Economic Growth

Your feedback is important to us. Please take our client survey today. Highlights For now, there is little evidence that the pandemic has adversely affected the global economy’s long-run growth potential. Even if one counts those who will be unable to work due to long-term health complications from the virus, the pandemic will probably reduce the global labor force by only 0.1%-to-0.15%. Labor markets have healed more quickly over the past few months than after the Great Recession. In the US, the ratio of unemployed workers-to-job openings has recovered most of its lost ground. Thanks in part to generous government support for businesses and the broader economy, commercial bankruptcy filings remain near historic lows. Meanwhile, new US business formation has surged to record highs. The combination of a vaccine and a decline in rents in city centres should persuade some people who were thinking of fleeing to the suburbs to stay put. This will ensure that most urban commercial and residential real estate remains productively engaged. Judging from corporate surveys, capital spending on equipment and intellectual property should continue to rebound. While the pandemic has caused numerous economic dislocations, it has also opened the door to a variety of productivity-enhancing innovations. An open question is whether all the debt that governments have taken on to alleviate the economic damage from the pandemic could in and of itself cause damage down the road. As long as interest rates stay low, this is not a major risk. However, today’s high government debt levels could become a problem if the pool of global savings dries up. Investors should continue to overweight stocks for the time being, while shifting their equity exposure from “pandemic plays” to “reopening plays.” A more cautious stance towards stocks may be appropriate later this decade.  The Pandemic’s Potentially Long Shadow In its latest World Economic Outlook, the IMF revised up its growth estimates for this year. Rather than contracting by 4.9%, as it expected in June, the Fund now sees the global economy shrinking by 4.4%. That said, the IMF’s estimates still leave global GDP in 2020 7.5% below where it projected it to be in January. Perhaps even more worrying, the IMF expects the global economy to suffer permanent damage from the pandemic (Chart 1 and Chart 2). It projects that real global GDP will be 5.3% lower in 2024 compared to what it expected last year. In the G7, real GDP is projected to be nearly 3% lower, with most of the shortfall resulting from a downward revision to the level of potential GDP (Chart 3). Chart 1Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part I) How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 2Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part II) How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?     The Congressional Budget Office is no less gloomy in its forecast. The CBO expects US real GDP to be 3.7% lower in 2024 than it projected last August. By 2029, it sees US GDP as being 1.8% below what it had expected prior to the pandemic, almost entirely due to slower potential GDP growth (Chart 4). Chart 3G7 Real GDP Growth Projections Have Been Revised Sharply Lower Due To The Pandemic How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 4A Gloomy Forecast For The US Thanks To Covid-19 How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? The worry that the pandemic will lead to a major permanent loss in output is understandable. That is precisely what happened after the Global Financial Crisis. Nevertheless, as we discuss below, there are good reasons to think that the damage will not be as pervasive as widely believed. The Drivers Of Potential GDP An economy’s potential output is a function of three variables: 1) the number of workers available; 2) the amount of capital those workers have at their disposal; and 3) the efficiency with which this labor and capital can be transformed into output, a concept economists call “total factor productivity.” Let us consider how the pandemic has affected all three variables. The Impact Of The Pandemic On The Labor Market At last count, the pandemic has killed over 1.1 million people worldwide, 222,000 in the US. While the human cost of the virus is immense, the economic cost has been mitigated by the fact that about four-fifths of fatalities have been among those over the age of 65 (Table 1). In the US, less than 7% of the labor force is older than 65. A reasonable estimate is that Covid deaths have reduced the US labor force by 55,000.1 Table 1Pandemic-Related Deaths Are Tilted Towards The Elderly, Who Are The Least Active Participants Of The Labor Force How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 5The Number Of New Cases Continues To Increase Globally How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Granted, mortality is not the only way that the disease can impair one’s ability to work. As David Cutler and Larry Summers point out in a recent study, for every single person who dies from Covid-19, seven people will survive but not before manifesting severe or critical symptoms of the disease.2 Based on the experience from past coronavirus epidemics, Ahmed, Patel, Greenwood et al. estimate that about one-third of these survivors will suffer long-term health complications.3 If one assumes that half of these chronically ill survivors are unable to work, this would reduce the US labor force by an additional 65,000.4 Of course, the pandemic is not yet over. The number of new cases continues to rise in the US and globally (Chart 5). The only saving grace is that mortality and morbidity rates are lower than they were earlier this year. Nevertheless, many more people are likely to die or suffer debilitating long-term consequences before a vaccine becomes widely available. Using the US as an example, if the total number of people who end up dying or getting so sick that they are unable to work ends up being twice what it is so far, the pandemic will reduce the labor force by about 240,000. This is not a small number in absolute terms. However, it is less than 0.15% of the overall size of the US labor force, which stood at 164 million on the eve of the pandemic. The impact of the pandemic on the labor forces of other major economies such as Europe, China, and Japan will be even smaller. Labor Market Hysteresis People can drop out of the labor force even if they do not get sick. In fact, 4.4 million have left the US labor force since February, bringing the participation rate down from 63.4% to 61.4%. How great is the risk of “hysteresis,” a situation where the skills of laid-off workers atrophy so much that they become unwilling or unable to rejoin the labor force? At least so far, hysteresis has been limited. According to surveys conducted by the Bureau of Labor Statistics, most US workers who have dropped out of the labor force still want a job. The pandemic has made it more difficult for people to work even when they wanted to. During the spring, more than four times as many employees were absent from work due to childcare requirements than at the same time last year. Now that schools are reopening, it will be easier for parents to go back to work. Admittedly, not everyone will have a job to return to. While about a third of US unemployed workers are still on temporary layoff, the number of workers who have suffered permanent job losses has been steadily rising (Chart 6). The good news is that job openings have recovered most of their decline since the start of the year. Unlike in mid-2009, when there were 6.5 unemployed workers for every one job vacancy, today there are only two (Chart 7). Chart 6US: Permanent Job Losses Have Been Rising Steadily... US: Permanent Job Losses Have Been Rising Steadily... US: Permanent Job Losses Have Been Rising Steadily... Chart 7...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year ...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year ...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year It is also worth noting that the vast majority of job losses during the pandemic has been among lower-income workers, especially in the retail and hospitality sectors. Most of these jobs do not require highly specialized sector-specific skills. Thus, as long as there is enough demand throughout the economy, unemployed workers will be able to find jobs in other industries. Wither The Capital Stock? The pandemic may end up reducing the value of the capital stock in two ways. First, it could render a portion of the existing capital stock unusable. Second, the pandemic could reduce the pace of new investment, leading to a smaller future capital stock than would otherwise have been the case. Let us explore both possibilities. On the first point, it is certainly true that the pandemic has left a lot of the capital stock idle, ranging from office buildings to shopping malls. However, this could turn out to be a temporary effect. Consider, for example, the case of China. After the pandemic began in Wuhan, China first shut down much of its domestic economy and then implemented an effective mass testing and contact tracing system. The strategy worked insofar as China is now nearly free of the virus. Today, few Chinese wear masks, the restaurants are full again, and domestic air travel is back to last year’s level. Even movie theatre revenue has rebounded. The rest of the world may not be able to replicate China’s success in combating the virus, but then again it won’t need to if an effective vaccine becomes available. Chart 8US Housing Is In A Good Place US Housing Is In A Good Place US Housing Is In A Good Place Even if the pandemic ends up leading to deep and lasting changes in the way people live, work, and shop, the market mechanism will ensure that all but the least desirable parts of the capital stock remain productively employed. As first year economics students learn, if the supply curve is vertical and the demand curve shifts inward, the result will be lower prices rather than diminished output. By the same token, if more companies and workers decide to relocate to the suburbs, urban rents will fall until enough people decide that they are better off staying put. An economy’s productive capacity does not change just because rents go down. What falling demand for urban real estate and increased interest in working from home will do is encourage people to buy larger homes in suburban areas. We have already seen this play out this year. Despite flagging commercial real estate construction in the US, residential construction has boomed. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales have reached new cycle highs. Homebuilder confidence hit a new record in October (Chart 8). The Service Sector Is Not Particularly Capital Intensive Most recessions take a greater toll on the goods-producing sectors of the economy than the service sector. The pandemic, in contrast, has mainly afflicted services. The service sector is the least capital-intensive sector of the economy. This is especially the case when it comes to spending on capital equipment and investment in intellectual property (Chart 9). Chart 9Capex-Intensive Industries Have Let Go Of Less Workers During The Pandemic How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 10Capex Intentions Have Bounced Back Capex Intentions Have Bounced Back Capex Intentions Have Bounced Back As such, it is not surprising that investment in equipment and IP fell less during this recession than one would have expected based on the historic relationship between investment and GDP growth. According to the Atlanta Fed’s GDPNow model, investment in equipment and IP is set to increase by 23% in the third quarter. The snapback in the Fed’s capex intention surveys suggests that investment spending should continue to rise in the fourth quarter and into next year (Chart 10). Productivity And The Pandemic Just as the impact of the pandemic on the labor supply and the capital stock is likely to be limited, the same is true for the efficiency with which capital and labor is transformed into output. For every person whose productivity is hampered by having to work from home, there is another person who feels liberated from the need to spend an hour commuting to work only to attend a series of pointless meetings. In fact, it is quite possible that the pandemic will nudge society from various “low productivity” equilibria to “high productivity” equilibria. For example, greater use of video conferencing could negate the need to take redeye flights to attend business meetings in person. Remote learning could enhance educational opportunities. More widespread use of telemedicine could eliminate the need to waste time waiting in a doctor’s office. Who knows, the pandemic could even fulfill my life-long mission to replace the unhygienic handshake with the much more elegant Thai wai. Granted, disruptive shifts could produce unintended consequences. There is a fine line between creative destruction and uncreative obliteration. If the pandemic forces otherwise viable businesses to close, this could adversely affect resource allocation. Chart 11New Business Applications Have Surged To Record Highs New Business Applications Have Surged To Record Highs New Business Applications Have Surged To Record Highs Chart 12Commercial Bankruptcy Filings Remain In Check How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Fortunately, at least so far, this does not seem to be happening on a large scale. After dropping by 25%, the number of active US small businesses has rebounded to last year’s levels. New business applications have surged to record highs (Chart 11). According to the American Bankruptcy Institute, commercial bankruptcy filings remain near historic lows. While Bloomberg’s count of large-company bankruptcies did spike earlier this year, it has been coming down more recently (Chart 12). Fiscal Stimulus To The Rescue Chart 13Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic How did so many households and businesses manage to avoid the financial suffering that usually goes along with deep recessions? The answer is that governments provided them with ample income support. In the US, real personal income rose by 11% in the first few months of the pandemic (Chart 13). Small businesses also benefited from the Paycheck Protection Program, which doled out low-cost loans to businesses which they will be able to convert into grants upon confirmation that the money was used to preserve jobs. Similar schemes, such as Germany’s Corona-Schutzschild, Canada’s Emergency Business Account program, and the UK’s Coronavirus Job Retention Scheme were launched elsewhere. The failure of the US Congress to pass a new stimulus bill could undermine the sanguine narrative presented above. Small businesses, in particular, are facing a one-two punch from the expiration of the Paycheck Protection Program and tighter bank lending standards. Ultimately, we think the US Congress will pass a new pandemic relief bill. However, the size of the bill could depend on the outcome of the election. In a blue sweep scenario, the Biden administration will push through a $2.5-to-$3.5 trillion stimulus package early next year, while laying the groundwork for a further 3% of GDP increase in government spending on infrastructure, health care, education, housing, and the environment. A fairly large stimulus bill could also emerge if President Trump manages to hang on to the White House, while the Democrats take control of the Senate. Unlike some Republican senators, Donald Trump is not averse to big increases in government spending. A continuation of the current political configuration in Washington would result in the smallest increase in spending. Nevertheless, some sort of deal is likely to emerge after the election. Even most Republican voters favor a large stimulus bill (Table 2). Table 2Strong Support For Stimulus How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? A Double-Edged Sword? Bountiful fiscal support has undoubtedly lessened the economic scarring from the pandemic. However, could the resulting increase in government debt lead to supply-side problems down the road? The answer depends on what happens to interest rates. As long as interest rates stay below the growth rate of the economy, governments will not need to raise taxes to pay for pandemic relief. In fact, in such a setting, the public debt-to-GDP ratio will return to its original level with absolutely no change in the structural budget deficit (Chart 14). GDP growth in most developed economies has exceeded government borrowing rates for much of the post-war era (Chart 15). Thus, a free lunch scenario where governments never have to pay back the additional debt they incurred for pandemic relief cannot be ruled out. That said, it would not be prudent to bank on such an outcome. If the excess private-sector savings that have kept down borrowing costs run out, interest rates could rise. In a world awash in debt, this could lead to major problems. Thus, while the structural damage to the global economy from the pandemic appears to be limited for now, that could change in the future. Chart 14A Fiscal Free Lunch When r Is Less Than g How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 15The Rate Of Economic Growth Has Usually Been Higher Than Interest Rates How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?     Investors should continue to overweight equities for the time being. With a vaccine on the horizon, it makes sense to shift from favoring “pandemic plays” such as tech and health care stocks to favoring “reopening plays” such as deep cyclicals and banks. A more cautious stance towards stocks will be appropriate later this decade if, as flagged above, a stagflationary environment leads to higher interest rates and slower growth.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 To estimate the direct impact of Covid-19 on the labor force, we calculate the decline in the labor force by age cohorts using Covid-19 death statistics and labor participation rates. 2 David M. Cutler, and Lawrence H. Summers, “The COVID-19 Pandemic and the $16 Trillion Virus,” JAMA Network, October 12, 2020. 3 Hassaan Ahmed, Kajal Patel, Darren Greenwood, Stephen Halpin, Penny Lewthwaite, Abayomi Salawu, Lorna Eyre, Andrew Breen, Rory O’Connor, Anthony Jones, and Manoj Sivan. “Long-Term Clinical Outcomes In Survivors Of Coronavirus Outbreaks After Hospitalisation Or ICU Admission: A Systematic Review And Meta-Analysis Of Follow-Up Studies,” medRxiv, April 22, 2020. 4 Calculated as 0.5 x (decline in labor force due to Covid-19 deaths) x 7 x (1/3).   Global Investment Strategy View Matrix How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Current MacroQuant Model Scores How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights The US saves too much to achieve full employment but not enough to close the current account deficit. According to the “Swan diagram,” a weaker dollar would move the US economy closer to “external” and “internal” balance. Structural forces are unlikely to have much effect on the value of the dollar over the next few years: The neutral rate of interest is higher in the US than in most other developed economies; the US still earns more on its overseas assets than it pays on its liabilities; and there is no meaningful competition to the dollar’s reserve currency status. Cyclical forces, in contrast, will become more dollar-bearish over the coming months: A vaccine would buoy the global economy next year; interest rate differentials have moved sharply against the dollar; and further fiscal stimulus should lift US inflation expectations. Stocks tend to outperform bonds when the dollar is weakening. Investors should remain overweight global equities on a 12-month horizon, favoring non-US stocks and cyclical sectors. A Clash Of Views? Today marked the last day of BCA’s Annual Investment Conference, held virtually this year in light of the pandemic. As in past years, it was a star-studded cavalcade of the who’s who in financial and policymaking circles. I always find it interesting when two of our speakers seemingly disagree on a critical issue. Such was the case with Larry Summers and Stephen Roach. Larry kicked off the proceedings with an update of his secular stagnation thesis. He argued that his thesis had gone from “a hypothesis that needed to be considered” to a “presumptively accurate analysis of the status quo.” In Larry’s mind, the core problem facing the US and most other economies is a surplus of savings. Excess savings results in a chronic shortfall of spending relative to an economy’s productive capacity. Faced with the challenge of maintaining adequate employment, central banks have been forced to cut rates to extraordinarily low levels. Perpetually easy monetary policy has periodically spawned destabilizing asset bubbles. Larry recommends that governments ease fiscal policy in order to take the burden off central banks. Later that morning, we heard from Stephen Roach. Stephen expects the real US trade-weighted dollar to weaken by 35% by the end of next year. What’s behind this bearish forecast? The answer, according to Stephen, is that the US economy suffers from a shortage of savings. Unable to generate enough domestic savings to cover its investment needs, the US has ended up running persistent current account deficits. How can the US be saving too much, as Larry Summers claims, while also saving too little, as Stephen Roach insists? The two views seem utterly unreconcilable. In fact, I think there is a way to reconcile them with something called the Swan diagram. The Swan Diagram True to the reputation of economics as the dismal science, the Swan diagram – named after Australian economist Trevor Swan – depicts four “zones of economic unhappiness” (Chart 1). Each zone represents a different way in which an economy can deviate from “internal balance” (full employment and stable inflation) and “external balance” (a current account balance that is neither in deficit nor in surplus). Chart 1The Swan Diagram And The Four Zones Of Unhappiness Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The four zones are: 1) high unemployment and a current account deficit; 2) high unemployment and a current account surplus; 3) overheating and a current account deficit; and 4) overheating and a current account surplus. The horizontal axis of the Swan diagram depicts the budget deficit. A rightward movement along the horizontal axis corresponds to an easing of fiscal policy. The vertical axis depicts the real exchange rate. An upward movement along the vertical axis corresponds to a currency appreciation. The external balance schedule is downward sloping because an easing of fiscal policy raises aggregate demand (which boosts imports, resulting in a current account deficit). To restore the current account balance to its original level, the currency must weaken. A weaker currency will spur exports, while curbing imports. The internal balance schedule is upward sloping because an easing in fiscal policy must be offset by a stronger currency in order to keep the economy from overheating. The US presently finds itself in the top quadrant of the Swan diagram: It saves too much to achieve internal balance, but not enough to achieve external balance. From this perspective, both Larry Summers and Stephen Roach are correct. Unlike the US, the euro area, Japan, and China run current account surpluses. Rather than pursuing currency depreciation, the Swan diagram says that all three economies would be better off with more fiscal easing. What It Would Take To Eliminate The US Trade Deficit By how much would the real trade-weighted US dollar need to weaken to achieve external balance? According to the New York Fed, a 10% dollar depreciation raises export volumes by 3.5% after two years, while reducing import volumes by 1.6%.1 Given that exports and imports account for 12% and 15% of GDP, respectively, this implies that a 10% dollar depreciation would improve the trade balance by 0.12*0.035+0.15*0.016=0.7% of GDP. Considering that the trade deficit is around 3% of GDP, the dollar may need to weaken by 30%-to-50% to eliminate the trade deficit, a range which encompasses Stephen Roach’s projection for the dollar’s decline.  