Currencies

Highlights Inflation Breakeven Trades: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, as breakevens in both countries are no longer below the fair values implied by our models. We are initiating a new trade this week, going long French 10-year inflation-linked bonds versus French nominal OATs, as French breakevens remain below fair value. Yield Curve Butterfly Trades: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Cross-Country Spread Trades: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months. Feature Dear Client, Next week, we will be jointly publishing our semi-annual Central Bank Monitor Chartbook along with our colleagues at BCA Research Foreign Exchange Strategy. You will receive that report a few days later than usual on Friday, December 11. We will return to our regular publishing schedule on Tuesday, December 15 with our 2021 Key Views report outlining our main investment themes and ideas for the upcoming year. Best Regards, Rob Robis As we enter the final weeks of an incredibly eventful and (unfortunately) all too memorable 2020, our attention now turns to investment ideas for the coming New Year. This week, all BCA Research clients will receive the 2021 Outlook report, detailing the key themes and recommendations from all our strategists. We will follow that up with our own 2021 Global Fixed Income Strategy outlook report later this month. The waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio. In addition, the waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio (Table 1). Several of our suggested trades have generated a solid profit (like inflation breakeven wideners) but have now outlived their original rationale. Others, like some of our yield curve trades in Europe, have not gone as we expected and should therefore be closed out. Table 1Changes To Our Tactical Overlay Portfolio A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades As a reminder to our regular readers, our Tactical Overlay is a portfolio of individual trade ideas within the global fixed income space with an investment horizon of six months or less. These differ from our more typical strategic (6-12 month) recommendations that also populate our model bond portfolio. Ideas for our Tactical Overlay trades often stem from our fair value models, but can also be plays on events that we expect will be market relevant on a near-term basis, like central bank meetings. All recommended trades are implemented using specific securities, rather than generic Bloomberg tickers or bond indices. This allows for a more transparent process where clients can follow along with the performance of our trades. Evaluating Our Tactical Inflation-Linked Breakeven Trades We currently have two open tactical trade recommendations involving inflation-linked bonds: Long 10-year Italian inflation-linked bonds vs short 10-year Italian bond futures Long 10-year Canadian inflation-linked bonds vs short 10-year Canadian bond futures We initiated both of these trades back in June of this year, as well as an additional trade involving US TIPS, based on the output of our inflation breakeven fair value framework. In our models, we regress 10-year inflation breakevens on the annual rate of change of oil prices in local currency terms and a multi-year moving average of realized headline inflation.1 At the time of our mid-year report, inflation breakevens were too low on our models in the majority of developed market countries with inflation-linked bonds – a lingering after-effect of the COVID-19 shock to global growth in the second quarter of 2020 (Chart 1). Since then, 10-year inflation breakevens have caught up to fair value in the US, Germany, Italy and Canada, and have even moved above fair value in the UK and Australia. Chart 1A Big Shift In Inflation Breakeven Valuations A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades In June, we also entered into a US 10-year TIPS breakeven widening trade, but we took profits on the trade once US breakevens returned back to our model fair value estimate in September. We now see a similar situation in Canada (Chart 2) and Italy (Chart 3) where breakevens have converged to our model-implied fair value. Chart 2Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model A move above fair value is possible, but could be harder to achieve with the Canadian dollar and euro steadily trending higher which could weigh on the market’s view on future inflation in Canada and Italy. We are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively.  Thus, we are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. The Italian returns were boosted considerably by the long side of this trade, as we entered the position when the 10-year real yield was +1.05% and which has since collapsed to -0.05% on the back of the massive rally in Italian bonds. One place where breakevens still look attractively cheap, trading close to one standard deviation below our model fair value, is in France (Chart 4). This contrasts with the breakevens in Italy and Germany that have fully converged to fair value. Thus, we are entering a new trade this week, going long the on-the-run 10yr French inflation-linked bond (OATi) and shorting French bond futures (Euro-OATs). The hedge ratio used for this trade to keep both legs duration matched, given the much shorter duration of the OATi relative to nominal French bonds, is 0.49 (see the Tactical Overlay table on page 17 for specific details on the securities used in the trade). Chart 3Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Chart 4French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model Bottom Line: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, while initiating a new breakeven widening position in France, based on the output of our breakeven fair value models. Evaluating Our Yield Curve/Butterfly Spread Trades Back in July, we initiated a series of yield curve butterfly spread trades in the US, UK, Italy and France.2 Butterfly spreads compare the yield of a single bond (bullets) to that of a duration-neutral combination of bonds with shorter and longer maturities relative to the bullet (barbells). Our valuation models produce fair value estimates of various butterfly combinations based on the relation of the butterfly spreads to the slope of the yield curve. We then combine those valuations with our own macro views on the future slope of yield curves to come up with potential value-based curve trades.3 We now evaluate our four existing curve trades in turn. Long UK 3/20 Barbell vs. 10-Year Bullet Our original rationale for entering this trade was two-fold. Firstly, this position was the most attractive butterfly combination in terms of the standardized deviation of the spread from its model-implied fair value. Secondly, there was a relatively low correlation between nominal UK bond yields and inflation breakevens--meaning that we could see a rise in long-dated inflation expectations that did not also push up nominal bond yields by a proportional amount. This made the trade consistent with our overall macro view back in July that the Gilt curve would flatten (the same rationale applies to the other two long barbell versus short bullet trades, or “flatteners”, in France and Italy that we discuss below). Unfortunately, our rationale did not play out as expected (Chart 5). Instead of reverting to fair value, the butterfly spread was mostly flat while the bullet grew more expensive relative to the barbell, driven by a rise in the model fair value. This in turn was due to significant steepening in the underlying 3/20 curve, contrary to our expectations. We also saw a significant overall upward shift in the overall UK Gilt curve, which generated losses on our long barbell position (which has a higher interest rate convexity) that overwhelmed the profits on our short bullet position. Going forward, there are good technical and strategic reasons to exit this trade. The butterfly spread is not yet at levels where it tends to mean-revert (second panel). In addition, Joe Biden’s US election victory has also increased the odds of a Brexit deal, which would put bear-steepening pressure on the UK Gilt curve. With that in mind, we are closing our Long UK 3/20 Barbell vs. 10-Year Bullet for a loss of -0.17%. Long France 2/30 Barbell vs. 5-Year Bullet Our rationale for entering this flattener was the same as in the UK. However, we fared quite a bit better here. The underlying 2/30 curve did flatten, as we expected, however, the butterfly spread itself moved further away from fair value, with the bullet component becoming relatively more expensive (Chart 6). So, as with the UK, the returns on this trade can be largely explained by the relative outperformance of the barbell component due to its higher convexity. In France, however, the effect worked to our favor as the yield curve shifted downwards significantly. The positive returns on the long French 30-year OAT component, where yields have been nearly slashed in half since July, dominated the other parts of the trade - even with the 30-year bond only being a small piece (11%) of the duration-weighted barbell Chart 5UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model Chart 6France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model Although we did make profits on the flattener, it turned into a convexity bet that was not our original intention. Seeing as our underlying logic did not work out as expected, we are not comfortable remaining in this position. Thus, we are closing our France butterfly trade for a profit of 0.56%. Long Italy 5/30 Barbell vs. 10-Year Bullet As with the UK and France, we entered this trade based on its attractive model-based valuation and the relatively low correlation between inflation breakevens and nominal yields in France. Our expectation of flattening in the underlying 5/30 curve did not bear out as it remained mostly flat (Chart 7). We did see some reversion in the butterfly spread towards our model-implied fair value, which helped us make profits on our trade. Again, we cannot ignore the effect of convexity when looking at the outperformance of the barbell component. Yields fell dramatically across the Italian curve in one of the clearest examples of the yield-chasing behavior we have been describing this year.4 As Italian yields continue their race to the bottom, supported by ECB asset purchases and perceptions of more fiscal co-operation between the countries of Europe, there is a chance that this trade will continue to perform by virtue of its exposure to the long end of the Italian curve. However, as our original bias towards curve flattening did not play out, we prefer to maintain our exposure to Italian government debt via an overweight allocation in our model bond portfolio instead. We therefore close our Long Italy 5/30 Barbell vs. 10-Year Bullet for a profit of 0.83% Long US 7-Year Bullet vs. 5/10 Barbell The US was the only region where we initiated a “steepener” trade, with a long bullet versus short barbell combination that does well when the yield curve steepens. We chose this particular 5/7/10 butterfly as it was the most attractive steepener available based on our model-implied valuation that also fit our fundamental macro bias back in July towards US Treasury curve steepening – a view that we still hold today. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Our rationale for initiating the trade was borne out, with the underlying 5/10 Treasury curve steepening and the butterfly spread tightening towards fair value (Chart 8). Our trade was supported by a continued rebound in long-dated US inflation expectations as well as the US election result, the most bond-bearish event of the year. Chart 7Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Chart 8US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model Going forward, we see good reasons to maintain this trade. The butterfly spread, after briefly reaching expensive levels, is back to being attractively valued. Even if the residual were to dip back below zero, it would still have room to become more expensive, shoring up our trade. This trade also remains the most attractive of all the steepener trades on a model-implied valuation basis, removing any incentive to rotate towards another part of the curve. The odds favor more reflationary Treasury curve steepening after the US election. President-elect Biden has a stated goal of more fiscal stimulus, while his selection of Janet Yellen as Treasury Secretary signaling increased cooperation between monetary and fiscal authorities. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Bottom Line: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Evaluating Our Cross-Country Yield Spread Trades We currently have two recommended trades involving plays on the spread between government bonds: Long 5-year New Zealand government bonds versus short 5-year UK Gilts, currency-hedged into GBP We initiated this trade on August 25, and to date the trade is severely underwater with a total return of -1.8%.5 That loss comes from the long New Zealand leg of the trade, as the 5-year NZ bond yield has increased by 34bps from our entry level. Chart 9A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations The rationale for this trade was based on our assessment of the relative probability of the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) moving to a negative interest rate policy. Both central banks hinted strongly at such a move throughout the summer months as part of their efforts to support pandemic-stricken economies. Our view back in late August was that it was more likely that the RBNZ would choose negative rates, as New Zealand had far lower inflation expectations than the UK and, unlike the British pound, the New Zealand dollar was not undervalued. This trade was initially profitable, but all that changed rapidly during the month of November. The RBNZ disappointed investor expectations on a move to negative rates at the November 11 monetary policy meeting. The central bank elected instead to increase the size of its existing quantitative easing program, while giving no hint that negative rates were coming soon. The response was a sharp move higher in both New Zealand bond yields and the New Zealand dollar (Chart 9). There was an even more violent adjustment in yields and the currency last week, after New Zealand Finance Minister Grant Robertson wrote a letter to RBNZ Governor Adrian Orr asking the central bank to change its policy remit to include controlling New Zealand house price inflation. Markets interpreted this blatant political pressure on the central bank as the end of any hopes of negative rates in New Zealand, with bond yields and the currency spiking higher once again. House prices have surged after the RBNZ aggressively cut interest rates earlier this year, with a rapidly rising share of new mortgages having higher loan-to-value ratios (Chart 10). House price inflation is now running at 19.8%, and Finance Minister Robertson did cite deteriorating housing affordability and inequality as the basis for his letter to the RBNZ. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. This shatters the underlying rationale for our long New Zealand/short UK yield spread trade (Chart 11). Chart 10RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices Thus, we are choosing to cut our losses and close out our recommended trade. Long 10-year German Bunds versus short 10-year US Treasuries Chart 11Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade We initiated this recommendation on October 27, and to date the trade is running a small loss of -0.17%.6 The rationale behind the trade was two-fold: Our valuation model for the 10-year UST-Bund yield spread showed that the spread was far below fair value; We turned more bearish on US Treasuries just before the US presidential election, downgrading our recommended allocation to underweight while also upgrading more defensive Germany – with its low yield-beta to US Treasuries - to overweight. The trade initially performed well, driven by faster growth and inflation in the US versus the euro area (Chart 12). The Treasury selloff has stalled of late, but we view this as more a consolidative pause than a near-term peak in yields. Chart 12Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread With our Treasury-Bund valuation model still showing that the spread is too tight, and with the spread not looking overly stretched versus its 200-day moving average (Chart 13), we are keeping our US versus Germany trade in our Tactical Overlay portfolio. Chart 13Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Bottom Line: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, " How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Yield Curve Trades: Netting Returns With Butterflies", dated July 7, 2020, available at gfis.bcaresearch.com. 3 Readers looking for more detailed background on butterfly trades and our yield curve modelling framework should refer to the July 7, 2020 Strategy Report where we initiated these trades. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rates Club", dated August 26, 2020, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Global Bond Implications Of Rising Treasury Yields", dated October 27, 2020 available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation, which we held remotely due to the COVID-19 pandemic. Mr. X: As always, I welcome the opportunity to discuss the economic and financial outlook with you. The past year has been truly ghastly with the wretched COVID-19 disease wreaking extraordinary economic and social havoc. I take comfort from the hope that a vaccine will allow a gradual return to more normal conditions in 2021, but my concerns about the longer-run outlook have increased. The extreme monetary and fiscal responses to the virus-related economic collapse may have been necessary but will leave most developed economies much more vulnerable down the road. Risk assets have been propped up by easy money, but I fear that simply means lower returns in the future. Ms. X: The social impact of the virus has weighed heavily on me, making me quite depressed about the outlook. I can only hope that my normal optimism will return when a vaccine ends the pandemic. Of course, I am happy that equities have done much better than might have been expected in the past year, but I share my father’s concerns about long-term returns. I look forward to discussing ideas about how to position our portfolio. BCA: The past year has indeed been grim on many levels. The economic disruption has been severe, but the social toll of the virus has been even more damaging for many people in terms of being forcibly isolated from family and friends. It is very encouraging that vaccines should start to become widely available early in the year, but the return to normality likely will take time. During the northern hemisphere winter months, the pandemic may even get worse before it gets better. As far as the longer run outlook is concerned, the policy response to the crisis will indeed have consequences. Government debt has soared in most countries and this raises the issue of how this will be dealt with in the years ahead. Meanwhile, central bank support to the markets cannot continue indefinitely, which raises the prospect of severe withdrawal pains at some point. Furthermore, both fiscal and monetary trends pose the question of whether higher inflation is inevitable. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures. Markets are forward looking and one could take the view that the strength of equity markets in the past eight months has reflected optimism about the economic outlook. However, a more plausible explanation is that hyper-stimulative monetary policies have been the main driving force behind asset prices. If that is the case, then there is some cause for optimism because central banks have made it clear that they will not be tightening policy for quite some time. While you are both right to be concerned about low returns over the long run, risk asset prices seem likely to rise further in the coming year with equities continuing to outperform bonds. We can get into that in more details later.  