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Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Chart 2.... As Do Betting Markets   Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures.  Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). 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. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Chart 7Democratic Districts Have Fared Better Over The Past Decade Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3   As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4  There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers.  What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix 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

Highlights Portfolio Strategy We recommend investors participate in the equity market rotation during the ongoing correction and position portfolios for next year’s bull market resumption by preferring unloved and undervalued deep cyclical laggards. Ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.    Recent Changes Our trailing stop got triggered and we downgraded the S&P internet retail index to neutral for a gain of 20% since the mid-April inception. This move also pushed our S&P consumer discretionary sector weighting to a benchmark allocation for a gain of 15% since inception. Table 1 Feature The S&P 500 broke below the important 50-day moving average last week, but managed to bounce off the early-June 3233 level – also a level where the SPX started the year – that could serve as temporary support (Chart 1). We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Chart 1Critical Support Levels The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated last week. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    Figure 1The Fiscal Policy Loop It is no surprise that the Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry (Chart 2). Chart 2In Dire Need Of Fiscal Stimulus If Congress fails to pass a new fiscal package by October 16, the latest now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse despite households drawing down their replenished savings (middle panel, Chart 3). This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. With regard to equity market specifics during the current FPL iteration, banks are most at risk as they are levered to the economic recovery, and commercial real estate ails remain a big headache. Absent a fiscal package bank executives will have to further provision for loan losses when they kick off Q3 earnings season in late-October as CEOs will err on the side of caution. Tack on the recent news on laundering money – including by US banks – and the Fed’s new stringent stress tests, and the risk/reward tradeoff remains poor for the banking sector (bottom panel, Chart 3).  Odds are high that volatility will remain elevated heading into the election, therefore this phase represents an opportunity for investors to reshuffle portfolios and prepare for an eventual resumption of the bull market in early-2021. We continue to recommend investors avoid our “COVID-19 winners” basket and prefer our “back-to work” equity basket that we initiated on September 8. Similarly, this pullback is serving as a catalyst to shift some capital out of the fully valued tech titans and into other beaten down parts of the deep cyclical universe. Chart 3Show Me The Money We doubt this correction is over as positioning in the NASDAQ 100 derivative markets is still lopsided; stale bulls are caught net long as NQ futures are deflating, thus a flush out looms (Chart 4).  Chart 4Flush Out The easy money has likely been made in the tech titans that near the peak on September 2, AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out.  Using a concrete rebalancing example to illustrate such a rotation is instructive.2 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift (Chart 5). As a reminder our portfolio has an above benchmark allocation in all three deep cyclical sectors, and this week we reiterate our overweight stance on both the industrials sector and on a key subgroup. Chart 5Rotation Rotation Rotation Buy The Machinery Breakout Were we not already overweight the S&P machinery index, would we upgrade today? The short answer is yes. Aggressive loosening in Chinese financial conditions have underpinned the economic recovery (second & third panels, Chart 6). Infrastructure projects are making a comeback and absorbing the slack in machinery demand caused by COVID-19. As a result, Chinese excavator sales have soared in the past quarter which bodes well for US machinery profit prospects (bottom panel, Chart 6). Beyond China, emerging markets demand for machinery equipment is robust as the commodity complex is recovering smartly (second panel Chart 7). The US dollar bear market is also bolstering global trade growth, despite the greenback’s recent technical bounce, and should continue to underpin machinery net export growth and therefore profit growth for US machinery manufacturers (third & bottom panels, Chart 7).   Chart 6Enticing Chinese Backdrop Chart 7Dollar The Great Reflator The domestic machinery demand backdrop is also conducive to a renormalization of top line growth to a higher run-rate. The ISM manufacturing new orders sub-component is shooting the lights out, heralding a jump in machinery orders in the coming months (second panel, Chart 8). Simultaneously, a quick inventory check is revealing: both in the manufacturing and wholesale channels cupboards are bare which means that the risk of a liquidation phase in non-existent (third panel, Chart 8). Encouragingly, an inventory buildup phase is looming in order to satisfy firming demand. The tick up in machinery industrial production growth, the V-shaped recovery in the utilization rate and newly expanding backlog orders, all suggest that domestic demand conditions are on the mend (Chart 9). Tack on still prudent payrolls management that is keeping the machinery industry’s wage bill at bay (bottom panel, Chart 8), and a profit margin expansion phase is a high probability outcome. Chart 8What’s Not… Chart 9…To Like Our resurgent S&P machinery revenue growth model and climbing profit growth model do an excellent job in encapsulating all the industry’s moving parts and suggest that the path of least resistance is higher for relative share prices in the New Year (Chart 10). Finally, relative valuations have also recovered from the depth of the recession, but are only back to the neutral zone leaving enough room for a multiple expansion phase (Chart 11). Chart 10Models Say Buy Chart 11Compelling Entry Point In sum, ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Industrials Are Jumpstarting Their Engines We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Industrials equities have been on the selling block and suffered a wholesale liquidation during the dark days of the COVID-19 pandemic, and have yet to regain their footing (top panel, Chart 12). The GE and Boeing sagas have dealt a big blow to this deep cyclical sector, but now this market cap weighted sector has filtered these stocks out as neither of these “fallen angels” is occupying a spot in the top 5 weight ranks. Relative valuations are washed out, and relative technicals are still deep in oversold territory (second & third panels Chart 12). Sell-side analysts are the most pessimistic they have been on record with regard to the long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 12)! All this bearishness is contrarily positive as a little bit of good news can go a long way. Already, relative EPS breadth is stealthily coming back, and net earnings revisions are rocketing higher (Chart 13).  Chart 12Liquidation Phase… Chart 13…Is Over One reason behind this optimism rests with the domestic recovery. Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (Chart 14). Emerging markets (EM) and China represent another source of industrials sector buoyancy. The EM manufacturing PMI clocking in at 52.5 hit an all-time high. China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 300 points from -240 to above +60 over the past six months. The upshot is that US industrials stocks should outperform when China and the EM are vibrant (Chart 15). Chart 14Domestic And … Chart 15… EM Green Shoots Are Bullish Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve (third panel, Chart 16). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel, Chart 16). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel, Chart 16). The US Equity Strategy’s macro based EPS growth model captures all the different earnings drivers and signals that an earnings-led recovery is in the offing (Chart 17). Chart 16The Greenback Holds The Key Chart 17Models Flashing Green Adding it all up, vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.   Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. 2     Our example assumes benchmark allocation in all sectors for illustrative purposes.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives 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). January 22, 2018 Favor value over growth

We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Figure 1The Fiscal Policy Loop The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated on Monday. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. Bottom Line: The odds of a fiscal policy mistake are rising quickly and risk an equity market riot point. We remain cautious on the short-term prospects of the equity market and recommend investors keep their powder dry as a better entry point will likely materialize in the coming months. Footnotes 1  The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth.  