Don’t Hold Your Breath In practice, we doubt that the dollar will decline anywhere close to that much. Despite a net international investment position of negative 67% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 2). This reflects the fact that US foreign liabilities are skewed towards low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 3). Chart 2The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 3A Breakdown Of US Assets And Liabilities Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Given that the Fed will keep rates on hold at least until end-2023, it is unlikely that US government interest payments will rise substantially in the next few years. Faster Growth Helps Explain America’s Chronic Current Account Deficit The neutral rate of interest is higher in the US than in most other developed economies. Economic theory suggests that global capital will flow towards countries with higher interest rates, producing current account deficits (Chart 4).2 Chart 4Interest Rates And Current Account Balances Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The higher neutral rate in the US can be partly attributed to faster trend GDP growth. There are three reasons why faster growth will raise investment while lowering savings, thus leading to a current account deficit: Faster-growing economies require more investment spending to maintain an adequate capital stock. For example, if a country wants to maintain a capital stock-to-GDP ratio of 200% and is growing at 3% per year, it would need to invest (after depreciation) 6% of GDP. A country growing at 1% would need to invest only 2% of GDP. Governments may wish to run larger budget deficits in faster-growing economies in the belief that they will be able to outgrow their debt burdens. To the extent that faster growth may reflect productivity gains, households may choose to spend more and save less in anticipation of higher real incomes in the future. While trend growth is just one of several factors influencing the balance of payments, in general, the evidence does suggest that fast-growing developed economies such as the US and Australia have tended to run current account deficits, while slower-growing economies such as the euro area and Japan have generally run current account surpluses (Chart 5). Chart 5Fast-Growing Developed Economies Tend To Run Current Account Deficits, While Slower- Growing Economies Tend To Run Surpluses Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The Dollar’s Reserve Currency Status Is Not In Any Jeopardy Even if many commentators do tend to overstate the importance of having a reserve currency, the dollar’s special status in the global financial system will still provide it with support. The US dollar’s share of global central bank reserves stood at 61.3% in the second quarter of 2020, only modestly lower than where it was a decade ago (Chart 6). While the euro area is not at risk of collapse, it remains an artificial political entity. China’s role in the global economy continues to increase. However, the absence of an open capital account limits the yuan’s appeal. Chart 6The US Dollar’s Share Of Global Central Bank Reserves Has Barely Fallen Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Then there’s the dollar’s first mover advantage. During our conference, Marc Chandler likened the greenback to the QWERTY keyboard: It may not be perfect, but like it or not, it has become the default choice for typing.  I like to equate the dollar’s role with that of the English language. When a Swede has a business meeting with another Swede, they will speak in Swedish. However, when a Swede has a business meeting with an Indonesian, chances are they will speak in English. By the same token, when a Swede wants to purchase Indonesian rupiah, the bank is unlikely to convert krona directly to rupiah since the probability is low that many people will just happen to be looking to exchange rupiah for krona at precisely the same time. Rather, the bank will first convert the krona to US dollars and then convert the dollars to rupiah. The dollar is the hub of the global financial system. Just like the pound remained the global currency long after the sun had set on the British Empire, King Dollar will endure for many years to come. Cyclical Forces Will Drive The Dollar Lower Chart 7The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The discussion above suggests that structural forces are unlikely to have much effect on the value of the dollar for the foreseeable future. Cyclical forces, in contrast, will become more dollar-bearish over the coming months. The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 7). According to the Good Judgment Project, there is a 43% chance that a Covid vaccine will be available by the first quarter of 2021, and a 91% chance it will be available by the end of the third quarter (Chart 8). A vaccine would supercharge global growth, causing the dollar to weaken.   Chart 8When Will A Vaccine Become Available? Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Interest rate differentials have moved considerably against the dollar – more so, in fact, than one would have expected based on the fairly modest depreciation that the greenback has experienced thus far (Chart 9). Chart 9A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Chart 10Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US   An open question is how additional fiscal support will affect the dollar and other financial assets. Equity investors have brushed off the dwindling prospects for a pandemic relief bill before the election on the assumption that a “blue sweep” will allow the Biden administration to enact even more stimulus than was possible under President Trump and a Republican senate. The dollar rallied in the weeks following Donald Trump’s victory. The dollar also surged in the early 1980s after Ronald Reagan lowered taxes and raised military spending. A key difference between now and then is that real interest rates rose during both of those two prior episodes. Today, the Fed is firmly on hold. This implies that real rates are unlikely to rise much, and could even fall if inflation expectations move up in response to easier fiscal policy. Stocks tend to outperform bonds when the dollar is weakening (Chart 10). In particular, stock markets outside the US often do well in a soft-dollar environment. Investors should remain overweight equities on a 12-month horizon, favoring non-US stocks and cyclical sectors.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Mary Amiti, and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Liberty Street Economics, (July 17, 2015). 2 There are many different ways to measure the neutral rate. As depicted in Chart 4, capital flows tend to equalize the neutral rate across countries. This is another way of saying that the neutral rate would be higher in the US were it not for the fact that the US runs a current account deficit.   Global Investment Strategy View Matrix Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Current MacroQuant Model Scores Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? ​​​​​​​

Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 5Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments   Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9).  Chart 7Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift     Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023.  The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating   Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future.   The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21).   Chart 21The Present Value Of Earnings: A Scenario Analysis Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield   Imagine having to decide whether to place your money either in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50% (Chart 24). Chart 24 (I)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 24 (II)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves   Chart 27USD Remains Overvalued Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks   BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge   Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth   Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul.   Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa.  Chart 37High-Yielding Bond Markets Are The Most Cyclical Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020.  2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020.  3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020.     Global Investment Strategy View Matrix Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Current MacroQuant Model Scores Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift

Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now The Greatest Ever Monetary Stimulus Is Over... For Now The Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading US Monetary Stimulus Is Fading US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading China Monetary Stimulus Is Fading China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade Euro Area Monetary Stimulus To Fade Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics.   Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow The Decline In The Bond Yield Establishes The Bank Credit Flow The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long.   Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News The Recent Acceleration Of Bond Yields Is Bad News The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market Tech And Healthcare Saved The Aggregate Stock Market Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent. World: Basic Resources Vs. Financials World: Basic Resources Vs. Financials   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 Expressed as short DAX versus 10-year T-bond. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights Bond Yields & Growth: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Inflation-Linked Trades: Our models suggest US TIPS breakevens are now at fair value. We are taking profits on our tactical long US 10-year inflation breakevens trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens. Feature Do bond investors even care about economic growth anymore? This is a valid question to ask, given how government bond yields in the developed markets have stayed in very narrow trading ranges over the past few months, even as economic data has rebounded from the global COVID-19 recession in the first half of 2020. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon.  