Fixed Income

Highlights The amount of fiscal stimulus in the pipeline is more than enough to close the US output gap. Inflation is likely to surprise on the upside this year. The Fed will brush off any evidence of economic overheating during the coming months, stressing the “transitory” nature of the problem. Still, long-term bond yields, over which the Fed has less control, will rise. As long as bond yields move higher in conjunction with improving growth expectations, stocks will remain in an uptrend. The bull market in equities will only end when the Fed starts to sound more hawkish. That is not in the cards for the next 12 months at least. Stimulus Smackdown During the past month, a debate has erupted over how much additional fiscal stimulus the US economy needs. The side arguing that the sea of red ink has gotten too deep includes an unlikely cast of characters like Larry Summers, who has famously contended that sustained large budget deficits are necessary to stave off secular stagnation. It also includes Olivier Blanchard, who previously served as the IMF’s chief economist and pushed the multilateral lender to abandon its historic adherence to fiscal austerity. Chart 1Generous Government Transfers Boosted Household Savings Generous Government Transfers Boosted Household Savings Generous Government Transfers Boosted Household Savings Rather than citing debt sustainability concerns, these newfound stimulus skeptics worry that large-scale fiscal easing at the present juncture risks overheating the economy. They point out that President Biden’s proposed $1.9 trillion package, coming on the heels of the $900 billion stimulus bill Congress passed in late December, would inject another 13% of GDP into the economy, on the back of the lagged boost from the first stimulus package. We estimate that US households had accumulated $1.5 trillion in excess savings (7% of GDP) as of the end of 2020, thanks to the fiscal transfers they received under the CARES Act (Chart 1). US real GDP in the fourth quarter of 2020 was 2.5% below its level in the fourth quarter of 2019. Assuming trend growth of 2%, this implies that the output gap – the difference between what the economy is capable of producing and what it actually is producing – has widened by about 4.5% of GDP since the onset of the pandemic.   The Congressional Budget Office (CBO) believes the US economy was operating 1% above potential in Q4 of 2019, suggesting that the output gap is around 3.5% of GDP. As it has in the past, the CBO is probably understating the amount of slack in the economy. Our guess is that the US was close to full employment in the months leading up to the pandemic, which implies that the output gap is currently somewhere between 4% and 5% of GDP. While fairly large in absolute terms, it is still smaller than the amount of stimulus currently in the pipeline. Gentle Jay Not So Worried About Overheating Stimulus advocates argue that households will continue to use stimulus checks to fortify their balance sheets, rather than rush out to spend the windfall. They also note that unemployment payments will come down if the labor market recovers more quickly than projected. And even if the economy does temporarily overheat, “so what” they say. The Fed has been trying to engineer an inflation overshoot for years. Now is its chance. Jay Powell seems to sympathize with this thesis. Speaking at a virtual conference organized by The Economic Club of New York this week, Powell repeated his call for fiscal easing and told attendees that the Fed is unlikely to “even think about withdrawing policy support” anytime soon. His words echo remarks made at the press conference following January’s FOMC meeting, where he said “I’m much more worried about falling short of a complete recovery and losing people’s careers,” before adding: “Frankly, we welcome slightly higher inflation.” Most other FOMC members have struck a similar tone. Earlier this year, Fed Governor Lael Brainard noted that “The damage from COVID-19 is concentrated among already challenged groups. Federal Reserve staff analysis indicates that unemployment is likely above 20 percent for workers in the bottom wage quartile, while it has fallen below 5 percent for the top wage quartile.” How Big Is The Fiscal Multiplier From Stimulus Checks? Chart 2Service Inflation Fell During The Pandemic, While Goods Inflation Rose Service Inflation Fell During The Pandemic, While Goods Inflation Rose Service Inflation Fell During The Pandemic, While Goods Inflation Rose One of the reasons that households saved much of last year’s stimulus checks was because there was not much to spend them on. Officially measured service inflation was well contained last year, but many services were simply not available for purchase. In contrast, goods prices, which usually fall over time, rose (Chart 2). As the economy opens up, total spending will recover. Rising household spending will have a multiplier effect. The simplest version of the Keynesian multiplier for fiscal transfer payments is equal to MPC/(1-MPC), where MPC is the marginal propensity to consume. Assuming that households initially spend 50 cents of every dollar they receive, the multiplier would be 0.5/(1-0.5)=1. In other words, every dollar of direct stimulus payments will eventually generate one additional dollar of aggregate demand. One could argue that this multiplier estimate overstates the impact on demand because it ignores the fact that households will regard stimulus checks as one-time payments rather than a continuous flow of income. One could also point out that taxes and imports will cut into the multiplier effect on domestic spending. There is truth to all these arguments, but they are not as compelling as they seem. According to a recent US Census study, only 37% of Americans reported no difficulty in paying for usual household expenses during the pandemic. A mere 16% of workers with incomes below $35,000 reported no difficulty, compared with more than two-thirds of workers with incomes above $100,000 (Chart 3). In the euphemistic parlance of economics, most US households are “liquidity constrained,” meaning that they are likely to spend a large chunk of any income they receive, even if it is a one-off grant.1 Chart 3The Pandemic Has Put A Spotlight On The Liquidity Constraints Of US Households Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point? As for taxes, while the income from subsequent spending will be taxed, the stimulus checks that households receive will remain untaxed. Granted, some of the demand generated by stimulus checks will leak abroad in the form of higher imports. However, keep in mind that the US is a fairly closed economy – imports account for only 15% of GDP. Moreover, the full impact on imports depends on what happens to the value of the dollar. If the Fed keeps rates unchanged but inflation rises, the accompanying decline in short-term real rates could weaken the dollar, curbing imports and boosting exports in the process. This could lead to a higher multiplier rather than a lower one. Lastly, higher consumption is likely to boost corporate capex, as companies scramble to raise capacity in anticipation of strong demand (Chart 4). Economists call this the “accelerator effect.” Investment spending is 2.5-times as volatile as consumption. Hence, even modest increases in consumption can trigger large increases in investment. Chart 4Stronger Consumption Tends To Boost Capex Stronger Consumption Tends To Boost Capex Stronger Consumption Tends To Boost Capex Unemployment Benefits: Adding To Aggregate Demand But Subtracting From Supply? As Chart 5 shows, stimulus payments to households account for 17% of the December stimulus bill and 26% of Biden’s proposed package for a combined total of around $650 billion (3% of GDP, or around two-thirds of the current output gap). The balance consists of expanded unemployment benefits, health and education funding, support for small businesses, and aid to state and local governments. Chart 5Stimulus Package Breakdowns Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point? Unemployment benefits are likely to be spent fairly quickly since, in most cases, they replace lost income that had previously been used to finance consumption. More generous unemployment benefits could temporarily reduce aggregate supply. Higher federal unemployment benefits would more than offset the lost income of close to half of jobless workers, potentially creating a disincentive to seek employment. Inflation Expectations Will Continue To Rise Aggregate demand is likely to outstrip the economy’s supply-side potential over the coming months. Hence, inflation will probably surprise on the upside this year, although not by enough to force the Fed to abandon its easy money stance. Inflation expectations have recovered since the depths of the pandemic. However, the 5-year/5-year forward TIPS breakeven rate is still below the level that BCA’s bond strategists believe the Fed regards as consistent with its long-term inflation objective, and even farther below the level that would cause the Fed to panic (Chart 6). This suggests that the Fed will brush off any evidence of overheating during the coming months, stressing the “transitory” nature of the problem. Still, rising inflation expectations will push up long-dated bond yields. At present, the 5-year/5-year forward Treasury yield stands at 1.89%. This is below the median estimate of the long-run equilibrium fed funds rate from the New York Fed’s Survey of Primary Dealers (Chart 7). With policy rates on hold, higher long-term bond yields will translate into steeper yield curves. We expect the 10-year Treasury yield to rise to 1.5% by the end of the year from the current level of 1.16%, with risks to yields tilted to the upside. Chart 6Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed Chart 7Forward Treasury Yields Are Below Primary Dealers' Projections Forward Treasury Yields Are Below Primary Dealers' Projections Forward Treasury Yields Are Below Primary Dealers' Projections   Can Stocks Stand The Heat? To what extent will higher bond yields hurt stocks? To get a sense of the answer, it is useful to consider a dividend discount model. The simplest model, the Gordon Growth Model, says that the price of a stock, P, should equal the dividend that it pays, D, divided by the difference between the long-term discount rate, r, and the expected dividend growth rate, g: Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point?   We can write the discount rate as the combination of the long-term risk-free rate and the equity risk premium such that r = rf + ERP and then solve for the dividend yield:   Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point?   Note that the value of the stock market becomes increasingly sensitive to changes in the risk-free rate when the dividend yield is low to begin with. For example, if the dividend yield is 2%, a 10-basis-point rise in the long-term risk-free rate will push down stock prices by 5%. In contrast, if the dividend yield is 1%, a 10-basis-point rise in the long-term risk-free rate will push down stock prices by 10%. Today, dividend and earnings yields for most global equity sectors are quite low, although not as low as they were in 2000 (Chart 8). Watch The Correlation Between  r  And  g The fact that dividend and earnings yields are below their long-term average does make stocks vulnerable to a rise in bond yields. This is especially the case for relatively expensive equity sectors such as tech and consumer discretionary. Nevertheless, there is an important mitigating factor at work: Increases in the risk-free rate have generally been accompanied by stronger growth expectations. Chart 9 shows that S&P 500 forward earnings estimates have moved in lockstep with the 10-year Treasury yield, a proxy for the long-term risk-free rate. Chart 8Global Dividend And Earnings Yields Are Quite Low, Although Not As Low As In 2000 Global Dividend And Earnings Yields Are Quite Low, Although Not As Low As In 2000 Global Dividend And Earnings Yields Are Quite Low, Although Not As Low As In 2000 Chart 9Earnings Estimates Move In Lockstep With Bond Yields Earnings Estimates Move In Lockstep With Bond Yields Earnings Estimates Move In Lockstep With Bond Yields   This suggests that the main danger to equity investors is not higher bond yields per se, but a rise in bond yields in excess of upward revisions to growth expectations, or worse, against a backdrop of faltering growth. Such a predicament could eventually manifest itself. However, it is only likely to happen when the Fed turns hawkish. This is not in the cards for the next 12 months at least.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1  The difficulty that many households have had in making ends meet predates the pandemic. For example, in May 2019, the Consumer Finance Protection Bureau found that about 40% of US consumers claimed that they had difficulty paying bills and expenses. Among those with annual household incomes of $20,000 or less, difficulties were experienced by 6 out of 10 people. Moreover, about half of consumers reported that they would be able to cover expenses for no more than two months if they lost their main source of income by relying on all available sources of funds, including borrowing, savings, selling assets, or even seeking help from family and friends. Global Investment Strategy View Matrix Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point? Special Trade Recommendations Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point? Current MacroQuant Model Scores Higher Bond Yields: Where Is The Breaking Point? Higher Bond Yields: Where Is The Breaking Point?

