Economic Growth

Highlights Stocks jumped earlier this week on encouraging news on the vaccine front. While we remain positive on equities over a 12-month horizon, we would stress five vaccine-related risks that stock market investors should be cognizant of. First, immunizing most of the world’s population could prove logistically challenging, especially in light of widespread skepticism about the safety of the vaccine. Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates. Third, vaccine optimism could, ironically, lead to weaker economic growth in the near term, even if it does lead to stronger growth in the medium and longer term. Fourth, improved prospects for a vaccine could reduce urgency around extending fiscal support. Fifth, bond yields could rise further in anticipation of an earlier return to full employment. This could pose a headwind for equities – especially growth stocks. V Is For Vaccine Stocks rallied this week on news that Pfizer’s trial of its Covid-19 vaccine had apparently immunized more than 90% of test participants. Such a high efficacy rate is on par with that of the childhood measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu (Chart 1). Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Not Exceptionally High Pfizer’s vaccine leverages messenger RNA (mRNA) technology developed by its German partner, BioNTech. The new technology is similar to the one being deployed by US-based Moderna. It uses synthetic genetic material to coax the body into producing antibodies, thus bypassing the time-consuming process of formulating a vaccine using dead or weakened forms of the actual pathogen. Pfizer began manufacturing the vaccine well before it knew it would work. It expects to ask the US Food and Drug Administration for emergency authorization to begin distribution by the end of November. If all goes well, the company will have 15-to-20 million doses available by the end of this year and enough to inoculate the entire US population by mid-2021. Ten other vaccines are in late-stage trials. It is widely expected that most of them will prove to be safe and effective (Chart 2). Chart 2When Will A Vaccine Become Available? Five Risks This week’s vaccine news is certainly encouraging, and it does pave the way for a rapid rebound in economic activity next year. Thus, we remain bullish on stocks over a 12-month horizon. Nevertheless, investors should be cognizant of five vaccine-related risks: Table 1Skepticism Over Vaccines Has Been Growing Over The Past Two Decades Risk #1: Immunizing most of the world’s population is likely to prove logistically challenging, especially in light of widespread public skepticism about the safety of the vaccine Pfizer’s version of the vaccine needs to be refrigerated at -70°C, making it difficult to store and transport. It will also need to be administered twice over the course of 21 days (Merck is the only company working on a single-dose vaccine). All this will require health care providers to keep track of who received which dose of the vaccine and at which time. There is also considerable uncertainty about how long immunity from the vaccine will last. Pfizer is cautiously optimistic that it will be over a year, but the truth is that no one really knows. Vaccinating most of the global population repeatedly year in, year out could prove to be challenging. In addition, the rollout of the vaccine could face widespread public skepticism. Even before the pandemic struck, confidence in the safety of vaccines was waning in the United States. A Gallup study published on January 14th of this year revealed that the share of Americans who thought it was important to get their children vaccinated fell from 94% in 2001 to 84% in 2019. The drop was particularly steep among Americans with children under the age of 18 (Table 1).1 Ten percent of Americans believed the thoroughly debunked claim that vaccines cause autism, while 46% were “unsure.”2  Things do not appear to have improved since then. According to a recent Pew Research Center survey conducted in September, only 51% of Americans said they would probably or definitely take the vaccine, down from 72% in May (Chart 3). The most common reason given for refusing to take it was “concern about side effects.” Chart 3Many Americans Are Wary Of A Covid-19 Vaccine The fact that all the Covid-19 vaccines under development do seem to produce worse side effects than the typical flu vaccine could amplify fears that “the cure is worse than the disease.” We could end up in a “You first; oh no you first; I insist you first” predicament where most people try to avoid being first in line to receive a vaccine. Still, it is important to keep in mind that not everyone has to be vaccinated for the virus to be eradicated. Suppose that 70% of the population needs to be inoculated to simulate herd immunity. If the vaccine works nine out of ten times, then 0.7/0.9 or 78% of the population would have to receive the vaccine. The true number could end up being less than that because some people who survived Covid will have antibodies for a while even if they remain unvaccinated. There is also tentative evidence that a few lucky souls may be naturally immune to the disease, perhaps by having contracted seasonal coronavirus colds in the past.3 Furthermore, both government and corporate policy are likely to push people to get vaccinated. For better or for worse, governments may require that children present vaccination certificates before being admitted to school. Airlines could also demand such certificates before one is allowed to travel. Insurance companies could cut off coverage for those who fail to get vaccinated. At any rate, it is difficult to see governments pursuing lockdown measures after a vaccine is widely available. The prevailing view will be that anyone who voluntarily chooses to remain unvaccinated cannot hold others hostage. Risk #2: The virus could mutate in a way that undercuts the efficacy of the vaccine Unlike most RNA-based viruses, coronaviruses carry an error-correction mechanism in their genomes. While this confers certain advantages to this family of viruses, it also means that they tend to mutate more slowly than notorious shape-shifters like the common flu. Nevertheless, there is plenty of evidence that SARS-CoV-2, the virus that causes Covid-19, has mutated since it first emerged in China.4 Viruses tend to become less lethal but more contagious over time. This is not surprising. A virus that kills its host will also kill itself. The speed at which a virus mutates is partly a function of how much of it is in circulation. The more copies of the virus there are, the larger the number of adaptive mutations there are likely to be. The fact that SARS-CoV-2 has spread to virtually every corner of the earth raises the risk that it will readily produce strains that the current batch of vaccines is not equipped to target. Unfortunately, this may not just be an idle threat. In Denmark, 12 people have already been infected with a novel strain of the virus that first emerged from mink farms. Although the data is still sketchy, the virus seemingly jumped from humans to minks early on in the pandemic, mutated within the mink population, and then jumped back to humans. The mutation appears to have altered the virus’s spike proteins. These are the proteins that the virus uses to gain entry into human cells. They are also the proteins that Pfizer’s vaccine is targeting. It is still not clear if the mutated strain will be vaccine-resistant, but governments are not taking any chances. The UK barred entry to travelers from Denmark on November 5th. Other countries may follow suit. Risk #3: Vaccine optimism could lead to weaker economic growth in the near term The release of the results of Pfizer’s vaccine trial comes at a time when the number of new confirmed global cases has reached record highs (Chart 4). The latest wave of the pandemic has hit Europe especially hard. European governments have responded by tightening lockdown measures (Chart 5). Euro area GDP is likely to contract in the fourth quarter. Chart 4The Number Of New Cases Continues To Rise Globally Chart 5Some Lockdown Measures Have Been Reintroduced While the development of a vaccine is good news for the economy in the medium-to-long term, it is not clear if it will help growth in the near term. On the one hand, vaccine optimism could cause firms to invest more, while curbing household precautionary savings. This would boost aggregate demand. On the other hand, vaccine optimism could prompt people to make even more effort to avoid getting sick. If you take shelter under a tree during an unforeseen rainstorm, you’re better off staying put until the storm passes... provided, of course, that the rainfall does not last too long. But what if you check your phone and see that the rain is supposed to fall uninterrupted for the next three days? That is a long time to spend under a tree. At that point, you are better off proceeding ahead. After all, you are going to get wet in any case. Chart 6Commercial Bankruptcy Filings Remain In Check The same logic applies to the pandemic. If you can avoid getting sick by hunkering down for a few more months until a vaccine becomes available, it is well worth doing so. However, if the prospects for a vaccine or effective treatment are poor, it makes less sense to hide from the rest of the world. Chances are you are going to get sick anyway. Risk #4: Improved prospects for a vaccine could reduce urgency around extending fiscal support So far, the pandemic has left only limited scarring on the global economy. For example, according to the American Bankruptcy Institute, corporate bankruptcies are lower now than they were this time last year (Chart 6). The same is true for delinquency rates on most consumer loans (Table 2).   Table 2A Snapshot Of Consumer Delinquencies Many economies have displayed resilience so far thanks to ample fiscal and monetary support. In Europe and Japan, the combination of wage subsidies and job retention programs has kept unemployment from rising significantly (Chart 7). The unemployment rate rose rapidly in the US, Canada, and Australia early on in the pandemic, but has since declined. In the US, there are now fewer than two unemployed workers per job opening (Chart 8). It took the US over five years to reach that point following the Global Financial Crisis. Chart 7Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Chart 8The Labor Market Is In A Better Place Now Compared To The Great Recession   The risk is that fiscal policy support will be withdrawn before lockdown measures can be lifted. While such a risk cannot be ignored, two things should help mitigate it. First, fiscal hawks are more likely to support a temporary stimulus package that lasts a few months rather than an open-ended support scheme that may be needed indefinitely. Second, public opinion still very much favors maintaining stimulus. According to a recent NY Times/Siena College poll, 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 3). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Risk #5: Bond yields could rise further in anticipation of an earlier return to full employment If a premature tightening of fiscal policy is unlikely to sink the stock market, could higher bond yields do the trick? Central banks will not raise interest rates for the next few years. However, rate expectations could still rise further along the forward curve if investors believe that a vaccine will allow the output gap to close earlier than previously anticipated. Chart 9Policy Rate Expectations Remain Below Pre-Pandemic Levels Investors expect US short-term rates to average only 1.25% in 2027-28. While this is higher than prior to the vaccine announcement, it is still well below where rate expectations were at the start of the year. Long-dated rate expectations are similarly below pre-pandemic levels in most other economies (Chart 9). Upward revisions to where policy rates will be later this decade could lift long-term bond yields. Higher yields, in turn, could raise the discount rate that stock market investors use to calculate the present value of future cash flows. This might lead to lower equity prices. The valuation of growth companies, whose earnings may not be realized for many years to come, is especially vulnerable to changes in discount rates. Despite the threat posed from rising bond yields, we suspect that the actual impact on equity prices will be fairly modest. There are three reasons for this. First, any increase in bond yields will probably occur alongside rising inflation expectations. As such, real yields may not increase that much. Conceptually, it is real yields, rather than nominal yields, that matter for equity valuations. Second, provided that higher yields are reflective of stronger growth, earnings estimates are likely to drift up. Rising profits will dampen the impact of higher bond yields on equity valuations. Third, central banks have both the tools, and just as importantly, the inclination to keep bond yields from spiking as they did during the 2013 “taper tantrum.” These tools include QE, aggressive forward guidance, and if necessary, yield curve control strategies. Investment Conclusions The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors overweighting equities versus bonds over the next 12 months. Within the equity portion of a portfolio, investors should reallocate funds from US stocks to overseas markets and from growth stocks to value stocks. Growth stocks benefited from the pandemic and from falling bond yields, but will suffer as yields rise modestly from current levels and investors shift exposure to stocks that will benefit from the reopening of economies. Chart 10Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Chart 11EM Stocks Are Cheap As a countercyclical currency, the trade-weighted US dollar is likely to weaken further in 2021. Non-US stocks typically outperform their US peers when the dollar depreciates (Chart 10). A weaker dollar will provide an additional boost to emerging market equities, given that many EMs have a lot of dollar-denominated debt. Assuming Joe Biden becomes president, a de-escalation of the trade war would also help emerging markets, particularly China. Lastly, EM equities are still quite cheap based on cyclically-adjusted earnings (Chart 11). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Attitudes towards vaccines have shifted notably over the past two decades. The following survey captures the erosion of trust towards vaccines: RJ Reinhart, “Fewer in U.S. Continue to See Vaccines as Important,” Gallup, January 14, 2020. 2 One of the most widely known parental concerns about the safety of vaccines is linked to the hypothesis that the measles-mumps-rubella (MMR) vaccine causes autism. Since this hypothesis was published more than three decades ago, dozens of researchers have presented studies showing that the original claims are critically flawed. The evidence provided by the scientific community dismisses the link between vaccines and autism. Please see Jeffrey S. Gerber and Paul A. Offit, “Vaccines and Autism: A Tale of Shifting Hypotheses,” National Center for Biotechnology Information; and “Vaccines and Autism,” Children’s Hospital of Philadelphia, May 7, 2018. 3 There has been much debate over why some people are affected more than others by Covid-19. While much attention is given to personal characteristics (such as age, weight, or the presence of chronic illnesses), researchers have also investigated the possibility that prior exposure to coronaviruses have helped some to obtain a certain degree of natural immunity to Covid-19. Please see Yaqinuddin, Ahmed, “Cross-immunity between respiratory coronaviruses may limit COVID-19 fatalities,” Medical hypotheses, vol. 144 110049, (30 June, 2020). 4 One of the latent fears since the emergence of Covid-19 has been the possibility that it will mutate as it spreads. The following study suggests that different strains of the virus have been evolving on different continents, although it is not clear to what extend these mutations could affect treatment and immunization efforts. Please see Pachetti, M., Marini, B., Benedetti, F. et al., “Emerging SARS-CoV-2 mutation hot spots include a novel RNA-dependent-RNA polymerase variant,” Journal of Translational Medicine, 18:179 (2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights US Election & COVID-19: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Fixed Income Strategy: The big news announcements do not motivate us to change our fixed income investment recommendations. Stay below-benchmark on overall duration, and underweight the US in global bond portfolios. Stay overweight global inflation-linked bonds versus nominal government debt, particularly in the US and Italy. Maintain an overweight stance on global spread product, focused on US corporates (investment grade and Ba-rated high-yield) and emerging market US dollar denominated corporates. Feature Chart of the WeekUS Yields Leading The Way Higher Investors have digested two major pieces of news over the past few days – the projected election of Joe Biden as the 46th US President and the positive results of Pfizer’s COVID-19 vaccine trial. Both outcomes are bond-bearish, but the bigger response came after the news of a potential vaccine, with the 10-year US Treasury yield hitting an 8-month high of 0.96% yesterday. Yields in other countries rose by a lesser amount, continuing the recent trend of US Treasury underperformance (Chart of the Week). After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios.  The introduction of a successful vaccine would obviously be a game-changer for all financial markets, not just fixed income, as it would allow investors to see an end to the pandemic and a return to more normal economic activity. While we are heartened by the vaccine trial announcement, there are still many hurdles that need to be cleared before any vaccine is approved and distributed around the world. It is still too soon to adjust our bond investment strategy in anticipation of a post-COVID world. After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. While a Biden victory combined with the Republicans likely keeping control of the US Senate was the least bond-bearish outcome - thus avoiding the big surge in government spending likely after a Democratic “blue wave” - there is clear upward momentum in US economic growth that suggests more upside for Treasury yields on both an absolute basis and relative to other countries. Cross-Country Divergences Are Starting To Appear Our recent decision to cut our recommended overall global duration stance to below-benchmark was motivated by our more bearish view on US Treasuries. However, a more defensive duration posture was justified by the rapid rebound in global growth seen since the depths of the COVID-19 recession. Our Global Duration Indicator, comprised of leading economic data, has been calling for a bottom in global bond yields toward the end of 2020 (Chart 2). The rise in global yields we are witnessing now appears to be right on cue. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. Chart 2Global Yields Are Bottoming Importantly, inflation expectations across the developed world have yet not risen by enough to force central banks to become less dovish. This suggests that global yield curves will have a steepening bias over at least the next six months, with longer-term yields rising more on the back of faster growth (and additional increases in inflation expectations) than shorter-maturity yields which are more sensitive to monetary policy shifts. Those trends will not be seen equally across all countries, though. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. For example, the October US manufacturing ISM and Payrolls data released last week showed robust strength, even in a month where new US COVID-19 cases rose sharply. Europe, on the other hand, has seen an even bigger surge in new cases, resulting in a wave of national lockdowns that has already begun to weigh on domestic economic activity. Thus, core European bond yields have remained stable, even with the euro area manufacturing PMI remaining elevated (Chart 3). We see similar divergences in other developed economies, with generally strong manufacturing PMIs and mixed responses from bond yields. When looking at the breakdown of nominal bond yields into the real yield and inflation expectations components, even more divergences are evident (Chart 4).1 Chart 3Mixed Responses To Rebounding Growth Chart 4Real Yield Trends Are Starting To Diverge Chart 5Discounting An Extended Period Of Negative Real Rates The real yields on benchmark 10-year inflation-linked bonds are slowly rising in the US and Canada, but remain stable in Germany, the UK and Australia. Market expectations for central bank policy rates, extracted from overnight index swap (OIS) curves, are currently priced for an extended period of low policy rates over the next few years. This is no surprise, as central banks have told the markets this would be the case via dovish forward guidance. Yet central banks are also projecting inflation rates to move higher between 2021 and 2023, even as they are signaling unchanged interest rates over that same period (Chart 5). Central banks are effectively telling markets that they want an extended period of negative real policy rates - a major reason why real bond yields are negative across the developed world. At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. Unemployment in the US and Canada has already declined sharply since spiking during the first wave of COVID-19 lockdowns. In the US, the unemployment rate has fallen from a peak of 14.7% to 6.9%; in Canada, the decline has been