Chart of the WeekBond Yields Are Responding To Inflation, Not Growth Bond Yields Are Responding To Inflation, Not Growth Bond Yields Are Responding To Inflation, Not Growth For example, the benchmark 10-year US Treasury yield has stayed between 0.65% and 0.75% since June 11, even though the US ISM Manufacturing index rose from 43 in May to 56 in August. Yields are also ignoring the ups and downs of the equity market. The 10-year Treasury yield now sits at 0.66% - the same level as on September 2 even though the NASDAQ equity index has fallen 12% from the all-time peak seen on that day. Our own Global Duration Indicator, comprised of cyclical measures like the global ZEW index and our global leading economic indicator, has surged to the highest level since 2008 (Chart of the Week). Given the usual lead time between broad turns in the Duration Indicator and the level of global bond yields (around 6-9 months), this suggests that yields have bottomed and should soon begin rising. Yet the reality is that the usual factors that typically drive yields higher during a cyclical upturn – namely, rising inflation expectations and a clearly understood signal from central banks that such a move would lead to tighter monetary policy – are not currently in place. Investors should get used to the current backdrop of rock-bottom interest rates and bond yields, which is unlikely to change anytime soon. Four Potential Triggers For A Rise In Bond Yields Chart 2A Breakdown Of The PMI/Yield correlation A Breakdown Of The PMI/Yield correlation A Breakdown Of The PMI/Yield correlation The breakdown of the positive correlation between growth and bond yields is not just visible in the US. For example, yields on German Bunds and UK Gilts also remain stuck at low levels despite sharp improvements in the German and UK manufacturing PMIs (Chart 2). Yet in China – where there is no zero interest rate policy (ZIRP) or large-scale quantitative easing (QE) programs - bond yields have steadily risen since the China manufacturing PMI bottomed back in April (bottom panel). What could change this backdrop? We see four potential catalysts, ranked below in our own subjective order of importance: Inflation Sustainably Returning Back To Central Bank Targets It may seem obvious, but it still needs to be said – dovish central bank policies are the biggest reason why developed market bond yields have de-linked from economic growth. That includes not only ZIRP or QE, but also forward guidance on future changes in interest rates. Central banks are telling markets they will not raise rates for a period measured in years, and will continue to expand their balance sheets to purchase assets and support bank lending, all in an effort to push undershooting inflation back to policy targets. This is a different message than bond investors have grown accustomed to hearing from central banks, most notably in the US. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The Fed is trying to do something that it has never intentionally done before – erode some of its hard-earned inflation fighting credibility. The recent shift by the Fed to an Average Inflation Targeting framework – where above-target inflation would be tolerated if inflation was below target for an extended period – is intended to change the perception that the Fed will hike rates preemptively based on a forecast of inflation, as they have done in the past. Chart 3Latest FOMC Projections Justify Years Of 0% Rates Latest FOMC Projections Justify Years Of 0% Rates Latest FOMC Projections Justify Years Of 0% Rates The latest set of Fed economic projections is consistent with this new framework (Chart 3): the unemployment rate is forecasted to fall back to the FOMC median estimate of full employment (4.1%) by 2023; headline PCE inflation is also projected to climb back to 2% by 2023; the fed funds rate is projected to stay unchanged near 0% until at least 2023. In many ways, the Fed is trying to atone for the mistakes made while normalizing policy after the extraordinary easing measures taken after the 2008 crisis. From signaling a slowing of QE bond purchases in 2013, to the 250bps of rate hikes and tapering of its balance sheet during 2016-18, the Fed moved aggressively relative to what was actually happening with US inflation. Core PCE inflation only inched above 2% for a few months in 2018 – towards the end of the normalization process - as did market-based inflation measures like TIPS breakevens (Chart 4). The Fed ended up raising the real fed funds rate during that tightening cycle to above its own estimate of neutral (r-star), even with inflation still not close to its target. Unsurprisingly, real US bond yields also rose during that same period, which tightened monetary conditions even further by boosting the value of the US dollar. No wonder US inflation could not stay at the 2% target for very long. This time around, the Fed is sending a much different signal to markets – that it wants to see inflation rise before raising rates, thus keeping real policy rates in negative territory for an extended period. If the Fed is looking for a real world case study of such an approach, it can look across the Atlantic to the Bank of England (BoE). On the surface, the BoE has been acting like a typical inflation-targeting central bank over the past several years, turning more hawkish in its commentary when the UK economy was improving and becoming more dovish when the economy was languishing. Yet since the 2008 crisis, the BoE has kept the Bank Rate in a range of 0.1% to 0.75%, well below realized UK inflation. While it has been difficult for the BoE to attempt to raise rates given the Brexit uncertainty since 2016 – which has also weakened the British pound, helping boost UK inflation - real UK policy rates have now been negative for 12 years (Chart 5). The result: steadily declining UK real bond yields with inflation expectations rising to levels well above the BoE 2% inflation target. Chart 4The Fed Is Trying To Erode Its Hard-Earned Credibility The Fed Is Trying To Erode Its Hard-Earned Credibility The Fed Is Trying To Erode Its Hard-Earned Credibility Chart 5Lessons From The BoE On How To Not Be Credible Lessons From The BoE On How To Not Be Credible Lessons From The BoE On How To Not Be Credible The experience of the ECB provides a cautionary tale for central banks not appearing dovish enough, even when policy settings are already extraordinarily accommodative. The message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. Chart 6Does The ECB Have Any Credibility Left? Does The ECB Have Any Credibility Left? Does The ECB Have Any Credibility Left? Inflation expectations have stayed below the ECB’s “just below 2%” target since 2013 (Chart 6), which forced the central bank into cutting nominal rates into negative territory while aggressively expanding its balance sheet through QE and long-term bank liquidity provision (i.e. LTROs). Yet the ECB has always put an expiration date on each of these programs, which sent a message to the markets that the central bank was not fully committed to keeping policy easy until inflation was back to target – however long that would take. In sum, the message from central banks on future rate increases – namely, that there will not be any without sustainably higher inflation – must change before bond yields can have any hope of climbing higher. A Shift From Central Banks To Concerns About Asset Price Bubbles Chart 7When Will CBs Start Worrying About Financial Market Valuations? When Will CBs Start Worrying About Financial Market Valuations? When Will CBs Start Worrying About Financial Market Valuations? Policymakers are paying lip service to the notion of the “financial stability” risks inherent in their new promises to keep rates low for a lot longer while intervening in financial markets more aggressively through asset purchase programs. Given the signs of froth in many important asset classes like US equities or global corporate debt, policymakers should at least be somewhat concerned that easy money policies are fueling asset bubbles (Chart 7). A big enough decline could erode confidence and spill over into the real economy, defeating the original purpose of easy money policies. However, given the still fragile state of much of the global economy that remains dependent on fiscal support amid ongoing COVID-19 restrictions, concerns over asset values will take a backseat to maintaining adequate monetary stimulus. Asset bubbles would have to become much larger before a central bank would even consider turning more hawkish to prick them through higher policy rates that would push up bond yields. The Announcement Of A Trustworthy COVID-19 Vaccine That Is Ready For Widespread Distribution Markets have already begun to worry about the “second wave” of the coronavirus that health officials had warned would happen in the cooler autumn months. The development of an effective, and safe, vaccine would thus be a game-changer for financial markets, particularly after the recent surge in new COVID-19 cases in Europe and the still elevated level of new cases in the US (Chart 8). Chart 8A Second Wave Of COVID-19 A Second Wave Of COVID-19 A Second Wave Of COVID-19 BCA Research’s Chief Global Strategist, Peter Berezin (a big fan of interesting data sets!), noted in his most recent report that, according to The Good Judgement Project, around 60% of “superforecasters” now expect a vaccine ready for mass distribution to be available by Q1/2021 (Chart 9).1 A vaccine appearing that rapidly – much faster than the usual multi-year process leading to a vaccine declared safe for use – would help boost business and consumer confidence and raise the odds of a return to pre-virus levels of economic activity. Bond yields would likely get a lift, as well, as markets would price in a shorter period of super low policy rates and a faster return of inflation to central bank targets. Yet even if a vaccine is presented to the world by next spring, there is no guarantee that a large enough share of the population will deem the vaccine safe enough to take to ensure “herd immunity”. A recent Economist/YouGuv survey noted that only 36% of American adults would choose to get vaccinated when a COVID-19 vaccine becomes available, 32% would not get vaccinated, while 32% were unsure (Chart 10). Thus, a vaccine would be a bond-bearish development only if it is trusted to be safe to use – the mere announcement of a vaccine will not be enough to declare an “end” to the pandemic. Chart 9High Odds Of A Vaccine In 6-To-12 Months What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? Chart 10Will Enough People Take The Vaccine? What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? Central Banks Slowing QE Purchases Relative To Increased Fiscal Issuance Chart 11Still Room For The Fed, ECB and BoE To Expand QE Still Room For The Fed, ECB and BoE To Expand QE Still Room For The Fed, ECB and BoE To Expand QE Right now, it is easy for the major central banks to aggressively expand their balance sheets and provide additional monetary stimulus through asset purchases. Yet there may come a point where a capacity constraint is reached on buying government bonds if it impairs market functionality. That is currently the case in Japan, where the Bank of Japan now owns 49% of the Japanese government bond (JGB) market after years of aggressive QE purchases of JGBs. This has damaged the day-to-day liquidity of JGBs, where there have been instances of days where no single JGB has traded in the secondary market. A move by central banks to buy fewer bonds because they own too many of them could potentially push bond yields higher by worsening the demand/supply balance for government bonds - assuming private investors do not pick up the slack and buy more bonds, of course. Currently, the Fed only owns 22% of the US Treasury market with little evidence suggesting that its purchases are impairing the trading of Treasuries (Chart 11). The BoE and ECB own much larger shares of the UK and euro area government bond markets – 37% and 38%, respectively – suggesting that those central banks are closer to a BoJ-like capacity constraint. However, given the rising budget deficits and surging government bond issuance seen in Europe (and the US) so far in 2020, the odds of a capacity constraint soon being reached