Ms. X: Before we get into our discussion of the outlook, let’s briefly review your predictions from last year. BCA: That will be a humbling experience given that we never built a global pandemic into our forecasts! A year ago, our key conclusions were that: Global equities would enter the end game of their nearly 11-year bull market. Stocks were expensive, but bonds were even more so. As a result, if global growth could recover and the US could avoid a recession in 2020, earnings would not weaken significantly and stocks would again outperform bonds. Low rates reflected the end of the debt super cycle in the advanced economies. However, the debt super cycle was still alive in EM, particularly in China. The global economic slowdown that began more than 18 months prior to our meeting started when China tried to limit debt growth. If Beijing continued to push for more deleveraging, global growth would continue to suffer as the EM debt super cycle would end. Nonetheless, we expected China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should have promoted a worldwide reacceleration in economic activity. Policy uncertainty would recede in 2020. Domestic constraints would force China and the US toward a trade détente. The risk of a no-deal Brexit was seen as marginal, and President Trump was still the favorite in the election. A decline in policy risk would foster a global economic rebound. That being said, some pockets of geopolitical risk remained, such as in the Middle East. Global central banks were highly unlikely to remove the punch bowl. Not only would it take some time before global deflationary forces receded, monetary authorities in the G-10 would want to avoid the Japanification of their economies. As a result, they were already announcing that they would allow inflation to overshoot their 2% target for a period of time. This would ultimately raise the need for higher rates in 2021, which would push the global economy into recession in late 2021 or early 2022. These dynamics were key to our categorization of 2020 as the end game. US growth would reaccelerate. The US consumer was in good shape thanks to healthy balance sheets as well as robust employment and wage growth prospects. Meanwhile, corporate profits and capex should have benefited from a decline in global uncertainty and a pickup in global economic activity. China would continue to stimulate its economy but would not do so as aggressively as it did over the past 10 years. Consequently, EM growth would also bottom but was unlikely to boom. Europe and Japan would reaccelerate in 2020. Bond yields would continue to grind higher in 2020. However, Treasury yields were unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures would not resurface quickly, so the Fed was unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds were particularly unattractive. Corporate bonds were a mixed offering. Investment grade credit was unattractive owing to low option-adjusted spreads and high duration, especially as corporate health was deteriorating. Agency mortgage-backed securities and high-yield bonds offered better risk-adjusted value. Global stocks would enjoy their last-gasp rally in 2020. As global growth would recover, we favored the more cyclical sectors and regions which also happened to offer the best value. US stocks were the least attractive bourse; they were very expensive and loaded with defensive and tech-related exposure, two groups that would suffer from higher bond yields. We were neutral on EM equities. We recommended that investors pare exposure to equities only after inflation breakevens had moved back into their 2.3% to 2.5% normal range and the Fed fund rates had moved closer to neutral. We anticipated this to be a risk in 2021. The dollar was likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations were also becoming headwinds. The pro-cyclical European currencies and the euro were expected to be the main beneficiaries of any dollar depreciation. We anticipated oil and gold to have upside. Crude would benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold would strengthen as global central banks would limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar would boost both commodities. We expected a balanced portfolio to generate an average return of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2018. Obviously, our forecasts were undone by the defining event of the year: the pandemic. Nonetheless, in February we warned that asset prices did not embed enough of a risk premium to protect investors against the threat that the pandemic could terminate the global business cycle. The more deflationary risk we confront today, the more inflation we will face in the future. At the beginning of the second quarter, we were quick to recommend buying stocks back, so we participated in the rally that followed. We erred in preferring foreign to US equities, which turned out to be key winners of the pandemic thanks to their heavy exposure to growth stocks (Table 1). The economic downturn meant that bond yields fell rather than rose. They have remained exceedingly low in response to exceptionally accommodative monetary conditions, a surge in savings and deeply negative output gaps. We were right to favor peripheral bonds, which benefited from the ECB’s purchases and the European Commission’s Recovery Fund (Table 1). Finally, the market rewarded our negative stance on the dollar and our bullish view on gold. However, we were offside on oil, where the continued impact of the pandemic on global transport has left crude prices at very depressed levels. Table 12020 Asset Market Returns OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World A Brave New World Mr. X: You mentioned that you prefer stocks over bonds for 2021. I can accept this view; while stocks are expensive, their valuations are less demanding than that of bonds. Moreover, I agree that policymakers around the world are very afraid of the deflationary consequences of removing accommodation too early but they cannot ease monetary policy much from here. This creates an asymmetric payoff in favor of stocks versus safe-haven securities. However, my favorite asset class for the near future is cash. Granted, I enjoy the luxury of not having to track a benchmark and my core focus is capital preservation. With both stocks and bonds richly valued, I see no margin of safety and I would rather stand on the sidelines. The longer-term outlook is particularly concerning. The extraordinary accommodation implemented this year was unavoidable, but its future consequences worry me greatly. Real rates have never been so low and we are leaving unprecedented public debt loads to our children and grandchildren. Moreover, I fear further adoption of populist policies because inequalities have risen in the wake of the crisis. The worst affected families stand at the bottom of the income distribution while people like me have benefited from inflated asset prices. Therefore, I am inclined to believe that we will suffer a large inflation shock in the coming decade. The global broad money supply has exploded and it is very unlikely that central banks will normalize interest rates in due time because of the burden created by gigantic public debt loads and the spectrum of further populism. My worries extend beyond these obvious concerns. Last year I was already anxious about the incredibly large stock of global debt with negative yields. This situation has only worsened since. Moreover, the various programs implemented by the Federal Reserve, the European Central Bank and other major monetary authorities to provide liquidity directly to the private sector at the apex of the crisis have prevented the purge of unhealthy firms necessary under a capitalist system. Instead of creative destruction, zombification has become the norm. Thus, I fear that more capital is misallocated than at any point in the past 10 years. Putting it all together, my expectations are that real returns will be poor for years to come, if not outright negative. I therefore believe that gold should stand at the core of my family’s portfolio. Ms. X: I share many of my father’s concerns. It is difficult to see how monetary and fiscal authorities will normalize policy. Hence, I agree that we will face the painful legacy of a large debt overhang and poor long-term returns. Moreover, the poor demographic profile in most advanced economies as well as China bodes ill for trend growth. I do see opportunities within this bleak picture. Healthcare stocks should benefit from an aging of the world’s population and tech equities will remain a source of disruption, innovation and profit growth in the coming decades. Thus, an equity portfolio built around these themes should generate positive real returns. In light of the positive vaccine news, next year will offer investors with both rapidly expanding profits and low discount rates and it is hard to imagine equities performing poorly. BCA: Clearly, we have many things to discuss. We should start with the COVID-19 pandemic. The news that vaccines developed by Pfizer/BioNTech and Moderna are around 95% effective is very encouraging. The Oxford/AstraZeneca announcement also is a source of optimism, even if the trial results have been less clear-cut. Moreover, other vaccines are currently in the mass-testing stage. By next winter, approximately 1.5 billion people globally should have been vaccinated. These positives hide many issues. First, transporting the Pfizer and Moderna vaccines (particularly the one produced by Pfizer, which needs to be kept at -70°C) will be challenging, especially for poorer countries. Second, the mRNA technology used in these vaccines is new and its long-term impact is unknown. Hence, many people will be reluctant to take this shot, especially as the confidence in the safety of vaccines has declined among the general public. Only 58% of Americans said they would probably take a COVID-19 vaccine, a number that will rise once the vaccine is demonstrated but which still highlights the challenge (Chart 1). Third, the virus could mutate and render the current generation of vaccines ineffective. The recent news of such mutations in mink farms in Denmark is worrisome, especially as the new strain of the virus has already jumped back into the human population. Chart 1The Vaccine Blues OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Our base case is that the vaccines will allow a progressive reopening of the economic sectors currently still under lockdown. They will lead to a further improvement in employment, consumer and business sentiment, and aggregate demand. With less fear of getting infected, consumers will return to shops, restaurants, hotels, etc. This will have a very beneficial impact on capex and profit growth. It will result in higher stock prices, especially for value stocks, cyclical stocks, as well as higher yields and commodity prices. Despite this optimistic base case, investors must have contingencies ready. The three aforementioned risks around the vaccines suggest that additional waves of infections cannot be entirely ruled out and that lockdowns may continue in 2021. Thus, we could still face periods of downward pressure on activity, yields, and value stocks. For now it remains prudent not to tilt portfolios fully toward a post-COVID bias. In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. Even if the vaccines enjoy widespread adoption, near-term threats to economic activity remain. The realization that the end of the pandemic is close may prompt a temporary period where households hunker down and behave in a very conservative fashion. After all, few consumers will want to contract the virus just before a vaccine becomes available. Moreover, the sight of the end of the lockdowns reduces the fiscal authorities’ urgency to provide additional support to the population and small businesses. These two dynamics could prompt a deep contraction in spending in the first quarter of 2021, which would hurt stock prices. Mr. X: Thank you. While these near-term dynamics are crucial, the emergence of the vaccine increases the importance of discussing the long-term implications of the extreme policy conducted in recent months. BCA: The long-term implications of aggressive policy stimulus tie into the evolution of the debt super cycle. As a share of US GDP, total private debt has spiked near a record high and total nonfinancial debt has surged to new all-time highs (Chart 2). This reflects two phenomena. First, the denominator of the ratio – GDP – has collapsed. Second, total nonfinancial debt also highlights the rapid increase in government deficits. Hence, climbing leverage was a consequence of the necessary dissaving by the public sector to alleviate the deflationary forces created by the crisis. This problem is repeated around the world. As Chart 3 demonstrates, nonfinancial debt levels across the G10 are rapidly rising. Moreover, debt loads in emerging markets are also extremely elevated. Chart 2COVID-19 Boosted Debt Ratios COVID-19 Boosted Debt Ratios COVID-19 Boosted Debt Ratios Chart 3Elevated Debt Everywhere Elevated Debt Everywhere Elevated Debt Everywhere   Going forward, either rising savings or faster nominal GDP growth will cause the debt ratios to decline. The first option is difficult; increasing savings is deflationary and it could worsen the debt arithmetic by keeping real interest rates stubbornly high. Moreover, it is politically unpopular, especially when the public sector has been the borrower. Here, we echo the words of Keynes from his 1923 Tract On Monetary Reform: "The progressive deterioration in the value of money through history is not an accident, and has had behind it two great driving forces – the impecuniosity of governments and the superior political influence of the debtor class (…). No state or government is likely to decree its own bankruptcy or its own downfall so long as the instrument of taxation by currency depreciation through the creation of legal tender (money) still lies at hand… The active and working elements (i.e., debtors) in no community, ancient or modern will consent to hand over to the rentier or bond holding class more than a certain proportion of the fruits of their work. When the piled up debt demands more than a tolerable proportion, relief has usually been sought in (…) repudiation (…) and currency depreciation." Nominal rates cannot fall further, while large inequalities and social immobility are fomenting populism (Chart 4). Moreover, the recent COVID-19 crisis has deepened the angst of the general population and its dissatisfaction with policymakers. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures that result from the high savings necessary to reduce public sector debt loads. Even a Republican-controlled US Senate will have to allow larger deficits than usual in today’s climate. Chart 4Inequalities And Immobility Are The Roots Of Populism OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Instead, we expect fiscal and monetary policy to work in tandem to lift inflation and deflate the global debt load. The rising popularity of Modern Monetary Theory fits within this paradigm shift. MMT posits that as long as governments issue debt in their own currency, central bank money printing can finance the deficit. The only constraint on policymakers becomes the level of inflation that society tolerates. Society is likely to tolerate a rise in inflation. MMT is unpalatable to savers, but the majority of citizens are debtors, not lenders. In an MMT framework where the median voter is a borrower, the tolerance for inflation will likely be high, which will hurt the value of financial assets. Moreover, the corporate sector is unlikely to fight strongly against large deficits funded by central banks. If we accept the Kalecki Equation of Profits, which can be simplified as: Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends then business profits will suffer if deleveraging takes hold, whether in the public or private sector. Instead, MMT-like policies, which will keep savings at low levels and prevent deleveraging, offers a way to keep nominal profits afloat. For businesses too, the path of least resistance steers toward higher inflation. Different countries will vary in their ability to pass MMT-like policies, but the policy shift toward inflationary policies is clear. The specter of rising populism should result in heavier regulation, at least in the EU and the US under the incoming Biden administration. Regulation further hurts the growth rate of the supply-side of the economy. It limits competition, it protects workers and it increases the cost of doing business. We expect additional fiscal stimulus will come through in the coming months. Beyond political forces, the demographic deterioration highlighted by Ms. X points in the same direction. An aging population means that the dependency ratio (the number of dependents per worker) is increasing. Moreover, analysis by the UN underscores that in old age, consumption increases due to rising spending on healthcare (Chart 5). We are therefore likely to witness a slowing expansion of the supply side relative to the demand side of the economy. By definition, this process is inflationary. In the second half of the decade, inflation could average as high as between 3% and 5%. Keep in mind that inflation is not a linear process. Once it starts to rise, it becomes very hard to control. In this regard, the experience of the late 1960s is extremely instructive. Through the 1960s boom, inflation was well behaved, contained between 0.7% and 1.2%. Then it started to rise in 1966, and quickly hit 6.1% by 1970 (Chart 6). While the average-inflation target the Fed recently adopted is well intentioned, in an environment where governments are unlikely to curtail deficits as fast as the private sector cuts its savings, it could easily unleash a long-term inflationary trend. Chart 5Aging Doesn't Spell Less Spending Aging Doesn't Spell Less Spensing Aging Doesn't Spell Less Spensing Chart 6Inflation Is Stable Until It Is Not Inflation Is Stable Until It Is Not Inflation Is Stable Until It Is Not   Ms. X: Why won’t technological advancements such as AI and automation cause low inflation to prevail for the rest of the decade? Chart 7Low Productivity Low Productivity Low Productivity BCA: The great paradox of this crisis is that the more deflationary risk we confront today, the more inflation we will face in the future. This relationship is the consequence of financial repression. Debt arithmetic will only stay manageable as long as real interest rates remain low; consequently, central banks will only be able to increase interest rates if nominal growth rises significantly from its low average of the past decade. Both workforce and productivity growth are low, thus quicker inflation is the only solution. As you hinted, technology is a risk to our long-term inflation view. However, technology has most often been a deflationary force. The key question is whether we are experiencing a greater impact than normal on productivity from current technological developments. So far, the answer seems to be no. Even if the statistical estimation methods for GDP overestimate inflation and thus underestimate productivity, we are still nowhere near the kind of productivity gains registered in the post-WWII period or at the turn of the millennium. We remain much closer to the productivity recorded in the 1970s or early 1980s (Chart 7).  As a result, we expect technology not to be enough of a game changer to undo the inflationary effect of the shift away from the pro-capital, deregulatory, pro-global-trade consensus that prevailed for the past forty years. Ms. X: Your view rests on an assessment that political forces are structurally moving toward populism. Doesn’t the most recent US election counter this argument? Was it not a victory of centrism over populism? Chart 8AValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8BValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8CValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8DValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns BCA: It was a victory of moderation over populism, but it was a narrow victory that reveals powerful populist undercurrents, particularly the strong demand for economic reflation. Despite a pandemic and recession in the election year, President Trump narrowly lost in the key swing states, and managed to garner roughly 74 million votes, the second highest tally in history. Moreover he led the Republican Party to gain seats in the House of Representatives and (likely) to retain control of the Senate. Exit polls reveal that the economy was still the number one issue on voters’ minds – they rejected Donald Trump’s personality but embraced his “growth at any cost” approach. By the same token, the Democratic Party lost elections down the ballot because they became associated with lockdowns and revolutionary social causes. President-Elect Joe Biden won the election, first, by not being Donald Trump, and second, by campaigning on a larger government spending program, a moderately liberal social stance, and a less belligerent protectionism on trade and China. The fact that both candidates wanted large stimulus packages and infrastructure programs tells us something about the median voter’s stance on economic policy: it is reflationary. Going forward, if Republicans control the Senate then the Biden administration will have to appeal to moderate Republican senators to get enough votes for COVID relief and economic recovery. If Democrats gain control of the Senate on January 5, they will have a one-vote majority and their legislative agenda will depend on winning over moderate Democratic senators. The Republican scenario is less reflationary but more likely, while the Democratic scenario is more reflationary but less likely. What investors can count on in 2021 is that the US government will not enact the mammoth splurge of government spending but that Republican senators will also be cognizant of the need for some fiscal support. Mr. X: If you expect inflation to rise structurally, how should we position our portfolio on a long-term basis? Bonds will obviously suffer, but so will an extremely expensive equity market that requires low bond yields to justify current prices. It seems like there is nowhere to hide but gold. BCA: The next one to two decades will not look like the past four, which were extraordinarily rewarding for investors. The taming of inflation, the broadening of globalization and far-reaching deregulation both cut interest rates and boosted profit margins. These trends stimulated demand and lifted asset valuations. These dynamics fed exceptional returns for all financial assets. However, these tailwinds have dissipated. The Fed will look through next year’s temporary inflation rebound. This change has many important implications for portfolio construction. You are correct that it will be hard for equities to generate decent real returns in the coming decade. Valuations may be a poor gauge of immediate stock returns, but they are clearly correlated with long-term returns (Chart 8). The odds of higher inflation in the second half of the decade will eventually cause policymakers to raise interest rates and force a normalization of equities multiples. Moreover, greater regulation and rising populism will raise the share of GDP absorbed by wages. Profit margins are likely to decline from here (Chart 9). Chart 9Profit Margins Under Threat? Profit Margins Under Threat? Profit Margins Under Threat? Despite the poor long-term outlook for real stock returns, equities should still outperform bonds. Over the past 150 years, shares beat bonds in each episode of cyclically rising inflation, even if stocks generate paltry inflation-adjusted returns (Table 2). This time will not be different. Equities are significantly cheaper than bonds. Based on the current level of bond and dividend yields, US, Eurozone, UK and Japan bourses need to fall in real terms 23%, 32% 50% and 20%, respectively, over the next 10-year to underperform local government bonds (Chart 10). Additionally, the duration of bonds is very high due to their extremely low yields, which means that bond prices are exceptionally sensitive to rising rates. Table 2Stocks Beat Bonds, Part I OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. During the period from 1965 to 1982, when US core CPI inflation rose from 1.2% to 13.6%, the 60/40 portfolio lost 30% of its value in real terms (Chart 11). Moreover, the portfolio started to suffer poor inflation-adjusted returns well before inflation moved