from 13.7% to 8.9% (Chart 6). This contrasts sharply to trends in Europe and Australia, where unemployment rates remain elevated. Chart 6Diverging Trends In Unemployment At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. With the Fed and Bank of Canada (BoC) projecting additional declines in unemployment over the next few years, markets are starting to discount a less dovish stance from both central banks. The US and Canadian OIS curves are now discounting one full 25bp policy rate hike by Aug 2023 and May 2023, respectively. This is a bit sooner than signaled by the forward guidance of the Fed and BoC. Thus, markets are now pricing in a less negative path for real policy rates – and, by association, real bond yields. Chart 7Markets Still Discounting Low Yields For Longer This contrasts to the euro area, Australia and the UK, where unemployment rates remain elevated. The recent surge in coronavirus cases across Europe means that the ECB and Bank of England will be under no pressure by markets to reconsider their current easy money policies. While in Australia, persistently weak inflation and, more recently, worries about an appreciating Australian dollar are keeping expectations for Reserve Bank of Australia (RBA) policy ultra-dovish. Given the likely hit to longer-term potential growth from the COVID-19 pandemic, coming at a time of elevated debt levels (both government and private), markets are justified in pricing in a structurally lower level of policy rates for longer (Chart 7). Yet even in such a world, there will be cyclical upswings in growth and inflation that will upward pressure on bond yields. At the moment, those pressures seem greatest in the developed world in the US and Canada. This suggests that global bond investors should underweight both the US and Canada. However, the Fed seems more willing to accept a period of rising bond yields than the BoC, which has been very aggressive in the expansion of its quantitative easing (QE) program, which leaves us to only consider the US as a recommended underweight. Bottom Line: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Recommended Fixed Income Strategy After A Busy Few Days Joe Biden’s election victory and the potential COVID-19 vaccine do not lead us to make any changes to our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On duration, we continue to recommend a moderate below-benchmark overall exposure. Our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On country allocation, we remain underweight the US, neutral Canada and Australia, and overweight the UK, core Europe, Italy, Spain and Japan. The country allocations are determined by each country’s sensitivity to changes in US Treasury yields, particularly during periods of rising yields. We are overweight the countries with a lower “yield beta” to changes in US yields. We view Italy and Spain as credit instruments, supported by large-scale ECB purchases and more fiscal cooperation within Europe. We are not recommending underweights to higher-beta Canada and Australia, however, with both the BoC and RBA being very aggressive with bond purchases (Chart 8). On credit, the backdrop remains very conducive to spread product outperformance versus government bonds, particularly with the monetary policy backdrop remaining highly accommodative (Chart 9). Chart 8Global QE Has Been Aggressive We expect some additional spread tightening for developed market corporate debt as well also emerging market US dollar denominated corporates. In terms of regions and credit tiers, we prefer US investment grade and Ba-rated high-yield to euro area credit. Chart 9Central Bank Liquidity Still Supportive For Global Credit Chart 10More Global QE Is Good For Inflation-Linked Bonds Finally, we continue to recommend overweight allocations to inflation-linked bods versus nominal government debt in the US, Italy and Canada. Central banks will continue to err on the side of maintaining stimulative monetary policy settings to keep financial conditions easy to support economic growth. That means no hawkish surprises on the interest rate front, while also continuing to buy bonds via quantitative easing (Chart 10) – reflationary policies that should help boost inflation expectations.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have deliberately left Japan out of this analysis, as the Bank of Japan’s Yield Curve Control policy has effectively short-circuited the link between Japanese economic growth, inflation and bond yields. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights According to betting markets, Joe Biden is likely to become the 46th US president, with the Republicans maintaining control of the Senate. Such a balance of power could produce less fiscal stimulus than any of the other possible outcomes that were in play on Tuesday. Nevertheless, public opinion still favors a more expansionary fiscal policy. There is also an outside chance that Republicans in the Senate and Democrats in the House could craft a “grand bargain” that raises spending while making Trump’s corporate tax cuts permanent. The combination of continued easy monetary policy, modestly looser fiscal policy, and progress on a vaccine should be enough to keep global growth on an above-trend path next year. Bank shares have been the big losers since the election, but should start to outperform as yield curves re-steepen, worries about soaring bad loans subside, and lending growth outpaces bleak expectations. Investors should remain overweight global equities versus bonds. Be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting. Another Election Rollercoaster Last week, we highlighted that BCA’s geopolitical quant model was predicting a much closer election than most pundits were expecting. This indeed turned out to be the case. For a brief while on Tuesday night, betting markets were giving Donald Trump a greater than 75% chance of being re-elected. Unfortunately for the president, the good news did not last long. As more mail-in ballots and ballots cast in large urban areas were counted, the needle began to swing towards Joe Biden. At the time of writing, betting markets are giving Biden an 88% chance of becoming President. Trump still has a chance of winning, but assuming he loses Nevada, Michigan, and Wisconsin, he would need to win Pennsylvania, Arizona, and Georgia. That is a tall order. According to PredictIt, the latter three states are all leaning towards Biden (Chart 1). Chart 1The Distribution Of Electoral College Votes According To Betting Markets More positively for the GOP, the Republicans gained a net six seats in the House of Representatives, and held onto the Senate thanks to surprise victories for their candidates in Maine and North Carolina. That said, the Senate could still revert to Democratic hands depending on the final vote tally in Georgia, North Carolina, and Alaska; PredictIt assigns a 22% probability to the Democrats taking the Senate. Moreover, even if they fall short this time around, the Democrats still have a chance of winning a 50-seat de facto majority in the Senate if both Georgia races go to a run-off election on January 5. Stimulus In Peril? Assuming that Republicans maintain their majority in the Senate, tax hikes will remain off the table. This is good for stocks. Joe Biden would also lower the temperature on trade tensions with China. This, too, is good for stocks. Conversely, the odds of a major fiscal stimulus package have dropped. Donald Trump is not averse to big spending programs. In contrast, the Republicans in the Senate have rejected calls for a large stimulus bill. With Joe Biden as President, Republican senators would have even less incentive to give the Democrats what they want. Nevertheless, there are three reasons to think that Republicans will agree on a new stimulus bill. First, the economy needs it. While US growth should remain reasonably firm in the fourth quarter, this is only because households were able to build up some savings earlier this year which they can now draw on. As Chart 2 shows, since April, labor earnings have only grown one-third as much as personal spending. Transfer income has also plunged, resulting in a renewed drop in savings. Once households run out of accumulated savings, there is a risk that they will cut back on spending. Second, government borrowing rates remain extremely low by historic standards. Real rates are negative across the entire yield curve (Chart 3). Chart 2Savings Have Dropped Since April As Transfers Declined Chart 3Real Rates Are Negative Across The Entire Yield Curve   Third, and perhaps most politically salient, public opinion favors more expansionary fiscal policy. About 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. It is noteworthy that when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Strong Support For Stimulus All this suggests that Republicans will accede to a medium-sized stimulus bill in the neighbourhood of $700 billion-to-$1 trillion in order to avoid being perceived as stingy and obstructionist. Senate Majority Leader Mitch McConnell noted on Wednesday that getting a deal done was “job one.” While not our base case, a significantly larger bill is also possible. Most Republicans are not opposed to bigger budget deficits per se. It is increased social spending that they do not like. Budget deficits in the service of tax cuts are perfectly acceptable to the majority of Republicans. This raises the possibility that Republicans in the Senate and Democrats in the House could strike a grand bargain that raises spending while also promising additional tax relief. Most of Trump’s corporate tax cuts expire in 2025. A sizeable stimulus bill that makes these tax cuts permanent while increasing long-term spending on infrastructure, health care, education, and other Democratic priorities could still emerge from a divided Congress.   