that could result in slower QE purchases are low. Bottom Line: Developed market bond yields have ignored improving cyclical economic data over the past few months, remaining stuck in narrow trading ranges at low levels. That broken correlation will persist until central banks become less concerned about supporting pandemic-ravaged economies and begin worrying more about rising inflation, financial stability or the size of their balance sheets. That shift will not happen anytime soon. Reviewing Our Tactical Inflation Breakeven Trades Back in June, we initiated a series of recommended inflation-focused trades in our Tactical Overlay portfolio. Specifically, we went long 10-year inflation breakevens in the US, Italy, and Canada by buying on-the-run inflation-linked bonds and selling government bond futures.2 We chose those trades based on the output of our fundamental valuation models for 10-year inflation breakevens in eight inflation-linked bond (ILB) markets: the US, UK, France, Italy, Japan, Germany, Canada, and Australia. Our fair value models use two inputs for all regions: a) a long-run moving average of headline inflation, representing the medium-term trend that anchors inflation expectations; and b) the annual percentage change of the Brent oil price in local currency terms, which creates shorter-term deviations from the trend to account for moves in oil and currencies. There looks to be little remaining upside to our tactical long TIPS breakeven position. The past few months have seen a sharp rise in global inflation expectations, owing to the extraordinary monetary policy actions taken by the major developed market central banks and recovering growth prospects coming out of the COVID-19 recession. This has led to a convergence between 10-year inflation breakevens and their model-implied fair values in the aforementioned ILB markets (Chart 12). Most notably, breakevens in the US are now at fair value, while breakevens in the UK and Australia are trading above fair value. In the US, 10-year breakeven inflation rates are now back to the long-run average of realized headline inflation, while the -8% decline in the Brent oil price so far this month has lowered the model-implied fair value (Chart 13). Therefore, there looks to be little remaining upside to our tactical long TIPS breakeven position with most of the easy gains following the pandemic-induced collapse having already been realized. Chart 12Global Inflation Breakevens Have Moved Higher Global Inflation Breakevens Have Moved Higher Global Inflation Breakevens Have Moved Higher Our colleagues over at BCA Research US Bond Strategy have reached a similar conclusion, noting that the Fed’s Jackson Hole announcement of the move to Average Inflation Targeting supercharged the rising trend in TIPS breakevens.3 Chart 13US Breakevens Are At Fair Value US Breakevens Are At Fair Value US Breakevens Are At Fair Value Although they also note the likelihood of stronger US CPI prints over the next few months should keep US breakevens well supported heading into year-end. The time horizon for trades that enter our Tactical Overlay portfolio is limited to no longer than six months. Thus, with TIPS breakevens reverting back to fair value after just three months in the trade, we are choosing to take profits on our long 10-year US inflation breakeven trade for a total return of 2.88%. Chart 14UK Breakevens Are Above Fair Value UK Breakevens Are Above Fair Value UK Breakevens Are Above Fair Value In other ILB markets, UK breakevens are now an intriguing case, and not only for the monetary policy driven interplay between UK real yields and breakevens discussed earlier in this report. The overshoot of UK breakevens relative to our fair value model may be related to growing market speculation that the BoE will move to negative interest rates – an outcome we deem to be unlikely, as we discussed in a recent report.4 Alternatively, the higher breakevens may be a reflection of UK political uncertainty. The risk of a hard Brexit has resurfaced as UK Prime Minister Boris Johnson’s Conservatives have now backed a bill that includes powers for the government to override its withdrawal agreement with the European Union; understandably, this has caused a sell-off in the pound. Within our fundamental fair value framework, the UK 10-year breakeven inflation rate has overshot both the 3-year moving average of headline inflation and the growth of GBP-denominated oil prices, leaving breakevens 0.72 standard deviations expensive (Chart 14). One possible explanation is that markets are pricing in a significant further depreciation in the pound given this resurfacing of Brexit risk. Within our model, GBP/USD impacts the fair value of breakeven inflation via Brent oil prices, which are denominated in local currency terms. Thus, we can back out an implied change in GBP/USD that would make the model-derived fair value breakeven rate equal to the actual 10-year UK inflation breakeven rate, holding all other variables in the model constant. This does produce some extreme results during periods of very rapid moves in UK breakevens, but we can standardize the data to use as an indicator of ILB market-implied views on the currency (Chart 15). With that in mind, pound bearishness in ILB markets is nearing levels where it has historically troughed. A favorable development in Brexit negotiations could cause a reversal in this pound-bearish trend and a sharp downward correction in UK inflation breakevens. We see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. On that front, BCA Research’s Chief Geopolitical Strategist, Matt Gertken, sees a no-deal Brexit by year-end as the less likely outcome, with odds of only 35%, given the political calculus that PM Johnson faces with the decision.5 Polls show that the UK public does not support a no-deal Brexit (Chart 16), which would severely hurt a UK economy that remains fragile due to the coronavirus, and would raise the odds of a new independence referendum in Scotland in 2021. Chart 15UK Breakevens Already Discount A Big Fall In GBP UK Breakevens Already Discount A Big Fall In GBP UK Breakevens Already Discount A Big Fall In GBP Chart 16Only 25% In The UK Think A No-Deal Brexit Is A Good Outcome What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? We will monitor the situation closely in the coming weeks, but we see a potential opportunity to play for narrower UK breakevens if our view on Brexit and negative rates in the UK prove to be correct. Finally, although the majority of the gains from our long inflation breakeven trades in Canada and Italy have likely been realized, there are still some chips left on the table. Canadian breakeven inflation rates have risen in lockstep with Brent prices but have yet to converge with the long-run moving average of inflation (Chart 17). In Italy, the increases in oil prices in euro terms has outstripped the rise in breakevens, pushing up the model-implied fair value and leaving breakevens remain more than one standard deviation under fair value (Chart 18). We will look for the gap between breakevens and fair values to shrink further in these two countries before closing these trades, even though we are substantially in the green on both (see the Tactical Overlay table on page 19). Chart 17Canadian Breakevens Are Just Below Fair Value Canadian Breakevens Are Just Below Fair Value Canadian Breakevens Are Just Below Fair Value Chart 18Italian Breakevens Are Well Below Fair Value Italian Breakevens Are Well Below Fair Value Italian Breakevens Are Well Below Fair Value Bottom Line: Our models suggest US TIPS breakevens are now at fair value. We are taking profit on our tactical long US 10-year inflation breakeven trade for a return of 2.88%. Stay long 10-year breakevens in Italy and Canada until we see further shrinkage in the gap between inflation breakevens and model-implied fair value and watch for a selling opportunity in UK 10-year breakevens.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Global Investment Strategy Weekly Report, "Pivot To Value", dated September 18, 2020, available at gis.bcaresearch.com. You can also learn more about The Good Judgement Project here: https://goodjudgment.com/about/ 2 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. 3 Please see BCA Research US Bond Strategy Portfolio Allocation Summary, "The Fed’s New Framework Is Bond Bearish…But Not Yet", dated September 8, 2020, available at usbs.bcaresearch.com. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rate Club", dated August 26, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Geopolitical Strategy Weekly Report, "The End-Game For Trump And Brexit", dated September 18, 2020, available at gis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Would It Take To Get Bond Yields To Rise Again? What Would It Take To Get Bond Yields To Rise Again? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

“Based on a broad set of indicators, it is hard not to see a certain amount of daylight between risky asset prices and economic prospects” – Claudio Borio, Head of Monetary and Economic Department, BIS, September 14, 2020 A pandemic, the resulting sharpest downturn in modern times and soaring government debt have made 2020 an annus horribilis for the US and world economy. Growth has rebounded strongly as economic lockdowns have ended, but most forecasts suggest that the level of activity will not return to its pre-virus level before the end of next year. That implies a lingering problem of high unemployment and there will be ongoing concerns about the eventual consequences of policymakers’ extreme monetary and fiscal actions. The long-run outlook for the US economy was already challenging before Covid-19 appeared on the scene. And this year’s events cannot have improved prospects relative to pre-crisis expectations. Thus, it is reasonable to wonder why the S&P500 hit a new all-time high in early September and currently is only slightly below that level. Is it a classic case of irrational exuberance or a sign that the economic outlook is much better than generally assumed? If we cannot come up with a convincing case for the latter then irrationality is left as a likely explanation. The sharp decline in interest rates certainly supports higher equity valuations, but a bull market that depends largely on stimulative monetary policy is problematic. The Stock Market Is Not The Economy, But… Finance theory states that equity prices should reflect the discounted long-run stream of expected dividend payments. In turn, those payments should be correlated with earnings growth which one would expect to have a close relation to underlying economic conditions. While prices often deviate significantly from so-called fundamentals, it is perfectly reasonable to assume a long-run correlation between the stock market and the performance of the economy. In practice, there is a loose relationship with occasional large deviations. Chart 1The US Economy vs. The Market The US Economy vs. The Market The US Economy vs. The Market Chart 1 shows the five-year annualized growth in US real GDP versus both real total returns from the S&P500 and real earnings.1 In making these comparisons, there are a few issues to consider. The stock market only represents quoted companies while GDP also includes the economic contribution of unincorporated businesses and the government. The sectoral composition of the S&P 500 is different from that of businesses at large. Many large US companies earn a significant share of their earnings from overseas operations that may be uncorrelated with domestic economic conditions. The price performance of stocks can reflect large swings in valuations driven by investor sentiment rather than fundamentals. Starting with the first point, corporate sector GDP accounts