into double digits. As soon as CPI accelerated in 1966, the standard portfolio began to lose value. This time, inflation will not reach the dizzying height of the late 70s, but equities are trading at price-to-sales, price-to-book or Shiller P/E 33% above that of 1965 and Treasury yields stand at 0.88%, not 4.65%. Chart 10Stocks Beat Bonds, Part II Stocks Beat Bonds, Part II Stocks Beat Bonds, Part II Chart 11The 60/40 Portfolio Doesn't Like Inflation The 60/40 Portfolio Doesn't Like Inflation The 60/40 Portfolio Doesn't Like Inflation   The problematic long-term outlook for the 60/40 portfolio will demand greater creativity from investors than over the past 40 years. We like assets such as farmland, timberland, and natural resources as inflation hedges. We also like precious metals. Silver is particularly attractive; like gold it thrives from rising inflation, but unlike its yellow counterpart, silver trades at a discount to its fair value implied by the long-term trend in consumer prices (Chart 12). Industrial metals are also interesting; the effort to reduce carbon emissions will hurt fossil fuel prices but will require greater reliance on electricity. Hence, the demand for copper will stay robust while investments in extraction capacity have been poor for the last decade. Silver, a great electricity and heat conductor, will also benefit from this trend. Chart 12Silver Is Cheaper Than Gold Silver Is Cheaper Than Gold Silver Is Cheaper Than Gold Within equity portfolios, winners and losers will also change. Empirically, technology, utilities and telecom services underperform when inflation rises durably. On the other hand, healthcare, materials and real estate outperform. The first group does not possess much pricing power in an accelerating CPI environment while the second does, justifying the bifurcated relative performances. We recommend tilting long-term equity exposure this way. Finally, this sectoral view implies a structural overweight in Europe and Japan at the expense of the US and emerging markets. Mr X: Thank you. This discussion about long-term risks and portfolio construction was very useful. That being said, the thought of MMT becoming more mainstream leaves me extremely uncomfortable. The Economic Outlook Ms. X: From your observations on the vaccine rollout, I presume you expect the recovery to remain robust next year. Aren’t you concerned that a big part of the G-10 could experience a double dip recession in the first half of the year? BCA: Near-term risks are very elevated and it is likely that Europe is experiencing a renewed slump in activity as we speak. In response to the recent violent second wave of infections, consumers have avoided public spaces and governments across the continent and in the UK have implemented increasingly stringent lockdowns. Various high-frequency indicators and live trackers for the regions already indicate that another contraction in activity is taking place (Chart 13). The US is not immune to a slowdown. The country is in the thrall of its third wave of infections and local governments are increasingly imposing lockdowns. Just look at New York City, which is somewhat of a canary in the coalmine for the nation, where schools have closed. This development is happening as the economy was already slowing down after a blistering recovery in the third quarter. Naturally, the US economic surprise index is quickly declining, which indicates that economic data is falling short of expectations (Chart 14). Chart 13The European Economy Is Slowing Right Now The European Economy Is Slowing Right Now The European Economy Is Slowing Right Now Chart 14The US Economy Is Decelerating The US Economy Is Decelerating The US Economy Is Decelerating   Growth is slowing but the level of US GDP is not doomed to contract. First, inventory restocking could add as much as 3.5% to current quarter GDP. Second, consumer spending is still robust. This summer, household savings jumped massively in response to both the large transfers created by the CARES act as well as the low marginal propensity to spend caused by depressed consumer confidence. Now, consumers are deploying this large pool of funds, which is buttressing expenditures. Despite these short-term headwinds, growth in 2021 should be well above trend in the US and in Europe. The ECB Target II balance permanently attaches Germany to its weaker neighbors. Mr. X: What about the risk that a lack of fiscal stimulus could scuttle the recovery? BCA: We are not overly concerned about that as we expect additional fiscal stimulus will come through in the coming months. Chart 15Borrowing Costs Are Not A Constraint To Spending OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World In Europe, the case for additional fiscal support is clear. All the major euro area countries, including Greece, can borrow at negative interest rates, depending on the maturity (Chart 15). This too is true for Sweden, Switzerland and even the UK. Within the Eurozone, the issuance linked to the European Commission’s Recovery Fund represents the first wave of common-debt issuance. It is an embryonic tool for fiscal risk sharing, one that goes further than the European Stability Mechanism, and it is an important driver of the spread compression in the European bond market. European governments are under little pressure to apply any fiscal brake because of these low borrowing costs. Moreover, the various European central banks are buttressing government bond markets. Thus, fiscal authorities have a free hand to provide additional support if they choose to do so while lockdowns remain in place. The loose fiscal setting will allow activity to recover quickly. In the US, the situation is more complex, but we expect at least a minimal level of support. The gridlock in Washington prevents the large stimulus that would have passed under a unified Democratic control of Congress. However, a Biden administration faced with a Senate controlled by the GOP also cannot increase taxes significantly. Meanwhile the Republicans are willing to provide additional help as long as it targets households and small businesses. Netting these forces out, we expect a stimulus package of $500 billion to $1 trillion. This is smaller than the various offers on the table prior to the election, but the more concrete eventuality of a vaccine deployment in the first half of 2021 also means that the economy needs help for a shorter period. While the risk to the forecast is that the Democrats and the Republican reach a larger compromise, investors may have to wait months for a deal. This delay could magnify the underlying weakness in the US economy. Chart 16The Chinese Locomotive Is Intact The Chinese Locomotive Is Intact The Chinese Locomotive Is Intact In Japan, the law prescribes a negative fiscal thrust of –7.1% of GDP. We doubt this will transpire. Prime Minister Suga does not want to kill a nascent recovery and feed powerful deflationary pressures. Hence, supplementary budgets will provide more support to growth. Ms. X: Last year, we spoke a lot about China as an important driver of the global manufacturing cycle and growth. Is this still the case? BCA: China remains an important factor supporting our positive stance on global growth in 2021. Thanks to the aggressive use of testing and tracing, China has contained the virus, which is letting the economy heal and respond normally to monetary policy. On this front, the lagged impact of the easing enacted since 2019 will continue. Total social financing flows have rebounded to 33% of GDP and are consistent with a further improvement in our China Activity Indicator (Chart 16). Strengthening Chinese cyclical spending will lift imports of raw materials and machinery. The uptick in the Chinese credit and fiscal impulse suggests that China will remain a positive force for the rest of the world until the second half of 2021. After the summer, the positive impact of China on global growth will ebb. The PBoC is already allowing market interest rates to increase, which suggests that the apex of the credit easing was reached in Q4. Nonetheless, President Xi Jinping cannot tolerate any kind of instability ahead of the 100th anniversary of the CCP in October 2021. Thus, the fiscal and monetary policy tightening will be calibrated before that date and will only become a major risk afterwards. As a result, global growth will enjoy its maximum contribution from Chinese demand around Q2 2021. After that, Chinese activity will still be high enough to keep global industrial production elevated, but not enough to cause a further acceleration.  Chart 17China's Marginal Propensity To Consume Augurs Well China's Marginal Propensity To Consume Augurs Well China's Marginal Propensity To Consume Augurs Well Another good news for the Chinese and global economies is the recent pickup in China’s marginal propensity to consume (MPC), as approximated by the gap between the growth rate of M1 and M2 money supply (Chart 17). When M1 accelerates faster than M2, demand deposits are growing quicker than savings deposits, which highlights that economic agents are positioning their liquidity for increased spending. The MPC’s uptick will reinforce the positive signal for global economic activity from China’s credit trend. It also creates upside risk for China’s economy in the second half of the year compared to what policy dynamics imply. Ms. X: Beyond China and fiscal policy, do you foresee any other tailwinds for the global business cycle? BCA: Yes, there are plenty. As we already mentioned, the vaccine should allow the service sector to normalize progressively over the course of the year. Households’ healthy balance sheets will underpin US consumer spending next year. At the end of 2019, debt to disposable income stood at an 18-year low and the debt servicing-costs ratio was near generational troughs. In addition, both of these measures of financial health only improved during the crisis. Collapsing interest rates allowed households to refinance their mortgages and government transfers boosted disposable income. Likewise, after a very negative shock in Q1, household net worth quickly rebounded in Q2 when asset prices surged and household savings grew (Chart 18). The wealth effect will therefore help consumption, especially because employment continues to improve. The odds of higher yields are most pronounced for longer maturities. The outlook for capex is also bright. Capex intentions have been surprisingly robust in recent months and core durable goods shipments have reached all-time highs (Chart 19). Admittedly, capex is a lagging economic variable – companies take their cues from the behavior of households. But, this means that, as household spending continues to recover, so will capital investment. Another way to approach this topic is to think about the link between capex and corporate profitability. In capital budgeting, the pecking order theory argues that retained earnings are the preferred source of financing for corporate investments. This theory is echoed by empirical evidence. Business capital formation follows operating profits by roughly six months (Chart 20). The positive outlook for profits therefore bodes well for capex. Chart 18Solid Household Balance Sheets In The US Solid Household Balance Sheets In The US Solid Household Balance Sheets In The US Chart 19Surprising Capex Rebound Surprising Capex Rebound Surprising Capex Rebound Chart 20Earnings Drive Capex Earnings Drive Capex Earnings Drive Capex A major concern for the US economy is commercial real estate. This sector’s losses will likely be very large because many buildings are now uneconomical. Even if vaccines normalize daily activities, post-pandemic life has in some ways been reshaped. Workers are likely to conduct more of their job from home and shoppers have become used to the convenience of E-commerce. As a result, the need for office and retail space will decrease, which falling rents are already reflecting. The hit to the US banking system is still unknown. While CRE accounts for 13% of bank assets, this exposure is concentrated within smaller regional banks, which are much frailer than their SIFI counterparts (Chart 21). We could therefore see some localized troubles within a banking system that is tightening credit standards already (Chart 22). This danger warrants close monitoring. Chart 21CRE Is A Threat For Small Banks CRE Is A Threat For Small Banks CRE Is A Threat For Small Banks Chart 22Another Tightening In Standards Would Be Dangerous Another Tightening In Standards Would Be Dangerous Another Tightening In Standards Would Be Dangerous Chart 23Europe Is More Exposed To Chinese Demand Europe Is More Exposed To Chinese Demand Europe Is More Exposed To Chinese Demand It is not clear whether the US or the euro area will enjoy the sharpest growth improvement in 2021. Normally, Europe benefits the most during a manufacturing upswing, especially when China’s marginal propensity to consume is expanding (Chart 23). The European economy is more cyclical than that of the US because exports and manufacturing constitute a larger share of employment and gross value added (Chart 23, bottom panel). Moreover, the fiscal drag in Europe is likely to subtract roughly 3% from GDP next year while it could subtract 5% to 7% from the US GDP. However, an important handicap will counterbalance these advantages for Europe; the biggest source of economic delta next year should be the service sector because spending on goods began to recover in earnest in 2020. There is simply more pent-up demand left in services than goods and the service sector accounts for a larger share of output in the US than in Europe. Three additional factors could also favor the US against both Europe and Japan. First, residential activity is rebounding more quickly in North America. Historically, residential investment makes a large contribution to cyclical expenditures and it galvanizes additional spending on durable goods. Second, the Fed was able to engineer deeper declines in real interest rates than the ECB or the BoJ while Washington expanded the deficit faster than Tokyo or most European capitals. Finally, the weak dollar is creating another relief valve unavailable to Japan and Europe. In fact, the euro’s strength is potentially the greatest dampener of the European recovery in the coming quarter. Finally, emerging economies face important domestic hurdles that will handicap them significantly versus advanced economies in the first half of the year. EM banking systems remain fragile after the violent capital outflows witnessed in the first half of 2020. Thus, their ability to expand credit is comparatively limited. Moreover, EM economies have yet to withstand the inevitable second wave of infections, and their healthcare systems are even weaker than in advanced economies. The logistical complications associated with the rollouts of the vaccine will be most acute in poorer countries. Mr. X: I share your worries about long-term inflation, but where do you stand regarding near-term dynamics? A faster inflation recovery would amount to the kiss of death for asset markets. BCA: You are correct that faster inflation would threaten asset markets. It would force a rapid re-pricing of the Fed’s policy path and lift yields higher. Expensive stocks would buckle under this impulse. However, while it is a risk we monitor closely, it is far from our base case. We particularly like real yield curve steepeners. To begin with, both the output gap and the unemployment gap will remain meaningful in 2021. Our US Composite Capacity Utilization Indicator is not consistent with higher inflation (Chart 24). Additionally, at 6.9%, the US unemployment rate understates the amount of slack in the labor market. The employment-to-population ratio for prime-age workers offers a more accurate read of the labor market because it accounts for discouraged workers. This labor market indicator points toward limited inflation in the Employment Cost Index (Chart 25). Chart 24Limited Immediate Inflationary Pressures Limited Immediate Inflationary Pressures Limited Immediate Inflationary Pressures Chart 25The Labor Market Is Replete With Slack OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Inflation is still likely to spike in the first half of the year, but this jump will prove temporary. In the second quarter, both the core CPI and the core PCE inflation will incorporate a strong base effect when annual comparisons include the extremely depressed numbers that prevailed at the nadir of the recession. Moreover, once the service sector reopens in response to broadening vaccination programs, service sector inflation could pop higher, as goods prices did once the goods sector reopened last summer. The base effect will quickly ebb and the initial surge in service inflation should also dissipate because shelter inflation will remain dampened by stubborn permanent unemployment (Chart 26). The Fed will look through next year’s temporary inflation rebound. Its new average inflation target officialized last September is designed to avoid this kind of premature response and Fed officials are currently more afraid of committing deflationary errors than inflationary ones. Markets understand this well. Hence, as long as inflation breakeven rates remain below the 2.3% to 2.5% band consistent with market participants believing in the Fed’s ability to achieve 2% inflation durably (Chart 27), market wobbles caused by higher inflation will create buying opportunities. Chart 26Shelter Inflation Will Remain Downbeat Shelter Inflation Will Remain Downbeat Shelter Inflation Will Remain Downbeat Chart 27The Fed Monitors Inflation Expectations The Fed Monitors Inflation Expectations The Fed Monitors Inflation Expectations   One factor could cause inflation to start moving durably higher than our base case anticipates. So far, money supply is behaving very differently than in the wake of the GFC. Back then, the Fed aggressively expanded its balance sheet, but the private sector’s deleveraging compressed money demand. Consequently, the Fed’s money injections stayed trapped in the banking system where excess reserves swelled. Broad money growth was tepid and the money multiplier collapsed. Today, the private sector is not deleveraging and M2 has surged at its fastest pace since 1944. Thanks to this lack of monetary bottlenecks, real interest rates fell much faster than in 2008/9 even if the nominal Fed Funds rate dropped to zero in both instances (Chart 28). Monetary conditions are therefore much more accommodative than they were 12 years ago. Another consequence of a functioning monetary system is that the broad money supply’s advance is outstripping the Treasury’s issuance. Historically, when money supply grows quicker than government debt, inflation emerges (Chart 29). We are tracking the velocity of money closely to gauge whether this risk is morphing into reality. Chart 28Policy Is More Accommodative Than During the GFC bca.ems_ctm_2024_04_29_c6 Policy Is More Accommodative Than During the GFC Policy Is More Accommodative Than During the GFC Chart 29An Inflationary Risk An Inflationary Risk An Inflationary Risk   Ms. X: Before we move on to asset market forecasts for 2021, I would like to hear your thoughts on Brexit and the extraordinary showing of European unity last summer. BCA: We came very close to ending the Brexit transition period without a free-trade agreement between the UK and the EU. First, PM Boris Johnson had been under attack from the right wing of the Conservative party. In response, his government ramped up the hard rhetoric in recent months. However, the negative impact on the British economy in the absence of a free trade agreement with the EU was always a binding constraint on the PM. Hence, the tough rhetoric was mostly bluster and negotiation tactic with Brussels. Second, the electoral defeat of President Donald Trump in the US means that the UK is unlikely to receive preferential treatment from the US if it cannot reach a trade deal with the EU. The UK would be on its own, especially because President-Elect Joe Biden is likely to side with the EU, with whom he wants to rebuild a relationship. On the EU side, it is highly unlikely that Berlin will let French demands on fishing rights threaten its capacity to sell to its 5th export market. Thus, we expect a deal to come to fruition imminently. The move toward fiscal integration in Europe is also crucial beyond its near-term bullish impact on Italian, Spanish or Portuguese bonds. Jean Monnet, one of the architects of the 1951 Treaty of Paris that created the European Coal and Steel Community (the EU’s embryo), famously wrote in his memoirs that: “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” We witnessed these dynamics last summer. The EUR750 billion Recovery Fund created by the European Commission to help economies struggling with the pandemic will issue its own bonds. It is the first step toward a permanent common bond issuance mechanism and fiscal risk sharing in the euro area. As expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The experience of last decade’s euro crisis shows that temporary solutions often become permanent features of the EU, even if its treaties originally forbade them. The latest move will be no exception. The euro is popular; it is supported by 83%, 60%, 72%, 76% and 82% of the Spanish, Italian French, Dutch and German populations, respectively (Chart 30). Moreover, German support for the euro is particularly important. Germany’s current account surplus equals 7% of GDP because of the euro. The euro is a lot weaker than the Deutsche mark would be, which boosts German exporters’ competitiveness in international markets and within the euro area. Without the common currency, German cars would be much more expensive in France, Italy or China than they are today. Chart 30The Glue That Binds Europe Together The Glue That Binds Europe Together The Glue That Binds Europe Together Likewise, the ECB Target II balance permanently attaches Germany to its weaker neighbors. Italy and Spain owe EUR 1 trillion to this settlement system while Germany is owed EUR915 billion. If Italy or Spain were to go bankrupt or to leave the euro and redenominate their debt in lira or pesetas, the resulting hit would threaten the viability of the German banking system (Chart 30, bottom panel). Chart 31Competitiveness Convergence Competitiveness Convergence Competitiveness Convergence The past competitiveness problems of the European periphery are also steadily diminishing. Compared to Germany, harmonized unit labor costs in Italy or Spain have fallen 15% since 2009 and are not far from the levels prevailing at the introduction of the euro in 1999 (Chart 31). Consequently, current account deficits in Spain and Italy are narrowing considerably. Germany’s euro benefits, the tie created by the Target II imbalances and the periphery's improved competitiveness only bring Europe together and they allow the COVID-19 crisis to force a closer union. While these developments have little implication for Europe’s growth next year, they constitute a major long-term positive because they will curtail the cost of capital in the periphery and permit the sharing of funds necessary to build a lasting monetary union. Ms. X: To summarize; at the beginning of 2021, global growth should remain volatile. However, the recovery will ultimately strengthen over the remainder of the year thanks to the rollout of vaccines, the sustained fiscal support across major economies, the continued positive impact of China’s economic healing, and the strength of household balance sheets. Capex will remain robust as well, even if commercial real estate is a dangerous spot that we must monitor. Moreover, it is too early to ascertain whether the US or the EU will experience the strongest recovery in 2021, but emerging economies should lag behind. In addition, while you are concerned about the long-term inflation risk, consumer prices should not experience a durable pickup this year. Likewise, you foresee a benign outcome to the UK-EU trade negotiations and are positive on European integration. BCA: Yes, you summed it up nicely. Bond Market Prospects Ms. X: I find the Treasury market very puzzling right now. On the one hand, demanding valuations of US government bonds worry me, particularly in light of the upbeat economic outlook for 2021. On the other hand, if inflation remains low and the Fed is unlikely to push up rates until 2022 at the earliest, the upside for yields should be limited.  