Australia

Highlights The pandemic is not yet over, but it appears that infections have peaked in the developed world and in most of the major developing economies. Economic growth will reaccelerate as social distancing abates and vaccination programs gather momentum. The current policy orthodoxy is night-and-day different from the orthodoxy that prevailed in the wake of the global financial crisis, as deficit shaming has given way to deficit positivity. Rapid expansion is more likely than a repeat of last decade’s tepid, plodding recovery and inflation will eventually supplant hysteresis as policymakers’ biggest worry. The impending passage of the $1.9 trillion American Rescue Act will vault the US ahead of its major economy counterparts in terms of pandemic spending. Washington’s massive fiscal commitment speeds up the timetable for closing the output gap in the US. Although inflation has become a hot topic among US investors, we do not see it materializing until next year at the earliest. Our base case has the Goldilocks backdrop of solid growth and ample monetary accommodation remaining in place for at least the rest of the year. Markets have fully discounted that scenario but investors should be aware that both downside and upside surprises are possible; bad virus news could drive a growth shortfall while households’ enormous excess savings could power a consumption breakout. The broad take-up of the Goldilocks scenario among equity investors will make it hard for stocks to dazzle in 2021. Nonetheless, we think conditions support mid-to-high single-digit returns, which will allow equities to outperform bonds. The combination of accelerating growth and quiescent central banks is catnip for equities but not so much for bonds, especially investment-grade sovereigns. Fixed-income investors should maintain below-benchmark duration as yield curves steepen. Steepening yield curves have given Financials a shot in the arm while weighing on the high-flying Tech sector. Reopening in the wake of COVID’s retreat should also redound to recent laggards’ benefit and we continue to expect value stocks will outperform their growth counterparts over the rest of the year. The US dollar will resume its downtrend as the virus is beaten back, albeit at a gentler pace than in 2020. Humanity Retakes The Lead Humankind cannot yet declare victory over COVID-19 but it does appear to have gained the upper hand as new case counts have plummeted from their January peak (Chart I-1). Restrictions helped turn the tide in Europe, albeit at the cost of cutting off oxygen to the economy (Chart I-2), but even in Sweden and the US, which eschewed EU-style restrictions, the virus has lost momentum. Increased vigilance apparently trumped fears that the coronavirus would flourish in the northern hemisphere winter. The potential for vaccine-resistant variants is a concern, but the pandemic news is clearly trending in the right direction. Chart I-1The Fever Has Broken Chart I-2Throwing The Merchants Out With The Bathwater As infections fall, so too does the strain on public health care systems. Plunging hospitalizations (Chart I-3) indicate that health care systems have recovered capacity. Hospitalizations are an important metric for tracking COVID’s impact on the economy because they lead restrictions on activity; when they are high and rising, officials are prone to limit person-to-person interaction, and when they are low and falling, officials roll back emergency limits. For services-heavy developed economies, easier restrictions are the key to a return to something more closely resembling normal activity until vaccinations confer herd immunity (Chart I-4). Chart I-3Restrictions Can Be Lifted As Health Care Systems Regain Capacity In the meantime, those who continue to be displaced by the pandemic and the distancing measures taken to combat it will fall back on fiscal support. Fourth-quarter deceleration in the United States highlighted the important role that fiscal transfers have played in keeping vulnerable households, businesses and communities afloat. The bulk of the transfers authorized under the CARES Act were distributed in two bursts. The first arrived in April and May via economic impact payments of $1,200 per adult and $500 per child that were paid in full to about two-thirds of American households1 (Chart I-5, top panel). Chart I-4Lockdowns Are A Drag Chart I-5Transfers Slowed To A Trickle In The Fall Chart I-6Fewer Transfers, Fewer Sales, ... The second burst came in the form of a weekly $600 federal unemployment insurance (UI) benefit supplement in April, May, June and July (Chart I-5, middle panel). Additional aid was provided by the pandemic unemployment assistance (PUA) program, which expanded UI benefits to independent contractors, self-employed individuals and other workers who would not otherwise qualify to receive them. The PUA program was the smallest of the three major transfer plans and the only one that ran until the end of the year, and as the arrival of the direct payment checks and final UI benefit supplements receded further into the past, the US economy began to show some signs of wear. Retail sales fell sequentially in all three months of the fourth quarter (Chart I-6) as total employment hit a wall (Chart I-7) and the economic surprise index swooned (Chart I-8).   Chart I-7... Fewer Jobs ... Chart I-8... And Fewer Positive Surprises Households’ ability to satisfy their obligations to creditors and landlords slipped as the year wore on as well. Fiscal transfers and forbearance programs have limited credit distress far more effectively than one would have expected when the COVID meteor hit the earth (Table I-1), but leading 30-day delinquency rates reveal a modest erosion since late summer (Chart I-9). The share of apartment renters paying at least some of their rent fell by more than one-and-a-half percentage points from year-ago levels in October, November, December and January, a first since the CARES Act transfers began to flow in time to help with the May rent (Chart I-10). It seems clear that lower-income households who relied most heavily on aid felt its absence as the year wore on. Table I-160- And 90-Day Consumer Delinquencies Are Down Year-Over-Year, ... Chart I-9... But Leading 30-Day Delinquencies Are On The Rise ... Chart I-10... And Apartment Rent Collections Have Been Slipping     We take the snapback in January retail sales as evidence that high marginal-propensity-to-consume households needed the second round of transfers provided for in December’s compromise spending bill. Both the economic impact payments ($600 per qualifying adult and $600 per child) and the supplemental UI benefits ($300 per week) were smaller, but the most vulnerable households put them to immediate use. We expect that February rent collections and consumer loan delinquencies will also show improvement, albeit not as dramatically as the retail sales series. With another, larger round of stimulus coming down the pike, it appears that the US economy will avoid a repeat of its fourth quarter fraying around the edges but slumps remain a possibility in economies that allow transfer schemes to lapse before COVID-19 can be tamed. And Now For Something Completely Different The global economy has confronted two significant crises in the space of a dozen years. The events that precipitated them could hardly have been more different: the global financial crisis (GFC) was an endogenous event with enough avarice, hubris, folly and villainy to support a cottage industry of books, movies and TV shows revisiting it, while the pandemic, for all of the official complacency and bumbling it laid bare, was simply an exogenous occurrence of great misfortune. The monetary policy response to both events has been substantially identical; the Fed swiftly took the fed funds rate back to zero, bought copious quantities of Treasury and agency securities, and launched a mix of old and new emergency