Inflation/Deflation
A profligate US government where $3 trillion + fiscal packages are passed with a strong bipartisan consensus, rising odds of increased defense and infrastructure spending, a renewed focus on protecting America’s industrial champions from competition (foreign or domestic), and a robust protectionist agenda (again, on both sides of the aisle), are all inherently inflationary and negative for bonds, ceteris paribus. A whiff of inflation would be a positive for the broad equity market, further fueling the “risk on”, liquidity-driven, melt-up phase. However, historically when inflation has entered the 3.7%-4% zone in the past, the broad equity market has stumbled (see chart). Despite these powerful longer-term inflationary forces, our working assumption is that, in the next 9-12 months, headline CPI inflation will only renormalize, rather than surge, as the coronavirus-induced deficient demand and excess supply dynamic will take time to reach a new equilibrium. Bottom Line: We remain constructive on the prospects of the broad equity market on a cyclical 9-12 month time horizon. For a detailed discussion on inflationary forces and their effects on the S&P 500 GICS1 sectors, please refer to this Monday’s Special Report.
Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Jonathan LaBerge. Jonathan will be examining the global effectiveness of recent pandemic containment measures to judge both the odds of a second infection wave and what policy responses are likely to be effective in countering one were it to occur. I hope you find the report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights Fiscal deficits have soared in the wake of the pandemic, putting government debt-to-GDP ratios on a trajectory to reach post-WWII highs in many countries. Contrary to popular belief, there is little reason to think that fiscal relief will make it more difficult for governments to repay their obligations down the road. Larger budget deficits tend to increase overall national savings when the economy is depressed because private savings rise more than enough to compensate for the decline in government savings. The end result is a higher level of national wealth that governments can tax in the future. That said, there is more than one way to tax national wealth. For political reasons, higher inflation coupled with financial repression may prove to be more feasible than other forms of taxation. While inflation is not an imminent risk, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. Gold prices will rise over the long haul. The yellow metal should perform well even in the near term if the dollar weakens during the remainder of this year, as we anticipate. Real estate investors should reallocate capital away from densely populated urban areas towards suburbs and farmland. Stay Cyclically Overweight Equities Global equities continued to climb higher this week, as more countries reopened their economies. As we discussed three weeks ago in our report entitled “Risks To The U,” the main downside risk facing stocks is a second wave of the disease.1 While the number of new COVID-19 cases has declined in many countries, it continues to rise in others. As a result, the global tally of new cases remains broadly flat. The daily number of deaths seems to be trending lower, but that could easily reverse if social distancing measures are abandoned too quickly (Chart 1). Chart 1COVID-19: Global New Cases Remain Broadly Flat, While Deaths Seem To Be Trending Slightly Lower Chart 2Joined At The Hip Given this risk, we do not have a strong near-term (3-month) view on the direction of equities. Google searches for the “coronavirus” have closely correlated with equity prices and credit spreads (Chart 2). If fears of a new outbreak were to escalate, risk assets would suffer. Looking at a cyclical (12-month) horizon, we still recommend a modest overweight to stocks. Even if a vaccine does not become available later this year, increased testing should allow for a more economically palatable approach to containment strategies. Ample fiscal support will also help. As we provocatively asked in a report entitled “Could The Pandemic Lead To Higher Stock Prices?”,2 one can easily imagine a scenario where central banks keep rates near zero for the foreseeable future, while ongoing fiscal stimulus enables the labor market to reach full employment. Such an outcome could allow corporate profits to return to pre-pandemic levels, but leave the discount rate lower than before. The end result would be a higher fair value for the stock market. Although we would not counsel investors to bank on such a fortuitous outcome, the probability of it occurring is reasonably high – probably in the range of 30%-to-40%. This makes us inclined to favor stocks over a cyclical horizon. Will Indebted Governments Spoil The Party? One potential flaw in this bullish thesis is that massive government deficits could push up interest rates, crowding out private-sector investment in the process. As we argue below, such worries are misplaced for now. For the time being, bigger budget deficits will likely lead to an increase in overall savings, thus raising investment relative to what would have happened in the absence of any stimulus. That said, as we conclude towards the end of this report, there will come a time – probably in two-to-three years – when most economies are back to full employment. If budget deficits are still high at that point, inflation and long-term bond yields could end up rising substantially. Keynes To The Rescue The IMF expects budget deficits in advanced economies to exceed 10% of GDP in 2020, significantly higher than during the financial crisis. The sea of red ink is projected to push government debt-to-GDP ratios to fresh highs in many economies (Chart 3). Chart 3AGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 3BGovernment Debt Levels Have Surged In The Wake Of The Pandemic Chart 4The Paradox Of Thrift: Not Just A Theory Should bond investors be worried? Not for now. One of John Maynard Keynes’ great insights was that an individual’s attempt to increase savings could lead to a collective decline in savings, a phenomenon he called the paradox of thrift. Keynes argued that if everyone tried to save more, the resulting contraction in spending would cause total employment to fall by so much that overall income would decline by more than spending. As a result, aggregate savings would fall. This is precisely what happened during the Great Depression and in the aftermath of the Global Financial Crisis (Chart 4). The paradox of thrift implies that bigger budget deficits in a depressed economy will lead to an increase in overall savings, as private savings rise more than one dollar for every dollar decline in government savings. S-I=CA One can see this point using the familiar macroeconomic accounting identity which says that the difference between what a country saves and invests should equal its current account balance.3 In the absence of a change in the current account balance, any increase in investment will translate into an increase in savings. If the government stimulates aggregate demand by increasing spending, cutting taxes, or boosting transfer payments, companies are likely to respond by investing more (or at least not cutting capital expenditures as much as they would otherwise). Thus, if fiscal stimulus raises investment, it will also raise aggregate savings. Chart 5Huge Spike In The US Personal Savings Rate This conclusion has important implications for bond yields. If bigger budget deficits lead to an increase in overall savings, there is no reason to expect real bond yields to rise very much, at least in the short term. The failure of bond yields to rise since March, when governments began to trot out one fiscal stimulus package after another, is a testament to this fact. So too is the stimulus-induced surge in the US personal saving rate, which reached a record high of 33% in April (Chart 5). All That Money Printing If bigger government budget deficits are, in some sense, self-financing, why are so many people convinced that the Fed and other central banks are effectively “monetizing” deficits by buying up bonds? Part of the answer has to do with how one defines monetization. Governments create money whenever they purchase goods or services or make transfers to the public by running down their deposits at the central bank. In theory, the public could use that money to buy government bonds, which would allow the government to replenish its account at the central bank. In practice, it is usually a bit more circuitous than that. Chart 6Commercial Banks Deposits, Bank Reserve Held At The Fed, And Fed Holdings Of Treasuries Have All Expanded This Year What normally happens is that the public places the money in a commercial bank deposit and the commercial bank then transfers the money to its account at the central bank. Next, the central bank buys the bonds from the government, crediting the government’s deposit account at the central bank in the process. Chart 6 shows that this is precisely what has happened this year: Commercial bank deposits, bank reserves held at the Fed, and the Fed’s holdings of Treasuries have all risen by roughly the same amount. Granted, there is a bit more to the story. If the central bank buys bonds, it will push down bond yields at the margin, allowing the government to finance itself more cheaply than it could otherwise. However, this is a far cry from the sort of “money printing” that many people have in mind. True debt monetization occurs when governments lose all access to outside financing, forcing the central bank to pick up the tab. Such situations invariably involve accelerating inflation and a collapsing currency, which often culminates in hyperinflation. This is clearly not the case today. Back To Full Employment The idea that bigger budget deficits can generate enough private savings to more than fully compensate for any loss in government savings is applicable only for economies with spare capacity. Once the economy reaches full employment, fiscal stimulus will not lead to more income or production since everyone who wants a job already has one. At that point, bigger budget deficits will cause the economy to overheat and inflation to rise, potentially forcing the central bank to raise rates. Higher interest rates will reduce investment. Higher rates will also put upward pressure on the currency, leading to a reduction in net exports and a corresponding deterioration in the current account balance. If investment and the current account balance both decline, then savings, which is just the sum of the two, must also fall. Strategies For Alleviating A Debt Burden Once the free lunch from fiscal stimulus disappears, the question of how to address the government debt accumulated during the downturn becomes paramount. There are four ways to reduce the ratio of government debt-to-GDP: 1) outgrow the debt burden; 2) tighten fiscal policy; 3) default; and 4) inflate away the debt. Outgrowing It At the end of the Second World War, many governments found themselves saddled with high levels of debt. In the US, the government debt-to-GDP ratio stood at 121% in 1945. In the UK, it hit 270%. In Canada, it reached 155%. For the most part, these governments did not repay the debt they incurred during the war. As Chart 7 shows, the nominal value of debt outstanding either rose or remained broadly constant following the war. What happened was that rapid GDP growth led to a shrinkage in debt-to-GDP ratios. Compared with the post-war period, the two drivers of an economy’s growth potential, labor force and productivity growth, are both weaker now. Thus, outgrowing the debt by raising the denominator of the debt-to-GDP ratio will be more difficult than in the past. It’s About g-r That said, the trajectory of the debt-to-GDP ratio does not depend solely on GDP growth; it also depends on the interest rate that the government pays to service its debt. Conceptually, it is the difference between the two that determines whether the level of any given budget deficit is sustainable or not. While trend GDP growth in advanced economies has declined since the 1950s, equilibrium interest rates have also fallen. As a consequence, the spread between growth rates and interest rates is only somewhat smaller in advanced economies today than it was in the 1950s and 60s and notably higher than it was in the 1980s and 90s (Chart 8). Indeed, as Chart 9 shows, g-r has been trending higher for hundreds of years! Chart 7The Case Of Outgrowing The Debt Burden Post-WWII Chart 8The Rate Of Economic Growth Has Been Higher Than Interest Rates Chart 9A Multi-Century Trend In The Spread Between Growth And Interest Rates Today, government borrowing rates in most economies are well below trend growth rates. No matter the size of the budget deficit, the ratio of debt-to-GDP will converge to a stable level as long as the interest rate the government pays on the debt is below the growth rate of the economy.4 A Gordian Fiscal Knot Of course, there is no guarantee that real rates will remain below the rate of trend growth. As we have discussed before, the exodus of baby boomers from the labor force, a peak in globalization, and rising political populism could all curtail aggregate supply, leading to a depletion of national savings.5 What would happen if governments allowed debt levels to reach very high levels only to find that the neutral rate of interest — the interest rate consistent with full employment and stable inflation — has risen above the growth rate of the economy? Raising the policy rate would be very painful in a high-debt environment because even a small increase in interest rates would lead to a large rise in interest payments. Faced with this reality, some governments might elect to tighten fiscal policy. An increase in taxes or a decline in government spending would not only create some resources to pay back debt, but it would also reduce aggregate demand, pushing down the neutral rate of interest in the process. Don’t Blame The Stimulus Ironically, all the fiscal relief efforts that governments have carried out over the past few months have probably left them better placed to pay back debt than if no stimulus had been undertaken in the first place. Box 1 illustrates this point with a numerical example, but the intuition for this claim can be seen easily enough. As noted earlier, fiscal stimulus in a depressed economy will raise overall savings. This means that after the pandemic is over, governments will have a larger tax base available to them than they would have had in the absence of any stimulus (although, obviously, the tax base would be even larger if the pandemic had never occurred). The Inflation Solution Chart 10Long-Term Inflation Expectations Remain Very Depressed Still, any decision to tighten fiscal policy down the road is going to be an inherently political one. What if governments do not have the political will to tighten fiscal policy even if the economy begins to overheat? Defaulting on the debt is always an option in that case, but not one that any sensible government would choose given the devastating impact this would have on the financial system and broader economy. Rather, it is conceivable that governments will lean on central banks to keep rates low and let inflation accelerate. While higher inflation will not boost real GDP, it will raise nominal GDP, allowing the ratio of government debt-to-GDP to decline. Investors currently assign very low odds to such an outcome. Long-term market-based inflation expectations remain very depressed (Chart 10). Yet, we think such an eventuality is more plausible than widely believed. As long as inflation does not spiral out of control, central banks are likely to welcome rising prices. A higher inflation rate would make monetary policy more effective by allowing central banks to bring real rates deeper into negative territory whenever the economy falls into recession. Higher inflation would also result in steeper yield curves, reoxygenating commercial banks’ profitability. Profiting From Higher Inflation The path to higher interest rates is paved with lower rates. In order to generate inflation, central banks will need to keep rates at very low levels even once the economy has returned to full employment. Given that unemployment is quite high today, inflation is not an imminent risk. However, it could become a formidable problem in two-to-three years. Investors should maintain below-benchmark levels of duration in fixed-income portfolios and favor inflation-linked securities over nominal bonds. While gold is no longer super cheap, it remains a good hedge against inflation. The yellow metal should also do well if the dollar weakens during the remainder of this year, as we anticipate. As a countercyclical currency, the dollar tends to fall whenever global growth picks up (Chart 11). Chart 11Gold Will Do Well When The Dollar Weakens As Global Growth Picks Up Chart 12Farmland Would Benefit From High Inflation Lastly, land will gain from low interest rates in the near term and higher inflation in the long term. Farmland and suburban land are particularly appealing. The pandemic has made remote working more commonplace. It has also highlighted the potential dangers of living in densely populated cities. Since most suburbs are built on top of land that was previously zoned for agriculture, farmland should benefit from the retreat from urban living, much like it did during the inflationary period of the 1970s (Chart 12). Box 1Saving More By Spending More Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Risks To The U,” dated May 7, 2020. 