that it will be less inclined to view an unemployment rate below its estimated natural level (NAIRU) as a signal that inflation is about to accelerate. The Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. Finally, at the September FOMC meeting, the Fed translated the changes it made to its Statement on Longer-Run Goals and Monetary Policy Strategy into more explicit guidance about when it will consider lifting rates off the zero bound. That guidance is as follows: … it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.3 The Timing Of Liftoff Table 1A Checklist For Liftoff Digging into the new guidance, we identify three criteria for lifting rates off the zero bound (Table 1). First, the unemployment rate must reach levels consistent with the Committee’s assessments of NAIRU. Currently, those estimates range from 3.5% to 4.5% (Chart 2). Practically, we view this as the least important of the three criteria. NAIRU estimates are revised based on what happens with inflation, and the Fed has already acknowledged that it is now less inclined to view a sub-NAIRU unemployment rate as an inflationary signal. In short, if inflation were to rise sustainably above 2% with the unemployment rate still at 5%, the Fed would simply revise up its NAIRU estimates and begin the rate hike cycle. Chart 2Criteria For Lifting Rates The Fed’s second criterion for lifting rates is also the most specific. Inflation must rise to 2 percent before the Fed will consider hiking rates. In a recent speech, Fed Vice-Chair Richard Clarida said he interprets this to mean that 12-month PCE inflation must be at least 2% before the Fed will consider hiking (Chart 2, bottom panel).4 This is helpful for bond investors. We can be certain that no rate hikes will occur at least until 12-month PCE inflation reaches 2%. Finally, the Fed also wants to be certain that inflation is “on track to moderately exceed 2 percent for some time.” This means that the event of 12-month PCE reaching 2% won’t automatically lead to a rate increase. The Fed must also view inflation gains as sustainable. This will likely become an issue in the first half of 2021 when we know that base effects will push 12-month PCE sharply higher, possibly even above 2%. However, we also know that those gains will be short lived.5 Of course, the Fed also knows about the impact of base effects and it will look past any temporary jump in inflation in H1 2021. More generally, while we advise investors to not pay much attention to the Fed’s NAIRU estimates, the unemployment rate will play a role in the Fed’s determination of whether above-2% inflation is sustainable. That is, the Fed is more likely to view above-2% inflation as sustainable if the unemployment rate is 4% than it is if the unemployment rate is 6%. What Does The Market Think? The bond market has been quick to price-in the big shift in the Fed’s interest rate guidance. At present, the overnight index swap curve is priced for a single 25 basis point rate hike in mid-2023 and only one more by mid-2024 (Chart 3). We see a good chance that the Fed’s three liftoff criteria are met before then, a view that forms the basis of our below-benchmark portfolio duration recommendation for 2021.6 In addition, the New York Fed’s Survey of Market Participants shows that only 43% of respondents expect liftoff before the end of 2023 and only 31% before the end of 2022 (Table 2A). This is further evidence that bond yields have room to rise if it looks like the Fed’s three liftoff criteria will be met in 2022 or the first half of 2023. Finally, the New York Fed’s survey shows that market participants understand the Fed’s three liftoff criteria and that differences in opinion about the timing of liftoff reflect differences in views about the economic outlook, not differences in understanding the Fed’s reaction function. The bulk of survey respondents think that the unemployment rate will be between 3.5% and 4.2% (consistent with the Fed’s NAIRU estimates) and that 12-month PCE inflation will be between 2.2% and 2.5% at the time of liftoff (Table 2B). Chart 3The Fed May Lift Rates Sooner Than Markets Expect Table 2ALiftoff Expectations Table 2BMarkets Understand The Fed’s Guidance The Pace Of Tightening And Why We’re Watching Inflation Expectations We’ve seen the three criteria upon which the Fed will condition its decision to hike rates off the zero bound. But the timing of liftoff is not the only thing that bond investors need to consider. We also need to get a sense of how quickly rate hikes will proceed once the next tightening cycle begins. According to the Fed’s interest rate guidance, even after liftoff the Fed will seek to maintain accommodative monetary conditions until it has achieved its price stability goal under its new Average Inflation Target. Recall that this goal is defined as achieving “inflation that averages 2 percent over time”. This is somewhat vaguer than the Fed’s liftoff guidance. Over what time period should we seek to hit average 2% inflation? One option is to start calculating the average when the new regime was adopted in August. In that case, average PCE inflation is running at 0.96%, well below 2%. Alternatively, we could calculate average inflation since the Fed last cut rates to zero in March 2020 (1.50%) or average inflation since