for only slightly more than half of total GDP, moving within a range of around 55% to 60% for the past 50 years (Chart 2). Yet the real growth in corporate GDP has moved in lockstep with that of total GDP. And aggregate sales of S&P500 companies have broadly tracked the swings in GDP. Thus, it cannot be argued that quoted companies can somehow miraculously avoid the ups and downs of the overall business cycle. The economy is based on a complex set of interconnected relationships and it would be remarkable if the performance of the country’s major corporations could deviate significantly from the economy at large for any length of time. Chart 2The Corporate Sector And Total GDP The Corporate Sector And Total GDP The Corporate Sector And Total GDP There certainly is an issue with the second point because the sectoral breakdown of the S&P500 does not exactly match that of the overall economy. While that does not always protect the stock market from general economic trends, it can help explain occasional large equity price moves. Table 1 shows the sector composition of the S&P500, weighted by market capitalization, sales and earnings, versus the composition of GDP. It is difficult to break down GDP exactly in line with the sector classifications of the market, but we have done as close a job as the data allows. Notable differences between the structure of the market and GDP are the relative weightings of the health care, industrials and information technology sectors. The following explanations seem plausible. Table 1Sector Composition: A Comparison The US Economy vs. The Stock Market: Is There A Disconnect? The US Economy vs. The Stock Market: Is There A Disconnect? For health care, the GDP weighting shown in the table is understated because it also is a significant part of the government sector’s contribution via Medicare and Medicaid. Other data show that total spending on health care accounts for around 18% of US GDP, broadly in line with the S&P index weighting. The large weighting of industrials in GDP compared with its share of the equity index probably reflects the fact that this broadly-defined group has a very large number of small and unquoted companies. On that point, it should be noted that unincorporated businesses account for 21% of national income – a non-trivial share. Last, but not least, there is the huge discrepancy in the weightings of information technology. This is a bit harder to explain, but two reasons come to mind. First, the S&P index market cap weighting has been boosted by the strong share price performance of these companies and high valuations thus flatter their index importance relative to underlying business activity. The IT weights based on sales and earnings are much lower, but still significantly exceed that in GDP. Secondly, some of these companies (Apple being a prime example) produce very little in the US relative to what they sell in the country. As GDP measures domestic output, this affects the relative weightings. Chart 3Growth In Overseas vs. Domestic Profits Growth In Overseas vs. Domestic Profits Growth In Overseas vs. Domestic Profits Let’s explore the issue about overseas earnings more closely. According to national income data, 45% of the corporate sector’s after-tax profits come from overseas earnings. And that is broadly consistent with the overseas share of sales for S&P500 companies. While the relationship is not perfect, the growth of overseas profits roughly tracks that of domestic profits (Chart 3). And where there have been large divergences, such as in 2009, that often has reflected large swings in oil prices. Overall, it hard to make the claim that the large share of earnings coming from overseas has been a factor supporting the strong performance of stocks relative to the underlying economy. This is especially true given that the US has performed better than most other economies in recent years and the dollar has been a strong currency. In sum, our analysis does not give compelling support to the idea that the fundamental performance of large quoted companies can sustainably diverge from that of the underlying economy. But that does not mean that share prices cannot deviate because of large swings in valuation. Is The US Equity Market Overvalued? This should be a simple question to answer, but often is not. Alternative approaches to valuation are sometimes in conflict and that is the current situation. Various valuation measures are shown in Chart 4 with the following observations. Chart 4AMeasures Of US Equity Valuation Measures Of US Equity Valuation Measures Of US Equity Valuation Chart 4BMeasures Of US Equity Valuation Measures Of US Equity Valuation Measures Of US Equity Valuation All the measures based on earnings (trailing, forward and cyclically-adjusted) suggest that the market is very expensive. While current earnings are affected by the economy’s second-quarter collapse, there remains considerable uncertainty about the speed of recovery. The current forward price-earnings ratio (PER) assumes that earnings will increase by around 30% over the next 12 months and that could prove to be optimistic. The market also looks significantly overvalued based on the ratios of price-to-book, price-to-sales and total market capitalization to GDP. While the valuation of the aggregate index has been boosted by the exceptional performance of the technology sector, it is important to note that the ratios of price to trailing earnings and to sales also are very elevated using the medians of 58 sub-groups, as calculated by BCA’s US Equity Strategy Service (Chart 5). In other words, this is not a story about overvaluation simply reflecting the hot technology sector. Chart 5Overvaluation Is Not Just About Technology Overvaluation Is Not Just About Technology Overvaluation Is Not Just About Technology The market looks much more attractive when comparing dividend and earnings yields with the returns available on cash and bonds. This is the so-called TINA argument (there is no alternative). It is hard not to prefer stocks when the dividend yield is above the yield on long-term government bonds. During the market overshoot of the late 1990s, the dividend yield was 500 basis points below the 30-year Treasury yield, highlighting that stocks were in a very risky phase. Moreover, the current environment of unusually low interest rates is unlikely to end any time soon. The Federal Reserve’s newly-released projections indicate that interest rates are expected to remain at current levels at least through the end of 2023. The Fed has made it abundantly clear that it is prepared to take risks with inflation in order to support a revival in economic activity. It is relatively straightforward when the different valuation metrics are all giving the same message, as was the case in the late 1990s. Even then, the market overshoot lasted longer and became more extreme than generally expected. Our composite valuation indicator takes account of 10 different measures and currently supports the idea that the market is indeed very expensive (Chart 6). Chart 6BCA Equity Valuation Indicator BCA Equity Valuation Indicator BCA Equity Valuation Indicator It currently is very difficult for institutional investors to favor fixed-income instruments over a higher-yielding equity market. However, there is no free lunch here. We cannot ignore the argument that low interest rates reflect a very bleak long-run outlook for economic growth and thus for earnings and stock prices. The secular stagnation view put forward by Larry Summers looks even more apposite today than when he outlined it several years ago. We are fortunate to have Larry as the opening speaker for our virtual Investment Conference on October 6th and it will be extremely interesting to hear his latest thinking. Some Thoughts On The Economic Outlook Equities are a long-duration asset so it makes sense to consider valuations in the context of the long-run economic outlook rather than the near-term ups and downs of activity. Of course, short-run economic moves do affect investor sentiment so cannot be ignored. The near-term outlook is extremely cloudy because of uncertainty about the future path of the pandemic. While the virus appears to have become less virulent, infection rates could climb sharply over the winter months as schools re-open and people spend more time indoors. In addition, there are doubts about the scale and timing of much-needed additional government stimulus. Chart 7Mixed Data On The US Economy Mixed Data On The US Economy Mixed Data On The US Economy Some recent data have been impressively strong. The value of retail sales has surpassed pre-virus peaks as have new and existing home sales (Chart 7). On the other hand, manufacturing and construction output and overall employment remain far below previous peaks. And we have yet to see the impact of the ending of the $600 a week income support. There are legitimate concerns that early 2021 will see a surge in home evictions and a marked increase in small business bankruptcies. Most likely, the economy will experience a bumpy and moderate recovery after its post-lockdown strong third-quarter growth. The Fed forecasts US growth of 4% in 2021 after a 3.7% drop this year and the OECD’s latest projections are similar. That still means that it will take until the end of 2021 before real GDP gets back to its end-2019 level. And there are downside risks to that forecast if the virus remains a lingering problem. Our conference on October 6th will have what is sure to be a lively debate about the US economic outlook between Ed Yardeni and Dave Rosenberg. These two very smart economists have a very different take on how things are likely to play out and what it means for the markets. This debate will follow the presentation by Larry Summers and after that, Peter Berezin, our Chief Global Strategist, and myself will discuss our views and will be open for audience questions. Should be very interesting! Let’s talk about the longer-run economic outlook. As noted at the outset, it was less than inspiring even before the virus arrived on the scene. The two drivers of long-run economic performance are demographics and productivity and the growth in both has been trending lower. Chart 8Demographics Are A Problem Demographics Are A Problem Demographics Are A Problem The demographics story is straightforward and essentially locked in place. A falling birth rate means that the working-age population will rise at a meager 0.2% a year over the next ten years compared with more than 1% a year in the 1980s, 1990s and 2000s. Moreover, growth is projected to remain low in subsequent decades (Chart 8). And even these forecasts may be optimistic if the current antipathy toward immigration leads to a more closed-door stance. Demographic trends not only imply a slow-growing workforce (impacting potential GDP) but also create a worsening picture for government finances. An aging population boosts spending on health care and pensions when the number of taxpayers is growing very slowly. This shows up in a dramatic drop in the ratio of the working-age population (i.e. potential taxpayers) to those aged 65 and above.2 This is happening when government finances are already in dire straits and implies that future tax rates can only go higher, regardless of which political party is in power. The issue of productivity is more contentious because it is hard to measure, and future trends are less predictable than for demographics.3 Nevertheless, the data present a relatively clear picture: the growth of output per hour in the non-financial corporate sector has slowed markedly after a tech-driven spurt in the second half of the 1990s (Chart 9). We show the trend as a five-year growth rate to smooth out the short-term noise in the series. Chart 9Productivity