measures. Other major central banks, which were largely unable to make any moves toward normalization between crises, simply maintained zero or negative interest rate policy and ramped up the pace and/or scope of their own asset purchase programs. The fiscal response has been dramatically different, however, in line with a 180-degree turn in budget orthodoxy. Chastened, perhaps, by Europe’s double-dip recession, or the protractedly tepid US expansion, economic mandarins have experienced a road-to-Damascus conversion. Whereas the OECD and the IMF began wagging their fingers at prodigal legislators while the global economy was still submerged under the GFC rubble, today they counsel that there is no rush to pull back on spending. As the OECD’s chief economist said in a January interview, “The first lesson [from the aftermath of the GFC] is to make sure governments are not tightening in the one to two years following the trough of GDP.2” The IMF has declared that “the near-term priority is to avoid premature withdrawal of fiscal support. Support should persist, at least into 2021, to sustain the recovery and to limit long-term scarring.3” Chart I-11What Goes Up Must ... Go Up Again The about-face in terms of fiscal deficits could have a profound effect on the character of the post-pandemic expansions. The plodding and protracted post-GFC recovery/expansion might be viewed as an object lesson in monetary policy’s limits. There is no gainsaying that central banks acted boldly to counter the GFC, cutting policy rates to zero and beyond, purchasing vast quantities of sovereign bonds, government agency securities and even debt and equity issued by private entities. The purchases caused central bank balance sheets to swell (Chart I-11), but the money creation impact was stunted by an offsetting wave of defaults and a general reluctance on the part of lenders and would-be borrowers to add to the stock of debt. Chart I-12GFC Stimulus Was Fleeting GFC fiscal spending was modest and largely limited to automatic stabilizers once emergency measures ran their course. Even the most celebrated efforts, like the United States’ 2009 Recovery Act, were intentionally modest in scope and limited in duration. Following the prevailing wisdom, national governments quickly moved to withdraw assistance and reduce their budget deficits once the worst of the crisis had passed (Chart I-12). Tepid investment, sluggish employment gains and fiscal drag all weighed on growth, defying the typical bigger-the-decline, bigger-the-bounce business cycle pattern. The picture is quite different today as central banks have gained a powerful and willing partner in their efforts to combat the damage wrought by a sudden shock. Pandemic fiscal stimulus initiatives have dwarfed GFC efforts across the major economies (Chart I-13). Once Congress passes the $1.9 trillion American Rescue Act, the US will have doubled down on its 2020 initiatives, committing to aid equivalent to an extraordinary 25% of its annual output. The ultimate effect on inflation, interest rates and exchange rates remains to be seen, but it is clear that the post-pandemic expansion will not unfold at the plodding pace of the post-GFC expansion. Chart I-13The COVID Fiscal Response Has Dwarfed The GFC's Goldilocks And The Two Tails Narrowing our focus to the US, which comprises nearly 60% of the market cap of the benchmark MSCI All-Country World Index, our base case is the Goldilocks scenario that markets appear to be discounting. That scenario would entail the just-right outcome of solid growth and continued monetary accommodation (Figure I-1). Since the Fed will only dial back accommodation if the economy appears to be at risk of overheating, it will take a growth disappointment, most likely from a negative virus surprise, for the US economy to tumble into the left-hand tail of the distribution. Figure I-1Goldilocks And The Two Tails Chart I-14Making Up For Lost Time We cannot rule out the possibility of virus-resistant mutations or new rounds of outbreaks from a weary populace that lets its guard down, but a failure to vaccinate at a pace consistent with achieving herd immunity by the end of September looks to be the most likely route to disappointment. To that end, we are monitoring vaccination progress against the pace required to get 50-80% of the population inoculated by the end of the third quarter (Chart I-14). The US got off to a slow start, but we are confident that it will catch up by early spring under an administration that has made crushing the virus its top priority and a Congress that is providing the resources to enable local health authorities to get the job done. The case for an upside near-term surprise stems from the notion that America’s solons have provided considerably more aid to households than was strictly necessary. As Chart I-7 showed, total employment fell by 25 million at the trough in April and close to 9 million fewer people are employed now than at the pre-pandemic peak. They can surely use a lifeline, along with the many Americans who are involuntarily working part time and those who are barely holding on even if they are fully employed. But they number far less than the 100 million households4 (two-thirds of all taxpayers) that received the full $1,800-per-adult economic impact payments ($1,200 last spring and $600 in January), and will be in line for another $1,400, as soon as March, under the terms of the new bill. Households who did not need the largesse have presumably saved the distributions, helping contribute to the $1.5 trillion of excess savings accumulated during the pandemic. Thanks to the transfers provided for by the CARES Act, our US Investment Strategy service estimates that aggregate household income from March through December was $450 billion greater than it would have been in the absence of COVID-19 (Table I-2). With the second round of direct payments amounting to about $150 billion and the third round likely to be more than double the second, household incomes will be boosted by another $500 billion and the excess savings horde will be on its way to $2 trillion and beyond. Even in a $21 trillion economy, that much dry powder has the potential to move the needle. Table I-2Households' Excess Pandemic Savings In the absence of even a somewhat related antecedent, no one can say for sure how much of the excess savings will be spent. Ricardian equivalence, which posits that households will be reluctant to spend fiscal windfalls if they anticipate that they will have to pay for them with higher future taxes, and Milton Friedman’s permanent income hypothesis, which posits that consumption decisions are based on lifetime earnings, both suggest that the multiplier effect of the direct payments to households may not be all it's cracked up to be. Empirical evidence does not definitively support either model, but increased income has only accounted for a third of households’ mountain of savings in any event. The remaining two-thirds, amounting to over a trillion dollars, came from reduced consumption. Even if Ricardo’s and Friedman’s hypotheses are mostly on the mark, if much of the $1 trillion of 2020’s reduced consumption was merely deferred rather than destroyed (Box I-1), pent-up consumer demand could be significant. The range of potential outcomes is wide: on the one hand, money has tended to burn a hole in US households’ pockets; on the other, Ricardo and Friedman aren’t exactly Larry Kudlow or Peter Navarro. It is hard to assert with any conviction how much of the savings cache will be spent, or how quickly, but we highlight its presence to point out that near-term US growth could surprise to the upside. BOX I-1 Demand Deferral Or Demand Destruction? February’s Bank Credit Analyst presented a table with simple estimates of the US pandemic spending gap. It showed that spending on goods is tracking above the level that would have been expected if the pandemic had not occurred but that spending on