Fixed Income

Highlights Chart 1Spending Held Up In August Spending Held Up In August Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Weathering The Storm … For Now Weathering The Storm … For Now Table 3BCorporate Sector Risk Vs. Reward* Weathering The Storm … For Now Weathering The Storm … For Now High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Weathering The Storm … For Now Weathering The Storm … For Now Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 63 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 63 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Weathering The Storm … For Now Weathering The Storm … For Now Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Portfolio Strategy Buybacks are down but not out. While financials have been weighing heavily on the S&P buybacks index, we would not write off the artificial engineering of higher EPS via equity retirement, especially in a world of ZIRP likely for the next five-to-seven years. COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Recent Changes There are no changes to our portfolio this week. Table 1 Of Buybacks And Bonds Of Buybacks And Bonds Feature Equities sunk late last week, as diminishing chances of fiscal easing coupled with news that the POTUS and the First Lady tested positive for COVID-19 more than offset buyers taking advantage of oversold conditions. Our sense is that the SPX will bounce around key moving averages during October (Chart 1), until the election outcome breaks the stalemate. In the back half of the month, banks also kick-start Q3 earnings season, which is important because banks’ wellbeing rests on a fresh stimulus bill. Peering over at the bond market is instructive in order to try to make sense of these crosscurrents. Two weeks ago, we first highlighted that the corporate bond market was waving a yellow flag. The selloff in the LQD ETF will continue to weigh on equities (top panel, Chart 2) and corroborates our view that the Fed is now a bystander, which puts added pressure on fiscal authorities to act. It is not a coincidence that the Fed’s balance sheet impulse peaked first and soon thereafter so did the LQD. Chart 1Trapped Between Moving Averages Trapped Between Moving Averages Trapped Between Moving Averages Worrisomely, the total return stock-to-bond ratio failed to break out to fresh all-time highs and has likely formed a head and shoulders pattern. The implication is that stocks are not out of the woods yet (bottom panel, Chart 2). Chart 2Bond Market… Bond Market… Bond Market… Junk spreads are also firing a warning shot. The high-yield option-adjusted spread (OAS) was in a tight range between 2017 and 2019. Then spreads exploded higher because of the pandemic. However, unlike the SPX making new all-time highs, junk spreads failed to make new all-time lows and more importantly have not settled back down to the 2017-2019 range (middle panel, Chart 3). The VIX index is following a similar pattern to the high-yield OAS, which is quite unnerving for equity bulls. Put differently, still elevated VIX futures in the 30s warn that in the near-term more turbulence lies ahead for the SPX (bottom panel, Chart 3). As a reminder, we first recommended buying the December VIX futures on July 27 in a joined Special Report with our sister Geopolitical Strategy service, and we continue to recommend such a hedge to long equity exposure. Chart 3…And VIX Signal Trouble For Stocks …And VIX Signal Trouble For Stocks …And VIX Signal Trouble For Stocks Bye-Bye Buybacks? According to the flow of funds data, a large dichotomy has taken shape between corporate debt issuance and net equity retirement. Up to very recently, the two moved in tandem. But now, the pandemic has caused a knee jerk reaction in non-financial corporate businesses that are tapping their credit lines and issuing debt at a breakneck pace. Worryingly, very little of these funds are used for equity retirement, which is a big break from recent past behavior (Chart 4). Not only does the Fed’s flow of funds data signal that buybacks have nearly ground to a halt, but also Standard and Poor’s data show that SPX buybacks collapsed to $88bn in Q2, from roughly $200bn in Q1. Crudely put, SPX buybacks have fallen by a whopping 67% quarter-over-quarter. Such a corporate buyer’s strike is negative for the near-term prospects of the S&P 500 (top panel, Chart 5). Chart 4Unsustainable Dichotomy Unsustainable Dichotomy Unsustainable Dichotomy Chart 5Buybacks Are Down… Buybacks Are Down… Buybacks Are Down… True, buybacks have come under intense scrutiny especially for bailed out sectors of the economy, nevertheless, the V-shaped economic recovery all but guarantees a rebound in depressed share buybacks sometime in 2021 (Chart 6). While our conservative $125/quarter buyback estimate proved overly optimistic in Q2, we maintain such an estimate for the next year (which it is the past decade’s average). On a cyclical 9-12 month horizon we have high conviction that SPX profits will return close to trend EPS of $162, and recovering CEO confidence should pave the way for a resumption of shareholder friendly activities, including equity retirement (middle panel, Chart 6). Drilling deeper beneath the surface is revealing. When we disaggregate the headline buybacks number into GICS1 sectors, we observe that once again the tech titans (comprising the S&P technology and the S&P communication services indexes) are doing all the heavy lifting accounting for 70% of the overall number (Chart 7). Q2 was the first time in recent memory where tech accounts for more buybacks that all the other sectors put together (bottom panel, Chart 5)! Chart 6But Not Out But Not Out But Not Out Chart 7GICS1 Sector Buyback Breakdown: Q1 & Q2 Of Buybacks And Bonds Of Buybacks And Bonds Chart 8 shows the ebbs and flows of sectoral SPX buybacks since late-2006. In order for our estimate to prove accurate in 2021, the Fed will have to allow financials to resume their buybacks, which collapsed from over $45bn in Q1 to just above $5bn in Q2 (Chart 7). Chart 8GICS1 Sector Buyback Breakdown: An Historical Perspective Of Buybacks And Bonds Of Buybacks And Bonds With regard to investable buyback indexes, financials dominate both the S&P 500 buyback index (Chart 9) and the NASDAQ US buyback achievers index. However, if the Fed does not relent and sustains a tight noose around banks’ shareholder friendly activities next year, then this index composition will change significantly in the 2021 rebalancing. While financials have been weighing heavily on the S&P 500 buyback index, its equal weighting methodology also partially explains why it has trailed the market cap weighted SPX by roughly 20% year-to-date (YTD). Nevertheless, in the long-haul buyback achievers come out on top. In fact, the S&P 500 buyback index has more than doubled the SPX’s return since the turn of the century (top panel, Chart 10) and such a portfolio tilt typically manages to shake off recession-related wobbles. Chart 9S&P 500 Buyback Index Sector Composition Of Buybacks And Bonds Of Buybacks And Bonds Bottom Line: We would not write off the artificial engineering of higher EPS via equity retirement, especially in a world where ZIRP is likely for the next five-to-seven years. Already buyback announcements have troughed (bottom panel, Chart 10) and factors are falling into place for a sizable resumption of buybacks in 2021 as the economy stands back on its own feet. Chart 10Buyback Comeback? Buyback Comeback? Buyback Comeback? Is CRE The Next Shoe To Drop? Last December in our 2020 Key Views report, the S&P real estate sector was one of our high-conviction underweight sectors for the year. However, frenetic trading in March compelled us to close out all our high-conviction trades and cement average relative gains of 3.4% in our eight high-conviction calls including 1.1% in the high-yielding S&P real estate sector. Nevertheless, we remained bearish on the prospects of this sector levered to commercial real estate (CRE) because the aftermath of the pandemic would leave this niche sector badly bruised. Already, YTD relative share prices are down 10%, and were it not for the tech/communications-laden – tower and digital storage – REITs that the S&P specialized REITs subgroup houses, then the relative underperformance would sink to 25% (Chart 11). In other words, the resilience of these mega cap tech-related REITs masks the carnage ongoing beneath the surface. Chart 11Specialized REITs Masking True Picture Specialized REITs Masking True Picture Specialized REITs Masking True Picture Charts 12 & 13 break down the YTD relative performance of the real estate sector’s sub-groups and it is clear that most REITs categories are in distress with the exception of specialized and industrial REITs. Chart 12REITs Are Weak… REITs Are Weak… REITs Are Weak… Chart 13…Across The Board …Across The Board …Across The Board Not only will the long-term negative ramifications due to the pandemic scar office-, apartment- and mall-exposed REITs, but also uncertainty surrounding the fiscal stimulus bill risks a fresh down-leg in the S&P real estate sector. According to the latest Q2 Fed release, CRE delinquencies are on the rise (not shown) and CRE prices are on the verge of contracting (bottom panel, Chart 14). A fresh stimulus bill could transfer funds directly to unemployed consumers and to cash-strapped business owners and extend the eviction/foreclosure moratorium as well as mortgage forbearance agreements. Absent this help, CRE will remain distressed. Refinancing risk is another threat that could cause a gap down in CRE prices, as bankers remain unwilling to dole out CRE loans despite a collapse in interest rates. Once the underlying asset gets repriced lower, then the debt related house of cards comes crumbling down (top & middle panels, Chart 14). Recent news that “Cerberus repackaged near junk rated CMBS paper into a AAA rated CDO” (effectively creating a AAA security out of thin air) is eerily reminiscent of the subprime crisis in 2008 and a stark warning that CRE excesses have yet to fully flush out.1 Chart 14More Pain Looms More Pain Looms More Pain Looms Chart 15Deflation Warning Deflation Warning Deflation Warning The downdraft in demand for CRE is already showing up in declining occupancy rates (Chart 15). We fear that there are more skeletons hiding in the closet. First the “amazonification” of the economy is still wreaking havoc on retail/shopping center REITs. Second the new “work from home” reality is putting strains on office landlords. Lastly, lodging will remain in distress at least until a vaccine is readily available. As a result, REITs cash flow growth will remain elusive, which will further dampen prospects of a recovery in the relative share price ratio (Chart 15). Finally, the relentless increase in supply is not showing any signs of abating. Non-residential construction is hovering near previous highs, and multi-family housing starts are perched close to prior cyclical peaks of 400K/annum (Chart 16). Undoubtedly, this excess supply backdrop will continue to weigh on CRE prices. Chart 16Mind The Supply Overhang Mind The Supply Overhang Mind The Supply Overhang Chart 17Valuations Have Yet To Fully Flush Out Valuations Have Yet To Fully Flush Out Valuations Have Yet To Fully Flush Out Despite all this dour news and near all-time lows in relative performance, valuations have only corrected down to the neutral zone, leaving ample room for an undershoot phase (middle panel, Chart 17). Encouragingly, persistent recent selling has pushed our relative Technical Indicator deep in oversold territory signaling that a near-term reflex rebound may be forthcoming. Netting it all out, COVID-19 has permanently scarred demand while non-residential construction is elevated. This combination will deflate commercial real estate (CRE) prices further, which risks unraveling a CRE debt deflation spiral. Continue to avoid the S&P real estate sector. Bottom Line: Stay underweight the S&P real estate sector. The ticker symbols for the stocks in this index are: BLBG: S5RLST-AMT, EQIX, PLD, CCI, DLR, PSA, SBAC, AVB, WELL, ARE, O, SPG, WY, CBRE, EQR, ESS, FRT, PEAK, VTR, BXP, DRE, EXR, MAA, UDR, AIV, HST, IRM, KIM, REG, SLG, VNO.