Growth Has Slowed Productivity Growth Has Slowed Productivity Growth Has Slowed We discussed the outlook for productivity in a recent Special Report and highlighted some worrying trends.4 These include weak growth in business investment, a retreat from globalization, increased government involvement in the economy and friction caused by new pandemic-related protocols to protect the safety of customers and workers in several industries. On a more positive note, the virus has forced many businesses to streamline their operations and the move to remote working should boost productivity in some cases. What about the issue of technological advances such as artificial intelligence (AI) and autonomous vehicles? These clearly have the potential to boost productivity in many areas but with a caveat. Previous major technological breakthroughs (often called general purpose technologies or GPTs) such as steam power, the internal combustion engine, electricity, and the internet had major impacts on both supply and demand. Generally, they were associated with creating completely new activities. For example, steam power led to the locomotive which in turn allowed the opening of the country and the movement of goods to distant markets. Similarly, the automobile led to the development of the suburbs and the associated demand for housing and related services. More recently, the internet boosted the demand for a wide range of tech goods and services. While that is still ongoing, its peak effect has passed, helping to explain the decline in productivity growth from late-1990s level. In contrast, a lot of current ‘new’ technologies simply are associated with doing existing tasks more efficiently (3-D printing would be an example). That is still important but not on the same scale as GPTs. There is no doubt that AI will be a big disruptor in many sectors but its impact on demand is less clear. Maybe one day all households will have a domestic robot but that is still far enough away to be in the realm of science fiction. The bigger near-term impact will be job displacement. And the same can be said for autonomous vehicles. The demand for new self-driving cars will rise, but these will simply replace gas-powered ones and perhaps the overall number of vehicles on the road will decline. In sum, there will be both positive and negative forces acting on future productivity growth and any predictions need to be treated with caution. Nonetheless, a base case should probably assume any improvements will be relatively modest. Finally, any discussion of long-run economic prospects cannot ignore the alarming rise in government debt. The US was already running $1 trillion federal deficits before this year’s crisis led to a further extraordinary explosion of red ink (Chart 10). Chart 10Soaring Government Debt Soaring Government Debt Soaring Government Debt Current large deficits are not fazing investors. In the past, the spread between 30-year and 10-year Treasurys widened as the deficit rose, but this relationship has weakened recently (second panel Chart 10). Fed buying of bonds may have had some impact, but it also reflects the weak economy and low inflation. It is hard to know at what point investors will take fright at US fiscal trends. The experience of other countries that faced sovereign debt crises suggests problems can arrive with little advance notice. One day investors seem complacent and the next they are running scared. The dollar’s status as the world’s main reserve currency gives the US more protection than other countries had when facing debt problems. And central banks’ willingness to be the bond buyers of first and last resort gives debt burdens more room to grow than in the past. However, debt arithmetic is relentless and will turn very ugly when bond yields eventually rise. It is futile to try and pin a date on when bond vigilantes might reassert themselves in the US. But it will happen at some point. Moreover, even before that happens, there will be political pressure to do something about soaring debt levels. Even without a market revolt, the burden of increased spending on entitlements and debt servicing will force the government to pursue austerity. Taxes will rise and spending growth will be curtailed. That is a further reason to be cautious about economic prospects. Increased debt is a way to bring spending forward but unless the money is used to invest in productive assets, the process eventually goes into reverse. Unfortunately, the surge in US government borrowing has been used to prop up consumption rather than to finance capital spending. The short- and long-run economic outlook would have been worse if there had not been a powerful fiscal response. Consumption would have suffered an even sharper decline with a catastrophic impact on employment, profits and capital spending. In that sense, the government really had no choice: the health of government finances becomes irrelevant in the midst of a pandemic-related economic collapse. Market Implications There are several explanations for the remarkable strength of the US equity market. Prime place goes to the Fed’s hyper-easy monetary stance. A policy of zero interest rates with a stated intention to keep them there for a long time has the desired effect of boosting risk-taking. A second factor has been excitement about technology that has created a bubble in that sector. And then there is the view that novice retail investors have been seduced into the market by online applications such as Robinhood that make day trading very easy. Missing from the above list is the suggestion that investors expect the economy to be strong enough to validate the market’s current level. That just does not seem plausible because it is not credible that earnings could grow strongly enough to lower valuations to more reasonable levels over the next five to ten years. If the bull case for stocks rests simply on the TINA argument, then it implies equities will remain in a bubble over the medium term. That certainly is possible but not the foundation for a sound investment strategy. It is not easy to come up with an investment strategy when no asset is cheap. BCA’s House View is still to prefer equities on a cyclical basis and the challenge will be timing when to jump off the train. In conclusion, my answer is that there is indeed a disconnect between the economy and equity market. This may persist for quite a while but does not appear sustainable. I am reminded of the late 1990s when the bull market lasted much longer and moved far higher than I and many others expected. Yet, fundamentals eventually did matter with the S&P500 dropping by almost 50% over the space of 30 months. I am not suggesting that a similar decline is imminent and if the 1990s example is relevant, then the market can continue to rise for quite a while, and I am sure the BCA view will prove to be correct. However, ever the skeptic, my bias is to err on the side of caution rather than try to maximize returns. Let me end by giving our upcoming conference another plug. The outlook for US equities will be discussed by Liz Ann Sonders and Ned Davis, two highly-respected market analysts and we will have a separate important session on coming up with the ideal investment strategy from three different perspectives: the buy side, the sell side and independent research In addition, over the four days of the event, we will have high-level discussions of all the other key issues that will drive markets including China, geopolitics, the US election, currencies, and policy challenges. Find out more at https://www.bcaresearch.com/conference2020.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com   Footnotes 1Total returns and earnings were deflated using the corporate price deflator. 2Obviously, not everyone of working age pays much in the way of taxes and there are many aged 65 above who pay lots of taxes. But that does not abstract from the dramatic change in the ratio.  3If you want to know how many 70-year old people there will be in 10 years’ time, simply count the number of 60-year olds today and apply an appropriate mortality rate. 4Please see BCA Special Report "Beyond the Virus," dated May 22, 2020, available at bca.bcaresearch.com

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week A Massive Shock To Growth ... And Interest Rates A Massive Shock To Growth ... And Interest Rates Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Table 2Global Spread Products In Our Analysis Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Equities and other risk assets face near-term headwinds from the surge in Covid cases in the US Sun Belt and the looming fiscal cliff. We think these problems will be resolved, but the next few weeks could be rough sledding for markets. Government bond yields have moved sideways-to-down since late March even though inflation expectations have rebounded. The resulting decline in real yields has been an important, if rather overlooked, driver of higher equity prices. The failure of government bond yields to rise in line with higher inflation expectations can be attributed to the ongoing dovish shift in monetary policy. Nominal yields are likely to increase modestly over the next two years as growth recovers. However, inflation expectations should rise even more. Hence, real yields may fall further, justifying an overweight position in TIPS and a generally positive medium-term view on equities. As long as there is spare capacity in the economy, fiscal stimulus will not push up real yields. This is because bigger budget deficits tend to raise overall savings, thus creating the resources with which to finance the deficits. Once economies return to full employment in about three years, the fiscal free lunch will end. At that point, the combination of easy monetary and fiscal policies could cause inflation to accelerate. Central banks will welcome higher inflation initially. However, they will eventually be forced to hike rates aggressively if inflation continues to march upwards. When this happens, bond yields will rise sharply, while stocks will tumble. A Curious Divergence Government bond yields have moved sideways-to-down in most developed economies since stocks bottomed in late March (Chart 1). In contrast, inflation expectations have risen. As a result, real yields have declined. In the US, TIPS yields have fallen into negative territory across all maturities (Chart 2). Chart 1Nominal Yields Have Moved Sideways-To-Down, Inflation Expectations Have Risen, And Real Yields Have Declined Nominal Yields Have Moved Sideways-To-Down, Inflation Expectations Have Risen, And Real Yields Have Declined Nominal Yields Have Moved Sideways-To-Down, Inflation Expectations Have Risen, And Real Yields Have Declined Chart 2TIPS Yields Have Fallen Into Negative Territory Across The Board TIPS Yields Have Fallen Into Negative Territory Across The Board TIPS Yields Have Fallen Into Negative Territory Across The Board The decline in real yields has been one of the unsung drivers of higher equity prices this year. The forward P/E ratios of the major US indices have moved closely in line with real yields (Chart 3). Gold prices have also risen, as they are often wont to do when real yields go down (Chart 4). Chart 3Lower Real Yields Have Lifted Stock Multiple Lower Real Yields Have Lifted Stock Multiple Lower Real Yields Have Lifted Stock Multiple Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields Gold Prices Have Risen On The Back Of Falling Real Yields Gold Prices Have Risen On The Back Of Falling Real Yields It is fairly uncommon for inflation expectations to rise without a commensurate increase in nominal bond yields (Chart 5). As a rule of thumb, when the economic data surprise to the upside, as has occurred over the past few months, bond yields go