the Fed cut rates to zero in December 2008 (1.43%). The point is that the Fed has not given us a clearly defined target. Differences in opinion about the timing of liftoff reflect differences in views about the economic outlook. For this reason, it’s important for bond investors to understand why the Fed has shifted to an Average Inflation Target. The reason has to do with trying to re-anchor inflation expectations. Box 1 shows an example of an Expectations-Augmented Phillips Curve, the Fed’s go-to framework for thinking about inflation. As the accompanying quote from Janet Yellen explains, the Fed thinks about inflation’s long-run trend as being driven by expectations. Shocks to economic slack and import prices can cause inflation to deviate from its long-run trend, but expectations drive the trend itself. This makes it critical for a central bank to keep expectations well anchored near its inflation target. Box 1The Expectations-Augmented Phillips Curve (aka The Fed’s Inflation Model) This is the underlying rationale for the Fed’s Average Inflation Target. The Fed has observed that inflation expectations have been too low in recent years. In the Fed’s model, this signals that inflation’s long-run trend has shifted down. In order to get expectations back up to target, the Fed understands that it will probably need to accept a period of above-target inflation. Since economic agents have just experienced a long period of sub-2% inflation, it will probably require a significant period of above-2% inflation before their expectations sustainably shift higher.7 To sum it all up, the Fed will seek to keep monetary conditions accommodative, and thus supportive for risk assets, until inflation expectations are deemed to be re-anchored. At that point, monetary policy will shift to a neutral or restrictive stance and risk asset performance will be challenged. But don’t just take our word for it. Here is what Vice-Chair Clarida said in a recent speech (referenced above): It is important to note, however, that the goal of the new framework is to keep inflation expectations well anchored at 2 percent, and, for this reason, I myself plan to focus more on indicators of inflation expectations themselves – especially survey-based measures – than I will on the calculation of an average rate of inflation over any particular window of time. It is clear that inflation expectations will dictate the eventual pace of Fed tightening. But the question of what measure of inflation expectations to track remains unresolved. Measures of inflation expectations fall into three main categories: Market-based measures Survey measures Trend measures Market-based measures are derived from inflation-linked bonds. Specifically, we derive TIPS breakeven inflation rates for different time horizons by taking the difference between a nominal yield and TIPS yield of the same maturity. In this publication, we often refer to the 10-year and 5-year/5-year forward TIPS breakeven inflation rates and have found that a range of 2.3% to 2.5% has historically been consistent with periods when inflation expectations were deemed “well anchored” (Chart 4A). One potential issue with using market-based measures of inflation expectations is that TIPS prices can sometimes move around for reasons unrelated to changing inflation expectations. That is, regulations or broader portfolio diversification concerns could change the risk premium an investor is willing to accept from TIPS, even if that investor’s underlying inflation view is unchanged. Academics have made attempts to solve this problem by using affine term structure models to decompose yields into various components. Chart 4B presents one such model from D’Amico, Kim and Wei (DKW).8 The DKW model splits the TIPS breakeven inflation rate (or inflation compensation) into an inflation expectation, a liquidity premium that compensates investors for the lower liquidity in TIPS compared to nominal Treasuries and an inflation risk premium that represents the extra compensation investors require to take inflation risk. We are skeptical of the usefulness of affine term structure models. In general, these models have too few inputs to reliably generate the components they purport to measure. However, the Fed clearly pays some attention to the DKW decomposition. If a future increase in TIPS breakeven inflation rates is driven entirely by movement in the liquidity or inflation risk premium components, it would be reasonable to question whether the Fed will react. Chart 4AInflation Expectations: Market-Based Measures Chart 4BA Decomposition Of TIPS##br## Breakevens Survey measures of inflation expectations are exactly that: Responses from surveys, usually of professional forecasters or households (Chart 4C). One drawback of survey measures compared to market-based measures is that they are updated less frequently. Another is that survey respondents, particularly households, may only be able to distinguish very large swings in prices. That said, the Fed tracks a wide range of survey measures and they were even singled out by Vice-Chair Clarida as being particularly important in the above quote. Trend inflation measures are statistical measures of the trend in the actual PCE or CPI inflation data. Chart 4D shows both a very simple trend