services is down sharply, with an enormous gap in categories like food service, recreation and transportation. The fate of US households’ massive excess savings might come down to what happens to the forgone consumption. Consumption that is not deferred to some later period will simply disappear. Given that the consumption shortfall is entirely confined to services, the key question becomes: Is forgone services consumption more likely to turn into demand destroyed than forgone goods consumption? We suspect the answer is yes. Considering it from the perspective of the categories that suffered the biggest shortfalls, one cannot catch up by eating multiple restaurant dinners in a day, going back in time to attend last season’s sports and entertainment events, or taking more than one flight and staying in more than one hotel room. Services demand may also incorporate more of a discretionary component: one might want to go to a ballgame or a concert, or get out of town over a long weekend, but one eventually has to replace a sputtering car or refrigerator. Some forgone services demand likely turned into accelerated goods demand as white-collar workers redirected workday spending to building out office capabilities at home. Even more may have been diverted to home theater and exercise equipment, or to making one’s outdoor space into a more inviting place to while away the pandemic. The bottom line is that some goods demand appears to have been pulled forward by the pandemic while some services demand has likely been destroyed. There is surely pent-up consumer demand, and it will begin to be released once the pandemic has been subdued, but only some of the accumulated savings will be directed to satisfying it. Conclusions And Investment Recommendations For investors focused on the coming 6-12 months, the key takeaways from our analysis are as follows: Provided that official measures and personal vigilance continue to curtail COVID-19 until vaccinations can stifle it, the growth outlook should steadily improve. In the United States, where the federal government is determined to err on the side of providing too much fiscal support, growth could pick up a lot of steam. If enough pandemic-weary people fail to maintain their vigilance and observe social distancing measures, vaccine distribution efforts become snagged or vaccine-resistant strains emerge, growth could fall short of the consensus expectation embedded in financial market prices. Based on its plans to double down on its initial infusion of fiscal support, the US is the major economy most likely to exceed expectations, perhaps even to the point of overheating. After drilling into the increased income/foregone consumption components of the mountain of savings American households have amassed during the pandemic, however, we reiterate our conclusion that all of the savings will not be spent. The US economy will accelerate smartly this year but overheating is a low-probability event. Chart I-15The Coming Regional And Style Rotation Given these conclusions, we recommend the following investment stance over the next 6-12 months: Overweight equities, which will generate excess returns over sovereign bonds and cash in the absence of a negative COVID surprise, and underweight fixed income. Maintain below-benchmark duration in fixed income portfolios. Underweight US stocks and overweight global ex-US stocks, which will benefit from the reopening of the global economy, and value over growth stocks, which will benefit from reopening and a steeper yield curve. The former broke out in January and held their lead last month (Chart I-15, top panel) while value is testing resistance at its 200-day moving average (Chart I-15, bottom panel). Underweight the US dollar versus the euro in particular and other more cyclical currencies in general. We do not expect the greenback to fall as sharply as it did last year from May through December but we do expect it will resume declining over the rest of the year. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com February 25, 2021 Next Report: March 31, 2021 II. Requiem For Volcker And The Gipper For this month’s Special Report, we are sending you a collaboration between our US Investment Strategy and US Political Strategy teams. US Political Strategy is our newest strategy service and it extends the proprietary framework of our Geopolitical Strategy service to provide analysis of political developments that is relevant for US-focused investors. Please contact your relationship manager if you would like more information or to begin trialing the service. Ronald Reagan cast a long shadow over the elected officials who followed him … :The influence of the economic policies associated with Ronald Reagan held such persistent sway that even the Clinton and Obama administrations had to follow their broad outlines. … just as Paul Volcker did over central bankers at home and abroad … : The Volcker Fed’s uncompromising resistance to the 1970s’ runaway inflation established the Fed’s credibility and enshrined a new global central banking orthodoxy. … but it appears their enduring influence may have finally run its course … : The pandemic overrode everything else in real time, but investors may ultimately view 2020 as the year in which Democrats broke away from post-Reagan orthodoxy and the Fed decided Volcker’s vigilance was no longer relevant. … to investors’ potential chagrin: If inflation, big government and organized labor come back from the dead, globalization loses ground, regulation expands, anti-trust enforcement regains some bite and tax rates rise and become more progressive, then the four-decade investment golden age that Reagan and Volcker helped launch may be on its last legs. The pandemic dominated everything in real time in 2020, as investors scrambled to keep up with its disruptions and the countermeasures policymakers deployed to shelter the economy from them. With some distance, however, investors may come to view it as a year of two critical policy inflection points: the end of the Reagan fiscal era and the end of the Volcker monetary era. The shifts could mark a watershed because Reagan’s and Volcker’s enduring influence helped power an investment golden age that has lasted for nearly 40 years. What comes next may not be so supportive for financial markets. Political history often unfolds in cycles even if their starting and ending dates are never as clear cut in real life as they are in dissertations. Broadly, the FDR administration kicked off the New Deal era, a 48-year period of increased government involvement in daily life via the introduction and steady expansion of the social safety net, broadened regulatory powers and sweeping worker protections. It was followed by the 40-year Reagan era, with a continuous soundtrack of limited government rhetoric made manifest in policies that sought to curtail the spread of social welfare programs, deregulate commercial activity, devolve power to state and local government units and the private sector and push back against unions. The Obama and Trump administrations challenged different aspects of Reaganism, but the 2020 election cycle finally toppled it. Ordinarily, that might only matter to historians and political scientists, but the Reagan era coincided with a fantastic run in financial markets. So, too, did the inflation vigilance that lasted long after Paul Volcker’s 1979-1987 tenure at the helm of the Federal Reserve, which drove an extended period of disinflation, falling interest rates and rising central bank credibility. Our focus here is on fiscal policy, and we touch on monetary policy only to note that last summer’s revision of the Fed’s statement of long-run monetary policy goals shut the door on the Volcker era. The end of both eras could mark an inflection point in the trajectory of asset returns. The Happy Warrior The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”5 Chart II-1After The Recession, Reagan Was A Hit Ronald Reagan held his conservative views with the zeal of the convert that he was.6 Those views were probably to the right of much of the electorate, but his personal appeal was strong enough to make them palatable to a sizable majority (Chart II-1). Substitute “left” for “right” and the sentiment just as easily sums up FDR’s ability to get the New Deal off the ground. Personal magnetism played a big role in each era’s rise, with both men radiating relatability and optimism that imbued their sagging fellow citizens with a sense of comfort and security that made them willing to try something very different. 