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://www.bloomberg.com/news/articles/2020-10-01/cerberus-is-repackaging-near-junk-cmbs-into-top-rated-securities   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Misunderstanding 1: The danger of Covid-19 is its short-term mortality rate. In fact, the danger of Covid-19 is its long-term mortality and morbidity rate. Misunderstanding 2: The government-imposed lockdown causes the pandemic recession. In fact, the pandemic causes the pandemic recession. Misunderstanding 3: The pandemic’s main economic casualty is output. In fact, the pandemic’s main economic casualty is employment. Misunderstanding 4: The pandemic is a temporary shock to the way we live, work, and interact. In fact, the pandemic is accelerating long-term shifts in the way we live, work, and interact. Misunderstanding 5: The pandemic is pulling Europe apart. In fact, the pandemic is pulling Europe together. Feature Chart of the WeekThe Pandemic Is Pulling Europe Together The Pandemic Is Pulling Europe Together The Pandemic Is Pulling Europe Together Covid-19 is a novel disease. And living through a pandemic is a novel experience for most of us. The result is that many things are not fully understood. In this report, we pull together five major misunderstandings about the Covid-19 pandemic. Or at least, five topics on which we disagree with the mainstream narratives. Misunderstanding 1: The danger of Covid-19 is its short-term mortality rate. Truth 1: The danger of Covid-19 is its long-term mortality and morbidity rate. Some people argue that the danger of Covid-19 is overstated. The mortality rate seems low, especially in the new waves of the pandemic. These people argue that we should just let the pandemic rip to achieve so-called ‘herd immunity’. Yet this focus on the low immediate mortality rate misunderstands the true danger (Chart I-2). Chart I-2Focussing On Covid-19’s Low Immediate Mortality Rate Misunderstands The Danger Five Major Misunderstandings About Covid-19 Five Major Misunderstandings About Covid-19 The true danger might come from the long-term impact on mortality and morbidity. A good analogy is a non-lethal dose of radiation. It won’t kill you straightaway, and you might not even feel any immediate ill effects, but the exposure does irreparable long-term harm. Unlike other diseases, Covid-19 appears to have long-term sequelae. Unlike other diseases, Covid-19 appears to have long-term sequelae. It can permanently damage your respiratory, vascular, and metabolic systems. As The Lancet points out:1 “Weeks and months after the onset of Covid-19, people continue to suffer. 78 of 100 patients in an observational cohort study who had recovered from Covid-19 had abnormal findings on cardiovascular MRI and 36 reported dyspnoea and unusual fatigue… these patients are not only those recovering from the severe form of the acute disease, but also those who had mild and moderate disease. Long-term sequelae of Covid-19 are unknown… Other concerns are rising: does it cause diabetes, or other metabolic disorders? Will patients develop interstitial lung disease? We owe good answers on the long-term consequences of the disease to our patients and healthcare providers.” Until we know these answers, letting the pandemic rip to achieve herd-immunity is a very dangerous misunderstanding. Misunderstanding 2: The government-imposed lockdown causes the pandemic recession. Truth 2: The pandemic causes the pandemic recession. A pandemic is a classic complex adaptive system, in which there is constant feedback from millions of individual human actions to the pandemic, and from the pandemic to millions of individual human actions. It is this complex adaptive behaviour that generates a pandemic’s classic waves of infection, as well as its recessions. In response to an escalating pandemic, our instinct for self-preservation makes us go into our shells. In response to an escalating pandemic, our instinct for self-preservation makes us go into our shells. We shun crowds and public places, with the result that so-called ‘social consumption’ collapses. The misunderstanding is that the government-imposed lockdown causes the collapse in social consumption. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is that the escalating pandemic is making millions of people go into their shells. But to the extent that an escalating pandemic also leads to an escalating lockdown, many people confuse the correlated lockdown with the underlying cause, the escalating pandemic. As we have previously pointed out, Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the government-imposed lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, based on the rise in unemployment rates, no-lockdown Sweden performed worse than lockdown Denmark (Chart I-3 and Chart I-4). Chart I-3No-Lockdown Sweden Performed No Better... No-Lockdown Sweden Performed No Better... No-Lockdown Sweden Performed No Better... Chart I-4...Than Lockdown Denmark ...Than Lockdown Denmark ...Than Lockdown Denmark Misunderstanding 3: The pandemic’s main economic casualty is output. Truth 3: The pandemic’s main economic casualty is employment. The widespread use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three highly labour-intensive sectors: hospitality, retail, and transport. Using the US as a template, hospitality, retail, and transport contribute 12 percent of economic output, but employ 25 percent of all workers (Table I-1). If the pandemic forces these sectors to operate one third below full capacity, the economy will lose a tolerable 4 percent of output. But it will lose a devastating 8.3 percent of jobs. And on less optimistic assumptions, the job destruction could rise to well over 10 percent. Table I-1Sectors Hurt By Social Distancing Employ 25% Of All Workers Five Major Misunderstandings About Covid-19 Five Major Misunderstandings About Covid-19 Conversely, sectors which are unaffected by physical distancing and face masks make a much bigger contribution to economic output relative to employment. Financial activities generate 19 percent of economic output, but just 6 percent of jobs. Information technology generates 5 percent of output, but just 2 percent of jobs. Sectors hurt by social distancing employ 25 percent of all workers. Hence, the main economic casualty of the pandemic is not output. The main casualty is employment (Chart I-5 and Chart I-6). Worse, as employment suffers much more than output, the pandemic is devastating low-paid jobs. Chart I-5The Main Economic Casualty Of The Pandemic Is Employment… Five Major Misunderstandings About Covid-19 Five Major Misunderstandings About Covid-19 Chart I-6…Not ##br##Output Five Major Misunderstandings About Covid-19 Five Major Misunderstandings About Covid-19 Misunderstanding 4: The pandemic is a temporary shock to the way we live, work, and interact. Truth 4: The pandemic is accelerating long-term shifts in the way we live, work, and interact. The pandemic appears to have crystallised many shifts in consumer and business behaviour: for example, de-urbanisation, the shift from offline to online retailing, the shift from office working to remote working, and the shift from business travel to virtual meetings. In fact, these shifts were already in motion well before the pandemic hit (Chart I-7 and Chart I-8). Chart I-7The Pandemic Is Accelerating The Structural Shifts To De-Urbanisation… Five Major Misunderstandings About Covid-19 Five Major Misunderstandings About Covid-19 Chart I-8…And Online ##br##Shopping Five Major Misunderstandings About Covid-19 Five Major Misunderstandings About Covid-19 If the pandemic suddenly ended tomorrow, would people flock back to full-time office work in city centres? Would they flock back to bricks and mortar retailers? Would they return to the same intensity of long-haul business travel? We think not, because the shifts from these activities are not temporary. They are structural. The pandemic is devastating low-paid jobs. The pandemic has accelerated the hollowing out of labour-intensive industries such as bricks and mortar retailing, city centre cafes, bars and restaurants, and commercial travel. Combined with the ongoing threat to jobs from AI, this hollowing out process is blighting the job prospects of a generation, creating large numbers of underemployed and unemployed workers. Misunderstanding 5: The pandemic is pulling Europe apart. Truth 5: The pandemic is pulling Europe together. Let’s end on a positive note. The pandemic has allowed Europe to smash two major taboos: explicit fiscal transfers across countries, and the large-scale issuance of common EU bonds. The EU recovery plan also starts discussions on how the EU can ‘increase its own resources’. Which is to say, raise its own taxes. 2020 might turn out to be the most important year for European integration. The EU’s €750 billion ‘Next Generation’ recovery plan comprises €390 billion of grants whose main beneficiaries will be Italy and Spain – and these grants will be funded by common EU issuance. In breaking the long-standing taboos of fiscal transfers and common issuance, Next Generation constitutes a giant step towards European integration. Specifically, Italy’s net grant entitlement is likely to outweigh its contributions to the EU’s 2021-27 budget cycle. Thereby, Italy will flip from a net contributor to a net recipient of EU funds. The willingness to flip the sign of Italy’s contribution marks a sea-change in the EU’s attitude on fiscal solidarity, whose long-term significance should not be underestimated. 2020 might turn out to be the most important year for European integration. The irony is that it took a global pandemic to achieve it. Investment Conclusions The huge and growing slack in labour markets means that zero and negative interest rate policy will become a permanent feature of our lives. Hence, the relatively higher yielding 30-year US T-bond remains an effective hedge against stock market dislocations, as it did in March. Equity sectors whose profits can thrive off the shifts in the way we live, work, and interact, will outperform – specifically, technology, biotechnology, healthcare, and communications. Thereby, stock markets with an overweighting to these sectors will also outperform. The devastation of low-paying jobs means that bank credit growth is set to remain structurally weak or even non-existent. As such, banks should be bought for tactical countertrend moves (as now), but not for the long term. The yield spreads on euro area ‘periphery’ bonds over Germany and France will continue to tighten, and ultimately reach zero (Chart of the Week and Chart I-9). Chart I-9The Pandemic Is Pulling Europe Together The Pandemic Is Pulling Europe Together The Pandemic Is Pulling Europe Together Fractal Trading System* Within the EM universe, the strong outperformance of India versus Czech Republic is vulnerable to a countertrend sell-off. Accordingly, this week’s recommended trade is short MSCI India versus MSCI Czech Republic. The profit target and symmetrical stop-loss is set at 8 percent. Chart I-10MSCI: India Vs. Czech Republic MSCI: India Vs. Czech Republic MSCI: India Vs. Czech Republic In other trades, long USD/PLN achieved its 4 percent profit target, and short AUD/CHF reached the end of its holding period in profit. The rolling 1-year 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 Please see The Lancet, Long-term consequences of Covid-19: research needs, September 1, 2020. 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 Near-Term Uncertainties: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Debt: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt. Feature Chart of the WeekMarkets Starting To Get Cautious Markets Starting To Get Cautious Markets Starting To Get Cautious As the third quarter of 2020 draws to a close, investors have developed a slight case of the jitters about the near-term outlook for global financial markets. The positives that drove risk assets higher during the spring and summer - rebounding global economic activity, fueled by aggressive policy stimulus and a slowing of the spread of COVID-19, along with a weaker US dollar – have given way to some fresh uncertainties. Economic data releases have started to disappoint versus expectations, the rapid expansion of central bank balance sheets in the major developed economies has temporarily stalled, a second wave of new COVID-19 cases appears to have started in Europe and the US, and the US dollar has strengthened by 2.7% from the 2020 lows (Chart of the Week). Risk assets have pulled back in response, with the MSCI World equity index down -6.1% from the 2020 peak and US high-yield corporate credit spreads 66bps wider from recent lows. So far, these moves appear more a correction of overbought markets, rather than a change in trend. From the perspective of our strategic (6-12 months) investment recommendations, we remain generally positive on risk assets. Within global fixed income, that means maintaining a modest overall overweight stance on spread products versus government bonds, while focusing more on relative opportunities between countries and sectors to generate alpha. A Quick Assessment Of The Cyclical Backdrop The recent in increase in market volatility has started to shake out crowded positioning in popular winning trades. For example, high-flying US tech stocks have seen deeper pullbacks than the overall US equity market, while investors yanked nearly $5 billion from US junk bond funds in the week ending last Wednesday according to the Financial Times – the highest such outflow since the apex of the COVID-19 market rout in mid-March. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class Mainstream financial pundits often dub such corrections of overheated markets as a “healthy” way to ensure the continuation of medium-term bullish trends. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class – the most important of which remain positive for risk assets, in general, and global fixed income spread products, in particular. Economic Data Chart 2Economic Data Is Mostly Optimistic Economic Data Is Mostly Optimistic Economic Data Is Mostly Optimistic While data surprise indices like the widely followed Citigroup series are topping out, this is more because of an improvement in beaten-up growth expectations, rather than a sharp decline in the actual data. The global ZEW economic expectations survey continues to point in an optimistic direction, while other reliable measures of business confidence like the German IFO and the US NFIB small business surveys have also continued to improve in recent months. Our own global leading economic indicator (LEI) is firming, with a majority of countries seeing a rising LEI (Chart 2). At the same time, the preliminary release of manufacturing PMI data for September showed continued improvements in the US and Europe. While the news is not 100% upbeat – the services PMI for the overall euro area fell -2.9 points in September, possibly due to the increase in new reported cases of COVID-19 in Europe – the tone of global economic data remains consistent with improving cyclical momentum. The US Dollar Chart 3Growth And Yield Differentials Signalling Dollar Weakness Growth And Yield Differentials Signalling Dollar Weakness Growth And Yield Differentials Signalling Dollar Weakness The most likely medium-term path of least resistance for the US dollar remains downward. Economic growth remains stronger outside the US, based on the differential between the US and non-US manufacturing PMI data – an indicator that our currency strategists follow closely given its strong correlation to US dollar momentum (Chart 3). Relative interest rate differentials also remain less positive for the US dollar, with the decline in real US bond yields seen in 2020 pointing to additional medium-term dollar depreciation (bottom panel). US Politics The US general election is now only 35 days away, with the latest polling data showing President Trump closing the lead on the Democratic Party candidate, Joe Biden. Our colleagues at BCA Research Geopolitical Strategy remain of the view that a Biden victory is the more probable outcome, given the more difficult time Trump will have in winning all the key swing states that gave him his narrow election victory in 2016. Chart 4A "Blue Sweep" Is Bearish For Markets A "Blue Sweep" Is Bearish For Markets A "Blue Sweep" Is Bearish For Markets The recent peak in US equity markets, and trough in the VIX index, coincided with improving odds of a Democratic Party sweep of the White House, House of Representatives and Senate (Chart 4). Such an outcome would give a President Biden the power, and perceived mandate, to implement many of the more progressive elements of the Democratic Party agenda – including a hike in corporate tax rates that could damage equity market sentiment. Our political strategists think that a “Blue Sweep” would only occur if the Republican Party fails to agree with the Democrats on a new fiscal stimulus bill.1 Both sides are playing hardball in the current negotiations, which is keeping investors on edge given how much of the US economy still requires fiscal support because of the pandemic. The Republicans will not want to take the blame for a failure to reach a stimulus deal, which would likely hand the Democrats the keys to the White House and Congress. Thus, a fiscal deal of sufficient size to calm jittery markets – most likely in the $2-2.5 trillion range sought by the Democrats – should be announced within the next couple of weeks before the final run up to the election. Financial/Monetary Conditions It will take more than a corrective pullback in equity and credit markets to threaten the economic recovery from the COVID-19 recession, given how highly stimulative financial conditions have become since the spring (Chart 5). In more normal times, booming equity and credit markets would eventually lead to upward pressure on government bond yields, since all would be reflecting improving economic growth and, eventually, expectations of faster inflation and tighter monetary policy. That move higher in yields would eventually act to restrain growth and depress the value of growth-sensitive risk assets. Chart 5Financial Conditions Remain Supportive For Growth Financial Conditions Remain Supportive For Growth Financial Conditions Remain Supportive For Growth As we discussed in last week’s report, government bond yields are now likely to stay very low for a period measured in years, with major central banks like the US Federal Reserve leaning dovishly to support growth during the pandemic and trigger a temporary overshoot of inflation expectations.2 Thus, loose monetary settings (including more quantitative easing) will remain a critical underpinning for keeping risk assets well supported, by eliminating the typical cyclical threat from rising bond yields. Summing it all up, the fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Of course, a major wild card could be that the latest surge in new COVID-19 cases becomes large enough to trigger renewed economic restrictions in the US or Europe. Yet any such moves would likely not be as severe as those that occurred back in the spring, given the much lower mortality rates seen during the current upturn in COVID-19 cases, which is reducing the public’s willingness to accept more economy-crushing lockdowns. Bottom Line: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Credit: Focus On Corporates Relative To Sovereigns Chart 6An Overview of USD-Denominated EM Debt An Overview of USD-Denominated EM Debt An Overview of USD-Denominated EM Debt Back in July of this year, we turned more positive on emerging market (EM) USD-denominated spread product, upgrading our recommended allocation to both EM USD sovereign and corporate debt to neutral from underweight in our model bond portfolio.3 The change was motivated by signs of rebounding global economic growth after the COVID-19 lockdowns and a loss of upward momentum in the US dollar, coming at a time when EM spreads still looked relatively cheap (wide) compared to developed market corporate debt. An underweight stance was inconsistent with that backdrop. EM credit has done well since our upgrade (Chart 6). Using Bloomberg Barclays index data, the yield on the EM USD-denominated sovereign index has fallen from 5.2% to 4.4%, while the option-adjusted spread (OAS) on that same index tightened from 447bps to 368bps. It has been a similar story for EM USD-denominated corporates, with the index yield falling from 4.1% to 3.9% and the index OAS narrowing from 361bps to 344bps.4 Given the close correlations typically exhibited between EM USD sovereign and corporate yields and spreads, we have tended to change our recommended allocations to both asset classes at the same time and in the same direction. Yet the EM credit universe is quite diverse, incorporating many different issuers of highly varying credit quality and risk (Table 1). Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. The fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Table 1Details Of The USD-Denominated EM Sovereign And EM Corporate & Quasi-Sovereign Indices Stay The Course Stay The Course A first step to analyzing the EM USD sovereigns versus corporates investment decision is to develop a list of macro factors that correlate to the relative performance of EM sovereign and corporate credit. From there, we can build a list of directional indicators that can help inform that sovereign versus corporates decision. Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. Our colleagues at BCA Research Emerging Markets Strategy have long held the view that overall EM debt performance is mostly driven by just two important macro factors: industrial commodity prices and the US dollar. Specifically, they have shown that the broad cyclical swings in EM sovereign and corporate spreads correlate strongly to the price momentum of a simple blend of industrial metal and oil prices, as well as the price momentum of a basket of EM currencies versus the US dollar (Chart 7). Chart 7EM Credit Spreads: A Commodity And Currency Story EM Credit Spreads: A Commodity And Currency Story EM Credit Spreads: A Commodity And Currency Story On that basis, the recent moderate widening of EM credit spreads is justified by the corrective pullback in industrial commodity prices and a bit of US dollar strength – trends that our EM strategists believe can continue in the near-term. Although they share our view that the medium-term trend in the US dollar is still bearish, thus any near-term EM debt selloff will represent a longer-term buying opportunity.5 The demand for industrial commodities remains largely driven by economic trends in the world’s largest commodity consumer, China. Thus, our China credit impulse (the change in overall Chinese credit relative to GDP), which leads Chinese economic activity, is a good leading indicator of industrial commodity prices. We will use the China credit impulse in our list of directional indicators to forecast EM sovereign versus corporate performance. We also will include the annual rate of change of the index of EM currencies versus the US dollar (shown in Chart 7). We also believe that a global monetary policy variable should be included in our indicator list, particularly in the current environment of super-low developed market interest rates and central bank purchase of government bonds – both of which tend to drive yield-starved investors into higher-yielding EM assets and, potentially, can influence the relative performance of EM sovereigns and corporates. To capture the global monetary policy trend in our indicator list, we use the combined annual growth rate of the balance sheets of the Fed, the ECB, the Bank of Japan and the Bank of England. The message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months. In Charts 8 & 9, we show the relative total return of the Bloomberg Barclays EM USD corporate and USD sovereign indices, expressed in year-over-year percentage terms, versus our list of three potential directional indicators of the relative total return. We have broken up the overall EM universe by broad credit quality, with index data used for investment grade issuers in Chart 8 and below investment grade (high-yield) issuers in Chart 9. For all three of our directional indicators, we have pushed them forward in the charts to look for a potential leading relationship to the relative returns. Chart 8EM Investment Grade Corporates Looking Set to Outperform ... EM Investment Grade Corporates Looking Set to Outperform ... EM Investment Grade Corporates Looking Set to Outperform ... Chart 9... But The High Yield Space Tells A More Mixed Story ... But The High Yield Space Tells A More Mixed Story ... But The High Yield Space Tells A More Mixed Story The charts show that China credit impulse leads the relative total returns of EM USD corporates versus EM USD sovereigns by between 9-18 months for investment grade and high-yield EM credit. The growth of the major central bank balance sheets also leads the relative performance of EM USD corporates versus EM USD sovereigns by one full year, both for investment grade and high-yield EM credit. Finally, the annual growth of EM currencies leads the relative return of EM USD corporates versus sovereigns by around nine months, although the correlation is the weakest of the three indicators in our list. In terms of current investment strategy, the message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months, both for investment grade and high-yield, largely due to aggressive credit stimulus in China and the rapid expansion of central bank balance sheets. In terms of the attractiveness of EM USD-denominated yields in a global fixed income portfolio, however, there is a difference between higher-rated and lower-rated EM debt. In Chart 10, we present a scatter chart that plots the yields on various global fixed income sectors, all hedged into US dollars and compared to trailing yield volatility, versus the average credit rating of each sector. Investment grade EM USD corporate and sovereign issuers offer relatively more attractive yields compared to other sectors with similar credit ratings, like investment grade corporates in the US and Europe. The same cannot be said for high-yield EM USD corporates and sovereigns, which only offer a more attractive volatility-adjusted yield compared to euro area high-yield corporates among the lower-rated global credit sectors. Chart 10EM USD-Denominated High Yield Debt Not Especially Attractive On A Risk-Adjusted Basis Stay The Course Stay The Course Based on this analysis, we are making the following changes in our model bond portfolio on page 14: Upgrading EM USD corporates to overweight Downgrading EM USD sovereigns to underweight Keeping the combined EM USD credit allocation at neutral. This fits with our current overall investment theme of keeping overall spread product exposure relative close to benchmark, while taking more active risks on relative allocations between fixed income sectors. Bottom Line: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Geopolitical Strategy Weekly Report, "Stimulus Will Come … But May Not Save Trump", dated September 25, 2020, available at gps.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "What Would It Take To Get Bond Yields To Rise Again?", dated September 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism", dated July 14, 2020, available at gfis.bcaraesearch.com. 4 Note that the index data we are using here includes both EM corporate and so-called “quasi-sovereign” debt, the latter being bonds issued by EM companies that are majority-owned by their local governments. 5 Please see BCA Emerging Markets Strategy Weekly Report, "A Reset In The Making", dated September 24, 2020, available at ems.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stay The Course Stay The Course Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Treasuries: Bond yields held steady in September, even as the stock market sold off sharply. This leads us to conclude that long-maturity Treasury yields have room to fall in the near-term if progress towards a fiscal stimulus package moves too slowly. We continue to recommend keeping portfolio duration close to benchmark on a 6-12 month horizon. Corporates: Corporate spreads widened significantly in September, but they still embed a relatively optimistic default outlook. While corporate leverage has peaked, some labor market indicators have stalled. This makes us question whether defaults can improve enough to meet lofty market expectations. Continue to overweight investment grade corporates and Ba-rated junk on a 6-12 month horizon, while avoiding junk bonds rated B and lower. A Fed-Driven Sell-Off? Chart 1Treasuries A Poor Hedge In September Treasuries A Poor Hedge In September Treasuries A Poor Hedge In September It might seem odd to think of this month’s market weakness as a reaction to an overly hawkish Fed. With the funds rate pinned at its effective lower bound and no rate hikes expected until 2024 (at least), monetary conditions have never been more accommodative. However, the relative performance of different asset classes in September leads us to only one conclusion. Financial markets had been priced for even more central bank dovishness this month, and came away disappointed. Equity Sectors Responded To Monetary Tightness, Not Weaker Growth First, consider the simple observation that risk assets (equities and credit) have sold off sharply since September 2nd but the Bloomberg Barclays Treasury Index actually underperformed a position in cash (Chart 1). Investors have seen none of the usual hedging benefits from bonds. Some of this can be chalked up to the relative performance of different equity sectors (Table 1). Tech stock underperformance was responsible for the bulk of September’s market weakness, particularly early in the month. Meanwhile, the most cyclical (or growth-sensitive) sectors – Industrials, Energy and Materials – performed only slightly worse than traditionally defensive sectors. Typically, cyclical sectors perform worst when the stock market is responding to a negative re-rating of economic growth expectations. The fact that cyclicals weren’t the worst performers this month suggests that the sell-off had a different catalyst. Table 1Equity & Treasury Returns: September 2nd To September 25th Out Of Bullets Out Of Bullets The sector composition of the sell-off has important implications for bond yields because the relative performance between cyclical and defensive equity sectors explains more of the variation in the 10-year Treasury yield than the overall performance of the stock market (Chart 2). Chart 2Relative Sector Performance Matters For Bond Yields Relative Sector Performance Matters For Bond Yields Relative Sector Performance Matters For Bond Yields Commodities Suggest A Hawkish Policy Surprise … Table 2Commodities & Bond Yields: September 2nd To September 25th Out Of Bullets Out Of Bullets Second, consider the performance of industrial commodities and gold (Table 2). Growth-sensitive industrial commodities held up pretty well this month, but gold fared poorly. The relatively strong performance of industrial commodities suggests that markets were not pricing-in a significant shock to global growth expectations. Weakness in gold suggests that investors started to price-in less long-run inflation risk. This is the exact sort of performance you would expect if the central bank delivered an unexpected dose of monetary tightening. Along with the relative performance of equity sectors, the relative performance between industrial commodities and gold also helps explain why Treasury yields remained stable. The ratio between the CRB Raw Industrials Index and gold is tightly correlated with the 10-year Treasury yield (Chart 3). Chart 3Bond Yields Track The CRB/Gold Ratio Bond Yields Track The CRB/Gold Ratio Bond Yields Track The CRB/Gold Ratio … As Do Inflation-Linked Bonds Third, we can look at relative movements in nominal yields, real yields and inflation breakevens. Recall that we like to think of nominal yields as being driven by fed funds rate expectations and of inflation breakevens as being driven by inflation expectations. Real yields have no independent driver, but can be calculated using the Fisher Equation:1 Real Yield = Nominal Yield – Inflation Expectations With that in mind, look at how yields have moved since the stock market’s September 2nd peak (Table 2). The 10-year TIPS breakevens rate is down sharply but the 10-year nominal yield is unchanged. This suggests that the market moved to price-in less long-run inflation risk alongside an unchanged path for the policy rate. The result of the interaction between those two drivers is a sharp move up in the 10-year real yield. Credit Performance Also Looks Policy Driven Table 3Corporate Bond Excess Returns*: September 2nd To September 25th Out Of Bullets Out Of Bullets Finally, we can look at the relative performance of different corporate bond credit tiers (Table 3). In a typical risk-off market driven by greater pessimism about the outlook for economic growth, we would expect to see the bulk of underperformance concentrated in the lowest credit tiers where bonds are most likely to default. However, since September 2nd, Ba-rated issuers have underperformed all lower-rated credit tiers, even distressed Ca/C-rated issuers. One possible explanation is that Ba-rated and higher corporate bonds generally benefit from the Fed’s emergency lending facilities while B-rated and lower credits are mostly locked out. It could be that September’s market moves reflect some increased pessimism about the Fed’s ability or willingness to stick with its emergency facilities. Or more likely, there had been some hopes that the Fed would somehow expand its current emergency lending facilities. Hopes that were dashed when Chair Powell testified to Congress last week and seemed to suggest that the Fed has already done all it can in this regard. Investment Implications For us, this is the main takeaway from September’s strange market moves: Fed policy is certainly in no rush to tighten, but equally, the Fed can’t deliver any further easing on its own. All it can do is continue to support credit markets with its current emergency facilities and refrain from lifting rates even if inflation starts to rise. Those looking for an additional dose of economic adrenaline should look to fiscal policymakers, not the Fed. With regards to markets, since September’s moves don’t appear to reflect expectations for weaker economic growth, we fret that such a shock could still emerge. The most likely near-term catalyst would be the failure of Congress to pass a new stimulus package. We have previously written that consumer spending will not be able to sustain a decent growth rate without additional income support from Congress.2 If it looks like a deal is not forthcoming or we see some negative consumer spending data, there is room for cyclical equity sectors and bond yields to move lower. We view this as a material near-term risk. September’s junk bond weakness was unusual in that higher-rated credits performed worse than lower-rated ones. Beyond the near-term, on a 6-12 month horizon, we continue to believe that the economic recovery will continue. Congress will ultimately deliver sufficient stimulus, though it may not come in time to prevent a near-term market reaction. The conflict between these near-term and medium-term views leads us to maintain our cautious cyclical investment stance. We recommend keeping portfolio duration close to benchmark while holding duration-neutral yield curve steepeners that are designed to profit from higher yields on a 6-12 month horizon.3 More specifically, we advise medium- and long-run investors who are already exposed to curve steepeners to stay the course. But if you aren’t yet exposed, it is a good idea to wait until a follow-up stimulus bill is announced before moving in. An Update On Corporate Sector Health And The Default Rate As noted above, September’s junk bond weakness was unusual in that higher-rated credits performed worse than lower-rated ones. As with our Treasury call, the fact that markets appeared to react to a policy shock and not a growth shock makes us nervous that a near-term growth shock is still not in the price. We see low-rated junk bonds as looking particularly complacent, especially when you consider that spreads continue to embed a relatively optimistic default outlook. Calculating The Spread-Implied Default Rate Our workhorse valuation tool for junk bonds is the Default-Adjusted Spread. This is the average index option-adjusted spread less default losses observed over the subsequent 12-month period. For example, the Default-Adjusted Spread came in at -301 basis points for the 12-month period ending August 2020. This is equal to the August 2019 index spread of 393 bps less realized default losses of 694 bps that occurred between August 2019 and August 2020. Over time, we have found that the Default-Adjusted Spread does a good job of explaining excess junk returns and that, typically, a Default-Adjusted Spread of at least 150 bps is required for high-yield to outperform duration-matched Treasuries on a 12-month investment horizon (Chart 4).4 Chart 4Calculating The Spread-Implied Default Rate Calculating The Spread-Implied Default Rate Calculating The Spread-Implied Default Rate With that knowledge, we can set a target Default-Adjusted Spread of 150 bps and calculate the default rate that would have to occur during the next 12 months to hit that target. We call this the Spread-Implied Default Rate, and it is presented in the bottom panel of Chart 4. As of today, the Spread-Implied Default Rate is 5.1%. This means that if the speculative grade default rate comes in below 5.1% during the next 12 months, then our Default-Adjusted Spread will be above 150 bps and junk bonds will likely outperform Treasuries. If the default rate turns out to be above 5.1%, then the prospects for junk bond outperformance look dimmer. Can The Default Rate Fall To 5%? The logical question then becomes whether it’s possible for the default rate to fall to 5% during the next 12 months. This would certainly be a rapid improvement from its current level of 8.7%, but not one that is without historical precedent. In fact, the default rate tends to fall very quickly when the economy is coming out of recession and, already, August saw only six default events. This is down from above 20 in May, June and July (Chart 5). Chart 5Only Six Defaults In August Only Six Defaults In August Only Six Defaults In August Obviously, whether August’s gains can be maintained depends on the speed of economic recovery. In particular, we focus on nonfinancial corporate sector gross leverage – the ratio between total debt and pre-tax profits – and job cut announcements (Chart 6). Chart 6Default Rate Drivers Default Rate Drivers Default Rate Drivers Looking first at leverage, corporate profits plunged in the second quarter but that will probably represent the cyclical trough (Chart 7, top panel). Already, we see that analysts are revising up their earnings expectations (Chart 7, panel 2). Typically, positive net earnings revisions coincide with positive profit growth. On the debt side, firms issued massive amounts of debt in the first and second quarters (Chart 7, panel 3), but that process is also over. We note that the Financing Gap – the difference between capital expenditures and retained earnings – dipped into negative territory in Q2 (Chart 7, bottom panel). This means that firms retained more earnings than they needed to cover capital expenditures and suggests that further debt issuance is not necessary. When the Financing Gap moved below zero in 2009, it ushered in a lengthy period of corporate deleveraging. Chart 7Firms Have Enough Retained Earnings To Cover Capex Firms Have Enough Retained Earnings To Cover Capex Firms Have Enough Retained Earnings To Cover Capex It is therefore quite likely that both corporate sector leverage and the default rate have already peaked. The question is whether both can fall quickly enough to meet market expectations. Of this, we are less certain. When the Financing Gap moved below zero in 2009, it ushered in a lengthy period of corporate deleveraging. Job Cut Announcements – another predictor of corporate defaults – have also improved markedly since April, but they remain well above pre-COVID levels (Chart 8). Further, an array of other employment indicators suggest that labor market improvement has stalled during the past few weeks. Initial unemployment claims have flattened off and remain well above pre-COVID levels (Chart 8, panel 2). What’s more, high frequency data from scheduling firm Homebase show that the total number of employees working for companies using the Homebase software is no longer rising and is far below its pre-COVID level (Chart 8, bottom panel). It’s important to note that the Homebase data are biased toward small businesses, mostly in the restaurant, food & beverage, retail and services sectors. Those sectors have obviously been hit the hardest by COVID, but those are also the sectors where we are likely to see the bulk of corporate defaults. Chart 8Labor Market Indicators Labor Market Indicators Labor Market Indicators Investment Conclusions We are confident that the default rate has peaked, but we aren’t yet confident enough to recommend owning B-rated and below junk bonds. To make that recommendation we would need to have confidence that the default rate will move to 5% or lower during the next 12 months. The default rate was already 4.5% in the 12 months prior to COVID, and it now appears that most labor market data are stalling at worse than pre-COVID levels. An array of employment indicators suggest that labor market improvement has stalled during the past few weeks. We reiterate our recommendation to overweight investment grade and Ba-rated corporate bonds, while avoiding high-yield bonds rated B and lower. We will consider adding exposure to low-rated junk bonds if spreads rise to more attractive levels in the near-term and/or if Congress announces a significant stimulus package that looks poised to boost the economic recovery and labor market. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities Out Of Bullets Out Of Bullets   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 3 For more details on our yield curve recommendations please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 4 To calculate the Spread-Implied Default Rate we also need to estimate the 12-month recovery rate. We assume a recovery rate of 25%, slightly better than the 20% recovery rate seen during the past 12 months. Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights Most sentiment and technical indicators suggest the dollar is undergoing a countertrend bounce rather than entering a new bull market. However, the internal dynamics of financial markets remain short-term constructive for the DXY. The DXY could rise to 96 before working off oversold conditions. Stay short USD/JPY as a core holding. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trigger point of -2%. Go long sterling if it drops to 1.25. Remain short EUR/GBP. Feature Chart I-1The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The world remains dominated by the reflation trade. The equity market downdraft this past March and the subsequent recovery since April has been a mirror image of the rise and fall of the dollar (Chart I-1). This suggests that at a minimum, the Federal Reserve’s actions and Washington’s policy decisions have served as important pillars in the global economic recovery. A falling dollar tends to reflate the global economy, so it is important to gauge whether the recent bounce is technical in nature or at risk of a more meaningful increase. From an investment perspective, the economic outlook as we enter the final stretch of 2020 is as uncertain as ever. Factors such as the potential for renewed lockdowns, a fiscal cliff in the US, political uncertainty due to Brexit, and the possibility of a contested US election all make for a very complex decision tree. As investors try to decipher the end game, we turn to the internal dynamics of financial markets for a more sober view. Sentiment and technical indicators make up an important component of our currency framework, and are usually good at gauging important shifts in financial markets. Given market action over the past few weeks, we are reviewing a few of these key indicators to help guide currency strategy into year-end and beyond. The Signal From Currency Markets The message from our currency market indicators suggests a technical bounce in the dollar rather than a renewed bear market. The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate.  Chart I-2DXY Is Testing Strong Resistance The Message From Dollar Sentiment And Technical Indicators The Message From Dollar Sentiment And Technical Indicators From a broad perspective, the DXY index was oversold, having broken below key support levels this year. More recently, the bounce in the DXY index has brought it a nudge above the upward-sloping trend line, which had defined the bull market since the 2011 lows (Chart I-2). A significant bounce from current levels will be worrisome. More likely, the dollar will churn near current levels before resuming its downtrend. In other words, we expect that, going forward, this upward-sloped line will act as powerful overhead resistance. The exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate (Chart I-3). Since the Great Recession, the yen has been the best performer during equity drawdowns, while the Aussie has been the worst. As a result, the AUD/JPY cross has consistently bottomed at the key support zone of 72-74. This defensive line notably held during the European debt crisis, China’s industrial recession, and the global trade war. The frontier was clearly breached during the March drawdown this year, but we have since re-entered the safe zone (Chart I-4). Going forward, a break below 72 will be worrisome. Looking at the intra-day charts, we see a clear pattern of lower highs and lower lows since the September 10th peak. That said, speculators are still short the cross, suggesting that the level of complacency going into the February equity market drawdown is not there today (Chart I-4, bottom panel). Chart I-3The Reflation Trade The Reflation Trade The Reflation Trade Chart I-4AUD/JPY: Watch The 72-24 Zone AUD/JPY: Watch The 72-24 Zone AUD/JPY: Watch The 72-24 Zone   High-beta carry currencies such as the RUB, ZAR, MXN, and BRL have been rather weak, even if they are still holding above their lows. These currencies are usually good at sniffing out a change in the investment landscape, specifically one becoming fertile for carry trades. Carry trades usually do well when US yields are low and the global growth environment is improving (Chart I-5). The message so far is that the drop in U.S. bond yields may not have been sufficient to make these currencies attractive again. This is confirmed by the performance of the Deutsche Bank carry ETF, DBV, which has been struggling to recover amid very low rates (Chart I-6). Chart I-5Carry Trades Are Lagging Carry Trades Are Lagging Carry Trades Are Lagging Chart I-6Carry Trade ETFs Have Underperformed Carry Trade ETFs Have Underperformed Carry Trade ETFs Have Underperformed Speculators are very short the dollar. Whenever the percentage of leveraged funds and overall speculators that are short the dollar is at or below 20%, a meaningful rally ensues (Chart I-7). However, because the dollar is a momentum currency, reversion-to-the-mean strategies work in the short term but not so much longer term. The dollar advance/decline line remains well below its 200-day moving average. Meanwhile, there is a death-cross formation between the 200-day and 400-day moving averages. This is a very bearish technical profile (Chart I-8). We cannot rule out rallies toward the 200-day moving average, but for now we remain well below this danger zone. Chart I-7Rising Number Of Dollar Bears Rising Number Of Dollar Bears Rising Number Of Dollar Bears Chart I-8A Cyclical Bear Market A Cyclical Bear Market A Cyclical Bear Market Finally, currency volatility is rising from very depressed levels. Usually, low currency volatility is a sign of complacency among traders and investors, while higher volatility signals a more balanced and healthy market rotation. Over the last three episodes where volatility rose from these oversold levels, the dollar soared and pro-cyclical currencies suffered severe losses. For example, the most significant episodes were 1997-1998, 2007-2008, and 2014-2015 (Chart I-9). The one difference this time around is that the dollar is expensive, while it was very cheap during previous riot points. This argues for a technical bounce, rather than a renewed bull market. Chart I-9Currency Volatility Has Spiked Currency Volatility Has Spiked Currency Volatility Has Spiked In a nutshell, the message from technical indicators is that the bounce in the dollar was to be expected. However, we are monitoring a few worrisome developments. First, the consensus is overwhelmingly bearish on the dollar, which could make this bounce advance much further than most expect. Second, spikes in volatility, especially as the equity market corrects, are traditionally dollar bullish. The Signal From Commodity Markets Commodity prices hold a special place as FX market indicators, since they are both driven by final demand and financial speculation. Over the years, we have found that the internal dynamics of commodity prices usually send key signals for underlying FX market trends. Overall, the signals are also mixed: The copper-to-gold ratio has bottomed and is heading higher from deeply oversold levels. Together with the stabilization in government bond yields, it signifies that the liquidity-to-growth transmission mechanism might be working. This is usually dollar bearish, as rising global growth leads to capital outflows from the US (Chart I-10). The Gold/Silver ratio (GSR) tends to track the US dollar, and its recent rebound is worrisome (Chart I-11). The GSR provides important information on the battleground between easing financial conditions and a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. Therefore, the GSR rallies during periods of financial stress that forces policymakers to act, and peaks as we exit a recession into a recovery. Chart I-10The Copper/Gold Ratio Leads The Dollar The Copper/Gold Ratio Leads The Dollar The Copper/Gold Ratio Leads The Dollar Chart I-11The Gold/Silver Ratio Is Rebounding The Gold/Silver Ratio Is Rebounding The Gold/Silver Ratio Is Rebounding We had a limit-sell order on the GSR at 75 that was triggered this week, putting our position offside by 7%. The key driver of GSR price action over the next few weeks will be silver prices. The next important technical level for silver is the $18-to-$20-per-ounce zone. This has acted as a strong overhead resistance since 2015, which should now provide strong downside support. If silver is able to stabilize around this level, it will indicate that the precious metals bull market remains intact. We eventually expect the GSR to drop toward 50. The Signal From Fixed-Income Markets The fixed-income market is a very powerful sentiment barometer for the dollar. Both cross-border flows and global allocation to FX reserves provide important information about investor preferences for the dollar. Below, we go through the indicators that we track frequently and which constitute an integral part of our framework. The bond-to-gold ratio is an important signal for the dollar, since both US Treasurys and gold are competing assets. Chart I-12Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets Gold And Treasurys Are Competing Assets The bond-to-gold ratio is an important signal for the dollar, since both US Treasurys and gold are safe-haven assets and thus, by definition are competing assets (Chart I-12). As the Fed continues to increase the supply of bonds, the ratio of the US bond ETF (TLT)-to-gold (GLD) will be an important proxy for investor sentiment on the dollar (Chart I-13). For now, the ratio is sitting on the key 0.94 support zone. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early ‘70s (Chart I-14). This makes it both a good short-term and long-term barometer. Chart I-13Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Watch The Bond-To-Gold Ratio Chart I-14Competing Assets And The Dollar Competing Assets And The Dollar Competing Assets And The Dollar Inflows into US government bonds are falling sharply, while those into gold are rising sharply (Chart I-15). With interest rates near zero and real rates deeply negative, this pattern is likely to continue in the near future. This should pressure the bond-to-gold ratio lower.   It is remarkable that in recent days investors have begun pricing even more negative real rates in the US compared to other G10 countries (Chart I-16). Again, should this materialize, this will send gold prices higher and cause further erosion in foreign bond purchases. Chart I-15Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Gold And USD Inflows Diverge Chart I-16Real Rate Expectations Are Relapsing Real Rate Expectations Are Relapsing Real Rate Expectations Are Relapsing Overall, the signal from fixed-income markets remain US dollar bearish.  The Signal From Equity Markets Equity market indicators continue to flag that the rally in the dollar has a bit further to go, but should remain a counter-trend bounce.  Currencies tend to move in sync with the relative performance of their equity bourses.  Chart I-17Cyclicals Have Outperformed Defensives Cyclicals Have Outperformed Defensives Cyclicals Have Outperformed Defensives Cyclical stocks have been underperforming defensive ones of late, but the pattern of higher lows in place since the March bottom continues to persist (Chart I-17). The dollar tends to weaken when cyclical stocks are outperforming defensive ones. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. Thus, whenever cyclical sectors are outperforming defensives, it is a clear sign that the marginal dollar is rotating outside of the US. Correspondingly, currencies tend to move in sync with the relative performance of their equity bourses (Chart I-18A and I-18B). So far, non-US equity markets have relapsed relative to the US, but are not yet breaking down. Earnings revisions continue to head higher across all markets. Bottom-up analysts are usually too optimistic about the level of earnings, but are generally spot on about their direction. That said, higher earnings revisions have been concentrated in the US so far, and will need to improve in other markets for the dollar bear market to resume (Chart I-19). Chart I-18ACurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-18BCurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-19V-Shape Recoveries In Earnings Revisions V-Shape Recoveries In Earnings Revisions V-Shape Recoveries In Earnings Revisions In a nutshell, corrections in equity markets are usually a healthy reset for the bull market to resume, but the character of this particular selloff is worth monitoring. Cyclical and value stocks that are already at historically bombed-out levels have started to underperform. This is usually dollar bullish. Whether the correction ensues or the bull market resumes, it will require a change in equity market leadership from defensives to cyclicals for the dollar bear market to resume. Investment Implications It is very difficult to gauge whether the current market shakeout will last just a few more weeks or continue into year-end. Given such a lack of clarity, our strategy is as follows: Stay long safe-haven currencies. Our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Focus on relative value at the crosses rather than outright dollar bets. We are short the NZD/CAD and EUR/GBP as a play on relative fundamentals. Stick with them. We already have limit orders on a few currencies, and are adding the Nordic currency basket to this list if it drops another 2%. We initially took profits on this trade last week, when our stop loss was triggered. As Scandinavian currencies continue to fall, they are becoming more compelling buys. Chart I-20Place Stops On Short GSR At 85 Place Stops On Short GSR At 85 Place Stops On Short GSR At 85 We have been long petrocurrencies versus the euro, and the drop in the EUR/USD has helped hedge that trade against market volatility. That said our stop-loss of -5% was triggered amid market volatility. We are reinstating this trade today, and will be looking to rotate into USD shorts once there is more clarity on the economic front. Our short gold/long silver trade was triggered at 75, putting the position offside. For risk management purposes, we are implementing a tight stop at 85 (Chart I-20).   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies US Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data from the US have been mixed: The current account deficit widened from $111.5 billion to $170.5 billion in Q2. The preliminary Markit Manufacturing PMI increased from 53.1 to 53.5 in September while the services PMI declined from 55 to 54.6. The Michigan Consumer Sentiment Index increased from 74.1 to 78.9 in September. Existing home sales increased by 2.4% month-on-month in August. Initial jobless claims increased by 840K for the week ending on September 19. The DXY index appreciated by 1.8% this week amid an equity market correction. While the risk-off sentiment provides a positive backdrop for the US dollar, rising twin deficits and unfavorable real rates both suggest a weaker dollar in the long term. Meanwhile, any incoming positive news on the vaccine will support cyclical currencies against the US dollar.   Report Links: Addressing Client Questions - September 4, 2020 A Simple Framework For Currencies - July 17, 2020 DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020   The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been mostly generally constructive: The current account surplus narrowed from €20.7 billion to €16.6 billion on a seasonally-adjusted basis in July. While the preliminary Markit Manufacturing PMI increased from 51.7 to 53.7 in September, the services PMI dropped from 50.5 to 47.6. Consumer confidence marginally increased from -14.7 to -13.9 in September. The German Ifo Business Climate index rose to 93.4 in September. The expectations component has broken above pre-pandemic levels. The euro declined by 1.6% this week against the US dollar. The ECB Economic Bulletin released this Thursday warned that the unemployment rate will continue to rise in the euro area as current figures are skewed by job subsides. The ECB also sees little upside in demand for consumer goods and repeated that it is ready to further adjust its policies to support the economy and boost inflation.   Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019   The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan have been positive: The manufacturing PMI was largely unchanged at 47.3 in September. The services PMI ticked up from 45 to 45.6. The All Industry Activity Index increased by 1.3% month-on-month in July. The Japanese yen depreciated by 1% against the US dollar this week. The latest BoJ Monetary Policy Meeting Minutes released on Thursday expects economic activity to pick up in the second half of 2020 through pent-up demand and supported by accommodative monetary policies, but it also warned about a slower recovery in the event of an upturn in COVID cases. Moreover, the Minutes said that core inflation is likely to be negative in Japan for now. Japan’s higher real rates make the yen an attractive safe-haven hedge.   Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020   British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the UK have been mixed: The Markit Manufacturing PMI declined from 55.2 to 54.3 in September. The services PMI also dropped from 58.8 to 55.1. Retail sales increased by 2.8% year-on-year in August. House prices increased by 5% year-on-year in September. The British pound plunged by 1.9% against the US dollar this week amid broad USD strength. Besides global synchronized risks, the internal risk from Brexit uncertainties still poses a big threat to the British pound. That said, the pound is still undervalued at current levels and its year-to-date performance lags behind those of other risky G10 currencies. The pound is poised to rebound with positive vaccine and Brexit news.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019   Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been mostly positive: The manufacturing PMI increased from 53.6 to 55.5 in September. The services PMI also ticked up from 49 to 50. The ANZ Consumer Confidence index increased from 92.4 to 93.5 for the week ending on September 20. Retail sales declined by 4.2% month-on-month in August. The Australian dollar dropped by 4% against the US dollar this week, only slightly above the pre-crisis level. We continue to favor the Australian dollar due to lower domestic COVID cases and effective measures for containing the virus. Moreover, China’s data continues to surprise to the upside, which bodes well for the Australian dollar.    Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019   New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data from New Zealand have been negative: Exports declined from NZ$5 billion to NZ$4.4 billion in August, while imports increased from NZ$4.6 billion to NZ$4.8 billion. The trade balance shifted from a positive NZ$447 million to a deficit of NZ$353 million. The New Zealand dollar plunged by 3.8% against the US dollar this week. On Wednesday, the RBNZ held its interest rate at 0.25%, but warned that the economy needs further support and implied further easing. The rising possibility of negative interest rates in New Zealand would hurt the kiwi especially against the Aussie dollar. Moreover, New Zealand’s services trade surplus evaporated as tourism continues to suffer. We will go long AUD/NZD at 1.05.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019   Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: Retail sales increased by 1.1% month-on-month in August. New housing prices increased by 2.1% year-on-year in August. Bloomberg Nanos Confidence edged up from 52.9 to 53.1 for the week ending on September 18. The Canadian dollar fell by 1.2% against the US dollar this week. Both retail sales and the housing market have been quite resilient so far, providing support for the Canadian dollar. We are long the Canadian dollar against the New Zealand dollar. Stay with it.   Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020   Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There have been scant data from Switzerland this week: Total sight deposit declined from CHF 704.1 billion to CHF 703.9 billion for the week ending on September 18. The Swiss franc fell by 1.4% against the US dollar this week. On Thursday, the SNB kept its interest rate unchanged at -0.75% and warned of a longer coronavirus impact on economic activity. We like the Swiss franc as a safe-haven hedge especially during a second COVID-19 wave. Moreover, if the October US Treasury Report lists Switzerland as a currency manipulator, it will limit downward pressure on the Swiss franc against the US dollar.     Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020   Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is no significant data from Norway this week. The Norwegian krone dropped by 2.8% against the US dollar this week. The Norges Bank held its key policy interest rate on hold at a record low 0% on Thursday, as widely expected, and said no rate hike is likely within two years. That said, with core inflation at 3.7% year-on-year in August, it’s unlikely that the Norges Bank will further lower rates into negative territory. Our NOK/USD and NOK/EUR trades from the long Nordic basket were stopped out last week with profits of 18.4% and 9.5%, respectively. We continue to like the Norwegian krone in the long term.   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 ​​​​​​​ Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 There is no significant data from Sweden this week. The Swedish krona fell by 3.2% against the US dollar this week. On Tuesday, the Riksbank kept its interest rate unchanged at 0% and implied that the rate will likely remain unchanged at least through late 2023. However, the Bank is also ready to further lower the repo rate if necessary. The Swedish krona remains one of our favorite procyclical currencies among the G10 universe supported by its cheap valuation.   Kelly Zhong Research Analyst   Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 ​​​​​​​​​​​​​​ Footnotes Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights While we are bearish on the US dollar in the long run, the greenback is primed for a rebound in the near term. Consistently, commodities prices will relapse and EM currencies will depreciate versus the US dollar. Global growth stocks will correct further because they are overbought/over-owned and expensive. The rest of the equity market will relapse because its fundamentals are poor, especially given the renewed rise in new infection cases across Europe and the US. Feature Global financial markets are in the process of a reset. Several segments have been through very sharp and considerable movements in recent months, and these movements are starting to partially unwind. The US dollar will rebound, commodities prices will correct and global equities will continue selling off. In brief, EM risk assets and currencies are entering a period of weakness, which will eventually lead to buying opportunities. Inter-Linkages Between Fixed-Income, Currencies And Commodities Chart I-1A Reset In US Inflation Expectations And Real Rates Is Overdue A Reset In US Inflation Expectations And Real Rates Is Overdue A Reset In US Inflation Expectations And Real Rates Is Overdue US inflation expectations have risen meaningfully, and US TIPS (real) yields have plummeted since April (Chart I-1). Consistent with plunging US real rates, the US dollar has sold off sharply (Chart I-1, bottom panel). Although our bias is that US inflation will rise in the coming years, for now, the rise in inflation expectations seems excessive. Given the tight correlation between oil prices and US breakeven inflation, as illustrated in the top panel of Chart I-1, lower crude prices will cause a drop in inflation expectations. Moreover, the absence of another large US fiscal stimulus will also lead to a downgrade in growth and inflation expectations. US nominal bond yields will likely remain largely range bound, and a drop in breakeven inflation will lead to higher real yields. The latter will help the US dollar to rebound from oversold levels, and EM currencies will depreciate against the dollar. In turn, a rebound in the greenback will be associated with lower commodities prices. Notably, investors’ net long positions in copper have become very elevated (Chart I-2). Investor sentiment on commodities in general is quite positive. Hence, from a contrarian perspective, commodities prices are primed for a pullback. In addition, Chinese imports of commodities will slow in the near term, reinforcing the correction in resources prices. China has evidently been stockpiling commodities, as its commodities imports have been considerably stronger than its underlying final demand. In particular, Chart I-3 demonstrates that mainland imports of copper, crude oil, steel and iron ore have been surging. Chinese imports of crude and industrial metals are likely to drop temporarily. Chart I-2Long Copper Is A Crowded Trade Long Copper Is A Crowded Trade Long Copper Is A Crowded Trade Chart I-3China Has Been Stockpiling Commodities China Has Been Stockpiling Commodities China Has Been Stockpiling Commodities   China’s booming intake of commodities in recent months was stipulated by the country’s previously depleted commodity inventories, low prices and the availability of cheap bank financing. Granted commodity inventories have been replenished and resource prices are no longer low, Chinese imports of crude and industrial metals are likely to drop temporarily.    That said, from a cyclical perspective, China’s economic recovery will continue, and final demand for resources will expand. Thus, we will see a material correction, not a crash, in commodities prices. EM credit spreads inversely correlate with commodities prices and currencies – EM sovereign and corporate credit spreads are shown as inverted on both panels of Chart I-4. As commodities prices retreat and the US dollar rebounds, EM credit markets will sell off. Chart I-4EM Credit Markets Will Weaken As EM Currencies And Commodities Sell Off EM Credit Markets Will Weaken As EM Currencies And Commodities Sell Off EM Credit Markets Will Weaken As EM Currencies And Commodities Sell Off EM local currency bond yields might slightly back up as EM currencies depreciate and US real yields rebound. However, economic conditions in many EM countries outside China remain extremely weak, and inflation is very subdued. Hence, any back up in EM domestic bond yields will be limited. Bottom Line: While we are bearish on the US dollar in the long run, the greenback is primed for a rebound in the near term. Consistently, commodities prices will relapse and EM currencies will sell off versus the US dollar. Notably, oil prices, as well as several EM and DM currencies, have rolled over at technical levels which typically herald a major reversal (Chart I-5A and I-5B). Chart I-5AFacing A Major Resistance Facing A Major Resistance Facing A Major Resistance Chart I-5BFacing A Major Resistance Facing A Major Resistance Facing A Major Resistance Finally, EM fixed-income markets will experience a correction that will provide a buying opportunity. The Equity Correction: More To Go The correction in global share prices has further to run. Market leaders – growth stocks – remain overbought, and it is reasonable to expect that they will at least retest their 200-day moving averages. Meanwhile, the parts of the global equity universe hardest-hit during March have failed to break above their 200-day moving average. This can be interpreted as an indication that they have not yet entered a bull market. These include: EM ex-TMT1 and global value stocks as well as the US Value Line Geometric Composite Index (Chart I-6). In short, growth stocks will correct further because they are overbought/over-owned and expensive; the rest of the equity market will relapse because its fundamentals are poor, especially given the renewed rise in new infection cases across Europe and the US. Chart I-6These Stocks Have Not Entered A Bull Market Yet These Stocks Have Not Entered A Bull Market Yet These Stocks Have Not Entered A Bull Market Yet Chart I-7Downside Risks To EM Equities Downside Risks To EM Equities Downside Risks To EM Equities In addition, the following indicators also point to further selloff in EM and DM share prices. Our Risk-On / Safe-Haven currency ratio2 has been falling since June and continues pointing to lower EM share prices (Chart I-7). The EM and DM advance-decline lines have relapsed below zero indicating a deteriorating equity market breadth (Chart I-8). This heralds lower stock prices. As EM corporate bond yields rise due to either weaker EM currencies or lower commodities prices, as we argued above, EM share prices will tumble (Chart I-9).      Chart I-8Deteriorating Breadth Points To Lower Share Prices Deteriorating Breadth Points To Lower Share Prices Deteriorating Breadth Points To Lower Share Prices Chart I-9Rising EM Corporate Bond Yields Will Reinforce EM Equity Selloff Rising EM Corporate Bond Yields Will Reinforce EM Equity Selloff Rising EM Corporate Bond Yields Will Reinforce EM Equity Selloff Bottom Line: Global and EM share prices are in a correction that has not run its course. Investment Strategy A meaningful setback in their EM currencies will lead us to recommend switching from receiving long-term rates to buying their cash local currency bonds (taking currency risks as well). EM Domestic Bonds: We continue recommending receiving 10-year swap rates in Mexico, Colombia, Russia, India, China, Korea and Malaysia. A meaningful setback in their EM currencies will lead us to recommend switching from receiving long-term rates to buying their cash local currency bonds (taking currency risks as well). EM Equities: Absolute-return investors should be cautious at the moment as EM share prices are set to deflate further. Within a global equity portfolio, we continue recommending a neutral allocation to EM. Better equity valuations in EM than in the US will be offset by a rebound in the US dollar, warranting a trading range in EM versus DM relative equity performance. Our country equity allocation within the EM universe is always presented at the end of our report (please refer to page 10).   EM Exchange Rates: Even though we expect a meaningful rebound in the nominal broad trade-weighted US dollar, we believe the safe-haven currencies – such as the JPY, CHF and the euro – will outperform EM currencies.  As such, we reiterate our strategy of shorting a basket of EM currencies versus an equally-weighted basket of JPY, CHF and the euro. Our short EM currency basket consists of BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Finally, we recommend a neutral allocation to EM credit markets (US dollar bonds) versus US corporate credit. Absolute-return investors should accumulate this asset class on a weakness.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1Technology, media and telecom stocks excluding information technology (IT) sector before December 2018 and excluding IT, media & entertainment and internet & direct marketing retail as of December 2018 2Average of CAD, AUD, NZD, BRL, IDR, MXN, RUB, CLP & ZAR total return indices relative to average of JPY & CHF; rebased to 100 at January 2000 Equities Recommendations Currencies, Credit And Fixed-Income Recommendations