Emerging Markets

Dear Client, Next week I will be presenting our 2021 outlook on China at our last webcasts of the year "China 2021 Key Views: Shifting Gears In The New Decade".  The webcasts will take place next Wednesday, December 16 at 10:00AM EST (English) and at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). In addition, our final weekly publication for 2020 will be on Wednesday, December 16, 2020. Best regards, Jing Sima, China Strategist   Highlights Chinese policymakers have shifted their focus from supporting economic growth at all costs to risk management. The trend will likely gather speed in 2021. A deceleration in credit growth next year is almost a certainty. While policymakers will be data dependent and the slowdown will be managed, our baseline scenario suggests a decline of approximately three percentage points in credit impulse in 2021. Chinese stocks could still trend higher in Q1, but prices will falter as the market starts to price in a tighter policy environment and slower profit growth in 2H21. We recommend a tactical neutral stance in both the onshore and offshore markets.  We continue to favor Chinese government bonds on a cyclical basis, while gyrations in the onshore corporate bond market will endure for at least the next six months. Feature China’s economic growth momentum has strengthened in recent months, but the nation’s policy stance has also turned more hawkish. As set out in the 14th Five-Year Plan, 2021 will mark the beginning of a new era in which policymakers will switch gears from building a "moderately prosperous society" to becoming a "great modern socialist nation.” The pivot means China’s top officials may tolerate slower economic growth, implement tougher financial and industry regulations, and accelerate structural reforms by allowing more bankruptcies and industry consolidations. As we pointed out in our November 4, 2020 Strategy Report,1 external challenges combined with a stronger domestic leadership will allow China to initiate more meaningful reforms in the next decade than in the past ten years. The reforms will strengthen our structural view on China’s economy and financial assets, but this restructuring will create headwinds for growth in the short to medium term.  Therefore, investors should maintain low expectations for Chinese growth and financial asset prices. In 2021, credit growth will decelerate, regulations will be tightened and the “old economy” will moderate in the second half of the year.  We will discuss four main themes in our outlook for 2021. Key Theme #1: Macro Policy: Turning More Hawkish Government officials recently stepped up mention of financial risk containment in their public announcements, along with tightened industry regulations. Many market commentators are downplaying the risk of a tighter policy in 2021, citing China’s fragile recovery and a weak global economy. However, the current environment resembles the policy backdrop in late 2016/early 2017 when President Xi Jinping began his financial deleveraging campaign. Our policy framework suggests that China currently faces fewer constraints than in 2016/2017. Thus, the odds are high that the leaders will turn their tough rhetoric into action in the next six to twelve months.   Importantly, despite low year-over-year GDP growth, the pace of China’s domestic economic recovery has been faster than in 2016 (Chart 1). The PMIs in both the manufacturing and service sectors have been above the 50 percent boom-bust threshold for nine consecutive months (Chart 2). The laggards in the economy - manufacturing investment and household consumption - have been consistently improving (Chart 3). Bond yields have climbed sharply, but given that corporate bond issuance only accounts for 10% of total social financing, the economic impact from rising corporate bond yields has been more than offset by the large number of government bonds issued (Chart 4). Moreover, the recovery in China’s export sector and current account balance has fared surprisingly well this year, propelled by the global demand for medical supplies and stay-at-home electronic goods (Chart 5). Portfolio inflows also have been strong, fueling a rapid appreciation in the RMB.  Chart 1Current Economic Recovery In Better Shape Than In 2016 Current Economic Recovery In Better Shape Than In 2016 Current Economic Recovery In Better Shape Than In 2016 Chart 2PMI Remains Strong PMI Remains Strong PMI Remains Strong Chart 3The Laggards Are Catching Up The Laggards Are Catching Up The Laggards Are Catching Up Chart 4Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Chart 5Exports Surged Exports Surged Exports Surged Chart 6Chinese Business Cycle Upswing Still Has Steam Chinese Business Cycle Upswing Still Has Steam Chinese Business Cycle Upswing Still Has Steam Looking forward, China’s economic recovery should continue for at least another two quarters due to this year’s credit expansion. Economic activities usually lag the turning points in credit growth by six to nine months (Chart 6). Moreover, headline economic data in 1H21 should be impressive, given the deep slump in domestic output during the same period in 2020. The strengthening economic data will provide China’s leadership with a long-awaited opportunity to focus on risk management. Chart 7A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus Furthermore, the ongoing deflation in the ex-factory prices should not stop the authorities from scaling back policy support. It is worth noting that Xi’s administration doubled down on squeezing shadow banking activity in early 2017 when the CPI was decelerating; the PPI turned positive only due to a low base factor from deep contractions in 2016 (Chart 7). In this vein, as long as the deceleration