Wall Street Versus Main Street If one needed any more proof that what is good for Wall Street is not necessarily good for Main Street, the last three trading days provided it. The S&P 500 is up 6% since Monday’s close, spurred on by the reassurance that corporate taxes will not rise. In contrast, the 10-year bond yield has fallen 8 basis points on diminished prospects for a big stimulus package. The drop in bond yields since the election has raised the present value of corporate cash flows, leading to higher equity valuations. Growth companies have benefited disproportionately from falling bond yields. In contrast to value companies, investors expect growth companies to generate the bulk of their earnings far in the future. This makes their valuations highly sensitive to changes in discount rates. It is not surprising that tech shares – the FAANGs in particular – soared following the election (Chart 4). Chart 4Growth Equities Benefited Disproportionately From A Post-Election Drop In Yields A Bottom For The Big Banks? Bank shares tend to be overrepresented in value indices. Unlike tech, banks normally lose out when bond yields fall. As Chart 5 shows, net interest margins have collapsed for banks this year as bond yields have cratered. The drop in yields since the election has further punished bank shares. Chart 5Bank Net Interest Margins Have Collapsed As Bond Yields Have Cratered This Year Chart 6Commercial Bankruptcy Filings Remain In Check Yet, as our earlier discussion suggests, bond yields could rise again if the US Congress delivers more stimulus than currently expected. This would help banks, while potentially taking some of the wind from the sails of tech stocks. The combination of further fiscal easing and a vaccine next year could help banks in another way. If the global economy bounces back, banks would suffer fewer loan defaults. The biggest US banks have set aside more than $60 billion to cover potential loan losses. They have done so even though commercial bankruptcies have declined so far this year (Chart 6). A stronger economy would allow banks to release some of those provisions back into earnings.   Bank Regulation Is Not A Major Worry Anymore Wouldn’t the potential benefits to banks from more fiscal support and higher bond yields be outweighed by a greater regulatory burden under a Biden administration? Probably not. For one thing, a Republican Senate could block legislation that expanded regulation. Moreover, Biden hails from Delaware, a state that derives more than a quarter of its GDP from the finance and insurance sectors. He was only one of two Democrats on the Senate Judiciary Committee to vote in favor of the 2005 bankruptcy bill that made it more difficult for households to discharge their debts. It should also be stressed that most of the regulatory reforms that the Democrats sought after the financial crisis have already been encoded in the Dodd-Frank Act. The Act was passed during the Obama administration. While the Trump administration did water down some of its provisions, the changes were modest and had bipartisan support. Big Banks Are More Resilient Than Small Ones Today, US banks are better capitalized than they were in the years leading up to the financial crisis (Chart 7). The largest banks – the so-called Systemically Important Financial Institutions (SIFIs) – are required to hold an additional capital buffer, which arguably makes them even safer. Unlike the smaller regional banks, the SIFIs have only modest exposure to the troubled commercial real estate sector. As my colleague Jonathan LaBerge has documented, big banks have only 6% of their assets tied up in commercial real estate compared to 25% for smaller banks (Table 2). Chart 7US Banks: Better Capitalized Today Than Right Before The Financial Crisis Table 2Most US Commercial Real Estate Loans Are Held By Small Banks The largest US banks have more exposure to residential real estate than to commercial real estate. The US housing market has been firing on all cylinders recently. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales are near cycle highs. The S&P/Case-Shiller 20-city home price index rose 5.2% in August, up from 4.1% in July. The FHFA index surged 8.1% in August over the prior year. Homebuilder confidence hit a new record in October (Chart 8). Homebuilder stocks are up more than 20% versus the broad market this year. Chart 8US Housing Market: Firing On All Cylinders According to TransUnion, consumer delinquencies have been trending lower across most loan categories (Table 3). Notably, the 60-day delinquency rate on residential mortgages stood at 1% in September, down from 1.5% the same month last year. Table 3A Snapshot Of Consumer Delinquencies The Forbearance Time Bomb? Some investors have expressed concern that various pandemic-related forbearance programs are distorting the delinquency data. Reassuringly, that does not appear to be the case. Summarizing the results from the latest round of earnings calls with top bank executives, BCA’s Chief US Investment Strategist Doug Peta wrote: “Last week’s calls assuaged our concerns … It now appears that consumer requests for forbearance at the outset of the COVID-19 outbreak were analogous to businesses’ credit line draws: exercises of emergency options that turned out not to be necessary, and are on their way to being unwound with little ado.”1 Banks Are Cheap From a valuation perspective, relative to the broad market, US banks trade at one of the largest discounts on record on both a price-to-book and price-to-earnings basis (Chart 9). Earnings estimates are also starting to move in the banks’ favor. Relative 12-month forward earnings estimates for US banks are trending higher even against the tech sector (Chart 10). This largely reflects the expectation that bank earnings will grow more quickly than other sectors in 2021/22. Chart 9Bank Stocks Are Cheap Chart 10Bank Earnings Estimates Are Catching Up   A Few Words About Global Banks Chart 11Euro Area Banks Have Fared Especially Badly Since The GFC Chart 12Banks: A Low Bar For Success Banks in a number of markets outside the US face greater structural challenges than their US counterparts. Most notably, euro area bank earnings remain well below their pre-GFC highs (Chart 11). That said, investors are not exactly expecting European bank profits to recover to their glory days anytime soon. Chart 12 shows that if euro area bank EPS were to simply go back to last year’s levels, banks would trade at 5.4-times earnings. This implies a very low bar for success. Investment Conclusions Stocks have run up a lot over the past few days on fairly weak breadth. A short-term pullback would not be surprising. Nevertheless, investors should remain overweight global equities versus bonds over a 12-month horizon. The combination of ongoing fiscal and monetary support, together with a vaccine, will buoy global growth. As Chart 13 shows, it’s rare for stocks to underperform bonds when the global economy is strengthening. Chart 13Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 14Value Stocks Typically Do Well When Economic Activity Is Picking Up   Value stocks typically do well when economic activity is picking up (Chart 14). That said, we are less sure about when the inflection point in the value/growth trade will arrive. As we have noted before, the “pandemic trade” benefits growth stocks, while the “reopening trade” benefits value stocks. For now, the number of new infections has not shown signs of peaking in either the US or Europe (Chart 15). Investors should continue monitoring the daily Covid data and be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting.   Chart 15The Number Of New Cases Continues To Rise Globally... But Mortality Rates Are Lower Than Earlier This Year Chart 16The Dollar Is A Countercyclical Currency As a countercyclical currency, the dollar should weaken next year as policy remains accommodative and pandemic risks recede (Chart 16). EM Asian currencies are especially appealing. A hiatus in the trade war should allow the Chinese yuan to strengthen even further. This will drag other regional currencies higher. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, October 2020,” dated October 19, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Your feedback is important to us. Please take our client survey today. Highlights A surge in the number of Covid cases worldwide and the failure of the US Congress to forge a stimulus deal has cast doubt on the “reflation trade.” European governments have responded to rising case counts with a flurry of restrictions. While not quite as extreme as those introduced in March, the new lockdown rules will still weigh on growth over the coming months. The good news is that progress on a vaccine continues, with the vast majority of experts expecting one to be widely available within the next 12 months. The degree to which US fiscal policy will turn stimulative again depends on the outcome of the election. A “blue wave” would produce the most fiscal stimulus, while a Biden victory coupled with continued Republican control of the Senate would produce the least. However, even in the latter scenario, popular support for further fiscal easing – including among Republican voters – will help catalyze a deal. The near-term picture for stocks is murky. Nevertheless, investors should remain overweight global equities on a one-to-two year horizon, while shifting exposure to non-US markets and value stocks. Worries About The Sanguine Narrative Chart 1The Number Of New Cases Continues To Rise Globally... But Mortality Rates Are Lower Than Earlier This Year Equities recovered some of their losses on Thursday, but remain down on the week. Investors have become increasingly concerned about the viability of the so-called reflation trade. Stocks rallied in the spring and summer on hopes that the worst of the pandemic was over and that fiscal stimulus would continue to prop up employment and spending. Now, both assumptions are being challenged. The number of coronavirus cases continues to rise worldwide (Chart 1). In both Europe and the US, the daily tally of confirmed new cases exceeds its March peak. The only saving grace is that the number of deaths has not risen by as much as many had feared. Governments are reacting to rising case counts by tightening social distancing rules. The German government ordered bars, clubs, theaters, concert halls, museums, cinemas, sit-down restaurants, and most athletic facilities to close in November. Hotels will no longer be able to cater to tourists, while private meetings of over 10 people will be prohibited. Along the same lines, France has imposed a comprehensive nationwide lockdown until December 1st, with President Macron stating the nation has been “overpowered by a second wave.” Earlier this week, the Italian government announced that bars and restaurants must close by 6pm. News reports indicate that the UK government is preparing a slate of new restrictions. While the most recent lockdowns in Europe are not as severe as those introduced earlier this year, they will still weigh on growth over the coming months. There has been less movement toward shuttering the US economy in response to what is now the third wave of the pandemic. This may be partly because the latest cluster of cases has been fairly localized, concentrated mainly in the central north of the country. So far at least, the heavily populated south and coastal states have been spared the brunt of the wave. However, if more states start seeing rising case counts, stricter restrictions could be introduced across most of the country. Fiscal Food Fight Meanwhile in Washington, both Republican and Democrat leaders conceded that there will be no stimulus deal before the election. House Speaker Nancy Pelosi said that Trump had “failed miserably” in his handling of the pandemic, the economy, and everything else. The President, for