1980 was hardly 1932 on the distress scale, but America was in a funk after the upheaval of the sixties, the humiliating end to Vietnam, Watergate, stagflation and a term and a half of uninspiring and ineffectual presidential leadership. Enter the Great Communicator, whose initial weekly radio address evoked the FDR of the Fireside Chats – jovial, resolute and confident, with palpable can-do energy – buffed to a shine by a professional actor and broadcaster whose vocal inflections hit every mark.7 The Gipper,8 with his avuncular bearing, physical robustness and ever-present twinkle in his eye, was just what the country needed to feel better about itself. Reaganomics 101 Government does not tax to get the money it needs; government always finds a need for the money it gets.9 President Reagan’s economic plan had three simple goals: cut taxes, tame government spending and reduce regulation. From the start of his entry into politics in the mid-sixties, Reagan cast himself as a defender of hard-working Americans’ right to keep more of the fruits of their labor from a grasping federal government seeking funding for wasteful, poorly designed programs. He harbored an intense animus for LBJ’s Great Society, which extended the reach of the federal government in ways that he characterized as a drag on initiative, accomplishment and freedom, no matter how well intentioned it may have been. That message hung a historic loss on Barry Goldwater in 1964 when inflation was somnolent but it proved to be far more persuasive after the runaway inflation of the seventies exposed the perils of excessive government (Chart II-2). Chart II-2Inflation Rises When The Labor Market Heats Up As the Reagan Foundation website describes the impact of his presidency’s economic policies, “Millions … were able to keep more of the money for which they worked so hard. Families could reliably plan a budget and pay their bills. The seemingly insatiable Federal government was on a much-needed diet. And businesses and individual entrepreneurs were no longer hassled by their government, or paralyzed by burdensome and unnecessary regulations every time they wanted to expand.” “In a phrase, the American dream had been restored.” The Enduring Reach Of Reaganomics I’m not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub. – Grover Norquist Though President-Elect Clinton bridled at limited government’s inherent restrictions, bursting out during a transition briefing, “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?” his administration largely observed them. This was especially true after the drubbing Democrats endured in the 1994 midterms, when the Republicans captured their first House majority in four decades behind the Contract with America, a skillfully packaged legislative agenda explicitly founded on Reagan principles. Humbled in the face of Republican majorities in both houses of Congress, and hemmed in by roving bands of bond vigilantes, Clinton was forced to tack to the center. James Carville, a leading architect of Clinton’s 1992 victory, captured the moment, saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or … a .400 … hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Reagan’s legacy informed the Bush administration’s sweeping tax cuts (and its push to privatize social security), and forced the Obama administration to tread carefully with the stimulus package it devised to combat the Great Recession. Although the administration’s economic advisors considered the $787 billion (5%-of-peak-GDP) bill insufficient, political staffers carried the day and the price tag was kept below $800 billion to appease the three Republican senators whose votes were required to pass it. Even with the economy in its worst state since the Depression, the Obama administration had to acquiesce to Reaganite budget pieties if it wanted any stimulus bill at all. Its leash got shorter after it agreed with House Republicans to “sequester” excess spending under the Budget Control Act of 2011. On the Republican side of the aisle, Grover Norquist, who claims to have founded Americans for Tax Reform (ATR) at Reagan’s request, enforced legislative fealty to the no-new-tax mantra. ATR, which opposes all tax increases as a matter of principle, corrals legislators with the Taxpayer Protection Pledge, “commit[ting] them to oppose any effort to increase income taxes on individuals and businesses.” ATR’s influence has waned since its 2012 peak, when 95% of Republicans in Congress had signed the pledge, and Norquist no longer strikes fear in the hearts of Republicans inclined to waver on taxes. His declining influence is testament to Reaganism’s success on the one hand (the tax burden has already been reduced) and the fading appeal of its signature fiscal restraint on the other. Did Government Really Shrink? When the legend becomes fact, print the legend. – The Man Who Shot Liberty Valance For all of its denunciations of government spending, the Reagan administration ran up the largest expansionary budget deficits (as a share of GDP) of any postwar administration until the global financial crisis (Chart II-3). Although it aggressively slashed non-defense discretionary spending, it couldn’t cut enough to offset the Pentagon’s voracious appetite. The Reagan deficits were not all bad: increased defense spending hastened the end of the Cold War, so they were in a sense an investment that paid off in the form of the ‘90s peace dividend and the budget surpluses it engendered. Chart II-3Cutting The Federal Deficit Is Harder Than It Seems Nonetheless, the Reagan experience reveals the uncomfortable truth that there is little scope for any administration or Congressional session to cut federal spending. Mandatory entitlement spending on social security, Medicare and Medicaid constitutes the bulk of federal expenditures (Chart II-4) and they are very popular with the electorate, as the Trump campaign shrewdly recognized in the 2016 Republican primaries (Table II-1). Discretionary spending, especially ex-defense, is a drop in the bucket, thanks largely to a Reagan administration that already cut it to the bone (Chart II-5). Chart II-4The Relentless Rise In Mandatory Spending ... Chart II-5Overwhlems Any Plausible Discretionary Cuts   Table II-1How Trump Broke Republican Orthodoxy On Entitlement Spending The Reagan tax cuts therefore accomplished the easy part of the “starve the beast” strategy but his administration failed to make commensurate cuts in outlays (Chart II-6). If overall spending wasn’t cut amidst oppressive inflation, while the Great Communicator was in the Oval Office to make the case for it to a considerably more fiscally conservative electorate, there is no chance that it will be cut this decade. As our Geopolitical Strategy service has flagged for several years, the median US voter has moved to the left on economic policy. Reagan-era fiscal conservatism has gone the way of iconic eighties features like synthesizers, leg warmers and big hair, even if it had one last gasp in the form of the post-crisis “Tea Party” and Obama’s compromise on budget controls. Chart II-6Grover Norquist Is Going To Need A Bigger Bathtub Do Republicans Still Want The Reagan Mantle? Chart II-7“Limited Government” Falling Out Of Fashion Reaganism is dead, killed by a decided shift in broad American public opinion, and within