in both the CPI and PPI does not drastically worsen, we think that policymakers will see less need to reflate the economy. China’s external environment will be less challenging in 2021 than in 2016/2017. Geopolitical tensions are set to ease, at least temporarily, with US President-elect Joe Biden taking office in January. This contrasts with 2016/2017 when President Xi began his financial deleveraging campaign despite increasing strain from then newly-elected President Donald Trump. In hindsight, Xi’s intention may have been to solidify China’s financial sector in preparation for a trade war with the US. The same logic can be applied to our view for next year: Xi will accelerate structure reforms to mitigate risk in the domestic economy before the Biden administration turns its focus to China. We do not think the Communist Party’s 100th anniversary next year will prevent Xi from adopting a hawkish policy bias either. Xi plowed ahead with tightening financial regulations in 2017 even as the ruling Communist Party Committee (CPC) was preparing for a generational leadership reshuffle. In the past two years, the escalation in US-China tensions has strengthened Xi’s power in the CPC and Chinese society. The recent large number of changes in provincial CPC leaders should help Xi to further consolidate his centralized power over local governments. All signs indicate that both the domestic and external landscapes should provide Xi with even more room to undertake reforms in 2021 compared with 2017. Key Theme #2: Stimulus: Deceleration Ahead A deceleration in both credit growth and fiscal support in 2021 is almost a certainty in light of the more hawkish tone by Chinese policymakers. Chart 8 shows that between 2017 and 2019, policymakers came close to stabilizing the macro leverage ratio, but the progress was more than reversed this year due to the pandemic. If policymakers are to allow the increase in the 2021 debt-to-GDP ratio to be within the range of the past four years, then credit may expand at a rate slightly above nominal GDP growth in 2021 (assuming nominal output growth at around 10-11% next year). This scenario, which is our baseline view, is in line with recent statements from the PBoC, which calls for aligning credit growth with nominal GDP in 2021.  Our calculation suggests that credit impulse will reach around 29% of next year’s GDP, about 2 to 3 percentage points lower than in 2020 (Chart 9). Chart 8Financial Deleveraging Efforts Erased By COVID-19 Financial Deleveraging Efforts Erased By COVID-19 Financial Deleveraging Efforts Erased By COVID-19 Chart 9Credit Growth Will Decelerate In 2021 Credit Growth Will Decelerate In 2021 Credit Growth Will Decelerate In 2021 Even if the PBoC keeps its official policy rate (i.e. the 7-day interbank repo rate) steady, tightening regulations and repricing credit risk will lead to higher funding costs and a lower appetite for borrowing (Chart 10). Banking regulators have made it clear that some of the one-off easing measures from this year, such as the extension of loan payments (through March 2021) and the delay of macro-prudential assessments (through end-2021), will end next year. Financial institutions will need to slow the pace of their asset balance sheet to comply with these regulations. The regulatory pressures will lead to de facto deleveraging. On the fiscal front, we expect the large budget deficit to remain intact next year. Targeted stimulus through subsidies and tax cuts to support household consumption and small businesses will likely continue. Government spending in the new economy sectors such as semiconductor and tech-related infrastructure will even accelerate. However, the new-economy infrastructure investment is estimated to only account for about 1% of China’s total capital formation, having limited impact on the overall economy.2 Chart 10Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Chart 11Fiscal Boost For Infrastructure Will Scale Back 2021 Key Views: Shifting Gears In The New Decade 2021 Key Views: Shifting Gears In The New Decade The proceeds from the large number of the local government special purpose bonds (SPBs) this year will continue to provide tailwinds for infrastructure investment into Q1 2021. However, as the laggards in the economic recovery catch up and government tax revenue improves next year, 2021 quotas for government general and SPBs are likely to be scaled back, reining in expenditure growth in the traditional infrastructure sector (Chart 11).   Finally, investors should watch for signs of further hawkishness from China’s leaders at the Central Economic Work Conference this December and the National People’s Congress next March.  While we expect policymakers to be data dependent and keep a controlled deceleration in credit and economic growth, risks of a policy overkill cannot be ruled out. A more bearish scenario would be if policymakers decide to fully revert the pace of debt accumulation to the average rate in 2017-2019. In this case, credit impulse in 2021 could fall by more than 5 percentage points compared with 2020 (Scenario 2 in Chart 9 on Page 6). Key Theme #3: Chinese Equities: Position For A Peak In Prices This year’s cyclical (6- to 12 months) call to overweight Chinese stocks within a global portfolio has panned out. In the next 12 months, the risks in Chinese stocks relative to global benchmarks are to the downside; Chinese stocks are vulnerable to setbacks in policy support next year, in both absolute and relative terms. We are closing the following trades: Long MSCI China Index/Short MSCI All Country World Index, for a 1.5% profit; Long MSCI China A Onshore Index/Short MSCI All Country World Index, for a 5.6% profit; Long MSCI China Ex-TMT/Short MSCI Global EX-TMT, for a 0.7% loss; Long Investable Materials/Short broad investable market, for a 5.6% profit; and Long Onshore Materials/Short broad A-Share market, for a 9.3% profit. Chart 12Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 In absolute terms, Chinese onshore stocks on an aggregate level could still inch higher in the next quarter, supported by an improving business and profit cycle (Chart 12). However, in Q2 the market may start to price in slower economic and profit growth in 2H21, erasing the gains from the first quarter.  