measure, the 10-year annualized rate of change, and a slightly more complex trend measure based on an exponential smoothing rule. Academics have developed even more complex trend inflation measures.9 The logic behind these measures is that expectations tend to adapt only slowly to changes in the actual inflation data. Chart 4CInflation Expectations: Survey Measures Chart 4DInflation Expectations: Trend Measures Finally, we should point out a relatively new measure that the Fed will be using to track inflation expectations going forward. It is called the Common Inflation Expectations Index and it is a composite of 21 different survey and market-based inflation measures (Chart 4E), no trend inflation measures are included.10 Chart 4EIntroducing The Common Inflation Expectations Index To summarize, the Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to levels that are considered “well anchored”. Once that happens, the Fed will no longer have an incentive to keep monetary conditions accommodative and risk asset performance will be challenged. Charts 4A-4E in this report provide a wide array of different measures of inflation expectations to monitor. We will keep an eye on all of them, but in particular, we will track the Common Inflation Expectations Index’s progress back to 2.1% and the 5-year/5-year forward TIPS breakeven inflation rate’s progress back to a range of 2.3%-2.5%. While we don’t expect the Fed’s rate hike criteria to be met in 2021, a 2022 liftoff is possible if the COVID vaccine spurs a rapid economic recovery. However, we do expect that, in 2021, the market will start to price-in an earlier liftoff date and quicker pace of tightening than is currently discounted, thus pushing bond yields higher. The Financial Conditions Wildcard Chart 5Financial Conditions Our base case view is that the eventual pace of Fed tightening will be determined by inflation expectations. However, there is one wildcard that could cause the Fed to abandon its inflation expectations goal and tighten policy earlier. That wildcard is financial conditions. Presently, financial asset valuations are a mixed bag (Chart 5). Corporate bond spreads are tight, but not at all-time expensive levels. Equity P/E ratios are very elevated, but equities don’t look expensive compared to bonds. If these valuations stay relatively stable, the Fed will continue to rely on inflation expectations to guide the pace of tightening. However, if inflation expectations take a long time to rise, it is conceivable that such a long period of low interest rates could lead to historically stretched financial asset valuations. In short, if inflation doesn’t return within the next couple of years, the Fed may have to tighten policy to take the wind out of an asset bubble that might otherwise burst and lead to an economic recession. We stress that we are not yet close to this point and that the bar for the Fed to abandon its inflation goal will be very high, but we would place financial conditions alongside inflation expectations as the two most important variables to monitor to assess the eventual pace of Fed tightening. Balance Sheet Policy With the funds rate pinned at zero and the Fed’s interest rate guidance essentially set in stone, changes to the pace and composition of asset purchases are the principal tool that the Fed will use to provide more or less immediate monetary accommodation in 2021. The Fed is currently purchasing $80 billion of Treasuries and $40 billion of Agency MBS each month, with Treasury purchases spread out across the yield curve. If this pace and distribution of Treasury purchases is maintained in 2021, the Fed will end up purchasing less and less of the Treasury flow. The Treasury Department has a stated policy goal of increasing the average maturity of the outstanding debt and it has been pursuing that goal by raising the amount of coupon issuance at the expense of bills. The Treasury has already given us its planned coupon issuance schedule for Q4 2020 and Q1 2021. Chart 6 shows that net Fed coupon purchases will gradually decline as a percentage of gross issuance, assuming the Treasury follows through with its plan and the Fed’s balance sheet policy is unchanged. Chart 6The Path For Treasury Supply And Fed Demand Can The Fed Do More? … Will The Fed Do More? It is possible that the Fed will use its balance sheet to provide more monetary easing in 2021. There are two ways it could do this. First, it could simply increase the monthly pace of asset purchases. Alternatively, it could keep the same pace of purchases but shift Treasury buying toward the long-end of the curve. The idea here would be to prevent long-dated yields from rising too quickly. One or both of these changes could happen in 2021, but only if the economy experiences a negative growth shock or risk asset prices (equities and corporate credit) fall significantly. In that case, the Fed will want to be seen as responding to a negative shock, but absent that, the Committee seems comfortable with its current balance sheet strategy. Chart 7Rate-Sensitive Sectors Have Recovered Some have suggested that, even if the economic recovery stays on track, the Fed will try to use its balance sheet to lean against rising long-maturity bond yields. We doubt this. First, it is not obvious that the Fed