the Republican and Democratic parties themselves. Americans are just as divided today as they were in Reagan’s era about the size of the government but the trend since the late 1990s is plainly in favor of bigger government (Chart II-7). Recent developments, including the 2020 election, reinforce our conviction that trend will not reverse any time soon. The Republicans are the natural heirs of Reagan’s legacy. Much of President Trump’s appeal to conservatives lay in his successful self-branding as the new Reagan. Though he lacked the Gipper’s charisma and affability, his unapologetic assertion of American exceptionalism rekindled some of the glow of Morning-in-America confidence. Following the outsider trail blazed by Reagan, he lambasted the Washington establishment and promised to slash bureaucracy, deregulate the economy and shake things up. Trump’s signature legislative accomplishment was the largest tax reform since Reagan’s in 1986. He oversaw defense spending increases to take on China, which he all but named the new “evil empire.”10 Like Reagan, he was willing to weather criticism for face-to-face meetings with rival nations’ dictators. Even his trade protectionism had more in common with the Reagan administration than is widely recognized.11 Chart II-8Reagan’s Amnesty On Immigration But major differences in the two presidents’ policy portfolios underline the erosion of the Reagan legacy’s hold. President Trump outflanked his Republican competitors for the 2016 nomination by running against cutting government spending – he was the only candidate who opposed entitlement reform. His signature proposal was to stem immigration by means of a Mexican border wall. While Reagan had sought to crack down on illegal immigration, he pursued a compromise approach and granted amnesty to 2.9 million illegal immigrants living in America to pass the Immigration Reform and Control Act of 1986, sparing businesses from having to scramble to replace them (Chart II-8). While Reagan curtailed non-defense spending, Trump signed budget-busting bills with relish, even before the COVID pandemic necessitated emergency deficit spending. Trump tried to use the power of government to intervene in the economy and alienated the business community, which revered Reagan, with his scattershot trade war. Trump’s greater hawkishness on immigration and trade and his permissiveness on fiscal spending differentiated him from Reagan orthodoxy and signaled a more populist Republican Party. Chart II-9Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy More fundamentally, Trump represents a new strain of Republican that is at odds with the party’s traditional support for big business and disdain for big government. If he leads that strain to take on the party establishment by challenging moderate Republicans in primary elections and insisting on running as the party’s next presidential candidate, the GOP will be swimming upstream in the 2022 and 2024 elections. It is too soon to make predictions about either of these elections other than to say that Trump is capable of splitting the party in a way not seen since Ross Perot in the 1990s or Theodore Roosevelt in the early 1900s (Chart II-9).12 If he does so, the Democrats will remain firmly in charge and lingering Reaganist policies will be actively dismantled. Even if the party manages to preserve its fragile Trumpist/traditionalist coalition, it is hard to imagine it will recover its appetite for shrinking entitlements, siding against labor or following a laissez-faire approach to corporate conduct and combinations. Republicans will pay lip service to fiscal restraint but Trump’s demonstration that austerity does not win votes will lead them to downplay spending cuts and entitlement reform as policy priorities – at least until inflation again becomes a popular grievance (Chart II-10). Republicans will also fail to gain traction with voters if they campaign merely on restoring the Trump tax cuts after Biden’s likely partial repeal of them. Support for the Tax Cut and Jobs Act hardly reached 40% for the general public and 30% for independents and it is well known that the tax reform did little to help Republicans in the 2018 midterm elections, when Democrats took the House (Chart II-11). Chart II-10Republicans Have Many Priorities Above Budget Deficits Chart II-11Trump Tax Cuts Were Never Very Popular On immigration the Republican Party will follow Trump and refuse amnesty. Immigration levels are elevated and Biden’s lax approach to the border, combined with a looming growth disparity with Latin America, will generate new waves of incomers and provoke a Republican backlash. On trade and foreign policy, Republicans will follow a synthesis of Reagan and Trump in pursuing a cold war with China. The Chinese economy is set to surpass the American economy by the year 2028 and is already bigger in purchasing power parity terms (Chart II-12). The Chinese administration is becoming more oppressive at home, more closed to liberal and western ideas, more focused on import substitution, and more technologically ambitious. The Chinese threat will escalate in the coming decade and the Republican Party will present itself as the anti-communist party by proposing a major military-industrial build-up. Yet it is far from assured that the Democrats will be soft on China, which is to say that they will not be able to cut defense spending substantially. Chart II-12China Is the New "Evil Empire" For GOP Will Biden Take Up The Cause? One might ask if the Biden administration might seek to adopt some elements of the Reagan program. President Biden is among the last of the pro-market Democrats who emerged in the wake of the Reagan revolution. Those “third-way” Democrats thrived in the 1990s by accommodating themselves to Reagan’s free-market message while maintaining there was a place for a larger federal role in certain aspects of the economy and society. The 2020 election demonstrated that the Democrats’ political base is larger than the Republicans’ and third-way policies could be a way to make further inroads with affluent suburbanites who helped deliver Georgia and Virginia. Alas, the answer appears to be no. The Democrats’ base increasingly abhors Reagan-era economic and social policies, and the country’s future demographic changes reinforce the party’s current, progressive trajectory. That means fiery younger Democrats don’t have to compromise their principles with third-way policies when they can just wait for Texas to turn blue. Chart II-13Democrats Look To New Deal, Eschew ‘Third Way’ Biden has only been in office for one month but a rule of thumb is that his party will pull him further to the left the longer Republicans remain divided and ineffective. His cabinet appointments have been center-left, not far-left, though his executive orders have catered to the far-left, particularly on immigration. In order to pass his two major legislative proposals through an evenly split Senate he must appeal to Democratic moderates, as every vote in the party will be needed to get the FY2021 and FY2022 budget reconciliation bills across the line, with Vice President Kamala Harris acting as the Senate tie breaker. Nevertheless his agenda still highlights that the twenty-first century Democrats are taking a page out of the FDR playbook and unabashedly promoting big government solutions (Chart II-13). Biden’s $1.9 trillion American Rescue Plan is not only directed at emergency pandemic relief but also aims to shore up state and local finances, education, subsidized housing, and child care. His health care proposals include a government-provided insurance option (originally struck from the Affordable Care Act to secure its passage in 2010) and a role for Medicare in negotiating drug prices. And his infrastructure plan is likely to provide cover for a more ambitious set of green energy projects that will initiate the Democratic Party’s next big policy pursuit after health