2 Please see Global Investment Strategy Weekly Report, “Could The Pandemic Lead To Higher Stock Prices?” dated April 23, 2020. 3 Gross Domestic Product (GDP) can be computed as the sum of consumption (C), investment (I), government spending (G), and net exports (X-M). Gross National Product (GNP) is equal to GDP except that the former includes net income from abroad (which is included in the current account balance). Thus, GNP=C+I+G+CA, or GNP-C-G=I+CA. Savings (S) is equal to GNP-C-G. Taken together, the two expressions imply S-I=CA, or S=I+CA. 4 Please see Global Investment Strategy Weekly Report, ”Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 5 Please see Global Investment Strategy Weekly Report, “A Structural Bear Market In Bonds,” dated February 16, 2018. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Risk assets continue to ignore the dire state of the economy. “Don’t fight the Fed” will dictate investment policy for the coming months. Populism and supply-chain diversification will shape the world after COVID-19. Global stimulus will result in higher long-term inflation when the labor market returns to full employment. Asset prices are not ready for higher inflation rates. Precious metals, especially silver, will offer inflation protection. Stocks should structurally outperform bonds, even if they generate lower returns than in the past. Tech will continue to rise for now, but this sector will suffer when inflation turns higher. Feature Despite the continued collapse in economic activity, the S&P 500 remains resilient, bolstered by the largesse of the Federal Reserve and US government, and generous stimulus packages in other major economies. Stocks will likely climb even higher with this backdrop, but a violent second wave of COVID-19 infections may derail the scenario in the near term. The biggest risk, which is long-term in nature, is rising inflation. Public debt ratios will skyrocket in the G-10 and many emerging markets. Private debt loads, which are elevated in most countries, will also increase. Add rising populism and ageing populations into this mix and the incentive to push prices higher and reduce real debt loads becomes too enticing. Long-term investors must be wary. For the time being, overweight equities relative to bonds, but the specter of rising inflation suggests that growth stocks (e.g. tech) will not offer attractive long-term returns. Investors with an eye on multi-year returns should use the ongoing surge in growth stocks to strategically switch their portfolios toward small-cap equities, traditional cyclicals and precious metals. Economic Freefall Continues Most economic indicators paint a dismal picture for the US. Industrial activity is suffering tremendously. In April, industrial production collapsed by 15%, a pace matching the depth of the Great Financial Crisis (GFC). The ISM New Orders-to-Inventories ratio remains extremely weak with no glimmer of a rebound in IP in May. The numbers for trucking activity and railway freight are equally poor. Chart I-1A Worried Consumer Saves The US labor market has not been this ill since the 1930s. 20.5 million jobs vanished in April and the unemployment rate soared to 14.7%, despite a 2.5 percentage point decline in the participation rate. The number of employees involuntarily working in part-time positions has surged by 5.9 million, which has hiked up the broader U-6 unemployment rate to 22.8%. Wage growth has rebounded smartly to 7.7%, but this is an illusion. Average hourly earnings rose only because low-wage workers in the leisure and hospitality fields bore the brunt of the pain, accounting for 37% of layoffs. The worst news is that the Bureau of Labor Statistics (BLS) classifies any worker explicitly fired due to COVID-19 as temporarily laid off, but without a vaccine it is highly unlikely that employment in the leisure, hospitality or airline sectors will normalize anytime soon. Unsurprisingly, lockdowns have limited the ability of households to spend. Americans have boosted their savings rate to 13.1%, the highest level in 39 years, as they worry about catching a potentially deadly illness, losing their jobs, watching their incomes fall, or all of the above (Chart I-1). This double hit to both employment and consumer confidence sparked a 22% collapse in retail sales on an annual basis in April, the worst reading on record. Putting it all together, real GDP contracted at a 4.8% quarterly annualized rate in Q1 2020 and the Congressional Budget Office expects second-quarter annual growth to plummet to -37.7%. The New York Fed’s Weekly Economic Index suggests a more muted contraction of 11.1% (Chart I-2), which would still represent a post-war record. Investors must look beyond the gloom. The economic weakness is not limited to the US. In Europe and in emerging markets, retail sales and auto sales are disappearing at an unparalleled pace. Industrial production readings in those economies have been catastrophic and manufacturing PMIs are still in deeply contractionary territory. As a result, our Global Economic A/D line and our Global Synchronicity indicator continues to flash intense weakness (Chart I-3). Chart I-2The Worst Is Still To Come Chart I-3Dismal Growth, Everywhere Chart I-4China Leads The Way Investors must look beyond the gloom. China’s experience with COVID-19 is instructive despite questions regarding the number of cases reported. China was the first country to witness the painful impact of COVID-19 and the quarantines needed to fight the disease. It was also the first country to control the virus’s spread and, most importantly, to escape the lockdown, along with being the first to enact economic stimulatory measures. The results are clear: industrial production, domestic new orders, and to a lesser extent, retail sales, are all experiencing V-shaped recoveries (Chart I-4). Even Chinese yields are rising, despite interest rate cuts by the People’s Bank of China. Accommodative Policy Matters Most The global policy “put option” is still in full force, which is boosting asset prices. A 41% rally in the median US stock reflects both a massive amount of funds inundating the financial system and a recovery that will take hold in the coming 12 months in response to this stimulus and the end of lockdowns. Global monetary policies have been even more aggressive than after the GFC. Interest rates have fallen as quickly and as broadly as they did around the Lehman bankruptcy. Moreover, unorthodox policy measures have become the norm (Chart I-5). Chart I-5Easy Policy, Everywhere In China, credit generation is quickly accelerating and has reached 28% of GDP, the highest in 2 years. Moreover, policymakers are emphasizing the need to create 9 million jobs in cities and keep the unemployment rate at 6%. Consequently, the recent rebound in construction activity will continue because it is a perfect medium to absorb excess workers. The ever-expanding quotas for local government special bonds to CNY3.75 trillion will also ensure that infrastructure spending energizes any recovery. Therefore, we expect Chinese imports of raw materials and machinery to accelerate into the second half of the year. The country’s orders of machine tools from Japan have already bottomed, which bodes well for overall Japanese orders (Chart I-6). Europe has also moved in the right direction. Government support continues to expand and combined public deficits will reach EUR 0.9 trillion, or 8.5% of GDP. Governmental guarantees have reached at least EUR1.4 trillion. Meanwhile, the European Central Bank’s balance sheet is swelling more quickly than during either the GFC or the euro area crisis (Chart I-7). Unsurprisingly, European shadow rates have collapsed to -7.6% and European financial conditions are the easiest they have been in 8 years. Chart I-6Will China's Rebound Matter? Chart I-7The ECB Is Aggressive More importantly, COVID-19 has broken the taboo of common bond issuance in Europe. Last week, Chancellor Merkel, President Macron and EC President von der Leyen hatched a plan to issue common bonds that will finance a EUR 750 billion recovery fund as part of the European Commission Multiannual Financial Framework. The EC will then allocate EUR 500 billion of grants (not loans) to EU nations as long as they adhere to European principles. The unified front by the three most senior European politicians reflects elevated support for the EU among all European nations and an understanding that economic ruin in the smaller nations could capsize the core nations (Chart I-8). Hence, fiscal risk-sharing will increasingly become the norm in Europe. Unsurprisingly, Italian, Spanish, Portuguese and Greek bond spreads all narrowed significantly following the announcement. Chart I-8The Forces That Bind Chart I-9Negative Rates Are Here, Sort Of US policymakers have abandoned any semblance of orthodoxy. The Fed’s programs announced so far have lifted its balance sheet by $2.9 trillion and could generate an expansion to $11 trillion by year-end. Moreover, Fed Chair Jerome Powell has highlighted that there is “no limit” to what the Fed can do with its unconventional policy apparatus. The nature of the US funding market makes negative rates very dangerous and, therefore, highly doubtful in that country. Nonetheless, the Fed is willing to buy more paper from the public and private sectors to push the shadow rate and real interest rates further into negative territory (Chart I-9). Moreover, the Federal government has already bumped up the deficit by $3 trillion and the House has passed another $3 trillion in spending. Senate Republicans will pass some of this program to protect themselves in November. According to BCA Research’s Geopolitical Strategy service, a total escalation in the federal deficit of $5 trillion (or 23% of 2020 GDP) is extremely likely this year. Chart I-10The Fed Is Monetizing The Deficit Combined fiscal and monetary policy in the US will have a more invigorating impact on the recovery than the measures passed in 2008-09. They represent a larger share of output than during the GFC (10.5% versus 6% of GDP for the government spending and 15.2% versus 8.3% for the Fed’s balance sheet expansion). Moreover, the Fed is buying a much greater percentage of the Treasury’s issuance than during the GFC (Chart I-10). Therefore, the Fed is much closer to monetizing government debt than it was 11 years ago. The combined monetary and fiscal easing should result in a larger fiscal multiplier because the private sector is not financing as much of the government’s largesse. Thus, the increase in the private sector’s savings rate should be short-lived and the current account deficit will widen to reflect the greater fiscal outlays. Low real rates and a larger balance-of-payments disequilibrium should weaken the dollar which will ease US financial conditions further. A Trough In Inflation Maintaining incredibly easy monetary and fiscal conditions as the economy reopens will lead to higher inflation when the labor market reaches full employment. Core CPI has collapsed to 1.4% on an annual basis and to -2.4% on a three-month annualized basis, the lowest reading on record. The breakdown of the CPI report is equally dreadful (Chart I-11). However, CPI understates inflation because the basket measured by the BLS includes many areas of commerce currently not frequented by consumers. Items actually purchased by households, such as food, have experienced accelerating inflation in recent months. Fiscal risk-sharing will increasingly become the norm in Europe. Beyond this technicality, the most important factor behind the anticipated structural uptick in inflation is a large debt load burdening the global economy. Total nonfinancial debt in the US stands at 254% of GDP, 262% in the euro area, 380% in Japan, 301% in Canada, 233% in Australia, 293% in Sweden and 194% in emerging markets (Chart I-12). Historically, the easiest method for policymakers to decrease the burden of liabilities is inflation; the current political climate increases the odds of that outcome. Chart I-11Weak Core Chart I-12Record Debt, Everywhere Households in the G-10 and emerging markets are angry. Growing inequalities, coupled with income immobility, have created dissatisfaction with the economic system (Chart I-13). Before the GFC, US households could gorge on debt to support their spending patterns, and inequalities went unnoticed. After the crisis revealed weakness in the household sector, banks tightened their credit standards and consumption slowed, constrained by a paltry expansion of the median household income. As a consequence, the American public increasingly supports left-wing economic policies (Chart I-14). Chart I-13Inequalities + Immobility = Anger Chart I-14The US Population's Shift To The Left COVID-19 is exacerbating the population’s discontent and highlighting economic disparities. The recession is hitting poor households in the US harder than the general population or highly skilled white-collar employees who can easily telecommute. Millennials, the largest demographic group in the US, are also irate. Their lifetime earnings were already lagging that of their parents because most millennials entered the job market in the aftermath of the GFC.1 Their income and balance sheet prospects were beginning to improve just as the pandemic shock struck. Finally, in response to the lockdowns and school closures caused by COVID-19, young families with children have to juggle permanent childcare and daily work demands from employers, resulting in a lack of separation between home and office.2 Economic populism will generate a negative supply shock, which will push up prices (Diagram I-1). BCA has espoused the theme of de-globalization since 20143 and COVID-19 will accelerate this trend. Firms do not want fragile supply chains that fall victim to random shocks; instead, they are looking to diversify their sources (Chart I-15). Additionally, workers and households want protection from foreign competition and perceived unfair trade practices. This sentiment is evident in a lack of trust toward China (Chart I-16). China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business (Chart I-17). Last year’s Sino-US trade war was a precursor of events to come. Diagram I-1The Inflationary Impact Of A Stifled Supply Side Chart I-15COVID-19 Accelerates The Desire To Repatriate Production Chart I-16China As A Political Piñata Chart I-17The Cost Of Doing International Business Will Rise Chart I-18A Problem For Productivity The rate of capital stock accumulation does not bode well for the supply side of the economy. Productivity trails the path of capex, with a long time lag. The 10-year moving average of non-residential investment in the US bottomed three years ago. Its subsequent uptick should enhance average productivity. However, the growth of the real net capital stock per employee remains weak and will not strengthen because companies are curtailing spending in the recession. Moreover, the efficiency of the capital stock is well below its long-term average and probably will not mend if supply chains are made less efficient. These factors are negative for productivity and thus, the capacity to expand the supply side of the economy (Chart I-18). Finally, a significant share of capital stock is stranded and uneconomical. The airline industry is a good example. Going forward, regulations will keep the middle row seats empty. Fewer filled seats imply that the capital stock has lost significant value, which creates a negative supply shock for the industry. To break even, airlines will have to raise the price of fares. IATA estimates that fares will increase by 43%, 49% and 54% on North American, European and Asian routes, respectively (Table I-1). The same analysis can be applied to restaurants, hotels, cinemas, etc. – industries that will have to curtail their supplies and change their practices in response to COVID-19. Table I-1The Inflationary Impact Of Supply Cuts Chat I-19Pandemics Boost Wages While rising populism will hurt the supply side of the economy, it will also hike demand. Redistribution is an outcome of populism. Corporate tax hikes hurt rich households that receive more than 50% of their income from profits. High marginal tax rates on high earners will also curtail their disposable income. Shifting a bigger share of national income to the middle class will depress the savings rate and boost demand. It is estimated that the middle class’s marginal propensity to spend is 90% compared with 60% for richer households. In fact, in the past 40 years, the shift in income distribution has curtailed demand by 3% of GDP. Pandemics