would be able to stop the 10-year Treasury yield from rising to a range of, say, 1.25% to 1.5% by increasing bond purchases in that maturity range by a few billion dollars. As long as the Fed’s interest rate guidance is unchanged, the market’s interest rate expectations will continue to exert a powerful influence on bond yields across the entire curve. Unless the Fed announces a cap on long-dated bond yields, and pledges to buy enough securities to enforce that cap, we are skeptical about the effectiveness of just changing the quantity of asset purchases. Second, it is also not clear that a 10-year Treasury yield between 1.25% and 1.5%, in the context of a steepening yield curve and improving economic growth, would be a problem for either the economy or risk assets. In fact, these sorts of environments tend to be very positive for risk asset performance.11 It is only when the Fed is shifting to a more restrictive monetary policy stance and the yield curve is flattening that bond yields start to exert a negative influence on the economy and risk assets. Even if the Fed is not worried about a moderate bear-steepening of the Treasury curve, a case could be made for providing more easing right now in order to spur a quicker recovery. This question was posed to Chair Powell several times at the last FOMC press conference. In response, Powell noted that the sectors of the economy that are most sensitive to interest rates – residential investment and consumer spending on durable goods – have already recovered (Chart 7). The lagging sectors of the economy – particularly consumer spending on services – cannot recover until the COVID vaccine is widely distributed, irrespective of the level of interest rates. In our view, this is an acknowledgement that the Fed does not see much value in trying to provide further accommodation through the balance sheet channel. All in all, our base case scenario is that the Fed will maintain its current pace and maturity distribution of asset purchases throughout 2021. However, it will increase the pace and/or lengthen the maturity if there is a significant shock to the economy and/or financial markets. Later in 2021, if the recovery stays on track, Fed communications will increasingly take up the issue of when it will be appropriate to taper its pace of asset purchases. The Exit From Asset Purchases And The Possibility Of A Taper Tantrum Chart 8Remember The Taper Tantrum The Fed has already given us a timeline for how it will wind down its asset purchases. According to the minutes from the November FOMC meeting, most participants support a timeline where the Fed will start tapering its pace of asset purchases sometime before the first rate hike. It will then begin lifting interest rates and will stop purchases altogether sometime after that. At the December FOMC meeting, the Fed gave us additional guidance on when it will start the tapering process. Unfortunately, this guidance is quite vague and only confirms the fact that tapering will start before the liftoff date. Specifically, the Fed said that tapering will begin when “substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” Because the guidance around the timing of the tapering process is quite vague, we think it’s possible that it could sneak up on investors and lead to a sharp upward re-adjustment in rate hike expectations, and thus a bond sell-off. In essence, a tamer version of the 2013 Taper Tantrum is possible in late-2021 or 2022. On May 22, 2013, Fed Chair Ben Bernanke explained the Fed’s plan to eventually start tapering its asset purchases. Because investors took this to mean that the rate hike cycle would start much sooner than anticipated, the bond market underwent a sharp re-adjustment. The market quickly went from pricing-in only 35 bps of rate hikes over the next 24 months to 116 bps, and Treasury returns fell precipitously as a result (Chart 8). The Fed has learned a few lessons about communications since then, and it will do its best to keep market expectations aligned with its own strategy. However, unless firmer guidance is provided about when tapering will begin, the risk of a hawkish surprise around the tapering announcement remains.  Bottom Line: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities In addition to cutting rates to zero and massively scaling up the size of its balance sheet, the Fed also responded to the COVID recession by launching a slew of emergency lending facilities, some re-treads from the financial crisis and some brand new. Facilities to support the corporate bond market (The Primary and Secondary Market Corporate Credit Facilities) and the Municipal Liquidity Facility were particularly successful at capping bond spreads versus Treasuries, even if their actual usage was quite low. In fact, corporate bond spreads peaked on the very day that the Fed announced its corporate credit facilities in March (Chart 1). More recently, however, Treasury Secretary Steve Mnuchin refused to authorize the continuation of most of the Fed’s emergency lending facilities beyond the end of the year. We wrote in November that, even with the Treasury taking back the funds used to set up the facilities, the Fed could re-launch them in 2021 if incoming Treasury Secretary Janet Yellen provides her approval.12 However, a late addition to the recently passed fiscal stimulus package appears to prohibit the re-authorization of the facilities without Congressional approval. At the time of publishing, we have not been able to see the details of the new provision, so there remains some uncertainty about what the Fed can and cannot do in this regard. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all. Nonetheless, while the new bill raises interesting questions about Fed independence in the long-run, we doubt that markets will respond negatively to the absence of the Fed’s emergency facilities in 2021. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all (Table 3). Table 3Usage Of The 2020 Federal Reserve Emergency Lending Facilities In short, we don’t see the Fed going out of its way to re-establish the facilities in 2021 because it will become clear that they are no longer needed. The Next Regime Shift In Fed Policy: Fiscal/Monetary Coordination The adoption of an Average Inflation Target represents a major regime shift in Federal Reserve policy. In the final section of this report, we expand our horizon beyond 2021 and speculate about what the next major regime shift for the Fed might be. The 2020 recession made two things crystal clear. First, traditional fiscal policy becomes essentially impotent once interest have been reduced to the zero-lower-bound. Once there, Fed policy is most impactful when it focuses on lending to the private sector. Lending to the private sector through an emergency lending facility is an act that blurs the distinction between monetary and fiscal policy. This was made abundantly clear by Congress’ recent push to legislate the Fed’s activities in this arena. Second, it is difficult for fiscal policy to act quickly enough during an economic downturn. While the CARES act was delivered in a timely manner, it has taken many months to pass a follow-up bill. The Fed’s independence allows it to act immediately when it is economically necessary, while Congress’ increasing polarization makes swift action a challenge. If we take these two observations to their logical conclusion, and throw in the strong chance that the traditional channels of monetary policy will be increasingly blocked in the future as rates bump up against zero, it seems to us that the strict separation of responsibilities between fiscal and monetary policymakers will fade over time. More specifically, greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities. Further, Congress will be more than happy to allow this encroachment as it finds itself unable to respond effectively in times of crisis. Of course, this will also lead to periodic push-back as some members of Congress fret about the Fed’s over-reach, but we expect this push-back will be the exception rather than the rule. Greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities.  In fact, the best idea might be for fiscal and monetary policymakers to join together proactively to craft programs that can be deployed during the next recession. One example of such an idea was recently presented by Julia Coronado and Simon Potter.13 Coronado and Potter’s idea relies on the use of instant payment processing technology (which the Fed is already working on) to create digital accounts at the Federal Reserve for every household. Once those accounts are in place, the federal government could issue Recession Insurance Bonds, zero coupon bonds with some pre-determined face value, and grant one bond to every household in the country. Then, during the next economic downturn, the Fed could decide to do a “people’s QE” where it buys all the Recession Insurance Bonds leaving every household with a direct cash payment equal to the face value of the bond. This scheme directly addresses the two main problems we named earlier. It is fiscal policy, not monetary policy, so it can still be effective at the zero-lower-bound. Also, Congress can take its time to deliberate on the bill that authorizes the creation of the Recession Insurance Bonds, as this can be done proactively during a period of economic recovery. Then, the Fed can use its ability to move quickly during the next downturn to “activate” the bonds and deliver the fiscal stimulus that Congress actually passed years earlier. While likely not a story for 2021, we see increased cooperation between monetary and fiscal policymakers as the next big regime shift for the Fed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 4 https://www.federalreserve.gov/newsevents/speech/clarida20201116a.htm 5 For a more complete discussion of our 2021 inflation outlook please see “BCA Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 6 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 7 This is the theory of adaptive expectations and we use it to model changes in the 10-year TIPS breakeven inflation rate. For further details please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/econres/notes/feds-notes/tips-from-tips-update-and-discussions-20190521.htm 9 Fed Governor Lael Brainard references several of these trend measures in this recent speech: https://www.federalreserve.gov/newsevents/speech/brainard20201021a.htm&…; 10 More details on how this aggregate measure is constructed can be found here: https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm 11 For more details on how corporate credit performs during different yield curve environments please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 13 https://www.piie.com/publications/policy-briefs/reviving-potency-monetary-policy-recession-insurance-bonds