Highlights The global recovery has legs, but it will follow a stop-and-go pattern. Global fiscal policy will ultimately remain loose enough to create an appropriate counterweight to three major risks. Risk assets are still attractive on a 12-month investment horizon despite short-term dangers. The dollar cyclical downtrend will be tested, but it will prevail. 10-year Treasury yields will be range bound between 0.5% and 1%. Industrials, materials, gold and Japanese equities are attractive. Feature Chart I-1Ebbing Surprises The S&P 500 correction remains minimal in the face of Washington’s inability to reach a much-needed fiscal compromise. This resilience reflects that economies in the G-10 and China have pleasantly surprised investors despite rolling second waves of infections across the world, fiscal policy paralysis and generalized unease (Chart I-1). Strong growth has fueled higher earnings expectations. Meanwhile, global central banks are promising to keep accommodative monetary conditions in place indefinitely, which has allowed valuations to balloon. The cyclical outlook for stocks remains attractive. Nonetheless, global equities have entered a period of heightened volatility and downside risk until year-end. The S&P 500 had overshot its fundamentals, but now the momentum of the economic surprise index is deteriorating and central banks have deployed their full arsenal. Investors are concerned by a lack of fiscal support and rising policy uncertainty created by the approaching US election in November. This nervousness will spark powerful fluctuations in stock prices.  Avoid Binary Judgments The global economy is at a complex juncture, buffeted between forces that will either propel its recovery or sink it. The positives will predominate in this contest, which suggests that the business cycle remains in an upswing, albeit, a volatile one. The Good… Five main positive forces underpin the nascent economic bounce and thus, the profit outlook. Pent-up demand and the inventory cycle: The economy is making up for the collapse of both cyclical spending and production at the end of Q1 and into Q2. Inventories of finished products have sharply declined in the past six months. In the US, rapidly shrinking inventories are supercharging the uptick in the new-orders-to inventories ratio. Similar dynamics are occurring in China, Europe and Japan (Chart I-2). China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. The Chinese engine is revving: An aggressive stimulus campaign followed Beijing’s swift actions to contain the domestic spread of COVID-19. China’s policies are generating economic dividends that will percolate through the global industrial and commodity sectors. Sales of floor space are already expanding by 40% annually, driven by a 60% jump in Tier-1 cities. In response, construction is forming a trough. Moreover, the large issuance of local government bonds is financing an increase in infrastructure spending. Thanks to an upturn in building activity, the equipment purchases, construction and installation components of China’s real estate investment are all bottoming (Chart I-3). Chart I-2The Inventory Adjustment Is Advanced Chart I-3China: A Policy-Driven Recovery   BCA Research’s Emerging Markets team recently showed that the expenditure rebound is not limited to the real estate sector.1 Vehicle sales are healthier and tech infrastructure outlays are reaccelerating (Chart I-4). Retail sales also moved back into positive territory in August. Thus, China’s cyclical spending has regained its footing. China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. Beijing’s unconstrained credit easing is the source for the turnaround in China’s cyclical and capital expenditures outlook. Hence, the sharp increase in China’s credit and fiscal impulse foreshadows a powerful rebound in imports and in global industrial production because Chinese capex demands plentiful commodities, industrial goods and capital goods (Chart I-5).  Chart I-4More Chinese Recovery Chart I-5Chinese Stimulus Matters Globally   Chart I-6Robust American Households Consumer balance sheets are robust: Unlike the aftermath of the Great Financial Crisis (GFC), US households do not need to rebuild destroyed balance sheets. This time around, the low level of household debt and the limited hit to net worth has allowed consumers to withstand an even greater income shock than during the GFC (Chart I-6). As a result, expenditures are rebounding much quicker than most investors anticipated six months ago. An extremely vigorous policy response: Policymakers in the G-10 did not wait to deploy their economic arsenal when the economic crisis erupted. Governments have racked up their largest budget deficits since World War II (Chart I-7). Monetary authorities also moved quickly to ease financial conditions. Broad money supply growth among advanced economies has skyrocketed, global corporate bond issuance stands at a record $2.6 trillion, and excess liquidity points to continued industrial production strength. In the US, our Financial Liquidity Index is climbing higher alongside the ISM Manufacturing Index. Even the performance of EM carry trades (a financial variable that shows whether funds are flowing into EM economies) is consistent with a stabilization in global IP (Chart I-8). Chart I-7Exceptional Fiscal Stimulus Chart I-8Liquidity Helps Growth     Stronger industrial production models: Our industrial production models for the major advanced economies are all moving up after experiencing massive collapses this past spring. These models encapsulate many influences and their uniformly positive message is very encouraging. In all likelihood, a virtuous cycle has been unleashed. As IP recovers, then so will income, which will fuel the demand expansion and thus, more production. We expect the models to rise even more in the coming quarters. … And The Bad Three near-term concerns still hang over the global economy. Hence, while Q3 is set to deliver stunningly strong numbers boosted by advantageous base effects, growth will recede in Q4.2  While fiscal policy was on point in late Q1 and Q2, Washington’s performance in the past three months has been questionable. Fiscal stimulus hiccups in the US: While fiscal policy was on point in late Q1 and Q2, Washington’s performance in the past three months has been questionable. The CARES Act’s expanded $600 per week unemployment benefit lapsed at the end of July. This benefit, along with one-time $1200 stimulus checks, pushed disposable income higher by 7.5% during the past five months. Thankfully, households managed to save a large proportion of the government support. Consequently, consumption remained strong in August, despite limited help from the federal government. The short-term outlook for consumption is fragile because households cannot continue to tap into their savings. In August, US retail sales disappointed. Calculations by our US fixed-income strategist show that in the coming months, Washington must spend almost $800 billion just for consumer expenditures to match its growth rate of -3% recorded at the depth of the last recession.3 Moreover, a potential wave of eviction of renters looms. Thus, the economy could relapse violently as long as Democrats and Republicans remain apart on a compromise for a new stimulus bill. The upcoming Senate confirmation process to fill the Supreme Court seat left vacant by Ruth Bader-Ginsburg’s passing only complicates the passage of these needed spending measures. Chart I-9Permanent Joblessness Is A Threat Rising permanent job losses: The US unemployment rate has fallen from a high of 14.7% in April to 8.4% in August. This bright picture hides a negative development. The number of permanent job losses has quickly escalated, reaching 4.1 million last month (Chart I-9). Moreover, continuing unemployment insurance claims are barely declining. Mounting long-term unemployment is not associated with an economic recovery. Furthermore, permanent joblessness could easily push down consumer confidence, which would lift the household savings rate and hurt consumption. This problem is not unique to the US. In the UK, an unemployment cliff looms on October 31 when there will be an end to government schemes allowing firms to receive funds as long as they do not permanently severe their links with furloughed workers. The UK’s unemployment rate of only 4.1% is bound to surge when these support measures disappear. In continental Europe, similar stimulus programs could also be rescinded this fall. The weak health of small businesses accentuates risks to the labor market. In the US, 21% of very small firms will run out of money by the end of the year if the government does not dispense supplemental help. Closing these businesses will push up permanent joblessness even more and thus, further weaken consumption. Either weaker stock prices or a deterioration in the economy will be the catalyst for Washington to strike a deal. COVID-19 and the service sector: Many major countries are now fighting a second wave of infections, which may surpass the first wave. Many schools have re-opened and winter in the Northern Hemisphere is approaching (which will force people to congregate inside), bringing with it the regular flu season. Chart I-10The Service Sector Is The Weakest Link This epidemiological backdrop still represents an elevated hurdle to overcome for large swaths of the service sector, especially leisure, food, hospitality and travel. While these industries account for only 10% of GDP in the US, they contribute roughly 25% of employment. If governments toughen social distancing rules and implement localized lockdowns, then the service sector will act as a drag on GDP and employment (Chart I-10). Which Side Will Win? Ultimately, we anticipate that the tailwinds supporting the economy will overcome the headwinds. On the policy front, governments will pass more stimulus. Our Geopolitical strategists believe that the following constraints will force greater spending in the US by mid-October: The Democrats face an election and they want to deliver benefits to their voters.  