his part, claimed that “Nancy Pelosi is only interested in bailing out badly-run, crime-ridden Democrat cities and states,” adding that “After the election, we will get the best stimulus package you have ever seen.” Of course, whether Trump can fulfill his “best ever” pledge depends on the outcome of the election. As we discuss below, there is considerable uncertainty over how the political landscape in Washington will look after November 3rd. Nevertheless, most roads still lead to more stimulus. The Election Homestretch Chart 2Opinion Polls Favor The Democrats ... Chart 3... As Do Betting Markets As the US election campaign winds down, both opinion polls and betting markets suggest that Joe Biden will become the next president while the Democrats will regain control of the Senate (Chart 2 and Chart 3). That said, this is not the only possible outcome. As this handy applet from The Cook Political Report makes clear, small changes in the assumptions about either voter preferences or turnout can shift the results significantly. For example, Trump saw his approval among African Americans rise from 25% last week to around 40% this week according to Rasmussen’s daily tracking poll. Such a large move in this one particular poll undoubtedly overstates the true magnitude of the trend, but it is consistent with the analysis that Matt Gertken and BCA’s geopolitical team has done showing that Trump has reduced the Democrats’ lead among minority voters relative to 2016. If Trump can improve his vote share among black voters from the meager 8% he received in the 2016 election to 11% this time around, it would be enough to tip the entire race in his favor. The quant model developed by BCA’s Geopolitical Strategy service, which elevates recent economic data over polling numbers in its computations, gives Donald Trump a 51% probability of remaining president and an equivalent chance of the Republicans picking up the Senate (Chart 4). Subjectively, Matt thinks Trump has a 45% chance of winning. While lower than his quant model, this is still above the 39% probability that betting markets assign to a Trump victory (Chart 5). Chart 4BCA’s Quant Model Points To Trump Victory And Favors Republicans In The Senate Chart 5Election Odds: BCA's Geopolitical Team Versus Betting Markets What Would The Stock Market Prefer? From the equity perspective, stocks would likely rise if Trump won and the Democrats took over the Senate. If re-elected, President Trump would block any efforts to raise taxes or tighten business regulations. However, unlike a number of Republican senators, Trump is not averse to increasing government spending. Earlier this month, the President proposed a $1.8 trillion stimulus bill. Senate Republicans have offered only $500 million for pandemic relief. The stock market would welcome both easier fiscal policy and the implicit guarantee that taxes will not rise. The stock market would also be content with a Democratic sweep, provided it did not result in a blowout victory. A narrow Senate victory would still allow the Democrats to pass a fiscal stimulus bill through the creative use of the “reconciliation process.” However, it would curb the influence of the party’s more left-leaning members. Several Democratic senators have expressed reservations about scrapping the filibuster rule which requires a supermajority of 60 votes to pass most non-budget related legislation. If the filibuster rule is eliminated, it would make it easier to strengthen antitrust law, tighten labor and environmental standards, and raise the minimum wage, all of which could dampen corporate profits. Investors would likely deem a continuation of the existing political configuration in Washington – where Donald Trump remains president and the Republicans maintain a slim majority in the Senate – as neutral for stocks. On the one hand, such an outcome would take the prospects of tax hikes off the table. On the other hand, it could prolong the trade war and extend the stalemate over a stimulus bill. Lastly, stock market investors might frown upon a scenario involving a Biden victory and continued Republican control of the Senate. Of all the scenarios mentioned above, the prospects for a major stimulus package would be lowest for this configuration of political outcomes. This is because Republican senators would have even less incentive to accede to more spending if Joe Biden, rather than Donald Trump, were pressing for it. Still, even in this scenario, it is unlikely that the US will shift to fiscal austerity anytime soon. As Table 1 shows, 72% of voters support the broad outline of the Democrat’s stimulus proposal. Strikingly, even most Republican voters support it, at least when the question is posed in nonpartisan terms. This suggests that a Democratic House could still find a way to strike a stimulus deal with a Republican Senate, perhaps by agreeing to further cut taxes in exchange for more government spending. Table 1Strong Support For Stimulus Investment Conclusions While governments have understandably tightened restrictions to control the latest surge in Covid cases, they are unlikely to fully revert to the extreme measures taken in March. Back then, there was considerable uncertainty over how fatal the virus was, with estimates for the mortality rate ranging from 0.5%  to over 5%. The latest research suggests that the true number is near the bottom of that range, and perhaps even below it.1 Progress continues to be made on a vaccine. Close to 95% of professional forecasters surveyed by The Good Judgement Project expect a vaccine to be widely available within the next 12 months (Chart 6). Chart 6When Will A Vaccine Become Available? Chart 7Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The combination of a vaccine and further fiscal support against a backdrop of ultra-easy monetary policy should be enough to lift global equities by about 15% towards the end of 2021. While the near-term picture for stocks is murky, investors should remain overweight global equities over a one-to-two year horizon. As a countercyclical currency, the US dollar is poised to weaken next year. Typically, non-US stocks outperform when global growth is strengthening and the dollar is weakening (Chart 7). Value stocks also tend to do better in such macro environments (Chart 8). Once the latest wave of the pandemic crests, as it inevitably will, investors should look to shift their equity portfolios from stocks that benefited from lockdowns towards those that will benefit from reopenings.   Chart 8 (I)... Ditto For Value Stocks Versus Growth Stocks Chart 8 (II)... Ditto For Value Stocks Versus Growth Stocks Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, Updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores

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

Your feedback is important to us. Please take our client survey today. Highlights Mounting populism has created a structural tailwind behind inflation. The risk that inflation accelerates quickly is greater than the market appreciates. Monetary dynamics strongly influence consumer prices when inflation is stationary. The Federal Reserve’s back-door monetization of debt is inflationary. Financial assets do not embed a sufficiently large risk premium against higher inflation. The long-term, real returns of equities are likely to be poor. Small cap stocks and commodities offer cheap protection against higher inflation. Feature The equity market is extremely vulnerable to positive inflation surprises. The expectation of an extended period of low interest rates and extraordinarily easy monetary policy is the crucial justification for the S&P 500’s exceptionally elevated multiples. Anything that could threaten this policy set up would create a danger for stocks. Whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The problem for the S&P 500 is that investors assign a much-too-small probability to the inflation risk, especially as structural and political forces point to an elevated chance that inflation will reach 3% to 5% within the next 10 years. There is also a non-trivial probability that inflation begins rising significantly faster than the market anticipates, even if it is not BCA Research’s base case. The dichotomy between the low odds of a quick turnaround in inflation embedded in financial asset prices and the inflationary threat created by monetary and fiscal choices is too large. It will force market participants to assign a greater inflation risk premium in bonds and stocks to protect against this eventuality. This process could precipitate painful corrections in both bond and equity prices. The good news is that inflation protection remains cheap. Three Stages Of Inflation The staggering recent increase in money supply and the extraordinary fiscal stimulus rolled out this year raise two questions: Are we exiting the recent period of low and stable inflation that has prevailed? Is inflation becoming a threat to financial asset prices? Major turning points in inflation provide context to assess the risk of an impending threat of increased inflation. From a statistical perspective, three phases in inflation dynamics have defined the past 100 years (Chart I-1): Chart I-1Three Stages Of Inflation 1922 to 1965: Inflation gyrated violently from as low as -12.1% to as high as 11.9% in response to various shocks such as the Great Depression or World War II. Nonetheless, inflation’s mean was stationary or trendless. 1965 to 1998: A period of great upheaval when inflation trended strongly, moving up until 1980 and then down until 1998. 