up (Chart 6). Chart 5It Is Unusual For Inflation Expectations To Rise Without A Corresponding Increase In Nominal Bond Yields It Is Unusual For Inflation Expectations To Rise Without A Corresponding Increase In Nominal Bond Yields It Is Unusual For Inflation Expectations To Rise Without A Corresponding Increase In Nominal Bond Yields Chart 6Bond Yields Usually Rise When Economic Data Surprise To The Upside Bond Yields Usually Rise When Economic Data Surprise To The Upside Bond Yields Usually Rise When Economic Data Surprise To The Upside An important exception to this rule occurs when monetary policy is becoming more expansionary. Bond yields tend to follow the path of expected policy rates (Chart 7). When central banks guide rate expectations lower, bond yields can fall, even as the reflationary impulse from lower yields delivers an upward kick to inflation projections. Chart 7ABond Yields Tend To Follow The Path Of Expected Policy Rates Bond Yields Tend To Follow The Path Of Expected Policy Rates Bond Yields Tend To Follow The Path Of Expected Policy Rates Chart 7BBond Yields Tend To Follow The Path Of Expected Policy Rates Bond Yields Tend To Follow The Path Of Expected Policy Rates Bond Yields Tend To Follow The Path Of Expected Policy Rates The last time such a divergence between yields and inflation expectations occurred was in early 2019. The stock market crash in late 2018 forced the Fed to abandon its plans to hike rates. Jay Powell’s dovish pivot occurred just three months after he said that rates were “a long way” from neutral. The Fed would go on to cut rates by 75 bps over the course of 2019. Real Yields Could Fall Further Chart 8Inflation Expectations Are Still Quite Depressed In Most Countries Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? The key question for investors is how much longer the pattern of rising inflation expectations and stable bond yields can persist. Our sense is that nominal bond yields will rise modestly over the next few years as growth recovers. However, inflation expectations are likely to rise even more, justifying an overweight position in TIPS relative to nominal bonds. Inflation expectations are still quite depressed in most countries (Chart 8). If global growth rebounds, both actual and expected inflation should edge higher. Chart 9 shows that the US ISM manufacturing index leads core inflation by about 12-to-18 months. Higher oil prices should also lift inflation expectations (Chart 10). Will global growth recover? The answer is “yes” if we are talking about a horizon of 12 months or so. That said, as we discuss below, there are some near-term risks to growth. This implies that equities and other risk assets could trade nervously over the next few weeks.   Chart 9Global Growth Recovery Will Lead To Higher Inflation Down The Line Global Growth Recovery Will Lead To Higher Inflation Down The Line Global Growth Recovery Will Lead To Higher Inflation Down The Line Chart 10Inflation Expectations And Oil Prices Move In Lockstep Inflation Expectations And Oil Prices Move In Lockstep Inflation Expectations And Oil Prices Move In Lockstep   Near-Term Risks To Global Growth The two biggest threats to global growth over the coming months are the Covid outbreaks in a number of countries and the possibility that fiscal stimulus will be rolled back, especially in the US, where a “fiscal cliff” is looming. Despite progress in suppressing the virus in Europe, Japan, and most of East Asia, the number of reported daily infections continues to rise globally (Chart 11). In the developed world, the US remains a major hotspot. Although the number of cases appears to have peaked in Arizona, it is still rising in the other Sun Belt states (Chart 12). Among emerging markets, the epicenter has moved from Brazil and Russia to India (Chart 13). Chart 11Despite Progress In Europe, Japan, And Most Of East Asia, The Number Of Covid Infections Continues To Rise Globally Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? Chart 12A Second Wave Is A Key Macro Risk Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? Chart 13BRICs: Covid Leaving No Stone Unturned Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? While efforts to contain the virus will boost growth in the long run, they will weigh on economic activity in the near term. Over half of the US population lives in states that have either reversed or suspended reopening plans (Chart 14). Chart 14Not So Fast Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? Google data on visits to shopping malls, recreation centers, public transport facilities, and office destinations have dipped in recent weeks. The decline in visits has occurred alongside a decrease in the New York Fed’s high-frequency economic activity indicator (Chart 15). Initial unemployment claims also rose this week. At this point, it looks likely that the recovery in US consumer spending will stall in July and August. Chart 15Covid Outbreak Is Weighing On Spending Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? While it is difficult to know what will happen starting in September, our guess is that the pandemic will ebb in the southern states, just like it did in the northeast. This is partly because mask-wearing is becoming more widespread. Back in early March, when most mainstream news sources were tweeting out misinformation such as “Oh, and face masks? You can pass on them,” we noted that both logic and evidence suggest that masks are an effective tool against the virus. Increased testing should also help identify asymptomatic people before they have had the chance to spread the virus to many others. Meanwhile, improved medical care should also help reduce the mortality and morbidity rates from the disease. Just this week, scientists presented the results of a double-blind clinical trial showing that the inhalation of interferon beta, a cytokine used to treat multiple sclerosis, reduced the risk of developing severe Covid symptoms by nearly 80%. Fiscal Cliff Ahead? In addition to the pandemic, investors have to grapple with uncertainty over whether fiscal policy will remain sufficiently accommodative to reflate the economy. Unlike the EU, which managed to cobble together a framework for creating a 750 billion euro pandemic relief fund earlier this week, the US Congress remains deadlocked on the size and complexion of a new stimulus bill. Under current law, US households will stop receiving expanded unemployment benefits at the end of July. These benefits were legislated as part of the original CARES Act and currently total over 4% of GDP. The Paycheck Protection Program for small businesses is also nearly drained, while state and local governments are facing a major cash crunch due to evaporating tax revenues and higher pandemic-related spending needs. We estimate that about $2-to-$2.5 trillion in new stimulus will be necessary to keep fiscal policy from turning unduly restrictive. Senate Majority Leader Mitch McConnell has been floating a number of $1.3 trillion. If McConnell gets his way, risk assets will likely sell off. Our guess is that he will not prevail, however. President Trump favors a larger stimulus bill, as do the Democrats. Critically, more than four out of five voters, both nationwide and in swing states, support extending benefits (Table 1). Thus, there is a high probability that Senate Republicans will agree on a much larger package than what they are currently proposing. Table 1There Is Much Public Support For Fiscal Stimulus Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? Fiscal Stimulus And Bond Yields Could continued fiscal stimulus deplete national savings, leading to significantly higher real yields? For the next few years, the answer is no. National savings depend not just on how much people spend, but on how much they earn. To the extent that fiscal stimulus raises GDP, it also raises national income. For the global economy as a whole, savings must equal investment. If fiscal stimulus in the major economies prompts firms to undertake more investment spending than they would have otherwise, overall savings will rise. How can that be? The answer is that fiscal stimulus raises private savings by more than it reduces government savings when an economy is operating below its full capacity. From the perspective of the bond market, this means that currently, large budget deficits are self-financing. Bigger budget deficits will produce an even bigger pool of private income, allowing the private sector to buy more government bonds.   Indeed, a premature pullback in fiscal support would almost certainly raise real rates by depressing inflation expectations. If that sounds far-fetched, recall that this is precisely what happened in March. Full Employment And Beyond Chart 16Government Debt Levels Have Surged In The Wake Of The Pandemic Government Debt Levels Have Surged In The Wake Of The Pandemic Government Debt Levels Have Surged In The Wake Of The Pandemic The fiscal free lunch will end only when economies return to full employment. At that point, bigger budget deficits will no longer be able to raise output since everyone who wants to work will already have found a job. Rather, increased government borrowing will crowd out private-sector investment. National savings will decline. If monetary and fiscal policy stay accommodative, inflation could accelerate. Central banks will probably welcome the initial burst of inflation, since they have been lamenting below-target inflation for many years now. However, if inflation continues to march higher, central banks may get spooked and start talking up the prospect of rate hikes. Higher rates would create a lot of problems for debt-saddled governments (Chart 16). It would not be at all surprising if politicians leaned on central banks to keep rates low. Governments could also end up forcing central banks to buy more debt in order to keep long-term yields from rising. In the extreme case, governments could even force central banks to cap yields. While such measures would prevent bond prices from tumbling, this would be cold comfort for bondholders. If central banks were to keep bond yields below their equilibrium level, inflation would rise even further, thus eroding the purchasing power of the bonds. In the end, central banks would still have to raise rates, probably more than they would have had they acted more swiftly to quell inflation. Investment Conclusions To answer the question posed in the title of this report, yes, bond yields will eventually go up. However, they are not likely to rise very much until inflation reaches intolerably high levels. That point is at least three years away. Despite the near-term risks posed by the pandemic and the looming fiscal cliff, investors should remain overweight equities over a 12-month horizon. Given the run-up in some of the large cap US tech names, we suggest shifting equity exposure to other parts of the stock market. The cyclically-adjusted price-earnings ratio is significantly lower outside the US, implying that international stocks are well placed to outperform their US peers over the coming decade (Chart 17). A weaker dollar should also help non-US stocks as well as the more cyclical equity sectors (Chart 18). Chart 17Non-US Stocks: The Place To Be Over The Coming Decade Non-US Stocks: The Place To Be Over The Coming Decade Non-US Stocks: The Place To Be Over The Coming Decade Chart 18A Weaker Dollar Should Boost Non-US Stocks Along With The More Cyclical Equity Sectors A Weaker Dollar Should Boost Non-US Stocks Along With The More Cyclical Equity Sectors A Weaker Dollar Should Boost Non-US Stocks Along With The More Cyclical Equity Sectors Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up? Current MacroQuant Model Scores Will Bond Yields Ever Go Up? Will Bond Yields Ever Go Up?