care: environmentalism. The takeaway is not that Biden’s administration is necessarily radical – he eschews government-administered health care and is only proposing a partial reversal of Trump’s tax cuts – but rather that his party has taken a decisive turn away from the “third-way” pragmatism that defined his generation of Democrats in favor of a return to the “Old-Left” and pro-labor policies of the New Deal era (Chart II-14). The party has veered to the left in reaction to the Iraq War, the financial crisis, and Trumpism. Vice President Harris, Biden’s presumptive heir, had the second-most progressive voting record during her time in the Senate and would undoubtedly install a more progressive cabinet. Table II-2 shows her voting record alongside other senators who ran against Biden in the Democratic primary election. All of them except perhaps Senator Amy Klobuchar stood to his left on the policy spectrum. Chart II-14Democrats Eschew Budget Constraints Fundamentally the American electorate is becoming more open to a larger role for the government in the economy and society. While voters almost always prioritize the economy and jobs, policy preferences have changed. The morass of excessive inflation, deficits, taxation, regulation, strikes and business inefficiencies that gave rise to the Reagan movement is not remembered as ancient history – it is not even remembered. The problems of slow growth, inadequate health and education, racial injustice, creaky public services, and stagnant wages are by far the more prevalent concerns – and they require more, not less, spending and government involvement (Chart II-15). Insofar as voters worry about foreign threats they focus on the China challenge, where Biden will be forced to adopt some of Trump’s approach. Table II-2Harris Stood To The Left Of Democratic Senators Chart II-15Public Concern For Economy Means Greater Government Help When inflation picks up in the coming years, voters will not reflexively ask for government to be pared back so that the economy becomes more efficient, as they did once they had a taste of Reagan’s medicine in the early 1980s. Rather, they will ask the government to step in to provide higher wages, indexation schemes, price caps, and assistance for labor, as is increasingly the case. The ruling party will be offering these options and the opposition Republicans will render themselves obsolete if they focus single-mindedly on austerity measures. Americans will have to experience a recession caused by inflation – i.e. stagflation – before they call for anything resembling Reagan again. The Post-Reagan Market Landscape Many investors and conservative economists were shocked13 that the Bernanke Fed’s mix of zero interest rates and massive securities purchases did not foster runaway inflation and destroy the dollar. They failed to anticipate that widespread private-sector deleveraging would put a lid on money creation (and that other major central banks would follow in the Fed’s ZIRP and QE footsteps). But a longer view of four decades of disinflation suggests another conclusion: Taking away the monetary punch bowl when the labor party gets going and pursuing limited-government fiscal policy can keep inflation pressures from gaining traction. Globalization, technology-enabled elimination of many lower-skilled white-collar functions and the hollowing out of the organized labor movement all helped as well, though they helped foment a revolt among a meaningful segment of the Republican rank-and-file against Reagan-style policies. The Volcker Fed set the tone for pre-emptive monetary tightening and subsequent FOMCs have reliably intervened to cool off the economy when the labor market begins heating up. The Phillips Curve may be out of favor with investors, but wage inflation only gathers steam when the unemployment rate falls below its natural level (Chart II-16), and the Fed did not allow negative unemployment gaps to persist for very long in the Volcker era. Without wage inflation putting more money in the hands of a broad cross-section of households with a fairly high marginal propensity to consume, it’s hard to get inflation in consumer prices. Chart II-16Taking The Punch Bowl Away From The Union Hall The Fed took the cyclical wind from the labor market’s sails but the Reagan administration introduced a stiff secular headwind when it crushed PATCO, the air traffic controllers’ union, in 1981, marking an inflection point in the relationship between management and labor. That watershed event opened the door for employers to deploy much rougher tactics against unions than they had since before the New Deal.14 Reagan’s championing of free markets helped establish globalization as an economic policy that the third-way Clinton administration eagerly embraced with NAFTA and a campaign to admit China to the WTO. The latter coincided with a sharp decline in labor’s share of income (Chart II-17). Chart II-17Outsourcing Has Not Been Good For US Labor The core Reagan tenets – limited government, favoring management over labor, globalization, sleepy anti-trust enforcement, reduced regulation and less progressive tax systems with lower rates – are all at risk of Biden administration rollbacks. While the easy monetary/tight fiscal combination promoted a rise in asset prices rather than consumer prices ever since the end of the global financial crisis, today’s easy monetary/easy fiscal could promote consumer price inflation and asset price deflation. We do not think inflation will be an issue in 2021 but we expect it will in the later years of Biden’s term. Ultimately, we expect massive fiscal accommodation will stoke inflation pressures and those pressures, abetted by a Fed which has pledged not to pre-emptively remove accommodation when the labor market tightens, will eventually bring about the end of the bull market in risk assets and the expansion. Investment Implications Business revered the Reagan administration and investors rightfully associate it with the four-decade bull market that began early in its first term. Biden is no wild-eyed liberal, but rolling back core Reagan-era tenets has the potential to roll back juicy Reagan-era returns. Only equities have the lengthy data series to allow a full comparison of Reagan-era returns with postwar New Deal-era returns (Table II-3), but the path of Treasury bond yields in the three-decade bear market that preceded the current four-decade bull market suggests that bonds generated little, if any, real returns in the pre-Reagan postwar period (Chart II-18). Stagnant precious metal returns point to tame Reagan-era inflation and downward pressure on input costs. Table II-3Annualized Real Market Returns Before And After Reagan Chart II-18Bond Investors Loved Volcker And The Gipper Owning the market is not likely to be as rewarding going forward as it was in the Reagan era. Active management may again have its day in the sun as the end of the Reagan tailwinds open up disparities between sectors, sub-industries and individual companies. Even short-sellers may experience a renaissance. We recommend that multi-asset investors underweight bonds, especially Treasuries. We expect the clamor for bigger government will contribute to a secular bear market that could rival the one that persisted from the fifties to the eighties. Within Treasury portfolios, we would maintain below-benchmark duration and favor TIPS over nominal bonds at least until the Fed signals that its campaign to re-anchor inflation expectations higher has achieved its goal. Gold and/or other precious metals merit a place in portfolios as a hedge against rising inflation and other real assets, from land to buildings to other resources, are worthy of consideration as well. BCA has been cautioning of a downward inflection in long-run financial asset returns for a few years, based on demanding valuations and a steadily shrinking scope for ongoing declines in inflation and interest rates. Mean reversion has been part of the thesis as well; trees simply don’t grow to the sky. Now that the curtain has fallen on the Volcker and Reagan eras, the inevitable downward inflection has received a catalyst. We remain constructive on risk assets over the next twelve months, but we expect that intermediate- and long-term returns will fall well short of their post-1982 pace going forward. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com III. Indicators And Reference Charts BCA’s equity indicators continue to demonstrate that US stocks are running hot. Our technical, valuation, and speculation indicators are very extended, and margin debt has soared since the S&P 500 bottomed last spring. With so little room for error, a near-term pullback in stock prices remains a significant risk. Our monetary indicator extended its downtrend, reflecting a diminished intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings are pricing in a remarkably swift earnings recovery, but after a third consecutive quarter of double-digit earnings beats, the 2021 earnings outlook continues to gather momentum. Net revisions and positive earnings surprises remain near multi-decade highs. Among global equities, the US extended its modest underperformance after a decade of leading the pack. China continues to outperform, though at a slower rate since it became the first country to escape COVID-19’s grip, while emerging markets and Australia have also outperformed. Euro area stocks continue to lag, but we expect they will eventually take their place among the cyclical winners later this year. The US 10-Year Treasury yield surged in February, following through on January’s convincing break above its 200-day moving average. Our technical indicator shows that long-dated bonds are firmly in oversold territory, though they remain extremely expensive. Our valuation index points to higher yields over the cyclical investment horizon even if the rate of ascent eventually slows. The technical and valuation profile is similar for the US dollar. The greenback is technically oversold, even after its modest rally, but it remains expensive according to our models. If our base-case Goldilocks scenario unfolds globally this year, the counter-cyclical dollar should encounter a mild headwind. As with Treasuries, we expect valuation to trump technicals and see the USD continuing to trend lower over the full year. Commodity prices are surging across the board, ex-gold. Sentiment is bullish and speculative positioning in the CFTC’s 17-commodity aggregate grouping is at its post-GFC high, although it may have peaked for the time being. The move in commodities underscores the risk-on profile across financial markets and aligns with EM, Chinese and Australian equity outperformance. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. 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   Doug Peta, CFA Chief US Investment Strategist   Footnotes 1 Every single adult taxpayer with adjusted gross income (AGI) of $75,000 or less (and every married filing jointly taxpayer with AGI of $150,000 or less) was eligible for the full payments, and taxpayers with AGIs below $99,000 and $198,000, respectively, were eligible for partial payments. 2 Giles, Chris. “OECD warns governments to rethink constraints on public spending,” Financial Times, January 4, 2021. OECD warns governments to rethink constraints on public spending | Financial Times (ft.com) Accessed February 20, 2021. 3 International Monetary Fund (IMF). 2020. Fiscal Monitor: Policies for the Recovery. Washington, October. p. ix. 4 An additional 20 million households have received partial payments. 5 August 12, 1986 Press Conference News Conference | The Ronald Reagan Presidential Foundation & Institute (reaganfoundation.org), accessed February 4, 2021. Reagan makes the quip in his prepared opening remarks. 6 Reagan was a Democrat until he entered politics in his fifties. He claimed to have voted for FDR four times. 7 April 3, 1982 Radio Address President Reagan's Radio Address to the Nation on the Program for Economic Recovery - 4/3/82 - YouTube, accessed February 4, 2021. 8 As an actor, Reagan was perhaps best known for his portrayal of Notre Dame football legend George Gipp, who is immortalized in popular culture as the subject of the “win one for the Gipper” halftime speech. 9 July 22, 1981 White House Remarks to Visiting Editors and Broadcasters reaganfoundation.org, accessed February 8, 2021. 10 Reagan famously urged his followers, in reference to the USSR, “I urge you to beware the temptation of pride—the temptation of blithely declaring yourselves above it all and label both sides equally at fault, to ignore the facts of history and the aggressive impulses of an evil empire.” See his “Address to the National Association of Evangelicals,” March 8, 1983, voicesofdemocracy.umd.edu. 11 Robert Lighthizer, the Trump administration trade representative who directed its tariff battles, was a veteran of Reagan’s trade wars against Japan in the 1980s. 12 “Exclusive: The Trump Party? He still holds the loyalty of GOP voters,” USA Today, February 21, 2021, usatoday.com. 13 Open Letter to Ben Bernanke,” November 15, 2010. Open Letter to Ben Bernanke | Hoover Institution Accessed February 23, 2021. 14 Please see the following US Investment Strategy Special Reports, “Labor Strikes Back, Parts 1, 2 and 3,” dated January 13, January 20 and February 3, 2020, available at usis.bcaresearch.com.

Highlights For the month of February, our trading model recommends shorting the US dollar versus the euro and Swiss franc. While we agree a barbell strategy makes sense, we would rather hold the yen and the Scandinavian currencies. In the near term, we recommend trades at the crosses, given the potential for the dollar rally to run further. An opportunity has opened up to short the AUD/MXN cross. We are tightening the stop on our short EUR/GBP position to protect profits. We believe EUR/CHF still has upside. While the US has been labelling Switzerland  a currency manipulator, the real culprit is Europe. Precious metals remain a buy. We are placing a limit sell on the gold/silver ratio at 70, after our initial target of 65 was touched. Platinum should also outperform in 2021. Remain long AUD/NZD, as the key drivers (relative terms of trade and cheap valuation) remain intact. Feature Currency markets are at a crossroads. On the one hand, news on the vaccine front continues to progress, raising the specter that we might return to normalcy sometime in the second half of this year. On the other hand, the current lockdowns are slowing down economic activity across the developed world, which is bullish for the dollar. With the DXY index up 1.4% this year, it appears near-term economic weakness is dominating the currency market narrative. Our long-term trade basket is centered on a dollar-bearish theme, but we have been shifting much focus in the near term to non-US dollar opportunities. Central to this has been our conviction that the dollar is due for a countertrend bounce, in an order of magnitude of 2%-4%.1 It appears we are already halfway there (Chart I-1). For the month of January, our trade recommendations outperformed the model allocation. Notable trades were being short gold versus silver and being short EUR/GBP. Silver in particular was a big winner in January (Chart I-2). Most emerging market currencies saw weakness, especially the Korean won, Russian ruble, and Brazilian real Chart I-1The Dollar Has Been Strong In 2021 Chart I-2Our FX Portfolio Did Well In January For the month of February, our trading model recommends shorting the US dollar, mostly versus the euro and Swiss franc (Chart I-3 and Chart I-4). The model gets its signal from three variables: Relative interest rates (both levels and rates of change), valuation, and sentiment.2 While some of these variables have moved in favor the dollar, the magnitude of these moves has not been sufficient to trigger a model shift. We