The resilient performance in Chinese stocks against a tightening policy backdrop in 2017 is not likely to repeat itself next year. Current valuations in both China’s onshore and offshore equity markets are higher than at the end of 2016; the price-to-forward earnings ratios in both markets this year have breached the peak levels achieved in 2017 (Chart 13A and 13B). Recovering earnings in the next year will help to digest the currently elevated valuations, i.e. the market has already priced in a substantial post-pandemic profit recovery and investors’ focus will soon switch to a more pessimistic outlook for corporate earnings in 2H21.  Chart 13AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Chart 13BA-Shares Are Less Expensive, But Valuations Still Elevated A-Shares Are Less Expensive, But Valuations Still Elevated A-Shares Are Less Expensive, But Valuations Still Elevated Additionally, a property market boom in 2017 boosted the stock performance of real estate developers and related sectors in the supply chain (Chart 14). Policies have already turned much more restrictive in the past month, and deleveraging pressures faced by property developers may weigh on both the sector’s profit growth and stock performance in the next six to twelve months.3 The investable market may not be insulated from tighter domestic policies either. Recent anti-trust regulations in China could create headwinds for mega-cap technology stocks in the near term. Global investors will demand a higher risk premium for China’s tech sector than in the past, as the rich valuations of tech stocks pose more downside risks in a less friendly policy environment (Chart 15).  Chart 14Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Chart 15Valuations In Chinese Tech Stocks Are Elevated Valuations In Chinese Tech Stocks Are Elevated Valuations In Chinese Tech Stocks Are Elevated Chart 16A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months Furthermore, if we presume a policy overkill with more aggressive deleveraging and a further appreciation in the RMB in 2021, our model shows a significant increase in the probability of a profit growth contraction in the next 12 months (Chart 16). In this scenario, selloffs in Chinese stock prices may start in Q1, a risk that cannot be ruled out. In relative terms, Chinese stocks will likely underperform global equities. It is doubtful that the impressive outperformance in Chinese investable stocks throughout 2017 will be repeated in 2021. Chinese equities have benefited from the successful containment of China’s COVID-19 situation in the past year (Chart 17). As breakthroughs in vaccines make the pandemic less threatening to the global economy, Chinese risk assets relative to global ones will become less appealing. Global cyclical stocks, particularly European and Japanese equities, should benefit from improvements in business activities and relatively low valuations (Chart 18). Chart 17Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chart 18...But Vaccines Will Give A Boost To Other Markets Next Year ...But Vaccines Will Give A Boost To Other Markets Next Year ...But Vaccines Will Give A Boost To Other Markets Next Year Importantly, despite strong inflows this year from foreign investors to China’s bond market, foreign portfolio flows into China’s onshore equity market have been less than one-third of that in 2019 (Chart 19). Looking ahead, global investors will be less keen to support Chinese stocks, based on the expectation of tighter onshore liquidity conditions and less buoyant economic growth.   Chart 19Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Everything considered, we anticipate that Chinese A-shares and investable stocks will start descending in Q2 in absolute terms. Their performance relative to global equities will also peak. We recommend a neutral stance on both bourses in the next three months to minimize the downside risks.  Key Theme #4: Chinese Bonds: Favor Onshore Government Over Corporate Bonds We continue to recommend a cyclical long position in Chinese government bonds within a global fixed-income portfolio. However, we are closing our long Chinese onshore corporate bond trade for now, for a 17% gain (Chart 20). The large interest rate differential between yields in Chinese bonds versus those in other major developed nations should remain intact into the new year. The yield on the short-duration government notes will continue to trend higher in 1H21, based on the prospect of tighter monetary policy. The yield on long-dated bonds will also escalate as the outlook for the economy continues to improve. We are pricing in a 70BPs increase in the 1-year government bond yield and a 40BPs rise in the yield of the 10-year bond from their current levels (Chart 21).   