also increase real wages. Òscar Jordà, Sanjay Singh, and Alan Taylor demonstrated that European real wages accelerated following pandemics (Chart I-19). Fewer willing workers contributed to the climb in real wages by decreasing the supply of labor. Higher real wages are positive for consumption. China-bashing will become a mainstay of American politics and rising tariffs will continue to increase the cost of doing business. Populism will also put upward pressure on public spending. Governments globally and in the US are bailing out the private sector to an even larger extent than they did after the GFC. Discontent with expanding inequalities and the perceived lack of accountability of the corporate sector4 will push the government to be more involved in economic management than it was after 2008. Moreover, the post-2008 environment showed that austerity was negative for private sector income growth and the economic welfare of the middle class (Chart I-20). Thus, government spending and deficits as a share of GDP will be structurally higher for the coming decade. Higher deficits mechanically boost aggregate demand which is inflationary if the advance of aggregate supply is sluggish. Chat I-20Austerity Hurts Central banks will likely enable these inflationary dynamics. The Fed knows that it has missed its objective by a cumulative 4% since former Chairman Ben Bernanke set an official inflation target of 2% in 2012. Thus, it has lost credibility in its ability to generate 2% inflation, which is why the 10-year breakeven rate stands at 1.1% and not within the 2.3%-2.5% range that is consistent with its mandate. Moreover, the Fed is worried that the immediate deflationary impact of COVID-19 will further depress inflation expectations and reinforce low realized inflation. This logic partly explains why the Fed currently recommends more stimulus and the Federal Open Market Committee will be reluctant to remove accommodation anytime soon. Inflation will likely move toward 4-5% after the US economy regains full employment. Central banks may fall victim to growing populism. Both the Democrats and Republicans want control over the US Fed. If Congress changes the Fed’s mandate, there would be great consequences for inflation. Prior to the Federal Reserve Reform Act of 1977, the Fed’s mandate was to foster full employment conditions without any explicit mention of inflation. Therefore, the Fed kept the unemployment rate well below NAIRU for most of the post-war period. This tight labor market was a key ingredient behind the inflationary outbreak of the 1970s. After the reform act explicitly imposed a price stability directive on top of the Fed’s employment mandate, the unemployment rate spent a much larger share of time above NAIRU, which contributed to the structural decline in inflation after 1982 (Chart I-21). Chat I-21The Fed's Mandate Matters Finally, demographics will also feed inflationary pressures. The global support ratio peaked in 2014 as the number of workers per dependent decreased due to ageing of the population in the West and China (Chart I-22). A declining support ratio depresses the growth of the supply side of the economy because the dependents continue to consume. In today’s world, dependents are retirees, who have higher healthcare spending needs. This healthcare spending will accrue additional government spending. Moreover, it will continue to push up healthcare inflation, which will contribute to higher overall inflation (Chart I-23). Chat I-22Demographics: From Deflation To Inflation Chat I-23Aging Will Feed Healthcare Inflation Bottom Line: COVID-19 has highlighted inequalities in the population and will accelerate a move toward populism that started four years ago. Consequently, the supply side of the economy will grow more slowly than it did in prior decades, while greater government interventions and redistributionist policies will boost aggregate demand. Additionally, monetary policy will probably stay easy for too long and demographic factors will compound the supply/demand mismatch. Inflation will likely move toward 4-5% after the US economy regains full employment, but will not surge to 1970s levels. Investment Implications Chat I-24Breakevens Will Listen To Commodities Extremely accommodative economic policy and a shift to higher inflation will dominate asset markets for the next five years or more. Breakevens in the G-10 are pricing in permanently subdued inflation for the coming decade, which creates a large re-pricing opportunity if inflation troughs when the labor market reaches full employment. Investors cannot wait for inflation to turn the corner to bet on higher breakevens. After the GFC, core CPI bottomed in October 2010, but US breakevens hit their floor at 0.15% in December 2008. Instead, a rebound in commodity prices and a turnaround in the global economic outlook may signal when investors should buy breakevens (Chart I-24). Chat I-25Deleterious US Balance Of Payments Dynamics A repricing of inflation expectations will depress real rates. Central banks want to see inflation expectations normalize towards 2.3%-2.5% before signaling an end to accommodation. Moreover, political pressures and high debt loads will likely loosen their reaction functions to higher breakeven. As a result, real interest rates will decline because nominal ones will not rise by as much as inflation expectations. This is exactly what central banks want to achieve because it will foster a stronger recovery. Our US fixed-income strategists favor TIPS over nominal Treasurys. The dollar will probably depreciate in the post-COVID-19 environment. As we wrote last month, the US is the most aggressive reflator among major economies. The twin deficit will expand while US real rates will remain depressed. This is very negative for the USD, especially in an environment where the US money supply is outpacing global money supply (Chart I-25).5 Additionally, Chinese reflation will stimulate global industrial production, which normally hurts the dollar. EM currencies are cheap enough that long-term investors should begin to bet on them (Chart I-26), especially if global inflation structurally shifts higher. Precious metals win from the combination of higher inflation, lower real rates and a weaker dollar. However, silver is more attractive than gold. Unlike the yellow metal, it trades at a discount to the long-term inflation trend (Chart I-27). Moreover, silver has more industrial uses, especially in the solar panel and computing areas. Thus, the post-COVID-19 recovery and the need to double up supply chains will boost industrial demand for silver and lift its price relative to gold. Our FX strategists recommend selling the gold-to-silver ratio.6 Chat I-26Cheap EM FX Chat I-27Silver Is The Superior Inflation Hedge Chat I-28Still Time To Favor Stocks Over Bonds Investors should favor stocks over bonds. This statement is more an indictment of the poor value of bonds and their lack of defense against rising inflation than a structural endorsement of stocks. The equity risk premium is elevated. To make this call, we need to account for the lack of stationarity of this variable and adjust for the expected growth rate of earnings. Nonetheless, once those factors are accounted for, our ERP indicator continues to flash a buy signal in favor of equities at the expense of bonds (Chart I-28). Moreover, bonds tend to underperform stocks when inflation trends up for a long time (Table I-2). Table I-2Rising Inflation Flatters Stocks Over Bonds Chart I-29Bonds Are Prohibitively Expensive In absolute terms, G-7 government bonds are also vulnerable, both tactically and structurally. They are overbought and currently trade at their greatest premium to fair value since Q4 2009 and Q1 1986, two periods followed by sharp rebounds in yields (Chart I-29). Moreover, the previous experience with QE programs shows that even if real rates diminish, the reflationary impact of aggressive monetary policy on breakeven rates is enough to increase nominal interest rates (Chart I-30). Additionally, as our European Investment Strategy team indicates, bond yields are close to their practical lower bound, which creates a negative skew to their return profile.7 This asymmetric return distribution destroys their ability to hedge equity risk going forward, making this asset class less appealing to investors. This problem is particularly salient in Europe and Japan. A lower dollar, which is highly reflationary for global growth, will likely catalyze the rise in yields. Chart I-30QE Will Lift Breakevens And Yields As long as real rates remain under downward pressure, the window to own stocks remains open, even if stocks continue to churn. Equities are expensive, but when yields are taken into consideration, their adjusted P/E is in line with the historical average (Chart I-31). Moreover, periods of weak growth associated with lower real interest rates can foster a large expansion in multiples (Chart I-32). Chart I-31Low Bond Yields Allow High Stock Multiples Chart I-32Multiples Will Rise Further As The Fed Floods The World With Low Rates Whether to have faith in stocks in absolute terms on a long-term basis is complicated by our view on inflation and populism. Strong inflation will increase nominal rates. Moreover, low productivity coupled with higher real wages, less-efficient supply chains and higher taxes will accentuate the margin compression that higher inflation typically creates. Thus, equities are expected to generate poor real returns over the long term, even if they beat bonds. Chart I-33Tech EPS Leadership Tech stocks are another structural problem for equities. Including Amazon, Google and Facebook, tech stocks account for 41% of the S&P 500’s market cap. As our US Equity Strategy service explains, wherever tech goes, so does the US market.8 Tech stocks are the current market darling. Today, the tech sector is the closest thing to a safe-haven in the mind of market participants, because a post-COVID-19 environment will favor tech spending (telecommuting, e-commerce, cloud computing, etc.). The problem for long-term investors is that this view is the most consensus view. Already, investors expect the tech sector to generate the highest EPS outperformance relative to the rest of the S&P 500 in more than 15 years (Chart I-33). Moreover, in a low-yield environment, investors are particularly willing to bid up the multiples of growth stocks such as tech equities because low interest rates result in muted discount factors for long-term cash flows. When should investors begin betting against the tech sector? Backed by a powerful narrative, tech stocks are evolving into a mania. Yet, contrarian investors understand, being too early to sell a mania can be deadly. Bond yields should not be relied on to signal an end to the bubble. During most of the 1990s, tech would outperform the market when Treasury yields declined. However, when the tech outperformance became manic, yields became irrelevant. From the fall of 1998 to the beginning of 2000, 10-year yields rose from 4.2% to 6.8%, yet the tech sector outperformed the S&P 500 by 127%. More recently, yields rose from 1.33% in the summer of 2016 to 3.25% in November 2018, but tech outperformed the broader market by 39%. Investors should favor stocks over bonds. Instead, higher inflation will be the key factor to end the tech sector’s infallibility. Since the 1990s, higher core inflation has led periods of tech underperformance by roughly six months. This relationship also held at the apex of the tech bubble in the second half of the 1990s (Chart I-34). Relative tech forward EPS suffers when core inflation rises, as the rest of the S&P 500 is more geared to higher nominal GDP growth. In essence, if nominal growth is less scarce, then the need to bid up growth stocks diminishes. Moreover, the dollar will likely be the first early signal because it leads nominal GDP. As a result, a weak dollar leads to a contraction in tech relative multiples by approximately 9 months (Chart I-35). Chart I-34Tech Hates Inflation... Chart I-35...And A Soft Dollar We recommend long-term investors shift their portfolios toward industrial equities when inflation turns the corner. As a corollary, the low exposure of European and Japanese stocks to the tech sector suggests these cheap bourses will finally reverse their more-than-a-decade-long underperformance at the same time. This strategy means that even if the S&P 500 generates negative real returns during the coming decade, investors could still eke out positive returns from their stock holdings. Higher inflation will be the key factor to end the tech sector’s infallibility. Chart I-36The Time For Commodities Is Coming Back Finally, commodities plays are also set to shine in the coming decade. Commodities are very cheap and oversold relative to stocks (Chart I-36). Commodities outperform equities in an environment where inflation rises, real rates decline and the dollar depreciates. Consequently, materials and energy stocks may be winners. As a corollary, Latin American and Australian equities should also reverse their decade-long underperformance when inflation and the dollar turn the corner. This month's Section II Special Report is an in depth study of the Spanish Flu pandemic, written by our colleague Amr Hanafy and also published in BCA Research’s Global Asset Allocation service. Amr thoroughly analyses the evolution of the 100-year old pandemic and which measures mattered most to contain the virus and allow a return to economic normality. Mathieu Savary Vice President The Bank Credit Analyst May 28, 2020 Next Report: June 25, 2020 II. Lessons From The Spanish Flu What Can 1918/1919 Teach Us About COVID-19? “Those who cannot remember the past are condemned to repeat it” George Santayana – 1905 Chart II-1Coronavirus: As Contagious But Not As Deadly As Spanish Flu Today’s economy is very different to that of 100 years ago. Many countries then were in the middle of World War I (which ended in November 1918). The characteristics of the Spanish Flu which struck the world in 1918 and 1919 were also different to this year’s pandemic. COVID-19 is almost as contagious as the Spanish Flu, but it is much less deadly (Chart II-1). Healthcare systems and treatments today are far more advanced than those of a century ago: many people who caught Spanish flu died of complications caused by bacterial pneumonia, given the absence of antibiotics. Influenza viruses tend to mutate rapidly: the influenza virus in 1918 first mutated to become far more virulent in its second wave, and then to become much milder. Coronaviruses have a “proofreading” capacity and mutate less easily.9 Nevertheless, an analysis of the pandemic of 100 years ago provides a number of insights into the current crisis, particularly now that policymakers are easing social-distancing rules to help the economy, even at the risk of more cases and deaths. Among the lessons of 1918-1919: Non-pharmaceutical interventions (NPIs) do lower mortality rates. The speed at which NPIs are implemented and the period of implementation are as important as the number of measures taken. Removing or relaxing measures too early can lead to a renewed rise in mortality rates. It is hard to compare current fiscal and monetary policies to those taken during the 1918 pandemic, since policy in both areas was already easy before the pandemic as a result of the world war. However, a severe pandemic would certainly call for a wartime-like fiscal and monetary response. The economy was negatively impacted by the pandemic in 1918-19 but, despite the shock to industrial activity and employment, the economy subsequently rebounded quickly, in a V-shaped recovery. Introduction Predicting how the economy will react to the COVID-19 pandemic is hard. Governments and policymakers face multiple uncertainties: How effective are different containment measures? Will cases and deaths rebound quickly if lockdown measures are eased? When will the coronavirus disappear? When will a vaccine be ready? With an event unprecedented in the experience of anyone alive today, perhaps there are some lessons to be learned from history. For this Special Report, we attempt to draw some parallels between the current situation and the 1918-19 Spanish flu. We focus on the different containment efforts implemented, the role that fiscal and monetary policies played, the impact on markets and the economy, and whether history can throw any light on how the COVID-19 crisis might pan out. The 1918 Spanish Flu Chart II-2The Spanish Flu Hit The World In Three Waves The 1918 influenza pandemic was the most lethal in modern history. Soldiers returning from World War I helped spread the pandemic across the globe. The first recorded case is believed to have been in an army camp in Kansas. While there is no official count, researchers estimate that about 500 million people contracted the virus globally, with a mortality rate of between 5% and 10%. The pandemic occurred over three waves in 1918 and 1919 – the first in the spring of 1918, the second (and most deadly) in the fall of 1918, and the third in spring 1919 (Chart II-2). In the US alone, official