BCA: We recommend a below-benchmark duration for fixed-income portfolios with an investment horizon of 12 months or so. Valuations partially underpin this recommendation. Our Global and US Bond Valuation Indices highlight that government bonds are at the level of overvaluation that, over the past 30 years, often produce a negative return in the following 12 months (Chart 32). However, valuations only indicate the degree of vulnerability of an asset but they rarely trigger price moves. Instead, timing most often relies on cyclical and technical factors. Favor cyclical equities relative to defensive ones. Cyclical forces are increasingly negative for bonds. In the US, our BCA Pipeline Inflation Indicator has perked up. It is not pointing toward an imminent rise in inflation but it suggests that deflationary risks are ebbing, something BCA’s Corporate Pricing Power Proxy also captures (Chart 33). A removal of the left-tail risk in CPI should push up yields, especially as our BCA Nominal Cyclical Spending Proxy is also firming, which normally happens ahead of meaningful yield pickups (Chart 33, bottom panel). Chart 32Pricey Bonds Pricey Bonds Pricey Bonds Chart 33Cyclical Risks For Bond Prices Cyclical Risks For Bond Prices Cyclical Risks For Bond Prices Chart 34Investors Will Want Protection Against Inflation Uncertainty Investors Will Want Protection Against Inflation Uncertainty Investors Will Want Protection Against Inflation Uncertainty The odds of higher yields are most pronounced for longer maturities. First, our central forecast expects a significant rise in inflation in the latter part of the decade. Second, monetary and fiscal policy will remain very accommodative over the coming years even as private demand increases, which will lift medium- to long-term inflation uncertainty. Rising inflation uncertainty usually facilitates a steepening of the yield curve (Chart 34). Despite these forces, the upside to yields will prove limited in 2021. The Fed’s new inflation target means that it will be patient, and waiting for core PCE inflation to move sustainably above 2% could take time. The US central bank is therefore unlikely to increase interest rates for many years. This inertia limits the immediate upside in Treasury yields, but does not preclude it. While the Fed will not be quick to lift off, its forward interest rate guidance is not going to get any more dovish and the bond market is already pricing-in the first rate hike for late 2023. This expected liftoff date will be brought forward as the economy recovers, meaning that long-maturity nominal yields, real yields and inflation breakeven rates all have moderate upside. The recent equity market leadership of growth stocks is another limiting factor for higher yields. Growth stocks are extremely sensitive to long bond yields. If the latter back up too fast, it will scuttle bourses and unleash risk aversion and deflationary pressures. This creates an upper bound on the speed at which yields can move up. Mr. X: Even with their limited room to fall in the near term, the meaningful long-term and valuation risks of bonds make them so unappealing to me that I refrain from using them as near-term portfolio hedges. How can I protect my equity holdings right now? BCA: Hedging near-term risks to stocks has become one of the most hotly discussed topic with our clients because investors are witnessing the increasingly asymmetric payoffs of bonds. When equity prices rise, bond prices typically decline, but when stocks correct, bond prices barely rally. This newfound behavior of safe-haven bonds is a consequence of global policy rates having moved to or near their lower bound. We increasingly like small-cap firms relative to large-cap ones. For non-US based investors, there is a simple solution to this problem: parking some funds in US cash because the USD still acts as an effective hedge against market corrections. For US-based investors, finding adequate protection is more challenging. Those who can short and use leverage should sell currency pairs with an elevated sensitivity to changes in risk aversion, such as the EUR/CHF, AUD/JPY or MXN/JPY, to achieve some protection. Otherwise, holding cash to buy back stocks at lower levels remains an appropriate strategy. Mr. X: Which government bond market do you like most, or more accurately, which one should I avoid most right now? BCA: At the moment, we prefer the European periphery. The valuation ranking we often use when we see you is clear: Portuguese, Greek, Italian or Spanish bonds are the cheapest while German Bunds and US T-Notes are exceptionally expensive (Chart 35). Real bond yields confirm this estimation. Additionally, the nascent fiscal risk-sharing created by the European Commission’s Recovery Fund should result in declining breakup risk premia embedded in peripheral bonds. Furthermore, the ECB’s asset purchases are set to rise in response to Frankfurt’s efforts to fight off the deflationary effect of both the euro’s appreciation and the second wave’s lockdowns. Chart 35The Value Is In Europe’s Periphery OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World We are more negative on US Treasuries than Bunds. The valuation difference between the two safe havens is minimal. However, in 2020 the US has been more reflationary than Europe and the recent decline in the USD should lift US inflation relative to Germany’s, which will widen yield differentials in favor of Bund prices (Chart 36). Besides, the US economy has a higher potential GDP growth than Europe, which warrants a superior neutral rate of interest. Consequently, investors should expect US real yields to rise relative to the euro area’s benchmark. Outside of these markets, dedicated fixed-income investors should also overweight JGBs within their portfolio. JGBs have a low yield beta, which will limit their price declines if global yields move up. If the global recovery peters off, this feature will not create a major handicap because global yields have limited room to fall from here. Moreover, Japanese bonds are the cheapest safe haven (Chart 37). Chart 36Bunds vs Treasuries: Follow The Inflation Gap Bunds vs Treasuries: Follow The Inflation Gap Bunds vs Treasuries: Follow The Inflation Gap Chart 37JGBs Are The More Attractive Safe Haven OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World   We are neutral Canadian and Australian bonds. Historically, Canadian and Australian yields tend to have high betas to US T-Note yields. However, the BoC and the RBA are very active purchasers in their domestic markets, which will dampen the volatility of Canadian and Australian bonds. Ms. X: Considering the limited scope for major interest rate moves next year, what are your high-conviction trades for fixed-income portfolios? BCA: Within US government bond markets, we like curve steepeners. We also recommend positioning for rising inflation expectations by going overweight TIPS relative to nominal Treasuries. We particularly like real yield curve steepeners (within the TIPS curve). The cost of short-maturity inflation protection is below that of long-maturity protection, which means that short-term inflation breakeven rates have more upside as core PCE returns to the Fed’s target. A TIPS-curve steepener benefits from both a flattening of the inflation breakeven curve and a steepening of the nominal Treasury curve. It is therefore a high-octane play on both our favored strategies. We like both Europe and Japan. Within US corporate credit, we are currently overweight investment grade and Ba-rated high-yield bonds. However, valuation at the upper-end of the credit spectrum heavily favors tax-exempt municipal bonds over corporates. Investors that can take advantage of the tax exemption should prefer munis over investment grade corporates. Elsewhere, we are underweight MBS as pre-payment risk is elevated, but we like consumer ABS due to the strong position of household balance sheets. Ms. X: Before we moved on to equities, where do you stand on EM credit? Do you expect any global search for yield to push EM bond prices higher? BCA: With a few exceptions like Mexico and Russia, we prefer US corporate bonds to dollar denominated EM bonds of similar credit quality. EM bonds offer poorer value, but EM spreads will continue to evolve in line with US corporate spreads. Because of this directional correlation, our preference for US investment grade bonds translates to EM bonds as well. Our more circumspect attitude toward EM high-yield bonds also reflects our more conservative stance on US high-yield bonds. For local-currency rates, we are receivers in the swap market because the near-term outlook for EM currencies is difficult. Most EM countries have a deflation problem, not inflation troubles. Hence, real and nominal rates in emerging economies will fall as central banks try to stimulate their economies. These declines will be positive for the local-currency performance of EM bonds but it will hurt their currencies. Over the next twelve months, this challenge will be most pronounced against non-US DM currencies. In the short-term, this hindrance will also exist against the USD because the Greenback should rebound temporarily, something we can discuss in more detail in our chat about the currency and commodity markets. Our favorite bets are to receive Mexican, Colombian, Russian, Indian, Chinese and Korean swap rates. Mr. X: I agree that the case to make a major duration bet next year is limited, but risks are slightly skewed toward upside for yields. I am a little surprised that you like European peripheral bonds so much and yet prefer Bunds to Treasuries. I will have to digest your view on EM bonds because I would have bought EM currencies outright. Finally, I find your real yield curve steepener idea extremely intriguing. Thank you for giving me ideas to ponder. Now, shall we move to next year’s equity outlook? Equity Market Outlook Chart 38The Bubble Can Grow The Bubble Can Grow The Bubble Can Grow Mr. X: I am a firm believer that growth stocks, tech in particular, are in a massive bubble. My daughter tries to convince me that we cannot generalize. Yet, both my gut and my brain tell me to seek refuge in value stocks. I appreciate that the outlook for tech stocks hinges on the evolution of monetary policy. Nonetheless, I think that any small shock can topple the so-called FANGs because they are so expensive and over-owned. I fear that where the FANGs go, so will the market. BCA: We have recently published a report broaching the question of bursting bubbles. When real interest rates are negative, when money supply is expanding at a double digit pace and when the Fed is extremely reluctant to tighten policy, the chances that a bubble will deflate are extremely low, even if stocks are furiously expensive (Chart 38). Beyond monetary tightening, an escalation in the supply of financial instruments also caused some bubbles to deflate. For example, an increase in the number of tulips following a harvest contributed to the end of the tulip mania. Bubbles from the eighteenth century, such as the South Sea Bubble and the Mississippi Company Bubble, followed stock issuances or regulatory changes. Even during the tech bubble, the large IPOs of the late 1990s added to the supply of securities available to investors. Right now, we are not witnessing this surge in supply. Buybacks, which are a contraction in supply, have acted as a key fuel to the bubble in the tech sector. Moreover, dominant tech titans have built large moats around their businesses because they often rely on pronounced network effects, if they are not a network themselves. These monopolistic behaviors account for their large profit margins, but they also prevent the emergence of viable competitors in the near term. Meanwhile, the mushrooming of Special Purpose Acquisition Companies (SPACs) is worrisome in the long-term. They are mostly vehicles to conduct backdoor IPOs of private firms. For now, they remain too small to topple the bubble. The real worry for tech investors is the eventual resurgence of inflation. During the tech bubble at the turn of the millennium, the rise in core CPI in early 2000 forced investors to discount more rate hikes, which toppled tech equities (Chart 39). As we discussed already, the outlook for inflation is benign for 2021, but if it were to change, tech stocks could fall in absolute terms. We expect tech names to underperform the S&P 500 over the next 12 months, but not to fall outright. This is akin to the experience of Japanese banks in the 1980s. In the first half of that decade, Japanese lenders stood at the forefront of the equity bubble. However, in the late 1980s, they lagged behind the rest of the Nikkei, even if they generated positive absolute returns (Chart 40). Chart 39Inflation Is The Threat To Tech Stocks Inflation Is The Threat To Tech Stocks Inflation Is The Threat To Tech Stocks Chart 40Without Falling, Bubble Leaders Can Still Lag Without Falling, Bubble Leaders Can Still Lag Without Falling, Bubble Leaders Can Still Lag   Ms. X: I agree, it is hard to be too negative on stocks next year with the Fed standing firmly on the sidelines. What do you see as the market’s main driver in 2021 and what is the biggest risk to the outlook? BCA: Many important factors underpin global equities. First, we still are in the early innings of a new business cycle upswing. Statistically, bull markets most often end when earnings permanently decline. This observation means that equity bear markets rarely develop in the absence of recession (Chart 41).  Chart 41Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Second, as expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The combination of our Valuation and Monetary Indicators remains in low-risk territory, which historically is consistent with positive absolute returns for the S&P 500 over the coming 12 to 18 months (Chart 42). However, the gap between the two indicators is narrower than it was last spring, which suggests that the easy market gains lie behind us. Another tool to think about valuations is the Equity Risk Premium. Our measure, which adjusts for the lack of stationarity of the ERP’s mean as well as for the expected growth of cash flows, is not as wide as it was in Q2 or Q3, but it remains congruent with positive prospective equity returns (Chart 43). Chart 42Monetary Policy Beats Valuations, For Now Monetary Policy Beats Valuations, For Now Monetary Policy Beats Valuations, For Now Chart 43The ERP Points To Positive Stock Returns in 2021 The ERP Points To Positive Stock Returns in 2021 The ERP Points To Positive Stock Returns in 2021   Third, forward earnings estimates will rise further. The gap between the Backlog of Orders and the Customers’ Inventories subcomponents of the ISM survey indicates that earnings revisions will continue to climb from here (Chart 44). Additionally, our Corporate Pricing Power Proxy is back into neutral territory after having flashed dangerous deflationary pressures. Thanks to the operating leverage embedded in equities, improving selling prices can quickly push the bottom line higher (Chart 45). The rollout of vaccines next year will only feed these dynamics and help profit growth even further. Chart 44Room For Positive Earnings Revisions Room For Positive Earnings Revisions Room For Positive Earnings Revisions Chart 45Less Deflation Is Good For Earnings Less Deflation Is Good For Earnings Less Deflation Is Good For Earnings     Fourth, our benign expectations for the credit market is consistent with both higher multiples and earnings. A well-functioning credit market is essential to risk taking and multiples. It also allows capex to remain well sustained and cyclical spending to expand. Both these forces are bullish for profits. Fifth, our negative stance on the dollar will ease global financial conditions. A weaker dollar pushes down the global cost of capital, which strengthens the global industrial cycle. Global stock markets overweight the industrial and goods sectors relative to the economy. Therefore, global bourses benefit from a weaker dollar. The greatest risk for stocks is an uncontrolled jump in bond yields, where 10-year Treasury yields climb above 1.2% in a short period, especially if real rates drive the leap. Too quick an adjustment in the cost of capital would threaten the ERP and it would hurt the multiples of growth stocks that are highly sensitive to fluctuations in the discount rate. Moreover, a rapid rise in borrowing costs would likely force a more precipitous deceleration in the housing sector, which is a key locomotive of the recovery. Another risk is that vaccine rollouts are delayed, which would rapidly sap growth expectations. Mr. X: Rather than taking a large net long exposure in equities, I would favor value stocks at the expense of growth stocks. The valuation gap between both styles is exceptionally wide, and value equities have not been this cheap on a relative basis since at least 2000, or more, depending on the indices used . As a result, they embed a much greater margin of safety than growth stocks, which makes me rest easier because I am less comfortable than you are about this equity bubble’s near-term prospects. Chart 46Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Ms. X: As I mentioned at the beginning of our chat, I, however, prefer growth stocks. The sectors most represented in the value indices face secular headwinds such as low rates, a move away from carbon, and the increasing role of software, not goods, as the source of value added in our economies. Meanwhile, growth stocks also benefit from the aging of the population, the historically low trend growth rate of the global economy, and the network effects, which protect the profit margins of large tech firms. As you can see, my father and I have been clashing on this topic. Where do you stand? BCA: Within the firm, we have had our disagreements on this topic as well. One thing we all agree upon is that the growth-versus-value debate amounts to a sector call. One common preference we share is to favor cyclical equities relative to defensive ones. Over the coming 12 months, a weak dollar, rising inflation expectations, the strengthening of the Chinese and global economy and improving capex will all conspire to boost the profit and multiples of cyclical stocks at the expense of defensive sectors (Chart 46). Nonetheless, if the Chinese economy starts to slow in the second half of 2021, we will have to evaluate if this bet remains valid. Within the cyclicals, we prefer the more traditional ones, like industrials and materials at the expense of the tech sector. The expected growth rate embedded in tech stocks is extremely elevated compared to the rest of the market in general and other cyclicals in particular (Chart 47). This aggressive pricing is rooted in the recent experience, whereby tech earnings significantly outperformed the rest of the market. However, this outperformance mirrored strong sales of techs goods and services during the pandemic, when households and firms prepared for long lockdowns and remote working. Gravity-defying sales in the midst of the deepest recession in 90 years stole demand away from the future. Now that the economy recovers, pent-up demand for tech goods is smaller than for other categories of cyclical spending. Thus, the current pricing of tech earnings growth leaves room for disappointments. Within traditional cyclicals, financials are a question mark. The broadening of the economic reopening subsequent to the rollout of the vaccines is positive for the quality of banks’ loan books. However, the scope for yields to rise is restricted, which will limit how steep the yield curve will become and how wide net interest margins will swell. Thus, for 2021, industrials and materials remain our favored sectors. Chart 47Too Much Earnings Optimism For Tech Stocks Too Much Earnings Optimism For Tech Stocks Too Much Earnings Optimism For Tech Stocks We also favor a basket of “back to work” stocks at the expense of “COVID-19 winners”. With vaccines coming through next year, this trade has further to run. The first group includes some airlines, hotels, oil producers, restaurant operators, capital goods manufacturers, credit card companies, automobile manufacturers and a steel producer.1 The second basket includes a bankruptcy