The White House needs to prevent financial turmoil in the final month of the campaign. If the Republicans fail to agree on a second stimulus bill, there is a significant risk they will lose the White House and their majority in the Senate. Chart I-11No Constraints There The package should total nearly $2 trillion. The Democrats have reduced their demands to $2.3 trillion, while the GOP has moved up its offer to $1.3 trillion. Moreover, a bi-partisan “Problem Solvers Caucus” has emerged in Congress with a $1.5 trillion bill proposal that the White House is considering. Either weaker stock prices or a deterioration in the economy will be the catalyst for Washington to strike a deal. Fiscal stimulus will also remain generous outside the US. In Europe, France is providing an attractive template. On September 3, the Macron government announced an additional EUR100 billion stimulus package, whereby 40% of the funds would come from the common bond issuance recently announced by the EU. In Japan, Prime Minister Yoshihide Suga will continue the policies of his predecessor. Finally, in emerging economies, the absence of inflation and well-behaved sovereign yields and spreads have provided room for local authorities to alleviate any economic pain created by COVID-19 (Chart I-11). Monetary policy will remain extremely stimulative. Central banks will not meaningfully ease policy further, but our monetary indicators are already at their most accommodative levels on record (see Section III). Plus, the US Federal Reserve’s switch to an average-inflation target last month raised the bar that inflation must reach before the FOMC tightens policy. The European Central Bank is contemplating a similar change. Furthermore, the continued woes of service-sector employment constitute another hurdle to clear before central banks can remove accommodation. Chart I-12US Housing Is The New Locomotive Finally, COVID-19 currently has a limited impact on the lion’s share of cyclical spending, which will continue to recover. Cyclical sectors include residential investment, business capex and spending on consumer durable goods. In the US, they account for only 20% GDP, but they generate 70% of the variance in its fluctuations. These sectors are heavily geared toward manufacturing, which is crucial for cyclical spending. Importantly, the robustness of household balance sheets and record low borrowing costs have allowed mortgage applications for purchases to rise sharply, home sales to recover and homebuilder confidence to surge to an all-time high (Chart I-12). Hence, residential activity will remain an important driver of domestic demand, especially because residential investment also often galvanizes other forms of cyclical spending. Bottom Line: The global economy remains buffeted between five positive forces that bolster the recovery and three negatives that hamper it. Ultimately, the authorities will have no choice but to add supplementary fiscal stimulus and monetary conditions will remain extremely accommodative. The recovery will then slow from its heady Q3 pace, but cyclical spending will still power ahead next year. In a nutshell, the economy will not be weaker nor much stronger than the base case presented by the IMF. Investment Implications Our somewhat upbeat position on the global economic outlook remains consistent with a favorable stance toward risk assets in the next 12 to 18 months, because adverse economic outcomes are unlikely to materialize, not because growth will be stronger than expected. Nonetheless, we are conscious that the market place remains fraught with many risks and that growth will stay volatile. As a result, episodic violent corrections will punctuate the upward path in risk asset. We are currently in the midst of such a correction. Chart I-13The Dollar Remains Expensive The Dollar We are still bearish on the dollar on a cyclical investment horizon. The USD remains expensive despite its recent weakness. Against major currencies, the dollar has climbed by 30% since 2008. On a broad, trade-weighted basis, it is up 36% in the same period. Therefore, the US currency trades 15% above its Purchasing Power Parity equilibrium, the most among the major currencies (Chart I-13).4  The US balance of payments picture is becoming increasingly problematic for the dollar. After a surge this spring, US private-sector savings are set to decline. Low interest rates and asset bubbles will increasingly incentivize consumption, while rising capex intentions point to a drop in the corporate sector’s savings. Given that we anticipate the fiscal balance to remain negative in the coming years, the national savings rate will sag, which will worsen the US current account (Chart I-14).5 In other words, the US twin deficits will balloon as the recovery progresses. Despite our bearish view on the dollar, our base case still anticipates a short-term bounce in the USD. The US capital account will not offset the impact on the dollar of a wider current account deficit. US real interest rate differentials have collapsed and foreigners have shunned the Treasury market (Chart I-15, top panel). The Fed conducts the loosest monetary policy among the major economies, which is pushing the US shadow rate lower versus the euro area. Such a trend is euro bullish (dollar bearish) because it draws capital outside of the US economy (Chart I-15, middle panel). Additionally, the USD’s counter cyclicality will be its final undoing during the global economic recovery and will create another hurdle for the US capital account. Chart I-14A Dollar-Bearish Savings Backdrop Chart I-15No Love For The Greenback Chart I-16The Dollar Is Ripe For A Rebound Despite our bearish view on the dollar, our base case still anticipates a short-term bounce in the USD. Our dollar capitulation index is overextended and if stocks experience heightened volatility (see equities on page 32), then a safe-haven asset such as the greenback will catch a temporary bid (Chart I-16). A correction in the euro to 1.15-1.14 is a reasonable target. Government Bonds Our reluctance to overweight bonds or duration is intact. The BCA US 10-Year Government Bond Valuation index is consistent with higher yields in the next 12 months (Chart I-17). Moreover, bond prices are losing momentum, which creates a technical vulnerability for this asset class. The economy is the potential catalyst to expose the underlying valuation and technical risks of government bonds. Inflation is still a distant danger, but our BCA Pipeline Inflation indicator highlights that deflationary pressures are receding (Chart I-18, top panel). Likewise, our Nominal Cyclical Spending proxy already warns that yields have upside; and an expanding recovery implies that bond-bearish pressures will progress (Chart I-18, bottom panel). Chart I-17The Traitorous Treasury Market Chart I-18Problems For Treasurys   The Fed’s switch to an average inflation target is also consistent with higher long bond yields. The Fed’s newfound tolerance for loftier inflation should lift long-term inflation expectations and medium-term inflation uncertainty, especially given current fiscal trends. Higher long-term inflation expectations and inflation uncertainty have the potential to generate a broader range of policy-rate outcomes, therefore they will also normalize the extraordinarily depressed term premium and lead to a steeper yield curve (Chart I-19). Thus, 10- and 30-year yields have room to increase even if current short rates remain anchored near their lower bounds for the next three years. Over the next 12 months, 10- and 30-year Treasury yields will be capped at 1% and 2%, respectively. The expected yield upside will be limited in the next year. While investors should anticipate some curve steepening, the most violent selloffs only take hold of the Treasury market when the Fed generates hawkish surprises, which is very unlikely in 2021 (Chart I-20). Moreover, the stock market creates its own constraints. As our European Investment strategist has reasoned, higher yields will hurt growth stocks that derive a disproportionate share of their intrinsic value from long-term cash flows.6 If bond prices fall too quickly, then these growth stocks would plunge and drag down the equity market. In essence, elevated bond yields can generate a deflationary shock that undoes the primary reason why yields would rise. Therefore, over the next 12 months, 10- and 30-year Treasury yields will be capped at 1% and 2%, respectively. Chart I-19Average-Inflation Targeting Hurts Long-Dated Bonds Chart I-20Limited Upside For Yields   Equities Several factors underpin our positive stance on global equities in the next 12 months. The lack of investment alternatives or TINA (There Is No Alternative) is a crucial support under stock prices. As BCA Research’s Global Investment Strategy service recently discussed, the S&P 500’s dividend yield stands at around 100 basis points above 10-year Treasury yields.7 Conservatively assuming that dividends per share remain constant in the next 10 years and inflation averages 2%, the real value of the US equity benchmark must decline by 25% during that period before it underperforms Treasurys. Given that gaps between dividend yields and bond yields are even larger outside the US, many foreign bourses must experience deeper real depreciation before they underperform their respective bond markets (Chart I-21). Corporate pricing power is returning, which is positive for the earnings outlook. The ability of firms