Chart 20Handsome Returns On Chinese Government Bonds Handsome Returns On Chinese Government Bonds Handsome Returns On Chinese Government Bonds Chart 21Our Projections On Government Bond Yield Hikes Next Year Our Projections On Government Bond Yield Hikes Next Year Our Projections On Government Bond Yield Hikes Next Year Chart 22RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year The ongoing appreciation in the RMB will also make Chinese government bonds attractive to global investors. The speed of the gain in the RMB against the US dollar may slow in 2021, but the economic fundamentals do not yet suggest that this trend will reverse. Relative growth and interest rates between China and the US will probably narrow and the geopolitical tailwinds affecting the RMB following the Biden win in the US election will subside in the new year (Chart 22). However, China's strong export sector should still support a record high trade surplus and provide a floor to the Chinese currency against the USD. Chinese onshore corporate bonds have undergone a major shakeout in the domestic corporate bond market in the past month. A slew of state-owned enterprise (SOE) bond defaults has pushed up the yields on the lower-rated corporate bond by nearly 40BPs in one month. In our view, the recent panic selloff in the onshore corporate bond market is overdone and domestic corporate bonds are starting to look attractive on a cyclical basis. Bloomberg data shows that the value of defaulted bonds in the first three quarters of this year is in fact much lower than in the past two years: it dropped to 85Bn RMB from 142Bn RMB defaults in 2019 and the default of 122Bn RMB in 2018. Bondholders have been spooked by the fact that the Chinese local government and top financial regulators allow defaults by state-backed firms. The policy change to shift risk to the markets should result in a continuation of risk-off sentiment among investors, inducing selling pressure in the domestic corporate bond market in the near term. However, on a cyclical basis, such selloffs could present good buying opportunities. While we expect China’s onshore corporate bond defaults to be higher in 2021, the default rate remains below the global average (Chart 23). As we pointed out in our previous report, since 2017 Chinese onshore corporate bonds have been priced with a significantly higher risk premium than their global peers, which in our view is overdone (Chart 24). Chart 23Chinese Corporate Bond Default Rate Lower Than Global Average... Chinese Corporate Bond Default Rate Lower Than Global Average... Chinese Corporate Bond Default Rate Lower Than Global Average... Chart 24...And Much Lower Than Their Risk Premiums Imply ...And Much Lower Than Their Risk Premiums Imply ...And Much Lower Than Their Risk Premiums Imply Chart 25Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes In addition, Chart 25 shows that the total returns on Chinese onshore corporate bonds briefly declined in 2017 when the government’s financial de-risking efforts intensified. It sequentially rebounded in 2018, suggesting a turnaround in investors’ sentiment after the first cleanup wave in the corporate sector.  As such, while we do not favor Chinese onshore corporate bonds in the next six months, on a 12-month horizon, conditions could become more favorable to initiate a long position. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see China Investment Strategy Report "The 14th Five-Year Plan: Meaningful Transformations Ahead," dated November 4, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Special Report "Chinese Economic Stimulus: How Much For Infrastructure And The Property Market?" dated March 25, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Special Report "China: The Implications Of Deleveraging By Property Developers," dated October 21, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Our semi-annual virtual meeting with the long-standing client Ms. Mea took place on December 1. Given it is the end of the year, Ms. Mea inquired about our strategies for 2021 and reviewed the evolution of our views during 2020. Below is a transcript of our discussion, which we hope will help clients better grasp our views and analysis. Chart 1EM Relative Equity Performance And EM Currencies Versus DM ex-US EM Relative Equity Performance And EM Currencies Versus DM ex-US EM Relative Equity Performance And EM Currencies Versus DM ex-US Ms. Mea: Before we get to investment recommendations for next year, let’s review which of your views have worked in 2020 and which have not. Answer: From a big picture perspective, we went from being very negative on EM over the last decade to being neutral on EM risk assets in both absolute terms and relative to DM peers. Since April, we have been waiting for a pullback to go long and overweight EM, but a meaningful setback has not materialized. That said, although EM risk assets and currencies have rallied substantially in absolute terms, they have not outperformed their DM peers, as shown in Chart 1. Concerning the evolution of our strategy, as you might recall, we had to chase EM stocks higher late last year after the trade deal between the US and China created euphoria in financial markets, pushing EM assets higher. But even then, we did not change our bullish view on the US dollar and continued recommending an underweight allocation in EM versus DM in global equity and credit portfolios. In our January 23, 2020 report we contended that the risk premium in global markets was extremely low and that risk assets were extremely overbought. The following week, as news of the COVID-19 outbreak in China emerged, we recommended closing the long position in EM stocks. On February 20, we asserted that odds of a breakdown were substantial and recommended shorting EM stocks outright. We closed this position on March 19 with a substantial gain. On March 26, we argued that it was too late to sell but too early to buy. In retrospect, the latter part of this assessment was incorrect. Then, on April 23, we recommended going long duration in EM local currency bonds or buying domestic EM bonds while hedging currency risk. We recommended receiving 10-year swap rates in several EM countries. We changed our long-standing strategic bullish stance on the US dollar to bearish on July 9. Simultaneously, we closed our shorts in various EM currencies versus the greenback and recommended shorting many of these EM currencies versus an equal-weighted basket of the euro, CHF and JPY (please refer to the bottom panel of Chart 1).   