Highlights The Fed will continue to have investors’ backs in 2021 (and beyond): The Fed will maintain extremely accommodative policy settings to combat low inflation expectations and growth that could still falter in the face of insufficient fiscal support or vaccination snafus. Congress appears to be nearing agreement on another round of fiscal aid: The economic outlook is much rosier than it was when the pandemic arrived but households and businesses in the hardest-hit segments need further assistance to tide them over until COVID-19 is definitively beaten. It appears as if a new wave of fiscal transfers is on the way. You wouldn’t know it to look at the equity market, but we’re not out of the woods yet, … : Stocks keep making new highs against a grim near-term public health backdrop and economic data that point to fading momentum. … and that’s giving rise to a general sense of cognitive dissonance: It is becoming more difficult to reconcile the fundamentals with a spreading tide of euphoria/exuberance. Feature You can always count on Americans to do the right thing – after they’ve tried everything else. Policymakers versus the virus has been the macro story since the pandemic reached the US in the spring and it’s not over yet. The remarkable success of Pfizer/BioNTech’s and Moderna’s vaccines in clinical trials is wonderful news for humanity, but the pandemic will be with us until around 70% of the population is inoculated against COVID-19 or has already contracted it. While it is reasonable to think that the pandemic may end within the next nine months, individuals and businesses that were directly in its path still need some support if the rest of the economy is to avoid the cascading effects of their distress. Just as my spending is your income and your spending is my income, timely debt service is essential for banks, specialty lenders, insurers and the broad range of businesses that allow customers to finance the purchase of goods and services. We have repeatedly made the case that the extraordinary monetary and fiscal support measures launched in the spring have shored up the aggregate positions of households, businesses and the banking system. As restrictions are re-imposed across the country in response to strained hospital capacity (Chart 1), months after the last supplemental unemployment insurance (UI) benefit checks were sent and days before many remaining idled workers lose expanded and/or extended access to UI benefits, some households at the lower end of the income and wealth distributions are becoming increasingly desperate. Since they have the highest marginal propensity to consume, their woes could eventually hem in the prospects for the recovery. Chart 1High Water Everywhere As a result, the economy would welcome some targeted stimulus to extend the bridge over the pandemic crater and ensure that hard-hit households and businesses can make it all the way across. Last week’s talks increased the probability that aid will be provided and sped up the timetable for its delivery. They increased the odds that our base-case scenario, in which the economy receives more aid than is strictly necessary, will come to pass. That scenario is positive for the economy and risk assets and reinforces our view that equities and credit will generate positive excess returns in 2021. The Fed Still Has Investors’ Backs Chart 2Mortgage Rates Are Low Enough Already Last week’s FOMC meeting was largely devoid of suspense. The Fed exhausted its shock-and-awe repertoire in the spring when it implemented nearly all of its emergency GFC measures in the space of a few weeks and topped them off with new facilities positioning it to lend directly to businesses and state and local governments. It played its longer-term trump card in August when it amended its monetary policy strategy statement to allow for deliberate inflation overshoots. Attempting to remediate past inflation shortfalls represents a meaningful shift in the direction of easier monetary policy across the cycle, given that the Fed is now pledging that it will no longer pre-emptively tighten when the labor market heats up. Anything the Fed can do to ease policy from this point forward is likely to amount to tinkering at the margin. Ahead of the meeting, some economists were looking for the Fed to increase the weighted average maturity of its Treasury purchases to hold down long rates. With mortgage applications already straining lenders’ capacity to process them and every component of homebuilder sentiment hovering near record levels (Chart 2), we don’t think Operation Twist-style measures would have a telling impact. Europe’s experience with NIRP does not suggest that venturing below the zero bound would help, either. Additional fiscal aid would be much more potent than any incremental monetary moves. Chair Powell agrees, and he kept up his ongoing lobbying campaign for renewed fiscal support at the post-meeting press conference. From our perspective, the Fed is already providing considerable accommodation and its baseline plans, which include maintaining $120 billion monthly asset purchases “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals,” will be amply accommodative going forward, given that the FOMC’s revised economic projections suggest that it doesn’t currently foresee tapering the purchases until sometime in 2022 at the earliest (Chart 3) or beginning to hike the fed funds rate until 2024 (Chart 4). Though we expect that upward inflation pressures will begin to gain traction sooner than the FOMC currently projects and that its timetable for hiking rates will be accelerated, we expect that monetary policy will remain easier for longer than it needs to, giving financial markets a tailwind for all of 2021. Chart 3 The Fed Will Taper Asset Purchases … Chart 4… Before It Hikes The Fed Funds Rate Better Late Than Never At the time of our publication deadline, Congress appeared to be nearing agreement on a new fiscal support package. Media reports project the bill will provide around $900 billion of aid via direct checks to taxpayers; income support for the unemployed, including a renewed UI benefit supplement; rental assistance; federally-backed loans for hard-hit businesses; aid to hospitals and schools; and dedicated funds for vaccine distribution. Republicans have dropped their demands for virus liability protection for businesses and Democrats have backed off of their insistence on direct aid to struggling state and local governments. A bipartisan group of moderate senators provided the impetus for the apparently successful talks, and it would be tempting to conclude that their ad hoc coalition points the way to a more productive Senate. Unfortunately, our geopolitical strategists expect that political polarization will remain elevated on Capitol Hill. Although Senate Republicans paid no political price for standing in the way of additional fiscal aid ahead of the November election, The New York Times reported that Senate Majority Leader McConnell cited the pending Georgia run-offs in urging his caucus to get behind the proposed bill, saying that the Republican incumbents were “getting hammered” on the campaign trail over the lack of new support. That election will be in the rear-view mirror after Inauguration Day and unless the Democrats surprisingly capture both of the Georgia seats, Congress will remain stalled for the foreseeable future. Do We Really Need More Stimulus? Future congressional dysfunction notwithstanding, successful stimulus negotiations arrived just in time. Recent releases suggest that economic momentum is waning. Initial unemployment claims surged to an eleven-week high for the week ended December 4th and a fourteen-week high for the week ended December 11th (Chart 5), suggesting that the initial scattering of lockdowns is already sparking a new wave of layoffs. Retail sales flopped in November and the economic surprise index has been steadily declining since June (Chart 6). At the aggregate level, it looks like we may have been able to get by without more stimulus, but many out-of-work households and travel, entertainment and hospitality businesses are gasping for air. Their problems could become everyone's problems once they spread to their lenders and their lenders' counter-parties. Chart 5New Lockdowns = New Layoffs Chart 6Coming Back To Earth Households are quite well positioned in the aggregate, having socked away a mountain of excess savings while riding the equity rally and the boom in home prices, but the gains have not been equally spread across the entire population. Wealth and income disparities influence consumption patterns in individual households as embodied in their marginal propensity to consume (MPC). Households living paycheck to paycheck at the lower end of the income and wealth distributions are far more likely to spend an incremental dollar than households at the upper end, who are prone to save or invest new inflows. All dressed up and nowhere to go: Increased wealth can't burn a hole in households' pockets until inoculation unlocks their spending options. Disparate marginal propensities to consume get to the crux of why further fiscal stimulus is needed despite the CARES Act’s income windfall, and the excess savings that have piled up in its wake. Although surging household net worth (Chart 7) will eventually translate into consumption gains (Chart 8), the lag may be longer this time if better-heeled households’ pent-up demand will not be slaked until the virus is definitively beaten. The economy is more sensitive in the near term to spending by high-MPC households, which may become increasingly vulnerable as fiscal support dwindles while renewed restrictions on activity loom. Chart 7What Recession? Aggregate Household Wealth Is Surging Chart 8Changes In Household Net Worth Lead Changes In Consumption With A Two-Quarter Lag Chart 9Has The Other Shoe Finally Dropped? Falling support and tighter restrictions also leave the economy vulnerable to a self-reinforcing cycle of defaults and bankruptcies. Monetary and fiscal accommodation have held credit stress at bay so far, with the Fed’s efforts clearing the way for record volumes of corporate bond issuance and income support and forbearance programs making it easy for consumers to keep up with their debt obligations. Monthly delinquency