to boost prices will be enhanced by the combination of a weak dollar, declining deflationary forces, rebounding commodity prices and a surge in the sales-to-inventory ratio. The pickup in pricing power is broadly based; 59% of the S&P 500 groups analyzed by our US equity strategist are experiencing mounting prices.8 When higher pricing power meets mending sales volumes, operating leverage allows profit margins to expand, which lifts earnings per share and stock prices (Chart I-22). Chart I-21TINA Flatters Stocks Chart I-22Corporate Pricing Power Is Coming Back Chart I-23Liquidity Underpins This Rally The global monetary environment also supports stocks. The swell in our US Financial Liquidity index is consistent with additional equity gains because it forecasts stronger economic activity (Chart I-23). Expectations of an upswing in the business cycle let earnings forecasts climb and can also improve the anticipated growth rate of long-term earnings while encouraging risk-taking, which compresses the equity risk premium. Moreover, generous liquidity limits the upside to real yields, which further boosts equity multiples. Another consequence of ample liquidity is a marked increase in corporate actions. Firms engage in greater M&A activity, which can generate gains in accounting earnings while withdrawing equity from the market. Businesses around the world have tapped the corporate bond market at a record pace this year, creating both large war chests and the capacity to deploy funds for capex. Higher capex boosts demand and cyclical spending, which creates a positive environment for earnings. Our positive cyclical view on stocks does not preclude a period of heightened volatility and further downside risk in the coming three months. The US and G-10 economic surprise indices are elevated, but they are losing momentum. This deterioration in the second derivative of activity is problematic when there is a non-trivial chance of a policy error in Washington. Importantly, the upcoming US election will raise questions about the regulatory environment for the two market heavyweights: technology and healthcare stocks. As we wrote last month, a shift of leadership away from these sectors will translate into episodic corrections for stocks at large.9 Additionally, investors must price in the risk of gridlock in Washington. If Senate Republicans are reluctant to write a check while an unpopular President Trump faces an imminent election, then their willingness to expand spending if Biden clinches the White House will be nonexistent. A complete refusal to add fiscal stimulus would nearly guarantee a double-dip recession. Equities must embed a risk premium against this scenario ahead of the election. Therefore, the S&P 500 is likely to test 3000 in the coming weeks before rebounding. Our positive cyclical view on stocks does not preclude a period of heightened volatility and further downside risk in the coming three months. Sector Considerations We are positive on the medium-term outlook for value versus growth stocks. The cheapness of value versus growth makes the former attractive, but is not enough to allocate funds to it aggressively. Instead, our bias takes root in our economic view. The forward earnings of global value stocks are very depressed relative to growth stocks. However, the ratio of value EPS to growth EPS is extremely pro-cyclical. Thus, our positive stance on global growth is consistent with a rebound in relative profits that will help value equities (Chart I-24, top panel). Moreover, higher yields correlate with a re-rating of relative equity multiples in favor of value stocks, which are less sensitive to rising discount rates than their growth counterparts (Chart I-24, bottom panel). In this context, we continue to favor industrials and materials; consumer discretionary stocks are also appealing.10 Investors should underweight the US, especially in common currency terms. Gold mining equities remain attractive long-term investments. In the near term, as long as the dollar counter-trend bounce continues, gold will purge its excess froth (Chart I-25, top panel). Nonetheless, our trend indicator remains positive for gold (Chart I-25, bottom panel). Moreover, if real yields start to stagnate at their current low levels, then gold will lose a tailwind but it will not develop a new handicap. In this context, an increase in inflation expectations will elevate gold prices (Table I-1). Other bullish cyclical forces underpinning gold include the dollar’s long-term bear market, limited supply expansion and the diversification of EM central banks away from Treasurys into gold. This positive backdrop should allow the attractive relative valuation of global gold mining firms and their improving operating metric (courtesy of rigorous cash flow management and limited expansion plans) to blossom into more equity price outperformance over the next year or so. Chart I-24Long Growth vs Value: A Cyclical Trade Chart I-25A Shakeout For The Gold Bull Market Table I-1Gold's Response To Yields Finally, Japan has become our favorite equity market for the next 9 to 12 months. Japanese stocks possess the perfect equity exposure to play the themes we espouse because they greatly overweight industrials and traditional consumer discretionary stocks at the expense of tech and healthcare (Table I-2). Moreover, we like auto stocks, an industry well represented in the Japanese bourse, which will benefit from a weak trade-weighted yen.11 Lastly, Japanese stock prices incorporate a large margin of safety. Most sectors in Japan trade at a significant discount to their European and US counterparts (Chart I-26). Nevertheless, it is too early to make a structural bet on Japan because its productivity problems and persistent deflation generate a long-lasting drag on corporate profitability. Table I-2Japan Possesses An Attractive Sector Composition Chart I-26Japan Is A Cheap Recovery Bet Section II presents a thought experiment by our Chief US Equity Strategist, Anastasios Avgeriou, which details the feasibility of a doubling of the S&P 500 over the coming 8 years. I trust you will find this report based on historical evidences thought-provoking.   Mathieu Savary Vice President The Bank Credit Analyst September 24, 2020 Next Report: October 29, 2020   II. SPX 7000 We present a thought experiment for the next eight years. 7000 constitutes a reasonable long-term target for the S&P 500. A doubling of the S&P 500 over the coming eight years is in line with the historical experience. Monetary policy is unlikely to tighten meaningfully, which will allow multiples to remain elevated Earnings per share can rise to $310 by 2028. Market technicals are also consistent with significant long-term gains for stocks. Chart II-1Prolonged ZIRP Neither Eliminates Corrections... Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart II-1). Seven years. As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart II-1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart II-2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart II-3). Chart II-2...Nor Mini Economic Cycles Chart II-3"Lowflation"/Disinflation Has Been The Story Of The Past 30 Years   Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart II-2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart II-3). Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. Table II-1 With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table II-1). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart II-4). Chart II-4Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart II-5). Chart II-5EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table II-2 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table II-2SPX EPS & Multiple Sensitivity With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart II-5). A few words on presidential cycles are relevant given our structural bullish equity market view. We first noticed Tables II-3 & II-4 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies12 dating back to Hoover. Table II-3Every Presidency Experiences Drawdowns Table II-4S&P 500 Returns During Presidential Terms What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart II-6). Chart II-6Of Megaphones And Diamonds Chart II-7Diamond Base Is Long Term Bullish While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart II-7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Anastasios Avgeriou US Equity Strategist III. Indicators And Reference Charts The stock market correction has begun in earnest. The S&P 500 is suffering as the economic surprise index deteriorates, the dollar rebounds and uncertainty surrounding fiscal policy takes center stage. The deteriorating performances of silver, investment grade bonds, small-cap stocks, EM currencies and the AUD/CHF cross confirm that the equity market will suffer more downside. Moreover, the number of NYSE stocks trading above their 10-week moving average is in free-fall but remain well above levels consistent with a bottom. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. The shift to an average-inflation target by the Fed, which the ECB is also considering, buttresses this dovish stance further as inflation will have to rise even more than normally before the major global central banks tighten policy. Moreover, outside of the US, fiscal policy remains accommodative. Even in the US, we expect more stimulus to come through before the November election. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator has softened but it remains at the top of its pre-COVID-19 distribution, which balances the expensiveness of the market flashed by our Valuation Indicator. Putting those forces together, our Intermediate-Term Indicator and our Revealed Preference Indicator strongly argues in favor or staying invested in equities. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor around 3000. At this level, the froth highlighted by our Speculation Indicator will have dissipated. Despite the equity correction, bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. Moreover, our Cyclical Bond Indicator has turned higher and is now flashing an outright sell signal. In effect, with rates near their lower bound, the market understands that yields have little room to decline and thus bonds seems to be losing their ability to hedge equity risk. Thus, bonds yields are unlikely to rise as stocks correct, but their lack of downside right now suggests that when equities regain their footing, 10-year Treasury yields could quickly move higher toward 1%. The dollar countertrend rally that we expected last month has begun. So far, the dollar has still not purged its oversold conditions and the deterioration in risk sentiment around the world will likely result in additional upside for the greenback. Ultimately, this rally will be temporary. The global economic recovery has just begun, the US balance of payments picture is deteriorating and the USD trades at a large premium to its purchasing power parity equilibrium. Commodities remain in a bull market, but their current correction has further to run. As investors absorb the deterioration in economic surprises and risk sentiment declines, the overbought commodity complex will remain under downward pressure. The strength in the US dollar is creating an additional powerful headwind against commodities. Gold’s decline has been particularly noteworthy. Gold remains above its short-term fair value, hence its vulnerability to the dollar and to the decline in our Monetary Indicator is particularly pronounced. A stabilization in gold and silver prices is required before the rest of the commodity complex and stocks can find a firmer footing. Stronger precious metals would indicate that the deterioration in liquidity visible at the margin is ending. It is likely to be contemporary with the passage of a new fiscal stimulus bill in the US. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see  Emerging Markets Strategy "Charts That Matter," dated September 10, 2020, available at ems.bcaresearch.com 2 The Atlanta Fed GDPNow model already points to an annualized growth rate of 32% in Q3 in the US, but the New York Fed’s model pencils in a much more modest 5.3% expansion rate for Q4. 3 Please see  US Bond Strategy "More Stimulus Needed," dated September 15, 2020, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy "Revisiting Our High-Conviction Trades," dated September 11, 2020, available at fes.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020 and The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 6 Please see European Investment Strategy "The Puppet Master Is The 30-Year Bond," dated August 6, 2020, available at eis.bcaresearch.com 7 Please see Global Investment Strategy "Stock Prices And Interest Rates: Can We Trust TINA?," dated September 11, 2020, available at gis.bcaresearch.com 8 Please see US Equity Strategy "Pricing Power Update," dated September 14, 2020, available at uses.bcaresearch.com 9 Please see The Bank Credit Analyst "September 2020," dated August 27, 2020, available at bca.bcaresearch.com 10 However, in the US, investors must be careful as the sector is dominated by one firm: Amazon, which trades as a tech stock, not as a traditional consumer discretionary. 11 Please see Daily Insights "More Cars Please!" dated July 20, 2020, available at di.bcaresearch.com 12 By term presidencies we are referring to the different duration of Presidents staying in office.

Feature In last week’s US Bond Strategy report, we presented the results of a scenario analysis on consumer spending.1 The goal of that analysis was to assess how much additional federal government income support is required to achieve consumer spending growth targets that won’t disappoint markets. The calculations regarding the amount of additional stimulus required to hit different spending targets are correct. However, a typo in our code (in fact, a missing letter “c”) caused us to specify the wrong targets. Last week, we targeted -3% 12-month over 12-month consumer spending growth for the period between March 2020 and February 2021. The rationale being that -3% was the worst spending growth seen during the 2008 Great Recession and would likely be the minimum that markets could tolerate this time around. As shown in the second panel of Chart 1, this number should have been -1.9%. Chart 1Consumer Spending Driven By Income & The Savings Rate We also considered spending growth targets for the 12-month period between August 2020 and July 2021. Last week we set our target range for that period at between 2% and 6%, the growth rates seen during the recovery years that followed the Great Recession. That range should have been set at 2.5% to 5%. We present revised results from our scenario analysis in Table 1 and Table 2. These tables are identical to the ones presented last week, except that they now have the correct consumer spending targets. Table 1Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Table 2At Least $600 Billion More Government Income Support Is Needed Our conclusion remains similar, though our corrected numbers suggest that more income support from the federal government will be required to hit reasonable spending targets. Last week, we concluded that extra income support on the order of $500 - $800 billion is the minimum that will be required. Our corrected numbers suggest that more stimulus will be necessary, on the order of $600 billion to $1 trillion.    Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com

Highlights Consumers are the beating heart of the US economy, … : By showering cash on the newly unemployed, and issuing checks to more than half of all taxpayers, the CARES Act arrested April’s free fall in consumption and helped households meet their financial obligations. … and if they’re waylaid by the pandemic, only a forceful fiscal response stands in the way of reduced future growth: Bankruptcies and widespread displacement of workers would turn a nasty cyclical shock into lower trend growth. How big does the next round need to be?: Applying a framework developed by our US Bond Strategy colleagues, we estimate that consumption growth will get back to trend if Congress provides $800 billion of aid to households through the first half of next year. Is it likely something that size can get through Capitol Hill?: Assistance for reeling states is a potential sticking point, but we continue to believe that a major aid package will pass. If it doesn’t, the election outcome will loom large over the 2021 outlook. Feature Over BCA’s 70-plus years, our research teams have developed hundreds if not thousands of proprietary indicators to project where financial markets and the major economies are headed. They are central to our process and we are continuously engaged in trying to improve them. Sometimes, though, it helps to take a step back and look at the landscape from the broadest and simplest perspective. When we do, we remind ourselves of what we have come to think of as macroeconomics’ fundamental lesson: My spending is your income and your spending is my income. Consumption isn't just four times as large as each of the other two main components of US GDP, it also exerts a gravitational pull on them. The truth of this simple formulation is especially easy to see in the United States, where consumption accounts for two-thirds of GDP (investment and government spending each contribute one-sixth, ignoring net exports’ modest drag). The US economy would shrivel if household spending were to fall sharply, and the second-order effects on investment and government receipts would prolong the agony. The former is a function of consumption; businesses only invest once it’s clear that demand has overtaken existing capacity or will soon do so. Reduced consumption would pressure employment and profits, squeezing federal revenues that are almost entirely composed of individual income taxes, payroll taxes and corporate income taxes (Chart 1). Transfers from the federal government account for one-third of the states’ total revenues (Chart 2); since most of them are forbidden to run budget deficits, they would face immediate cutbacks if the flows from Washington were to slow. Chart 1Consumption Exerts An Outsized Impact On Federal ... Chart 2... And State Government Revenues Plugging The Gap Recognizing that a wobbling consumer has the potential to topple several economic dominos, Congress undertook extraordinary measures to keep a vicious short-term shock from impairing growth into the intermediate and long term.1 The CARES Act included provisions to support ailing industries and small businesses, but its efforts at shoring up vulnerable households have been the most effective by far. Direct payments of $1,200 to every adult and $500 to every child in households earning less than $99,000 ($198,000 for married filing jointly taxpayers) and weekly $600 supplemental unemployment benefits helped push personal income well above February’s pre-pandemic level (Chart 3). Chart 3The CARES Act Gave Lower-Income Households An Enormous Boost With income rising, especially for those at the lower end of the income distribution, households were able to stay current on their rent (Table 1), their mortgage and all their other obligations (Table 2). They were even able to pay down their credit card balances, an unusual occurrence at the start of a recession (Chart 4). Residential landlords and personal lenders breathed a sigh of relief, along with the entities that have lent to them, though they must be wondering how their obligors will fare now that the CARES Act’s supplemental unemployment benefit