data estimate that around 500,000 deaths (or over 25% of all deaths) in 1918 and 1919 were caused by pneumonia and influenza.10 The pandemic moved swiftly to Europe and reached Asia by mid-1918, but became more lethal only towards the end of the year (Map II-1).11 Map II-1The Spread Of Influenza Through Europe Initially, scientists were puzzled by the origin of the influenza and its biology. It was not until a decade later, in the early 1930s, that Richard Shope isolated the particular influenza virus from infected pigs, confirming that a virus caused the Spanish Flu, not a bacterium as most had thought. Many of those who caught this strain of influenza died as a result of their lungs filling with fluid in a severe form of pneumonia. In reporting death rates, then, it is considered best practice to include deaths from both influenza and pneumonia. The first wave had almost all the hallmarks of a seasonal flu, albeit of a highly contagious strain. Symptoms were similar and mortality rates were only slightly higher than a normal influenza. The first wave went largely unnoticed given that deaths from pneumonia were common then. US public health reports show that the disease received little attention until it reappeared in a more severe form in Boston in September 1918.12 Most countries did not begin investigating and reporting cases until the second wave was underway (Chart II-3). Chart II-3Most Countries Began Reporting Only When The Second Wave Hit This second wave – which was more lethal because the virus had mutated – had a unique characteristic. Unlike the typical influenza mortality curve – which is usually “U” shaped, affecting mainly the very young and elderly – the 1918 influenza strain had a “W”-shaped mortality curve – impacting young adults as well as old people (Chart II-4). This pattern was evident in all three waves, but most pronounced during the second wave. The reason for this was that the infection caused by the influenza became hyperactive, producing a “cytokine storm” – when mediators secreted from the immune system result in severe inflammation.13 Simply put, as the virus became virulent, the body’s immune system overworked to fight it. Younger people, with strong immune systems, suffered most from this phenomenon. Chart II-4A Unique Characteristic: Impacting Younger Adults By the summer of 1919, the pandemic was over, since those who had been infected had either died or recovered, therefore developing immunity. The lack of records makes it difficult to assess if “herd immunity” was achieved. However, some historical accounts and research – particularly for army groups in the US and the UK – suggest that those exposed to the disease in the first mild wave were not affected during the second more severe wave.14 The failure to define the causative pathogen at the time made development of a vaccine impossible. Nevertheless, some treatments and remedies showed modest success. These varied from using a serum – obtained from people who had recovered, who therefore had antibodies against the disease – to simple symptomatic drugs and various oils and herbs. The Effectiveness Of Non-Pharmaceutical Interventions (NPIs) Chart II-5Travel Slowed...Just Not Enough What we today call “social distancing” showed positive effects during the 1918-19 pandemic. These included measures very similar to those applied today: school closures, isolation and quarantines, bans on some sorts of public gatherings, and more. However, there were few travel bans. The number of passengers carried during the months of the pandemic did noticeably decline though (Chart II-5). Table II-1, based on research by Hatchett, Mecher and Lipsitch, breaks down NPIs by type for 17 major US cities. Most cities implemented a wide range of interventions. But it was not only the type of NPIs implemented that made a difference, but also the speed and length of implementation. Further research by Markel, Lipman and Navarro based on 43 US cities shows that the median number of days between the first reported influenza case and the first NPI implementation was over two weeks. The median period during which various NPIs were implemented was about six weeks (Table II-2). Table II-1Measures Applied Then Are Very Similar To Those Applied Today Table II-2NPIs Were Implemented Only For Short Periods Markel, Lipman and Navarro's findings show that a rapid public-health response was an important factor in reducing the mortality rate by slowing the rate of infection, what we now refer to as “flattening the curve.” There were major differences in cities’ policies: both the speed at which they implement NPIs, and the length of the implementation period. Chart II-6 shows that: Cities that acted quickly to implement NPIs slowed the rate of infections and deaths (Chart II-6, panel 1) Cities that acted quickly had lower mortality rates from influenza and pneumonia (Chart II-6, panel 2) Cities that implemented NPIs for longer periods had fewer deaths (Chart II-6, panel 3) Chart II-7 quantifies the number of NPIs taken, the time it took to implement the measures, and the length of NPIs to gauge policy strictness. Cities with stricter enforcement had lower death rates than those with laxer measures. Chart II-6Fast Response And Longer Implementation Led To Fewer Deaths... Chart II-7...So Did Policy Strictness For example, Kansas City, less than a week after its first reported case, had implemented quarantine and isolation measures. By the second week, schools, churches, and other entertainment facilities closed. Schools reopened a month later (in early November) but quickly shut again until early January 1919. While we do not have definitive dates on when each NPI was lifted, some sort of protective measures in Kansas City were in place for almost 170 days. By contrast, Philadelphia, one of the cities hardest hit by Spanish Flu, took more than a month to implement any measures. Its tardiness meant that it reached a peak mortality rate much more quickly: in 13 days compared to 31 days for Kansas City. Even after the first reported case, the Liberty Loans Parade was still held on September 28, 1918 – with the knowledge that hundreds of thousands of spectators might be vulnerable to infection.15,16 It was not until a few days later that institutions were closed and a ban on public gatherings was imposed. Many other cities also held a Liberty Loans Parade, including Pittsburgh and Washington DC, but Philadelphia’s was the deadliest. Studies also show that relaxing interventions too early could be as damaging as implementing them too late. St. Louis, for example, was quick to lift restrictions and suffered particularly badly in the second wave as a result. It later reinstated NPIs up until end of February 1919. Other cities that eased restrictions too early (San Francisco and Minneapolis, for example) also suffered from a second swift, albeit milder, increase in weekly excess death rates from pneumonia and influenza (Chart II-8). Chart II-8Relaxing Lockdown Measures Too Early Can Lead To A Second Rise In Deaths... Chart II-9...And So Can Highly Effective Measures Of course, NPIs cannot be implemented indefinitely. A recent research paper by Bootsma and Ferguson raises the point that suppressing a pandemic may not be the best strategy because it just leaves some people susceptible to infection later. They argue that highly effective social distancing measures, which allow a susceptible pool of people to reintegrate into society when the measures are lifted, are likely to lead to a resurgence in infections and fatalities in a second peak (Chart II-9).17 They suggest an optimal level of control measures to reduce R (the infection rate) to a value that makes a significant portion of the population immune once measures are lifted. The Impact Of The Spanish Flu On The Economy And Markets How did the Spanish Flu pandemic affect the economy? Many pandemic researchers ignore the official recession identified by the NBER during the months of the pandemic (between August 1918 and March 1919).18 The reason is that most of the evidence indicates that the economic effects of the 1918-19 pandemic were short-term and relatively mild.19 Disentangling drivers of the economy is, indeed, tricky given that WW1 ended in November 1918. However, it is easy to underestimate the negative impact of the pandemic since the war had such a big impact on the economy, as well as investor and public sentiment. Various research papers support the fact that, while the pandemic did indeed have an adverse effect on the economy, NPIs did not just depress mortality rates, but also sped the post-pandemic economic recovery.20 Research by Correia, Sergio, and Luck showed that the areas most severely affected by the pandemic saw a sharp and persistent decline in real economic activity, whereas cities that intervened earlier and more aggressively, experienced a relative increase in economic activity post the pandemic.21 Their findings are based on the increase in manufacturing employment after the pandemic compared to before it (1919 versus 1914). However, note that the rise of manufacturing payrolls in 1919 was high everywhere given the return of soldiers post-WWI. The researchers also note that those cities hardest hit by the pandemic also saw a negative impact on manufacturing activity, the stock of durable goods, and bank assets. Chart II-10Short-Term Price Impact Was Disinflationary Because Spanish flu disproportionately killed younger adults, many families lost their breadwinner. In economic terms, this implies both a negative supply shock and negative demand shock. If fewer employees are available to produce a certain good, supply will fall. The same reduction in employment also implies reduced income and therefore lower purchasing power. Both cases will result in a decrease in output. However, the change in prices depends on the decline of supply relative to demand. In 1918-19, the impact was disinflationary: demand declined by more than supply, and both spending and consumer prices fell during the pandemic (Chart II-10). US factory employment fell by over 8% between March 1918 and March 1919 – the period from the beginning of the first wave until the end of the second wave. It is important to note, however, that few businesses went bankrupt during the pandemic years (Chart II-11). Additionally, the November 1918 Federal Reserve Bulletin highlighted that many cities, including New York, Kansas City, and Richmond, experienced a shortage of labor due to the influenza.22 Factory employment in New York fell by over 10% during this period. The link between the labor shortages and the decline in industrial production is unclear. Industrial activity in the US peaked just before the second wave, contracting by over 20% during the second wave (Chart II-12). Various industries reported disruptions: automobile production fell by 67%, anthracite coal production and shipments fell by around 45%, and railroad freight revenues declined by over seven billion ton-miles (Chart II-12, panels 2, 3 & 4). However, some of this decline is attributed to falling defense production after the war. Chart II-11Loss Of Middle-Aged Adults = Loss Of Breadwinners Chart II-12Activity Slowed, But Rebounded Quickly Chart II-13The War Had A Bigger Impact On The Stock Market Than The Pandemic Chart II-14Monetary Policy Was Easy...Even Before The Pandemic Started The equity market moved in a broad range in 1915-1919 and fell sharply only ahead of the 1920 recession (Chart II-13). Seemingly, stock market participants were more focused on the war than the pandemic. The lack of reporting of the pandemic could have contributed to this: newspapers were encouraged to avoid carrying bad news for reasons of patriotism and did not widely cover the pandemic until late 1918.23 The Federal Reserve played an active role in funding the government’s spending on the war, and so monetary policy was very easy during the pandemic – but for other reasons. The Fed used its position as a lender to the banking system to facilitate war bond sales.16 Interest rates were cut in 1914 and 1915 even before the US entered the war. The US economy had been in recession between January 1913 and December 1914. Policy rates remained low throughout 1916 and 1917 and slightly rose in 1918 and 1919. It was not until 1920 that Federal Reserve Bank System tightened policy rapidly to choke off inflation, which accelerated to over 20% in mid-1920 – rising inflation being a common post-war phenomenon (Chart II-14). The Lessons Of 1918-19 For The Coronavirus Pandemic Non-pharmaceutical interventions should continue to be implemented until a vaccine, effective therapeutic drugs, or mass testing is available. Relaxing measures prematurely is as damaging as a tardy reaction to the pandemic. Reacting quickly and imposing multiple measures for longer periods not only reduces mortality rates, but also improves economic outcomes post-crisis. The economy suffers in the short-term: supply and demand shocks lead to lower output. The demand shock however is larger leading to lower prices and disinflationary pressures, at least during and immediately after the pandemic. Amr Hanafy Senior Analyst Global Asset Allocation III. Indicators And Reference Charts Last month, we maintained a positive disposition toward stocks, especially at the expense of government bonds. The global economy may be in the midst of its most severe contraction since the Great Depression, but betting against stocks is too dangerous when fiscal and monetary policy are both as easy as they are today. In essence, don’t fight the Fed. This view remains in place, even if the short-term risk/reward ratio for holding stocks is deteriorating. On a cyclical basis, the same factors that made us willing buyers of stocks remain broadly in place. Stocks are not as cheap as they were in late March, but monetary conditions have only eased further as real interest rates weakened. Additionally, our Speculation Indicator has eased, which indicates that contrary to many commentators’ perceptions, speculation is not rampant. Confirming this intuition, the equity risk premium remains elevated (even when one takes into account its lack of stationarity) and expected growth rates of earnings are still very low. Finally, our Revealed Preference Indicator is finally flashing a strong buy signal. Tactically, equities are still overbought. We have had four 5% or more corrections since March 23. More of them are in the cards. However, the most likely outcome for the S&P 500 this summer is a churning pattern, not a major downward move below 2700. The median stock is still 26% below its August 2018 low and only a fraction of equities on the NYSE trade above their 30-week moving average. These indicators do not scream that a major correction is on the horizon, especially when policy is as accommodative as it is today. We continue to recommend investors take advantage of the supportive backdrop for stocks by buying equities relative to bonds. In contrast to global bourses, government bonds are still massively overbought on a cyclical basis and trading at their largest premium to fair value since Q4 2008 and late 1985. Additionally, the vast sums of both monetary and fiscal stimulus injected in the economy should lift inflation expectations and thus, bond yields. The yield curve is therefore slated to steepen further. Since we last published, the dollar has not meaningfully depreciated, but the DXY is trying to breakdown while our composite technical indicator is making lower highs. It is too early to gauge whether the recent rebound in the IDR, the MXN, or the ZAR is anything more than an oversold bounce, but if it were to continue, it would indicate that the expensive greenback is starting to buckle under the weight of the quickly expanding twin deficit. The widening in the current account deficit that will result from extraordinarily loose fiscal policy means that the large increase in money supply by the Fed will leak out of the US economy. This process is highly bearish for the dollar. Ultimately, the timing of the dollar’s weakness will all boil down to global growth. As signs are building up that global growth is bottoming, odds are rising that the dollar will finally breakdown. Get ready for a meaningful downward move over the coming months. Finally, commodities seem to be gaining traction. The Continuous Commodity Index’s A/D line is quickly moving up and our Composite Technical Indicator is quickly rising from extremely oversold levels. Oil will hold the key for the broad complex. Oil supply has started to adjust lower and oil demand is set to improve starting June/July as the global economy re-opens, fueled with massive amounts of stimulus. As a result, inventories should start to meaningfully decline this summer, which will support the recent recovery in oil prices. If oil can rebound further, industrial commodities will follow. Finally, gold is a mixed bag in the near term. The dollar is set to weaken significantly and inflation breakevens to move higher, which will mitigate the negative impact of declining risk aversion. Silver is a superior play to gold as it will benefit from a recovery in global growth. 