We upgraded EM credit from underweight to neutral on June 4 and lifted the allocation to EM stocks from underweight to neutral on July 30. EM relative equity performance versus DM has been in a broad trading range for the whole of 2020 (please refer to the top panel of Chart 1). Chart 2Facing Technical Resistance Facing Technical Resistance Facing Technical Resistance Ms. Mea: What is your EM outlook going into 2021? Answer: The odds of a major breakout in EM equities, currencies and fixed-income markets have risen, yet there could be a shakeout before the breakout. Both EM equity and the global ex-US equity indexes have risen to their previous highs which proved to be a formidable resistance level (Chart 2). The main reasons to expect a major breakout in EM and global ex-US share prices are as follows: First, the global economy could experience periodic setbacks, but things cannot be worse than they were during the pandemic-induced lockdowns in early 2020. The deployment of vaccines is likely to improve global economic conditions in 2021, especially in hard hit services sectors. Second, asset purchases by major central banks around the world have effectively removed many securities (mostly government bonds) from the marketplace while creating an enormous supply of money (Chart 3). The upshot is that too much money is chasing fewer assets. Chart 4 illustrates this phenomenon in the case of US dollar securities. Cash in both US institutional and retail money market funds is still elevated. As a share of market value of US dollar denominated equities and bonds, the amount in US money market funds has declined but it is still above its February lows. Provided that US money market rates are zero, one can make the case for more flows from money markets into both equities and bonds. Chart 3Booming Money Supply Worldwide Booming MoneySupply Worldwide Booming MoneySupply Worldwide Chart 4How Much Cash On-SidelinesIs There Left In The US? How Much Cash On-SidelinesIs There Left In The US? How Much Cash On-SidelinesIs There Left In The US?   Finally, odds that EM equities will break above the trading range they have been in over the last 10 years have increased. As we discussed in our previous reports, EM ex-China, Korea and Taiwan have been facing hard budget constraints due to limited fiscal stimulus packages, a breakdown in their monetary transmission mechanism, and massive foreign capital outflows in early 2020. These harsh conditions have forced many companies to restructure to boost their efficiency. The banking system has been recognizing and provisioning for bad assets. Finally, some governments have adopted difficult structural reforms. These could be sowing seeds of structural transformation in these economies, in turn producing a secular bull market in their equities and currencies. As was discussed in a recent Country In-Depth report, India is one example where structural reforms stand to have a positive effect on its long-term outlook. Indonesia, Colombia, Mexico, and Brazil are other candidates that could undergo similar transformations. In a nutshell, unless the global economy craters – which has low odds – one can envision a scenario in which risk assets continue marching higher. Ms. Mea: However, you mentioned that there could be a shakeout before the breakout. What makes you say that? Answer: A potential shakeout before the breakout may occur due to the following three peaks: Peak investor sentiment: Investor sentiment is very elevated and risk assets are overbought. The ZEW global growth expectations index (a survey of analysts on DM economies) has rolled over after reaching an all-time high (Chart 5, top panel). The Sentix survey of investor future expectations has reached an apex (Chart 5, bottom panel). Importantly, net long positions in copper and net bullish sentiment on copper are at their previous highs (Chart 6). This is a plausible proxy for investor sentiment on both China and global growth. Chart 5Investor Expectations Are Elevated Edited Investor Expectations Are ElevatedEdited Investor Expectations Are ElevatedEdited Chart 6Investors Are Super Bullish On And Very Long Copper Investors Are Super Bullish On And Very Long Copper Investors Are Super Bullish On And Very Long Copper   Chart 7Investors Are Bullish On US Equities Investors Are Bullish On US Equities Investors Are Bullish On US Equities Finally, sentiment among US equity investors is also elevated (Chart 7). Peak stimulus: In China, both credit and fiscal stimulus will likely peak in Q4 2020, as demonstrated in Charts 8 and 9. The US and the euro area will experience a negative fiscal thrust in 2021 equal to 7.4% and 3.8% of GDP, respectively. A new fiscal package worth $1.5 trillion is needed in order for the US fiscal thrust to be neutral. As Republicans are likely to retain control of the Senate, even after Georgia’s Senate election vote on January 5, 2021, a new fiscal package larger than $500-750 billion is unlikely. On the whole, many countries in DM and EM are experiencing peak stimulus in 2020. Chart 8China: Peak Credit Stimulus China: Peak Credit Stimulus China: Peak Credit Stimulus Chart 9China: Peak Fiscal Stimulus China: Peak Fiscal Stimulus China: Peak Fiscal Stimulus   Peak manufacturing growth: We should differentiate between the top in a business cycle and an end in growth acceleration. As far as global manufacturing is concerned, we are likely currently experiencing growth acceleration at its height. Global manufacturing will continue to expand, but at a slower rate. Share prices could either rally or correct when growth begins to decelerate. The stock market reaction is contingent upon how overbought and how expensive equity prices are. The top panel of Chart 10 illustrates that the tops in the US ISM manufacturing new orders-to-inventory ratio have historically marked setbacks in global cyclical stocks. Similarly, EM share prices and industrial metals fluctuate with the EM and China manufacturing PMI (Chart 10, middle and bottom panels). Having risen sharply to very elevated levels, odds are that global and China manufacturing PMIs are probably topping out. Granted, these are diffusion indexes, and declines/rollovers in global manufacturing PMIs do not necessarily imply that a recession is on the horizon. Rather, they signal the end of the acceleration phase in a cycle. Bottom Line: Given how overbought and expensive they are, share prices might react negatively to peak stimulus. Ms. Mea: Your outlook on the Chinese economy has become more nuanced since the spring. How do you see China’s business cycle and financial markets evolving? Answer: We upgraded our view on the Chinese business cycle in late May after it had become apparent that China had again injected enormous credit and fiscal stimulus into the economy. On June 18, we upgraded Chinese stocks to overweight within an EM equity portfolio. We continue to expect decent growth numbers and reviving corporate profits in most of H1 2021. That said, authorities have been tightening monetary policy since May. Policymakers realize that China’s credit excesses have become even larger and they have been proactive in policy tightening to rein in leverage and speculative activities. The central bank has siphoned off banks’ excess reserves causing interbank rates to rise considerably (Chart 11). With a time lag, money/credit will decelerate and the business cycle will follow. We expect the Chinese business cycle to crest around the middle of 2021. Chart 10Cyclical Assets Fluctuate With Manufacturing PMIs Cyclical Assets Fluctuate With Manufacturing PMIs Cyclical Assets Fluctuate With Manufacturing PMIs Chart 11China: Liquidity Tightening Works With A Time Lag China: Liquidity Tightening Works With A Time Lag China: Liquidity Tightening Works With A Time Lag   The recent shakeout in the onshore corporate bond market will lead to a reduction in corporate bond issuance as investors now require higher yields to finance SOEs. In addition, banks and non-bank financial institutions have to comply with the asset management regulation by the end of 2021. This will restrict banks’ ability to expand their balance sheets and curb NBFI risk appetite. All in all, credit-sensitive sectors like capital spending and the property market will decelerate considerably in H2 2021. Provided that they make up a large share in the mainland economy, overall income growth will also slump. Concerning financial markets, if there is a selloff in Chinese stocks in the coming weeks or months, it will give way to another upleg later in H1 2021. Ms. Mea: Going forward, what will be the driving forces of EM risk assets and how will they shape up? Answer: EM risk assets – equities, credit markets and high-yielding domestic bonds – are by and large driven by three factors: (1) China’s import and commodities cycles (which often move in tandem); (2) domestic fundamentals in EM ex-China; and (3) sharp swings in US growth and the S&P500. (1) We elaborated on the intricacies of the Chinese business cycle above and will now offer a few insights on commodities prices. There has been a broad-based recovery in Chinese demand for commodities and various commodities prices have risen substantially. Nevertheless, the outlook for commodities prices is less certain going forward. Chart 12China's Booming Copper Imports Imply Inventory Accumulation China's Booming Copper Imports Imply Inventory Accumulation China's Booming Copper Imports Imply Inventory Accumulation In particular, copper prices have surged but the rally is only partially attributable to recovering real demand in China. Other forces, namely inventory restocking in China and financial (investor) demand, have been responsible for the massive rise in copper prices. The mainland’s imports of copper and copper products have boomed since spring, growing at a rate of 70-80% from a year ago. Meanwhile, the recovery in Chinese infrastructure investment in electricity, water, and gas – which are the largest consumers of copper – has been considerable but not extraordinary (Chart 12). This surge leads us to infer that a sizable inventory restocking cycle has been taking place in China since last spring. Such large inventory accumulation has likely been prompted by the easy availability of credit and rising copper prices. Besides, investors hold record net long positions in copper on the New York Mercantile Exchange (refer to Chart 6). In brief, as we discussed in detail in the Special Report from November 25, Chinese purchases of copper will decline even as its real demand for copper continues to expand. Oil prices are at risk of excess supply as many producers are reluctant to continue suppressing their crude output. Saudi Arabia has been trying hard to limit OPEC+ production. However, it will be increasingly difficult for it to do so. The basis is that many producers are naturally looking to maximize the net present value of cash flow from their oil reserves. Due to inflation, $45 today is worth more than $45 in five years. As and when oil producers accept that global demand for oil will stagnate as the world switches to more