has expired. Households built up $325 billion of savings from March through July, which helped tide them over in August and is presumably doing so in September, but we expect that cracks may be beginning to show and that they will emerge in force in October if another round of aid is not forthcoming. Emergency CARES Act fiscal transfers were so large that they more than offset the drag from declining compensation as employees were laid off or worked less than full time during the lockdowns. Table 1September Slowdown? Table 2Credit Performance Across Personal Loan Categories Was Solid Through July Chart 4Strapped Households Usually Run Up Their Credit Card Balances When Recessions Hit How Much Will It Take? Deficit spending is a charged issue, especially among those at the upper end of the income distribution who will ultimately be taxed to repay the debt to fund today’s deficits. However, we agree with the mainstream economic consensus that issuing another two or three trillion dollars of debt at negative real yields is preferable to suffering the hysteresis effects of an uncontained surge of bankruptcies. From a short-term perspective, vigorous fiscal support is the only thing that can preserve the seeming dichotomy between the real economy’s struggles and the equity and credit markets’ bliss.2 The key practical question is how big the next round needs to be to allow policymakers to extend the bridge over the gap opened by the pandemic. Our US Bond Strategy colleagues addressed that question head on last week.3 They proceeded from the assumption that a certain minimum level of consumer spending growth is necessary to meet market participants’ generally sanguine recovery expectations. They then focused on how household income (what comes in) and the savings rate (how much is held back) might evolve under pessimistic and optimistic scenarios and a base-case scenario that splits the difference between the two. Their estimates of required support from a new round of fiscal transfers are simply the difference between the spending that would occur without the transfers and the minimum required spending. Looking at the 12-month moving average of consumer spending to smooth out single-month swings, and comparing it to its year-ago level (a 12-month-over-12-month basis), we map out three nominal growth targets for the August 2020 to July 2021 period: 3%, 4% and 5%, consistent with the range that prevailed once the economy found its footing after the global financial crisis (Chart 5). Instead of performing the analysis under all three of our colleagues’ scenarios, we simply use the split-the-difference base case that has household income ex-CARES Act transfers (Chart 6, top panel) and the savings rate (Chart 6, bottom panel) returning to their pre-pandemic level by September 2021. Chart 5Outside Of Recessions, Consumer Spending Growth Typically Occupies A Tight Range Chart 6Recovery Scenarios For Consumption's Drivers The results are shown in Table 3. The 4% nominal rate of consumption matches the economy’s trend growth since the GFC (2-to-2.25% real plus 1.75-to-2% inflation), 3% allows for a sluggish recovery in which the virus only slowly loosens its grip and 5% covers the possibility of a burst of above-trend growth that might follow a better-than-expected virus outcome. We project that households will require an average of $70-to-94 billion of monthly income support to grow 12-month-on-12-month consumption by 3-to-5%. A repeat round of stimulus checks would chip in $23 billion, leaving supplemental unemployment insurance benefits and the extension of benefits to workers that would not otherwise be covered by their state unemployment insurance program to pick up much of the rest of the $50-to-70 billion tab. Once those programs were fully up and running in May, June and July, they distributed an average of $92 billion per month ($77 billion supplemental benefits and $15 billion expanded eligibility). Those numbers suggest that unemployment-related transfers amounting to 55-to-75% of the CARES Act transfers would suffice, which is encouraging because the Senate and the White House now view its $600 weekly supplement as too generous. The unemployment rate has fallen since the spring, however, with fewer households in line to receive payments, so lawmakers will have to devise other ways to get money into the hands of consumers. Given that states and municipalities face an acute cash crunch and Democrats have insisted on addressing it, there is a good chance that states will receive a healthy allocation and some of the state funds will eventually find their way to households. Table 3Another Round, Please The bottom line for investors assessing the adequacy of a stimulus bill is that we think it should allocate at least $800 billion to support household income. A bill in the mid-to-high $1 trillion range that would split the difference between Republican and Democratic proposals should suffice and it would leave ample room for desperately needed support for state and local governments. Public transit systems like the gasping New York city subway, which suffered ridership declines of as much as 80-90% at the height of the lockdown while incurring significant new cleaning costs, may otherwise have to impose draconian service cutbacks that undermine their local economies’ efforts to reopen. The Fundamental Theorem Of Microeconomics At the University of Chicago’s Booth School of Business, Introductory Microeconomics is called Price Theory to keep the central lesson of the course in every student’s mind: people respond to incentives. We have come to think of this as the fundamental rule of microeconomics. It is the foundation of public policy’s attempts to shape behavior: If you want more of something, subsidize it; if you want less of something, tax it. When mulling the prospects for the passage of a significant new aid bill, we begin and end with a consideration of the key players’ incentives. The Democrats want a bill to demonstrate that government can be the solution and to push back against the anti-government narrative that has taken root over the last 40 years. The administration should be doing its utmost to obtain a robust spending package since recessions have reliably sunk incumbent presidents’ re-election prospects. Republican senators, even those who are not up for election this year, should want a bill because control of the Senate is likely to go to the party that wins the White House and individual senators’ power and influence are magnified when they are in the majority. Despite months of posturing and foot-dragging, we second our geopolitical strategists’ view that an aid package aligning with all the major players’ interests will pass soon. Investment Implications Much of our constructive take on markets and the economy proceeds from our view that another significant round of fiscal aid is forthcoming. If it is not, we would revisit our bullish 12-month asset allocation recommendations and we would close out our overweight on the SIFI banks’ stocks. An assumption that humankind will find a way to tame COVID-19 on a timetable in line with market expectations is also embedded in our 12-month equity overweight. If a second wave of infections takes hold, the mortality rate moves significantly higher and treatment and/or vaccine progress unexpectedly reverses, our recommendations will get more cautious. If it is in the interests of all of Washington's key players to pass a bill, there's an awfully good chance that bill will get passed. Although those in the know have lately become more optimistic that the first installment(s) of an effective vaccine(s) will become available in the next two quarters (Chart 7), such an outcome is not assured. A client asked us last week what would ensue if a vaccine is not available until the third or fourth quarter of 2021. As we talked through it with her, we could not escape the idea that the election could be hugely consequential for markets if the lack of a vaccine coincides with a failure to pass a stimulus package before the election, or with a stimulus package that does not extend beyond the end of March. Chart 7Rising Odds Of A Vaccine Within The Next Six Months If the next round of stimulus is not passed before the election, or if it is set to expire two or three quarters before an effective vaccine will be available in sufficient quantities to turn the public health tide, fiscal policy would become the single most important driver of the near-term market and economic outlook, given our view that the Fed has already done nearly all it can do. Congress would then take center stage, with the White House playing a secondary role based on its veto power and the influence of the bully pulpit. In that case, we would expect equity and credit markets to fare much better under a Blue Wave outcome in which the Democrats sweep the election than they would in any outcome that leaves Republicans in control of the Senate. Think of it like this: if the economy needed fiscal aid to counter six-to-twelve more months of pandemic disruptions two years before Congress again had to face voters, would you rather appeal to Pelosi, Schumer and Biden, champing at the bit to demonstrate how government can alleviate suffering, or Mitch McConnell, itching to teach profligate cities and states a lesson?   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The Fed leaped into the breach as well, but we have already discussed its efforts in detail. This report focuses on fiscal policy. 2 Please see the September 18, 2020 BCA Research Special Report, "The US Economy vs. The Stock Market: Is There A Disconnect?" available at www.bcaresearch.com. 3 Please see the September 15, 2020 US Bond Strategy Weekly Report, "More Stimulus Needed," available at usb.bcaresearch.com.