rates on auto loans, credit cards, home mortgages and other unsecured consumer debt remain strikingly low and are not signaling any problems. Apartment rent collections had been reinforcing the message from low consumer delinquencies, but a steep year-over-year falloff over the first six days of December may be a canary in the coalmine for struggling households (Chart 9). Howard Marks Versus The Newbies Equities have staged a breathtaking rally since bottoming in late March. Although 2020 full-year S&P 500 earnings per share (~$138) are projected to miss pre-pandemic expectations (~$176) by more than 20%, and 2021 estimates (~$169) are over 10% shy of the number analysts had penciled in at the end of January (~$196), the S&P 500 has gained 15% year to date. Some of the rebound off the trough has come from a better-than-expected recovery in corporate earnings, but multiple expansion has been the dominant engine driving the advance. The S&P 500’s forward multiple is already two standard deviations above its mean, and the index will trade very close to its December 1999 peak of 24.8 once Tesla is officially included (Chart 10). Chart 10Back To The Future (In A Tesla This Time) Peak equity valuations are a sign of a market-specific battle between exuberance and moderation that is an outgrowth of the policymaker-virus clash. We expect that exuberance, embodied by neophyte males in their twenties and thirties who found playing the market on Robinhood a diverting substitute for sports betting while college and pro leagues were idled, will eventually be put in its place. The full weight of history is arrayed against it, along with the impeccable cyclical analysis of Howard Marks, who is often cast as the voice of reason by overheating markets. We don't like the excesses that are popping up all over the investment landscape, but we think uber-accommodative policy will sustain them over the next twelve months. We are especially mindful of Marks’ Minskyesque admonition that a run of persistently strong fundamentals can presage investment disappointments, as prices get bid higher and higher and optimism crowds out skepticism and caution. Investing is a relative game; a stock or bond issuer’s absolute performance is less important than how it shapes up against expectations. A company growing at a good clip will face a falling multiple or wider bond spreads if markets were discounting very good growth, and the securities of a company with bad growth will appreciate if markets thought its growth would be terrible. We remain constructive because we continue to believe that economic and corporate earnings growth still has scope to surprise to the upside. We continue to believe that the time-release aspects of the initial stimulus efforts, manifest in massive savings and burgeoning household net worth, are underappreciated. We were concerned that the loss of support for lower-income households could deliver a shock to the economy via drop-offs in consumption and credit performance, but our take on the news from Capitol Hill suggests that the economy is going to dodge that shock in the nick of time. We remain vigilant for signs of an inflection point driven by an economic stumble, a dramatically negative turn on the pandemic front or an imminent reversal of investor excesses that can no longer be sustained. We are uneasy about budding signs of excess, but we think the best course for multi-asset investors with 12-month timeframes is to remain overweight equities and credit because we expect that policy tailwinds and the release of pent-up consumer demand will keep the rally going through 2021.   This is our final report of 2020. Our next report will be published on Tuesday, January 5th. We wish you a happy, healthy and prosperous new year.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

In our "Millennials Are Not Coming Of Age; They Are Already Here” Special Report where we first created the BCA Millennial Basket we mentioned that “we would not hesitate to add other sharing economy stocks, including Airbnb and Uber, to this basket should they become investable.” We did eventually add UBER to the basket, which replaced FB on December 13, 2019. Today, in light of the recent Airbnb IPO, we are compelled to make another substitution. We are banking all the TSLA gains and removing it from our millennial basket as the S&P is adding it in the S&P 500. And, we are reinvesting the funds into ABNB and rebalance all the stocks in the millennial basket back to a 10% weight for each of the constituents. The main reason behind the substitution is because the easy money has already been made in TSLA, but not in ABNB (Chart 1). In other words, now that TSLA is worth as much as all the other car manufacturers in the world put together, it is difficult to continue rising at the same frenetic pace of the past few years. In contrast, were ABNB to follow a similar trajectory and rise to a similar stardom to TSLA, then there is a long runway ahead for this new IPO.  Our Millennial Basket is currently up 137% in absolute terms, and 77% in relative to S&P 500 terms, since the June 11 2018 inception (Chart 2). Recently, we also instituted an 18% rolling stop that we plan to obey it. Chart 1 Chart 2 Bottom Line: ABNB takes TSLA’s seat in our Millennial Basket.