consultant, a software company, some grocers, some biotech names, a Big Pharma company, a large e-commerce business, an online streaming service, a teleconferencing company and two household products leaders.2  For the next 12 to 18 months, we favor value stocks at the expense of growth stocks, which is a consequence of our preference for traditional cyclical names and of the “back to work” names. Moreover, since 2008, periods of economic acceleration correspond to quicker earnings growth of value stocks compared to growth equities (Chart 48). Additionally, if bond yields move up – even if not much, the multiples of value stocks should expand relative to growth firms (Chart 48, bottom panel). We also increasingly like small-cap firms relative to large-cap ones. Small cap indices have substantial underweights in healthcare and tech names, which contrasts with the S&P 500 or the S&P 100. Accordingly, the Russell 2000 both has a cyclical and value bend relative to large-cap benchmarks. Moreover, small call equities outperform the S&P 500 when the dollar declines and when commodity prices appreciate (Chart 49). Additionally, the recent sharp rebound in US railroad freight volumes will support the more-cyclical Russell 2000. Besides, greater shipments lead to upgrades of junk-bond credit ratings, which decreases the perceived riskiness of the heavily levered small cap firms (Chart 50). Chart 48Value Investors Will Like 2021 Value Investors Will Like 2021 Value Investors Will Like 2021 Chart 49The Case For Small Cap Stocks, Part I The Case For Small Cap Stocks, Part I The Case For Small Cap Stocks, Part I Chart 50The Case For Small Cap Stocks, Part II The Case For Small Cap Stocks, Part II The Case For Small Cap Stocks, Part II The long-term picture is less clear. Many key supports for growth stocks remain in place. Principally, the aging of the population and the risk of rising inflation in the second half of the decade should flatter healthcare stocks. In addition, the wide profit margins of tech stocks are unlikely to fully mean-revert because firms like Amazon, Google or Microsoft benefit from monopolistic positions that have decoupled their profitability from their capital stock. For now, the biggest risk to these sectors would be a regulatory onslaught from Washington and Brussels. Meanwhile, the sectors composing value indices suffer from the structural headwinds that Ms. X already noted. Counterbalancing this narrative, the extreme relative overvaluation of growth stocks suggests that their prices reflect these long-term forces already. On a very near-term basis (next two to three months), the rapid rise in investor sentiment as well as the collapse in the put-call ratio are consistent with a correction or sideways move in equities (Chart 51). When this correction materializes, no meaningful trend in growth relative to value stocks should emerge. Therefore, we recommend tactical traders play relative value within growth stocks and within value equities, where overextended sectors should correct. Within growth, we would like to rotate away from tech into healthcare. Within value, the next three months should reward financials at the expense of materials. Chart 51Near-Term Risks For Stocks Near-Term Risks For Stocks Near-Term Risks For Stocks Ms. X: Based on these sectoral views, I gather you would underweight the US market. But where do you stand on emerging markets? BCA: You are correct, in 2021, we expect US equities to underperform the rest of the world. Their large weight in healthcare combined with the low beta of the US economy to global growth gives a defensive twist to the S&P 500. In addition to healthcare, the most significant overweight in the US equity benchmark is tech, which reinforces the growth style of US stocks. The US’s tech overweight is greater than appears because US communication services and consumer discretionary sectors are mostly tech names such as Facebook, Google, Netflix or Amazon (Table 3). Finally, our bearish outlook on the USD creates an additional hurdle for US equities relative to the rest of the world (Chart 52). Table 3Sector Representation In Various Regions OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World While we like both Europe and Japan, the latter stands out for 2021. Japanese stocks have particularly large allocations to the most attractive deep cyclicals (industrial and consumer discretionary equities) and are very cheap, even on a sector-to-sector comparison (Chart 53). To like Japan, we do not need to bet on a multiples convergence. This equity market’s low valuations mean that we are buying each unit of profit growth at a discount to the same sectors in the rest of the world. As a result, Japanese equities are more levered to our positive view on the earnings of deep cyclicals than any other major bourse. Chart 52US Stocks Underperform When The Dollar Weakens US Stocks Underperform When The Dollar Weakens US Stocks Underperform When The Dollar Weakens Chart 53Japan Offers The Right Exposure At The Right Price OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World   Finally, we are neutral on EM stocks. We like them more than US equities but less than Japan or Europe. EM stocks will benefit from a weaker dollar, but they have become tightly correlated to the NASDAQ due to the leadership of a few large tech names in Asia. Essentially, like the US, EM stocks have a very large weighting in the tech sector. If our view is correct that growth underperforms value next year, North Asian EM, which have driven EM stocks since March, will lag behind Latin America in 2021. Mr X: Thank you for your thoughts on equities. I agree that a monetary shock normally is needed to burst bubbles, but I also worry that the current extreme overvaluation of tech stocks could lead to gravity taking hold without the help of the Fed. This means that I am slightly less confident than you are that equities will rise this year. However, I agree with you that value stocks should beat growth stocks and that US equities should become the laggards after years of leadership. Ms. X: Should we move on to the currency and commodity markets? Currencies And Commodities Chart 54The Dollar Is Vulnerable Technically OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Mr. X: I was skeptical last year, but your bearish dollar view panned out very well. However, you did not get its cause correctly. For one, you were constructive on global growth and consequently, negative on the dollar. I am skeptical that the dollar will depreciate much further in 2021 because it possesses a considerable yield advantage over other G-10 currencies. BCA: Today, the dollar sits at a critical spot. As you mentioned, we were negative on the USD last year; since then, it has breached all the major trend lines that have defined its bull market over the past nine years (Chart 54). This technical configuration suggests that more weakness is in store.  One thing is very clear, dollar bulls have gone missing. Speculators are heavily selling the USD. Bullish sentiment on the euro is at its most elevated level in a decade. Historically, when it faces such one-sided negativity, the dollar enjoys temporary rebounds. Nonetheless, the DXY’s upside should be limited, at 2-4%, not more. A few forces cap the dollar’s upside. The currencies with the most upside against the dollar in 2021 are the European currencies. The liquidity crunch that handicapped global markets in March is over. Most foreign central banks have ample access to dollar liquidity and do not rely on the Fed anymore, as its outstanding swap lines stand close to zero (Chart 55). In 2009, this was a clear signal that the dollar liquidity shortage was behind us. The Fed has increased its supply of domestic currency more aggressively than other central banks. Today, interest rates around the world are at zero. Therefore, central banks’ balance sheet policy and forward guidance are the main tools to communicate the future path of interest rates. Chart 56 shows that other G-10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has hurt the dollar and benefitted other currencies. Chart 55No More Liquidity Crunch No More Liquidity Crunch No More Liquidity Crunch Chart 56Currencies Respond To Balance Sheets Currencies Respond To Balance Sheets Currencies Respond To Balance Sheets   US growth is lagging the rest of the world. This might not last, but growth differentials will continue to drive the performance of currencies, as they did in recent years. The November PMIs showed that the US economy held up well, but 2021 growth expectations from the IMF and other agencies favor the Eurozone. Finally, we are also deeply uncomfortable with negative interest rates. However, negative rates are the symptom and not the disease. China has positive interest rates because its domestic demand is strong. Europe or Japan are very sensitive to Chinese growth, which could cause the US rate advantage to evaporate. Ms. X: Earlier, you mentioned that the dollar is the perfect hedge for non-US based investors, which is a view I share. Are there any other currencies outside the dollar that we should hold that provide some safety? BCA: The currencies with the most upside against the dollar in 2021 are the European currencies, especially the Norwegian krone and the Swedish krona. They are the most undervalued currencies within the G-10, and they offer some margin of safety. While less attractive than the Scandinavian currencies, the pound will nonetheless appreciate more than the euro next year. Even if most currencies should gain against the USD, the yen is the one that will offer the most protective ability in a portfolio. It would be an excellent defensive complement to the dollar for investors looking to hedge portfolio risk. Gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. First, the yen is cheap. Over the years, falling Japanese price levels have tremendously improved the value of the yen. This cheapness makes Japanese equities an attractive investment, especially on an unhedged basis. These unhedged flows into Japan are very positive for the yen. Second, Japan offers the highest real interest rates in the G10. This attribute will incite investors to purchase JGBs. Moreover, Japanese investors could represent a major source of fixed-income flows into the country because of a large proportion of US Treasuries will mature, which will invite repatriation flows. Chart 57The Yen Likes A Weaker USD The Yen Likes A Weaker USD The Yen Likes A Weaker USD Finally, the yen is a low beta currency versus the USD. Both the DXY and the USD/JPY are positively correlated, thus when the dollar declines, the yen rises, but less so than other currencies (Chart 57). This means that when global equity markets enter risk-off phases, the yen appreciates against non-dollar currencies, but it loses less value against these same currencies when markets are rallying. This places the yen in a very enviable “heads I win, tails I don’t lose too much” position, which is what we need out of a portfolio hedge.  Mr. X: I find it difficult to share your enthusiasm for the yen, but I agree that it is an interesting portfolio hedge. Nonetheless, my precious metals still provide me with a lot more comfort than any fiat currencies. Moving to commodities; it has been a remarkable year. Oil was crushed by the COVID-19 pandemic – more so than other commodities. Crude now appears to be attempting a comeback. Gold did well this year, but it recently dipped below $1,800/oz., and seems to be struggling to get back above that level. Let’s start with oil. Where do you see it going and how should we play it? BCA: Oil is about one principle: Supply and demand have to clear the market. Even more than with other commodities, the COVID-19 pandemic clobbered oil demand, especially those segments of the market tied to transportation, such as motor fuels (gasoline and diesel fuel), jet and marine fuels. While the news around vaccines are encouraging, it will be months before these treatments are available on the massive scale required to revive transportation demand. Chart 58Crude Forecasts Crude Forecasts Crude Forecasts Ms. X: Are you saying the oil prices will remain depressed in 2021?   BCA: Not really. We expect demand to recover following local – as opposed to national – lockdowns in the US and Europe. This process will become evident even before the vaccines have been rolled out on a large-enough scale to affect transportation demand. The impact on energy demand of the vaccines themselves should become visible toward the end of the first half of 2021.  On the supply side, we believe the producer coalition lead by Saudi Arabia and Russia will continue to adjust supply to meet demand. Hence, global oil inventories will fall further, which will tighten the market. Based on these supply/demand dynamics, Brent crude-oil prices will average $63/bbl next year, which is above the forward curve in oil markets (Chart 58). Mr. X: Oil-market risk seems very difficult to pin down right now. Do you expect downside or upside risks to dominate prices next year? BCA: At the current juncture, risks to the oil market are exceptionally two-sided. On the downside, with the exception of China, most major economies have been unable to control the rapid spread of COVID-19. If the health crisis lingers, oil demand could remain weaker than our base case anticipates. On the upside, Big Pharma has acted with unprecedented speed in developing vaccines to combat this coronavirus. Netting all these forces out, the balance of risks, in our view, favors the upside, as our price forecast indicates. Mr. X: Thank you. I would like to move on to gold. You mentioned that the dollar was your favourite hedge against equity risk for non-US based investors. As I mentioned earlier, I tend to prefer gold. BCA: Gold and the US dollar are both safe-haven assets; when risk aversion and uncertainty increase, investors buy both these assets to hedge their portfolios. Typically, a weaker dollar is good for gold, and vice versa. The past four or five years have been extraordinarily uncertain – trade wars, political uncertainty, the global rise of nationalist populism, the COVID-19 pandemic, you name it. All of these factors drove investors to hold dollars and gold at the same time.  While the bullish dollar forces are dissipating, we cannot say the same for gold. The Fed is committed to maintaining an ultra-accommodative monetary policy indefinitely, which, along with the US government’s ever-expanding budget deficits, will keep the supply of money and credit extremely high for years. As we already argued, this policy setup will have a positive impact on inflation expectations. On the geopolitical front, even if the Sino-US tensions become less acute in the near-term, an undercurrent of distrust and rivalry will prevail. This combination will let bullion prices reach $2,000/oz. next year. Despite these positive fundamentals, gold will not hedge portfolios well against temporary deflationary shocks. Stuck at their lower bound, interest rates cannot decline any more. Consequently, negative growth shocks weigh on inflation expectations, which lifts real interest rate and the dollar, albeit briefly. This process is bearish for gold. Thus, gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. Mr. X: Thank you. Any other natural resource you would highlight for 2021? BCA: In our research, we heavily focus on the evolution of the global economy toward a low-carbon regime. Hence, we have opened up a whole line of investigation on CO2 markets, particularly in the EU, which is the largest such venue in the world. We are expecting it to become a leading indicator of global efforts to price carbon going forward.  On a related note, we are very interested in the buildout and modernization of China’s electric grid as it embarks on its 14th Five-Year Plan in 2021. Similar efforts are arising globally. We think this will be very important for base metals prices, particularly copper and aluminium. Geopolitics Mr. X: Before we conclude, let us talk about global geopolitical risks. The past two years were replete with tensions, many stocked by the Trump administration. Does a change of leadership in the US will fundamentally alter global relations, especially between the US and China?   Chart 59Peak US Polarization Peak US Polarization Peak US Polarization BCA: The fundamental geopolitical dynamic at the outset of the 2020s is the division of the United States and the rise of China.   The sharp increase in US political polarization began with the decline of a common enemy, the Soviet Union, in the 1980s. Pro-growth policies that widened the wealth gap, and a series of political, military, economic, and financial shocks in the twenty-first century, drove polarization to levels not witnessed since the late nineteenth and early twentieth centuries. The anti-establishment Trump administration marked the latest peak in polarization (Chart 59). Now, in 2020, the Democratic Party-led political establishment has reclaimed the White House, but only narrowly. The popular vote was roughly evenly divided (47% to 51%) and the Republicans have likely retained the Senate. Because the popular vote and Electoral College vote are now aligned, and because Biden looks limited to center-left policies, polarization is likely to come off its highs. But it will remain elevated due to gridlock in Congress and persistent socio-economic disparities. President Xi Jinping’s “New Era” has led to a backlash from foreign powers. Polarization is globally relevant because it increases uncertainty over the US’s role in the world, particularly on fiscal policy and foreign policy. At home, gridlock produces periodic budget crises that weigh on global risk appetite. Abroad, partisanship causes new presidents to reverse the foreign policies of their predecessors (see President Obama on Iraq and President Trump on Iran). These dramatic reversals increase global policy uncertainty and geopolitical risk (Chart 60). Chart 60A Bull Market In Policy Uncertainty A Bull Market In Policy Uncertainty A Bull Market In Policy Uncertainty As the US descended into internal partisan conflict, China expanded its global influence. In the wake of the 2008 crisis, the Communist Party was forced to change its national strategy to better handle demographic decline, structural economic transition, rising social ills, and foreign protectionism. Slower trend growth increases long-term risks to single-party rule, forcing the CCP to shift the basis of its legitimacy from rapid income growth to Chinese nationalism. Hence Beijing has aggressively sought a technological “Great Leap Forward” to improve productivity while adopting a much more assertive foreign policy to build a sphere of influence in Asia Pacific. President Xi Jinping’s “New Era” has led to a backlash from foreign powers, most markedly with COVID-19 but also with the removal of Hong Kong’s autonomy, saber-rattling in neighboring seas, and politically motivated boycotts of neighboring countries like Australia. The sharp decline in China’s international image has occurred despite the damage that President Trump did to America’s image at the same time (Chart 61). The Xi administration is not likely to change course anytime soon as it seeks to consolidate power even further ahead of the critical 2022 leadership transition. Chart 61A Broadening Distrust Of China OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World American polarization and Chinese nationalism are a dangerous combination. China is increasingly fearful of US containment policy and is adopting a new five-year plan built on accelerating its quest for economic self-sufficiency and technological leadership. The US is fearful of China as the first peer competitor that it has faced since the Soviet Union, and one of the few sources of national unity is the bipartisan agenda of confronting China over its illiberal policies. The Biden administration will mark the third US presidency in a row whose foreign policy will be preoccupied with how to handle Beijing. With Biden likely facing gridlock at home, and likely a one-term president due to old age, his administration will largely amount to restoring the Obama administration’s policies. Internationally, this means an attempt to rejoin or renegotiate the Iranian nuclear deal of 2015 so that the US can reduce its involvement in the Middle East and pivot to Asia. Assuming that any American or Israeli action against Iran in the waning days of the Trump administration is limited, Biden will probably achieve a temporary solution with Iran, which otherwise faces economic collapse just ahead of a critical presidential election and eventual succession of the supreme leader. But the process could involve force or the threat of force before a solution is reached, and this would temporarily trouble markets. The greatest geopolitical opportunity in 2021 lies in Europe. Biden will also seek to re-engage China to manage the dangerous rise in tensions, while making amends with US allies for Trump’s “America First” approach. There is already a tension between Biden’s commitment to multilateralism and his need to get things done. The Trump tariffs are viewed as illegal according to the WTO but give Biden leverage over China. Biden is forced to confront China and Russia over their authoritarian actions, but he also needs their assistance on Iran and North Korea. Meanwhile unforeseen crises will emerge, likely in emerging markets badly shaken by this year’s deep recession. Chart 62The Taiwan Strait Is The Top Geopolitical Risk In 2021 OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World The greatest geopolitical risk in 2021 lies in the Taiwan Strait. If China becomes convinced that Biden is not attempting a real diplomatic reset, but is instead pursuing a full-fledged containment policy and technological blockade, then it will be increasingly aggressive over rising Taiwanese pro-independence sentiment (Chart 62). A fourth Taiwan Strait crisis is still possible and would have a cataclysmic impact on markets. But Biden will start by trying to lower tensions with Beijing, which is positive for global equity markets until otherwise indicated. China’s long-run strategy has paid off in Hong Kong so it will likely think long-term on Taiwanese matters as well. Ms. X: In your opinion, which region will experience the greatest geopolitical tailwind next year? The greatest geopolitical opportunity in 2021 lies in Europe. The UK will likely be forced to accept a trade deal with the EU for the sake of the economy and internal unity with Scotland. Meanwhile Trump will not be able to impose sweeping unilateral tariffs on Europe and his maximum pressure policy on Iran will dissipate, reducing the risk of a major war in the Middle East. Germany’s transition from the era of Chancellor Angela Merkel will bring debates and concerns, but Germany is fundamentally stable and its agreement with France to upgrade European solidarity puts a lid on Italian political risk as well (Chart 63). Russia remains aggressive, but it is increasingly worried about domestic stability, and now faces an onslaught of democracy promotion from the Biden administration. Chart 63EU Solidarity Is The Top Geopolitical Opportunity In 2021 EU Solidarity Is The Top Geopolitical Opportunity In 2021 EU Solidarity Is The Top Geopolitical Opportunity In 2021 Investors are rightly optimistic about 2021 because of the vaccine for COVID-19 are the reduction in global policy uncertainty and geopolitical risk as a result of the change in the White House. But a lot of optimism is being priced as we go to press, whereas the US-China and US-Russia rivalries have gotten consistently more dangerous since 2008. While geopolitical risk is abating from the extreme peaks of 2019-20, it will remain elevated in 2021 and the years after.     Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned. On the one hand, the global reflationary policies  forced through the system this year remains positive for risk assets. On the other, valuations of both stocks and bonds are uncomfortably stretched for my taste. Moreover, the pandemic is still not under control and while the news on the vaccine front is encouraging, the economy still has ample room to negatively surprise next year. Furthermore, I find the long-term picture particularly concerning, especially if inflation and populism rear their ugly heads. As a result, while I feel like I must be invested in equities rights now, I prefer to slant my portfolio toward value stocks and to keep generous holdings of cash and gold to protect myself. Ms. X: I agree with my father that the uncertain nature of the evolution of the pandemic, especially when contrasted with the demanding valuations of equities, creates many risks for investors. Nonetheless, I do not expect inflation to come back anytime soon. Thus, monetary policy will not become a threat in the near future. Moreover, I am quite optimistic on the earnings outlook. Accordingly, I am more comfortable than my father is with taking some risk in our portfolio this year, even if a slightly larger-than-normal allocation to cash and gold is reasonable. Unlike the BCA team, I believe growth stocks, not value stocks, will generate excess returns from equities in the coming years. Thus, I favor US markets and I am less negative on the US dollar than you are. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach to investing. Nonetheless, many assets have become more expensive this year and long-term inflation risks are increasing. Thus, real long-term returns are likely to be uninspiring compared to recent history. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.0% over the next ten years, or 1.0% after adjusting for inflation. That is a deterioration from our inflation-adjusted estimate of 2.4% from last year, and also still well below the 6.1% real return that a balanced portfolio earned between 1990 and 2020. Table 4Lower Long-Term Returns OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World The uncertainty around the base case scenario for the global economy and asset markets remains very large. Hence, as we did last year, we recommend a list of guideposts to evaluate whether global markets stay on track to generate gains in 2021: The rollout of the vaccines: Much of the outlook will depend on the global health crisis. As the recent weeks have shown, the subsequent waves of COVID-19 are still debilitating and deadly, even if recent lockdowns are not as stringent as in the spring. Thus, if the vaccines take longer to be distributed, the economy will suffer a greater risk of relapse, which will hurt asset prices. Realized and expected inflation: If both realized and expected inflation rise quickly, the market will price in a faster withdrawal of monetary accommodation. The market is too expensive to withstand this shock, which would prove more painful than another wave of lockdowns. A stronger dollar and a flattening yield curve: If these two phenomena develop in tandem, this will indicate that the global economy is suffering another deflationary shock. Because fiscal and monetary authorities remain on guard, this may not force any meaningful equity correction. However, growth stocks and defensive names will outperform the rest of the market. US diplomacy: Starting January 20, a new president will occupy the Oval Office. Markets have rejoiced at the anticipation of a more conciliatory approach by the US toward its allies and commercial partners. If the US proves colder than expected, markets will have to reprice their optimistic take on global relations. Bank health: We expect sour commercial real estate loans to create limited damage to the banking system. If we are wrong, credit standards will tighten further instead of easing. This would be a bad omen for global demand and would suggest that yields have downside and that growth stocks would beat value stocks. Fiscal policy: We expect fiscal policy to remain accommodative next year, even if less so than in 2020. An absence of a deal in Washington and a quicker return to fiscal rectitude in the rest of the world would mean that global growth will be weaker than we expect. This would impact equities negatively, especially value stocks. Ms. X: Thank you for this list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It would be our pleasure. The key points are as follows: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. The uncertainty around the base case scenario for the global economy and asset markets remains very large. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS.   Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. We sincerely hope that next year, we will get to see each other in person instead of via computer screens. Finally, we would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 30, 2020   Footnotes 1  The tickers of the stocks in the “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. 2  The tickers of the stocks in the “COVID-19 winners” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN.

Highlights President Trump’s final actions and the US fiscal impasse pose non-trivial risks to the rally. Biden’s foreign policy cabinet picks have limited impact but are mildly positive for now. Biden’s multilateralism will eventually conflict with the need to get things done. Continuities with Trump foreign policy are underrated. The RCEP trade agreement is not a game changer but a pro-trade shift in the US would be. Europe is a clear winner of the US election but continental politics risk will pick up next year from today’s lows. Book profits on select risk-on trades, but go strategically long GBP-EUR. Feature Global financial markets are surging on a raft of good news. We are booking some gains as we expect the rally to be capped in the near term either by Trump’s final actions as president or by the US fiscal impasse. First, the good news. The US power transition is officially under way, reducing US policy uncertainty. The popular vote within the critical battleground states acted as a restraint on the Republican Party’s ability to dispute the results or appoint Republican electors to the Electoral College.1 Chart 1US And Global Policy Uncertainty Falling US And Global Policy Uncertainty Falling US And Global Policy Uncertainty Falling President-Elect Joe Biden is preparing the US for a return to rule by experts. This will not prevent grand policy errors in the future but it will give confidence to the market today. Biden is nominating a slate of White House advisers and cabinet members who are traditional Democrats or left-leaning technocrats. For example, former Fed Chair Janet Yellen looks to serve as Treasury Secretary, longtime Biden and Barack Obama adviser Anthony Blinken as Secretary of State, and former Hillary Clinton and Obama staffer Jake Sullivan as national security adviser. Biden may nominate a few far-left officials (e.g. for the Labor Department) but the most important positions are quickly filling up with conventional faces, a boon for financial markets. Democrats are unlikely to win control of the Senate on January 5 but even if they do their single-vote majority will probably be too small to enable any radical cabinet picks – or radical legislation.2 The downside is that spending will be constrained and monetary and fiscal policy will remain uncoordinated, regardless of Yellen’s unique ability to work with Fed Chair Jay Powell. With Biden reportedly leaning on House Democrats to cut a COVID fiscal relief deal, there is a 50/50 chance that a $500-$750 billion bill passes in the “lame duck” session of Congress prior to Christmas. This would be a positive surprise. We are not counting on a deal until the first quarter next year. Hence US policy uncertainty will remain elevated. Meanwhile global policy uncertainty could spike again as long as President Trump remains in office and seeks to achieve policy objectives on the way out. Biden does not take office until January 20, but over a 12-month horizon we see a clear case for cyclical sectors and European stocks to outperform defensive sectors and American stocks as a result of Biden’s trade peace dividend, i.e. eschewing sweeping unilateral tariffs (Chart 1). Chart 2Vaccine On The Horizon Keep The Rally At Arm's Length – (GeoRisk Update) Keep The Rally At Arm's Length – (GeoRisk Update) While COVID-19 spikes, consumer wariness, and partial lockdowns will weigh on fourth quarter economic activity, several vaccines are on the way. The latest wave of the outbreak is already rolling over in Europe, which bodes well for the United States (Chart 2). Again, the 12-month outlook is brighter than the near term. Over the long haul, investors also have reason to be optimistic about governance in the developed world. The takeaway from this year is that the US and UK, the two major developed markets that saw right-wing populist movements win big votes in 2016, and two governments whose handling of the pandemic was at best muddled, led the development of vaccines in record time to deal with an entirely novel coronavirus and global pandemic.3 The US constitutional system withstood a barrage of partisan assaults both from President Trump and his supporters and their opponents. The British constitutional system is handling Brexit. Most other developed markets also navigated the crisis reasonably well. Weaknesses were revealed, and there will be aftershocks, but the sky is not falling. Near term US policy uncertainty will remain elevated due to fiscal impasse. Bottom Line: The rise in global risk assets may overshoot on positive news, but the US fiscal impasse could undercut the rally, as could Trump’s parting actions over the next two months. Market Not Priced For Lame Duck Trump There is a fair chance of an American or Israeli surgical strike against Iran or its militant proxies to underscore the red line against nuclear weaponization. Financial markets are not prepared for a major incident of armed conflict. Neither Israeli nor UAE equities are priced for near-term risks to materialize. The same goes for UAE or Saudi credit default swaps (Chart 3). An even greater risk to financial markets comes from the Trump administration’s pending actions on China. Trump is highly likely to take punitive or disruptive actions against China. His major contribution to US foreign policy is the confrontation with China, which was also the origin of the coronavirus and hence his electoral defeat. Already since the election Trump has imposed sanctions on US investments in state-owned enterprises. China’s fiscal and quasi-fiscal stimulus is peaking at the moment. This provides some buffer for its economy and the global economy if Trump hikes tariffs or imposes sweeping sanctions. But there are signs of instability beneath the surface. Authorities have tightened interbank rates sharply and intervened to prevent asset bubbles. The country is seeing turmoil in the bond market as a result of these actions and ongoing economic restructuring (Chart 4). Chart 3Risk Of US Or Israeli Strike On Iran Risk Of US Or Israeli Strike On Iran Risk Of US Or Israeli Strike On Iran Chart 4Chinese Stimulus And Bond Market Volatility Chinese Stimulus And Bond Market Volatility Chinese Stimulus And Bond Market Volatility Once again the market is not prepared for another major shock in the US-China relationship. The People’s Bank has allowed the renminbi to appreciate drastically this year. This trend will reverse if President Trump punishes China. As China’s economic momentum wanes and a new US administration enters office, it would make sense to allow the currency to depreciate. After all, the Biden administration will expect the renminbi to appreciate just as all previous administrations have done, but the People’s Bank will not want the yuan to fall much below the ~6.2 level that prevailed just before the trade war started in early 2018 (Chart 5). Chart 5Renminbi Priced For Zero Trump Tariffs Renminbi Priced For Zero Trump Tariffs Renminbi Priced For Zero Trump Tariffs Biden’s Foreign Policy: Continuities With Trump It is too soon to speak of the “Biden Doctrine.” Cabinet appointments will have limited impact relative to geopolitical fundamentals. Neither Biden nor Blinken have a consistent theme to their foreign policy decisions. Michèle Flournoy may or may not be nominated as Defense Secretary. What is clear is that Biden is in favor of establishment national security policymakers who want the US to work more closely with allies and international institutions. Starting in January, this shift will make US foreign policy somewhat more predictable. On Iran, Biden will seek to rejoin the 2015 nuclear deal prior to the June 18, 2021 Iranian presidential election, but he will also have reason to sustain the Arab-Israel rapprochement that the Trump administration initiated via the Abraham Accords. News reports indicate that Israeli Prime Minister Bibi Netanyahu met with Saudi crown prince Mohammad bin Salman along with US Secretary of State Mike Pompeo in a “secret” meeting on November 23. The Saudis could eventually normalize ties with Israel, but only once an Israeli-Palestinian settlement is reached. The Democrats have a long-running interest in negotiating such a settlement. Progress can be made as long as the Saudis and Israelis do not try utterly to sabotage Biden’s Iran deal. They would risk isolation from American support – an intolerable risk for both states. An American détente with Iran combined with normalized Arab-Israeli relations would create something resembling a balance in the region, which is what the Biden administration needs in order to maintain the “pivot to Asia” that will be its dominant foreign policy agenda. Biden’s pivot to Asia will start with a diplomatic “reset” with China so that strategic dialogue can resume and areas of cooperation can be identified. As Chart 5 above shows, the market is priced for Biden to reduce tariffs back to their September 2018 level (25% on $50 billion of imports and 10% on $200 billion). Anything is possible, since tariffs are an executive decision, but we would not bet on Biden sacrificing all of his leverage when the US-China strategic tensions are fundamentally rooted in the US’s loss of global standing and China’s rejection of the liberal world order. What is clear is an emerging contradiction that Biden will eventually have to resolve between multilateralism and getting things done. The Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. If Biden relies on multilateral diplomacy to update and extend the Iranian nuclear deal, he will find it much more difficult to gain Russian and Chinese cooperation than Obama did. Russia’s interference in the 2016 election and Trump’s trade war have poisoned the well. If Biden does not give enough ground to get Russo-Chinese cooperation, then he will have to use unilateral American power (i.e. Trump’s maximum pressure policy) or just settle for rejoining the 2015 nuclear deal without any safeguards against ballistic missiles or militant proxies. The original deal expires in 2025. Chart 6Greater China Still Center Of Geopolitical Risk Greater China Still Center Of Geopolitical Risk Greater China Still Center Of Geopolitical Risk The same goes for Biden’s handling of Trump’s China policy. Biden wants to revive the World Trade Organization. But if he adheres to the WTO then he will have to rescind all of Trump’s tariffs, since they have been declared illegal. This will reduce his leverage on unresolved structural disagreements. Biden wants to reach out to the allies on how to handle China. It is not clear how he will respond to the Trump administration’s outgoing scheme to create an alliance of liberal democracies that would arrange to purchase each other’s goods and possibly implement counter-tariffs in response to Chinese boycotts, such as the one placed on Australia today. Biden may not adopt the scheme. But the alternative would be to leave states to succumb to China’s political boycotts, thus failing to build an effective multilateral response to China’s aggressive foreign policy. China’s fourteenth five-year plan reveals that the Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. Thus we expect the Biden administration to conduct a foreign policy that is tougher on China than the Obama administration, that retains most of the Trump tariffs and tech sanctions, and that more resolutely attempts to build a coalition to pressure China into adopting international liberal norms. This policy trajectory virtually ensures that Biden will have to adopt some of Trump’s policies. Chinese equities are not priced for this risk. The pronounced risk of a fourth Taiwan Strait crisis is just starting to be recognized (Chart 6). The risk to our view is a grand US-China re-engagement. This is possible, but we think the current trajectory of China will cause a new confrontation even if Biden is less hawkish than Trump. Bottom Line: Financial markets are underrating Chinese/Taiwanese political and geopolitical risks, both from Trump’s lame duck period and from Biden’s pivot to Asia. Did China Just Take Charge Of Global Trade? Several clients have written to ask us about the Regional Comprehensive Economic Partnership (RCEP), a large new free trade agreement (FTA) signed by China and its Asian trading partners. RCEP is not a game changer but it is marginally positive for the global economy. Moreover it has the potential to ignite a new round of trade agreements, for instance by provoking the US (and the UK) to join the Trans-Pacific Partnership. RCEP is a traditional free trade agreement that will cut tariffs by an average of 90% for its members. Membership includes China, Japan, South Korea, the Association of Southeast Asian Nations (ASEAN), Australia, and New Zealand. It has not been ratified and will take ten years to fully implement after ratification. Over the past 30 years, manufacturing-oriented East Asian nations have reflexively responded to global shocks and slowdowns by deepening their trade integration. RCEP shows that this trend remains intact. China is the only member of the pact that is seeing trade grow at the moment – the others are still seeing declines due to the global recession but are hoping to increase nominal growth by removing trade barriers (Chart 7). RCEP is also notable because it is China’s second multilateral trade deal (the first was the China-ASEAN FTA). Beijing normally prefers bilateral deals where its size gives it the advantage, but it is trying to demonstrate greater willingness to work multilaterally. President Xi Jinping has rhetorically positioned himself as an advocate of free trade and multilateralism on the global stage, despite his pursuit of import substitution and state industrial subsidies at home. As long as China continues expanding trade with others it will smooth the painful restructuring of its manufacturing sector and blunt some of the criticisms about mercantilism. Ironically it is Japan’s decision to join, rather than China’s, that makes RCEP distinct. Japan did not have an FTA with South Korea and it was the only member of RCEP that did not already have a free trade deal with China. (Japan also lacked a deal with New Zealand.) This decision is not new but reflects the paradigm shift in Japanese national policy that began after the global financial crisis of 2008. In 2011, Japan signed an FTA with India. Thereafter Abenomics supercharged international trade and investment policies as part of the “third arrow” of pro-growth structural reform, which Abe’s successor Yoshihide Suga is continuing. So why is RCEP not a game changer? Because all of these countries other than Japan already have FTAs with each other and their tariff rates are already quite low. Moreover there is nothing particularly advanced about RCEP. It is a traditional deal focused on trade in goods and does not really attempt anything groundbreaking with services, or to incorporate new industries, lay down standards for labor or environment, or remove non-tariff barriers. Contrast the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the trade deal originated by the United States for Pacific Rim countries that attempts to do all these things, but was hobbled by the Trump administration’s decision to withdraw from it. The real significance of RCEP is that even as it shows continuity in Asian economic policy, with China at the center, it will also provoke new deal-making. Now that China, Japan, and South Korea are joining a single trade agreement, they will have a foundation on which to move forward with their long-delayed trilateral FTA. These developments will provoke the Biden administration into rejoining the CPTPP, which in turn would create a new higher standard type of trade bloc that has the potential to attract democracies into a high-standards bloc that