Dear Client, We will be working on our Fourth Quarter Strategy Outlook next week, which will be published on Tuesday, September 29th. 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 Investors should favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term and vulnerable to a further correction.  Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. While we ultimately expect a deal to be reached, it may take a stock market sell-off to force Republican leaders to accede to Democratic demands for more spending. US monetary policy will stay accommodative for at least the next two years, a view that this week’s FOMC meeting further validated. Investors should pivot into cheaper areas of the stock market – in particular, deep cyclicals and financials, non-US stocks, and value stocks. Value stocks are especially appealing, as they are now trading at the biggest discount on record relative to growth stocks. The “pandemic trade” will give way to the “reopening trade.” The latter will benefit value stocks. In addition, stronger global growth, ongoing Chinese stimulus, a weaker US dollar, and modestly steeper yield curves all favor value indices. Value investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Market Commentary Chart 1Drastic Drop In Weekly Unemployment Insurance Payments We continue to favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term despite correcting modestly over the past few weeks. Tech stocks rallied hard into September. Aggressive buying of out-of-the-money call options helped fuel the rally. While some big institutional players such as Softbank have reportedly scaled back their positions, many retail investors remain unfazed. The triple leveraged long Nasdaq 100 ETF, TQQQ, experienced the largest weekly inflow on record in September. In addition to being technically stretched, equities face near-term risks from the impasse in the US Congress over a new stimulus bill. Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. Chart 1 shows that weekly unemployment payments have fallen by $15 billon since the end of July, representing a drop of more than 50%. At an annualized rate, this amounts to 3.7% of GDP in fiscal tightening. On top of that, the funds in the small business Paycheck Protection Program have run out, while many state and local governments face a severe cash crunch. BCA’s geopolitical strategists expect a fiscal deal to be reached over the next few weeks. The fact that Speaker Nancy Pelosi has said that Congress will stay in session until both sides agree on an aid package is good news in that regard. Nevertheless, given all the acrimony in Washington in the run up to the November election, there is still a non-negligible chance that a deal falls through. Why, then, are we still bullish on stocks on a 12-month horizon? Partly it is because voters want more stimulus, which means that fiscal policy is likely to be loosened again, even if this does come after the election. It is also because the pandemic seems to be receding. While the number of new cases is rising again in the EU and some other regions, fatality rates remain much lower than during the first wave. Progress also continues to be made on developing a viable vaccine. According to The Good Judgment Project, about 60% of “superforecasters” expect a mass-distributed vaccine to be available by Q1 of 2021, up from 45% just four weeks ago. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 2). Chart 2High Odds Of A Vaccine Within 6-To-12 Months Lastly, monetary policy remains exceptionally accommodative. The Fed this week formally incorporated its new flexible average inflation targeting strategy into its post-meeting statement. The FOMC promised to keep rates at rock-bottom levels until the economy has reached “maximum employment” and inflation “is on track to moderately exceed two percent for some time.” The dot plot indicated that the vast majority of FOMC members did not expect rates to rise until at least the end of 2023. As Chart 3 shows, the global equity risk premium remains quite elevated. This favors stocks over bonds. Not all stocks are equally attractive, however. Four weeks ago, in a report titled “The Return of Nasdog,” we made the case that investors should pivot away from growth stocks towards value stocks. The report generated quite a bit of interest from readers. Below, we review and elaborate on some of the issues raised in a Q&A format. Q: Being long value stocks relative to growth stocks has been a widowmaker trade for more than a decade. Why do you think we have reached an inflection point? A: 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 4). Chart 3Global Equity Risk Premium Remains Quite Elevated Chart 4Value Stocks Are Extremely Cheap Relative To Growth Stocks     Admittedly, valuations are not a good timing tool. One needs a catalyst to unlock those valuations. Good news on the virus front may end up being such a catalyst. The “pandemic trade” benefited tech stocks, which are overrepresented in growth indices. It also favored health care stocks, which are similarly overrepresented in growth indices, at least globally (Table 1). 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. Table 1Breaking Down Growth And Value By Sector Chart 5 shows that retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels. 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. 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 6). 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. Chart 5Are Brick-And-Mortar Retailers Coming Back To Life? Chart 6The Pandemic Has Caused Global Server And PC Shipments To Surge     Q: How are investors positioned towards value versus growth? A: According to the September BofA Global Fund Manager Survey, tech and pharma were the two sectors with the largest reported overweights. Thus, there is significant scope for money to shift out of these sectors. Q: What about the overall macro environment underpinning growth and value? A: While the relationship is far from perfect, value stocks tend to outperform growth stocks when the US dollar is weakening (Chart 7). Recall that growth stocks did very well during the late 1990s, a period of dollar strength. In contrast, value stocks outperformed between 2001 and 2007, a period during which the dollar was generally on the back foot. As we have spelled out in past reports, we expect the dollar to weaken over the next 12 months, which should benefit value stocks. Value stocks also tend to do best when global growth is accelerating (Chart 8). Provided that governments maintain adequate levels of fiscal support and a vaccine becomes available by early next year, global GDP should bounce back swiftly. Chart 7Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Chart 8Value Stocks Also Tend To Do Best When Global Growth Is Accelerating   Q: Won’t lower real bond yields favor growth stocks? A: By definition, growth companies generate more of their earnings further in the future than value companies. As such, a decline in real yields will tend to increase the present value of cash flows more for growth companies than for value companies. We do not expect real yields to rise significantly over the next two years. However, given that real yields are already deeply negative in almost all countries, they probably will not fall either. Q: You seem to be making the cyclical case for the outperformance of value stocks. But what about the secular case? It appears to me that the stronger earnings growth displayed by growth stocks will ultimately translate into higher long-term returns. A: Historically, that has not been the case. As Chart 9 and Table 2 illustrate, value stocks have outperformed growth stocks by a wide margin over the past century. In particular, small cap value has clobbered small cap growth. Chart 9Value Stocks Have Outperformed Growth Stocks By A Wide Margin Over The Past Century Table 2Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns How did value stocks manage to triumph over growth stocks if, as you say, growth stocks usually experience faster earnings growth? The answer has to do with what is priced in and what is not. If everyone expects a company’s earnings to grow next year, this will already be reflected in its share price. It is only unanticipated earnings growth that should move share prices. For the most part, both analysts and investors have tended to overextrapolate near-term earnings growth. As we discussed in a special report titled “Quant-Based Approaches To Stock Selection And Market Timing,” while analysts are generally able to predict which companies will display superior earnings growth over the next one-to-two years, they systemically overestimate earnings growth on longer-term horizons (Chart 10). As a result, investors tend to overpay for growth, causing growth stocks to lag value stocks. Chart 10A Mug’s Game Q: That may have been true historically, but it seems that more recently, investors have been guilty of underpaying for growth. A: Yes and no. If one looks at the period between 2007 and 2017, the superior performance of growth stocks was broadly matched by their superior earnings growth. As a result, relative P/E ratios did not change much. Since 2017, however, the P/E ratio for growth indices has soared relative to value indices (Chart 11).  