environmentally friendly sources of energy, they will have an incentive to produce and sell as much crude as possible at current prices. Chart 13EM Sovereign Credit Spreads (Shown Inverted) Fluctuate With Commodities Prices EM Sovereign Credit Spreads (Shown Inverted) Fluctuate With Commodities Prices EM Sovereign Credit Spreads (Shown Inverted) Fluctuate With Commodities Prices If Saudis lose control over output, they will ramp up their own production to increase their market share. Crude prices will plunge anew. The timing is uncertain, but we expect it to happen sooner rather than later. Overall, even though China’s business cycle recovery will continue in H1 2021, prices for certain important commodities like oil and copper will likely struggle. Setbacks in commodities prices will have ramifications for financial markets in resource-producing EM countries. EM currencies, as well as their sovereign spreads, correlate with commodities prices (Chart 13). (2) Domestic demand in EM ex-China, Korea and Taiwan will gradually improve but from a very low point. Many developing countries still face major hurdles, including banking systems that are struggling with non-performing loans, a looming fiscal drag, and a lack of control over the pandemic. Further, EM outside North Asia will lag behind advanced countries in procuring and deploying COVID-19 vaccines. Consequently, consumer and business confidence will be slow to recover in these countries, and their business cycle revival will continue to trail that of North Asia (China, Korea and Taiwan) and advanced economies. (3) Finally, any shakeout in the S&P500 will reverberate through EM. Having rallied considerably, North Asian equity and currency markets have already priced in a great deal of good news. In EM ex-North Asia, the level of economic activity, albeit reviving, remains low. This makes these EM ex-North Asian financial markets very sensitive to fluctuations in global/US financial markets. Chart 14EM Equities Have Been A Low-Beta Play On The S&P500 EM Equities Have Been A Low-Beta Play On The S&P500 EM Equities Have Been A Low-Beta Play On The S&P500 The resilience of US equity and credit markets in recent months in the face of numerous challenges has surprised us. US share prices and credit markets have not corrected meaningfully despite (1) the third wave of COVID-19 which has resulted in partial lockdowns and a deterioration in consumer sentiment; (2) the lack of a second fiscal stimulus package and (3) uncertainty surrounding the presidential elections. In retrospect, investors have been willing to buy any small dip. Interestingly, in the past three years, EM share prices outperformed DM share prices when the S&P500 sold off and underperformed when US stocks rallied (Chart 14). EM versus DM relative share prices are shown inverted on this chart. This reveals that EM stocks are not a high beta on the S&P 500 and rising US equity markets do not guarantee that EM share prices will outperform their DM peers. Overall, the outlook for EM risk assets is convoluted, warranting a neutral stance for now both in absolute terms and relative to DM. Chart 15The US Dollar Is Oversold The US Dollar Is Oversold The US Dollar Is Oversold Ms. Mea:  Where and how does the US dollar enter your analysis? Answer: The dynamics between EM and the US dollar is push-pull in nature, i.e., the causality runs both ways. EM fundamentals – that could be broadly defined as return on capital in these economies – drive their exchange rates’ trends versus the US dollar. Further, US dollar trends are also shaped by several global macro forces, including the global business cycle. The US fiscal position and monetary policy stance also drive fluctuations in the value of the greenback. Over the next several years, the US dollar will likely be in a bear market because US inflation will rise and the Federal Reserve will fall behind the inflation curve. US real rates will remain negative, which will continue to undermine the dollar’s value. All that said, the US dollar has become very oversold and investor sentiment is bearish on the greenback (Chart 15). From a contrarian perspective, the dollar might be set up for a countertrend rebound. Interestingly, after the 2016 US elections, the US dollar rallied strongly for several weeks before selling off violently. It seems that the broad trade-weighted dollar is now following a reverse pattern (Chart 16).  The US dollar in 2016 is shown inverted in this chart. The greenback was selling off before the 2020 US elections and has continued weakening since. If this reverse pattern were to play out, the US dollar will near its bottom soon and then stage a playable rebound. Chart 16The US Dollar Before And After 2016 And 2020 Presidential Elections The US Dollar Before And After 2016 And 2020 Presidential Elections The US Dollar Before And After 2016 And 2020 Presidential Elections Chart 17EM Stocks Are Cheap If The Structural EPS Trend Is Up EM Stocks Are Cheap If The Structural EPS Trend Is Up EM Stocks Are Cheap If The Structural EPS Trend Is Up In short, a long-term bear market but near-term rebound in the US dollar is consistent with our view of a shakeout before a breakout for EM equities and risk assets. Ms. Mea: What about EM equity and currency valuations? Are they not still cheap despite their recent rally? Answer: From a secular perspective, EM equities appear modestly cheap as illustrated by our cyclically-adjusted P/E (CAPE) ratio (Chart 17). However, it is vital to realize that this CAPE valuation model assumes that EPS (earnings per share) in real (inflation-adjusted) US dollar terms will revert to its long-term trend sooner rather than later (Chart 17, bottom panel). There is a lot of uncertainty regarding