agree a barbell strategy makes sense. That said, we would rather hold the yen (as the safe haven, compared to the CHF) and the Scandinavian currencies (compared to the EUR). These are our two strategic positions, and we made the case for yen long positions last week. Chart I-3Our FX Model Remains ##br##Short USD... Chart I-4...Especially Versus The Euro And Swiss Franc Circling back to our trades at the crosses, we maintain that they should continue to perform well in February and beyond. We revisit the rationale behind these trades, as well as introduce a new idea: Short the AUD/MXN cross. Go Short AUD/MXN A tactical opportunity has opened up to go short the AUD/MXN cross. Central to this thesis are three catalysts: relative economic activity, valuation, and sentiment. The Australian PMI has rebounded quite strongly relative to that in Mexico, driven by the performance of the Chinese economy, versus that of the US economy. Australia exports mostly to China, while Mexico is heavily tied to the US economy. With the Chinese credit impulse rolling over, the US economy has been outperforming of late. If past is prologue, this will herald a lower AUD/MXN exchange rate (Chart I-5). Correspondingly, oil prices are outperforming metals prices. China is the biggest consumer of metals, while the US is the biggest consumer of oil. A higher oil-to-metal ratio is negative for AUD/MXN. Terms of trade between Australia and Mexico have been an important driver of the exchange rate (Chart I-5). China had a massive restocking of metals last year, much more than oil and natural gas. This implies that the destocking phase (should it occur) will be most acute among metal inventories (Chart I-6), suggesting oil imports into China could fare better than metals. On a real effective exchange rate basis, the Aussie is expensive relative to the Mexican peso. Historically, this has heralded a lower exchange rate (Chart I-7). Chart I-5AUD/MXN And Terms Of Trade   Chart I-6Chinese Destocking: From Crude Oil To Metals? Chart I-7AUD/MXN Is ##br##Expensive Back in 2020, when everyone was short the Aussie and long the MXN, being a contrarian paid off handsomely. Now, speculators are roughly neutral both crosses. Should the trends we are highlighting carry on into the next few months, this will be a powerful catalyst for speculators to jump on the bandwagon. We recommend opening a short AUD/MXN trade today, with a stop loss at 16.50 and an initial target of 13. Stay Short EUR/GBP Chart I-8An Asymmetry In Pricing Our short EUR/GBP position is performing well, amidst a more hawkish Bank of England this week. Technically, there remains room for much downside on the cross. Real interest rates in the UK are rising relative to those in the euro area. The Brexit discount has not been fully priced out of the EUR/GBP cross, whereas broad US dollar weakness has eroded the discount in cable (Chart I-8). From a technical perspective, speculators are still very long the EUR/GBP, even though our intermediate-term indicator is nearing bombed-out levels (Chart I-9). Chart I-9EUR/GBP Still Has Downside Finally, short EUR/GBP tends to benefit from an outperformance of oil prices. We will be revisiting the fair value of the pound in upcoming reports given the fundamental shifts that are happening in the post-EU relationship. For now, we are tightening stops on our short EUR/GBP position to 0.89, in order to protect profits. Remain Long NOK And SEK Chart I-10NOK Follows Oil Prices The Scandinavian currencies are  extremely cheap and an attractive bet for 2021. As such, we believe the recent relapse in their performance provides an opportunity for fresh long positions. For the NOK, a rising oil price is bullish, both against the EUR and USD (Chart I-10). Meanwhile, superior handling of the pandemic has buoyed domestic economic data in Norway. Both retail sales and domestic inflation have been perking up, pushing the Norges Bank to dial forward expectations of a rate lift-off. Sweden is also holding up relatively well this year. Part of the reason for this is that over the years, the drop in the Swedish krona, both against the US dollar and euro, has made Sweden very competitive. With our models showing the Swedish krona as undervalued by 13% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. The bottom line is that both Norway and Sweden are well positioned  to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to remain the best performers versus the USD in the coming year.  Stay Long EUR/CHF While the US has been labelling Switzerland  a currency manipulator, the real culprit is the euro area. To be clear, the SNB has been actively intervening in the currency markets. However, when one looks at relative monetary policy, the expansion in the ECB’s balance sheet far outpaces that of the SNB (Chart I-11). With the correlation between balance sheet policy and the exchange rate shifting, it may embolden Switzerland to intervene even more strongly in currency markets. Historically, the Swiss franc was buffeted by the global environment (improving global trade) and rising productivity in Switzerland. As a result, the SNB had no alternative but to try to recycle those excess savings abroad by lifting its FX reserves, or see even stronger appreciation of its currency. With global trade much more muted, intervention in the FX market could be a more potent headwind for the franc. Chart I-11The SNB Is More Hawkish Than The ECB Chart I-12EUR/CHF And The Global Cycle In the near-term, the risk to this trade is that safe-haven flows  reaccelerate, as investors re-price risk. However, this will be a short-term hiccup. EUR/CHF is a procyclical cross and will benefit from improvement in the Eurozone economy relative to the rest of the world (Chart I-12). Meanwhile, by many measures, the Swiss franc remains expensive versus the euro. Stay Long AUD/NZD Chart I-13RBA QE Will Hurt AUD/NZD The rally in the kiwi has provided an exploitable opportunity to lean against it. We remain long the AUD/NZD cross, despite the RBA stepping up the pace of QE at its latest meeting. The rationale is as follows: The balance sheet of the RBA was already lagging that of the RBNZ, so the latest move is simply  catch up (Chart I-13). It has no doubt been negative for the cross, as Australia-New Zealand rates have compressed. However, when the program expires, the AUD will be subject to external forces once again.  The Australian bourse is heavy in cyclical stocks, notably banks and commodity plays, while the New Zealand stock market is the most defensive in the G10. Should value outperform growth, this will favor the AUD/NZD cross. The kiwi has benefited from rising terms of trade, as agricultural prices have catapulted higher. Should a correction ensue, as we expect, this will favor NZD short positions. Our conviction on long AUD/NZD has clearly been hit with the RBA’s latest move. As such, we are tightening stops to 1.05 for risk management purposes. Stay Long Precious Metals, Especially Silver And Platinum We are placing a limit sell on the gold/silver ratio at 70, after our initial 65 target was hit. The rationale for the trade remains intact: In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. However, silver has underperformed the rise in gold. The long-term mean for the gold/silver ratio is 50, providing ample alpha for this trade (Chart I-14). Chart I-14The Case For Short Gold Versus Silver Silver is heavily used in the electronics and renewable energy industries, which are capturing the new manufacturing landscape. Silver faced resistance near $30/oz. However, this will be a temporary hiccup. The next important level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange Strategy report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

Special Report

Your feedback is important to us. Please take our client survey today. Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).6 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com