Highlights The Biden administration’s budget reconciliation bill will close the output gap, so markets will have to start thinking about upcoming tax hikes, rising wages, and eventual Fed interest rate hikes. Biden’s lax immigration policies will not have a major negative impact on wage growth. A doubling of the minimum wage, which could still make it into one of two budget reconciliation bills, would include a measure to index the post-2026 minimum wage to the average rate of wage rises. Biden’s industrial policy and support of labor unions would also increase wages. Stay long Treasury inflation-protected securities versus duration-matched Treasuries and long value stocks over growth stocks.  Feature The Senate and House of Representatives passed a concurrent resolution on the budget for FY2021, the first step in the budget reconciliation process that will enable Democratic leadership to pass President Joe Biden’s $1.9 trillion American Rescue Plan with only a simple majority in the Senate. The budget resolution is a fantasy that the ruling party uses to bypass the Senate filibuster, as was the case under George W. Bush, Barack Obama, and Donald Trump. The latest such resolution claims that the budget deficit will be smaller, not larger, after the Biden rescue plan than what is currently projected by the Congressional Budget Office (Chart 1). It envisions the entire $1.9 trillion being spent in 2021 and then a huge drop in expenditures in 2022. A fiscal cliff ahead of the 2022 midterm election will not occur. Instead the second budget reconciliation maneuver, for FY2022, will increase spending levels once again with infrastructure and green projects, as per Biden’s campaign platform. Chart 1Democrats Pass Budget Resolution Biden Opens The Border Biden Opens The Border The FY2021 budget resolution does not contain any tax increases, “revenue offsets,” to keep the budget in line because the COVID relief is emergency spending that is one-off, not recurring. The FY2022, however, will aim partially to repeal President Trump’s tax cuts. As such financial markets will continue to “buy the rumor” of additional fiscal spending for now but they will also sell the news given that the next reconciliation bill will push up inflation expectations even further, hasten the Federal Reserve’s policy normalization, and include tax hikes. And the current buy-the-rumor phase could be interrupted anyway by Biden’s immediate foreign policy challenges. Larry Summers And The Output Gap Democrats will err on the larger side of the $1.9 trillion stimulus because they regret erring on the smaller side back in 2009. But it is still possible for the price tag to be knocked down to around $1.5 trillion given that the economy is recovering and several moderate Democrats will balk at the enormous size. After all, $900 billion passed at the end of the year is not yet spent. Biden has already compromised by raising the eligibility requirements for households to receive $1,400 stimulus checks. Larry Summers, a frequent guest at the annual BCA conference and a veteran of the Clinton and Obama White Houses, has stirred up a firestorm over the past month by warning that too much federal money spent on short-term cash handouts today would crowd out the administration’s political capital and the amount of deficit spending that is available for long-term, productivity-enhancing investments. Summers warned that the current proposed stimulus is three times larger than required to fill the output gap. Chart 2 shows the output gap from 2009-12 and projected from 2021-24 alongside the size of the relevant stimulus packages to illustrate his point. Treasury Secretary Janet Yellen defended the $1.9 trillion price tag – like Summers, she is not normally one to worry about overheating the economy, but unlike Summers, she is now an administration official. She predicted that this size of package would bring the economy back to full employment by next year. The Congressional Budget Office, based on earlier congressional actions, had predicted employment would not return to its pre-COVID level until around 2024. The administration will look to Yellen now and in future to make the call on when enough stimulus is enough. With inflation expectations recovering rapidly, the Fed could be forced to hike rates as early as late 2022, though we think 2023 is more likely given our methodological bias as political analysts. This means the scope for overheating is quite large – a point reinforced by the comparison with the economic recovery back in 2009 (Chart 3). Summers’s criticism is not remiss and could come back to haunt the administration.1 When inflation picks up, the Fed will have to allow an overshoot according to its new policy of targeting average inflation. But once it is assured, it will have to start hiking rates. And once it starts hiking rates it could trigger a recession. Plus, even if we set recession risks aside, Summers’s critical point is that too much stimulus today will reduce the political and budgetary scope for Biden’s long-term agenda, which includes what will likely be his second major bill focused on infrastructure and renewables. The reconciliation process makes it highly likely that Democrats will drive through this initiative through the Senate but not if moderate Senate Democrats balk in the face of rising budget deficits and inflation. Chart 2How Much Is Too Much Stimulus? Biden Opens The Border Biden Opens The Border Our base case still holds that Democrats will pass both reconciliation bills over the next roughly 12 months but investors should keep Summers’s warning in mind. Chart 3Recovery Is Ahead Of The Previous Cycle Recovery Is Ahead Of The Previous Cycle Recovery Is Ahead Of The Previous Cycle There are tailwinds for Biden’s agenda. First, his political capital is moderate-to-strong and likely to strengthen over the coming year. It will get bumped up by improving economic conditions, including most recently a marked decline in bankruptcy filings from Q3 to Q4. Our updated Political Capital Index is shown in the  Appendix. Second, concern about budget deficits has eroded, as Republican fiscal largesse showed under Trump – the pandemic and atmosphere of crisis greatly reinforce this point. Third, divisions in the Republican Party have produced as many as five moderates who could assist Biden in winning close legislative votes – even beyond the relatively easy passage of the American Rescue Plan in his honeymoon period. This Republican Party split is the only significance of President Trump’s second impeachment. Trump’s legal woes will continue after he is acquitted in the Senate. The deeper Republicans are divided over Trump’s legacy the harder time they will have recovering in the 2022 midterms, where opposition parties are normally favored. But the Biden administration’s leftward agenda will bring Republicans together, especially once the country moves out of the crisis. One of the biggest battles looms over the southern border. Bottom Line: The $1.9 trillion American Rescue Plan will more than close the output gap and yet it is only one of two budget reconciliation bills that the Biden administration will seek to pass over the next 12 months. There are still domestic and international factors that could impede the recovery, not least China’s policy tightening, but the risk of excessively short-term stimulus at the expense of long-term public investment is clear. Republicans Will Regroup Over Immigration To Summers’s warning about Biden’s legislative window of opportunity, recall that President Trump never achieved his signature 2016 policy promise – to build a wall on the border with Mexico – because congressional Republicans led him to prioritize repealing and replacing the Affordable Care Act (which failed) and passing the Tax Cut and Jobs Act (which succeeded). There was no political capital left for a major legislative push on the border and immigration. Immigration is one of the areas where Biden has a major incentive to push his policies aggressively. Immigrants tend to skew Democratic in their party affiliations. Americans increasingly believe immigration should be increased, a trend that accelerated after Trump’s election on an avowedly anti-immigration platform (Chart 4, top panel). Today 34% believe it should be increased in addition to 36% who are comfortable with the current level. Meanwhile the number who believe it should be decreased has fallen to 28%, down from 34%-38% around the time of Trump’s election. An anti-immigration candidate may be able to win within the Republican Party (especially under the specific circumstances of 2015-16) but he or she will have trouble winning general elections. Trump himself discarded the topic in the 2020 race. For Democrats, immigration is also probably the single most effective way to drive a wedge between the populist and establishment factions of the Republican Party. For example, establishment Republican presidents oversaw huge infusions of foreigners into US society, the 1986 Immigration and Reform Control Act, which granted amnesty to three million illegal immigrants, and the 1990 Immigration Act, which increased the quota of legal immigrants. By contrast Trump rose to power by attacking the bipartisan consensus on “open borders.” As long as a substantial cohort of Republicans defends immigration on free market principles, and upholds the corporate interest in having plentiful availability of lower wage seasonal and specialized workers, the party will be divided. The above points explain why the Biden administration will pursue immigration reform more intently than public opinion would leave one to believe. Polls show that voters want to focus on the economic recovery, the pandemic response, and social and civil rights policies more than immigration. There is no question that Biden is prioritizing the pandemic, the economy, and health care (Chart 4, bottom panel). But the Democratic Party has a strategic interest in expanding immigration so Biden will continue to plow forward with executive orders and comprehensive immigration reform in Congress. The US does need immigration reform – to ensure the flow is orderly. President Trump’s “wall” proposal did not come out of nowhere. Like the “Know Nothing Party” that emerged in the 1840s and rose to prominence in the 1850s, the Trump movement arose amid a historic increase in the foreign-born share of the population (Chart 5). But Trump’s policies hardly made a dent in the flow of legal immigrants into the US. Now Biden will reverse them and encourage more incomers. Therefore immigration will persist as a bone of contention in the 2020s. Granted, immigration has amply attested positive effects on the economy – including most clearly by lifting the US’s fertility rate so that it does not suffer from as rapid of an aging process as other developed countries. Indeed, voters are primarily concerned about illegal, not legal, immigration. Still, Republicans will struggle to walk the line between tighter immigration policies and appealing to an audience beyond “old white folks.” This suggests the Biden administration has room to run. Chart 4Public Not Too Concerned About Immigration Public Not Too Concerned About Immigration Public Not Too Concerned About Immigration Chart 5Historically Large Foreign-Born Population Biden Opens The Border Biden Opens The Border It helps Biden that the post-World War II and post-Cold War booms in legal immigration are relatively measured when compared to the overall population. The inflow of migrants was around 0.3% in 2019, very far from its post-war peak of 0.7% per year (Chart 6). Thus the Biden administration will not be overly concerned about being too progressive on this issue. Chart 6Boom In Legal Immigration Less Impressive Relative To Population Biden Opens The Border Biden Opens The Border Chart 7Detainees On The Mexican Border Biden Opens The Border Biden Opens The Border Illegal immigration is the biggest factor motivating periodic public backlashes such as in 2016. Southwestern border apprehensions – the only credible way to measure the unauthorized flow of people over the Mexican border – spiked under President Obama as well as President Trump, though US agents detained nowhere near the numbers witnessed in the 1980s and 1990s (Chart 7). The stock of illegal immigrants in the US ranges from 10-11 million and has remained flat, or fallen slightly, since the financial crisis of 2008. The weakening of the US economy, in the context of tighter border security, reduced incentives to make the difficult journey (Chart 8). The fact that President Obama and Trump increased detentions suggests that the demand to get into the country recovered over the course of the last business cycle. Based on President Biden’s voting record in the Senate and statements during the 2020 campaign, he is not an ultra-dove on the border – but his party has moved to the left on the issue. This is clear from his rivals’ positions in the Democratic primary election. Even his Vice President Kamala Harris, who was not the most radical on stage, supported decriminalizing illegal border crossings and downgrading Immigration and Customs Enforcement. Still, until Democrats repeal the filibuster in the Senate, they will not have a chance of passing comprehensive immigration reform with Republicans unless they accept stronger enforcement provisions. Biden voted for the 2006 Secure Fence Act but more recently has emphasized high-tech upgrades to better monitor crossovers. Harris also accepted high-tech security funding that did not involve building a wall. Even with these compromises, it will still be a stretch to find 10 Republicans willing to cross the aisle on this issue while Trump and his faction remain active to punish them in primary elections. Chart 8Estimate Of Total Illegal Immigrants Biden Opens The Border Biden Opens The Border The demand to enter the US will revive once the pandemic is over. The big surge in illegal border crossings in the 1980s-90s coincided with a period in which US economic growth and wellbeing far outpaced that of Mexico and Central America (Chart 9). The gap in GDP per capita is the crudest possible measure and does not reflect the dramatic differences in quality of life that drive people to relocate. Nevertheless, the gap remains drastic, especially with Mexico. Chart 9The Grass Is Greener On The Other Side Biden Opens The Border Biden Opens The Border The gap in current economic activity, such as manufacturing PMIs, between the US and Mexico is as wide as ever. Even as manufacturing contracts in Mexico, the demand for workers in US service industries is soaring (Chart 10). Moreover the US economic revival will be super-charged by the gargantuan fiscal stimulus of 2020-21 whereas Mexican government support for the economy is comparatively austere (Chart 11) Chart 10Super-Charged US Recovery Opens Big Gap With Mexico Super-Charged US Recovery Opens Big Gap With Mexico Super-Charged US Recovery Opens Big Gap With Mexico Chart 11Less Government Support In Mexico Than US Less Government Support In Mexico Than US Less Government Support In Mexico Than US Bottom Line: Biden is opening up the borders at a time of economic disparity between the US and Latin America that will lead to an influx of immigration. This is positive for US labor force growth and productivity but it will be hard to pass a long-term solution through Congress. The Republican Party is deeply divided on the issue today but it is likely to become a rallying cry as numbers of newcomers increase and as Trump-style populism remains an active force within the party. Immigration, Wages, And The Minimum Wage   The macroeconomic and market impact of easier border and immigration controls boils down to the impact on wages. There is a vast literature on this subject and we will not pretend to be comprehensive. We will merely make a few observations. The foreign-to-native-born wage differential has narrowed substantially over the past twenty years. The discount to hire immigrants has shrunk from 24% to 15% (Chart 12). This is a reflection of the high demand for immigrant labor and especially the increase in high-skilled workers alongside the booming tech, legal, financial, personal care, and health care industries in the United States – the fastest growing sectors for foreign-born workers since 2003. Earnings growth for foreign workers is more cyclical than for native workers and has been rising faster in recent decades (Chart 13). Chart 12Immigrants Command A Higher Price Than They Used To Biden Opens The Border Biden Opens The Border Chart 13Immigrant Wages Grow In Boom Times Biden Opens The Border Biden Opens The Border Immigrants work the lowest-wage jobs and hence there is some correlation between the share of foreign-born workers in any given industry and the hourly wage, just as there was at the turn of the century (Chart 14). But it does not follow that an increase in immigration suppresses wages as a whole. Chart 15 shows that, over the last business cycle at least, a change in the foreign worker share of a given industry does not correlate with a change in wage growth. Of course, it stands to reason that increasing the supply of labor decreases the price. But not if demand is growing sufficiently to raise the price for all workers. As we have seen, since migrants are willing to undertake long and dangerous journeys for work, they are likely to go where the demand is strong and the price is right – and the flow drops when the jobs dry up. Chart 14Immigrants Work The Lowest Wage Jobs Biden Opens The Border Biden Opens The Border Chart 15More Immigration Not Necessarily A Pay Cut Biden Opens The Border Biden Opens The Border Academics debate the impact on wages. There could be a negative impact, especially for low-skilled native workers, but the aggregate effect is small. One study showed that wages for native workers fell by three percent cumulatively over the 20-year period from 1980-2000 due to immigration.2  This is not dramatic. We can test the connection between immigration and wage growth informally by plotting the growth of southwest border detentions and legal permanent residence admissions alongside that of real wages. There is no clear relationship either way (Chart 16). The same is true if we test it with real median wages – the surge in border apprehensions under President Trump coincided with a boom in wages across the spectrum.  Chart 16Border Influx Does Not Suppress Wages Border Influx Does Not Suppress Wages Border Influx Does Not Suppress Wages Thus we cannot rule out the possibility that the Biden administration’s relaxation of border controls will have a dampening effect on wages over the long run but we cannot endorse it either. Chances are that the rollout of COVID-19 vaccines and government spending will continue to power a recovery that tightens the labor market and lifts wages for most workers.   What about the administration’s simultaneous policy of doubling the federal minimum wage to $15 per hour by the year 2026 – and indexing wage growth after that date to the median hourly wage? The minimum wage hike might yet make it into the budget reconciliation bill under negotiation – but Biden has already signaled it can be delayed. There is a growing fear about the negative impact on small businesses struggling during the pandemic. The Congressional Budget Office estimates that anywhere from 1 million to 2.7 million jobs could be lost in 2025 if the wage hike were implemented now and businesses would pay $333 billion.3 But the proposal will return when the second budget reconciliation bill is up for consideration unless the Senate parliamentarian rules it out, in which case its passage becomes much less likely. Only about 2% of workers are paid at or below the current minimum wage of $7.25 per hour so a minimum wage hike but the CBO estimates that 10 percent of workers would be below the proposed wage level by 2025 (Chart 17). The states with higher proportions of minimum wage workers will be the ones most affected and are mostly in the south, including South Carolina, Mississippi, Kentucky, and Texas, though there are a few in the north such as New Hampshire and Pennsylvania (Chart 18). Chart 17Most Workers Earn More Than Minimum Wage Biden Opens The Border Biden Opens The Border Chart 18Minimum Wage Workers By State Biden Opens The Border Biden Opens The Border Previous minimum wage hikes did not prevent the economy from reaching full employment – nor did they lead to a lasting pickup in overall wage growth. But indexation to overall wage growth would mark a big change in favor of an eventual wage-price spiral. It cannot be ruled out given that the reconciliation option might be available to Democrats, though it would not take effect till 2026. Bottom Line: There is no firm link between immigration growth and wage growth. Increased immigration flows often coincide with higher incomes and wages as growth and productivity improve. Meanwhile a change in the minimum wage will have a limited impact from a macro point of view alone but a bigger impact if it is indexed to wage growth after 2026, which is possible. In the coming years the much greater impact of Biden’s policies will stem from the massive infusion of fiscal spending he is likely to pass through Congress, which will close the output gap quickly and put upward pressure on wages.    Investment Takeaways Easier immigration and a higher minimum wage are not the only Biden policies that will affect wages. One of the biggest developments since Biden took office is his confirmation that he will maintain a tougher trade policy than his predecessors, excluding Trump. Biden won the election among Midwestern blue collar voters at least partly by stealing Trump’s thunder on trade and globalization. Since taking office he has issued a “Buy American” executive order and declared that he will maintain “extreme” competition with China. His cabinet appointees – notably Antony Blinken at the State Department and Janet Yellen at the Treasury – have given words of warning to China over trade as well. Geopolitical risk is one reason we are cutting back on our participation in the market’s exuberance at the moment, given that critical foreign policy stances are likely to be tested early in Biden’s term. But there is also a long-term implication of the Democrats’ marginal increase in protectionism.   It was the overall policy context of hyper-globalization that led to sluggish wage growth in the United States over the previous forty years. A major factor was the decline of manufacturing and unionization as a result of a lack of competitiveness in the US as global production came online. The erosion in manufacturing jobs only stopped in recent years (Chart 19). Popular support for unions has risen to levels last seen in the late 1970s and 1990s since the Great Recession – under Trump even Republicans talked up unions. Chart 19Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Biden’s policies outlined above are reminiscent of the “third way” Democrats in the 1990s – particularly Bill Clinton, who oversaw an increase in the minimum wage and a surge in both legal and illegal immigration. But on trade Biden is shaping up to be more like Trump than Clinton, albeit directing his protectionism more at China than other trade partners. His spending bills will also use fiscal spending to promote industrial policy. Meanwhile labor protections will go up and unionization will at least stem its multi-decade decline.    For the stock market the risk of higher wages looms mostly due to the super-charging of the economy with stimulus. But shoring up domestic manufacturing, unions, labor perks and protections, and possibly indexing the minimum wage will contribute to faster wage growth and – to corporations – higher employment costs (Chart 20). This is a headwind to the corporate earnings outlook. But like the Biden administration’s tax hikes it is not yet affecting the market’s overall bullishness – and may not until the first reconciliation bill passes and the narrative shifts from stimulus to structural reform. Investors may soon find out that they will be dealing with higher wages, higher taxes, higher inflation, and a higher cost of capital. Chart 20Higher Wages, Lower Corporate Profits Higher Wages, Lower Corporate Profits Higher Wages, Lower Corporate Profits Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Biden Opens The Border Biden Opens The Border Table A1BPolitical Capital: Household And Business Sentiment Biden Opens The Border Biden Opens The Border Table A1CPolitical Capital: The Economy And Markets Biden Opens The Border Biden Opens The Border Table A2Political Risk Matrix Biden Opens The Border Biden Opens The Border Table A3Biden’s Cabinet Position Appointments Biden Opens The Border Biden Opens The Border     Footnotes 1     See BCA Global Investment Strategy, “Fiscal Stimulus: How Much Is Too Much?” January 8, 2021, bcaresearch.com. 2     George J. Borjas and Stephen J. Trejo, “The Evolution of the Mexican-Born Workforce in the United States,” in Borjas, ed, Mexican Immigration to the United States (Chicago: Chicago University Press, 2005), pp.13-55.     3    See “The Budgetary Effects of the Raise the Wage Act of 2021,” Congressional Budget Office, February 2021, cbo.gov.  

Dear client, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Ox (Bull)! Gong Xi Fa Chai, Jing Sima, China Strategist   Highlights A projected 8% increase in China’s real GDP for 2021 will not be an acceleration from the V-shaped economic recovery from the second half of last year. Excluding an exceptionally strong year-over-year economic expansion in Q1, the average growth in the rest of this year will be slower than in 2H20, which implies China’s economic growth momentum has already passed its peak. On a quarter-over-quarter basis, an expected 18% annual growth in Q1 would mean that China’s economic growth momentum has moderated from Q4 last year. Chinese policymakers are not in a hurry to press the stimulus accelerator again, with good reason. Commodity and risk-asset prices will be the most vulnerable to a weakened demand growth.   Feature China’s real GDP is expected to grow by more than 8% this year, which would be a significant improvement over last year’s 2.3%.1 However, it is misleading to compare this year’s growth with that of 2020 as a whole. The first three months of this year will undergo an exceptionally high year-on-year growth (YoY) rate due to the deep contraction experienced in Q1 last year. An 8% annual growth for 2021 would imply that the rate of economic expansion in the rest of this year will be slower than the sharp recovery in 2H20.  From a policy perspective, an 8% real GDP growth in 2021 implies an average rate of 5% over the 2020-2021 period, within the long-term growth range targeted in China’s 14th Five-Year Plan - this removes policymakers’ incentives to further stimulate the economy. The annual National People's Congress (NPC) in early March should provide clues about the government's growth priorities and policy directions. If policymakers set 2021’s real GDP growth target at around 8%, our interpretation is that Chinese leaders are not looking to accelerate growth beyond where it ended in 2020. Major equity indexes are already richly valued. A moderating growth momentum from China will weigh on commodity and risk asset prices, both in China and globally.  We reiterate our view that downside risks are high in the near term; the market could take the easing demand growth from China as a reason for a long overdue correction. A Perspective On Growth In 2021 Investors should put this year’s GDP growth projections into perspective given last year’s distortions in China’s economic conditions and data. On a YoY basis, data in the first quarter this year will be artificially boosted due to the deep contraction in Q1 last year. The market consensus is that Q1 2021 will register an 18% YoY rate of real GDP expansion. If we assume the economy can expand by 8% this year over 2020, then the YoY GDP growth rates in the rest of this year will average less than 6%. This would be below the 6.5% YoY rate in the fourth quarter of 2020 – meaning that on a YoY basis, China’s growth momentum has peaked (Chart 1). Importantly, sequential growth, such as month-over-month (MoM) and quarter-over-quarter (QoQ), drives the financial markets. On a QoQ basis, Q1 business activities are typically weaker due to the Chinese New Year. However, when we compare the rate of QoQ slowdown in Q1 this year with previous years, an 18% YoY increase would mean China’s output in the first three months of 2021 would be one of the worst in the past 20 years (Chart 2).  Chart 1Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Chart 2…But Will Be On The Weaker Side, On A QoQ Basis Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 The moderating growth momentum in Q1 this year was already reflected in high-frequency data in January. Most major components in last week’s PMI surveys in both the manufacturing and service sectors had larger setbacks than in January of previous years. Prices in major commodities as well as the Baltic Dry Index softened (Chart 3). Cyclical sector stocks in China’s onshore market, which is highly sensitive to domestic economic policies, have halted their outperformance relative to defensive stocks (Chart 4).  Chart 3Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chart 4Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Furthermore, it is useful to look past the growth outliers in the previous four quarters to gain insight into the status of China’s business cycle. On a two-year smoothed term, an 8% annual output growth in 2021 would represent a continuation of China’s downward economic growth trend (Chart 5). Chart 5This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend Bottom Line:  It is misleading to consider an 8% YoY real GDP growth rate in 2021 as an acceleration in China’s economic recovery. On a quarterly basis, Q1 will undergo a moderation in growth momentum. The economy in the rest of the year will remain on a downward growth trend. No Rush To Stimulate Anew If Q1 growth turns out to be weaker than the market anticipates, then will Beijing continue to dial back stimulus? Or, will it become concerned about the underlying fragility in the economy and provide more support? So far, all signs point to a continuation of a stimulus pullback. Chart 6Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy The resurgence of domestic COVID-19 cases contributed significantly to January’s shaky demand. However, tighter monetary conditions in 2H20 are likely another reason for the growth moderation (Chart 6). Here are some factors that may have prompted Chinese authorities to stay on track to scale back stimulus: Policymakers appear to consider the massive fiscal stimulus last year overdone. In contrast with the previous two years, local governments are not issuing special-purpose bonds (SPBs) before the NPC sets its quota in early March. China’s broader fiscal budgetary deficit widened to 11% of GDP in 2020 from 6% in 2019. Local governments issued nearly 70% more SPBs in 2020 than in the previous year (Chart 7). SPBs are mostly used for investing in infrastructure projects and last year’s fiscal support along with substantial credit expansion helped to speed up infrastructure investment. However, towards the end of last year local governments reportedly experienced a shortage in profitable investment projects and thus, parked more than 400 billion yuan of proceeds from last year’s SPB issuance at the central bank (Chart 8). This will likely convince the central government to reduce the SPB quota by a large margin this year. Chart 7Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Chart 8Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year In addition, government revenues in 2020 were surprisingly strong and spending was well below budgeted annual expenditures, resulting in 2.5 trillion yuan in idle funds (Chart 9). Based on China’s fiscal budget laws, any unspent funds from the previous year will be carried over to the next year. In other words, the 2.5 trillion yuan will contribute to fiscal deficit reduction this year and are not extra savings that can be distributed.  In addition, asset price bubbles are a perennial concern. Land sales and housing demand for top-tier cities roared back last year due to cheap loans and a relaxed policy environment (Chart 10). In our opinion, Chinese leaders allowed the real estate market to temporarily heat up last year to avoid a deep economic recession. As the economy recovered to its pre-pandemic level by late 2020, policymakers have sharply reduced their tolerance for the booming housing market and substantially tightened restrictions in the real estate sector. Chart 9Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Chart 10Housing Market Heats Up Again Housing Market Heats Up Again Housing Market Heats Up Again The domestic labor market has been surprisingly resilient, removing the leadership’s political constraints and incentives to further stimulate the economy.  Labor market conditions and household income are improving. The gap between household disposable income and spending growth has narrowed, the unemployment rate is back to its pre-pandemic level and consumer confidence has rebounded (Chart 11). More importantly, China’s labor market in urban areas is tightening again, with migrant workers receiving higher pay than prior to the pandemic (Chart 12).  Chart 11Labor Market Is On The Mend Labor Market Is On The Mend Labor Market Is On The Mend Chart 12China’s Urban Labor Market Is Tightening Again Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 Bottom Line: Growth rates will moderate, but policymakers will wait for more evidence of a pronounced slowdown in economic conditions before they ease policies. Concerns about financial risks and excesses in the property market entail authorities to allow stimulus of 2020 to relapse. It will take a much deeper slowdown in the business cycle before easing is re-introduced. Investment Implications Our baseline view indicates that credit growth will decelerate by two to three percentage points in 2021 from 2020, and the local government SPB quota will drop by 10%. The projected pullbacks on stimulus are small and more measured than the last policy tightening cycle in 2017/18. Nevertheless, a smaller stimulus and tighter policy environment will consequently lead to moderating growth momentum in China’s domestic economy and demand, particularly in the second half of this year.   Chart 13How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds Commodity prices may be at high risk of easing demand. The strong rebound in China’s commodity imports in 2H20 was not only due to a recovery in domestic consumption, but also inventory restocking from an extremely low level. Chart 13 shows that the change in China’s industrial inventories relative to exports has risen substantially from a two-year contraction. Going forward, the pace of inventory accumulation will slow following a weaker policy tailwind and growth momentum, which will weigh on the demand for and prices of key industrial raw materials. Corporate profits should continue to recover, albeit at a slower rate than in 2H20. At the same time, risks are tilted to the downside, and policy initiatives should be closely monitored going forward. As such, we maintain a cautious view on Chinese stocks.    Jing Sima China Strategist jings@bcaresearch.com   Footnote: 1     IMF World Economic Outlook and World Bank Global Outlook, January 2021   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: Long-maturity Treasury yields are closing in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Ba Versus Baa Corporates: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Feature Chart 1Uptrend Intact Uptrend Intact Uptrend Intact Bond yields moved higher last week, maintaining their post-August uptrend despite a brief lull in the second half of January (Chart 1). The 30-year yield even touched 1.97%, its highest level since last February. Given the sharp up-move, the first section of this week’s report considers whether bond yields look stretched. More broadly, we discuss several factors that will help us decide when to increase portfolio duration. How Much Higher Can Yields Rise? We have maintained a recommended below-benchmark duration stance since October and have been targeting a range of 2% to 2.25% for the 5-year/5-year forward Treasury yield.1 That target range is based on median estimates of the long-run equilibrium fed funds rate from the New York Fed’s surveys of market participants and primary dealers (Chart 2). The rationale is that in an environment of global economic recovery where the Fed is expected to eventually lift the funds rate back to equilibrium, long-dated forward yields should reflect expectations of that long-run equilibrium. At present, the 5-year/5-year forward Treasury yield is 1.97% meaning that there is between 3 bps and 28 bps of upside before our target is met. Chart 2Almost At Target Almost At Target Almost At Target A 5-year/5-year forward Treasury yield between 2% and 2.25% would not automatically trigger an increase in our recommended portfolio duration, but it would mean that further increases in yields would need to be justified by upward revisions to survey estimates of the long-run equilibrium fed funds rate. In a similar vein, the 5-year/5-year forward TIPS breakeven inflation rate has risen considerably in recent months, but at 2.15%, it remains below the 2.3% to 2.5% range that the Fed would consider “well anchored” (Chart 2, bottom panel). In other words, there is still some running room for reflationary economic outcomes to be priced into bond yields. Cyclical Growth Indicators Treasury yields may be encroaching on the lower bounds of our target ranges, but cyclical economic indicators suggest further increases ahead. The CRB Raw Industrials / Gold ratio remains in a solid uptrend, and encouragingly, it is being driven by a surging CRB index and not just a falling gold price (Chart 3). Separately, the outperformance of cyclical equity sectors over defensives has moderated in recent weeks, but not yet by enough to warrant reversing our duration call (Chart 3, bottom panel). Chart 3Cyclical Bond Indicators Cyclical Bond Indicators Cyclical Bond Indicators Value Indicators Chart 4Bond Valuation Indicators Bond Valuation Indicators Bond Valuation Indicators While cyclical indicators point to further bond weakness ahead, a couple valuation measures show yields starting to look stretched. Two survey-derived estimates of the 10-year zero-coupon term premium have moved up sharply. The estimate derived from the New York Fed’s Survey of Market Participants has jumped into positive territory and the estimate derived from the Survey of Primary Dealers is close behind (Chart 4). These surveys ask respondents to estimate what they think the fed funds rate will average over the next ten years. By comparing the median survey response to the current spot 10-year Treasury yield we get a measure of how much term premium the median investor expects to earn. These term premium estimates have typically been negative during the past few years, though they did rise to about +50 bps before Treasury yields peaked in 2018. In other words, a positive term premium estimate, on its own, is no reason to extend duration. All it tells us is that if the median investor is correct about the future path of the fed funds rate, then there is more money to be made at the long-end of the curve than in cash. This doesn’t rule out investors revising their funds rate expectations higher, or the term premium becoming even more stretched. Another related bond valuation indicator is the difference between the market’s expected path for the fed funds rate and the path projected by the FOMC (Chart 4, bottom panel). Here we see that, for the first time since 2014, the market is priced for a faster pace of tightening over the next two years than the median FOMC participant anticipates. Again, this is not a decisive signal to buy bonds. The FOMC could revise its funds rate projections higher when it meets next month. However, the longer that market pricing remains more hawkish than the Fed, the stronger the case to increase duration becomes. The Dollar Chart 5Dollar Still Supports Higher Yields Dollar Still Supports Higher Yields Dollar Still Supports Higher Yields Finally, we should note that the trade-weighted dollar appreciated last week as bond yields rose (Chart 5). A stronger dollar certainly supports the case for extending duration, the only question is whether the dollar has strengthened enough to dent US economic growth and pull US yields back down. Our sense is that we haven’t reached that breaking point yet, but we could if US real yields continue to rise relative to real yields in the rest of the world (Chart 5, panels 2 & 3). We think of the relationship between US bond yields and the dollar as a feedback loop. A weaker dollar supports economic reflation, which eventually sends yields higher. However, once higher US yields de-couple too far from yields in the rest of the world, the dollar appreciates. A stronger dollar impairs the economic outlook and sends US yields back down, the dollar then depreciates and the cycle repeats. At present, we appear to be in the stage of the feedback loop where US yields are rising relative to the rest of the world, putting upward pressure on the dollar. However, we don’t think the dollar is yet strong enough to prevent US yields from climbing. Dollar bullish sentiment, for example, remains below 50% suggesting that most investors remain dollar bears. A sub-50 reading on this index also tends to coincide with rising US Treasury yields (Chart 5, bottom panel). A move above 50 in the dollar sentiment index would be another signal that the bond bear market is becoming stretched. Bottom Line: Long-maturity Treasury yields are closing-in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Comparing Baa- And Ba-Rated Corporate Bonds Chart 6The Ba Index OAS Is Unusually High The Ba Index OAS Is Unusually High The Ba Index OAS Is Unusually High We have previously written that the macro environment is extremely positive for credit risk and we recommend moving down in quality within corporate bonds. We have also pointed out that the incremental spread pick-up earned from moving out of Baa-rated bonds and into Ba-rated bonds is elevated compared to typical historical levels. As such, the Ba-rated credit tier looks like the sweet spot for corporate bond allocation from a risk/reward perspective.2 In this week’s report we delve a little deeper into the relative valuation between Baa- and Ba-rated bonds. First, we note the difference between the average option-adjusted spread (OAS) of the Ba index and the average OAS of the Baa index. The Ba index OAS is 126 bps above the Baa index OAS, a level that looks high compared to recent years (Chart 6). One problem with this simple comparison of index OAS is that the average duration of the Ba index is much lower than the average duration of the Baa index (Chart 6, bottom panel). However, after doing our best to match the duration between the two indexes, we still find that Ba offers an attractive yield advantage, particularly compared to levels seen in 2017 and 2018 (Chart 6, panel 2). Going back to our simple OAS differential, we conducted a small study looking at calendar year excess returns between 1989 and 2020. Our results show that the differential between the Default-Adjusted Ba OAS and the Baa OAS does a good job predicting relative excess returns between the two sectors (Table 1).3 The Default-Adjusted Ba OAS is the Ba index OAS at the beginning of the calendar year minus realized Ba default losses that occurred during the year in question. We also use the Baa index OAS from the beginning of the year, but don’t make any adjustments for Baa default losses. Table 1Annual Excess Return Differential & Relative Spreads: Ba Corporates Over Baa Corporates Ba-Rated Bonds Look Best Ba-Rated Bonds Look Best Our results show that Ba excess returns outpaced Baa excess returns in every calendar year for which the Adjusted Ba/Baa OAS differential exceeds 100 bps. The raw Ba/Baa OAS differential is currently 126 bps. This means that we should be very confident that Ba-rated bonds will outperform Baa-rated bonds in 2021, as long as Ba default losses come in below 0.26%. This seems likely. For context, Ba default losses came in at 0.09% in 2020, despite the 12-month default rate spiking to almost 9%. Fallen Angels Another interesting issue to consider when looking at the intersection between the Baa and Ba credit tiers is the presence of fallen angels – bonds that were initially rated investment grade but have been downgraded to junk. The 2020 default cycle coincided with a huge spike in ratings downgrades and the number of outstanding fallen angels jumped dramatically (Chart 7). Not only that, but fallen angels also performed exceptionally well in 2020. Fallen angels outperformed duration-matched Treasuries by 800 bps in 2020 compared to 431 bps for the Ba-rated index, -10 bps for the Baa-rated index and -13 bps for the B-rated index (Chart 7, bottom panel). All that outperformance has compressed fallen angel valuations a lot. The incremental spread pick-up in fallen angels over duration-matched Baa-rated bonds is 201 bps, about one standard deviation below its post-2010 average (Chart 8). Fallen angels look even worse compared to the Ba index, offering only a 30 bps spread advantage (Chart 8, panel 2). Chart 7Fallen Angels Dominated In 2020 Fallen Angels Dominated In 2020 Fallen Angels Dominated In 2020 Chart 8Fallen Angels No Longer Look Cheap Fallen Angels No Longer Look Cheap Fallen Angels No Longer Look Cheap Bottom Line: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes.   Labor Market Update Chart 9Employment Growth Has Slowed Employment Growth Has Slowed Employment Growth Has Slowed Last week’s January employment report was a disappointment with nonfarm payrolls growing only 49k after having contracted by 227k in December (Chart 9).   Two weeks ago, we calculated the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 4.5% by certain future dates.4 In our view, an unemployment rate of 4.5% would meet the Fed’s definition of maximum employment, making it an important pre-condition for monetary tightening. Revising our calculations to incorporate January’s report, a 4.5% unemployment rate by the end of 2021 still looks like a long shot. Nonfarm payroll growth would have to average between +328k and +705k per month to meet that target, depending on the path of the participation rate (Table 2). That said, we still view a 4.5% unemployment rate by the end of 2022 as achievable. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% ##br##By The Given Date Ba-Rated Bonds Look Best Ba-Rated Bonds Look Best Yes, even that will require average monthly payroll growth of between +210k and +411k, but we are likely to see a re-opening of certain shuttered sectors – Leisure & Hospitality, for example – during that timeframe. When it occurs, this re-opening will lead to a surge in employment growth that will push average monthly payroll growth dramatically higher. Notice that almost 40% of the 9.9 million drop in overall employment since February 2020 has come from the Leisure & Hospitality sector (Chart 10). Chart 10Waiting For The Post-COVID Snapback Waiting For The Post-COVID Snapback Waiting For The Post-COVID Snapback Bottom Line: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Excess returns are calculated relative to duration-matched Treasury securities in all cases. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Italy looks like it will form a national unity coalition under Super Mario Draghi – though it is not yet a done deal. A snap election is still our base case, whether in 2021 or 2022, but the ECB will do “whatever it takes,” as will Draghi if he becomes Italy’s prime minister. Even if the right-wing populist parties win power in a snap election, their goal is to expand fiscal spending, not exit the Euro Area. And they would rule in a world where even Germany and Brussels concede the need for soft budgets. Go long BTPs versus German bunds, and Italian stocks versus Spanish stocks, on a tactical 3-6 month horizon. The structural outlook for Italy is still bearish until Italy can secure its recovery and launch structural reforms. Feature In 2016-17 we wrote two special reports on Italy under the heading of “Europe’s Divine Comedy.” In “Inferno” we focused on Italy’s structural flaws and in “Purgatorio” we explained why Italy would stay in the European Union. We have long awaited the chance to write the third installment, which must be called “Paradiso” in honor of Dante Alighieri. But the tragedy of the pandemic makes this title sadly inappropriate. The new government that is tentatively taking shape is not the solution to the country’s long-term problems either. Former European Central Bank President Mario Draghi is an excellent policymaker and would ensure that Italy does not add political chaos to its pandemic woes this year. A unity government under Draghi – which is not yet a done deal as we go to press – would be a tactical and even cyclical positive for Italian equity and bond prices but not a structural positive. The paradise of national revival will have to wait for a later date. In the meantime Italy’s performance will be dictated by its surroundings. The Black Death Italy suffered worse than the rest of Europe from COVID-19, judging both by deaths and the economic slump (Chart 1). It was the first western country to suffer a major outbreak. Outgoing Prime Minister Giuseppe Conte was the first western leader to impose a Chinese-style lockdown – which came as a shock for democratic populations unfamiliar with such draconian measures. Few will forget the terrifying moment in March when the military was deployed in Bergamo to help dispose of the bodies.1 Chart 1Italy's National Crisis Italy's National Crisis Italy's National Crisis Chart 2Italy’s Unemployment Problem – Especially In The South Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The crisis struck at an awkward time in Italian politics as well. Like the US and UK, Italy saw a surge of populism in the 2010s. Hostility toward the political elite arose largely in reaction to hyper-globalization, the adoption of the euro, and deep structural flaws that have engendered a sluggish and unequal economy: Poor demographics: Italy’s population peaked in 2017 and is expected to fall from 61 million to 31 million by the year 2100. Its fertility rate is 1.3, the lowest in the OECD except South Korea. It has the third smallest youth share of population (13%) and stands second only to Japan in elderly share of population (23%).2 North-South division: Southern Italy, the Mezzogiorno, is poorer, less educated, less efficient, and less well governed than northern Italy. Unemployment is 7 percentage points higher in the south than in Italy on average (Chart 2). In our “Inferno” report we concluded that regional divisions discourage exiting the Eurozone and EU, since southern Italy benefits from EU transfers and northern Italy would refuse to subsidize southern Italy without EU support (Chart 3).   Chart 3EU Budget Allocations Favor Italy Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Low productivity: Italy’s real output per hour has lagged that of its European peers as the country has struggled to adjust to globalization, digitization, aging, and emerging technologies (Chart 4). Chart 4Italy's Lagging Productivity Italy's Lagging Productivity Italy's Lagging Productivity High debt: Italy’s debt-to-GDP ratio is expected to rise from to 134.8% to 152.6% by the year 2025, putting it on a higher-debt trajectory than even the worst case projections prior to the pandemic (Chart 5). Normally Italy runs a current account surplus and primary budget surplus, although the pandemic has pushed the country down the road of budget deficits (Chart 6). The debt problem is manageable as long as inflation is low and the ECB purchases Italian government bonds – which it will do in the interest of financial stability. But it sucks away growth and investment over time, a problem that will revive whenever the EU Commission tries to return to semi-normal fiscal policy restraints. Chart 5Italy’s Debt Pile Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Chart 6Italy’s Budget Surplus Destroyed By COVID-19 Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Italy’s predicament can be illustrated simply by comparing the growth of GDP per capita over the past decade to that of Spain, which is a structurally comparable Mediterranean European economy and yet has generated a lot more wealth for its people after having slashed government spending and reformed the labor market and pension system in the wake of the debt crisis (Chart 7). Chart 7Spain Reformed, Italy Didn't Spain Reformed, Italy Didn't Spain Reformed, Italy Didn't Structural reforms undertaken by the technocratic Mario Monti government in the wake of the sovereign debt crisis proved insufficient. Subsequent reform efforts went up in a puff of smoke when Matteo Renzi’s pro-reform constitutional referendum failed in 2016. Italy’s government is congenitally gridlocked because the lower and upper houses of the legislature have equal powers, like in the US, but its parliamentary governments can be easily toppled by either house. The 2016 constitutional reforms would have given the central government historic new powers to force through painful yet necessary structural changes – but centrist voters of different stripes hesitated to grant these new powers since they looked likely to go to populist parties on the brink of victory in the looming 2017 elections. The populists – the right-wing League in the north and the left-wing Five Star Movement in the south – did indeed come to power in 2017 but Italian’s political establishment subsequently restrained them from pursuing either serious euroskepticism or massive fiscal spending. Pro-establishment President Sergio Mattarella rejected any cabinet members who would attack the monetary union. Subsequent battles with Brussels and Germany prevented Italy from passing a blowout stimulus that challenged EU fiscal orthodoxy and threatened to precipitate a solvency crisis in the banking system. In 2019 the ambitious League broke with the Five Star Movement, which collaborated with the center-left Democratic Party to form a new coalition. But the resulting compromise government, its populism diluted, only managed one structural reform – to reduce the size of parliament – plus a moderate increase in government spending. The populist parties ended up being right about the need for more proactive fiscal policy, as Germany conceded in late 2019 and as COVID-19 lockdowns made absolutely necessary in early 2020. French President Emmanuel Macron and German Chancellor Angela Merkel agreed to launch a €750 billion EU Recovery Fund that enabled jointly issued debt for EU members, solidifying a proactive fiscal turn in the bloc. Italy now has €209 billion coming its way. This is a boon for the recovery, though it is also the origin of the politicking that brought down the ruling coalition last month. With central banks monumentally dovish, European and American fiscal engines firing on all cylinders, and China’s 2020 stimulus still coursing through the world’s veins, the macro backdrop is positive for Italy. But with Italy’s economy still shackled by fundamental flaws, it will not be a lead actor or an endogenous growth story. Bottom Line: Italy missed the chance in the 2010s to undertake structural reforms that could lift productivity and potential growth. Now it is struggling to maintain political order in the wake of a devastating pandemic and recession. The vaccine and global recovery will lift Italian assets but the future remains extremely uncertain, given the eventual need to climb down from extreme stimulus and impose painful structural reforms. Paradiso? Or Paradiso Perduto? The latest political turmoil arose over the EU Recovery Fund and how Italy will spend the €209 billion allotted to it, as well as the €38.6 billion allotted to the country under the EU’s structural budget for 2021-28. Ostensibly Matteo Renzi pulled his Italia Viva party out of the ruling coalition because he feared that former Prime Minister Conte, together with his economy and industry ministers, would spend the funds on short-term vote-winning handouts rather than long-term structural fixes in health, education, and culture. But Renzi was not appeased when Conte offered to spend more on health and education as requested. Renzi’s party fares poorly in opinion polls and the recent electoral reforms were not favorable to it, so he can hardly have wanted a new election. He wanted Italy to tap €36 billion from the European Stability Mechanism in addition to taking EU recovery funds, since this would come with strings attached in the form of structural reform. He apparently wanted to precipitate a new pro-establishment coalition. President Mattarella’s appointment of Mario Draghi to lead a national unity coalition is the solution. But as we go to press it is not certain that Draghi will be able to command a majority in parliament. Chart 8Salvini's League Lost Steam But Populist Right Still Powerful Salvini's League Lost Steam But Populist Right Still Powerful Salvini's League Lost Steam But Populist Right Still Powerful Matteo Salvini and the League are the pivotal players now. Salvini and his party suffered loss of popular support in 2019 as a result of his ambitious attempt to break from the government, force new elections, and rule on its own. The party especially suffered from the pandemic, which hit its base of voters in Lombardy hard and sent voters in support of the central government as well as the political establishment (Chart 8). Salvini must now decide whether to try to rebuild his status by joining Draghi in the national interest, to show he can be a team player, albeit at risk of being seen as an institutional politician. If so, he would cede the right-wing anti-establishment space to his partner Giorgia Meloni, who leads the Brothers of Italy, which has eaten up all the support Salvini has lost since the European parliament election of 2019. What is clear is that his current strategy is not working, and he played ball with the big boys during the 2017-19 period, so we would not rule him out of a Draghi government. If Draghi does not win over Salvini and the League, he would need to win the support of the Five Star Movement to form a coalition. The party’s leaders initially said they would not join Draghi, who epitomizes the establishment of which they are sworn enemies. Yet Five Star has not lost any popular support for working with the conventional Democratic Party, in stark contrast with the League, which stayed ideologically pure but lost supporters. Some Five Star members, including Foreign Minister Luigi Di Maio, former leader of the party, want to work with Draghi and stay in government. Hence the party could still join Draghi, or it could break apart with some members defecting. It would require 33% of Five Star members in the Chamber of Deputies and 28% of Five Star members in the Senate to join Draghi to give him a majority, assuming the League and Brothers of Italy refuse to cooperate (Table 1). Interestingly, if the League is absent from the vote, and all parties other than the Brothers and Five Star join Draghi, then he could also form a government. This would give cover to the League under the pretense of COVID vigilance, without being seen as actively preventing a government formation. Table 1'Whatever It Takes' To Build A National Unity Coalition Under Super Mario Draghi Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? We have favored an early election and this could still occur. If there is an election it will happen before June because an election cannot happen within the last six months of the current president’s term, as per Article 88 of the Constitution. If Italy avoids a snap election till June, political stability is ensured at least till January. The pandemic was the justification for avoiding a snap election but the pandemic did not prevent the regional elections or constitutional referendum in September. The referendum was a hurdle that needed to be cleared before the next election, so now the way is open. All of the parties are greedily eying the presidency, with President Mattarella’s seven-year term set to expire next January. Mattarella has emerged as a staunch defender of the establishment and a check on anti-establishment parties. If the populists gain a plurality prior to January, then they can try to get a more sympathetic or neutral policymaker in that position. By contrast, the pro-establishment parties are hoping that a Draghi coalition can last long enough to ensure that one of their own holds that post. Since the latter need either the League or Five Star to govern, they would have to compromise on the next president – which is a very big concession. In distributing EU recovery funds, there is little doubt that a unity government under Draghi would be a credible way of proceeding. Draghi has joined other central bankers, like the Fed’s Janet Yellen, in voicing strong support for fiscal policy to get the developed democracies out of their current low-growth morass. He would have the authority and expertise to direct spending to productivity-enhancing projects at home while working with Brussels to allow Italy the greatest possible flexibility. Italy’s portion of EU recovery funds is shown in Chart 9, with the black bar indicating the part consisting of loans. The sector breakdown of total EU recovery fund is shown in Table 2. Chart 9Italy’s Fiscal Stimulus To Receive EU Top-Up Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Table 2Composition Of EU Recovery Fund By Economic Sector Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Yet a Draghi government is not a permanent solution to Italy’s political crisis or its economic malaise. Currently the political parties are squabbling over how to distribute a windfall of special funds – Italy is benefiting from a more pragmatic EU policy as it emerges from a crisis. But in future the parties will be fighting over what to do when the funds are spent. Even if the EU continues to be generous the stimulus will decelerate, while structural reforms will have to be attempted yet again. A technocratic Draghi government would be well positioned to institute the reforms that Italy needs but the economic medicine could sow the seeds for another voter backlash – in which case the anti-establishment right would be in prime position. This would set up a giant clash with Germany and Brussels. Italy, The EU, And Global Power Politics Geopolitically, Italy matters because it is a test of whether the European Union will continue consolidating power within its sphere of influence. If Draghi can form a unity government, oversee economic recovery and long-delayed structural reforms, and survive to reap the benefits at the voting booth, it would mark a historic victory for the EU as it lurches from crisis to crisis in pursuit of deeper integration and ever closer union. The Italian question would effectively be resolved and the EU would have the capacity to handle other challenges elsewhere. Europe’s geopolitical coherence is critical for global geopolitics as well. Europe is the prime beneficiary of US-China competition – at least until such time as it is forced to choose sides. Since Europe is a great power, it can remain neutral for a long time, using America as a stick against Chinese technology theft while expanding market share in China as it diversifies away from the United States (Chart 10). Chancellor Merkel has already signaled to Biden that she is not eager to join any “bloc” against China. Biden will have to devote a massive diplomatic effort to convince the Europeans, who are not as concerned about China’s military and strategic threat, that it is necessary to form a grand alliance toward containing China’s rise. Chart 10EU Balances Between US And China Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The EU’s efforts to carve out a sphere of influence have momentum. The German and EU approach to fiscal policy has become more dovish and proactive, a concession to the southern European economies that will improve their support for the European project. Across the Atlantic the EU states see President Trump’s rise and fall as a story of America’s declining influence, which improves the EU’s authority over its own populace, and yet has not resulted in an American-imposed trade war that would undermine the recovery. To the east, EU states see Russian authoritarianism and its discontents, which reinforce the public’s commitment to democratic values and the single market. To the north, they see the negative example of Brexit, which continues to plague the UK, with Scotland pushing for independence again. To the south, Europeans have become less concerned about illegal immigration, having watched the inflow of migrants from Turkey, the Middle East, and North Africa fall sharply – at least until the next major regime failure in these regions causes a new wave of refugees (Chart 11). These events have encouraged various countries to fall in line behind the consensus of European solidarity and geopolitical independence. A technocratic government in Italy would reinforce these trends but a populist government would not be able to avoid or override them. Chart 11Europe Less Concerned About Refugees (For Now) Europe Less Concerned About Refugees (For Now) Europe Less Concerned About Refugees (For Now) Chart 12Italian Euroskeptics Constrained By Public Opinion Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The Italian populist parties are still in the ascent but they do not seek to exit the EU or monetary union (Chart 12). We fully expect Italy to see snap elections in 2022 if not 2023, given the fragility of any new coalition to emerge today. If the right-wing League and Brothers should win control of government, and clash with Germany and Brussels, they would still operate within an environment circumscribed by these geopolitical limitations. Otherwise greater solidarity gives the EU greater room for maneuver among the US, China, and Russia. Investment Takeaways In the short run, the Draghi government is bullish for Italian assets. If Draghi fails and snap elections are called, the downside to European equities and the euro is limited, since any risk of an Italian exit from the EU dissipated back in 2016-18. Past turmoil resulted in higher Italian bond yields and wider spreads between BTPs and German bunds because markets had to price in the risk that the Euro Area would break up. We have long highlighted that this risk was overstated and markets are well aware of that by now. The market’s muted reaction to this latest kerfuffle proves the point (Chart 13). Chart 13Markets Unimpressed By Italian Political Turmoil Markets Unimpressed By Italian Political Turmoil Markets Unimpressed By Italian Political Turmoil On overweight stance toward Italian government bonds has been one of the highest conviction calls of our fixed income strategist, Rob Robis, over the past year. He expects that Italian bond yields (and spreads over German debt) will converge to Spanish levels, thus restoring a relationship last seen sustainably in 2016. He also notes that the ECB is willing to use quantitative easing to support Italy when its politics inject a risk premium into government bonds and spreads widen. The central bank is also providing additional support to Italy via cheap bank funding (TLTROs) that helps limit Italian risk premia at a time when underlying credit growth is exceedingly weak. During the height of the COVID lockdowns last year, the ECB increased its buying of Italian bonds higher than levels implied by its Capital Key weighting scheme, which officially governs bond purchases. Once Italian yields fell back to pre-pandemic levels, the ECB slowed the pace of purchases to levels at or below the Capital Key weights. As long as the pandemic lingers, the ECB will have the ability and pretext to ensure that Italian spreads do not rise too high (Chart 14). Chart 14Overweight Italian Government Bonds Overweight Italian Government Bonds Overweight Italian Government Bonds True, investors may be more reluctant to drive Italian yields and spreads to new lows as long as there is a risk of elections this year or next that could bring anti-establishment leaders to power and trigger an increase in Italian political risk premia. But this trap between politics and QE still justifies an overweight stance within global bond portfolios, as Italian yields will remain too attractive for investors to ignore given the puny levels of alternative sovereign bond yields available elsewhere in the Euro Area. Go tactically long Italian BTPs relative to German bunds. Italian stocks have seen a long and dreary downtrend versus global stocks, whether relative to developed or emerging markets, including or excluding the US and China. However, they are trading at a heavy discount in terms of price-to-book and price-to-sales metrics and a Draghi government to direct stimulus funding is doubly good news. Italian stocks have rebounded against Spanish equities since 2017 – as have Italian banks versus Spanish banks. Italian non-performing loans declined from a peak of €178 billion in 2015 to €63 billion in 2020. The banks raised enough equity capital to cover these NPLs. Since banks form a significant part of the Italian bourse, an improvement in bank balance sheets would be positive for the overall market. A Draghi government would reinvigorate this tendency, especially if it credibly commits to structural reforms that elevate potential growth. Spain’s structural reforms are priced in and it is next in line for a post-COVID political shakeup (Chart 15). Go tactically long Italian stocks relative to Spanish. While a Draghi coalition is marginally positive for the euro there are several factors motivating the dollar’s counter-trend bounce in the near term (Chart 16). US and Eurozone growth are diverging, with the EU struggling to roll out its COVID vaccine while the US prepares to pile a new $1.5-$1.9 trillion fiscal stimulus on top of the unspent $900 billion stimulus passed at the end of last year. Chart 15Italian Stocks Have Upside Versus Spanish Italian Stocks Have Upside Versus Spanish Italian Stocks Have Upside Versus Spanish Chart 16Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Over the long run, a Draghi government provides limited upside with regard to Italian assets. The new coalition serves to avoid an election, not enable structural reform. An unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. An early election and anti-establishment victory are not unlikely, if not in 2021 then in 2022 when Italy faces a falling stimulus impulse and the need for painful reforms. For now the truly bullish development is Germany’s dovish shift on fiscal policy rather than any temporary sign of Italian political functionality. Dysfunction can return to Italy fairly quickly but an accommodative Germany is hard to be gotten. Hence Italy’s biggest political risks will come if populist parties win full control of government in the next election while Germany and Brussels seek to normalize fiscal policy and impose some semblance of restraint in the wake of the crisis. It is also possible that a new economic shock or wave of immigration could bring Italy’s populists not only to take power but to rediscover their original euroskepticism. Thus any preference for Italian assets should be seen as a cyclical play on global growth and European solidarity and reflation – not a structural play on Italy’s endogenous strengths. Last week we shifted to the sidelines of the stock rally due to our concern that political and geopolitical risks have fallen too much off the radar. The Biden administration faces tests over China/Taiwan and Iran/Israel. Biden’s tax hikes will come into view soon. Chinese policy tightening is also a concern, even for those of us who do not expect overtightening. These factors pose downside risk to bubbly global stock markets in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Angela Giuffrida and Lorenzo Tondo, "‘A generation has died’: Italian province struggles to bury its coronavirus dead," The Guardian, March 19, 2020, theguardian.com. 2 See Stein Emil Vollset et al, "Fertility, mortality, migration, and population scenarios for 195 countries and territories from 2017 to 2100: a forecasting analysis for the Global Burden of Disease Study," The Lancet, July 14, 2020, thelancet.com.

In lieu of the next strategy report, I will be presenting the quarterly webcast titled ‘Five Contrarian Predictions For 2021-22’ on Thursday February 11 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join. Highlights Many of the ‘short squeezed’ investments that day traders have bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side. The biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. The happy corollary is that the structural bull market in equities will only end when the 10-year T-bond yield reaches zero. Until then, stay structurally overweight equities. Structurally overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal trade: short AUD/JPY. Feature Chart of the WeekShort-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Gamestop) There is no divine law that decrees the ‘correct’ time-horizon for any investment. Depending on your objectives and skills, a correct investment horizon could be anything spanning a few milliseconds to a hundred years. Once you absorb this fundamental point, it leads to a profound conclusion:  The ‘correct’ price for any investment depends on your investment horizon. The Most Important Investment Question Is, Who Is Setting The Price? A long-term investor and a day trader will go through completely different thought processes to determine a stock’s ‘correct’ price. The long-term investor, intending to buy and hold the stock for ten years, will receive 40 quarterly dividend payments plus the stock price as it stands in 2031. Hence, the correct price is the discounted value of those expected cashflows. But for the day trader, intending to buy today to sell tomorrow, only one cashflow matters – tomorrow’s price. Hence, the correct price is simply the expected price at which he can sell tomorrow. The longer-term cashflows are irrelevant, unless they set the selling price tomorrow. Yet this is unlikely, because as Benjamin Graham put it:   In the long run the market is a weighing machine, but in the short run it is a voting machine. Therefore, a long-term investor and a day trader are completely different animals, whose price-setting behaviour must be seen through different lenses. This matters because the price is always set by the last marginal transaction. The important question then is, who is setting the price? All of which brings us to the battle raging between a cabal of day traders and a group of hedge funds. The day trader is buying today because he expects that the hedge fund, desperate to cover its short positions, must buy at an even higher price tomorrow. The day trader’s behaviour is rational, so long as it is within the law, and so long as the hedge fund short-covering is the marginal price taker. Eventually though, the desperate hedge fund will not take the price, because there are no more short positions left to cover. At this point, if the day trader wants to exit his position, the marginal buyer will be a longer-term investor who will only buy at a much lower fundamentally-determined price. The day trader will have won the battle, but lost the war. The crucial takeaway is that we should always monitor which time-horizon of investors is setting the marginal price of an investment. We can do this by continually measuring the fractal structure of the investment’s price. We should always monitor which time-horizon of investors is setting the marginal price of an investment. When the fractal structure of an investment has collapsed, it means that the time-horizon of investors setting the price has compressed to a near-term limit. Thereby it signals that the price-setting baton will return to long-term investors who will reset the price to valuation anchors, such as discounted long-term cashflows. The implication is that the preceding trend, fuelled by short-term price setters, is likely to reverse. Today, we observe that many of the investments that day traders have recently bid up are at, or approaching, collapsed short-term fractal structures. As such, patient long-term investors should take the other side (Chart of the Week, Chart I-2 and Chart I-3). Chart I-2Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Short-Squeezed Investments Now Have Collapsed Fractal Structures (AMC Entertainment) Chart I-3Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) Short-Squeezed Investments Now Have Collapsed Fractal Structures (Blackberry) The Major Misunderstanding About Real Bond Yields A common question we get is, should we compare the prospective returns on equities and bonds in nominal terms or in real terms? In an apples-for-apples comparison it shouldn’t really matter. The problem is that while we know the prospective nominal return from bonds (it is just the bond yield), it is extremely difficult to know the prospective real return from bonds. As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield. A trustworthy ex-ante real bond yield requires a trustworthy prediction of inflation. But both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds are lousy at predicting inflation.1 As the markets are lousy at predicting inflation, the ex-ante real bond yield is a lousy predictor of the ex-post real bond yield (Chart I-4 and Chart I-5). Chart I-4The Markets Are Lousy At Predicting Inflation In Europe... The Markets Are Lousy At Predicting Inflation In Europe... The Markets Are Lousy At Predicting Inflation In Europe... Chart I-5...And In The ##br##US ...And In The US ...And In The US A second point is that the required excess return on equities versus bonds is a nominal concept. This is because the bond yield’s lower limit is set in nominal terms, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. As the riskiness of equities and bonds converges, the required nominal return on equities collapses towards the ultra-low nominal bond yield. There are two important takeaways. First, we should always compare the valuation of equities and their prospective nominal return with the nominal bond yield. Second, the valuation of equities is exponentially sensitive to an ultra-low nominal bond yield (Chart I-6). Chart I-6The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential The Relationship Between The Bond Yield And Stock Market Valuation Is Exponential We conclude that the biggest risk to the stock market remains the vulnerability of valuations to even a modest rise in bond yields. Yet the happy corollary is that the structural bull market in equities will only end when bond yields can go no lower. In practice, this means when the 10-year T-bond yield reaches zero. Until then, long-term investors should stay in the stock market. The Major Misunderstanding About Valuation Another common question we get is, is it always meaningful to compare an investment’s valuation versus its own history? The answer is no. The comparison with a historical average is meaningful only if the valuation is mathematically stationary, which is to say it has not undergone a ‘phase-shift’. If the valuation has undergone a phase-shift, then the comparison with its own history is meaningless.  As an analogy, nobody would compare their bodyweight with its lifetime average, because we understand that our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our bodyweight with its lifetime average, it would give the false signal that we were permanently overweight! Likewise, to avoid getting a false signal from a valuation, we should always ask, has it undergone a phase-shift? If a valuation has undergone a phase-shift, then a comparison with its own history is meaningless. Unfortunately, the structural prospects for financials, oil and gas, and basic resources – sectors that dominate ‘value’ indexes and stock markets – did suffer a major downward phase-shift at the start of the 2000s (Chart I-7). It follows that we cannot compare the valuations of ‘value heavy’ indexes with their long-term history, and draw any meaningful conclusions. Chart I-7Value' Sector Profits Are In A Major Structural Downturn Value' Sector Profits Are In A Major Structural Downturn Value' Sector Profits Are In A Major Structural Downturn Proving this point, the relationship between value-heavy European valuations and subsequent 10-year return is much worse for periods ending after the global financial crisis compared with periods ending before it. Whereas the relationship between growth-heavy US valuations and subsequent return has barely changed, because the structural prospects for growth sectors have not suffered downward phase-shifts (Chart I-8 and Chart I-9). Chart I-8The Relationship Between Valuation And Future Return Has Changed In Europe... The Relationship Between Valuation And Future Return Has Changed In Europe... The Relationship Between Valuation And Future Return Has Changed In Europe... Chart I-9...But Not So Much ##br##In The US ...But Not So Much In The US ...But Not So Much In The US Given the ongoing trends in value versus growth profits, it is much safer to overweight value-heavy European equities versus value-heavy emerging markets (EM) equities. Do not structurally overweight value-heavy European equities versus growth-heavy US equities. This is a ‘widow maker’ trade. Fractal Trading System* The rally in AUD/JPY is at a potential a near-term top based on its collapsed 65-day fractal structure. Accordingly, this week’s recommended trade is short AUD/JPY, setting the profit target and symmetrical stop-loss at 2.8 percent. Chart I-10AUD/JPY AUD/JPY AUD/JPY In other trades, short European basic resources versus the market achieved its 4 percent profit target and is now closed. The rolling 12-month win ratio now stands at 57 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights We are hesitant to call a top to the volatility spike just yet. The US dollar is experiencing a counter-trend bounce. We also see political and geopolitical risks flashing yellow. House Democrats are drafting a reconciliation bill that will remind financial markets of looming tax hikes. President Biden faces imminent tests on China/Taiwan and Iran. The tech sector has bounced amid the setback to the reflation trade. Over the long run the Biden administration’s reflationary agenda suggests tech will no longer outperform. Biden’s regulatory risk to the tech sector is not immediate but still a downside risk. No major piece of bipartisan legislation is forthcoming but the Department of Justice, FCC, and FTC can bring negative surprises. We are hitting pause on our S&P trades until Biden passes some early hurdles. Feature Volatility has room to run, judging by past post-crisis periods (Chart 1), and this time we are especially concerned with brewing geopolitical risks, namely the US-China tensions over the Taiwan Strait. This geopolitical risk comes on top of the short squeezes and battles that retail investors are having against hedge funds all over the market. China is reminding the world of its red line against Taiwanese independence while testing the newly seated Joe Biden administration over whether it will seek a technological blockade against the mainland. Economic and trade policy uncertainty have collapsed but they would surge in the event of a crisis incident (Chart 2). While war is not likely, it is possible, so we need to see the Biden administration defuse the situation and pass this first test before we are willing to take on more risk on a tactical three-to-six-month time frame. Chart 1Volatility Can Go Higher Still Volatility Can Go Higher Still Volatility Can Go Higher Still Chart 2Uncertainty Down But Beijing Testing Biden Uncertainty Down But Beijing Testing Biden Uncertainty Down But Beijing Testing Biden Chart 3Biden's Approval Starts At 55% Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same President Biden’s average approval rating in his first two weeks in office is 55%, right where former President Trump’s disapproval rating would have suggested (Chart 3). This is a significant but not extravagant improvement in political capital for the White House. Our Political Capital Index shows Biden’s position as moderate-to-strong (Table 1). Table 1Biden’s Political Capital Moderate-To-Strong Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same The implication is that he still has a chance of passing his $1.9 trillion American Rescue Plan as a bipartisan bill with 10 Republican senators, a feat that would likely lower the topline value to around $1.3 trillion (Republicans proposed $618 billion) and exclude an increase in the federal minimum wage to $15 per hour. There is also a strong swing of independents in favor of Democrats in the opinion polling, in the wake of the incident on Capitol Hill on January 6, despite the fact that Republican and Democratic party identification are both stuck at around 30% — meaning that the Biden administration does have something to gain by appearing bipartisan (Chart 4).1 Republicans might cooperate to staunch the bleeding of their own support. Even Republicans approve of stimulus amid the pandemic and they would later be able to oppose Biden’s more controversial proposals with better optics having demonstrated bipartisan intent at the outset. However, House Democrats are already proceeding with a budget resolution, the first step in the budget reconciliation process that enables them to bypass Republicans entirely and get almost everything they want (Diagram 1). Chart 4Will Independents Keep Breaking Toward Democrats? Will Independents Keep Breaking Toward Democrats? Will Independents Keep Breaking Toward Democrats? Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Biden’s political capital should strengthen over the next year as the vaccine rollout improves and the economy comes roaring back. Official economic projections suggest that growth will glide solidly above potential until 2026 and that the output gap will close by 2024 (Chart 5). These estimates will be disappointed in various ways, of course, but in the near-term the risk is to the upside as they do not include Biden’s proposed $1.9 trillion rescue plan or his remaining, post-COVID agenda afterwards, which could cost anywhere from $3.7-$6.4 trillion over a ten-year period.2 The economy will be at less risk of relapsing than of overheating. This is especially true given the Federal Reserve’s new average inflation targeting strategy, which will discourage rate hikes till next year at the very earliest (and, from a political point of view, we would think 2023). Looking at the chart, Biden’s economic backdrop is far more propitious than that of his former boss Barack Obama’s back in 2009. Biden’s political momentum is therefore sustainable when it comes to the two budget reconciliation bills he wants to pass this year and next year. Republican internal divisions will help him. These were highlighted this week by Republican National Committee Chair Ronna McDaniel’s criticism of former New York Mayor Rudy Giuliani’s claims of voter fraud after the election and Senate Minority Leader Mitch McConnell’s recent scathing criticism of controversial pro-Trump freshman House member Marjorie Taylor Greene of Georgia. Republicans are only beginning their internal struggle and it is not certain that it will be resolved in time for the 2022 midterm elections. This is another reason to think that Biden’s political capital will be sustained and that moderate Republicans might assist with some Democratic legislation. The risks to Biden’s momentum stem from foreign policy (China, Iran, Russia), rapidly emerging financial instability, his party’s attempts at social control, and any major (not minor) negative developments involving the still-running pandemic and vaccine rollout. Chart 5US Economic Outlook Over Biden’s Term Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Macro Reflation Says Stay Underweight Tech The tech sector experienced a manic phase last year when COVID-19 struck and lockdowns kept consumers at home with nothing to do but work, shop, and stare at their phones. The big five companies – Apple, Microsoft, Google, Amazon, and Facebook – together witnessed an extraordinary run up relative to the other 495 companies in the S&P index that has since peaked and dropped off (Chart 6). Chart 6Fade The Big Tech Bounce Over Long Run Fade The Big Tech Bounce Over Long Run Fade The Big Tech Bounce Over Long Run Tech stock market capitalization accounts for 34% of American economic output – an extreme sign of over-concentration at a time when the market is generally inflated, according to the Buffett Index of stock market cap relative to GDP (Chart 7). Tech outperformance rests on strong earnings growth – supercharged due to the COVID crisis – as well as the secular fall in bond yields as a result of the global backdrop of excessive savings, low inflation, and scarce growth. Tech stocks are especially sensitive to bond yields because markets are projecting their earnings far into the future, as our colleague Mathieu Savary explained back in August. Ultra-dovish monetary policy with zero interest rates for longer and longer time frames is a perennial gift to these companies (Chart 8). Chart 7Buffett Indicator Says Big Tech Too Big Buffet Indicator Says Big Tech Too Big Buffet Indicator Says Big Tech Too Big Chart 8Big Tech Maxing Out As Bond Yields Rise? Big Tech Maxing Out As Bond Yields Rise? Big Tech Maxing Out As Bond Yields Rise? The catch is when and if growth and inflation expectations pick up. Even during the Dotcom bubble in the 1990s, the tech sector could not withstand rising interest rates (Chart 9). Eventually higher inflation will translate into central bank hikes and rising real interest rates – which should be very bad for tech as future cash flows lose value. Rising rates increase the cost of capital, while cyclical industries perform better in high growth environments with rising commodity prices. A recovery of inflation is becoming a more visible risk to investors over the coming few years. Even though unemployment is still elevated, and the output gap negative, the sea change in fiscal policy is likely to close this gap quickly and put upward pressure on expectations and prices. It will still take time to close the gap but each new dose of government spending on top of what is needed to plug the gap in demand due to the pandemic-stricken service sector will accelerate the time frame in which the labor market will tighten and price pressure will return. Investors are increasingly wary of this inflation risk as it is the logical consequence of the new combination of extreme monetary and fiscal accommodation. Earnings in the tech sector relative to the rest of the market have also peaked – and did not exceed their previous high point in 2010 despite the uniquely favorable backdrop (Chart 10). The big five have nearly saturated a lot of markets which raises the possibility that if the policy backdrop darkens, then they will see earnings disappointments. The Biden administration’s plan to raise the corporate tax rate to 28% and impose a 15% minimum tax on company book income would come as a double whammy for tech earnings, as they are relatively more exposed to increases in effective tax rates than other sectors. Chart 9Big Tech Wants Deflation, Big Government Wants Reflation Big Tech Wants Deflation, Big Government Wants Reflation Big Tech Wants Deflation, Big Government Wants Reflation Chart 10Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Big Tech Earnings Outperformance Hit Ceiling Amid Pandemic Finally, there is the long building problem of regulatory risk, as Americans have clearly become more concerned about Big Tech’s power and influence over their daily lives and politics. Here we do not think the Biden administration poses an immediate threat of frontal legislative assault, but we do think the end game is greater regulation, including tougher enforcement from antitrust agencies. Combined with geopolitical risk from Europe and other countries also seeking to tax and regulate these companies, the recent global semiconductor shortage, and the potential for a Taiwanese tech blockade, the political risk is clearly to the downside. Bottom Line: The macro backdrop has darkened for the tech sector. With governments turning more reflationary via a sea change in fiscal policy on top of ultra-easy monetary policy, inflation expectations should recover and inflation-sensitive sectors like tech should underperform. This risk is clear despite the fact that inflation requires the labor market to heal first. Any political, geopolitical, or regulatory risks would only further undermine the case for tech sector outperformance. Tech, Polarization, And Disinflation A critical question for investors is the relationship between US political polarization, the tech sector, and the disinflationary macroeconomic context that has proven so beneficial for Big Tech’s stock market performance. If polarization leads to gridlock, austerity, and disinflation, then tech can continue to enjoy the policy environment. But if polarization subsides, or if it coexists with a reflationary backdrop – as is the case today – then tech faces a new risk. It is fair to hypothesize that the rise of Silicon Valley and especially of social media has something to do with the explosion in US polarization over the past three decades. A simple chart of the S&P 500 alongside our polarization proxy – which measures the difference in presidential approval based on party – suggests that polarization could have some connection with tech sector outperformance (Chart 11). This is not a coincidence but the causality may work differently than some assume. The first period of tech sector outperformance, which rested on the “peace dividend” period of hyper-globalization, strong growth, strong dollar, low inflation, and technical innovation, occurred during the explosion of US polarization in the wake of the Cold War, when the US’s common enemy fell and the country’s political parties turned to do battle with each other for global supremacy. The structural changes of Reaganomics and NAFTA coincided with the political battles of the Republican revolution of 1994 and Bill Clinton’s sex scandal and impeachment. This heady period came to a peak in 2000 when the dotcom bubble burst and the US suffered its first contested election since 1876. Essentially globalization led to a deflationary backdrop that favored tech but also triggered the political struggle within the US for the spoils of victory in the Cold War. Chart 11Big Tech Likes Polarization And Gridlock Big Tech Likes Polarization And Gridlock Big Tech Likes Polarization And Gridlock The second period of tech sector outperformance emerged from the Great Recession, still higher wealth inequality, and the slow-burn economic recovery of the 2010s. The disinflationary environment and dollar bull market proved beneficial to the tech companies. In this case globalization’s deflationary effects continued but were compounded with US household deleveraging, which was far more malicious for the American middle class. Crucially, polarization created gridlock in Congress from 2010, preventing the US from pursuing a robust fiscal policy in the wake of the crisis that might have led to a more rapid recovery. Instead an extended disinflationary environment fed into social unrest and populism. While public animus naturally turned against Wall Street and the Big Banks in the wake of the financial crisis, the Dodd-Frank financial reform helped to pacify the public’s anger (though not entirely – and financial regulation is gradually reemerging as a relevant political risk). As the financial crisis faded from memory, but the low-growth, disinflationary environment continued to take a toll on households, an angry electorate began to freely express itself in the digital realm. Tech companies were happy to ride this wave and outperformed other sectors. As the backlash continued mounting, tech companies failed to rein in the angry userbase they had cultivated, and now they are staring at massive regulatory and legal risks from policymakers. Both Barack Obama and Donald Trump used Twitter and social media as a tool to establish direct engagement with their political base, much as Franklin Delano Roosevelt had used the radio and the fireside chat. This rising political heft ultimately made the companies conspicuous as conservatives blamed them for supporting the Obama administration (and Clinton campaign) while liberals especially blamed them for getting Trump elected. The Trump saga in particular gave rise to the so-called “tech-lash,” or backlash, as the companies’ core base of young, urbanized, cosmopolitan, and international users called on the tech companies to stop the spread of Russian propaganda, or other propaganda they disagreed with, and undertake socially progressive causes. Meanwhile the older, conservative, and rural population doubted that Russian interference caused the 2016 election result and sensed that the tech companies’ content moderators might not be all that scrupulous regarding the difference between conservative views and Russian information warfare (Chart 12, top panel). In combination with the heated election year campaigning, the pandemic and the backlash against lockdown, tension in the virtual world came to a peak last year and spilled out into the real world. This all came to a head with Twitter and Facebook first censoring and then banning President Trump from their platforms amid his claims of voter fraud and the riot on Capitol Hill. Chart 12Big Tech Not The Chief Driver Of Polarization Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Two major policy changes have occurred that threaten to reverse this macro backdrop. First, as a result of the 2020 crisis the Democrats won control of the White House and Congress and can now pass their mammoth spending agenda, which goes beyond pandemic relief to expanding the role of government in American economy and society – including by reflating the economy and imposing higher taxes on corporations, both of which threaten to undermine the tech sector’s outperformance. Second, China’s secular slowdown, reduction of trade dependency, and divorce from the US economy have undermined hyper-globalization. The Biden administration is pursuing on-shoring and China restrictions albeit to a lesser extent than its predecessor. If technological advance and social media cause political polarization, then these policy shifts may not last long or have a durable macro effect. But technology and communication tools have advanced throughout history regardless of whether polarization in any given country was rising or falling. Older people are the most partisan in the US yet they are the least enthusiastic users of social media (Chart 12, bottom panel). Tech and social media have proliferated across the world and yet polarization has fallen in Germany, Australia, Sweden, and other economies even as it has risen in the United States and arguably the United Kingdom (Chart 13). If social media enabled populist outcomes like Trump and Brexit, then why did populism fall short in France, Spain, Italy, and Germany? Social media participation thrived on the rise of polarization through the 2000s and 2010s but it exacerbated the problem – and once polarization erupted in the form of an anti-establishment presidency, Russian interference, the Cambridge Analytica scandal, and real world riots and social unrest, the tech platforms found themselves in the crosshairs of both of the political factions and the various politicians trying to appease their anger. Silicon Valley and the FAANGs operate in a power struggle – not merely a politicized environment – that is here to stay and will direct their attention away from their primary business and toward paying for lobbyists in Washington, Brussels, and elsewhere. This in itself is a danger to their business models even if it were not the case that the macro and policy backdrop is less supportive. Bottom Line: The reflationary fiscal and policy backdrop will continue in the coming years, a macro headwind for tech outperformance, while political risks to the tech sector have grown substantially. Chart 13Polarization Falls In Many Countries Despite Social Media Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Congress In Check But Regulatory Risk Persists Democrats and Republicans have a different and opposed set of grievances against Big Tech, which is likely to prevent comprehensive legislation from developing anytime soon. But legislation is still possible, and in the meantime risks will come from emboldened regulators. Based on the House judiciary hearing in July 2020, Democrats are concerned with content moderation and market concentration. They want to fortify their recent gains in preventing social media companies from aiding what they regard as the spread of seditious and libelous material or propaganda that favors the anti-establishment Trumpist right wing. Judging by the Senate Republicans’ hearings in October and November 2020, Republicans are primarily concerned with content moderation– i.e. preventing conservatives from being de-platformed, and conservative views from being censored. Republicans are less concerned about market concentration, i.e. accusations of monopolistic and anti-competitive behavior.3 Now that the social media companies have more or less thrown in with the Democrats on content moderation, Democratic priorities are likely to shift to antitrust and anti-competitive behavior. But serious changes would require either abolishing the filibuster in the Senate (which is not happening for the time being due to last month’s bipartisan power-sharing arrangement) or winning over 10 Republicans. This will be difficult, especially when it comes to the Democratic belief that a generational shift in antitrust doctrine and practice is necessary. A frontal assault on the sector would require passing a law that resolves a number of jurisprudential issues so that the courts could be instructed to interpret antitrust issues with a greater focus on rooting out anti-competitive or collusive behavior (as opposed to lowering prices and preventing consumer harm). This is possible but Republican agreement would require major compromises that the Democrats are not inclined to make. A bipartisan bill is still possible because last year’s hearings revealed that there is common ground between the two parties. Both have agreed that anti-trust agencies should be strengthened and empowered to examine Big Tech; that data should be portable and platforms should be interoperable (rather than favoring their own services or imposing penalties for users who would switch services); that mergers and acquisitions should be examined with the presumption that consumers will be harmed, so that the merging parties must show that they cannot otherwise achieve the desired consumer benefits and that their actions will serve some public good; and that regulators need not trouble themselves excessively about the problem of accurately defining the market, which is always a sticking point for such fast evolving services.4 Moreover there is overlap between the populist sides of both parties, comparable to the bipartisan populist demands to give larger household rebates amid the COVID crisis. For example, Democrats want to revise Section 230 of the Communications Decency Act, which protects the tech companies from being held liable for the actions and comments of third parties on their platforms. The Democratic proposal is to break down the distinction between neutral tools and content creation, arguing that tech platforms can be “negligent” and that in order to benefit from the liability protections they should have to demonstrate that they have taken reasonable steps to prevent unlawful misuse of their platforms that cause harm to others. This idea of “reasonable moderation” would leave a very vague standard for judges that would lead to a complex operating environment across different jurisdictions, but it is attractive to Trumpists and right-wing populists who support greater ability to sue the platforms for alleged bias.5 Thus revising Section 230 could create a bridge between the two parties, albeit isolating the free-market contingent in either party. It would foist huge new liabilities not only on the tech giants but also on startups and market entrants with far fewer lawyers. The mechanism will be a decisive feature of any future legislative proposal, however. Republicans are staunchly opposed to creating an Internet oversight committee, similar to the Consumer Financial Protection Bureau, or anything that smacks of Big Brother and would risk too cozy of a relationship between the regulatory state and the immense capabilities of the tech companies. But they could be amenable to law that strengthens the antitrust agencies and alters the parameters of judicial scrutiny if they believed it would make consumer choice and innovation more likely. If popular opinion suggested great urgency on this issue then perhaps the parties’ differences could be resolved more quickly in the form of a major bill. But polls suggest the populace is also divided on tech regulation – in part because the pandemic left consumers largely thankful for the Internet services that they relied on so heavily while under lockdown. A bare majority of conservative Republicans and liberal Democrats now favor tech regulation, the average voter is lukewarm, and moderates of both parties show little enthusiasm (Chart 14). By contrast, at the height of Democratic anxiety over Trump’s election and Russian interference, a clear majority of Democrats and Democrat-leaning independents favored tougher regulation. Chart 14Public Split On Government Regulation Of Big Tech Companies Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same In short, the public is split, the parties are split, and the various 2020 crises have temporarily subsided, so tech regulatory risk will emanate from regulatory authorities but not from major new legislation anytime soon. Regulatory agencies thus threaten to give tech stocks negative surprises – even if the process takes time. Biden will replace one commissioner on the Federal Trade Commission (FTC) immediately but may only be able to replace two Republican commissioners toward the end of his term, in September 2023 and 2024, meaning that the commission will be divided (Table 2). Any major crackdown on market concentration will have to proceed upon bipartisan grounds unless Democrats gain control of this commission sooner. Meanwhile Biden will be able to replace outgoing Republican Ajit Pai on the Federal Communications Commission (FCC) right away, giving a Democratic tilt to this body, which is capable of pursuing the administration’s goals on content regulation (Table 3). Here the Supreme Court may eventually weigh in to defend free speech and press rights, which Section 230 ultimately reinforces, but the tech companies will be in the firing line until then. Table 2Federal Trade Commission Balance Of Power Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Table 3Federal Communications Commission Balance Of Power Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Finally, Biden’s nominee for the US Assistant Attorney General for the antitrust division will be a critical post to watch for the Department of Justice’s involvement in tech regulation and antitrust, though this position requires Senate confirmation, which will rule out any populist candidate. If Biden picks a former Facebook lawyer as rumored then he clearly will not be prioritizing a tough antitrust stance.6 Bottom Line: With the Senate filibuster intact for the time being, Democrats need 10 Republican senators to join them to pass any significant legislation that would amount to a frontal assault on the tech sector. This is possible but not probable in the short run, as Congress prioritizes the fight against the pandemic, Republicans and Democrats remain divided and the public is lukewarm about regulation. Much more likely is a regulatory slow boil at the hands of the DOJ, FCC, FTC, and the states. Biden Maintains Obama Alliance With Silicon Valley Public opinion is wishy washy about Big Tech, as mentioned above. Compare attitudes toward Wall Street and the major pharmaceutical corporations. Opinion shifted against the banks drastically during the financial crisis and has since recovered to about 24% net approval, although there are also polls showing that consumers of all stripes believe the banking sector got off easy and could use more regulation (Chart 15). The health care industry also took a hit during the Great Recession, when laid off workers also lost their health insurance, and has also largely recovered due to its conduct during the pandemic. The exception is Big Pharma, which is widely blamed for excessive drug prices, got bashed under President Trump, and is about to get bashed by President Biden in the form of price caps and Medicare negotiations. By contrast with these sectors, the computer and Internet industry has seen a hit to its popular support since Trump’s election but never dipped into net negative territory and may be recovering due to its helpful role during the COVID lockdowns. When net popular approval turns negative then it will be a flashing red light for the tech sector that sweeping regulation is imminent. While some of the opinion polling is lagging, the crisis over the election is unlikely to produce this effect because the public views break down along partisan lines. Chart 15Big Tech More Popular Than Big Banks, Big Pharma Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Thus unlike the Trumpists, or the populists in the Democratic Party, the Biden administration is only inclined gradually to dial up the pressure on Big Tech. Biden would bite off more than any president could chew if he tackled tech aggressively along with other big corporations. His campaign platform and early executive orders show that he is already tackling Big Health Insurance and Big Oil, sectors that make up 7.5% and 1.4% of GDP respectively. There is at least some focus on re-regulating the financial industry as well (7.7% of value add), albeit with lower priority. To attempt a major overhaul of Big Tech (at least 5.3% of GDP) on top of all this would be impracticable even if Biden were inclined to listen to the anti-monopoly crusaders in his party. Information services are obviously important to the economies of solid blue states like California, New York, and Washington but they are increasingly important to critical swing states like Georgia and Pennsylvania – places where voters will be skeptical of Biden’s policies on energy and immigration. The information sector is growing fastest in blue states and in battlegrounds like Arizona. It employs more people in blue states and in battlegrounds like Georgia. And it is rapidly employing more people in the grand prize of Democratic designs, Texas, where an exodus of Californians fleeing poor governance and high costs holds out the possibility of creating a decisive Democratic ascendancy in the Electoral College. Silicon Valley and other tech clusters will maintain their unique strengths and network effects for a long time but the dispersion of the tech sector to cheaper heartland regions has electoral consequences that mainline Democrats will not want to suppress. Not only did the tech firms help Biden get elected through votes and media controls but also through campaign contributions. The financial and health care industries punished the Democrats for passing the Affordable Care Act (Obamacare) and Dodd-Frank reforms in 2009-12 (Chart 16). By contrast the tech heavily favors Democrats over Republicans (with donations at $170 million versus $20 million in the 2020 election). Biden’s priorities are two budget reconciliation bills that will partially reverse the Trump tax cuts in order to pay for the entrenchment and expansion of Obamacare and other aspects of his health care and child care agenda. He is also focused on infrastructure, particularly green infrastructure and renewables, to create jobs and galvanize the climate change coalition. Broad re-regulation is coming down the pike, but health, immigration, energy, and labor are higher priorities than tech. The tech sector faces greater scrutiny than before, first from the FCC and later from the DOJ and FTC, but the administration will have more room for maneuver later in its term. Bottom Line: The Obama administration forged an alliance with Silicon Valley that Biden will largely maintain. The purpose of regulatory pressure is to build leverage over the tech giants. Chart 16Big Tech A Big Donor To Democratic Party Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Investment Takeaways Not all of the dominoes are lined up to topple Big Tech in a massive display of federal monopoly busting. The public is lukewarm and the political elite are divided. Nevertheless the long-term trajectory points to greater government scrutiny – and the tech sector has no margin of safety for political risk as the macro backdrop has started to shift in a more inflationary direction. Our colleague Juan Correa Ossa has shown that antitrust action to curb corporate power has tended to occur at times in US history where stock market earnings are elevated or rising rapidly relative to average wages, when inflation is running hot, and yet the economy has entered a bust phase where politicians are looking for a scapegoat to deflect public anger (Table 4). Table 4Stock Performance In Selected Judicial Events Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same While inflation is not an immediate problem (at least not yet), it was not a problem when the FTC and DOJ went after Microsoft starting in 1998. The distressed economy and tech bubble are good enough reason for investors to expect the government to increase antitrust pressure (Chart 17). If inflation recovers in the coming years around the time the Biden administration gains room to maneuver on this issue then it is doubly bad for the tech sector. Chart 17Anti-Trust Usually Follows Economic Bust Anti-Trust Usually Follows Economic Bust Anti-Trust Usually Follows Economic Bust In Microsoft’s case, the stock fell when the government first brought charges but rallied throughout the twists and turns of the courtroom – especially after 2002 when the case was settled, and ever since (Chart 18). Fortunately for the company the DOJ backed away from breakup and instead ordered it to open up its application programming to others. But even firms that are broken up usually create buying opportunities. Note that Microsoft cleared its image and has not become the subject of government or popular scrutiny again today. Today’s regulators are likely to place a greater burden of proof on tech companies attempting mergers and acquisitions. The alternative for startups is to hold an initial public offering – and IPOs have exploded amid the current context of low rates, easy money, investor exuberance, a chilling effect on M&A, and a lingering pandemic. The markets are frothy, buyer beware (Chart 19). Chart 18Microsoft's Anti-Trust Warning Microsoft's Anti-Trust Warning Microsoft's Anti-Trust Warning Chart 19Regulators Will Crack Down On M&A Regulators Will Crack Down On M&A Regulators Will Crack Down On M&A Strategically we remain favorable toward value stocks over growth stocks given the changing macro and policy backdrop outlined above (Chart 20). However, in the very near term we would not encourage investors to take on any additional risk. The latest bout of volatility is not necessarily over, political and geopolitical risks are now underrated after a period in which they subsided from peak levels, and exuberant markets are subject to very sharp corrections.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 20Take A Pause Amid Value Vs Growth Setback Take A Pause Amid Value Vs Growth Setback Take A Pause Amid Value Vs Growth Setback   Appendix Table A1Political Risk Matrix Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Table A2Biden’s Cabinet Position Appointments Big Tech Regulation Is A Slow Boil – But A Boil Just The Same Big Tech Regulation Is A Slow Boil – But A Boil Just The Same   Footnotes 1     Congressional Budget Office, “Overview of the Economic Outlook: 2021-2031,” February 2021, cbo.gov. 2     Committee for a Responsible Federal Budget, “The Cost of the Trump and Biden Campaign Plans” October 7, 2020, and “The Cost of the Trump and Biden COVID Response Plans,” October 29, 2020, October 7, 2020, crfb.org. 3    The huge gap between the two parties can be illustrated by the recent case of Parler, the microblog that sought to rival Twitter by maintaining laissez faire content moderation standards. When Parler came under fire for attracting conservatives in the wake of the Twitter ban against Trump, Apple and Amazon teamed up to block it from their app purchasing and cloud services, thus effectively banning the app for 99% of users. There is no doubt that any private platform can regulate content according to its own standards on its own sites. In the words of Section 230, this extends not only to “obscene” or “excessively violent” material but to anything “otherwise objectionable.” But once tech companies prevent the emergence of competitors and alternatives, and cooperate in doing so, they enter much more dangerous legal territory. And yet the response from the House Democrats on the oversight committee was to ask the FBI to investigate Parler for hosting far-right extremists. Conservatives are therefore up in arms. The courts have not yet weighed in but the case represents a larger risk to the tech firms than the usual challenges under Section 230. 4    Representative Ken Buck, “The Third Way,” House Judiciary Committee, Subcommittee on Antitrust, Commercial, and Administrative Law 5    See Will Duffield, “Circumventing Section 230: Product Liability Lawsuits Threaten Internet Speech,” Cato Institute, January 26, 2021, cato.org. 6    See Ryan Grim and David Dayen, “Merrick Garland Wants Former Facebook Lawyer To Top Antitrust Division,” The Intercept, January 28, 2021, theintercept.com.