the structural trend in EM EPS. For the past decade – and therefore well before the pandemic – EM EPS in nominal US dollar terms has been fluctuating in a wide range (Chart 18). Not surprisingly, EM share prices have been flat for the past ten years. Further, EM EPS has massively underperformed US EPS in local currency terms for the past ten years (Chart 19). Consistently, EM share prices have underperformed the S&P 500 even in local currency terms. Chart 18EM EPS: No Growth For 10 years EM EPS: No Growth For 10 years EM EPS: No Growth For 10 years Chart 19EM Versus US: Relative Stock Prices And Relative EPS EM Versus US: Relative Stock Prices And Relative EPS EM Versus US: Relative Stock Prices And Relative EPS   As for EM currencies, the aggregate real effective exchange rate of EM ex-China, Korea, Taiwan currencies suggests that they are cheap (Chart 20). Overall, to argue that EM stocks are cheap, one should be confident that EM EPS in real (inflation-adjusted) USD terms will be expanding in the years to come (Chart 17, bottom panel). While some EM economies have undertaken some restructuring, there is currently no strong evidence to suggest that EM EPS will be in a structural uptrend. From a cyclical perspective, EM EPS will certainly be recovering in 2021 (Chart 21). However, a notable chunk of this profit recovery has already been largely priced in. Chart 20EM ex-China, Korea, Taiwan: Currency Valuations EM ex-China, Korea, Taiwan: Currency Valuations EM ex-China, Korea, Taiwan: Currency Valuations Chart 21EM Profits Will Recover In 2021 EM Profits Will Recover In 2021 EM Profits Will Recover In 2021   To sum up, a bet on EM share prices breaking out above their decade-long trading range implies betting on EM EPS entering a period of structural growth. Over the past ten years, EM companies have not delivered the secular growth needed to warrant higher equity multiples. We are open to the idea that structural reforms carried out in several nations will allow for higher productivity, income and profit growth. However, it is still too early to jump to that conclusion. Chart 22Will Asian Markets Finally Break Out? Will Asian Markets Finally Break Out? Will Asian Markets Finally Break Out? Ms. Mea: Where in your analysis and strategy might you be wrong? Answer: The key risks to our view are twofold: First, FOMO (fear of missing out) on the part of investors continues to propel EM risk assets higher while either their fundamentals remain mediocre or they are already very expensive. As we have shown in Chart 4, there is still a lot of US dollar cash sitting in US money market funds and these could feed the EM rally, preventing the materialization of a shakeout. Second, we might be late to recognize structural shifts in certain EM economies and, might therefore miss breakouts in those bourses. Notably, there is no single EM equity market that has clearly broken above its previous highs (Chart 22). Ms. Mea: What are your overweights and underweights for equity, currency and fixed-income portfolios? Answer: For an EM equity portfolio, our strong conviction overweights have been and remain China, Korea and Mexico. Chart 23 shows the performance of our fully-invested EM equity portfolio based on our recommended country allocation. It has outperformed the EM MSCI equity benchmark by 3.7% in 2020 and by 74% since its initiation in May 2008. The latter translates into a 4.7% CAGR outperformance versus the EM MSCI equity benchmark in 10.5 years. Critically, this outperformance has been achieved with very low volatility and small drawdowns. Chart 23Performance Of Our EM Equity Country Allocation Portfolio (Country Recommendations) Performance Of Our EM Equity Country Allocation Portfolio (Country Recommendations) Performance Of Our EM Equity Country Allocation Portfolio (Country Recommendations) As for EM local bonds, we continue to recommend receiving ten-year swap rates in Korea, Malaysia, Russia, Mexico, Colombia, South Africa, China and India. We are looking for a setback in their currencies to switch to holding cash bonds, i.e., without hedging currency risk. Among EM currencies, our short basket consists of BRL, CLP, ZAR, TRY and IDR while our favored ones have been MXN, RUB, CZK, INR THB and SGD. All these country recommendations and positions as well as the one in the EM sovereign credit space (US dollar bonds) are always presented at the end of our reports (please refer to the following pages). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     Below is a set of market relevant charts along with our observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Credit Impulse Has Peaked... Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021.   Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit   Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices.  Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months.  Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes.  Chart 6Rising Deflation Risks Rising Deflation Risks Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year   Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales ...And Promote NEV Sales ...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support   Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector.   Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects   This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks   Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021.  Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21.  Chart 24Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited   Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%.   3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations

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