excludes China. Biden will also revive the Transatlantic Trade and Investment Partnership (TTIP), the European counterpart to the Pacific deal. On the campaign trail, Biden said that he would “renegotiate” Trans-Pacific Partnership in order to rejoin it, a Trumpian formulation. This is feasible. After the US withdrawal, the various members of the Trans-Pacific Partnership modified the deal (dubbing it the CPTPP) to remove provisions that the US had insisted on and restore provisions that the US had demanded they remove. But they will gladly readmit the US now that Trump is gone, creating a trade bloc of comparable size to RCEP but with much more ambitious aims (Chart 8). The UK, South Korea, Thailand and others will be interested in joining. But China can only join if it embraces liberal reforms that are at odds with its new five-year plan, including reduced support for state-owned enterprises. Chart 7Weak Trade Prompts Asian Trade Deal Weak Trade Prompts Asian Trade Deal Weak Trade Prompts Asian Trade Deal Chart 8Putting RCEP Into Perspective Putting RCEP Into Perspective Putting RCEP Into Perspective The Republican Senate will be required to get approval for CPTPP, which is an obstacle, but Biden’s secret weapon is that the CPTPP has special appeal for Republicans precisely because it excludes China. Pro-trade moderates will find common cause with China hawks. As long as Trade Promotion Authority is renewed by the deadline on July 1, 2021, then the US can rejoin CPTPP on a simple majority vote. This is precisely how Republicans ratified Trump’s USMCA (the revised NAFTA). Trump also signed a trade deal with Japan, revealing that even under Trump’s leadership the US agreed to TPP-like deals with its biggest trading partners within the CPTPP (Canada, Mexico, Japan). More broadly, Trump’s experiment with protectionism has revealed that American attitudes toward global trade are not uniformly hostile. Polls show that Americans are generally pro-trade, and while they are skeptical that global trade creates jobs and higher wages, they are mostly skeptical of business-as-usual with China.4 Geopolitically, the US will not be able to stand idly by while China increases its sphere of influence in Asia. Therefore we should expect the Biden administration to pursue the CPTPP and other trade initiatives. The GOP Senate is the key constraint but it is not utterly prohibitive. Bottom Line: China and Asia continue to expand trade in the face of economic slowdown. The US Senate will be the key bellwether for US trade initiatives in 2021-22, but the geopolitical need to counter China will likely force the US to rejoin the CPTPP. Strategically we are long CPTPP equities – which includes some key RCEP members – as well as RCEP equities like South Korea. Chinese equities have already rallied a lot this year due to the country’s better handling of the pandemic and quicker economic recovery – they also face headwinds from US policy. Whereas emerging Asia equities ex-China, relative to all global equities, have plenty of catching up to do and will be beneficiaries of a global recovery in which both the US and China are courting them. Not Too Late To Go Long Pound Sterling The Brexit finale is approaching as the UK and EU enter the eleventh hour in their negotiation of a post-Brexit trade deal for the period after December 31, 2020. The market expects the UK, which is more dependent on EU trade than vice versa, to capitulate to an agreement that prevents a 3% tariff hike on all of its exports to the EU. This hike would occur if the UK-EU relationship reverted to WTO Most Favored Nation status. Boris Johnson promised in the Conservative Party manifesto to negotiate a trade deal and won a resounding single-party majority in December 2019. This gives him the room to marginalize hard Brexiteers and get a deal passed in parliament. The pound has rallied by 1.45% against the dollar since the beginning of the year and it is now rallying against the euro, moving off the “hard Brexit” lows (Chart 9), suggesting that the market is tentatively anticipating a trade deal. Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside UK-EU Trade Deal Expected, But GBP-EUR Offers Upside UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside UK-EU Trade Deal Expected, But GBP-EUR Offers Upside UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Failing to get a trade deal would require Johnson to break the EU withdrawal deal, since that deal requires a system of trade checks on the Irish Sea that introduces a barrier between Northern Ireland and the rest of the United Kingdom. Johnson has no incentive to stick to this deal if he does not have privileged access to the EU’s single market. But then a hard border of physical customs checks would arise on Northern Ireland’s border with the Republic of Ireland. This would not only aggravate relations with Ireland and the EU but would alienate the incoming American administration, which would view it as a violation of the US-brokered Good Friday Agreement (1998) and refuse to agree to a trade deal with the UK. Irish equities are not behaving as if a 3% tariff on all imports from the UK is about to take effect (Chart 10). Both GBP-USD and Irish equities have considerable downside if the deal falls through. The fact that the GBP-EUR appreciation is slight suggests less downside and more upside here. Subjectively we have argued there is a 35% chance that the UK will quit the EU “cold turkey” at the end of the year. The cost of more than $6 billion in foregone trade, which would grow each year, is not prohibitive. The economy is already subsisting on monetary and fiscal stimulus due to COVID-19. Boris Johnson does not face an election until 2024. The hardest limitation facing the UK is the relationship with Scotland. The hardest limitation facing the UK is the relationship with Scotland. Northern Ireland is not likely to leave anytime soon but 45% of Scots voted for independence in 2014. Support for independence meets resistance at 50% of the population (Chart 11), but an economic shock stemming from a failure to get a trade deal would push it above the limit (given that 62% of Scots never wanted to leave the EU in the first place). Chart 10Irish Equities Already Priced UK Trade Deal Irish Equities Already Priced UK Trade Deal Irish Equities Already Priced UK Trade Deal Chart 11Scotland Drives UK Toward A Trade Deal Scotland Drives UK Toward A Trade Deal Scotland Drives UK Toward A Trade Deal Johnson has the ability to conclude a deal, avoid an economic shock on top of COVID, keep the Scots in the union, and then set about overseeing his government’s mammoth economic recovery plan. His popularity is tenuous enough that the other pathway is not only more economically costly but also more likely to get him unseated and potentially to burden him with the legacy of being the last prime minister of a united kingdom. Bottom Line: It is not too late to go long GBP-EUR. A near-term global risk-off move would work against this trade but it is a strategic opportunity. Low EU Political Risk Will Pick Up In 2021 In our annual outlook for 2020 we highlighted how the EU was relatively politically stable while its geopolitical competitors – Russia, China, even the US – were far from stable. Today this is still the case – Europe’s political fundamentals are fine. But risks are rising due to partial COVID lockdowns, fiscal risks, and the approach of a series of important elections from now through 2022. A major problem for the global economy is the looming contraction in fiscal deficits in 2021 as economies step down from this year’s extraordinary fiscal stimulus measures. This downshift will be especially disruptive for the US, UK, and Italy due to the size of their stimulus packages, resulting in a fiscal drag of 5% of GDP if no additional measures are taken. But even Germany, France, and other EU members face at least a 2.5% of GDP contraction (Chart 12). Chart 12Europe's Fiscal Cliff Needs Attention Europe's Fiscal Cliff Needs Attention Europe's Fiscal Cliff Needs Attention Chart 12Europe's Fiscal Cliff Needs Attention Europe's Fiscal Cliff Needs Attention Europe's Fiscal Cliff Needs Attention Adding more fiscal support should be feasible in a world where the Fed and ECB are maintaining ultra-dovish monetary policy for the foreseeable future and the EU has agreed to allow mutualized debt issuances. Germany has embraced deficit spending in the wake of the austerity-laden 2010s, which brought significant populist challenges to the European political establishment. However, developed market economies are still highly indebted, a constraint on deficits, and those with political blockages could still have trouble passing large enough spending measures to remove the impending fiscal drag. The US faces gridlock in 2021 and therefore its fiscal cliff is a significant headwind to financial markets. One positive factor in providing fiscal support thus far is that, with the exception of Spain and the UK, European leaders and ruling coalitions have received a bounce in popular opinion this year (Chart 13). Chart 13EU Leaders’ Approval Bounced – Now What? Keep The Rally At Arm's Length – (GeoRisk Update) Keep The Rally At Arm's Length – (GeoRisk Update) Mark Rutte and his People’s Party for Freedom and Democracy (VVD) have benefited more than other countries but the combined support for opposition parties is rising ahead of the March 17, 2021 general election (Chart 14, top panel). A leading anti-establishment candidate has dropped out of the race. Fiscal measures will depend on the election. Chart 14Will EU Elections Really Be A Cakewalk? Will EU Elections Really Be A Cakewalk? Will EU Elections Really Be A Cakewalk? Chart 15European Risk To Rise On Looming Elections European Risk To Rise On Looming Elections European Risk To Rise On Looming Elections The German and French governments have also seen a bounce in support but need to maintain it for a longer period, as they have elections due by October 24, 2021 and May 13, 2022 respectively. French President Emmanuel Macron can still summon majorities in the National Assembly, despite losing his single party majority, and has sidelined his structural reform agenda to boost the economy. Germany is also capable of passing new measures, and has time to do so before momentum wanes amid the contest to succeed Chancellor Angela Merkel. The leadership race in the ruling Christian Democratic Union will at least raise hawkish rhetoric (Chart 14, middle panels). But markets will be placated by the fact that popular opinion is not pro-austerity at present, and the alternative to the CDU is a fiscally profligate left-wing coalition consisting of the Greens, Social Democrats, and possibly the anti-establishment hard-left, Die Linke. Spain and Italy have the least stable governments, are the likeliest to see snap elections, and thus could surprise the market with fiscal risks. Both governments lack a strong mandate and rule over a divided political scene. Italy’s Prime Minister Giuseppe Conte has seen a swell of support but he is a fairly non-partisan character and his coalition has been flat in opinion polling. It is less popular than the combined right-wing opposition, which is striving for power ahead of the fairly consequential 2022 presidential election. In Spain, not only has popular approval dropped, but the Socialist Party and the left-wing Podemos run a minority government, meaning that there is potential for gridlock to increase fiscal risk (Chart 14, bottom panels). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections (Chart 15). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections. The silver lining is that Brussels, Berlin, and the wider political establishment have become fundamentally more accepting toward budget deficits during times of distress. The ECB and European Commission Recovery Fund provide a combined monetary and fiscal backstop. Negative interest rates on debt enable fiscal largesse with minimum implications for sustainability. And none of these elections raise systemic risks regarding EU and EMU membership, other than conceivably Italy. So while fiscal risk will become more relevant in 2021, it is not a problem while COVID is still raging, and there are better chances of maintaining a fiscally proactive policy than at any previous time over the past two decades. Bottom Line: European elections and a looming fiscal drag will keep EU political risk from collapsing after the latest round of lockdowns ease. Biden And Emerging Market Strongmen Most of the emerging market strongmen – Recep Erdogan, Vladimir Putin, Jair Bolsonaro – have increased their popular support this year, benefiting from national solidarity in the face of crisis. The exception is Narendra Modi, who is struggling (Chart 16). Still, Modi has a single-party majority and four years on the election clock, and is thus more stable than Bolsonaro, who fundamentally lacks a political base despite his bounce in polls, and Erdogan, whose increase in support will fade amid a host of domestic and international challenges ahead of the 2023 elections. The US election will have limited impact on these leaders. None of them have good relations with the Democratic Party and some were openly pro-Trump. But this is only marginally negative and may not have concrete ramifications. The key is that the Biden administration will be more conducive toward a global trade recovery, will relax restrictions on immigration, will favor US diversification away from China, and will put pressure on authoritarian regimes. Chart 16Strongman Popularity Boost Will Fade Keep The Rally At Arm's Length – (GeoRisk Update) Keep The Rally At Arm's Length – (GeoRisk Update) Other things being equal, Biden is therefore positive for India, neutral for Brazil and Turkey, and negative for Russia. Our GeoRisk Indicators suggest that political risk has peaked for Brazil and Russia and equities could bounce back, but we think Russian political risk will surprise to the upside (Chart 17). Chart 17Political Risk Still High In Emerging Markets Political Risk Still High In Emerging Markets Political Risk Still High In Emerging Markets In the case of Russia, the Biden administration will take a more confrontational approach than previous presidents, including Obama and Bush as well as Trump. However, it still needs to rejoin the Iran nuclear deal and extend the New START (Strategic Arms Reduction Treaty) with Russia through 2026, so the pro-democracy pressure campaign will have to be balanced with negotiations. Russia, for its part, is increasingly focused on the need for domestic stability, at least until Biden makes concrete steps with NATO that threaten Russian core interests. Bottom Line: Emerging market political risk is high, the vaccine will arrive more slowly, and the Biden administration will take a tougher approach toward authoritarian regimes. This creates an opportunity for India but a risk for Russia, and is neutral for Brazil and Turkey. Strategically we are constructive on EM equities but in the near 0-3 month time frame all bets are off. Investment Recommendations With clear near-term political and geopolitical risks, and extremely elevated equity prices and sentiment, we think it is a good time to book some profits. We are closing our long global equities relative to bonds trade for a gain of 27%. Chart 18Reinitiate Long Global Aerospace/Defense Stocks Reinitiate Long Global Aerospace/Defense Stocks Reinitiate Long Global Aerospace/Defense Stocks We are closing our long investment grade corporate bonds relative to similarly dated Treasuries for a gain of 15%. We are closing our long China Play Index trade for a gain of 7% in recognition that China’s stimulus is nearing its peak while the Trump administration will take punitive measures in his final two months. We will also retain our long gold trade. Gridlock in the US government is not reflationary but gold is still attractive due to geopolitical risk. Strategically we recommend going long GBP-EUR. We also recommend reinitiating a strategic long position in defense stocks. Specifically, global aerospace and defense stocks relative to the broad market (Chart 18). We have been long defense stocks since 2016 but COVID decimated the trade. The coming vaccines promise to reboot the aerospace part of this trade while there was never any reason to doubt the strong basis for global defense spending amid geopolitical great power struggle.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Black Wave “What happened to us?” Black Wave seeks to answer the cardinal question facing both Middle Easterners and those looking into the Middle East from the outside.5 It takes us back four decades to events that shaped the region and walks us through time and space, politics, religion, history and culture, to where we stand – in the crosshairs of the very clash that started it all. Few are better equipped than author Kim Ghattas in doing so. A native of Beirut, she grew up amid the Lebanese civil war, living the events that created the post-1979 Middle Eastern reality. Later, she spent two decades covering the Middle East as a journalist for the BBC and Financial Times. A term first coined by Egyptian filmmaker Youssef Chahine, “black wave” characterizes the religious tide that swept Egypt in the 1990s from the Persian Gulf – one that Chahine saw as alien to Egyptians. Instead he argued that while Egyptians had always been very religious, they also had joie de vivre – enjoying art, music, talent, all taboos according to the Wahhabi interpretation of Islam. Iranians in the late 1970s were not much different from Egyptians in the 1990s. At the time, they were unified in their opposition to the Pahlavi dynasty for being too Western and corrupt. As an exile in the sacred Iraqi city of Najaf and later in the French village of Neauphle-le-Chateau, Ayatollah Ruhollah Khomeini’s speeches were capable of inspiring minds, galvanizing support, and gathering crowds. He was the right character, at the right time, but with the wrong ideas. Ideologically, Khomeini was an outsider in Najaf. The Iraqi clergy considered him too politically involved and his vision of wilayat al-faqih – a state based on Islamic jurisprudence – did not have widespread appeal. It was dismissed as outlandish by those around him who aimed to take advantage of his widespread appeal for their own gains, while hoping to limit Khomeini’s ideological influence on his audience. This proved to be a grave disregard for Iranians. 1979 was also a transformative year for Saudi Arabia. The young monarchy faced a national awakening as Juhayman al-Otaybi staged a siege on the Muslim world’s most sacred site, the Grand Mosque in Mecca. It was the first act of terrorism in opposition to Western influence – the birth of Saudi extremism – and was echoed in subsequent acts of violence in the kingdom, in 1995 and later in 2003. Fearing the spread of political Islam, the House of Saud responded by emphasizing Wahhabism, Riyadh’s homegrown Islamic movement, by empowering clerics and religious authorities. The quid pro quo was that the clerics supported the monarchy from both internal and external threats. The clash between the Iranian Revolution and Saudi Wahhabism in 1979 gave rise to the first sectarian killings. The 1987 Sunni-Shia clash in Pakistan marked the beginning of the modern day Sunni-Shia divide, spreading through Pakistan and eventually the Middle East to Lebanon, Iraq, and Syria. Today, as youth across the Middle East struggle in despair of the aftermath of these events, Ghattas sees hope. Protests ringing from Beirut to Baghdad call for a post sectarian political system. The Saudi monarchy is relaxing its puritanical grip, and a new generation brings newfound hope of rectifying past miscalculations. We ultimately agree with Ghattas’s optimism that these changes are hopeful indications that the people of the Middle East are ready to shift gears and move past the conflicts that have dominated the past four decades. However, there are other forces at play and the Saudi-Iranian rivalry is still a dominant feature of the region’s geopolitical landscape. True, Ghattas’s account not only highlights how deeply engrained the conflict is, but also that the early signs of tidal shifts can be easily missed. But we cannot ignore the specter of near-term risk facing the Middle East that continue to challenge its economic and political ascent. Thus, from an investment standpoint, we favor a more cautious approach and remain on the lookout for a better entry point once the near-term manifestation of these long-standing hurdles are overcome.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Supreme Court could still rule that Pennsylvania should have stuck with its November 3 deadline for ballots, but such a ruling would not change the outcome of the election. As with Florida following the disputed election in 2000, the various states’ electoral systems will likely be stronger as a result of this year’s polarized contest and narrow margins. 2 Biden could use the Vacancies Act or recess appointments to ram through his cabinet picks, but it would be controversial and at present he looks to be taking advantage of the Republican veto to nominate center-left figures that are more ideologically lined with his lane of the Democratic Party. 3 US-based Moderna developed one vaccine while US-based Pfizer and Germany-based BioNTech developed another. The Anglo-Swedish company AstraZeneca jointly developed its vaccine with Oxford University. Vaccine trials were administered across these countries and others, including South Africa, India, Brazil, and the entire global health care and pharmaceutical supply chain contributed. 4 See Pew Research. 5 Kim Ghattas, Black Wave: Saudi Arabia, Iran, and the Forty-Year Rivalry That Unraveled Culture, Religion, and Collective Memory in the Middle East (New York: Henry Holt, 2020), 377 pages. Section II: GeoRisk Indicators China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator   Section III: Geopolitical Calendar