1998 to present: Inflation has been stable, flatlining between 0.6% and 2.9%. Chart I-2More Often Than Not, Money Matters Empirically speaking, whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The era of stationary inflation from 1922 to 1965 saw M2 closely correlated with changes in US consumer prices, but the link was severed from 1965 to 1998 when inflation trended strongly (Chart I-2, top and bottom panel). When inflation stabilized again from 1998 to 2020, M2 growth again explained gyrations in consumer prices (Chart I-2, bottom panel). Why did inflation behave differently from 1965 to 1998 compared with other episodes in the past 100 years? The defining factor of the pre-1965 era was an adherence to the gold standard. The gold standard created a hard anchor on prices because its rigidity made monetary policy credible, which produced stable inflation expectations. The velocity of money was also steady. Consequently, using the Fisher formulation of the equation of exchange (Price*Output = Money*Velocity or PY=MV), inflation became a direct derivative of the money supply. Various shocks such as a war or a depression would impact the rate of expansion of money, leading to a nearly linear effect on prices. When we examine unstable inflation from 1965 to 1998, it helps if we split the period into two subsamples: 1965 to 1977 and 1977 to 1998. The first interval generated accelerating inflation due to a multitude of factors. In the mid-1960s, slack in the US economy disappeared while demand became excessive as a result of the federal government’s increased spending from The Great Society programs and the Vietnam War. Additionally, by 1965, the gold standard was under attack. The US current account disappeared between 1965 and 1969. Worried by the deteriorating US balance of payment dynamics, French President De Gaulle sent his navy to repatriate France’s gold at the New York Fed. Other countries followed suit. The continued pressure on the US balance of payments, along with the need for easier monetary policy following the 1970 recession, lead to the 1971 Smithsonian Agreement whereby President Nixon unpegged the dollar from gold, effectively killing the gold standard. Any semblance of monetary rectitude disappeared and inflation expectations began to drift up. The oil shock of 1973 fueled the inflationary dynamics and pushed inflation higher through the rest of the decade. The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. The second interval began in 1977, three years before inflation peaked. This date marks the implementation of the Federal Reserve Reform Act, which modified the Fed’s mandate from only targeting full employment to full employment and stable inflation. At first, the Act had little practical impact until Paul Volker became Fed chair in 1979 and began to combat inflation. Prior to 1977, the unemployment rate was below NAIRU (the unemployment rate consistent with full employment) most of the time, the economy overheated and ultimately, inflation trended up (Chart I-3). However, since 1977, the unemployment rate has mostly been above NAIRU and the labor market has predominantly experienced excess slack. Consequently, inflation expectations re-anchored to the downside and realized inflation collapsed. Chart I-3The Effect Of The Federal Reserve Reform Act Of 1977 Chart I-4The Monetarist Fed: 1977 to 1998 The relationship between short rates and money supply provides another way to appreciate the change in monetary policy after 1977. The Fed opted for a monetarist approach (officially and unofficially) when it had to combat high realized and expected inflation. During most of the past 100 years, money supply changes and short rates were either negatively correlated or not linked at all (Chart I-4, top and second panel); however, they began to move together from 1979 to 1998 (Chart I-4, bottom panel). The Fed boosted rates to preempt the inflationary impact of faster money supply expansion, which curtailed the link between prices and M2. Between 1977 and 1998, major structural forces also pushed down inflation and severed the bond between money supply and CPI. Starting with President Reagan, a period of aggressive deregulation and union-busting increased competition and removed some pricing power from labor.1 Most importantly, the rapid widening in globalization resulted in international trade representing an ever-climbing portion of global GDP. By adding more people to the global network of supply chains, globalization further entrenched the loss of workers’ pricing power, which caused wages to lag productivity and decline as a share of national income (Chart I-5). The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. In the final phase from 1998 to 2020, the stabilization of inflation reunited prices and money supply. Inflation flattened due to several factors. By 1998, 70% of the global population lived in a capitalist system (compared to market shares only 28% in 1977). Thus, most of the expansion of the global labor supply was completed. China entered the WTO only in 2001, but it had been exerting its deflationary influence for many years by stealing market share away from newly industrialized Asian economies. Additionally, following the Asian Crisis of 1997, many Asian economies (including China and Japan) elected to build large dollar FX reserves to contain their currencies versus the USD, and subsidize economic activity. This process created some stability in global goods prices and slowed the USD’s depreciation started in 2002. In response to these influences, inflation expectations stabilized in the late 1990s, creating an anchor for realized inflation (Chart I-6). Thanks to this steadiness in inflation expectations, the Phillips curve (the inverse link between wages and the unemployment rate) flattened. The economy entered a feedback loop where consistent inflation rates begat stable wages, which in turn created more stability in aggregate prices. Fluctuations in the rate of inflation became directly linked to changes in the output gap and thus, variations in demand. Importantly, the flat Phillips curve and the well-anchored inflation expectations freed the Fed to maintain easier policy during expansions and allow money supply to expand in line with money demand. Chart I-5Expanding Globalization Robbed Labor Of Its Bargaining Power Chart I-6The Anchoring Of Inflation Expectations   Bottom Line: The correlation between inflation and M2 growth since 1998 is as relevant as it was from 1922 to 1965. What The Future Holds Structurally, inflation will likely trend higher. The Median Voter Theory (MVT), developed by Anthony Downs and upheld by our Geopolitical Strategy service as the key constraint on global and US policymakers, is at the heart of our position. Over the past 40 years, income and wealth inequalities have soared worldwide, especially in the US and the UK, which have both embraced ‘laissez-faire’ capitalism enthusiastically. Moreover, these countries also suffer from pronounced levels of intergenerational social immobility.2 The effect of these aforementioned trends has become so pervasive that life expectancy for a large swath of the US population is decreasing (Chart I-7). The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. This policy mix will add a secular drift to inflation. In response to widening inequalities, voter preferences have shifted to the left on economic matters and toward populism. Brexit and the election of President Trump both fit this pattern because they represent the repudiation of the prevalent neoliberal discourse that pushed toward more globalization, more immigration and more deregulation. Moreover, voters in the UK and the US increasingly doubt the benefits of free trade (Chart I-8). Chart I-7Inequalities Are Physically Hurting Many US Voters Chart I-8Free Trade Is Out…   Attitudes toward the government’s role in the economy have also changed. Voters in the US are much more open than they were 10 or 20 years ago to a greater involvement of the public sector in the economy. Additionally, support toward socialism has become more widespread among various demographic groups (Chart I-9). The MVT posits that politicians who want to access or remain in power must cater to voter preferences. Hence, when compared with the Great Financial Crisis, the swift fiscal policy easing that accompanied the COVID-19 recession illustrates the understanding by politicians that spending is popular, especially in times of crisis (Chart I-10). Chart I-9…But State Intervention Is In Chart I-10Politicians Deliver What Voters Want   Greater government spending and larger fiscal deficits are used to achieve faster nominal growth. When the output gap is negative, public spending helps the economy and may even increase national savings. However, if profligacy continues after the economy has reached full employment, it generates excess demand relative to aggregate supply and puts downward pressure on the national savings rate. This is inflationary. To redistribute income toward the middle class, populists aim to diminish competition in the economy. They reregulate the economy, which indirectly protects workers. They also limit global trade flows as much as possible. Free trade is good for the economy, but it puts downward pressure on the price of goods relative to services. Therefore, to remain competitive domestic goods producers must compress their labor costs, which either hurts wages for middle-class workers or destroys the number of manufacturing jobs with high wages. Undoing this process raises labor costs and undermines a major deflationary influence on the economy. Tax policy is another tool to force a redistribution of income and wealth toward the middle class. We should expect increased taxes on higher-income households. This process puts more money in the pockets of a middle class whose marginal propensity to consume is around 95% to 99% compared with 50% to 60% for households at the top of the income distribution. Re-shuffling the composition of national income toward the middle class will boost demand and puts upward pressure on consumer prices. Central banks are not immune to the preference of the median voter. As we showed earlier, the Fed Reform Act of 1977 had a meaningful impact on inflation, but only after Volcker took the helm of the FOMC. Given the damages wrought by high inflation in the 1970s, the median voter wanted to see less inflation, which enabled Volcker’s hawkish shift. As Marko Papic argued in a recent BCA Research webcast,3 a minority of voters (and policymakers) remember the pain created by inflation, but everyone is aware of the difficulties created by low nominal growth. Moreover, the Fed is still a creature of Congress and the median voter’s preferences greatly affect the legislative body’s decisions. Consequently, the Fed’s policy stance will likely become structurally looser in response to indirect voter pressure. Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. The Fed’s recent adoption of an average inflation mandate fits within this paradigm. According to its new strategy, the Fed will start tightening policy after the unemployment gap has closed and inflation is above 2%. This is reminiscent of the model prior to 1977 (when full employment conditions were paramount), which generated a significant inflation upside. Bottom Line: The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. It will also contribute to a more dovish bias by central banks. This policy mix will add a secular drift to inflation. What About Now? Markets may be failing to recognize the risk that inflation will rise sooner rather than later. Low yields, subpar inflation expectations, dovish central bank pricing and the valuation premium of growth relative to value stocks already reflect the strong deflationary force created by a deeply negative output gap. Thus, a quicker-than-expected recovery in inflation threatens the financial markets. Our structural inflation view is not the source of this danger. The hidden, near-term inflationary risk arises because we are still in an environment where broad money matters because inflation remains stationary. M2 is expanding at 23.7%, its fastest rate on record. If relationships of the past 20-plus years hold, then this is a warning sign for inflation. The catalyst to crystalize the structural inflationary pressures created by economic populism may be the loose monetary and fiscal conditions caused by the COVID-19 recession. Chart I-11The Real Near-term Inflation Risk This view may seem simplistic in light of the current large output gap, but when fiscal policy is included in the assessment, the picture becomes clearer. Since 1998, the gap between the expansion of M2 and the issuance of debt to the public by the federal government has explained inflation better than broad money alone (Chart I-11). Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. However, inflation decelerates when the Fed expands the money supply slower than the public sector pulls in private funds. In other words, if the Fed eases monetary conditions enough to finance the deficit, then debt monetization occurs, the private sector is not crowded out and demand gets a massive boost. This point is crucial and feeds the stronger economic recovery compared with the one post-GFC. In 2009 and 2010, the private sector was deleveraging and commercial banks were retrenching their lending. Neither the demand for nor the supply of credit was ample. Therefore, the Fed’s rapid balance sheet expansion had a limited impact on broad money. Instead, it skewed the composition of M2 toward commercial bank excess reserves at the Fed and away from private-sector deposits. Broad money was not rising quickly enough to fully finance the government and real interest rates did not fall as far as they should have. The economy suffered. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. Nowadays, broad money responds much better to the Fed’s intervention because the balance sheets of the nonfinancial private sector are much healthier than in 2008 and deleveraging is absent. This mitigates the tightening credit standards of commercial banks. As Chart I-12 illustrates, household net worth is more robust than it was 12 years ago, debt-servicing costs account for a much narrower slice of disposable income and the government’s aggressive actions have bolstered household finances. Moreover, the majority of job losses have been concentrated in low-income jobs, thus, above-average earners have kept their incomes. Under these conditions, households have taken advantage of record low mortgage rates to purchase real estate, which is contributing to growth in the residential sector (Chart I-13, top two panels). Meanwhile, the rapid rebound in businesses’ capex intentions (which even small firms exhibit) and in core capital goods orders indicates that animal spirits are much more vigorous than anyone expected this past spring (Chart I-13, bottom two panels). At that time, the dominant narrative posited that firms were tapping their credit lines to set aside cash. Chart I-12Robust Household Balance Sheets = No Liquidity Trap Chart I-13Housing And Capex Are In The Driver's Seat   Chart I-14Unlike In 2008/09, Real Rates Have Collapsed Thanks to these more favorable balance sheet dynamics, the Fed’s injection of liquidity is boosting M2 enough to finance the Treasury’s issuance. Hence, real interest rates are much lower than in 2009/10 even if the economy is recovering much more quickly (Chart I-14). Policymakers are not crowding out the private sector. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. A counterargument is that technology is too deflationary for the above dynamics to matter. The reality is that technology is always a deflationary force. The expansion of the capital stock has always been about providing each worker with access to newer and better technology to boost productivity. The current low level of productivity gains suggests that the dominant discourse exaggerates the economic advances from new technologies. Thus, inflation stationarity and the interplay between monetary and fiscal policy still matters to CPI. Investors should monitor factors that would indicate if the upside risk to near-term inflation described above is morphing into reality. Doing so would seriously damage financial asset prices made vulnerable to higher inflation by prohibitive valuations. We propose tracking the following variables: The household savings rate. If savings normalize faster because consumer confidence firms, then spending will accelerate, profits will rise more quickly and money will expand further, all of which will bring back inflation sooner. A Blue Sweep in the US presidential election. If the Democrats take control of both the executive and legislative branches, then they will expand stimulating policies that will bolster demand. This, too, would boost profits and broad money supply, which would be inflationary. The velocity of money. An increase in money velocity, which remains depressed, would accentuate the impact of rapid money growth. It would also suggest that animal spirits are strengthening, which will further encourage economic transactions. A weak dollar. The dollar is set to weaken because of savings dynamics and the global recovery. A runaway decline in the USD would indicate that the interplay between monetary and fiscal policy is debasing money, unleashing an inflationary spiral.  Bottom Line: The probability that inflation returns quickly is much more meaningful than financial markets appreciate because of the interplay between money growth, fiscal deficits and robust private-sector balance sheets. This dissonance will create a substantial risk for asset prices next year. Investment Implications The most important implication of the analysis above is that investors should consider inflation protection in all asset classes. However, this protection is cheap to acquire because investors are focusing on deflation, not inflation. Chart I-15Inflation Protection Remains Cheap Bonds Our bond strategists recently moved to a below-benchmark duration in fixed-income portfolios in light of the economic recovery and the increasing probability of a Blue Wave on November 3, an argument highlighted in the Section II Special Report written by our colleagues Rob Robis and Ryan Swift. The Fed’s new average-inflation target, coupled with the global economic recovery, should put upward pressure on inflation breakeven rates, which are still well below 2.3%-2.5% normally associated with stable inflation near 2% (Chart I-15). The underestimated upward risk to inflation further favors climbing yields. Beyond lifting inflation breakeven rates, this risk would also raise inflation uncertainty, which warrants a greater term premium and a steeper yield curve (Chart I-16). Additionally, higher inflation would occur lockstep with declining savings. The recent surge in excess savings was a primary driver of the collapse in yields; its reversal would push up long-term interest rates (Chart I-17). Chart I-16Rising Inflation Uncertainty Will Steepen The Yield Curve Chart I-17Excess Savings Will Fall And Yields Will Rise   The Dollar The US dollar is the major currency most exposed to growing populism because of the extraordinary income inequalities observed in the US. Moreover, a generous combined monetary and fiscal policy setting in the US has eroded the dollar’s appeal as the country’s trade deficit widens (it normally narrows during a recession) in response to pronounced national dissaving (Chart I-18, left panel). Furthermore, US broad money growth stands far above that of other major economies (Chart I-18, right panel). Compared with other major central banks, the Fed is more guilty of financing the public-sector’s debt binge. Debt monetization creates a real risk to a stable USD. Chart I-18AFalling Savings And The Fed's Generosity Will Tank The Greenback Chart I-18BFalling Savings And The Fed’s Generosity Will Tank The Greenback   The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing (Chart I-19, top panel). Sturdy Chinese demand results in climbing global industrial production, which will hurt the greenback. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan (Chart I-19, bottom panel). A strong CNY flatters China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the US.  Investors should consider inflation protection in all asset classes. Equities BCA Research still prefers global equities to bonds on a cyclical basis. The early innings of a pickup in inflation would solidify this bias. Our Adjusted Equity Risk Premium, which accounts for the expected growth rate of earnings and the non-stationarity of the traditional ERP, shows a solid valuation cushion in favor of stocks (Chart I-20). Moreover, forward earnings for the S&P 500 have upside, judging by the gap between the Backlog of Orders and the Customer Inventories components of the ISM Manufacturing survey (Chart I-21). Chart I-19China's Robust Growth Hurts The Dollar Chart I-20The Adjusted ERP Still Favors Stocks   We also continue to overweight cyclical sectors over defensive ones. The existence of greater inflation risk than the market believes confirms this view. Cyclicals would outperform if investors priced in quicker inflation because they would also bid down the dollar and push up inflation breakeven rates (Chart I-22). These relationships exist because industrials and materials enjoy greater pricing power in an inflationary environment and financials would benefit from a steeper yield curve. An outperformance of deep cyclicals relative to defensive equities should result in an underperformance of US shares relative to the rest of the world. Chart I-21Earnings Revisions Have Upside Chart I-22Deep Cyclicals Will Like The Brand New World   The long-term outlook for real stock returns is poor, despite a positive six- to nine-month view. Higher inflation will force a greater upside in yields. However, the current extraordinary market multiples can only be justified if one believes that yields will stay depressed for many more years. Thus, inflation would likely prompt a de-rating of equities. Furthermore, our structural inflation view rests on the imposition of populist economic policies. A move backward in globalization and redistributionist policies would lift the share of wages in national income, which would compress extraordinarily wide profit margins (Chart I-23). Therefore, real long-term profits will probably suffer. Paradoxically, nominal stock prices may still eke out positive nominal gains, but that will be a consequence of the money illusion created by higher inflation. Chart I-23Populism Threatens Profit Margins BCA Research still prefers global equities to bonds on a cyclical basis. Investors should continue to overweight equities versus bonds, despite pronounced hurdles to long-term, real returns in stocks. Historically, periods of transition from low inflation to higher inflation have allowed stocks to outperform bonds, even if equities generate negative real returns (Table I-1). The exceptionally low real yields and thin inflation protection offered by government bonds increases the likelihood that history will be repeated. Table I-1Rising Inflation: Equities Beat Bonds A size bias may offer some protection against higher inflation both in the near and long term. We have been positive on small cap equities since September and our US Equity Strategy service upgraded the Russell 2000 to overweight this week.4 A bump in railroad freight volumes augurs well for the domestic economy to which small caps are very sensitive. Additionally, stronger railroad freight volumes also indicate net rating upgrades for junk bonds, which decreases the riskiness of a highly levered small cap sector (Chart I-24). Moreover, small cap stocks are positively linked to major trends produced by higher inflation, such as a weaker dollar and higher commodity prices (Chart I-25). Small firms also enjoy rising consumer confidence, a variable targeted by populist politicians (Chart I-26). Therefore, the potential for a re-rating of the Russell 2000 relative to the S&P 500 is elevated, especially if investors reassess the likelihood of higher inflation.  Chart I-24Small-Cap Stocks Are Set To Shine Chart I-25Small-Cap Will Enjoy Higher Inflation... Chart I-26...And Populists Commodities BCA Research remains positive on the prices of natural resources on a cyclical basis even if there is more risk of a near-term correction for this asset class. Commodities are highly sensitive to a global industrial cycle that offers significant upside and to China in particular. Moreover, commodities are high-beta plays on a weaker dollar and higher inflation expectations (Chart I-27). Natural resources will benefit from economic populism because it lifts demand for cyclical spending. Moreover, commodities are natural hedges against the risk of higher inflation. In this context, it makes sense to allocate more funds to resource stocks to protect an equity portfolio against inflation. Investors worried about the near-term outlook for commodities should rotate out of copper into crude. Copper has withstood the COVID-19 shock much better than Brent despite the strong cyclicality of both natural resources. Following this move, net speculative positions and sentiment measures for copper are toward the top of their ranges of the past 15 years. Meanwhile, the opposite is true for oil. Since 2005, increases in the Brent-to-copper ratio have followed declines to the current levels in the relative Composite Sentiment Indicator (Chart I-28), which includes sentiment and positioning measures for both commodities. Chart I-27Commodities Remain Efficient Inflation Hedges Chart I-28A Contrarian Tactical Trade: Buy Brent / Sell Copper   Fundamentals also point in that direction. After collapsing in recent months, global inventories of copper are beginning to climb relative to Brent. Moreover, oil production has dropped significantly relative to copper. Oil demand fell even more dramatically than that of copper, but the gap between production and demand growth is moving in favor of crude. Real long-term profits will probably suffer. This trade is agnostic to the direction of the business cycle. Copper prices embed a much more optimistic take toward global economic activity than Brent. Therefore, copper is more vulnerable to a negative economic upset than oil and less likely to benefit from a positive economic surprise. Mathieu Savary Vice President The Bank Credit Analyst October 29, 2020 Next Report: November 30, 2020   II. Beware The Bond-Bearish Blue Sweep US Election & Duration: We estimate that there is an 72% 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. With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).5 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.6 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).7 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).8 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).9 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).10 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com III. Indicators And Reference Charts The S&P 500 is experiencing its second correction in the past two months. The market looks even more fragile than it did in September. COVID-19 is heating up fast enough that lockdowns are re-emerging globally, the odds of an imminent fiscal deal have cratered to a near-zero chance, and investors are paying more attention to the growing risk of gridlock in Washington where a Biden Presidency and a Republican Senate majority would result in temporary fiscal paralysis. In this context, the decline in the momentum of the BCA Monetary Indicator, the elevated reading of our Speculation Indicator and the overvaluation of the stock market create the perfect cocktail for a dangerous few weeks. The longer we live in uncertainty regarding the elections’ result, the worse the market will fare. Short-term indicators confirm that equities are likely to remain under downward pressure in the coming weeks. Both the proportion of NYSE stocks above their 30-week and 10-week moving averages are still deteriorating after forming negative divergences with the S&P 500. They are also nowhere near levels consistent with a solid floor under the market. Moreover, our Intermediate Equity Indicator and the S&P 500 as a deviation from its 200-day moving average have rolled-over after reaching extremely overbought levels. Finally, both the poor performance of EM stocks as well as the underperformance of the Baltic Dry index and global chemical stocks relative to bond prices and the VIX indicate that cyclical assets could suffer from a wave of growth disappointment. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. Moreover, the economic and financial risks created by the tepidity of fiscal support in recent months is self-limiting. As the economy progressively teeters toward a second leg of the recession, the pressure will rise for policymakers to spend generously once again to support their nations. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator remains at the top of its pre-COVID-19 distribution, which will put a natural floor under stocks, even if its recent deterioration is consistent with a market correction. Moreover, our Revealed Preference Indicator continues to flash a buy signal for stocks. Additionally, the BCA Composite Sentiment Indicator stands toward the middle of its historical distribution and the VIX has not hit the extremely compressed levels that normally precede major cyclical tops in the S&P 500. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor between 3000 and 3100. At this level, the froth highlighted by our Speculation Indicator will have dissipated.  The bond market’s dynamics are interesting. Despite the violent sell-off in equities, Treasury yields are not declining much. Bonds are too expensive and with short-term rates near their lower bound, Treasurys are losing their ability to hedge equity risk in portfolios. Moreover, the bond market seems to understand that any recession will encourage additional fiscal profligacy, which puts a floor under yields. These dynamics suggest that once equities stabilize, yields could start rising meaningfully. Finally, the dollar continues its sideways correction. However, as risk aversion rises and global growth deteriorates, the dollar is likely to catch further upside in the near term, especially as it has not fully worked out this summer’s oversold conditions. Moreover, the dollar is a momentum currency. Thus, once its start to turn around, its rally is likely to be more powerful than most expect, which will put additional downward pressures on commodity prices. Consequently, it is too early to start selling the USD again or to bottom fish natural resources. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst Special Report "Labor Strikes Back," dated February 27, 2020, available at bca.bcaresearch.com 2 High odds of staying in the income decile of your parents. 3 Please see Geopolitical Strategy Webcast "Geopolitical Alpha In 2020-21," dated October 21, 2020. Marko also recently published a book "Geopolitical Alpha." 4 Please see US Equity Strategy Weekly Report "Vigilantes Gone Missing?" dated October 26, 2020, available at uses.bcaresearch.com 5 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 6 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 7 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 8 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 9 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 10 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

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) Chart 2Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part II)     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 Chart 4A Gloomy Forecast For The US Thanks To Covid-19 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 Chart 5The Number Of New Cases Continues To Increase Globally 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... Chart 7...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 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 Chart 10Capex 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 Chart 12Commercial Bankruptcy Filings Remain In Check 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 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 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 Chart 15The Rate Of Economic Growth Has Usually Been Higher Than Interest Rates     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 Current MacroQuant Model Scores

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 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 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 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 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 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? Chart 6Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 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 Chart 8Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own 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 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 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 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 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 Chart 3A Breakdown Of US Assets And Liabilities 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 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 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 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 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? 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 Chart 10Stocks 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 Current MacroQuant Model Scores ​​​​​​​

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