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 Reid Cramer et al., The Emerging Millennial Wealth Gap, Divergent Trajectories, Weak Balance Sheets, and Implications for Social Policy, New America, Oct 2019. 2 https://www.wsj.com/articles/new-normal-amid-coronavirus-working-from-home-while-schooling-the-kids-11584437400 3 Please see Geopolitical Strategy Special Report "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com 4 Please see The Bank Credit Analyst Special Report "The Productivity Puzzle: Competition Is The Missing Ingredient," dated June 27, 2019, available at bca.bcaresearch.com 5 Please see The Bank Credit Analyst Monthly Report "May 2020," dated April 30, 2020, available at bca.bcaresearch.com 6 Please see Foreign Exchange Strategy Weekly Report "A Few Trades Amidst A Pandemic," dated May 22, 2020, available at fes.bcaresearch.com 7 Please see European Investment Strategy Weekly Report "European Investors Left Defenceless," dated May 21, 2020, available at eis.bcaresearch.com 8 Please see US Equity Strategy Special Report "Debunking Earnings," dated May 19, 2020, available at uses.bcaresearch.com 9 Please see the Q&A with immunologist and Nobel laureate Professor Peter Doherty, published by BCA Research April 1st 2020: BCA Research Special Report, “Questions On The Coronavirus: An Expert Answers,” available at bcaresearch.com 10 Please see “Leading Cause of Death, 1990-1998,” CDC Centers for Disease Control and Prevention. 11 Please see Ansart S, Pelat C, Boelle PY, Carrat F, Flahault A, Valleron AJ, “Mortality burden of the 1918-1919 influenza pandemic in Europe,” NCBI. 12 Please see Public Health Report, vol. 34, No. 38, Sept. 19, 1919. 13 Please see Qiang Liu, Yuan-hong Zhou, Zhan-qiu Yang Cell Mol Immunol. 2016 Jan; 13(1): 3–10. 14 Please see Shope, R. (1958) Public Health Rep. 73, 165–178. 15 The Liberty Loans Parade was intended to promote the sale of government bonds to pay for World War One. 16 Please see Hatchett RJ, Mecher CE, Lipsitch M (2007) "Public health interventions and epidemic intensity during the 1918 influenza pandemic,"PNAS 104: 7582–7587. 17 Please see Bootsma M, Ferguson N, “The Effect Of Public Health Measures On The 1918 Influenza Pandemic In U.S. Cities,” PNAS (2007). 18 Please see https://www.nber.org/cycles.html 19 Please see https://www.stlouisfed.org/~/media/files/pdfs/community-development/res…12 Please see https://libertystreeteconomics.newyorkfed.org/2020/03/fight-the-pandemic-save-the-economy-lessons-from-the-1918-flu.html. 20 Please see Correia, Sergio and Luck, Stephan and Verner, Emil, Pandemics Depress the Economy, Public Health Interventions Do Not: Evidence from the 1918 Flu (March 30, 2020). Available at SSRN: https://ssrn.com/abstract=3561560 or http://dx.doi.org/10.2139/ssrn.3561560. 21 Please see Board of Governors of the Federal Reserve System (U.S.), 1935- and Federal Reserve Board, 1914-1935. "November 1918," Federal Reserve Bulletin (November 1918). 22 Please see https://newrepublic.com/article/157094/americas-newspapers-covered-pandemic. 23 Please see https://www.federalreservehistory.org/essays/feds_role_during_wwi.
Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1 Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a) Offer attractive yields/spreads b) Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt 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. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3 https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf 7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Fear of deflation – especially at current debt levels – will keep central-bank policy looser for longer. As a result, monetary authorities will do whatever it takes to revive inflation and inflation expectations to move policy rates away from the zero lower bound. EM income growth will rebound, and the US dollar will weaken as monetary and fiscal stimulus reach the real economy. This will be bullish for commodities, including gold. Over the medium to long term, the reversal in globalization and the atrophy of working-age populations will be inflationary: Labor markets will tighten as economic growth recovers and baby-boomers continue to retire, pushing wages higher and savings lower. Over the short term, we are neutral gold from a pricing standpoint, and believe $1,700/oz is close to fair value. When gold pushes through $1,800/oz, longer-term demographic and economic trends will become apparent and will catalyze gold’s rally. We continue to favor gold as a portfolio hedge, as it has held value throughout the COVID-19 pandemic and the re-emergence of geopolitical tensions, particularly the return of Sino-US trade acrimony. Feature Gold will remain at ~ $1,700/oz after rallying 15% from its mid-March bottom, as markets consolidate over the short term. This new equilibrium has been fueled by North American retail investors and is slightly above our model’s fair value (Chart of the Week). While gold’s short-term price drivers appear to have stabilized over the past few weeks – i.e. real rates, US dollar, and equity uncertainty are holding fairly steady – a temporary pullback is likely. Strategically, however, the balance of risks is skewed to the upside. Chart of the WeekRetail Investment Demand Supports Gold Above Our Fair-Value Estimates Our usual framework classifies gold’s drivers into three broad categories: Demand for inflation hedges; Monetary and financial aggregates; and Demand for portfolio-diversification assets. In this report, we are narrowing our focus to concentrate on the tactical vs. strategic drivers of gold prices, to assess the metal’s upside potential over the short- and long-term horizons (Table 1). Table 1Short- vs. Long-Term Drivers Of Gold Prices Over the short-term, gold prices fluctuate mostly with changes in risk aversion, opportunity costs and relative prices vis-à-vis other assets. Longer term, gold prices trend with income and inflation cycles, along with structural changes in households’ savings rates. Short- and Medium-term Drivers Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. Western Buyers To The Rescue The COVID-19 pandemic greatly altered the composition of gold demand in 1Q20. Jewellery and bar-and-coin demand dropped 42% and 11% y/y in the wake of a collapse of Chinese and Indian demand (Chart 2, panel 1). This was offset by sharp inflows to ETF products – mainly from DM investors. ETF inflows increased by ~ 300 tons in 1Q20, and by 170 tons in April 2020 (Chart 2, panel 3). Elevated global uncertainty and falling US real rates are keeping total gold demand resilient in the West. However, the short-term outlook for gold could be volatile as investment and jewellery demand normalize. As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand. Chart 2Weak EM Consumer Demand Offset By Strong North America ETF Inflows Chart 3Investment Demand Overtakes Jewellery's Since 2010, investment and jewellery demand represented ~ 33% and ~ 58%, respectively, of total gold demand – excluding central bank net purchases (Chart 3). As economies reopen, we expect economic uncertainty will fade, which will bring retail and speculative gold demand down in the West, while a recovery in EM economic activity will revive jewellery, bar and coin demand – albeit at a slower pace (Chart 4). NB: A large mismatch in the speed of these adjustments could lead to an undershoot in prices – especially at current elevated positioning. Chart 4Elevated Interests In Gold From Retail Investors Chart 5Investors Allocation To Gold Is Close To 2012 Levels We’ve argued in February there was still an opportunity for investment-led growth to support prices based on the low value of investors’ total holdings of gold compared to global equities on a market-cap basis. This measure is now approaching its 2012 peak and moving toward unknown territory in terms of portfolio and wealth allocation to gold (Chart 5). This is flagging up a risk that short-term traders will want to take profits on their speculative positions, if virus-related uncertainty diminishes. On the other hand, retail buyers could hold on to their hedges. Historically, profound economic dislocations and persistent uncertainty have been complemented by shifts in investors’ behavior, leading to higher average saving rates – e.g. 1929, WWII, 2008’s GFC – (Chart 6). Additionally, downside risks to the reopening of economies worldwide remain significant, particularly given the uncertainty of the COVID-19 pandemic’s evolution: A second wave of contagion would trigger a massive flight to safety and further central bank actions to keep rates depressed. Chart 6Precautionary Savings Rise In Highly Uncertain Periods Awaiting A Setback To The USD The Fed and other systemically important central banks have taken decisive action to keep money markets functioning and to prevent a solvency crisis (Chart 7, panel 1). Ample liquidity, low economic growth, and collapsing inflation expectations pushed bond yields lower globally, which, in large measure, powered the rally in gold prices (Chart 7, panel 2). The protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year. In recent weeks, US yields have stabilized, meaning this factor will not provide much support to gold at current levels – assuming, again, no major second wave in COVID-19 contagion. The upside to rates is also limited over the short term as the increase in Treasury supply will be offset by the Fed’s dovish forward rate guidance. Still, the protection offered by US bonds is much weaker at the lower bound. This will benefit gold as a safe-haven asset if uncertainty intensifies this year (e.g., ahead of the US elections). Moreover, the Fed appears to be willing to risk remaining behind the curve for the foreseeable future. Bonds' protection would suffer if the Fed allows inflation overshoot (more on this below). In 2H20, we expect the USD to weaken as virus-related safe-haven demand – which fueled its 14% rally ytd vs. EM currencies – abates and the Fed’s and the US government’s responses to the crisis floods markets globally with USD liquidity.1 Relative balance-sheet and interest-rate dynamics will reassert themselves as important drivers of currency movements (Chart 8). Chart 7QE Infinity Will Keep Bond Yields Depressed Chart 8USD Deviating From Interest Rate Differentials The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Bottom Line: The sum of gold’s short-term drivers are neutral at the current $1,700/oz equilibrium. The tailwinds from declining US real rates ended and a decline in virus-related uncertainty will be offset by the positive effect of a weaker dollar. A temporary pullback is likely. Long-term Drivers The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. Stimulative Policies To Boost EM Income Growth Global income growth is one of the core drivers of gold prices over long horizons (Chart 9, panel 1). As countries get wealthier, the pool of savings rises, which benefits gold, along with most financial assets. Because gold-mining production growth is relatively stable and inelastic to prices in the short-term, changes in income growth above production growth have a crucial influence on gold’s trajectory over the long run. EM countries – chiefly China and India – are the largest buyers of jewellery, bars and coins, and remain among the fastest-growing economies on the planet. Hence, since 2000, gold’s annual price change correlates strongly with their income growth (Chart 9, panel 2). In addition, central banks’ net gold purchases – which have been increasingly positive since 2009 – effectively reduce available supply to consumers. We include net purchases in our measure of total supply to separate it from consumer and investor demand – which respond to entirely different incentives (Chart 9, panel 3). We expect EM central banks will continue diversifying part of their US dollar reserves to gold.2 Chart 9Global Income Growth Drives Long Term Gold Returns Chart 10China's Economic Activity Close To Pre-COVID-19 Levels The underlying trend in gold prices will remain positive, supported by accelerating EM income growth over the next 12 months. China’s economic activity appears to have partly recovered from the COVID-19 shock (Chart 10). Going forward, the country’s surging fiscal and monetary stimulus, in addition to a weakening US dollar, will revive growth in neighboring Asian economies this year. Structural Deflationary Pressures Are Easing We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system. As we’ve argued in previous reports, gold acts as a good inflation hedge when there is an increase in perceived risks of significant overshoots.3 In normal times, inflation expectations move slowly and trend more or less with past inflation prints (Chart 11). However, the unprecedented global fiscal and monetary stimulus deployed to combat the COVID-19-induced recession could shift expectations rapidly and profoundly. We do not believe the lack of inflationary pressure post-GFC will be repeated this time. The stimulus is radically larger and geared more toward the real economy as opposed to rescuing the banking system (Chart 12). Moreover, a combination of deflationary structural factors – i.e. trade globalization, expanding global value chains, and demographics – are reversing, and will gradually become inflationary.4 This is a stark difference to the post-GFC quantitative easing. Chart 11Inflation Expectations Trend Along Past Realized Inflation Rates Chart 12Surging US Broad Money Supply Firstly, globalization’s deflationary impulse – thru increasing trade and expanding global value chains – stalled a few years ago (Chart 13). Recently, ramping anti-globalization policies amidst the Sino-US trade tensions exposed vulnerabilities in the current trade infrastructure. The COVID-19 pandemic risks accelerating these trends. Following widespread quarantine measures in China, US imports from China fell sharply in February and March, and firms without pre-established supply chain relationships with other Asian countries that could backstop supply disruptions were left unable to find alternative suppliers (Table 2). Firms will likely continue diversifying their supply sources and insource critical activities to the US, post-COVID-19.5 Additionally, our Geopolitical strategists see increasing risks of renewed US pressures on China ahead of the election.6 An acceleration in de-globalization trends post-COVID-19 will disrupt international supply chains and amplify inflationary pressures. Chart 13The Structural Reversal In Globalization Trends Will Be Inflationary Table 2Vulnerability In US Supply Chains China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking. Secondly, structural demographic trends are reversing. The world’s support ratio – i.e. the number of workers per dependent – has been trending downward since 2015 (Chart 14, panel 1). As more people around the world reach retirement age, this trend is expected to continue. This trend is especially powerful in China, whose workforce was one of the great deflationary demographic factors in previous decades. Effectively, this implies aggregate demand is likely to exceed aggregate supply as more workers become consumers. In theory, this also implies lower global savings and a higher neutral rate of interest. Consequently, a rising neutral rate, combined with our belief central bankers will be behind the curve in raising rates, increases the risks of inflation moving sharply above target. Chart 14Demographic Trends Will Become Inflationary China’s declining support ratio also means the pool of cheap offshore labor for DM economies is shrinking – the country could lose ~ 400 million workers over the remainder of the century (Chart 14, panel 2). The integration of the Chinese – and other EM countries – workforce during the 2000s led to a doubling of the global pool of labor supply and reduced the average labor cost. Investment Conclusion Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges. Investors need to assess the long-term consequences of these trends and policies vs. the short-term deflationary COVID-19 shock. Asset markets are not positioned for higher inflation, thus, investors seeking refuge ahead of a widespread re-pricing of inflation risk likely will benefit from current relatively inexpensive hedges (Chart 15). While we expect higher US inflation expectations and headline rates in 2H20 – driven by the decline in the USD and the increase in oil and base-metals’ prices – we do not expect meaningful inflation-overshoot risks until late 2021. Core inflation rates will remain depressed until the large labor-supply overhang clears – in the US and globally – and the effect of the lower USD pass-through to higher prices emerges (Chart 16). Chart 15Gold Is Not Relatively Expansive, Except Vs. Commodities Chart 16The COVID-19-Induced Deflationary Effects Will Last Until Next Year Re-anchoring expectations will necessitate periods of above-target inflation rates. The short-term drivers of gold are neutral at the current $1,700/oz equilibrium, as inflation pressure won’t surface until 2H21. Moreover, there is a non-negligible risk of a short-term pullback if DM economies are successfully reopened without significant increases in COVID-19 infection rates. This should serve as a buying opportunity, as the medium- and long-term outlook remains bullish for the yellow metal. EM income growth is poised to rebound as global monetary and fiscal stimulus reach the real economy and the USD depreciates. The reversal in globalization and demographic trends will become inflationary. Policymakers will do whatever it takes to revive inflation and inflation expectations to move away from the zero lower bound. Re-anchoring expectations will necessitate periods of above-target inflation rates. Thus, real rates should be contained as QE continues to depress the term premium and inflation starts to move higher. Fear of deflation – especially at current debt levels – will keep central banks too easy for too long. Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Commodities Round-Up Energy: Overweight Oil production globally is falling faster than expected, based on anecdotal press reports showing the Kingdom of Saudi Arabia (KSA) took an additional 1mm b/d of production off the market, bringing its total shut-in level to 7.5mm b/d for next month. The Saudi government urged OPEC 2.0 member states to follow its lead and reduce production further. The US EIA this week reported it expects Russia’s production to fall more than 800k b/d, while in the US production is expected to decline by a similar amount this year, and another 600k b/d in 2021. Canada’s production is expected to fall 400k b/d. Non-OPEC production overall is expected to fall 2.4mm b/d this year. We will be updating our supply-demand balances and prices forecasts in next week’s report. Base Metals: Neutral Steel markets are becoming concerned COVID-19-induced production declines will reduce iron-ore shipments. Earlier this month, 10 cities in the Brazilian state of Para, an ore-producing region, were placed under lockdown, according to FastMarkets MB, a sister publication of BCA Research. Even though ore mining and shipping have been exempted, concern that COVID-19 could reach the producing regions and affect output is growing. Benchmark 62% Fe ore is down 6.2% from its January highs (Chart 17). Precious Metals: Neutral A forecast by Australia’s Department of Industry, Science, Energy and Resources (ISER) that Australia would become the world’s largest gold producer in 2021 was seconded this week by a private forecaster, Resources Monitor. The ISER forecast Australia would overtake China as the top gold producer in its March 2020 forecast, with output reaching 383 tons next year. Australia produced 326 tons last year, vs. China’s 380 tons. Ags/Softs: Underweight The USDA released its first estimate for the 2020/2021 marketing year, projecting corn ending stocks at 3.318 Bn bushels for the season, the largest stockpile since 1987/1998 (Chart 18). Huge planting projections will outweigh increases in exports demand of 35 Mn bushels and in usage for ethanol biofuel of 5.2 Bn bushels compared to the current season. Nonetheless corn futures hedged higher on Tuesday, rising 5.25 cents/bu, as the weak outlook was offset by downward revisions to old crop inventories. Finally wheat’s ending stocks were moderately revised up for the current season, but futures still fell to the lowest in a week due to better than expected weather in the US and higher global stocks expectations. Chart 17Supply Constraints Could Boost Prices Chart 18USDA Expects Large US Corn Stocks Increase Footnotes 1 We’ve outlined our view on the dollar for 2020 in our April 23, 2020 Weekly Report. Please see USD Strength Restrains Commodity Recovery, available at ces.bcaresearch.com 2 The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is fading. 3 Please see our Weekly Report titled "All That Glitters ... And Then Some," published July 25, 2019. It is available at ces.bcaresearch.com 4 For more details on these structural factors please see The Bank Credit Analyst Special Reports titled "Troubling Implications Of Global Demographic Trends," and "Three Demographic Megatrends," published 28 February, 2019 and October 26, 2017. 5 Please see Sebastian Heise, “How Did China’s COVID-19 Shutdown Affect U.S. Supply Chains?,” Federal Reserve Bank of New York Liberty Street Economics, May 12, 2020. 6 Please see BCA's Geopolitical Strategy Special Alert titled "#WWIII," published May 1, 2020. It is available at gps.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades
Highlights Real Yield Curve: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). High-Yield: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Bank Bonds: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. Feature Oil was the big mover in financial markets last week, with the WTI price dropping briefly into negative territory on the day before expiry of the May futures contract.1 Bond markets didn’t react much to the negative oil price (Chart 1), but this doesn’t mean that the energy market is unimportant for yields. On the contrary, the oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Chart 1Negative Oil Didn't Shock The Bond Market A Bond Market Trade Inspired By Negative Oil The Fisher Equation is the formula that relates nominal yields, real yields and inflation expectations. In its simplest form the Fisher equation is: Nominal Yield = Real Yield + Inflation Expectations When applying this equation to the act of bond yield forecasting we find it helpful to note that both the nominal yield and inflation expectations have specific valuation anchors. The Federal Reserve sets the valuation anchor for nominal yields because it controls the overnight nominal interest rate. If you enter a long position in a nominal Treasury security and hold to maturity you will make money versus a position in cash if the average overnight nominal interest rate turns out to be lower than the nominal bond yield at the time of purchase. The oil price often sends important signals about the near-term outlook for inflation, a key input for bond investors. Similarly, inflation expectations are anchored by the actual inflation rate. If you enter a long position in inflation protection and hold to maturity you will make money if actual inflation turns out to be higher than the rate that was embedded in bond prices at the time of purchase.2 Turning to real yields, we see why the Fisher Equation is important. Real yields have no obvious valuation anchor. This means that the best forecasting technique is often to: (1) Use our known valuation anchors (the fed funds rate and inflation) to forecast the nominal yield and inflation expectations. (2) Use the Fisher Equation to back-out a fair value for real yields. With all that said, let’s apply this framework to today’s bond market in light of last week’s dramatic oil price moves. Inflation Compensation The cost of inflation protection tracks the oil price, more so at the front end of the curve than at the long end. This makes sense given that recent oil price trends tell us a fair amount about the outlook for inflation over the next year but very little about the outlook for inflation over the next 10 or 30 years. The inflation market didn’t react much to oil’s dip into negative territory last week, but this year’s broader drop in the WTI price from above $50 to below $20 had a big impact on TIPS breakeven inflation rates and CPI swap rates, particularly at short maturities (Chart 2). In fact, consistent with expectations for a very low oil price, the bond market is now pricing-in deflation over the next two years. Chart 2Bond Market Priced For Deflation Nominal Yields The Fed’s zero interest rate policy is having a profound effect on nominal bond yield volatility. Because the consensus investor expectation is that the Fed will keep rates pinned near zero for a long time, almost irrespective of economic outcomes, even a significant market event like a plunge in the oil price will do very little to move nominal bond yields. During the last zero-lower-bound period, nominal bond yield volatility fell across the entire yield curve but fell much more at the short end of the curve than at the long end (Chart 3). The same phenomenon will re-occur during the current zero-lower-bound episode. Chart 3The Zero Lower Bound Crushes Nominal Bond Yield Volatility Real Yields Using the Fisher Equation, we can deduce how real yields must move given changes in inflation expectations and nominal bond yields. With the Fed ensuring that short-maturity nominal yields remain stable, the recent decline in oil and inflation expectations caused short-dated real yields to jump (Chart 4). Long-maturity real yields remain low because (a) the shock to inflation expectations was smaller at the long-end of the curve and (b) the Fed’s forward rate guidance doesn’t suppress nominal bond yield volatility as much for long maturities. Chart 4There's Value In Short-Maturity Real Yields Investment Implications If we assume that last week’s -$37.60 WTI print will mark the cyclical trough in oil prices, US bond investors can profit by implementing real yield curve steepeners.3 Short-dated real yields will fall as oil and short-dated inflation expectations recover and nominal yields remain stable. In this scenario, real yields are more likely to rise at the long-end of the curve, given the greater volatility in long-dated nominal yields and the fact that long-maturity inflation expectations are not as depressed. Looking at the 2008 episode as a comparable, we see that the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI (Chart 5). After that trough, with the Fed keeping short-dated nominal rates pinned near zero, the inflation compensation curve flattened and the real yield curve steepened. Chart 5Initiate Real Yield Curve Steepeners Bottom Line: Last week’s negative oil print could signal the peak in deflationary sentiment for this cycle. It’s a good time for bond investors to enter real yield curve steepeners. Buy a short-maturity real yield (1-year or 2-year) and sell a long-maturity real yield (10-year or 30-year). Poor Junk Bond Valuations Illustrated In recent reports we have been advising investors to own spread products that offer attractive spreads and that benefit from Fed support.4 This includes investment grade corporate bonds and Ba-rated high-yield bonds, but not junk bonds rated B or below. In past reports we also showed that B-rated and below junk spreads don’t adequately compensate investors for likely default losses. But this week, we want to quickly illustrate that junk spreads are trading too tight even compared to other common coincident indicators. Specifically, we zero in on the VIX and ratings migration. In 2008, the cost of inflation protection bottomed around the same time as the trough in oil, and about 7 months before the trough in 12-month headline CPI. Charts 6A, 7A and 8A show the historical relationship between the VIX and Ba, B and Caa junk spreads. In all three cases, spreads are well below levels that have been historically consistent with the current reading from the VIX. Charts 6B, 7B and 8B show the historical relationship between the monthly Moody’s rating downgrade/upgrade ratio and Ba, B and Caa spreads. These charts tell a similar story. In fact, March saw nearly 12 times as many ratings downgrades as upgrades, the third highest monthly ratio since 1986. With more downgrades coming in the months ahead, it is apparent that junk spreads are stretched. Chart 6ABa Spreads & VIX Chart 6BBa Spreads & Ratings Chart 7AB Spreads & VIX Chart 7BB Spreads & Ratings Chart 8ACaa Spreads & VIX Chart 8BCaa Spreads & Ratings Relatively tight spreads are probably justified in the Ba space where firms will benefit from the Federal Reserve’s Main Street Lending facilities.5 However, B-rated and below securities have mostly been left out in the cold. We see high odds of spread widening for those credit tiers. Bottom Line: High-yield bond spreads are much too tight relative to the VIX and ratings migration. This is justified for Ba-rated issuers that can tap the Fed’s emergency programs. However, B-rated and below spreads look vulnerable. Investors should overweight Ba-rated junk bonds and underweight the B-rated and below credit tiers. Subordinate Bank Debt Is A Good Bet The Fed’s decision to exclude bank bonds from its primary and secondary market corporate bond purchases complicates our investment strategy. We want to focus on sectors that offer attractive spreads and that benefit from Fed support, but should we carve out an exception for bank bonds? Bank Bonds Are A Defensive Sector First, we note that banks are a defensive corporate bond sector. This is due to bank debt’s relatively high credit rating and low duration. Notice that banks outperformed the rest of the corporate index when spreads widened in March, but have lagged the index by 131 bps since spreads peaked on March 23 (Chart 9). Bank equities don’t exhibit the same behavior and have in fact steadily underperformed the S&P 500 since the start of the year (Chart 9, bottom 2 panels). Chart 9Bank Bonds Are Defensive... However, if we consider senior and subordinate bank debt separately, a different picture emerges (Chart 10). Senior bank bonds behave defensively, as described above, but the lower-rated/higher duration subordinate bank bond index is more cyclical. It has outperformed the corporate benchmark by 316 bps since March 23 (Chart 10, bottom panel). Chart 10...Except Subordinate Debt The Value In Bank Bonds Despite being a defensive sector, senior bank bonds offer attractive risk-adjusted value. The average spread of the senior bank index is 18 bps above the spread offered by the equivalently-rated (A) corporate bond benchmark. Further, the senior bank index has lower average duration than the A-rated benchmark, making the sector very attractive on a per-unit-of-duration basis (Chart 11A). Chart 11ASenior Bank Bond Valuation Chart 11BSubordinate Bank Bond Valuation Turning to subordinate bank bonds, risk-adjusted value looks only fair compared to other equivalently-rated (Baa) corporate bonds (Chart 11B). However, in absolute terms the subordinate bank index offers a spread of 246 bps, compared to a spread of 178 bps on the senior bank index. Downgrade Risk Is Minimal We think investors should overweight subordinate bank bonds for two reasons. First, we think the Fed’s aggressive policy response means that investment grade corporate bond spreads, in general, have already peaked. We would expect defensive senior bank bonds to underperform in this environment of spread tightening, even though they offer attractive risk-adjusted value. Subordinate bank bonds should outperform the index in this environment, even if other Baa-rated sectors offer better value. Second, other Baa-rated corporate bond sectors offer elevated spreads because downgrade risk remains high. The Fed’s facilities will prevent default for investment grade firms, but many Baa-rated issuers will end up taking on a lot of debt to avoid bankruptcy and will get downgraded. We think banks are insulated from this downgrade risk. Even in the Fed's "Severely Adverse Scenario", three of banks' four main capital ratios remain above pre-GFC levels. Chart 12 shows the four main capital ratios calculated for US banks, and the dashed line shows the minimum value the Fed estimates that those ratios will hit under the “Severely Adverse Scenario” from the 2019 Stress Test. Three of the four ratios would remain above pre-crisis levels, and the Tier 1 Leverage Ratio would be only a touch lower. Chart 12Banks Have Huge Capital Buffers Further, our US Investment Strategy service observes that the large banks had sufficient earnings in the first quarter to significantly ramp up loan loss provisions without taking any capital hit at all.6 Our US Investment Strategy team believes that, as long as the shutdown doesn’t last more than six months, the big banks will have sufficient earnings power to absorb loan losses this year, without having to mark down their capital ratios, which in any case are extremely high. Bottom Line: US bond investors should overweight subordinate bank bonds within an allocation to investment grade corporate credit. Subordinate bank bonds are Baa-rated and thus offer reasonably high spreads. But unlike other Baa-rated bonds, banks should avoid ratings downgrades during this cycle. In short, subordinate bank debt looks like a reasonably safe way to capture high-beta exposure to the investment grade corporate bond market. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed explanation of the WTI price’s shocking move please see Commodity & Energy Strategy Special Alert, “WTI In Free Fall”, dated April 20, 2020, available at ces.bcaresearch.com 2 An example of a long position in inflation protection would be buying the 5-year TIPS and shorting the equivalent-maturity nominal Treasury security. 3 Our Commodity & Energy Strategy service’s view is that the WTI oil price will average ~$60 to $65 in 2021. For further details please see Commodity & Energy Strategy Weekly Report, “US Storage Tightens, Pushing WTI Lower”, dated April 16, 2020, available at ces.