Highlights There is some evidence that the euro could gravitate to 1.50 over the next few years. The key assumption is that the equilibrium rate of interest will rise in the euro area relative to that in the US. Our bias is that fair value for the euro is closer to 1.35, or 15% above current levels. Over the very near term, the risks are tilted towards the downside. But while EUR/USD could punch below 1.15, an undershoot towards parity is highly unlikely. In our FX portfolio, we are long EUR/CHF and short EUR/GBP. We would buy the euro outright below 1.15. Feature The markets have rejoiced at the success of a few vaccine trials and are looking forward to a return to normalcy in 2021. Around the world, equity markets have rallied in symphony. Even secular dogs such as the Japanese Nikkei, which has been in a relative bear market for many decades, broke to fresh 21-year highs. Copper prices are rising fervently, and measures of risk, such as the VIX index or high-yield corporate spreads, are collapsing to pre-pandemic levels both in the US and Europe. As a procyclical currency, the euro has also been quite cheerful. Bullish sentiment on the euro is at a decade high and the currency has rallied 11% from the lows, commensurate with the drop in the DXY index (Chart 1). As a share of total open interest, 80% of speculators are bullish on the euro. Historically, sentiment at this level has been usually associated with the euro being closer to 1.50. Chart 1Sentiment On The Euro Is Elevated Sentiment On The Euro Is Elevated Sentiment On The Euro Is Elevated Chart 2The Euro Is Lagging Copper Prices The Euro Is Lagging Copper Prices The Euro Is Lagging Copper Prices The juxtaposition of much welcomed good news and elevated sentiment sets the euro in a very precarious tug of war. Standard theory suggests that the post-pandemic trade may already be priced into the common currency, given bullish sentiment. This augurs for a reversal. On the other hand, other measures also suggest that the rally in the euro has more room to run. For example, copper prices and the euro have tended to move together, and the red metal suggests EUR/USD should be above 1.20 (Chart 2). Similarly, EUR/JPY has lagged the stellar performance of global equity prices. Is the lagging performance of EUR/USD sending the right signal, suggesting caution? Or is the common-currency a coiled spring ready to head much higher in 2021? How To Forecast The Euro According to Bloomberg forecasts, the euro will be at 1.25 by the end of 2022 (Chart 3). By our reckoning, these forecasts are much too pessimistic. The key driver of the EUR/USD exchange rate is the relative growth profile between the euro area and the US, how that profile is likely to evolve in the future, and the implication for relative monetary policies. Anything else that tries to predict the euro is a subset of this much bigger question. How is growth in the euro area likely to evolve compared to the US? There are many ways to approach this issue, with surprisingly similar results. The key driver of the EUR/USD exchange rate is the relative growth profile between the euro area and the US. The first is just to take the IMF growth estimates at face value. According to the Fund, the euro area economy is projected to contract by 8.3% this year, almost double that of the US, which is 4.3%. But by next year, the economy is expected to bounce back more fervently. Euro area growth is expected to advance by 5.2% compared to 3.1% in the US. Much of the rise will be due to a surge in investment within the euro area, especially driven by pent-up demand in the peripheral countries. This growth acceleration is projected to continue well into 2023. Back-of-the envelope calculations suggest that this will pin EUR/USD around 1.35 (Chart 4) Chart 3Few Expect The Euro Above 1.25 Few Expect The Euro Above 1.25 Few Expect The Euro Above 1.25 Chart 4EUR/USD And Relative Growth EUR/USD And Relative Growth EUR/USD And Relative Growth The Case For European Growth We tend to side with the IMF’s forecasts and even argue that this might actually be on the conservative side for the euro area. There are two major reasons for this, both of which are bilaterally important. First, the neutral rate of interest in the euro area may have moved a step function higher relative to the US. The standard dilemma for the euro zone is that interest rates have always been too low for the most productive nation, Germany, but too expensive for others, such as Spain and Italy. The silver lining is that the European Central Bank (ECB) has now lowered domestic interest rates and eased policy to the point where they are accommodative for all euro zone countries.1 Bond yields in peripheral Europe are collapsing relative to those in Germany and France (Chart 5). This makes it much easier for the less-productive, peripheral countries to borrow and invest. This will boost productivity, lifting the neutral rate. Chart 5The Neutral Rate In The Euro Area The Neutral Rate In The Euro Area The Neutral Rate In The Euro Area Second and equally important, the periphery has become as competitive as the core. Through labor market reforms, internal devaluation, and recurring recessions throughout the last decade, unit labor costs in Greece, Ireland, Portugal, and Spain have converged with that in Germany and France. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades (Chart 6). Even Italy, which remained saddled with a rigid and less productive workforce, has seen unit labor costs begin to crest. Chart 6Southern Europe Is Competitive Again Southern Europe Is Competitive Again Southern Europe Is Competitive Again According to the Holston-Laubach-Williams estimates at the NY Fed, the natural rate of interest in the euro area is now higher than in the US, something that has rarely occurred over the 20-year history of the common currency. Based on these estimates, the euro could gravitate towards 1.50 (Chart 7). Chart 7EUR/USD And The Neutral Rate EUR/USD And The Neutral Rate EUR/USD And The Neutral Rate US Versus Europe Chart 8Productivity In Europe Has Lagged Productivity In Europe Has Lagged Productivity In Europe Has Lagged In today’s world, 1.50 for the euro is certainly very high and will surely stir up some action from the ECB well before we approach these levels. As most of my colleagues would argue, no central bank wants a strong currency.2 But how can we gauge the above premise that the neutral rate of interest should be higher in the euro area due to the tectonic shifts over the last few years? One way is to look at trend productivity growth. Since the 1960s, up until the Great Financial Crisis, trend productivity growth was around 2.2% in the US and 2.8% in the euro area. However, since 2009, productivity growth has been 0.6% per year in the euro area and 1.1% in the US (Chart 8). In other words, the European debt crisis has substantially subdued productivity growth in the euro area. If indeed the crisis is behind us, and we assume European productivity growth returns back to trend over the next 10 years, while making up for the shortfall relative to the US, this will pin it at roughly 1.6% higher in Europe relative to the US. Cumulatively, that is a rise of around 20%. Meanwhile, we highlighted last week that the euro was undervalued by over 10%.3 This pins the euro above 1.50. The Euro At Parity And Inflation Chart 9US Versus Euro Area Inflation US Versus Euro Area Inflation US Versus Euro Area Inflation While the euro might gravitate higher in the next few years, it is unlikely to do so in a straight line. Meanwhile, deflation is a key near-term threat for the euro (Chart 9). With the ECB clearly telegraphing that it will do more easing in December, the relative monetary policy stance is not favorable. That said, there are three key points to consider about inflation. First, most G10 central banks were unable to meet their inflation mandate when output gaps were closing and the economy was at full employment. This makes it less likely they will meet their mandate anytime soon. This is not just an ECB problem, but one for the Fed, BoJ, and even the RBA. Second, inflation tends to be a global phenomenon in the developed world, meaning desynchronized cycles in inflation dynamics are quite rare. Finally, with balance sheets expanding everywhere in the G10, the potential for higher inflation once output gaps close will be universal. European productivity growth will have to outpace that in the US by roughly 1.6%, to play catch up. Going forward, an agreement on the mutualization of European debt means we can begin to expect more synchronized business cycles as fiscal stabilizers kick in. The reason is that both fiscal and monetary policy can now be synchronized across member states. This makes shortfalls in inflation less likely. Finally, while deflation can be a sign of an expensive currency, there is little evidence that this is the case for the euro. The euro area continues to sport very healthy trade and current account surpluses, a sign that the euro remains very competitive among its trading partners. Intra-European trade represents a large share of cross-border transactions in Europe, meaning currency considerations are less important. In 2019, most member states had a share of intra-EU exports of between 50% and 75%. The bottom line is that disappointing inflation dynamics could lead to a knee-jerk selloff in the euro, but this should be an opportunity to accumulate long positions. The Cyclical Catalyst Ultimately, European growth is cyclically tied to export growth. And with a huge concentration of cyclical sectors, such as financials, industrials, materials and energy, in European bourses, the euro tends to be largely driven by pro-cyclical flows. Earnings revisions between the euro area and the US have generally led the EUR/USD exchange rate by about 9-12 months (Chart 10).  Chart 10EUR/USD Tracks Relative Profits EUR/USD Tracks Relative Profits EUR/USD Tracks Relative Profits So far, the signs are positive. The impulse from Chinese credit is providing a release valve for European exports (Chart 11). So even if social distancing remains in place for longer than people expect, it still allows economies that are geared more towards manufacturing such as Europe, Japan, and China to keep churning higher. This could boost European earnings in a meaningful way. Chart 11Chinese Demand For European Goods Chinese Demand For European Goods Chinese Demand For European Goods Fortunately for investors, European equities, especially those in the periphery, remain unloved, given that they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world (Chart 12A). Over the next decade, it would be surprising if some of these “old economy” stocks did not unwind their discount via both rising earnings and multiples. Many emerging markets, including China, still depend on “old-economy” materials such as oil, and industrial machinery, that Europe sells. The impulse from Chinese credit is providing a release valve for European exports. Even in the commodity space, cyclical metals like copper are still massively underperforming safe havens like gold. This has largely  tracked the discount between European stocks and US stocks. A bet on a reversal could prove very profitable (Chart 12B).   Chart 12AEuro Stocks Are Cheap Euro Stocks Are Cheap Euro Stocks Are Cheap Chart 12BEuro Stocks Could Rerate Euro Stocks Could Rerate Euro Stocks Could Rerate Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, "EUR/USD And The Neutral Rate Of Interest," dated June 14, 2019, available at fes.bcaresearch.com 2 Please see Global Fixed Income Strategy Weekly Report, "Nobody Wants A Strong Currency," dated November 17, 2020, gfis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "Updating Our PPP Models," dated November 13, 2020. fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights In the first nine months of 2020, China's capital outflows, measured by the Balance of Payments (BoP) data, have been the largest since 2016. Unlike 2016, the outflows are mainly driven by a strategic accumulation of foreign currency (FX) assets by domestic entities rather than capital flight. Chinese banks may have been using some of their FX holdings and transactions to slow the pace in the RMB appreciation.  The RMB can still devalue relative to the USD in the next two months, but in the next 6-12 months, the RMB should continue to revert to its pre-trade war value. Feature Chart 1Large Capital Outflows Despite A Strong RMB Large Capital Outflows Despite A Strong RMB Large Capital Outflows Despite A Strong RMB China’s official BoP data imply that approximately $200 billion capital left the country in the first three quarters of the year, the largest amount since 20161 (Chart 1). The large capital outflows occurred when China’s post COVID-19 economic recovery was strengthening, the current account surplus was surging, and both direct and portfolio investment flows were net positive.  Moreover, unlike 2015-16 when capital outflows were driven by, and in turn, reinforced the depreciation in the Chinese currency, the RMB has been strengthening against the USD. In this report, we examine China’s BoP data and related figures, and use the framework from a previous Special Report to assess China’s capital outflows.2 Our research shows that at least a good portion of the capital outflows was likely an effort by Chinese policymakers to slow the pace of the RMB’s appreciation against a basket of its trading partners’ currencies. A Puzzling BoP Picture Official BoP data shows that China’s current account surplus was $170 billion in the first three quarters of this year, and net FDI and portfolio flows totaled at $54 billion. The surplus has been mostly offset by an estimated $155 billion of “Other Investment” outflow in the non-reserve FX account and $53 billion in Net Errors and Omissions (Table 1). Table 1China’s Balance Of Payments Demystifying China’s Capital Outflows Demystifying China’s Capital Outflows During the 2015-16 period, large outflows were driven by reduced foreign inflows, domestic firms paying down US dollar debt, and enterprises and households moving their assets overseas.  This time, however, the outflows appear to be largely government driven and strategic FX asset accumulations, and most likely through Chinese state-owned banks and institutional investors. Chart 2FX Settlement Has Been Net Positive FX Settlement Has Been Net Positive FX Settlement Has Been Net Positive Chart 2 shows a positive net FX settlement rate by banks on behalf of clients. This means more non-financial enterprises (such as exporters and investors) sold their foreign exchange holdings to banks than bought foreign exchange from banks. This is drastically different from the deep contraction in the net settlement data following the RMB devaluation in August 2015. Chart 3 also highlights that the level of Chinese firms’ short-term foreign obligations (outstanding foreign currency loans, trade credit and liquid deposits) has remained steady this year. This implies that domestic firms are not rushing to pay off their external debt as was the case in 2015/16. Chart 3Chinese Firms Are Not Rushing To Pay Off External Debt Demystifying China’s Capital Outflows Demystifying China’s Capital Outflows Chart 4Relatively Low Level Of Illicit Capital Outflows Relatively Low Level Of Illicit Capital Outflows Relatively Low Level Of Illicit Capital Outflows Moreover, service trade deficits from outbound tourism have narrowed substantially due to international travel restrictions, which have made it difficult for Chinese residents to move capital out of the country. Additionally, the illicit capital outflows through import over-invoicing are very low (Chart 4). Hence, a large negative reading in the “Other Investment” and “Net Errors and Omission” categories implies an accumulation of FX assets by China’s banks and intuitional investors. The net FX asset accumulation by commercial banks was $117 billion in the first nine months, largely offsetting the $170 billion current account surplus in the same period. A closer examination of BoP data also shows that in June the PBoC recorded a $118 billion fund transfer from a FX asset balance sheet, which has otherwise been flat over the past five years. It is unclear where the funds have gone, but coincidently the amount matches a $118 billion outflow in the BoP’s non-reserve FX assets during the same quarter (Chart 5). China’s non-reserve FX assets3 are mostly in offshore investment and lending, which is intermediated by a small group of state-owned entities. Given that external lending through China’s banks and financial institutions has slowed in the post-COVID-19 environment, direct and portfolio investments must have been the main sources of the FX asset accumulation (Chart 6). Chart 5Unexplained FX Fund Transactions Unexplained FX Fund Transactions Unexplained FX Fund Transactions Chart 6No Sign Of Extended Loans Or Trade Credit No Sign Of Extended Loans Or Trade Credit No Sign Of Extended Loans Or Trade Credit Capital Outflows As An Exchange Rate Stabilizer The sharp rise in the trade surplus and foreign capitals into China’s bond market this year explains the upward pressure on the RMB. Chinese policymakers may have been trying to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by large state-owned banks and other financial institutions. Following the devaluation of the RMB in August 2015, China had to liquidate a quarter of its official FX reserves to defend the currency. The rapid depletion in the official reserves fueled market jitters and reinforced the RMB depreciation. The FX assets held by China’s state-owned banks and institutional investors, on the other hand, can mostly fly under the radar and, in recent years, may have become the policymakers’ preferred channel of regulating fluctuations in the currency market. We tested this theory by assessing the relationship between the net FX purchases by China’s banks and the RMB exchange rate against the USD and a basket of its trading partners’ currencies (measured by the CFETS index). The latter is the exchange rate reference regime that China switched to in 2017.4 The official “net FX settlement by bank itself” data series represents the difference between the banks’ purchases and sales of foreign exchange in the interbank system. We exclude settlements and sales by banks on behalf of clients to filter out the demand for FX from enterprises and households. Chart 7 shows that, prior to 2018, the banks’ net FX purchases ticked up when the RMB appreciated against the USD, and banks sold more FX when the USD rose against the RMB. The interventions intended to slow the market move in either direction to keep the USD/CNY exchange rate swings within the PBoC’s comfort zone. Chart 7Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Chart 8Since 2018 China Targeted A Basket Of Currencies Since 2018 China Targeted A Basket Of Currencies Since 2018 China Targeted A Basket Of Currencies Interestingly, the tight relationship loosened somewhat after 2018. On several occasions, banks made more FX purchases even when the RMB was weakening against the USD. It appears that since US tariffs on Chinese goods began in 2018, Chinese policymakers have been more willing to allow market forces drive down the RMB in relation to the USD. Meanwhile, China has targeted a relatively stable value of the RMB against a basket of its trading partners’ currencies in the CFETS index. As Chart 8 (top panel) illustrates, since 2018, net FX purchases by Chinese banks have been more tightly correlated with the spread between the CNY/USD exchange rate and the CFETS index (both rebased to December 2014=100). When the RMB falls relative to the USD but not by enough to slow its increase against other trading partners, China’s banks would ramp up their FX purchases to push down the CNY/USD exchange rate or raise the value of other currencies in the CFETS basket (Chart 8, bottom panel). Investment Conclusions Chart 9Mean Reversion In The USD/CNY Will Continue Mean Reversion In The USD/CNY Will Continue Mean Reversion In The USD/CNY Will Continue The market sentiment has been overwhelmingly bullish on RMB. Partially, the CNY/USD market has been pricing in the possibility of a Biden administration in the US, and improved Sino-US relations. In our view, the RMB has not moved into outright expensive territory and will continue to revert to its pre-trade war value against the USD in the next 6-12 months (Chart 9). In the next two months, however, the RMB may still give back some of this year’s gains against the USD. A contested US election may bring negative surprises to the global financial markets. The COVID-19 pandemic also remains a headwind in Europe and North America until a vaccine is widely available. As such, the USD will likely have a near-term countercyclical rebound. In fact, a depreciation in the RMB would be a boon to China’s domestic economy as it currently faces disinflationary pressures. Meanwhile, the net FX settlement among Chinese banks has been trending sideways in the past three months, which signals that Chinese policymakers may be comfortable with the RMB’s current value. We think China will allow the RMB to appreciate against the USD as long as the RMB does not climb too rapidly against the basket of other major currencies. If the upward pressure on the RMB continues to push the CFETS index higher, then China may choose to step up its purchases of FX assets. Assets in Euro, the Japanese Yen, and the Korean Won may be high on the shopping list (Chart 10 and Chart 11). Chart 10China May Step Up Purchases Of Other Major Currencies China May Step Up Purchases Of Other Major Currencies China May Step Up Purchases Of Other Major Currencies Chart 11The CFETS RMB Index Composition Demystifying China’s Capital Outflows Demystifying China’s Capital Outflows     Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1Based on the Balance Of Payments methodology, short-term capital outflows = current account surplus + changes in reserve assets + direct investment ≈ net flows in portfolio investment + net flows in other investment + net errors & omissions. 2Please see China Investment Strategy Special Report "Monitoring Chinese Capital Outflows," dated March 20, 2019, available at cis.bcaresearch.com 3FX assets held at banks and financial institutions other than the PBoC. 4CFETS RMB Index refers to CFETS (China Foreign Exchange Trade System) currency basket, including CNY versus FX currency pairs listed on CFETS. The sample currency weight is calculated by international trade weight with adjustments of re-export trade factors. The sample currency value refers to the daily CNY Central Parity Rate and CNY reference rate. Cyclical Investment Stance Equity Sector Recommendations