Chart 11AThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion Chart 11BThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion   Q: What has happened since 2017 that has caused growth stocks to become so much more expensive? A: FANG, FAANG, FANGMAN, whatever acronym you want to use, it was mainly a story about investors becoming infatuated with mega cap tech stocks. After seeing these companies beat earnings estimates quarter after quarter, investors decided that they deserve to trade at much higher valuation multiples. Q: What about other tech companies? A: For the most part, they were left in the dust. Our proprietary Equity Analyzer system allows us to sort companies based on all types of fundamental and technical factors. Chart 12 shows that “value tech” companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales have gotten completely clobbered by “growth tech” companies trading in the top quartile of these valuation metrics. Chart 12Value Tech Versus Growth Tech Interestingly, the opposite pattern was true among financials: “Value financials” – financials that trade cheaply based on the valuation measures listed above – have outperformed “growth financials.” The net result is a bit surprising: Since “value tech” underperformed the average tech stock, while “value financials” outperformed the average financial stock, the average “value tech” stock has delivered a return over the past decade that was almost identical to the average “value financial” stock. Chart 13There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years Q: This seems to suggest that value managers would not have made any money by shifting exposure from financials to tech? A: Correct. Consider the iShares MSCI USA Value Factor ETF (ticker: VLUE). It is structured to have the same sector weights as the overall US market. It currently has 27% of its assets in technology and 10% in financials. Compare that to the Vanguard Value Index Fund ETF Shares (ticker: VTV). It has 10% of its assets in technology and 19% in financials. As Chart 13shows, VTV has actually outperformed VLUE over the past five years. Year to date, VTV is down 10%, while VLUE is down 15%. Q: While value managers would not have made money by shifting capital from financials to tech, I presume the same thing could not be said for growth managers. A: You can say that again. “Growth tech” outperformed the average tech stock, while “growth financials” underperformed the average financial stock. Thus, shifting money from “growth financials” to “growth tech” would have supercharged returns. Q: This still leaves open the question of why mega cap stocks were able to grow earnings so rapidly? A: Two explanations come to mind. First, tech companies often gain from so-called network effects: The more people there are who use a particular tech platform, the more attractive it is for others to use it. Second, tech companies benefit from scale economies. Once a piece of software has been written, creating additional copies costs 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. Q: It seems this process could go on indefinitely? A: Not indefinitely. No company can control more than 100% of its market. There is also a limit to how big the overall market can get. 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. Q: These companies have plenty of cash. Can’t they try to enter new types of businesses if they want to keep growing? A: They can try, but there is no guarantee they will succeed. Kodak was one of the pioneers in digital photography. However, it could never really reinvent itself and ended up fading into oblivion. Moreover, while first-mover advantage is a powerful force, it is not invincible. 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. Q: And I suppose government policy could also turn less friendly towards tech? A: That is a definite risk. Republicans have been cheap dates for tech companies. Republican politicians have showered tech companies with tax cuts and allowed them to exploit a variety of loopholes in the tax code. They also kept tech regulation to a minimum. All this happened despite the fact that many tech leaders have publicly panned conservative viewpoints, while tech company employees have rewarded Democratic politicians with the lion’s share of campaign donations (Chart 14). Chart 14Tech Company Employees Donate Heavily Towards Democrats Going forward, Republicans are likely to sour on big tech. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). Tucker Carlson, a leading indicator for where the Republican party is heading, has frequently lambasted tech companies on his highly popular television show. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies For their part, the Democrats are moving to the left. Alexandria Ocasio-Cortez, a leading indicator for the Democratic party, has voiced her support for Senator Elizabeth Warren’s calls to break up big tech. She has also accused Amazon of paying starvation wages, adding that "If Jeff Bezos wants to be a good person, he'd turn Amazon into a worker cooperative." Q: The political climate for tech companies may be souring. But couldn’t one say the same thing about banks and energy companies, which are overrepresented in value indices? A: One difference is that tech companies trade at premium valuations, while banks and energy companies trade near book value (Chart 16). Another difference is that banks have already felt the wrath of regulators. Thanks to Dodd-Frank and pending Basel III regulations, banks today function more like utilities than like the casinos of yesteryear. While private credit growth is unlikely to return to its pre-GFC pace, banks will still profit from a revival in global growth and increasing consolidation within their industry. Stronger global growth should also allow for modestly higher nominal bond yields and somewhat steeper yield curves. This will benefit bank shares (Chart 17). Chart 16Tech Firms Trade At Premium Valuations Chart 17Modestly Higher Bond Yields Will Benefit Bank Shares     As far as energy stocks are concerned, again, we need to benchmark our views to what the market expects. Oil is not going back above $100 per barrel anytime soon, but it does not need to for energy stocks to go up. Bob Ryan, BCA’s chief commodity strategist, sees Brent averaging $65/bbl in 2021, $19 above what is currently priced in forward markets. Q: What about materials and industrial stocks? They are also overrepresented in value indices. A: Both materials and industrials tend to outperform the broader market when global growth accelerates (Chart 18). To the extent we expect global growth to rise, this is good news for these two sectors. They also trade at attractive valuations. Q: How does China figure into this value/growth debate? A: As we saw during the 2001-2007 period, strong Chinese demand for commodities and industrial goods benefits value indices. Even though trend Chinese GDP growth has decelerated over the past decade, the Chinese economy is five-times as large as it was back then. In absolute terms, Chinese consumption of most metals continues to increase (Chart 19). Chart 18Materials And Industrials Usually Outperform When Growth Accelerates Chart 19Chinese Consumption Of Most Metals Continues To Rise   Chart 20 shows that Chinese GDP would need to grow by about 6% per year over the next decade to keep output-per-worker on track to converge with, say, South Korea by the middle of the century. Thus, Chinese demand for natural resources and machinery is unlikely to weaken anytime soon. Chart 20China Still Has Some Catching Up To Do Q: Let’s wrap up. What final tips would you give investors who want to pivot towards value? A: There are a number of ETFs that track value indices. We expect them to outperform the broad indices over the coming years. For investors who want even higher returns, a selective approach would help. Distinguishing between value stocks and value traps is not easy. True value stocks have often congregated in the shadows of the market, where there is limited analyst coverage and thin institutional ownership. The small-cap sector offers more opportunities for finding such mispriced stocks. Hence, it is not surprising that historically, the value premium has been greater in the small cap realm. The same is true for emerging markets and smaller developed economies (Chart 21).1 Thus, investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Chart 21AHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Chart 21BHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes   1 Please see Global Asset Allocation Special Report, “Value? Growth? It Really Depends!” dated September 19, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. 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.   Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy.   Box 1The Arithmetic Of Debt Sustainability   Global Investment Strategy View Matrix Current MacroQuant Model Scores