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 For more details on the Fed’s different emergency facilities please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, April 2020”, dated April 20, 2020, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Inflation-Linked Bonds: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy awakens from the COVID-19 slumber, depressed market-derived inflation expectations can move higher across the developed markets – most notably in the US, the UK, Australia and Canada. Favor inflation-linked government bonds versus nominals in those countries on a strategic (6-12 months) basis. UK Corporates: The Bank of England (BoE) is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases, with credit spreads at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from BoE buying. Feature Chart of the WeekThe Link Between Oil & Bond Yields Remains Strong The shocking, albeit brief, journey of the West Texas Intermediate (WTI) oil price benchmark below zero last week was another in a long line of stunning market moves seen during the COVID-19 pandemic. Those negative oil prices were technical in nature and lasted all of one day, but the ramifications for global bond markets of the falling cost of oil in 2020 have been more enduring. Government bond yields have largely followed the ebbs and flows in energy markets for most of the past decade, and this year has been no exception (Chart of the Week). That link from oil has been through the inflation expectations component of yields, which have been (and remain) highly correlated to oil prices in virtually every developed market country. This is likely due to the persistent low global inflation backdrop since the 2008 financial crisis, which has made cyclical swings in energy prices the marginal driver of both realized and expected inflation. Chart 2BCA's Commodity Strategists Expect Oil Prices To Recover Our colleagues at BCA Research Commodity & Energy Strategy now anticipate higher oil prices over the next 12-18 months.1 Global growth is expected to recover from the COVID-19 recession sooner (and faster) than global oil production, helping to improve the demand/supply balance in energy markets and boost oil prices (Chart 2). Our energy strategists expect the benchmark Brent oil price to rise to $42/bbl by the end of 2020 and $78/bbl by the end of 2021. Those are big moves compared to the current spot price around $20/bbl, and would impart significant upward pressure on inflation expectations if the history of the past decade is any guide. That kind of move in oil prices should also help lift overall nominal government bond yields. Although the real (inflation-adjusted) component of yields is likely to remain low as major central banks like the Fed and ECB will remain highly accommodative, even when growth and inflation begin to recover, given the severity of the COVID-19 global recession. With market-based inflation expectations now at such beaten-up levels, and with the disinflationary effect of falling energy prices set to fade, we see an opportunity to play for a cyclical rebound in inflation breakevens across the developed markets by favoring inflation-linked government bonds versus nominal yielding equivalents. A Simple Framework For Finding Value In Inflation Breakevens Given the remarkably tight correlation between oil prices and market-determined inflation expectations in so many countries, it should be fairly straightforward to model the latter using the former as the main input. We have developed a series of fair value regressions for breakevens in the major developed countries which do exactly that. In this simple approach, we attempt to model the 10-year breakeven from inflation-linked bonds for eight countries – the US, the UK, Germany, Japan, France, Italy, Canada and Australia - as a function of a short-run variable (oil prices) and a long-run variable (the trend in realized inflation). Specifically, we are using the annual percentage change in the Brent oil price benchmark in local currency terms (i.e. converted from US dollars at spot exchange rates) as the short-run variable and a five-year moving average of realized headline CPI inflation as the long-run variable. The latter is included to provide an “anchor” for breakevens based on the actual performance of inflation in each country. In other words, expectations about what inflation will look like in the future are informed by what it has done in the past – what economists refer to as “adaptive” expectations. The generic regression equation used for each country is: 10-year inflation breakeven = α + β1 * (annual % change of Brent oil price in local currency terms) + β2 * (60-month moving average of headline CPI inflation) In Table 1, we present the results of the regressions of each of the eight countries, which use weekly data dating back to the start of 2012 to capture the period when oil prices have most heavily influenced inflation expectations. The coefficients, R-squareds and standard errors of the regressions are all shown, as well as the most recent model residual (i.e. the deviation of 10-year inflation expectations from model-determined fair value). All the coefficients for each model are significant. The R-squareds of the models vary, with the models for France and Australia doing the best job of explaining changes in inflation expectations in those two countries. Table 1Details Of Our New 10-Year Inflation Breakeven Models For the UK and Japan, we added an additional “dummy” variable to control for the unique situations that we believe have influenced inflation breakevens in those countries. For the UK, the period since the June 2016 Brexit vote has seen the path of inflation expectations stay nearly 50bps higher than implied by moves in GBP-denominated oil prices and the trend in actual UK inflation. For Japan, the period since the Bank of Japan initiated its Yield Curve Control policy in September 2016 has seen breakevens stay nearly 60bps below fair value as derived from JPY-denominated oil prices and the trend in actual Japanese inflation. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. In Charts 3 to10 over the next four pages, we show the models for each country. 10-year inflation breakevens versus the independent variables in the models are shown in the top two panels, the model fair value is presented in the 3rd panel, and the deviation from fair value is in the bottom panel. In all cases, breakevens are below fair value, suggesting that inflation-linked bonds look relatively attractive versus nominal government bonds. Chart 3Our US 10-Year TIPS Breakevens Model Chart 4Our UK 10-Year Breakeven Inflation Model Chart 5Our France 10-Year Breakeven Inflation Model Chart 6Our Italy 10-Year Breakeven Inflation Model Chart 7Our Japan 10-Year Breakeven Inflation Model Chart 8Our Germany 10-Year Breakeven Inflation Model Chart 9Our Canada 10-Year Breakeven Inflation Model Chart 10Our Australia 10-Year Breakeven Inflation Model Chart 11Real Inflation-Linked Bond Yields Will Remain Subdued For Longer The largest deviations from fair value can be found in Canada (-70bps), Australia (-48bps), the UK (-29bps), and the US (-26bps). 10-year breakevens are also below fair value in the euro zone countries and Japan, but not by more than one standard deviation as is the case for the other four countries. Bond investors with longer-term investment horizons looking to play for a global growth recovery from the COVID-19 recession over the next 12-18 months should position for some widening of breakevens by favoring inflation-linked bonds over nominal paying government debt. Focus on the four markets with breakevens furthest from fair value, although from a market liquidity perspective it is easier to implement those positions in the US and UK, which represent a combined 69% of the Bloomberg Barclays Global Inflation-Linked bond index. A rise in inflation expectations should also, eventually, put some sustained upward pressure on nominal bond yields. We would rather play that initially by positioning for higher inflation breakevens, rather than having outright below-benchmark duration exposure, as developed market central banks will stay accommodative for longer given the severity of the COVID-19 recession - that will keep real bond yields lower for longer (Chart 11). Breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Bottom Line: The plunging price of oil has put renewed downward pressure on global bond yields via lower inflation expectations. With oil prices set to recover over the next 6-12 months as the global economy starts to awaken from the coronavirus induced slumber, breakevens from inflation-linked bonds are now too low across the developed markets – most notably in the US, the UK, Australia and Canada. Favor linkers over nominals in those countries. Where Is The Value In UK Corporate Bonds? Chart 12Upgrade UK IG Corporates To Overweight On BoE Buying The Bank of England (BoE) initiated its Corporate Bond Purchase Scheme (CBPS) in August 2016 as part of a package of stimulus measures to cushion the economic blow from the UK’s vote to exit the European Union. As we noted in recent joint report with our sister service, BCA Research US Bond Strategy,2 the CBPS helped tighten spreads by lowering downgrade and default risk premiums and also helped spur corporate bond issuance (Chart 12). Shortly after that report was published, the BoE announced that it would be purchasing a further £10 billion in investment grade nonfinancial corporate bonds in the coming months, doubling the scheme’s aggregate holdings to £20 billion. In addition, the bank would make these purchases at a significantly faster pace than in 2016, which implies a faster transmission towards tightening of spreads. Compared to other central bank peers, however, the BoE’s program still has room to expand, which makes UK investment grade credit attractive over tactical and strategic investment horizons. Using the market value of the Bloomberg Barclays UK corporate bond index (excluding financials) as a proxy for the total value of eligible bonds, the CBPS is on track to own roughly 9% of all eligible bonds by the time the £20 billion target is reached. The neighboring European Central Bank, on the other hand, already owns 23% of the stock of eligible euro area corporate bonds in its market, and that figure is only set to increase with policymakers set to do “whatever it takes” to backstop the investment grade market. Year-to-date, UK corporate bonds appear to have recovered somewhat from the panicked selloff earlier this quarter (Table 2), with the Bloomberg Barclays UK investment grade corporate bond index down only -0.3% in total return terms. In excess return terms relative to duration-matched UK corporate bonds, however, the index is down -5.2%, indicating that weakness has persisted in the pure credit component. Table 2UK Investment Grade Corporate Bond Returns At the broad sector level, Other Industrials appear to be the outlier, having delivered positive excess returns (+0.6%) and significant total returns (+16%). These returns are not nearly as attractive, however, on a risk-adjusted basis once you consider that this sector has an index duration more than three times that of the overall index.3 Outside of that sector, the best performers, in excess return terms, are predominantly the more “defensive” sectors—Utilities (-3.4%), Technology (-3.7%), Communications (-4.2%) and Consumer Non-Cyclical (-4.6%). Meanwhile, the sectors most exposed to vanishing consumer demand and weak global growth have performed the worst—Transportation (-9.5%), Capital Goods (-7%), Energy (-6.8%), and Basic Industry (-6.2%). Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases. Credit spreads in the UK indicate that the market has already begun to stabilize in response to the BoE’s new round of corporate bond purchases (Chart 13). The overall index spread, although still elevated at 228bps, has already tightened by 57bps from the peak in late March. The gap between the index spreads of Baa-rated and Aa-rated UK debt remained relatively stable through the wave of sell-offs, peaking at +53bps, below the 2019 high of +55bps, and settling now to +36bps. Outside the purview of the CBPS, however, the situation is a bit rockier, with the overall high-yield index spread +590bps above that of the investment grade index. Broadly speaking, there is a clear disparity between those credit tiers that have the support of the monetary authorities and those that do not. Investment grade spreads will continue to tighten as the BoE rapidly increases its holdings of investment grade corporate bonds. However, high-yield bonds remain exposed to downgrade/default risk and ongoing uncertainty stemming from the COVID-19 economic shock. To drill down into which credit tier spreads offer the most value within the UK investment grade space, we use the 12-month breakeven spread percentile rankings. This is one of the tools we use to assess value in global credit spreads, as measured by historical “spread cushions”. Specifically, we calculate how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. Chart 14 shows the 12-month breakeven spread percentile rankings for all the credit tiers in the UK investment grade space. Aaa-rated debt appears most unattractive, with the spreads currently ranking below the historical median. Between the other three tiers, Aa-rated debt offers the most value, although all three are at historically attractive levels. Chart 13UK IG Has Held Up Well During The COVID-19 Shock Chart 14UK IG Breakeven Spreads Look Most Attractive For Aa-Rated Bonds On the sector-level, the disparity in spreads is most clearly visible in the sectors most exposed to the pandemic. In Charts 15 & 16, we show the history of option-adjusted spreads (OAS) for the major industrial sub-groupings of the Bloomberg Barclays UK investment grade corporate index. Spreads look widest relative to history for sectors such as Energy and Transportation, while spread widening has been contained in more insulated sectors such as Financials. Chart 15A Mixed Performance For UK IG By Sector In 2020 … Chart 16… But Spreads, In General, Remain Below Previous Cyclical Peaks Another way to assess value across UK investment grade corporates is our sector relative value framework. Borrowing from the methodology used for US corporate credit by our colleagues at BCA Research US Bond Strategy, the sector relative value framework determines “fair value” spreads for each of the major and minor industry level sub-indices of the overall UK investment grade universe. The methodology takes each sector's individual OAS and regresses it in a cross-sectional regression with all other sectors. The dependent variables in the model are each sector's duration, 12-month trailing spread volatility and credit rating - the primary risk factors for any corporate bond. Using the common coefficients from that regression, a risk-adjusted "fair value" spread is calculated. The difference between the actual OAS and fair value OAS is our valuation metric used to inform our sector allocation ranking. We see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. The latest output from the UK relative value spread model can be found in Table 3. We also show the duration-times-spread (DTS) for each sector in those tables, which we use as the primary way to measure the riskiness (volatility) of each sector. The scatterplot in Chart 17 shows the tradeoff between the valuation residual from our model and each sector's DTS. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Chart 17UK Investment Grade Corporate Sectors: Valuation Versus Risk We can then apply individual sector weights based on the model output and our desired level of overall spread risk to come up with a recommended credit portfolio. The weights are determined at our discretion and are not the output from any quantitative portfolio optimization process. The only constraints are that all sector weights must add to 100% (i.e. the portfolio is fully invested with no use of leverage) and the overall level of spread risk (DTS) must equal our desired target. Amid a backdrop of global uncertainty, we reiterate one of our major themes this quarter—buy what the central banks are buying. Given that UK corporate spreads are attractive on a breakeven basis, and with the BoE purchasing corporate debt at an even faster pace than during the volatile period following the shock Brexit vote in 2016, we see this as an opportune time to upgrade our recommended allocation for UK investment grade corporates to overweight. This is both on a tactical (0-6 months) and strategic basis (6-12 months). In our model bond portfolio, we have added two percentage points to our recommended UK corporate bond allocation, funded by reducing further our existing underweight on Japanese government bonds. At the sector level, given this positive backdrop for credit performance, we do not see a need to favor lower risk sectors with a DTS score below that of the overall UK investment grade index. On that basis, we are looking to go overweight sectors with higher relatively higher DTS and positive risk-adjusted spread residuals from our relative value model (and vice versa). Those overweight candidates would ideally be located in the upper right quadrant of Chart 17. Based on the latest output from the relative value model, the strongest overweight candidates are the following UK investment grade sectors: selected Financials (Insurance, Subordinated Bank Debt, and Other Financials), Media Entertainment, Cable Satellite, Tobacco, Diversified Manufacturing, and Communications. The least attractive sectors within this framework are: Packaging, Lodging, REITs, Other Industrials, Metals, Natural Gas, Restaurants, Transportation Services, Financial Institutions, and Midstream Energy. Bottom Line: The BoE is supporting the UK investment grade corporate bond market with an unprecedented level and pace of purchases. Spreads have already begun to tighten in response but are still at attractive levels. Upgrade UK investment grade corporates to overweight on a tactical (0-6 months) and strategic (6-12 months) basis. Across credit tiers, favor Aa-rated debt. Across sectors, favor debt from sectors such as non-bank Financials and Communications that are less exposed to pandemic-related uncertainty but still benefit from the CBPS. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate shaktis@bcaresearch.com Footnotes 1 Please see BCA Commodity & Energy Strategy Weekly Report, "US Storage Tightens, Pushing WTI Lower", dated April 16, 2020, available at ces.bcaresearch.com. 2 Please see BCA US Bond Strategy Special Report, "Trading The US Corporate Bond Market In A Time Of Crisis", dated March 31 2020, available at usbs.bcaresearch.com. 3 Other Industrials has an index duration of 28.6 years, compared to 8.5 years for the overall UK investment grade corporate bond index. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay. Such testing will become available, but probably not for a few more months. Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains. Despite the fact that the supply of goods and services has fallen sharply during this recession, the overall effect has been deflationary. Deflationary pressures should subside later this year as demand picks up, commodity prices rise, and the US dollar weakens. Looking several years out, deglobalization and the increasing politicization of central banking could lead to accelerating inflation. Long-term investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. Now What? Imagine being chased through the woods by an angry bear. You manage to climb a tree, getting high enough so that the bear cannot reach you. You breathe a sigh of relief. You are out of harm's way. Or so you think. You look down, and the bear is waiting for you at the base of the tree. You have no weapons. You feel cold and hungry. It is getting dark. This is the state the world finds itself in today. We have climbed up the tree. The number of new infections has peaked in Italy and Spain, the first large European countries hit by the virus. Hospital admissions in New York are falling. This, combined with a generous dose of economic stimulus, has allowed stocks to rally by 28% from their March 23 intraday lows. Yet, we have neither a vaccine nor a cure for the virus (although as we go to press, unconfirmed news reports suggest that Gilead’s drug, remdesivir, has had success in treating patients at a Chicago hospital). Chart 1Widespread Social Distancing Dampened The Spread Of All Flus And Colds COVID-19 is part of the coronavirus family, which includes four members that are responsible for up to 30% of common colds (most other colds are caused by rhino-viruses). Social distancing has driven the number of cold and influenza-like cases in the US to very low levels (Chart 1). But does anyone really think that the common cold or flu will be permanently eradicated because of recent measures? If not, what will prevent COVID-19, which is no less contagious than these other illnesses, from resurfacing? In short, the bear is still there, waiting for us to reopen the economy. A Deep Recession As we wait, the economic damage continues to mount. The IMF’s baseline scenario foresees the global economy contracting by 3% in 2020, with advanced economies shrinking by 6.1%. This is far deeper than during the 2008/09 financial crisis (Chart 2). The IMF’s projections assume that the pandemic subsides in the second half of 2020, allowing containment measures to be relaxed. If the pandemic were to last longer than that, global output would fall by an additional 3% in 2020 relative to the Fund’s already bleak baseline. A second outbreak next year would push global GDP almost 5% below the IMF’s baseline in 2021, while the combination of a longer outbreak this year and a second outbreak next year would cause the level of output to fall 8% below the 2021 baseline (Chart 3). Chart 2Severe Damage To The Global Economy This Year Chart 3Downside Risks To The IMF's Projections The Ties That Bind The sudden stop in economic activity has led to a dramatic surge in unemployment. US initial unemployment claims have risen by a cumulative 22 million over the past four weeks. The true scale of layoffs is probably higher than that, given that some state websites have been unable to handle the flood of insurance applications. Chart 4Only About One-Third Of Those Who Lose Their Jobs Apply For Benefits Historically, only about one-third of those laid off have applied for benefits (Chart 4). While the take-up rate will be higher this time – the CARES Act increases weekly unemployment compensation, while expanding eligibility to self-employed workers – it is still reasonable to assume that the claims data do not capture how much of the workforce has been laid idle. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. This is encouraging because it implies that in most cases, the ties that bind workers to firms have not been permanently severed. In this respect, the recovery in employment following this recession may end up resembling that of another “man-made” recession: the 1982 downturn (Chart 5). Back then, policymakers felt that a recession was a price worth paying to quash inflation. Once inflation fell, central banks were able to cut rates, allowing economic activity to recover. Today, the hope is that by shutting down all nonessential businesses, the virus will be quashed, and life will return to normal. Chart 5Comparing The 1982 Recession Versus Today: Employment Edition Exit Plans It remains to be seen whether vanquishing the virus will be as straightforward as vanquishing inflation was in the early 1980s. As we noted last week, in the absence of a vaccine or an effective treatment, our best hope is that mass testing will allow businesses to reopen.1 The technology for such tests already exists; it just has yet to become available on a large enough scale. Just like during the Second World War, the production of weapons necessary to fight the virus will grow at an exponential pace (Chart 6). Chart 6Now Let's Do The Same For Test Kits Near-Term Pressures On Risk Assets Exponential change is a difficult concept for the human mind to grasp. What seems painfully slow at first can quickly become unfathomably fast later on. The apocryphal story about the origins of the game of chess comes to mind.2 This puts investors in a bit of a quandary. Growth is likely to recover in the latter half of 2020 as COVID-19 testing becomes pervasive and the effects of fiscal and monetary stimulus make their way through the economy. But, the near-term picture could be soured by news stories of continued acute shortages of medical supplies and delays in providing financial assistance to hard-hit households and businesses, not to mention dire corporate earnings performance. The one piece of good news is that at least so far, temporarily laid-off workers account for the vast majority of the increase in unemployment. Indeed, bottom-up analyst earnings estimates still have further to fall. The Wall Street consensus expects S&P 500 companies to earn $142 per share this year and $174 in 2021. Our US equity strategists are projecting only $100 and $140 in EPS, respectively. Stock prices and earnings estimates generally travel together (Chart 7). On balance, we continue to favor global equities over bonds on a 12-month horizon, owing to the fact that the cyclically-adjusted earnings yield is quite a bit higher than the bond yield (Chart 8). However, we have less conviction about the near-term (3-month) direction of stocks, and would recommend that investors maintain above-average cash levels for now which can be deployed on any major selloff. Chart 7Negative Earnings Revisions Will Weigh On Stocks In The Near Term Chart 8Favor Equities Over Bonds Over A 12-Month Horizon Inflation And Supply Shocks: A Keynesian Paradox? One of the distinguishing features of this recession is that it has involved a simultaneous supply shock and a demand shock. Businesses have had to curb supply in order to allow workers to stay at home, while workers have reduced spending out of fear of going to stores or other venues where they could inadvertently contract the virus. Worries about job losses have further dented demand. There is no question about what happens to output when both demand and supply decline: output falls. In contrast, the impact on the price level depends on which shock dominates (Chart 9). Chart 9Inflation And Supply Shocks As Appendix 1 illustrates with a set of simple numerical examples, in theory, a negative supply shock spread evenly across all sectors of the economy should cause the price level to rise. This is because unemployed workers, who are no longer contributing to output, will still end up consuming some goods and services by tapping into their savings, taking on new debt, or by receiving income transfers from the government. In the current situation, however, the supply shock has not been spread evenly throughout the economy. Some businesses have been completely shuttered, while others deemed essential have been allowed to operate. As the appendix shows, in such cases, the drop in aggregate demand is likely to be larger than if all sectors were equally impacted. In fact, it is possible for a supply shock to trigger a demand shock that is larger than the supply shock itself, leading to a perverse situation where a decline in supply results in a surfeit of output. A recent paper by Guerrieri, Lorenzoni, Straub, and Werning argues that the current pandemic represents such a “Keynesian supply shock.”3 Intuitively, such perverse supply shocks can arise if workers are cut off from purchasing many of the goods that they would normally buy. When the menu of available goods shrinks, even workers who are still employed could end up saving much of their income. Deflationary For Now All this implies that the pandemic is likely to be deflationary until more businesses reopen. The data seem to bear this out. The US core consumer price index fell by 0.1% month-over-month in March on a seasonally adjusted basis, led by steep declines in airfares and hotel lodging prices. High-frequency indicators, as well as the prices paid components of various purchasing manager indices, suggest that deflationary pressures have persisted into April (Chart 10). Chart 10Deflation Reigns For NowShelter inflation was reasonably firm in March but should soften over the coming months. A number of major apartment operators have announced rent freezes. In addition, the lagged effects from a stronger dollar and lower energy prices will contribute to lower goods inflation, while higher unemployment will hold back service inflation. Inflation Should Bounce Back In 2021 The discussion of Keynesian supply shocks suggests that aggregate demand will increase faster than supply as more sectors of the economy reopen. This should ease deflationary pressures. In addition, a rebound in global growth starting in the second half of 2020 will prompt a recovery in commodity prices. The forward oil curve is predicting that Brent and WTI crude prices will rise by 42% and 79%, respectively, over the next 12 months (Chart 11). Inflation expectations and oil prices tend to move closely together (Chart 12). Chart 11H2 2020 Rebound In Growth Will Lift Oil Prices Chart 12Inflation Expectations And Oil Prices Tend To Move Closely Together As a countercyclical currency, the US dollar will weaken over the next 12-to-18 months as global growth rebounds, providing an additional reflationary impulse (Chart 13). Falling unemployment will also eat into labor market slack, helping to support wages. Chart 13Stronger Global Growth In The Back Half Of The Year Will Weaken The Dollar, Putting Upward Pressure On US Inflation The Structural Outlook For Inflation… And Bond Yields Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or abate. On the one hand, it is possible that the pandemic will cast a pall over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth. On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labor market recovers. This could eventually lead to economic overheating in two-to-three years. Chart 14Global Trade Was Already Stagnating A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up (Chart 14). The pandemic may further inflame nationalist sentiment. Against the backdrop of high unemployment, Donald Trump is likely to campaign as a “war president,” relentlessly chiding Joe Biden for having too cozy a relationship with China. On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on TIPS breakevens. Market-based inflation expectations are even more subdued in most other advanced economies. If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Investors should maintain a structurally below-benchmark duration stance in fixed-income portfolios, and position for steeper yield curves. APPENDIX 1: Keynesian Supply Shocks Suppose there are two sectors, A and B. The economy consists of 2,000 workers, with each sector employing 1,000 workers. To keep things simple, assume that workers in each sector evenly split their consumption between the two sectors. Thus, a worker in sector A spends as much on goods from sector A as from sector B, and vice versa. Also assume that each worker, if employed, produces $1,000 of goods and receives a salary of $1,000 for his or her efforts. With this in mind, let us consider three scenarios: Scenario 1: Both Sectors Are Open For Business In this scenario, $1 million of good A and $1 million of good B are produced and supplied to the market. Since each of the 2,000 workers spends $500 on good A and $500 on good B, a total of $1 million of both goods are demanded. Aggregate demand equals aggregate supply. Scenario 2: Partial Closure Of Both Sectors Suppose that half the workers in both sectors are laid off. While the unemployed workers do not earn any income, they still spend half as much as they used to by tapping into their savings ($250 on good A and $250 on good B for each unemployed worker). Each employed worker continues to spend $500 on good A and $500 on good B. Now there is $500,000 in total of each good produced, but $750,000 of each good demanded. Aggregate demand exceeds supply. Scenario 3: Sector A, Deemed The Essential Sector, Remains Completely Open, While B Is Closed In this case, all sector A workers are still employed, earning $1,000 each. Since good B is no longer available for purchase, sector A workers increase spending on good A by 20% (from $500 to $600 per worker). Workers in sector B are all unemployed. However, they continue to tap into their savings. Rather than spending $250 on good A as they did in scenario 2, they increase their expenditures on good A by 20% (from $250 to $300). A total of $900,000 of good A is now demanded ($600*1,000+$300*1,000), which is less than the $1 million of good A supplied. Aggregate supply now exceeds demand for the part of the economy that is still open. The chart and table below summarize the results. The key insight is that a 50% shock to the entire economy curbs aggregate demand less than a 100% shock to half the economy. This implies that demand is likely to grow faster than supply as mass testing allows more of the economy to reopen. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 2 In one account, the King of India was so impressed when the game of chess was demonstrated to him that he offered its inventor any reward he desired. After thinking for a while, the inventor said “Your Highness, please give me one grain of rice for the first square on the chessboard, two grains for the next square, four grains for the one after that, doubling the number of grains until the 64th square.” Stunned that the inventor would ask for such a puny reward, the King quickly agreed. A week later, the King’s treasurer informed His Highness that he would need to give the inventor 18 quintillion grains of rice, which is more than enough rice to cover the entire planet’s surface. “Holy Ganges, what have I done?” the King exclaimed, before having the inventor executed. 3 Veronica Guerrieri, Guido Lorenzoni, Ludwig Straub, and Iván Werning, “Macroeconomic Implications of COVID-19: Can Negative Supply Shocks Cause Demand Shortages?” NBER Working Paper No. 26918 (April 2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores