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Dear Client, In addition to this week’s abbreviated report, we are sending you a Special Report on Bitcoin. I don’t recommend you buy it. Best regards, Peter Berezin Highlights Real government bond yields have increased in recent weeks, which could put further downward pressure on equity prices in the near term. Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. Historically, rising real yields have been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Investors should favor cyclical and value-oriented stocks over defensive and growth-geared plays. Higher Real Yields: A Near-Term Risk For Stocks Chart 1Government Bond Yields Have Increased Since Bottoming Last Year Government Bond Yields Have Increased Since Bottoming Last Year Government Bond Yields Have Increased Since Bottoming Last Year Bond yields have jumped in recent weeks. After bottoming at 0.52% in August, the US 10-year Treasury yield has climbed to 1.54%, up from 0.93% at the beginning of the year. Government bond yields in the other major economies have also risen (Chart 1). While inflation expectations have bounced, the most recent increase in yields has been concentrated in the real component of bond yields (Chart 2). Optimism about a vaccine-led global growth recovery, reinforced by continued fiscal stimulus – especially in the US – has prompted investors to move forward their expectations of how soon and how high policy rates will rise (Chart 3). Chart 2AThe Real Component Has Fueled The Most Recent Rise In Bond Yields (I) The Real Component Has Fueled The Most Recent Rise In Bond Yields (I) The Real Component Has Fueled The Most Recent Rise In Bond Yields (I) Chart 2BThe Real Component Has Fueled The Most Recent Rise In Bond Yields (II) The Real Component Has Fueled The Most Recent Rise In Bond Yields (II) The Real Component Has Fueled The Most Recent Rise In Bond Yields (II) How menacing is the increase in bond yields to stock market investors? Chart 4 shows that there has been a close correlation between real yields and the forward P/E ratio at which the S&P 500 trades. The 5-year/5-year forward real yield, in particular, has moved up sharply, which could put further downward pressure on stocks in the near term. Chart 3Path Of Expected Policy Rates Being Revised Upwards Path Of Expected Policy Rates Being Revised Upwards Path Of Expected Policy Rates Being Revised Upwards Chart 4Rise In Real Rates Is A Headwind For Equity Valuations Rise In Real Rates Is A Headwind For Equity Valuations Rise In Real Rates Is A Headwind For Equity Valuations Nevertheless, we continue to advocate overweighting equities over a 12-month horizon. As we pointed out two weeks ago, rising real yields have historically been most toxic for stocks when yields have increased in response to hawkish central bank rhetoric. This is manifestly not the case today. In his testimony to Congress this week, Jay Powell downplayed inflation risks, stressing that the US economy was “a long way” from the Fed’s goals. He pledged to tread “carefully and patiently” and give “a lot of advance warning” before beginning the process of normalizing monetary policy. We expect the 10-year Treasury yield to stabilize in the 1.6%-to-1.7% range, still well below the level that would threaten the health of the economy. Favor Cyclical And Value-Oriented Stocks In  A Weaker Dollar Environment The Fed’s accommodative stance should limit any near-term upward pressure on the US dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with US trading partners (Chart 5). Since the Fed is unlikely to tighten monetary policy anytime soon, US short-term real rates could fall further as inflation rises.  Chart 5The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials The Dollar Is Sensitive To Changes In Short-Term Real Rate Differentials Chart 6Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar Cyclical Stocks Tend To Benefit The Most From Stronger Global Growth And A Weaker Dollar   Cyclical stocks, which are overrepresented outside the US, tend to benefit the most from strengthening global growth and a weakening dollar (Chart 6). Value stocks also generally do well in a weak dollar-strong growth environment (Chart 7). Moreover, bank shares – which are concentrated in value indices – typically outperform when long-term bond yields are rising (Chart 8). Chart 7AA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (I) Chart 7BA Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II) A Weaker US Dollar And Stronger Global Growth Should Help Value Stocks (II)     Chart 8Bank Shares Typically Excel When Long-Term Bond Yields Are Rising Bank Shares Typically Excel When Long-Term Bond Yields Are Rising Bank Shares Typically Excel When Long-Term Bond Yields Are Rising In contrast, as relatively long-duration assets, growth stocks often struggle when bond yields go up. The same is true for more speculative plays such as cryptocurrencies. In this week’s Special Report, we discuss the fate of Bitcoin, arguing that investors should resist buying it.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com     Global Investment Strategy View Matrix When Good News Is Bad News When Good News Is Bad News Special Trade Recommendations When Good News Is Bad News When Good News Is Bad News Current MacroQuant Model Scores When Good News Is Bad News When Good News Is Bad News

Highlights The price of Bitcoin has surged this year as the digital currency has gained increasing acceptance. Just as was the case with gold, a global financial system built around Bitcoin would be precariously unstable. Bitcoin transactions are expensive to make and slow to execute, making the currency unsuitable as a medium of exchange. Bitcoin miners consume more energy than many countries. ESG funds are likely to shun companies that associate themselves with the currency. Governments, which stand to lose billions of dollars in seigniorage revenue, will put up more obstacles to Bitcoin. As a result, Bitcoin will lose most of its value over time. Bitcoin And Bullion: Back To The Future? Modern banks grew out of the activity of goldsmith guilds during the Middle Ages. Not only did goldsmiths craft beautiful items from precious metals, but because they had to maintain adequate security, they also tended to offer safekeeping services. Chart 1An Inelastic Money Supply Historically Led To More Banking Crises Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem A wealthy merchant who deposited some gold coins with a goldsmith would receive a receipt validating his claim on the coins. Rather than rushing back to the goldsmith to withdraw some coins in order to make a purchase, it became common practice to offer the receipt instead. To facilitate commerce, goldsmiths began to offer receipts for specific values, marking the creation of the first proto-banknotes. On a typical day, only a small fraction of the gold held on deposit would be withdrawn. As long as goldsmiths always had enough gold on hand to meet demand, they could issue notes in excess of the amount of gold that they held in their vaults. Sometimes the goldsmiths would use those additional notes to purchase goods for themselves. Other times, they would lend out the notes, with interest charged to the borrower. The fractional reserve banking system was born. As the fledgling banking system evolved, it became more sophisticated. Nevertheless, it continued to suffer from a fundamental flaw: It was highly vulnerable to self-fulfilling crises. If people began to fear that a bank would run out of gold reserves, they would rush to the bank to be the first to withdraw their funds. Chart 1 shows that bank runs were very common during the 19th century. What Is Bitcoin Good For? Not Much When Bitcoin enthusiasts talk about a world in which global finance is centred on cryptocurrencies, they see the future. Personally, I see the past. John Maynard Keynes famously called the gold standard a barbarous relic. He had a point. A world based on the “Bitcoin standard” would be just as chaotic as the one that was built on the gold standard. Bitcoin’s defenders would argue that the digital currency has advantages that gold, and more importantly, fiat money do not have. But what exactly are those advantages? It certainly is not ease of use. Whereas the Visa network processes nearly 25,000 transactions per second, the Bitcoin mempool, the pool of unconfirmed transactions, has trouble handling five (Chart 2). Bitcoin transactions take 10 minutes to an hour to complete compared to just a few seconds for most debit or credit cards. The average fee for a Bitcoin transaction is around $30 – a number that has been rising over the past year (Chart 3). Chart 2Bitcoin: The Speed Of Transactions, Or Lack Of It Bitcoin: The Speed Of Transactions, Or Lack Of It Bitcoin: The Speed Of Transactions, Or Lack Of It Chart 3Bitcoin: The Cost Per Transaction Is Rising Bitcoin: The Cost Per Transaction Is Rising Bitcoin: The Cost Per Transaction Is Rising Crypto-optimists insist that these impediments will recede over time. However, this is far from certain. Efforts to expedite Bitcoin transactions have run into “fundamental issues.” Markus Brunnermeier and Joseph Abadi have argued that no cryptocurrency can fully satisfy the three desirable properties of decentralization, correctness, and cost-efficiency. Unlike centralized institutions such as banks, blockchain technology works by generating a sort-of consensus among its participants about what constitutes a legitimate transaction. By its nature, the process tends to be very resource-intensive. Bitcoin’s Big Environmental Footprint Chart 4Bitcoin Is Not Your Eco-Currency (I) Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem This raises another problem with Bitcoin: Its environmental impact. A single Bitcoin transaction consumes more than four times as much energy as 100,000 Visa transactions (Chart 4). Bitcoin’s annual electricity consumption now exceeds that of Pakistan and its 217 million inhabitants (Chart 5). The Bitcoin algorithm requires that “miners” solve computationally intensive problems to earn new coins. It should be stressed that the solutions to these problems have no social value. Miners are not solving protein-folding algorithms that are useful for the discovery of new drugs. They are basically wasting CPU cycles by competing with one another to guess extremely large numbers in the hopes of acquiring a shrinking volume of new coins (the total number of Bitcoins that can ever be produced is limited to 21 million). Chart 5Bitcoin Is Not Your Eco-Currency (II) Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem To make matters worse, more than two-thirds of Bitcoin mining takes place in China, where electricity is primarily generated using coal. Companies that claim to be environmentally conscious have no business trafficking in Bitcoin. What Explains The Bitcoin Bubble? Given the seemingly intractable existential problems that Bitcoin faces, why has its price gone through the roof? To some extent, the euphoria over Bitcoin is part of a broader speculative mania that has swept over everything from shares of electric vehicle companies to dubious SPACs and highly shorted “meme stocks.” No commentary about Bitcoin on the internet is complete with an obligatory prediction that it is “going to da moon.” Chart 6Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Lower Spending And Higher Income Led To Mounting Excess Savings Occasionally funny late-night talk show host John Oliver has joked that Bitcoin is “everything you don’t understand about money combined with everything you don’t understand about computers.” When people don’t have a good basis for determining what something is worth, they can let their imaginations run wild, causing prices to become unhinged from reality. Bitcoin and other cryptocurrencies are especially susceptible to feedback loops because they rely on network effects: The more people that use Bitcoin, the more appealing it is for others to use it. PayPal’s decision to let its customers trade Bitcoin on its platform, as well as Tesla’s announcement that it will accept it as payment, have stoked hopes that the digital currency is about to go mainstream. A surfeit of savings has also helped propel Bitcoin. US households accumulated $1.5 trillion in excess savings in 2020, two-thirds of which came from spending less than they normally would (Chart 6). The counterpart to the savings glut is a dearth of high-yielding assets. Bitcoin does not generate any cash flow, but with real rates still in negative territory, the prospect of capital appreciation has been more than enough to compensate investors for that deficiency. Bitcoin: Risks Tilted To The Downside Of course, if the price of Bitcoin were to start trending lower, speculators could flee the currency en masse. And therein lies the problem: If people decide that Bitcoin is not worth much, then it will not be worth much. Chart 7The Uses Of Gold: A Breakdown Bitcoin: A Solution In Search Of A Problem Bitcoin: A Solution In Search Of A Problem One could argue that the same risk plagues gold. There is some truth to this argument, but it should be noted that gold does have alternative uses, most notably jewelry. According to the World Gold Council, jewelry comprised 46% of the above-ground stock of gold at the end of 2020. Private investors held 22% of the gold stock, while central banks held 17% (Chart 7). Bitcoin has absolutely no alternative use to fall back on. Whereas central banks have been willing to hold gold as part of their external reserves, the same courtesy is unlikely to be extended to Bitcoin. The existence of fiat currencies gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin would deprive them of that power. Governments derive significant benefits from the ability of their central banks to create money out of thin air and use it to purchase goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. Bitcoin threatens this stream of revenue. Speaking to The New York Times DealBook conference on Monday, Treasury Secretary Janet Yellen panned Bitcoin: “To the extent it is used I fear it’s often for illicit finance” she said, adding “It’s an extremely inefficient way of conducting transactions, and the amount of energy that’s consumed in processing those transactions is staggering.” Many companies have cozied up to Bitcoin in order to associate themselves with the digital currency’s technological mystique. As ESG funds start to flee Bitcoin, its price will begin a downward spiral. Stay away.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com    

Highlights Market-based geopolitical analysis is about identifying upside as well as downside risk. So far this year upside risks include vaccine efficacy, coordinated monetary and fiscal stimulus, China’s avoidance of over-tightening policy, and Europe’s stable political dynamics. Downside risks include vaccine rollout problems, excessive US stimulus, a Chinese policy mistake, and traditional geopolitical risks in the Taiwan Strait and Persian Gulf. Financial markets may see more turmoil in the near-term over rising bond yields and the dollar bounce. But the macro backdrop is still supportive for this year. We are initiating and reinitiating a handful of trades: EM currencies ex-Brazil/Turkey/Philippines, the BCA rare earth basket, DM-ex-US, and the Trans-Pacific Partnership markets, and global value plays. Feature Chart 1Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Bond Yield Spike Threatens Markets In Near Term Investors hear a lot about geopolitical risk but the implication is always “downside risk.” What about upside risks? Where are politics and geopolitics creating buying opportunities? So far this year, on the positive side, the US fiscal stimulus is overshooting, China is likely to avoid overtightening policy, and Europe’s political dynamics are positive. However, global equity markets are euphoric and much of the good news is priced in. On the negative side, the US stimulus is probably too large. The output gap will be more than closed by the Biden administration’s $1.9 trillion American Rescue Plan yet the Democrats will likely pass a second major bill later this year with a similar amount of net spending, albeit over a longer period of time and including tax hikes. The countertrend bounce in the dollar and rising government bond yields threaten the US and global equity market with a near-term correction. The global stock-to-bond ratio has gone vertical (Chart 1). Meanwhile Biden faces immediate foreign policy tests in the Taiwan Strait and Persian Gulf. These two are traditional geopolitical risks that are once again underrated by investors. The near term is likely to be difficult for investors to navigate. Sentiment is ebullient and likely to suffer some disappointments. In this report we highlight a handful of geopolitical opportunities and offer some new investment recommendations to capitalize on them. Go Long Japan And Stay Long South Korea China’s stimulus and recovery matched by global stimulus and recovery have led to an explosive rise in industrial metals and other China-sensitive assets such as Swedish stocks and the Australian dollar that go into our “China Play Index” (Chart 2). Chart 2China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) China Plays Looking Stretched (For Now) While a near-term pullback in these assets looks likely, tight global supplies will keep prices well-bid. Moreover long-term strategic investment plans by China and the EU to accelerate the technology race and renewable energy are now being joined by American investment plans, a cornerstone of Joe Biden’s emerging national policy program. We are long silver and would buy metals on the dips. Chinese President Xi Jinping’s “new era” policies will be further entrenched at the March National People’s Congress with the fourteenth five-year plan for 2021-25 and Xi’s longer vision for 2035. These policies aim to guide the country through its economic transition from export-manufacturing to domestic demand. They fundamentally favor state-owned enterprises, which are an increasingly necessary tool for the state to control aggregate demand as potential GDP growth declines, while punishing large state-run commercial banks, which are required to serve quasi-fiscal functions and swallow the costs of the transition (Chart 3). Xi Jinping’s decision to promote “dual circulation,” which is fundamentally a turn away from Deng Xiaoping’s opening up and liberal reform to a more self-sufficient policy of import substitution and indigenous innovation, will clash with the Biden administration, which has already flagged China as the US’s “most serious competitor” and is simultaneously seeking to move its supply chains out of China for critical technological, defense, and health goods. Chart 3Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Xi Jinping Leans On The Banks To Save The SOEs Chinese political and geopolitical risks are almost entirely priced out of the market, according to our GeoRisk Indicator, leaving Chinese equities exposed to further downside (Chart 4). Hong Kong equities have traded in line with GeoRisk Indicator for China, which suggests that they also have downside as the market prices in a rising risk premium due to the US’s attempt to galvanize its allies in a great circumvention of China’s economy in the name of democracy versus autocracy. Chart 4China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China/HK Political Risk Priced Out Of Market China has hinted that it will curtail rare earth element exports to the US if the US goes forward with a technological blockade. Biden’s approach, however, is more defensive rather than offensive – focusing on building up domestic and allied semiconductor and supply chain capacity rather than de-sourcing China. President Trump’s restrictions can be rolled back for US designed or manufactured tech goods that are outdated or strictly commercial. Biden will draw the line against American parts going into the People’s Liberation Army. Biden has a chance in March to ease the Commerce Department’s rules implementing Trump’s strictures on Chinese software apps in US markets as a gesture of engagement. Supply constraints and shortages cannot be solved quickly in either semiconductors or rare earths. But both China and the US can circumvent export controls by importing through third parties. The problem for China is that it is easier for the US to start pulling rare earths from the ground than it is for China to make a great leap forward in semiconductor production. Given the US’s reawakening to the need for a domestic industrial policy, strategic public investments, and secure supply chains, we are reinitiating our long rare earth trade, using the BCA rare earth basket, which features producers based outside of China (Chart 5). The renminbi is starting to rolling over, having reached near to the ceiling that it touched in 2017 after Trump’s arrival. There are various factors that drive the currency and there are good macro reasons for the currency to have appreciated in 2016-17 and 2020-21 due to strong government fiscal and monetary reflation. Nevertheless the People’s Bank allowed the currency to appreciate extensively at the beginning of both Trump’s and Biden’s terms and the currency’s momentum is slowing as it nears the 2017 ceiling. We are reluctant to believe the renminbi will go higher as China will not want to overtighten domestic policy but will want to build some leverage against Biden for the forthcoming strategic and economic dialogues. For mainland-dedicated investors we recommend holding Chinese bonds but for international investors we would highlight the likelihood that the renminbi has peaked and geopolitical risk will escalate. There is no substantial change on geopolitical risk in the Taiwan Strait since we wrote about it recently. A full-scale war is a low-probability risk. Much more likely is a diplomatic crisis – a showdown between the US and China over Taiwan’s ability to export tech to the mainland and the level of American support for Taiwan – and potentially a testing of Biden’s will on the cybersecurity, economic security, or maritime security of Taiwan. While it would make sense to stay long emerging markets excluding Taiwan, there is not an attractive profile for staying long emerging markets excluding all of Greater China. Therefore investors who are forced to choose should overweight China relative to Taiwan (Chart 6). Chart 5Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Rare Earth Miners Outside China Can Go Higher Market forces have only begun to register the fact that Taiwan is the epicenter of geopolitical risk in the twenty-first century. The bottleneck for semiconductors and Taiwan’s role as middleman in the trade war have supported Taiwanese stocks. It will take a long time for China, the US, and Europe to develop alternative suppliers for chips. But geopolitical pressures will occasionally spike and when they do Taiwanese equities will plunge (Chart 7). Chart 6EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk EM Investors Need Either China Or Taiwan ... Taiwan Most At Risk South Korean geopolitical risk is also beneath the radar, though stocks have corrected recently and emerging market investors should generally favor Korea, especially over Taiwan. The first risk to Korea is that the US will apply more pressure on Seoul to join allied supply chains and exclude shipments of sensitive goods to China. The second risk is that North Korea – which Biden is deliberately ignoring in his opening speeches – will demand America’s attention through a new series of provocations that will have to be rebuked with credible threats of military force. Chart 7Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Markets Starting To Price Taiwan Strait Geopolitical Risk Chart 8South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North South Korea Favored In EM But Still Faces Risks Over Chips, The North   Chart 9Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door Don't Worry About Japan's Revolving Door The North Korean risk is usually very fleeting for financial markets. The tech risk is more serious but the Biden administration is not seeking to force South Korea to stop trading with China, at least not yet. The US would need to launch a robust, multi-year diplomatic effort to strong-arm its allies and partners into enforcing a chip and tech ban on China. Such an effort would generate a lot of light and heat – shuttle diplomacy, leaks to the press, and public disagreements and posturing. Until this starts to occur, US export controls will be a concern but not an existential threat to South Korea (Chart 8). Japan is the geopolitical winner in Asia Pacific. Japan is militarily secure, has a mutual defense treaty with the US, and stands to benefit from the recovery in global trade and growth. Japan is a beneficiary of a US-driven tech shift away from excess dependency on China and is heavily invested in Southeast Asia, which stands to pick up manufacturing share. Higher bond yields and inflation expectations will detract from growth stocks more than value stocks, and value stocks have a larger market-cap weight in European and Japanese equity markets. Japanese politics are not a significant risk despite a looming election. While Prime Minister Yoshihide Suga is unpopular and likely to revive the long tradition of a “revolving door” of short-lived prime ministers, and while the Liberal Democratic Party will lose the super-majorities it held under Shinzo Abe, nevertheless the party remains dominant and the national policy consensus is behind Abe’s platform of pro-growth reforms, coordinated dovish monetary and fiscal policy, and greater openness to trade and immigration (Chart 9). Favor EU And UK Over Russia And Eastern Europe Russian geopolitical risk appears to be rolling over according to our indicator but we disagree with the market’s assessment and expect it to escalate again soon (Chart 10). Not only will Russian social unrest continue to escalate but also the Biden administration will put greater pressure on Russia that will keep foreign investors wary. Chart 10Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over Russia Geopolitical Risk Will Not Roll Over While geopolitics thus poses a risk to Russian equities – which are fairly well correlated (inversely) with our GeoRisk indicator – nevertheless they are already cheap and stand to benefit from the rise in global commodity prices and liquidity. Russia is also easing fiscal policy to try to quiet domestic unrest. The pound and the euro today are higher against the ruble than at any time since the invasion of Ukraine. It is possible that Russia will opt for outward aggressiveness amidst domestic discontent, a weak and relapsing approval rating for Vladimir Putin and his government, and the Biden administration’s avowed intention to prioritize democracy promotion, including in Ukraine and Belarus (Chart 11). The ruble will fall on US punitive actions but ultimately there is limited downside, at least as long as the commodity upcycle continues. Chart 11Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Ruble Can Fall But Probably Not Far Biden stated in his second major foreign policy speech, “we will not hesitate to raise the cost on Russia.” There are two areas where the Biden administration could surprise financial markets: pipelines and Russian bonds. Biden could suddenly adopt a hard line on the Nordstream 2 pipeline between Russia and Germany, preventing it from completion. This would require Biden to ask the Germans to put their money where their mouths are when it comes to trans-Atlantic solidarity. Biden is keen to restore relations with Germany, and is halting the withdrawal of US troops from there, but pressuring Germany on Russia is possible given that it lies in the US interest and Biden has vowed to push back against Russia’s aggressive regional actions and interference in American affairs. The US imposed sanctions on Russian “Eurobonds” under the Chemical and Biological Weapons Control and Warfare Elimination Act of 1991 (CBW Act) in the wake of Russia’s poisoning of secret agent Sergei Skripal in the UK in 2018. Non-ruble bank loans and non-ruble-denominated Russian bonds in primary markets were penalized, which at the time accounted for about 23% of Russian sovereign bonds. This left ruble-denominated sovereign bonds to be sold along with non-ruble bonds in secondary markets. The Biden administration views Russia’s poisoning of opposition leader Alexei Navalny as a similar infraction and will likely retaliate. The Defending American Security from Kremlin Aggression Act is not yet law but passed through a Senate committee vote in 2019 and proposed to halt most purchases of Russian sovereign debt and broaden sanctions on energy projects and Kremlin officials. Biden is also eager to retaliate for the large SolarWinds hack that Russia is accused of conducting throughout 2020. Cybersecurity stocks are an obvious geopolitical trade in contemporary times. Authoritarian nations have benefited from the use of cyber attacks, disinformation, and other asymmetric warfare tactics. The US has shown that it does not have the appetite to fight small wars, like over Ukraine or the South China Sea, whereas the US remains untested on the question of major wars. This incentivize incremental aggression and actions with plausible deniability like cyber. Therefore the huge run-up in cyber stocks is well-supported and will continue. The world’s growing dependency on technology during the pandemic lockdowns heightened the need for cybersecurity measures but the COVID winners are giving way to COVID losers as the pandemic subsides and normal economic activity resumes. Traditional defense stocks stand to benefit relative to cyber stocks as the secular trend of struggle among the Great Powers continues (Chart 12). Specifically a new cycle of territorial competition will revive military tensions as commodity prices rise. Chart 12Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber Back To Work' Trade: Long Defense Versus Cyber By contrast with Russia, western Europe is a prime beneficiary of the current environment. Like Japan, Europe is an industrial, trade-surplus economy that benefits from global trade and growth. It benefits as the geopolitical middleman between the US and its rivals, China and Russia, especially as long as the Biden administration pursues consultation and multilateralism and hesitates to force the Europeans into confrontational postures against these powers. Chart 13Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Political Risk Still Subsiding In Continental Europe Meanwhile Russia and especially China need to court Europe now that the Biden administration is using diplomacy to try to galvanize a western bloc. China looks to substitute European goods for American goods and open up its market to European investors to reduce European complaints of protectionism. European domestic politics will become more interesting over the coming year, with German and French elections, but the risks are low. The rise of a centrist coalition in Italy under Mario Draghi highlights how overstated European political risk really is. In the Netherlands, Mark Rutte’s center-right party is expected to remain in power in March elections based on opinion polling, despite serious corruption scandals and COVID blowback. In Germany, Angela Merkel’s center-right party is also favored, and yet an upset would energize financial markets because it would result in a more fiscally accommodative and pro-EU policy (Chart 13). The takeaway is that there is limit to how far emerging European countries can outperform developed Europe, given the immediate geopolitical risk emanating from Russia that can spill over into eastern Europe (Chart 14). Developed European stocks are at peak levels, comparable to the period of Ukraine’s election, but Ukraine is about to heat up again as a battleground between Russia and the West, as will other peripheral states. Chart 14Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Favor DM Europe Over EM Europe Chart 15GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May GBP: Watch For Scottish Risk Revival In May Finally, in the UK, the pound continues to surge in the wake of the settlement of a post-Brexit trade deal, notwithstanding lingering disagreements over vaccines, financial services, and other technicalities. British equities are a value play that can make up lost ground from the tumultuous Brexit years. There is potentially one more episode of instability, however, arising from the unfinished business in Scotland, where the Scottish National Party wants to convert any victory in parliamentary elections in May into a second push for a referendum on national independence. At the moment public opinion polls suggest that Prime Minister Boris Johnson’s achievement of an EU trade deal has taken the wind out of the sails of the independence movement but only the election will tell whether this political risk will continue to fall in the near term (Chart 15). Hence the pound’s rally could be curtailed in the near term but unless Scottish opinion changes direction the pound and UK domestic-oriented stocks will perform well. Short EM Strongmen Throughout the emerging world the rise of the “Misery Index” – unemployment combined with inflation – poses a persistent danger of social and political instability that will rise, not fall, in the coming years. The aftermath of the COVID crisis will be rocky once stimulus measures wane. South Africa, Turkey, and Brazil look the worst on these measures but India and Russia are also vulnerable (Chart 16). Brazilian geopolitical risk under the turbulent administration of President Jair Bolsonaro has returned to the 2015-16 peaks witnessed during the impeachment of President Dilma Rousseff amid the harsh recession of the middle of the last decade. Brazilian equities are nearing a triple bottom, which could present a buying opportunity but not before the current political crisis over fiscal policy exacts a toll on the currency and stock market (Chart 17). Chart 16EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises EM Political Risk Will Bring Bad Surprises Chart 17Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Brazil Risk Hits Impeachment Peaks On Bolso Fiscal Populism Bolsonaro’s signature pension reform was an unpopular measure whose benefits were devastated by the pandemic. The return to fiscal largesse in the face of the crisis boosted Bolsonaro’s support and convinced him to abandon the pretense of austere reformer in favor of traditional Brazilian fiscal populist as the 2022 election approaches. His attempt to violate the country’s fiscal rule – a constitutional provision passed in December 2016 that imposes a 20-year cap on public spending growth – that limits budget deficits is precipitating a shakeup within the ruling coalition. Our Emerging Market Strategists believe the Central Bank of Brazil will hike interest rates to offset the inflationary impact of breaking the fiscal cap but that the hikes will likely fall short, prompting a bond selloff and renewed fears of a public debt crisis. The country’s political crisis will escalate in the lead up to elections, not unlike what occurred in the US, raising the odds of other negative political surprises. Chart 18Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil Reinitiate Long Mexico / Short Brazil While Latin America as a whole is a shambles, the global cyclical upturn and shift in American policy creates investment opportunities – particularly for Mexico, at least within the region. Investors should continue to prefer Mexican equities over Brazilian given Mexico’s fundamentally more stable economic policy backdrop and its proximity to the American economy, which will be supercharged with stimulus and eager to find ways to use its new trade deal with Mexico to diversify its manufacturing suppliers away from China (Chart 18). In addition to Brazil, Turkey and the Philippines are also markets where “strongman leaders” and populism have undercut economic orthodoxy and currency stability. A basket of emerging market currencies that excludes these three witnessed a major bottom in 2014-16, when Turkish and Brazilian political instability erupted and when President Rodrigo Duterte stormed the stage in the Philippines. These three currencies look to continue underperforming given that political dynamics will worsen ahead of elections in 2022 (possibly 2023 for Turkey) (Chart 19). Chart 19Keep Shorting The Strongmen Keep Shorting The Strongmen Keep Shorting The Strongmen Investment Takeaways We closed out some “risk-on” trades at the end of January – admittedly too soon – and since then have hedged our pro-cyclical strategic portfolio with safe-haven assets, while continuing to add risk-on trades where appropriate. The Biden administration still faces one or more major foreign policy tests that can prove disruptive, particularly to Taiwanese, Chinese, Russian, and Saudi stocks. Biden’s foreign policy doctrine will be established in the crucible of experience but his preferences are known to favor diplomacy, democracy over autocracy, and to pursue alliances as a means of diversifying supply chains away from China. We will therefore look favorably upon the members of the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) and recommend investors reinitiate the long CPTPP equities basket. These countries, which include emerging markets with decent governance as well as Japan, Australia, New Zealand, and Canada all stand to benefit from the global upswing and US foreign policy (Chart 20). Chart 20Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Reinitiate Long Trans-Pacific Partnership Chart 21Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth Reinitiate Long Global Value Over Growth The Biden administration will likely try to rejoin the CPTPP but even if it fails to do so it will privilege relations with these countries as it strives to counter China and Russia. The UK, South Korea, Thailand and others could join the CPTPP over time – though an attempt to recruit Taiwan would exacerbate the geopolitical risks highlighted above centered on Taiwan. The dollar is perking up, adding a near-term headwind to global equities, but the cyclical trend for the dollar is still down due to extreme monetary and fiscal dovishness. Tactically, go long Mexican equities over Brazilian equities. From a strategic point of view we still favor value stocks over growth stocks and recommend investors reinitiate this global trade (Chart 21). Strategically, wait to overweight UK stocks in a global portfolio until the result of the May local elections is known and the risk of Scottish independence can be reassessed. Strategically, favor developed Europe over emerging Europe stocks as a result of Russian geopolitical risks that are set to escalate. Strategically go long global defense stocks versus cyber security stocks as a geopolitical “back to work” trade for a time when economic activity resumes and resource-oriented territorial, kinetic, military risks reawaken. Strategically, favor EM currencies other than Brazil, Turkey, and the Philippines to minimize exposure to economic populism, poor macro fundamentals, and election risk. Strategically, go long the BCA Rare Earths Basket to capture persistent US-China tensions under Biden and the search for alternatives to China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Supply-Side Structural Reform Supply-Side Structural Reform, a compilation of Chinese economic and policy research, discusses several aspects of Chinese economic reform as it is practiced under the Xi Jinping administration, spanning the meaning and importance of supply-side structural reform in China as well as five major tasks.1 The book consists of contributions by Chinese scholars, financial analysts, and opinion makers in 2015, so we have learned a lot since it was published, even as it sheds light on Beijing’s interpretation of reform. 2015 was a year of financial turmoil that saw a dramatic setback for China’s 2013 liberal reform blueprint. It also saw the launch of a new round of reforms under the thirteenth Five Year Plan (2016-20), which aimed to push China further down the transition from export-manufacturing to domestic and consumer-led growth. Beijing’s renewed reform push in 2017, which included a now infamous “deleveraging campaign,” ultimately led to a global slowdown in 2018-19 that was fatefully exacerbated by the trade war with the United States – only to be eclipsed by the COVID-19 pandemic in 2020. Built on fundamental economic theory and the social background of China, the book’s authors examine the impact of supply-side reform on the Chinese financial sector, industrial sector, and macroeconomic development. The comprehensive analysis covers short-term, mid-term and long-term effects. From the perspective of economic theory, there is consensus that China's supply-side structural reform framework did not forsake government support for the demand side of the economy, nor was it synonymous with traditional, liberal supply-side economics in the Western world. In contrast to Say’s Law, Reaganomics, and the UK’s Thatcherite privatization reforms, China's supply-side reform was concentrated on five tasks specific to its contemporary situation: cutting excessive industrial capacity, de-stocking, deleveraging, cutting corporate costs, and improving various structural “weaknesses.” The motives behind the new framework were to enhance the mobility and efficiency of productive factors, eliminate excess capacity, and balance effective supply with effective demand. Basically, if China cannot improve efficiencies, capital will be misallocated, corporations will operate at a loss, and the economy’s potential will worsen over the long run. The debt buildup will accelerate and productivity will suffer. Regarding implementation, the book sets forth several related policies, including deepening the reform of land use and the household registration (hukou) system, and accelerating urbanization, which are effective measures to increase the liquidity of productive factors. Others promote the transformation from a factor-driven economy to efficiency and innovation-driven economy, including improving the property rights system, transferring corporate and local government debt to the central government, and encouraging investment in human capital and in technological innovation. The book also analyzes and predicts the potential costs of reform on the economy in the short and long term. In the short run, authors generally anticipated that deleveraging and cutting excessive industrial capacity would put more pressure on the government’s fiscal budget. The rise in the unemployment rate, cases of bankruptcy, and the negative sentiment of investors would slow China’s economic growth. In the medium and long run, this structural reform was seen as necessary for a sustainable medium-speed economic growth, leading to more positive expectations for households and corporates. The improved efficiency in capital allocation would provide investors with more confidence in the Chinese economy and asset market. Authors argued that overall credit risk was still controllable in near-term, as the corresponding policies such as tax reduction and urbanization would boost private investment and consumption in the short run. These policies increased demand in the labor market and created working positions to counteract adverse impacts. Employment in industries where excessive capacity was most severe only accounted for about 3% of total urban employment in 2013. Regarding the rise in credit risk during de-capacity, the asset quality of banks had improved since the 1990s and the level of bad debt was said to be within a controllable range, given government support. Moreover, in the long run, the merger and reorganization of enterprises would increase the efficient supply and have a positive effect on economic innovation-driven transformation. We know from experience that much of the optimism about reform would confront harsh realities in the 2016-21 period. The reforms proceeded in a halting fashion as the US trade war interrupted their implementation, prompting the government to resort to traditional stimulus measures in mid-2018, only to be followed by another massive fiscal-and-credit splurge in 2020 in the face of the pandemic. Yet investors could be surprised to find that the Politburo meeting on April 17, 2020 proclaimed that China would continue to focus on supply-side structural reform even amid efforts to normalize the economy and maintain epidemic prevention and control. Leaders also pledged to maintain the supply-side reform while emphasizing demand-side management during annual Central Economic Work Conference in December 2020. In other words, Xi administration’s policy preferences remain set, and compromises forced by exogenous events will soon give way to renewed reform initiatives. This is a risk to the global reflation trade in 2021-22. There has not been a total abandonment of supply-side reform. The main idea of demand-side reform – shifts in the way China’s government stimulates the economy – is to fully tap the potential of the domestic market and call for an expansion of consumption and effective investment. Combined with the new concept of “dual circulation,” which emphasizes domestic production and supply chains (effectively import substitution), the current demand-side reforms fall in line with the supply-side goal of building a more independent and controllable supply chain and produce higher technology products. These combined efforts will provide “New China” sectors with more policy support, less regulatory constraint, and lead to better economic and financial market performance. Despite the fluctuations in domestic growth and the pressure from external demand, China will maintain the focus on reform in its long-term planning. The fundamental motivation is to enhance efficiency and innovation that is essential for China’s productivity and competitiveness in the future. Thus, investors should not become complacent over the vast wave of fiscal and credit stimulus that is peaking today as we go to press. Instead they should recognize that China’s leaders are committed to restructuring. This means that the economic upside of stimulus has a cap on it– a cap that will eventually be put in place by policymakers, if not by China’s lower capacity for debt itself. It would be a colossal policy mistake for China to overtighten monetary and fiscal policy in 2021 but any government attempts to tighten, the financial market will become vulnerable. A final thought: it is unclear whether there is potential for an improvement in China’s foreign relations contained in this conclusion. What the western world is demanding is for China to rebalance its economy, open up its markets, cut back on the pace of technological acquisition, reduce government subsidies for state-owned companies, and conform better to US and EU trade rules. There is zero chance that China will provide all of these things. But its own reform program calls for greater intellectual property protections, greater competition in non-strategic sectors (which the US and EU should be able to access under recent trade deals), and targeted stimulus for sustainable energy, where the US and EU see trade and investment opportunities. Thus there is a basis for an improvement in cooperation. What remains to be seen is how protectionist dual circulation will be in practice and how aggressively the US will pursue international enforcement of technological restrictions on China under the Biden administration. Jingnan Liu Research Associate JingnanL@bcaresearch.com Footnotes 1 Yifu L, et al. Supply-Side Structural Reform (Beijing: Democracy & Construction Publishing House, 2016). 351 pages. Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising US Goods Prices Are Rising US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection US Markets Are Priced To Perfection US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative. Looking ahead, stock prices will fall when US bond yields rise and will rally when Treasury yields drop. The basis is that the key macro risk to equities is shifting from low inflation/deflation to higher inflation. Global growth stocks will underperform value stocks. US equities will lag international markets. Investment strategies and frameworks that have worked over the past 24 years might require modifications. Feature From 1966 until 1997, US equity prices were negatively correlated with US Treasury yields (Chart 1, top panel). Since 1997, US share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship. Chart 1US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 US Stock-Bond Correlation: Paradigm Shifts In 1966 And 1997 The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian currency devaluation of 1997. The latter followed the Chinese currency devaluations of early 1994 and the Mexican peso’s crash of early 1995 (Chart 2). All these currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world, including the US. US import prices from emerging Asia ex-China began plummeting in 1997 (Chart 3). Chart 2EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s EM Currency Devaluations Set Off A Deflation Shock In Second Half Of 1990s Chart 3Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Deflating Asian Export Prices Reinforced Disinflation Trends In US Due to this deflationary shock from EM currency devaluations and other forces (productivity gains, globalization and outsourcing, among others), the US core inflation rate dropped to 2% in 1997 (Chart 3). This marked a regime shift in global equity markets where concerns about deflation, rather than inflation, became the prime focus of investors. Consequently, share prices rallied when bond yields rose, i.e., stock investors cheered stronger growth because the latter meant diminished deflation risks and only a modest inflation pickup.   The positive relationship also prevailed in the period prior to the mid-1960s when inflation was below 2% (Chart 1). Looking ahead, the main risk to share prices, at least in the US, will be higher inflation. As investors gain confidence that US core inflation will exceed 2%, US share prices will once again exhibit a negative correlation with Treasury yields, as they did prior to 1997. Inflation Redux Odds are that US core inflation will rise well above 2%, and could potentially overshoot, over the coming 12-36 months. Chart 4US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months US Core Inflation Lags Business Cycle By About 12 Months Cyclical factors driving core inflation higher in the US are as follows: 1. Core inflation lags the business cycle by about 12 months (Chart 4). A continuous economic recovery points to higher core inflation starting this spring. 2. A combination of surging money supply and a potential revival in the velocity of money heralds higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 5. In the Special Report from October 22, BCA’s Emerging Markets team discussed in depth why US money growth is currently substantially stronger than it was in the post-GFC period. Chart 5An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom An Unprecedented US Broad Money Boom With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed (genuine public debt monetization), the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we arrive at: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 6). Chart 6As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate As Velocity Of Money Rises, Inflation Will Accelerate Chart 7US Goods Prices Are Rising US Goods Prices Are Rising US Goods Prices Are Rising 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has, accordingly, produced shortages. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia, China and Mexico are rising (Chart 7). Lockdowns will likely permanently curtail capacity in some service sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services. As a result, demand for some services will overwhelm supply and companies will take advantage of this new reality by charging considerably higher prices. Consumers will not mind paying higher prices to enjoy services that were not available to them for 18 months or so. This will lead to higher inflation expectations, which might become engrained. Critically, this could happen even if the unemployment rate is high or the output gap is large. 4. Pandemic-related fiscal stimulus in the US has amounted to 21% of GDP. We reckon this exceeds the lingering output gap that opened up in response to the economic crash last year. In short, US authorities are over-stimulating. On top of cyclical forces, there are several structural forces pointing to higher inflation: Higher concentration in US industries and the consequent reduction in competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed: it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulations, large companies have acquired smaller competitors. Chart 8 shows the number of anti-trust enforcement cases has been in a secular decline and is currently very low. In the recent past, there were slightly more than 100 cases per annum while the 1970s averaged more than 400 cases per annum when the economy was much smaller and industry concentration was much lower than now. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases where conditions permit. Chart 9 demonstrates a measure of market concentration across all US industries. A higher number indicates higher industry concentration. Presently, we have the highest concentration in 50 years, which creates fertile ground for companies to raise their prices. Notably, the sharp drop in this measure of market concentration in the early 1980s was one of reasons behind the secular disinflation trend that followed. Chart 8In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US In Past 20 Years Antitrust Regulations Have Not Been Reinforced In US Chart 9US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High US Industry Concentration Is At A Record High Chart 10US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation US Demographic Points Towards Higher Wage Inflation   Retirement of baby boomers entails more consumption and less production and is inflationary, ceteris paribus. The US support ratio1 (shown inverted on the chart) portends that the US is transitioning from an environment of low to higher wage growth (Chart 10). This ratio is calculated as the number of workers relative to consumers. This means more consumers exist versus workers available to produce goods and services and, hence, entails higher wages. Higher employee compensation, unless supported by rapid productivity gains, will beget higher inflation.   Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will be jeopardized. Businesses will attempt to raise prices to restore their profit margins. Provided that income and spending are robust, companies might succeed in raising their prices. In the US, a (moderate) wage-inflation spiral is probable in the coming years.   De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. US import prices are already rising (Chart 7 above). If the US dollar continues to depreciate, exporters to the US will have no other choice but to raise US dollar prices to protect their profit margins. Bottom Line: The US core inflation rate will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite rising wages. An Invincible Fed? Many investors are relying on the Fed and other central banks to get things right. Yet, policymakers are not always infallible. We offer several reasons why putting one’s faith squarely in the Fed at present might not be the most appropriate investment strategy.   It is not unusual for central banks and other government agencies to fight previous wars. As long as the same war lingers, the Fed’s vision and strategy will remain adequate and its policies and actions will secure financial and economic stability, to the benefit of both bond and equity markets. Chart 11US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility US Financial Markets Aggregate Volatility However, if we are experiencing a macro paradigm shift from low to higher inflation, the Fed’s strategy and actions will likely prove inadequate, begetting higher financial market volatility, i.e., instability (Chart 11). In brief, if our inflation redux thesis is correct, the Fed will fall behind the inflation curve. In such a scenario, the bond market will continue selling off and rising yields will depress equity valuations.   The Fed is excessively and singularly relying on the output gap models and the Phillips curve to forecast inflation. Yet, inflation is a complex and intricate phenomenon, and it is shaped by numerous cyclical and structural forces beyond the output gap and unemployment. Importantly, the output gap and the Phillip’s curve are theoretical models that do not have great success in real-time forecasting. If these models turn out to be wrong, policy decisions will be suboptimal. Financial markets, which up until now have put their faith in the Fed, will riot. Chart 12Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Inflation Could Rise And Stay High Amid High Unemployment Interestingly, a popular economic index in the 1970s was the Misery Index, which is calculated as the sum of the inflation rate and the unemployment rate (Chart 12, top panel). The Misery Index was extremely elevated in the 1970s because both unemployment and inflation were high (Chart 12, bottom panel). The point is that inflation can be high alongside elevated unemployment. In its recent report, BCA Research’s Global Investment Strategy service argued: “Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies. They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand.”   Inflation is a very inert and persistent phenomenon, and it is not easy to reverse its trajectory. The Fed is now explicitly targeting higher inflation with full confidence that it can easily deal with high inflation when it transpires. We would bet that the Fed will get higher inflation this time, but that high inflation will turn out to be an unpleasant outcome for US policymakers. The basis is that US equity and credit markets are not priced for higher interest rates. By directly and indirectly super-charging equity and bond prices, the Fed has crafted excesses that are vulnerable to higher interest rates (Chart 13). Chart 13US Markets Are Priced To Perfection US Markets Are Priced To Perfection US Markets Are Priced To Perfection On the whole, the Fed is set to fall behind the inflation curve as policymakers will be late to acknowledge higher inflation and alter their policy accordingly. This will be bad news for both equity and corporate bond markets that are priced for perfection. The 1960s Roadmap For Financial Markets? There are many similarities between the US macro picture now and as it was in the late 1960s. In the late 1960s: US inflation was subdued, and interest rates were very low in the preceding two-three decades, i.e., inflation expectations were well anchored heading into the second half of the 1960s. America’s fiscal policy was extremely easy, and the budget deficit was swelling. US domestic demand was robust, and the current account deficit was widening. Chart 14FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s FAANGM Now And Nifty-Fifty Mania In The 1960s Finally, US equities were in a long bull market and a dozen large-cap stocks (the Nifty-Fifty) was leading the rally. Notably, the decade-long profile of FAANGM2 stock prices in real terms (adjusted for inflation) resembles that of Walt Disney – one of the leaders of the Nifty-Fifty pack – in the 1960s (Chart 14). The following dynamics of financial markets in the 1960s and 1970s are noteworthy and could serve as a roadmap for the present: In the mid-1960s, US share prices initially ignored rising bond yields. However, obstinately rising Treasury yields eventually led to a major equity sell-off (bond yields are shown inverted on this panel) (Chart 15, top panel). Yet, bond yields continued ascending despite plunging share prices. Chart 151962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation 1962-1974: Stock Prices, Bond Yields, Business Cycle And Inflation The culprit was US core inflation surging well above 2% in 1966. This marked a paradigm shift in the relationship between equity prices and US Treasury yields. Share prices bottomed in late 1966 only after bond yields began declining. Notably, the S&P 500 fell by 22% in 1966, even though economic growth remained robust (Chart 15, middle panel). Critically, US bond yields in the period from 1966 until the early 1980s were more correlated with the core inflation rate than with the business cycle (Chart 15, middle and bottom panels). In short, sticky and persistent inflation not economic growth was the main worry for both US bond and stock markets from the mid-1960s until the early-1980s.  Presently, the US recovery will continue, and economic growth will be rather robust. However, core inflation will climb well above 2% and US Treasury yields will increase further. At some point, this will upset the equity market. Chart 16US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated US And EM EPS Growth Expectations Are Already Very Elevated A pertinent question for stocks from a valuation standpoint is whether profit growth expectations can continue to increase enough to offset the rise in the discount factor. US equities are already pricing in a lot of earning growth: analysts’ expectations for the S&P 500’s EPS growth are 24% for 2021 and another 15% for 2022. Worth noting is that long-term EPS growth expectations have skyrocketed for both US and EM equities (Chart 16). In short, the main problem with US equities is that their valuations are expensive at a time when inflation and interest rates are set to rise. Investment Strategy The equity rally is entering a risky period. Major shakeouts are likely. Share prices will advance when US bond yields drop, and they will dip when Treasury yields ascend. As and when US share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind. However, financial markets will resume selling off if evidence from the real economy corroborates the thesis of higher inflation. The Fed will again soothe the investment community. Although equity and bond prices might firm up anew, such a rebound might not last long as investors will begin to question the appropriateness of the Fed’s policy. Chart 17No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys No Contrarian Buy Signal For US Treasurys The sell-off in US Treasurys is unlikely to be over for now as traders’ sentiment on government bonds is far from a bearish extreme (Chart 17). Ultimately, to cap inflation, the Fed will have to hike interest rates more than the fixed-income market is currently pricing. This will not go down well with stock or bond markets. Higher US bond yields entail that global growth stocks will underperform global value stocks. The former is much more expensive and, hence, is more vulnerable to a rising discount rate. Global equity portfolios should underweight the US, adopt a neutral stance on EM and overweight Europe and Japan. The market-cap weight of growth stocks is the highest in the US followed by EM. European and Japanese bourses are less vulnerable to rising bond yields. The Fed falling behind the inflation curve is fundamentally bearish for the US dollar. That is why the primary trend for the dollar remains down. However, the greenback is very oversold and a rebound is likely, especially if US yields continue to rise, triggering a period of risk-off in global financial markets.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1This measure was originally shown by BCA’s Global Investment Strategy team and is calculated as the ratio of the number of workers to the number of consumers. The number of workers incorporates age-specific variation in labor force participation, unemployment, hours worked, and productivity while the number of consumers incorporates age-specific variation in needs or wants based on age-specific consumption data. 2An equally-weighted index of Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft stock prices.    

Highlights The multiple paid for oil sector profits is collapsing because the market fears that the profits slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility, but an existential fear for fossil-fuelled road transportation in the post-pandemic world. Stay structurally underweight oil and gas. Within the cyclical and value segments of the equity market, overweight metals and miners versus oil and gas. Structurally underweight the stock markets of Norway and the UK which are oil and gas heavy. Structurally overweight the stock markets of Germany, Switzerland, and Denmark which have zero exposure to oil and gas or basic resources. Fractal trade: tin’s near-vertical rally is at high risk of correction. Feature Chart of the WeekOil Production Has Gone Nowhere Oil Production Has Gone Nowhere Oil Production Has Gone Nowhere The Brent crude oil price recently hit $65, not far below its pre-pandemic level of $69. Yet in the stock market, oil and gas equities remain the dogs, languishing 32 percent below their pre-pandemic price level. Relative to the market, the oil and gas sector has underperformed by 42 percent, and the underperformance has been almost a straight line down. Moreover, since last June when the crude oil price has risen by 50 percent, oil and gas equity prices have gone nowhere. This massive divergence of a surging crude oil price from slumping oil and gas equities raises the obvious question, what can explain this dichotomy? (Chart I-2 and Chart I-3) Chart I-2Oil And Gas Equities Have Slumped In Absolute Terms... Oil And Gas Equities Have Slumped In Absolute Terms... Oil And Gas Equities Have Slumped In Absolute Terms... Chart I-3...And In Relative ##br##Terms ...And In Relative Terms ...And In Relative Terms One apparent puzzle is that the oil sector’s profits have underperformed their established relationship with the crude oil price. In fact, there is no puzzle. The oil sector’s profits might appear to track the oil price, but the reality is that profits track the value of oil production, meaning the product of oil production and the oil price. Clearly though, if output is flat, then profits will appear to track the oil price.  But as it took a massive cut in oil output to support the oil price, the value of oil production and therefore, the oil sector’s profits, have significantly underperformed the oil price. Put another way, if you need to cut output to boost the commodity price it might help the commodity price, but it doesn’t much help the equity sector’s profits! (Chart I-4 and Chart I-5). Chart I-4Oil And Gas Profits Appear To Track The Oil Price Oil And Gas Profits Appear To Track The Oil Price Oil And Gas Profits Appear To Track The Oil Price Chart I-5In Reality, Oil And Gas Profits Track The Value Of Oil Output In Reality, Oil And Gas Profits Track The Value Of Oil Output In Reality, Oil And Gas Profits Track The Value Of Oil Output Will Fossil-Fuelled Road Transportation Be Driven To Extinction? We can now explain the 42 percent underperformance of oil equities, and perhaps more importantly, forecast what will happen next. When the pandemic took hold, and economic mobility ground to a halt, the oil sector’s 12-month forward profits slumped. Bear in mind that aviation accounts for 8 percent of oil consumption but, more crucially, road transportation accounts for half of all oil consumption. However, as the pandemic’s impact was expected to be short-lived, the multiple paid for those depressed 12-month forward profits rose. This partly compensated for the profit slump, but still left oil equity prices much lower. The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. When profits started to recover – albeit, as just discussed, by much less than the oil price rise – it should have boosted oil equity prices. The problem was that the multiple paid for those profits fell by much more than the recovery in profits, with the result that oil equities continued to underperform. Begging the question, why is the multiple paid for oil sector profits collapsing? (Chart I-6) Chart I-6Why Is The Multiple Paid For Oil Sector Profits Collapsing? Why Is The Multiple Paid For Oil Sector Profits Collapsing? Why Is The Multiple Paid For Oil Sector Profits Collapsing? The multiple paid for oil sector profits is collapsing because the market fears that the profit slump will not be short-lived. The fear is not just of a lasting hit to aviation and a slower recovery in road mobility. The fear has become existential. Governments’ plans for pandemic stimulus and recovery have put green energy at front and centre stage. Thereby the recovery has fast-tracked the ultimate nemesis of the oil industry – the extinction of fossil-fuelled road transportation. Are the fears for oil consumption justified? Yes. Aviation is not likely to reach its pre-pandemic level of oil consumption for many years, and long-haul aviation may never get there. But the much bigger threat is fossil-fuelled road transportation. From October 2021, London will extend its Ultra Low Emission Zone (ULEZ) to an 8 mile radius from the city centre.1 The effect will be to banish from London all diesel-fuelled vehicles made before 2015 as well as some older petrol-fuelled vehicles. We expect other major cities to follow London’s example. In most cases, this initiative will happen regardless of the success (or not) of electric vehicles (EVs). Combined with other green initiatives around the world, policymakers’ unashamed aim is to drive fossil-fuelled road transportation to extinction. To repeat, road transportation accounts for half of all oil consumption. The upshot is that the structural downtrend in oil consumption will persist unless the shift away from fossil-fuelled road transportation hits a brick wall, or at least a bottleneck. We do not see such a brick wall or a bottleneck in the foreseeable future. We conclude that though the sector may offer occasional countertrend tactical buying opportunities, long-term equity investors should underweight oil and gas. Structurally Prefer Metals And Miners To Oil And Gas The preceding analysis of the oil sector can be extended to other commodity equities, like the metals and miners. To reiterate, it is the total value of commodity output – the product of commodity production and the commodity price – that drives the profits of commodity equities. On this basis, the long-term prospects for the metals and miners appear somewhat brighter than for oil and gas equities (Chart I-7). Chart I-7Commodity Sector Profits Track The Value Of Commodity Output Commodity Sector Profits Track The Value Of Commodity Output Commodity Sector Profits Track The Value Of Commodity Output Looking at the production of copper, it has increased by around 25 percent over the past decade, albeit this is just in line with world real GDP. By comparison, the production of oil has gone nowhere (Chart of the Week). It is the total value of commodity output that drives the profits of commodity equities. Turning to price, relative to the 2011 high the copper price is around 15 percent lower, whereas the oil price is 50 percent lower (Chart I-8). Chart I-8The Copper Price Has Outperformed The Oil Price The Copper Price Has Outperformed The Oil Price The Copper Price Has Outperformed The Oil Price Hence, on the all-important value of output, copper has moved in a sideways channel over the past decade while oil has been in an unmistakeable structural downtrend, with lower highs and lower lows (Chart I-9). Chart I-9The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil The Value Of Output Is Trending Sideways For Copper, But Downwards For Oil This relative trend is likely to continue as the shift from fossil-fuelled road transportation to EVs will weigh on oil demand, while supporting copper (and other metal) demand. We do not recommend an outright overweight in metals and miners given that their profits are just moving in a sideways channel. However, within the cyclical and value segments of the equity market, a good structural position is to overweight metals and miners versus oil and gas. When Oil And Gas Underperforms, So Does Norway’s OBX And The UK’s FTSE 100 Regional and country equity market performances is driven by the dominant sectors within each stock market. In relative terms, it is also driven by the sectors that are missing. If the oil and gas sector is a structural underperformer, then oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too. If the oil and gas sector is a structural underperformer, it inevitably means that oil and gas heavy stock markets such as Norway and the UK will be structural underperformers too (Chart I-10 and Chart I-11). Chart I-10When Oil And Gas Underperforms, Norway's OBX Underperforms... When Oil And Gas Underperforms, Norway's OBX Underperforms... When Oil And Gas Underperforms, Norway's OBX Underperforms... Chart I-11...And The UK's FTSE 100 ##br##Underperforms ...And The UK's FTSE 100 Underperforms ...And The UK's FTSE 100 Underperforms The corollary is that stock markets which are under-exposed to the structurally underperforming sector will be at a relative advantage. This supports our structural overweighting to the stock markets of Germany, Switzerland, and Denmark, which all have zero exposure to oil and gas and basic resources. Fractal Trading System* Tin’s near-vertical rally is at high risk of correction based on fragility on all three fractal structures: 65-day, 130-day, and 260-day. A good trade is to short tin versus lead, setting a profit target and symmetrical stop-loss at 13 percent. In other trades, the underweights to China and Korea surged, but short AUD/JPY and short copper/gold reached their stop-losses. The rolling 12-month win ratio stands at 57 percent. Chart I-12Tin Vs. Lead Tin Vs. Lead Tin Vs. Lead 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   ULEZ will be the zone inside London’s North Circular and South Circular Roads. 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 - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   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 The pandemic is not yet over, but it appears that infections have peaked in the developed world and in most of the major developing economies. Economic growth will reaccelerate as social distancing abates and vaccination programs gather momentum. The current policy orthodoxy is night-and-day different from the orthodoxy that prevailed in the wake of the global financial crisis, as deficit shaming has given way to deficit positivity. Rapid expansion is more likely than a repeat of last decade’s tepid, plodding recovery and inflation will eventually supplant hysteresis as policymakers’ biggest worry. The impending passage of the $1.9 trillion American Rescue Act will vault the US ahead of its major economy counterparts in terms of pandemic spending. Washington’s massive fiscal commitment speeds up the timetable for closing the output gap in the US. Although inflation has become a hot topic among US investors, we do not see it materializing until next year at the earliest. Our base case has the Goldilocks backdrop of solid growth and ample monetary accommodation remaining in place for at least the rest of the year. Markets have fully discounted that scenario but investors should be aware that both downside and upside surprises are possible; bad virus news could drive a growth shortfall while households’ enormous excess savings could power a consumption breakout. The broad take-up of the Goldilocks scenario among equity investors will make it hard for stocks to dazzle in 2021. Nonetheless, we think conditions support mid-to-high single-digit returns, which will allow equities to outperform bonds. The combination of accelerating growth and quiescent central banks is catnip for equities but not so much for bonds, especially investment-grade sovereigns. Fixed-income investors should maintain below-benchmark duration as yield curves steepen. Steepening yield curves have given Financials a shot in the arm while weighing on the high-flying Tech sector. Reopening in the wake of COVID’s retreat should also redound to recent laggards’ benefit and we continue to expect value stocks will outperform their growth counterparts over the rest of the year. The US dollar will resume its downtrend as the virus is beaten back, albeit at a gentler pace than in 2020. Humanity Retakes The Lead Humankind cannot yet declare victory over COVID-19 but it does appear to have gained the upper hand as new case counts have plummeted from their January peak (Chart I-1). Restrictions helped turn the tide in Europe, albeit at the cost of cutting off oxygen to the economy (Chart I-2), but even in Sweden and the US, which eschewed EU-style restrictions, the virus has lost momentum. Increased vigilance apparently trumped fears that the coronavirus would flourish in the northern hemisphere winter. The potential for vaccine-resistant variants is a concern, but the pandemic news is clearly trending in the right direction. Chart I-1The Fever Has Broken The Fever Has Broken The Fever Has Broken Chart I-2Throwing The Merchants Out With The Bathwater Throwing The Merchants Out With The Bathwater Throwing The Merchants Out With The Bathwater As infections fall, so too does the strain on public health care systems. Plunging hospitalizations (Chart I-3) indicate that health care systems have recovered capacity. Hospitalizations are an important metric for tracking COVID’s impact on the economy because they lead restrictions on activity; when they are high and rising, officials are prone to limit person-to-person interaction, and when they are low and falling, officials roll back emergency limits. For services-heavy developed economies, easier restrictions are the key to a return to something more closely resembling normal activity until vaccinations confer herd immunity (Chart I-4). Chart I-3Restrictions Can Be Lifted As Health Care Systems Regain Capacity Restrictions Can Be Lifted As Health Care Systems Regain Capacity Restrictions Can Be Lifted As Health Care Systems Regain Capacity In the meantime, those who continue to be displaced by the pandemic and the distancing measures taken to combat it will fall back on fiscal support. Fourth-quarter deceleration in the United States highlighted the important role that fiscal transfers have played in keeping vulnerable households, businesses and communities afloat. The bulk of the transfers authorized under the CARES Act were distributed in two bursts. The first arrived in April and May via economic impact payments of $1,200 per adult and $500 per child that were paid in full to about two-thirds of American households1 (Chart I-5, top panel). Chart I-4Lockdowns Are A Drag Lockdowns Are A Drag Lockdowns Are A Drag Chart I-5Transfers Slowed To A Trickle In The Fall March 2021 March 2021 Chart I-6Fewer Transfers, Fewer Sales, ... Fewer Transfers, Fewer Sales, ... Fewer Transfers, Fewer Sales, ... The second burst came in the form of a weekly $600 federal unemployment insurance (UI) benefit supplement in April, May, June and July (Chart I-5, middle panel). Additional aid was provided by the pandemic unemployment assistance (PUA) program, which expanded UI benefits to independent contractors, self-employed individuals and other workers who would not otherwise qualify to receive them. The PUA program was the smallest of the three major transfer plans and the only one that ran until the end of the year, and as the arrival of the direct payment checks and final UI benefit supplements receded further into the past, the US economy began to show some signs of wear. Retail sales fell sequentially in all three months of the fourth quarter (Chart I-6) as total employment hit a wall (Chart I-7) and the economic surprise index swooned (Chart I-8).   Chart I-7... Fewer Jobs ... ... Fewer Jobs ... ... Fewer Jobs ... Chart I-8... And Fewer Positive Surprises ... And Fewer Positive Surprises ... And Fewer Positive Surprises Households’ ability to satisfy their obligations to creditors and landlords slipped as the year wore on as well. Fiscal transfers and forbearance programs have limited credit distress far more effectively than one would have expected when the COVID meteor hit the earth (Table I-1), but leading 30-day delinquency rates reveal a modest erosion since late summer (Chart I-9). The share of apartment renters paying at least some of their rent fell by more than one-and-a-half percentage points from year-ago levels in October, November, December and January, a first since the CARES Act transfers began to flow in time to help with the May rent (Chart I-10). It seems clear that lower-income households who relied most heavily on aid felt its absence as the year wore on. Table I-160- And 90-Day Consumer Delinquencies Are Down Year-Over-Year, ... March 2021 March 2021 Chart I-9... But Leading 30-Day Delinquencies Are On The Rise ... March 2021 March 2021 Chart I-10... And Apartment Rent Collections Have Been Slipping March 2021 March 2021     We take the snapback in January retail sales as evidence that high marginal-propensity-to-consume households needed the second round of transfers provided for in December’s compromise spending bill. Both the economic impact payments ($600 per qualifying adult and $600 per child) and the supplemental UI benefits ($300 per week) were smaller, but the most vulnerable households put them to immediate use. We expect that February rent collections and consumer loan delinquencies will also show improvement, albeit not as dramatically as the retail sales series. With another, larger round of stimulus coming down the pike, it appears that the US economy will avoid a repeat of its fourth quarter fraying around the edges but slumps remain a possibility in economies that allow transfer schemes to lapse before COVID-19 can be tamed. And Now For Something Completely Different The global economy has confronted two significant crises in the space of a dozen years. The events that precipitated them could hardly have been more different: the global financial crisis (GFC) was an endogenous event with enough avarice, hubris, folly and villainy to support a cottage industry of books, movies and TV shows revisiting it, while the pandemic, for all of the official complacency and bumbling it laid bare, was simply an exogenous occurrence of great misfortune. The monetary policy response to both events has been substantially identical; the Fed swiftly took the fed funds rate back to zero, bought copious quantities of Treasury and agency securities, and launched a mix of old and new emergency measures. Other major central banks, which were largely unable to make any moves toward normalization between crises, simply maintained zero or negative interest rate policy and ramped up the pace and/or scope of their own asset purchase programs. The fiscal response has been dramatically different, however, in line with a 180-degree turn in budget orthodoxy. Chastened, perhaps, by Europe’s double-dip recession, or the protractedly tepid US expansion, economic mandarins have experienced a road-to-Damascus conversion. Whereas the OECD and the IMF began wagging their fingers at prodigal legislators while the global economy was still submerged under the GFC rubble, today they counsel that there is no rush to pull back on spending. As the OECD’s chief economist said in a January interview, “The first lesson [from the aftermath of the GFC] is to make sure governments are not tightening in the one to two years following the trough of GDP.2” The IMF has declared that “the near-term priority is to avoid premature withdrawal of fiscal support. Support should persist, at least into 2021, to sustain the recovery and to limit long-term scarring.3” Chart I-11What Goes Up Must ... Go Up Again What Goes Up Must ... Go Up Again What Goes Up Must ... Go Up Again The about-face in terms of fiscal deficits could have a profound effect on the character of the post-pandemic expansions. The plodding and protracted post-GFC recovery/expansion might be viewed as an object lesson in monetary policy’s limits. There is no gainsaying that central banks acted boldly to counter the GFC, cutting policy rates to zero and beyond, purchasing vast quantities of sovereign bonds, government agency securities and even debt and equity issued by private entities. The purchases caused central bank balance sheets to swell (Chart I-11), but the money creation impact was stunted by an offsetting wave of defaults and a general reluctance on the part of lenders and would-be borrowers to add to the stock of debt. Chart I-12GFC Stimulus Was Fleeting March 2021 March 2021 GFC fiscal spending was modest and largely limited to automatic stabilizers once emergency measures ran their course. Even the most celebrated efforts, like the United States’ 2009 Recovery Act, were intentionally modest in scope and limited in duration. Following the prevailing wisdom, national governments quickly moved to withdraw assistance and reduce their budget deficits once the worst of the crisis had passed (Chart I-12). Tepid investment, sluggish employment gains and fiscal drag all weighed on growth, defying the typical bigger-the-decline, bigger-the-bounce business cycle pattern. The picture is quite different today as central banks have gained a powerful and willing partner in their efforts to combat the damage wrought by a sudden shock. Pandemic fiscal stimulus initiatives have dwarfed GFC efforts across the major economies (Chart I-13). Once Congress passes the $1.9 trillion American Rescue Act, the US will have doubled down on its 2020 initiatives, committing to aid equivalent to an extraordinary 25% of its annual output. The ultimate effect on inflation, interest rates and exchange rates remains to be seen, but it is clear that the post-pandemic expansion will not unfold at the plodding pace of the post-GFC expansion. Chart I-13The COVID Fiscal Response Has Dwarfed The GFC's March 2021 March 2021 Goldilocks And The Two Tails Narrowing our focus to the US, which comprises nearly 60% of the market cap of the benchmark MSCI All-Country World Index, our base case is the Goldilocks scenario that markets appear to be discounting. That scenario would entail the just-right outcome of solid growth and continued monetary accommodation (Figure I-1). Since the Fed will only dial back accommodation if the economy appears to be at risk of overheating, it will take a growth disappointment, most likely from a negative virus surprise, for the US economy to tumble into the left-hand tail of the distribution. Figure I-1Goldilocks And The Two Tails March 2021 March 2021 Chart I-14Making Up For Lost Time Making Up For Lost Time Making Up For Lost Time We cannot rule out the possibility of virus-resistant mutations or new rounds of outbreaks from a weary populace that lets its guard down, but a failure to vaccinate at a pace consistent with achieving herd immunity by the end of September looks to be the most likely route to disappointment. To that end, we are monitoring vaccination progress against the pace required to get 50-80% of the population inoculated by the end of the third quarter (Chart I-14). The US got off to a slow start, but we are confident that it will catch up by early spring under an administration that has made crushing the virus its top priority and a Congress that is providing the resources to enable local health authorities to get the job done. The case for an upside near-term surprise stems from the notion that America’s solons have provided considerably more aid to households than was strictly necessary. As Chart I-7 showed, total employment fell by 25 million at the trough in April and close to 9 million fewer people are employed now than at the pre-pandemic peak. They can surely use a lifeline, along with the many Americans who are involuntarily working part time and those who are barely holding on even if they are fully employed. But they number far less than the 100 million households4 (two-thirds of all taxpayers) that received the full $1,800-per-adult economic impact payments ($1,200 last spring and $600 in January), and will be in line for another $1,400, as soon as March, under the terms of the new bill. Households who did not need the largesse have presumably saved the distributions, helping contribute to the $1.5 trillion of excess savings accumulated during the pandemic. Thanks to the transfers provided for by the CARES Act, our US Investment Strategy service estimates that aggregate household income from March through December was $450 billion greater than it would have been in the absence of COVID-19 (Table I-2). With the second round of direct payments amounting to about $150 billion and the third round likely to be more than double the second, household incomes will be boosted by another $500 billion and the excess savings horde will be on its way to $2 trillion and beyond. Even in a $21 trillion economy, that much dry powder has the potential to move the needle. Table I-2Households' Excess Pandemic Savings March 2021 March 2021 In the absence of even a somewhat related antecedent, no one can say for sure how much of the excess savings will be spent. Ricardian equivalence, which posits that households will be reluctant to spend fiscal windfalls if they anticipate that they will have to pay for them with higher future taxes, and Milton Friedman’s permanent income hypothesis, which posits that consumption decisions are based on lifetime earnings, both suggest that the multiplier effect of the direct payments to households may not be all it's cracked up to be. Empirical evidence does not definitively support either model, but increased income has only accounted for a third of households’ mountain of savings in any event. The remaining two-thirds, amounting to over a trillion dollars, came from reduced consumption. Even if Ricardo’s and Friedman’s hypotheses are mostly on the mark, if much of the $1 trillion of 2020’s reduced consumption was merely deferred rather than destroyed (Box I-1), pent-up consumer demand could be significant. The range of potential outcomes is wide: on the one hand, money has tended to burn a hole in US households’ pockets; on the other, Ricardo and Friedman aren’t exactly Larry Kudlow or Peter Navarro. It is hard to assert with any conviction how much of the savings cache will be spent, or how quickly, but we highlight its presence to point out that near-term US growth could surprise to the upside. BOX I-1 Demand Deferral Or Demand Destruction? February’s Bank Credit Analyst presented a table with simple estimates of the US pandemic spending gap. It showed that spending on goods is tracking above the level that would have been expected if the pandemic had not occurred but that spending on services is down sharply, with an enormous gap in categories like food service, recreation and transportation. The fate of US households’ massive excess savings might come down to what happens to the forgone consumption. Consumption that is not deferred to some later period will simply disappear. Given that the consumption shortfall is entirely confined to services, the key question becomes: Is forgone services consumption more likely to turn into demand destroyed than forgone goods consumption? We suspect the answer is yes. Considering it from the perspective of the categories that suffered the biggest shortfalls, one cannot catch up by eating multiple restaurant dinners in a day, going back in time to attend last season’s sports and entertainment events, or taking more than one flight and staying in more than one hotel room. Services demand may also incorporate more of a discretionary component: one might want to go to a ballgame or a concert, or get out of town over a long weekend, but one eventually has to replace a sputtering car or refrigerator. Some forgone services demand likely turned into accelerated goods demand as white-collar workers redirected workday spending to building out office capabilities at home. Even more may have been diverted to home theater and exercise equipment, or to making one’s outdoor space into a more inviting place to while away the pandemic. The bottom line is that some goods demand appears to have been pulled forward by the pandemic while some services demand has likely been destroyed. There is surely pent-up consumer demand, and it will begin to be released once the pandemic has been subdued, but only some of the accumulated savings will be directed to satisfying it. Conclusions And Investment Recommendations For investors focused on the coming 6-12 months, the key takeaways from our analysis are as follows: Provided that official measures and personal vigilance continue to curtail COVID-19 until vaccinations can stifle it, the growth outlook should steadily improve. In the United States, where the federal government is determined to err on the side of providing too much fiscal support, growth could pick up a lot of steam. If enough pandemic-weary people fail to maintain their vigilance and observe social distancing measures, vaccine distribution efforts become snagged or vaccine-resistant strains emerge, growth could fall short of the consensus expectation embedded in financial market prices. Based on its plans to double down on its initial infusion of fiscal support, the US is the major economy most likely to exceed expectations, perhaps even to the point of overheating. After drilling into the increased income/foregone consumption components of the mountain of savings American households have amassed during the pandemic, however, we reiterate our conclusion that all of the savings will not be spent. The US economy will accelerate smartly this year but overheating is a low-probability event. Chart I-15The Coming Regional And Style Rotation The Coming Regional And Style Rotation The Coming Regional And Style Rotation Given these conclusions, we recommend the following investment stance over the next 6-12 months: Overweight equities, which will generate excess returns over sovereign bonds and cash in the absence of a negative COVID surprise, and underweight fixed income. Maintain below-benchmark duration in fixed income portfolios. Underweight US stocks and overweight global ex-US stocks, which will benefit from the reopening of the global economy, and value over growth stocks, which will benefit from reopening and a steeper yield curve. The former broke out in January and held their lead last month (Chart I-15, top panel) while value is testing resistance at its 200-day moving average (Chart I-15, bottom panel). Underweight the US dollar versus the euro in particular and other more cyclical currencies in general. We do not expect the greenback to fall as sharply as it did last year from May through December but we do expect it will resume declining over the rest of the year. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com February 25, 2021 Next Report: March 31, 2021 II. Requiem For Volcker And The Gipper For this month’s Special Report, we are sending you a collaboration between our US Investment Strategy and US Political Strategy teams. US Political Strategy is our newest strategy service and it extends the proprietary framework of our Geopolitical Strategy service to provide analysis of political developments that is relevant for US-focused investors. Please contact your relationship manager if you would like more information or to begin trialing the service. Ronald Reagan cast a long shadow over the elected officials who followed him … :The influence of the economic policies associated with Ronald Reagan held such persistent sway that even the Clinton and Obama administrations had to follow their broad outlines. … just as Paul Volcker did over central bankers at home and abroad … : The Volcker Fed’s uncompromising resistance to the 1970s’ runaway inflation established the Fed’s credibility and enshrined a new global central banking orthodoxy. … but it appears their enduring influence may have finally run its course … : The pandemic overrode everything else in real time, but investors may ultimately view 2020 as the year in which Democrats broke away from post-Reagan orthodoxy and the Fed decided Volcker’s vigilance was no longer relevant. … to investors’ potential chagrin: If inflation, big government and organized labor come back from the dead, globalization loses ground, regulation expands, anti-trust enforcement regains some bite and tax rates rise and become more progressive, then the four-decade investment golden age that Reagan and Volcker helped launch may be on its last legs. The pandemic dominated everything in real time in 2020, as investors scrambled to keep up with its disruptions and the countermeasures policymakers deployed to shelter the economy from them. With some distance, however, investors may come to view it as a year of two critical policy inflection points: the end of the Reagan fiscal era and the end of the Volcker monetary era. The shifts could mark a watershed because Reagan’s and Volcker’s enduring influence helped power an investment golden age that has lasted for nearly 40 years. What comes next may not be so supportive for financial markets. Political history often unfolds in cycles even if their starting and ending dates are never as clear cut in real life as they are in dissertations. Broadly, the FDR administration kicked off the New Deal era, a 48-year period of increased government involvement in daily life via the introduction and steady expansion of the social safety net, broadened regulatory powers and sweeping worker protections. It was followed by the 40-year Reagan era, with a continuous soundtrack of limited government rhetoric made manifest in policies that sought to curtail the spread of social welfare programs, deregulate commercial activity, devolve power to state and local government units and the private sector and push back against unions. The Obama and Trump administrations challenged different aspects of Reaganism, but the 2020 election cycle finally toppled it. Ordinarily, that might only matter to historians and political scientists, but the Reagan era coincided with a fantastic run in financial markets. So, too, did the inflation vigilance that lasted long after Paul Volcker’s 1979-1987 tenure at the helm of the Federal Reserve, which drove an extended period of disinflation, falling interest rates and rising central bank credibility. Our focus here is on fiscal policy, and we touch on monetary policy only to note that last summer’s revision of the Fed’s statement of long-run monetary policy goals shut the door on the Volcker era. The end of both eras could mark an inflection point in the trajectory of asset returns. The Happy Warrior The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”5 Chart II-1After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit Ronald Reagan held his conservative views with the zeal of the convert that he was.6 Those views were probably to the right of much of the electorate, but his personal appeal was strong enough to make them palatable to a sizable majority (Chart II-1). Substitute “left” for “right” and the sentiment just as easily sums up FDR’s ability to get the New Deal off the ground. Personal magnetism played a big role in each era’s rise, with both men radiating relatability and optimism that imbued their sagging fellow citizens with a sense of comfort and security that made them willing to try something very different. 1980 was hardly 1932 on the distress scale, but America was in a funk after the upheaval of the sixties, the humiliating end to Vietnam, Watergate, stagflation and a term and a half of uninspiring and ineffectual presidential leadership. Enter the Great Communicator, whose initial weekly radio address evoked the FDR of the Fireside Chats – jovial, resolute and confident, with palpable can-do energy – buffed to a shine by a professional actor and broadcaster whose vocal inflections hit every mark.7 The Gipper,8 with his avuncular bearing, physical robustness and ever-present twinkle in his eye, was just what the country needed to feel better about itself. Reaganomics 101 Government does not tax to get the money it needs; government always finds a need for the money it gets.9 President Reagan’s economic plan had three simple goals: cut taxes, tame government spending and reduce regulation. From the start of his entry into politics in the mid-sixties, Reagan cast himself as a defender of hard-working Americans’ right to keep more of the fruits of their labor from a grasping federal government seeking funding for wasteful, poorly designed programs. He harbored an intense animus for LBJ’s Great Society, which extended the reach of the federal government in ways that he characterized as a drag on initiative, accomplishment and freedom, no matter how well intentioned it may have been. That message hung a historic loss on Barry Goldwater in 1964 when inflation was somnolent but it proved to be far more persuasive after the runaway inflation of the seventies exposed the perils of excessive government (Chart II-2). Chart II-2Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up As the Reagan Foundation website describes the impact of his presidency’s economic policies, “Millions … were able to keep more of the money for which they worked so hard. Families could reliably plan a budget and pay their bills. The seemingly insatiable Federal government was on a much-needed diet. And businesses and individual entrepreneurs were no longer hassled by their government, or paralyzed by burdensome and unnecessary regulations every time they wanted to expand.” “In a phrase, the American dream had been restored.” The Enduring Reach Of Reaganomics I’m not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub. – Grover Norquist Though President-Elect Clinton bridled at limited government’s inherent restrictions, bursting out during a transition briefing, “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?” his administration largely observed them. This was especially true after the drubbing Democrats endured in the 1994 midterms, when the Republicans captured their first House majority in four decades behind the Contract with America, a skillfully packaged legislative agenda explicitly founded on Reagan principles. Humbled in the face of Republican majorities in both houses of Congress, and hemmed in by roving bands of bond vigilantes, Clinton was forced to tack to the center. James Carville, a leading architect of Clinton’s 1992 victory, captured the moment, saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or … a .400 … hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Reagan’s legacy informed the Bush administration’s sweeping tax cuts (and its push to privatize social security), and forced the Obama administration to tread carefully with the stimulus package it devised to combat the Great Recession. Although the administration’s economic advisors considered the $787 billion (5%-of-peak-GDP) bill insufficient, political staffers carried the day and the price tag was kept below $800 billion to appease the three Republican senators whose votes were required to pass it. Even with the economy in its worst state since the Depression, the Obama administration had to acquiesce to Reaganite budget pieties if it wanted any stimulus bill at all. Its leash got shorter after it agreed with House Republicans to “sequester” excess spending under the Budget Control Act of 2011. On the Republican side of the aisle, Grover Norquist, who claims to have founded Americans for Tax Reform (ATR) at Reagan’s request, enforced legislative fealty to the no-new-tax mantra. ATR, which opposes all tax increases as a matter of principle, corrals legislators with the Taxpayer Protection Pledge, “commit[ting] them to oppose any effort to increase income taxes on individuals and businesses.” ATR’s influence has waned since its 2012 peak, when 95% of Republicans in Congress had signed the pledge, and Norquist no longer strikes fear in the hearts of Republicans inclined to waver on taxes. His declining influence is testament to Reaganism’s success on the one hand (the tax burden has already been reduced) and the fading appeal of its signature fiscal restraint on the other. Did Government Really Shrink? When the legend becomes fact, print the legend. – The Man Who Shot Liberty Valance For all of its denunciations of government spending, the Reagan administration ran up the largest expansionary budget deficits (as a share of GDP) of any postwar administration until the global financial crisis (Chart II-3). Although it aggressively slashed non-defense discretionary spending, it couldn’t cut enough to offset the Pentagon’s voracious appetite. The Reagan deficits were not all bad: increased defense spending hastened the end of the Cold War, so they were in a sense an investment that paid off in the form of the ‘90s peace dividend and the budget surpluses it engendered. Chart II-3Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Nonetheless, the Reagan experience reveals the uncomfortable truth that there is little scope for any administration or Congressional session to cut federal spending. Mandatory entitlement spending on social security, Medicare and Medicaid constitutes the bulk of federal expenditures (Chart II-4) and they are very popular with the electorate, as the Trump campaign shrewdly recognized in the 2016 Republican primaries (Table II-1). Discretionary spending, especially ex-defense, is a drop in the bucket, thanks largely to a Reagan administration that already cut it to the bone (Chart II-5). Chart II-4The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... Chart II-5Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts   Table II-1How Trump Broke Republican Orthodoxy On Entitlement Spending March 2021 March 2021 The Reagan tax cuts therefore accomplished the easy part of the “starve the beast” strategy but his administration failed to make commensurate cuts in outlays (Chart II-6). If overall spending wasn’t cut amidst oppressive inflation, while the Great Communicator was in the Oval Office to make the case for it to a considerably more fiscally conservative electorate, there is no chance that it will be cut this decade. As our Geopolitical Strategy service has flagged for several years, the median US voter has moved to the left on economic policy. Reagan-era fiscal conservatism has gone the way of iconic eighties features like synthesizers, leg warmers and big hair, even if it had one last gasp in the form of the post-crisis “Tea Party” and Obama’s compromise on budget controls. Chart II-6Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Do Republicans Still Want The Reagan Mantle? Chart II-7“Limited Government” Falling Out Of Fashion March 2021 March 2021 Reaganism is dead, killed by a decided shift in broad American public opinion, and within the Republican and Democratic parties themselves. Americans are just as divided today as they were in Reagan’s era about the size of the government but the trend since the late 1990s is plainly in favor of bigger government (Chart II-7). Recent developments, including the 2020 election, reinforce our conviction that trend will not reverse any time soon. The Republicans are the natural heirs of Reagan’s legacy. Much of President Trump’s appeal to conservatives lay in his successful self-branding as the new Reagan. Though he lacked the Gipper’s charisma and affability, his unapologetic assertion of American exceptionalism rekindled some of the glow of Morning-in-America confidence. Following the outsider trail blazed by Reagan, he lambasted the Washington establishment and promised to slash bureaucracy, deregulate the economy and shake things up. Trump’s signature legislative accomplishment was the largest tax reform since Reagan’s in 1986. He oversaw defense spending increases to take on China, which he all but named the new “evil empire.”10 Like Reagan, he was willing to weather criticism for face-to-face meetings with rival nations’ dictators. Even his trade protectionism had more in common with the Reagan administration than is widely recognized.11 Chart II-8Reagan’s Amnesty On Immigration March 2021 March 2021 But major differences in the two presidents’ policy portfolios underline the erosion of the Reagan legacy’s hold. President Trump outflanked his Republican competitors for the 2016 nomination by running against cutting government spending – he was the only candidate who opposed entitlement reform. His signature proposal was to stem immigration by means of a Mexican border wall. While Reagan had sought to crack down on illegal immigration, he pursued a compromise approach and granted amnesty to 2.9 million illegal immigrants living in America to pass the Immigration Reform and Control Act of 1986, sparing businesses from having to scramble to replace them (Chart II-8). While Reagan curtailed non-defense spending, Trump signed budget-busting bills with relish, even before the COVID pandemic necessitated emergency deficit spending. Trump tried to use the power of government to intervene in the economy and alienated the business community, which revered Reagan, with his scattershot trade war. Trump’s greater hawkishness on immigration and trade and his permissiveness on fiscal spending differentiated him from Reagan orthodoxy and signaled a more populist Republican Party. Chart II-9Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy March 2021 March 2021 More fundamentally, Trump represents a new strain of Republican that is at odds with the party’s traditional support for big business and disdain for big government. If he leads that strain to take on the party establishment by challenging moderate Republicans in primary elections and insisting on running as the party’s next presidential candidate, the GOP will be swimming upstream in the 2022 and 2024 elections. It is too soon to make predictions about either of these elections other than to say that Trump is capable of splitting the party in a way not seen since Ross Perot in the 1990s or Theodore Roosevelt in the early 1900s (Chart II-9).12 If he does so, the Democrats will remain firmly in charge and lingering Reaganist policies will be actively dismantled. Even if the party manages to preserve its fragile Trumpist/traditionalist coalition, it is hard to imagine it will recover its appetite for shrinking entitlements, siding against labor or following a laissez-faire approach to corporate conduct and combinations. Republicans will pay lip service to fiscal restraint but Trump’s demonstration that austerity does not win votes will lead them to downplay spending cuts and entitlement reform as policy priorities – at least until inflation again becomes a popular grievance (Chart II-10). Republicans will also fail to gain traction with voters if they campaign merely on restoring the Trump tax cuts after Biden’s likely partial repeal of them. Support for the Tax Cut and Jobs Act hardly reached 40% for the general public and 30% for independents and it is well known that the tax reform did little to help Republicans in the 2018 midterm elections, when Democrats took the House (Chart II-11). Chart II-10Republicans Have Many Priorities Above Budget Deficits March 2021 March 2021 Chart II-11Trump Tax Cuts Were Never Very Popular March 2021 March 2021 On immigration the Republican Party will follow Trump and refuse amnesty. Immigration levels are elevated and Biden’s lax approach to the border, combined with a looming growth disparity with Latin America, will generate new waves of incomers and provoke a Republican backlash. On trade and foreign policy, Republicans will follow a synthesis of Reagan and Trump in pursuing a cold war with China. The Chinese economy is set to surpass the American economy by the year 2028 and is already bigger in purchasing power parity terms (Chart II-12). The Chinese administration is becoming more oppressive at home, more closed to liberal and western ideas, more focused on import substitution, and more technologically ambitious. The Chinese threat will escalate in the coming decade and the Republican Party will present itself as the anti-communist party by proposing a major military-industrial build-up. Yet it is far from assured that the Democrats will be soft on China, which is to say that they will not be able to cut defense spending substantially. Chart II-12China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP Will Biden Take Up The Cause? One might ask if the Biden administration might seek to adopt some elements of the Reagan program. President Biden is among the last of the pro-market Democrats who emerged in the wake of the Reagan revolution. Those “third-way” Democrats thrived in the 1990s by accommodating themselves to Reagan’s free-market message while maintaining there was a place for a larger federal role in certain aspects of the economy and society. The 2020 election demonstrated that the Democrats’ political base is larger than the Republicans’ and third-way policies could be a way to make further inroads with affluent suburbanites who helped deliver Georgia and Virginia. Alas, the answer appears to be no. The Democrats’ base increasingly abhors Reagan-era economic and social policies, and the country’s future demographic changes reinforce the party’s current, progressive trajectory. That means fiery younger Democrats don’t have to compromise their principles with third-way policies when they can just wait for Texas to turn blue. Chart II-13Democrats Look To New Deal, Eschew ‘Third Way’ March 2021 March 2021 Biden has only been in office for one month but a rule of thumb is that his party will pull him further to the left the longer Republicans remain divided and ineffective. His cabinet appointments have been center-left, not far-left, though his executive orders have catered to the far-left, particularly on immigration. In order to pass his two major legislative proposals through an evenly split Senate he must appeal to Democratic moderates, as every vote in the party will be needed to get the FY2021 and FY2022 budget reconciliation bills across the line, with Vice President Kamala Harris acting as the Senate tie breaker. Nevertheless his agenda still highlights that the twenty-first century Democrats are taking a page out of the FDR playbook and unabashedly promoting big government solutions (Chart II-13). Biden’s $1.9 trillion American Rescue Plan is not only directed at emergency pandemic relief but also aims to shore up state and local finances, education, subsidized housing, and child care. His health care proposals include a government-provided insurance option (originally struck from the Affordable Care Act to secure its passage in 2010) and a role for Medicare in negotiating drug prices. And his infrastructure plan is likely to provide cover for a more ambitious set of green energy projects that will initiate the Democratic Party’s next big policy pursuit after health care: environmentalism. The takeaway is not that Biden’s administration is necessarily radical – he eschews government-administered health care and is only proposing a partial reversal of Trump’s tax cuts – but rather that his party has taken a decisive turn away from the “third-way” pragmatism that defined his generation of Democrats in favor of a return to the “Old-Left” and pro-labor policies of the New Deal era (Chart II-14). The party has veered to the left in reaction to the Iraq War, the financial crisis, and Trumpism. Vice President Harris, Biden’s presumptive heir, had the second-most progressive voting record during her time in the Senate and would undoubtedly install a more progressive cabinet. Table II-2 shows her voting record alongside other senators who ran against Biden in the Democratic primary election. All of them except perhaps Senator Amy Klobuchar stood to his left on the policy spectrum. Chart II-14Democrats Eschew Budget Constraints March 2021 March 2021 Fundamentally the American electorate is becoming more open to a larger role for the government in the economy and society. While voters almost always prioritize the economy and jobs, policy preferences have changed. The morass of excessive inflation, deficits, taxation, regulation, strikes and business inefficiencies that gave rise to the Reagan movement is not remembered as ancient history – it is not even remembered. The problems of slow growth, inadequate health and education, racial injustice, creaky public services, and stagnant wages are by far the more prevalent concerns – and they require more, not less, spending and government involvement (Chart II-15). Insofar as voters worry about foreign threats they focus on the China challenge, where Biden will be forced to adopt some of Trump’s approach. Table II-2Harris Stood To The Left Of Democratic Senators March 2021 March 2021 Chart II-15Public Concern For Economy Means Greater Government Help March 2021 March 2021 When inflation picks up in the coming years, voters will not reflexively ask for government to be pared back so that the economy becomes more efficient, as they did once they had a taste of Reagan’s medicine in the early 1980s. Rather, they will ask the government to step in to provide higher wages, indexation schemes, price caps, and assistance for labor, as is increasingly the case. The ruling party will be offering these options and the opposition Republicans will render themselves obsolete if they focus single-mindedly on austerity measures. Americans will have to experience a recession caused by inflation – i.e. stagflation – before they call for anything resembling Reagan again. The Post-Reagan Market Landscape Many investors and conservative economists were shocked13 that the Bernanke Fed’s mix of zero interest rates and massive securities purchases did not foster runaway inflation and destroy the dollar. They failed to anticipate that widespread private-sector deleveraging would put a lid on money creation (and that other major central banks would follow in the Fed’s ZIRP and QE footsteps). But a longer view of four decades of disinflation suggests another conclusion: Taking away the monetary punch bowl when the labor party gets going and pursuing limited-government fiscal policy can keep inflation pressures from gaining traction. Globalization, technology-enabled elimination of many lower-skilled white-collar functions and the hollowing out of the organized labor movement all helped as well, though they helped foment a revolt among a meaningful segment of the Republican rank-and-file against Reagan-style policies. The Volcker Fed set the tone for pre-emptive monetary tightening and subsequent FOMCs have reliably intervened to cool off the economy when the labor market begins heating up. The Phillips Curve may be out of favor with investors, but wage inflation only gathers steam when the unemployment rate falls below its natural level (Chart II-16), and the Fed did not allow negative unemployment gaps to persist for very long in the Volcker era. Without wage inflation putting more money in the hands of a broad cross-section of households with a fairly high marginal propensity to consume, it’s hard to get inflation in consumer prices. Chart II-16Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall The Fed took the cyclical wind from the labor market’s sails but the Reagan administration introduced a stiff secular headwind when it crushed PATCO, the air traffic controllers’ union, in 1981, marking an inflection point in the relationship between management and labor. That watershed event opened the door for employers to deploy much rougher tactics against unions than they had since before the New Deal.14 Reagan’s championing of free markets helped establish globalization as an economic policy that the third-way Clinton administration eagerly embraced with NAFTA and a campaign to admit China to the WTO. The latter coincided with a sharp decline in labor’s share of income (Chart II-17). Chart II-17Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor The core Reagan tenets – limited government, favoring management over labor, globalization, sleepy anti-trust enforcement, reduced regulation and less progressive tax systems with lower rates – are all at risk of Biden administration rollbacks. While the easy monetary/tight fiscal combination promoted a rise in asset prices rather than consumer prices ever since the end of the global financial crisis, today’s easy monetary/easy fiscal could promote consumer price inflation and asset price deflation. We do not think inflation will be an issue in 2021 but we expect it will in the later years of Biden’s term. Ultimately, we expect massive fiscal accommodation will stoke inflation pressures and those pressures, abetted by a Fed which has pledged not to pre-emptively remove accommodation when the labor market tightens, will eventually bring about the end of the bull market in risk assets and the expansion. Investment Implications Business revered the Reagan administration and investors rightfully associate it with the four-decade bull market that began early in its first term. Biden is no wild-eyed liberal, but rolling back core Reagan-era tenets has the potential to roll back juicy Reagan-era returns. Only equities have the lengthy data series to allow a full comparison of Reagan-era returns with postwar New Deal-era returns (Table II-3), but the path of Treasury bond yields in the three-decade bear market that preceded the current four-decade bull market suggests that bonds generated little, if any, real returns in the pre-Reagan postwar period (Chart II-18). Stagnant precious metal returns point to tame Reagan-era inflation and downward pressure on input costs. Table II-3Annualized Real Market Returns Before And After Reagan March 2021 March 2021 Chart II-18Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Owning the market is not likely to be as rewarding going forward as it was in the Reagan era. Active management may again have its day in the sun as the end of the Reagan tailwinds open up disparities between sectors, sub-industries and individual companies. Even short-sellers may experience a renaissance. We recommend that multi-asset investors underweight bonds, especially Treasuries. We expect the clamor for bigger government will contribute to a secular bear market that could rival the one that persisted from the fifties to the eighties. Within Treasury portfolios, we would maintain below-benchmark duration and favor TIPS over nominal bonds at least until the Fed signals that its campaign to re-anchor inflation expectations higher has achieved its goal. Gold and/or other precious metals merit a place in portfolios as a hedge against rising inflation and other real assets, from land to buildings to other resources, are worthy of consideration as well. BCA has been cautioning of a downward inflection in long-run financial asset returns for a few years, based on demanding valuations and a steadily shrinking scope for ongoing declines in inflation and interest rates. Mean reversion has been part of the thesis as well; trees simply don’t grow to the sky. Now that the curtain has fallen on the Volcker and Reagan eras, the inevitable downward inflection has received a catalyst. We remain constructive on risk assets over the next twelve months, but we expect that intermediate- and long-term returns will fall well short of their post-1982 pace going forward. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com III. Indicators And Reference Charts BCA’s equity indicators continue to demonstrate that US stocks are running hot. Our technical, valuation, and speculation indicators are very extended, and margin debt has soared since the S&P 500 bottomed last spring. With so little room for error, a near-term pullback in stock prices remains a significant risk. Our monetary indicator extended its downtrend, reflecting a diminished intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings are pricing in a remarkably swift earnings recovery, but after a third consecutive quarter of double-digit earnings beats, the 2021 earnings outlook continues to gather momentum. Net revisions and positive earnings surprises remain near multi-decade highs. Among global equities, the US extended its modest underperformance after a decade of leading the pack. China continues to outperform, though at a slower rate since it became the first country to escape COVID-19’s grip, while emerging markets and Australia have also outperformed. Euro area stocks continue to lag, but we expect they will eventually take their place among the cyclical winners later this year. The US 10-Year Treasury yield surged in February, following through on January’s convincing break above its 200-day moving average. Our technical indicator shows that long-dated bonds are firmly in oversold territory, though they remain extremely expensive. Our valuation index points to higher yields over the cyclical investment horizon even if the rate of ascent eventually slows. The technical and valuation profile is similar for the US dollar. The greenback is technically oversold, even after its modest rally, but it remains expensive according to our models. If our base-case Goldilocks scenario unfolds globally this year, the counter-cyclical dollar should encounter a mild headwind. As with Treasuries, we expect valuation to trump technicals and see the USD continuing to trend lower over the full year. Commodity prices are surging across the board, ex-gold. Sentiment is bullish and speculative positioning in the CFTC’s 17-commodity aggregate grouping is at its post-GFC high, although it may have peaked for the time being. The move in commodities underscores the risk-on profile across financial markets and aligns with EM, Chinese and Australian equity outperformance. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes   Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Doug Peta, CFA Chief US Investment Strategist   Footnotes 1 Every single adult taxpayer with adjusted gross income (AGI) of $75,000 or less (and every married filing jointly taxpayer with AGI of $150,000 or less) was eligible for the full payments, and taxpayers with AGIs below $99,000 and $198,000, respectively, were eligible for partial payments. 2 Giles, Chris. “OECD warns governments to rethink constraints on public spending,” Financial Times, January 4, 2021. OECD warns governments to rethink constraints on public spending | Financial Times (ft.com) Accessed February 20, 2021. 3 International Monetary Fund (IMF). 2020. Fiscal Monitor: Policies for the Recovery. Washington, October. p. ix. 4 An additional 20 million households have received partial payments. 5 August 12, 1986 Press Conference News Conference | The Ronald Reagan Presidential Foundation & Institute (reaganfoundation.org), accessed February 4, 2021. Reagan makes the quip in his prepared opening remarks. 6 Reagan was a Democrat until he entered politics in his fifties. He claimed to have voted for FDR four times. 7 April 3, 1982 Radio Address President Reagan's Radio Address to the Nation on the Program for Economic Recovery - 4/3/82 - YouTube, accessed February 4, 2021. 8 As an actor, Reagan was perhaps best known for his portrayal of Notre Dame football legend George Gipp, who is immortalized in popular culture as the subject of the “win one for the Gipper” halftime speech. 9 July 22, 1981 White House Remarks to Visiting Editors and Broadcasters reaganfoundation.org, accessed February 8, 2021. 10 Reagan famously urged his followers, in reference to the USSR, “I urge you to beware the temptation of pride—the temptation of blithely declaring yourselves above it all and label both sides equally at fault, to ignore the facts of history and the aggressive impulses of an evil empire.” See his “Address to the National Association of Evangelicals,” March 8, 1983, voicesofdemocracy.umd.edu. 11 Robert Lighthizer, the Trump administration trade representative who directed its tariff battles, was a veteran of Reagan’s trade wars against Japan in the 1980s. 12 “Exclusive: The Trump Party? He still holds the loyalty of GOP voters,” USA Today, February 21, 2021, usatoday.com. 13 Open Letter to Ben Bernanke,” November 15, 2010. Open Letter to Ben Bernanke | Hoover Institution Accessed February 23, 2021. 14 Please see the following US Investment Strategy Special Reports, “Labor Strikes Back, Parts 1, 2 and 3,” dated January 13, January 20 and February 3, 2020, available at usis.bcaresearch.com.

Highlights US inflation is set to increase sharply over the coming months as base effects kick in. Higher fuel prices, fiscal stimulus, and the partial relaxation of lockdown measures should also boost inflation. The Fed is unlikely to react hawkishly to higher inflation, arguing that it is largely transitory in nature. While the Fed’s relaxed attitude towards inflation risks may be justified in the near term, there is a high probability that inflation will get out of hand later this decade. Contrary to conventional wisdom, many of the factors that led to high inflation in the 1970s could reassert themselves. Investors should overweight stocks for now, but be prepared to reduce equity exposure in about two years. US Inflation Has Bottomed US inflation surprised on the downside in January. The core CPI was flat on the month, compared with the consensus estimate for an increase of 0.2%. We expect US inflation to move higher over the coming months. The weakness in January’s inflation print was concentrated in sectors of the economy that have been hard hit by the pandemic. Airline fares dropped 3.2%, hotel rates fell 1.9%, and entertainment admission prices declined 5.5%. Prices in these sectors should rise on a year-over-year basis as base effects kick in (Chart 1). The relaxation of lockdown measures should also help to partially restore demand in these areas. WTI crude prices have risen 70% since the end of October. Rising energy prices should push up headline inflation, with some bleed-through to core prices. Chart 2 shows that there is a strong correlation between gasoline prices and headline inflation. If gasoline prices evolve in line with what is predicted by the futures market, headline inflation could temporarily rise to 4% this spring. Chart 1Base Effects Will Push Inflation Higher 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Chart 2Strong Link Between Gasoline Prices And Headline Inflation Strong Link Between Gasoline Prices And Headline Inflation Strong Link Between Gasoline Prices And Headline Inflation   In addition, the lagged effects from a weaker dollar should translate into higher goods prices in the US (Chart 3). A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation (Chart 4).  Chart 3A Weaker Dollar Will Be A Tailwind For Inflation A Weaker Dollar Will Be A Tailwind For Inflation A Weaker Dollar Will Be A Tailwind For Inflation Chart 4Stronger Labor Market Will Boost Housing Inflation Stronger Labor Market Will Boost Housing Inflation Stronger Labor Market Will Boost Housing Inflation Fiscal stimulus should further supercharge demand, adding to inflationary pressures. Ironically, Republican unwillingness to offer modest, politically palatable cuts to President Biden’s proposed aid bill has opened the door to the Democrats ramming through the entire $1.9 trillion package via the reconciliation process. As we discussed last week, the amount of stimulus in the pipeline easily dwarfs the size of the output gap.   From Reflation To Inflation? Deflation is bad for stocks, just as is high and accelerating inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. Chart 5Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed Inflation Expectations Have Recovered But Are Still Below Levels That Would Cause Concern For The Fed We are currently in a reflationary Goldilocks zone, where inflation expectations have risen but not by enough to force the Fed’s hand. There is a high probability we will stay in this Goldilocks zone for the remainder of the year. The 5-year/5-year forward TIPS breakeven rate is still below the level that the Fed regards as consistent with its long-term inflation objective, and even farther below the level that would cause the Fed to panic (Chart 5). Jay Powell told The Economic Club of New York last week that the Fed is unlikely to “even think about withdrawing policy support” anytime soon. The Fed minutes released on Wednesday echoed this view. That ‘70s Show? The path to higher interest rates is lined with lower interest rates. A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened during the 1970s, it is prudent to ask whether something like that could happen again. Investors certainly do not believe a replay of the 70s is in the cards, at least if long-term CPI swaps are any guide (Chart 6). Yet, we think that a 1970s-style inflationary episode is a greater risk than most investors realize. As we discuss below, much of what investors believe about how inflation emerged during that period is either based on myths, or at best, half-truths. Let’s examine each of these misconceptions in turn. Myth #1: High inflation in the 1970s was primarily driven by supply disruptions, with oil shocks being the most prominent. Fact: Oil shocks exacerbated the inflation problem in the 1970s, but it was an overheated economy that permitted inflation to rise in the first place. Inflation took off in 1966, seven years before the first oil shock. By 1969, core CPI inflation was running at close to 6% (Chart 7). Chart 6Investors Do Not Expect Inflation To Vault Higher 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Chart 7Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again   Similar to today, fiscal policy was exceptionally accommodative in the mid-1960s. The escalation of the Vietnam War produced a surge in military expenditures. Social spending rose dramatically with the introduction of Lyndon Johnson’s “Great Society” programs. Medicare and Medicaid took effect in July 1966. Amy Finkelstein has estimated that Medicare, the larger of the two health care programs, led to a 37% increase in real hospital expenditures between 1965 and 1970. Johnson’s “guns and butter” policies caused government spending to surge in the second half of the decade. The budget deficit, which was broadly balanced during the first half of the 60s, swelled to 4% of GDP (Chart 8). As fiscal policy was loosened, the economy began to overheat. The unemployment rate fell to 3.8% in 1966, two percentage points below what economists later concluded had been its full-employment level. Chart 8US "Guns And Butter" Policies In The 1960s Caused Government Spending To Swell US "Guns And Butter" Policies In The 1960s Caused Government Spending To Swell US "Guns And Butter" Policies In The 1960s Caused Government Spending To Swell Myth #2: The Phillips curve is much flatter today. Chart 9The Increase In Inflation In 1966 Was Broad-Based The Increase In Inflation In 1966 Was Broad-Based The Increase In Inflation In 1966 Was Broad-Based Fact: The Phillips curve was also flat during the 1960s. Core inflation was remarkably stable during the first half of the 60s, averaging about 1.5%, even as the unemployment rate steadily declined. Then, starting in 1966, core inflation more than doubled within the span of ten months. As Chart 9 illustrates, the sudden spike in inflation in 1966 was fairly broad-based. A “kink” in the Phillips curve had been reached. That the relationship between inflation and unemployment turned out to be non-linear is not surprising. As long as there is some slack in the labor market, employers are likely to resist raising wages. Thus, a decline in unemployment from a high level to a merely moderate level is unlikely to lead to meaningful wage inflation. It takes a truly overheated labor market – one that forces firms to engage in a tit-for-tat battle to entice workers – for the relationship between unemployment and inflation to reassert itself. In the near term, there is little risk that the US economy will reach a kink in the Phillips curve. Jason Furman estimates that the unemployment rate stood at 8.3% in January if one adjusts for the drop in labor force participation and methodological problems with how the BLS defines temporarily furloughed workers. This is well above the level that could trigger a price-wage spiral. Chart 10Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Yet, it would be naïve to think that such a spiral could not materialize in a few years. As Chart 10 shows, over the past 40 years, every time the US labor market was on the cusp of overheating, something would invariably come along to push up unemployment. Last year, it was the pandemic. In 2008, it was the Global Financial Crisis. In 2000, it was the dotcom bust. In the early 1990s, it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a truly exogenous shock. The preceding three recessions were fomented by growing economic imbalances, which were ultimately laid bare by a Fed hiking cycle. One can debate the degree to which the US economy is suffering from non-pandemic related imbalances today, but one thing is certain: The Fed is not keen on raising rates anytime soon. Thus, whatever imbalances exist today may not be exposed before the economy has had the chance to overheat. Myth #3: Inflation expectations are better anchored these days. Chart 11Long-Term Bond Yields Lagged Inflation During The 1960s Long-Term Bond Yields Lagged Inflation During The 1960s Long-Term Bond Yields Lagged Inflation During The 1960s Fact: Inflation expectations certainly became unmoored in the 1970s. However, there is not much evidence that expectations were adrift prior to the sudden increase in inflation in 1966. At the time, the US had not experienced a major episode of inflation since the Civil War. While long-term bond yields did rise in the second half of the 60s, they generally lagged inflation, suggesting that investors were caught off-guard (Chart 11). It should also be noted that the US and other major economies operated under the Bretton Woods system of fixed exchange rates during the 1960s. Each US dollar was convertible into gold at the official rate of $35 per ounce. The existence of this quasi-gold standard helped anchor inflation expectations. The system began to fall apart in the late 1960s as inflation rose. When President Nixon suspended the dollar’s convertibility into gold in August 1971, the US CPI had already increased by nearly 30% from its 1965 level. While the collapse of the Bretton Woods system in the early 1970s undoubtedly caused inflation expectations to become further unhinged, the breakdown of the system would not have occurred if inflation had not risen in the first place. Myth #4: Widespread wage indexation and powerful trade unions fueled an acceleration in the 1960s. Fact: Just as was the case with the unmooring of inflation expectations, wage indexation was more a response to rising inflation than a cause of it. Chart 12 shows that the share of workers covered by cost of living adjustments only jumped after inflation had accelerated. Chart 12Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around As far as unions are concerned, the US unionization rate peaked by the end of the 1950s and was already on a downward path when inflation began to rise. Revealingly, Canada experienced a similar decline in inflation as the US in the early 1980s even though unionization rates remained elevated (Chart 13). This suggests that union power was not a dominant driver of inflation. Chart 13Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate   Myth #5: Today’s globalized economy will limit inflationary pressures. Fact: The empirical evidence generally suggests that the impact of globalization on US inflation has been smaller than widely supposed.1 This is not surprising. The US is a fairly closed economy. Imports account for only 15% of GDP. As a result, a fairly large change in relative prices is necessary to prompt Americans to shift a meaningful fraction of their expenditures towards foreign-made goods. Such a shift in spending would require a real appreciation of the US dollar. A real appreciation could occur either if US inflation exceeds inflation abroad or if the nominal value of the dollar strengthens against other currencies. (Admittedly, the standard terminology can be a bit confusing; just think of a real US dollar appreciation as anything that makes the US economy less competitive). Here’s the thing though: The US dollar is unlikely to strengthen unless the Federal Reserve starts to sound more hawkish. If the Fed remains in the dovish camp, real rates could fall as inflation edges higher. This will put downward pressure on the dollar, leading to a smaller trade deficit and even more aggregate demand.  Myth #6: Demographics are much more deflationary now than they were in the past. Fact: Demographic trends arguably did help push down inflation over the past few decades. However, population aging is likely to boost inflation going forward. Chart 14 shows that the ratio of workers-to-consumers in the US and around the world – the so-called “support ratio” – rose steadily in the 1980s, 1990s, and 2000s as more women entered the labor force and the number of dependent children per household declined. An increase in the ratio of workers-to-consumers is equivalent to an increase in the ratio of production-to-consumption. A rising support ratio is thus deflationary. More recently, however, the support ratio has begun to decline as baby boomers retire but continue to spend. Consumption actually increases in old age once health care spending is included in the tally (Chart 15). As production falls in relation to consumption, inflation could rise. Chart 14Support Ratios Are Declining Globally After Rising Steadily For Three Decades Support Ratios Are Declining Globally After Rising Steadily For Three Decades Support Ratios Are Declining Globally After Rising Steadily For Three Decades Chart 15Consumption Increases In Old Age Once Health Care Spending Is Factored In 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again   Myth #7: Today’s fast pace of technological innovation will keep inflation down. Chart 16Total Factor Productivity Growth Is Lower Than It Was During The Great Inflation Total Factor Productivity Growth Is Lower Than It Was During The Great Inflation Total Factor Productivity Growth Is Lower Than It Was During The Great Inflation Fact: Total factor productivity growth – a broad measure of innovation – is not just low by historic standards today; it is lower than during the period of the Great Inflation spanning from 1966 to 1982 (Chart 16). Some have argued that productivity growth is mismeasured. We have examined this argument in the past and found it wanting. In any case, economic theory does not necessarily say that technological innovation should be deflationary. Economic theory states that faster innovation should lead to higher real incomes. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Myth #8: Policymakers have learned from their mistakes. It is easy to dismiss this claim, but it is worth considering it seriously. Some of the mistakes that policymakers made during the 60s and 70s were far from obvious at the time. Athanasios Orphanides, who formerly served as a member of the ECB’s Governing Council, has documented that central banks in the US and other major economies systematically overestimated the amount of slack in their economies (Chart 17). They also overestimated trend growth, with the result that they came to see the combination of sluggish growth and seemingly high unemployment as evidence of inadequate demand. Chart 17Central Banks Overestimated The Degree Of Slack In Their Economies During The Great Inflation 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Is it possible that economic analysis has improved so much over the past 40 years that such mistakes would not be repeated today? Perhaps, but it is worth noting that not only did most economists fail to predict the productivity boom in the late 1990s, most were not even aware that it had happened until after it had ended. Knowing what is happening to the economy in real time is hard enough. Predicting what will happen to such things as trend growth and the natural rate of unemployment is even more difficult. Myth #9: The Fed is a lot more independent now. Fact: We will only know for sure when this independence is tested. History clearly shows that inflation tends to be higher in countries which lack independent central banks (Chart 18). The Fed’s independence was compromised in the 1970s. In his exhaustive study of the Nixon tapes, Burton Abrams documented how Richard Nixon sought, and Fed Chairman Arthur Burns obligingly delivered, an expansionary monetary policy in the lead-up to the 1972 election. Chart 18Inflation Is Higher In Countries Lacking Independent Central Banks 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Starting with the appointment of Paul Volcker, the Fed sought to regain its independence. Most recently, Jay Powell publicly resisted Donald Trump’s efforts to prod the Fed to ease monetary policy. Yet, the Fed’s independence may turn out to be illusory. The Fed wasted little time in slashing rates and relaunching its QE program once the pandemic began. But will it be as quick to tighten monetary policy if inflation starts getting out of hand? Jay Powell’s four-year term as chair runs through February 2022. He will need to stay in Joe Biden’s good graces if he hopes to be reappointed to a second term. The fact that government debt levels are so high further complicates matters. Higher interest rates would force the government to shift funds from social programs towards bond holders. Will the Fed raise rates even if it faces strong political opposition? Time will tell. Investment Conclusions Chart 19Social Unrest Can Fuel Inflation 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and the present day. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: Just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy. The 1960s was a decade of rising political and social unrest. Crime rates went through the roof, a trend that was eerily matched by rising inflation rates (Chart 19). Early estimates suggest that the US homicide rate jumped by 37% in 2020 – easily the largest one-year increase on record. As was the case in the 1960s, most of the news media has ignored this disturbing development. What should investors do? Our tactical MacroQuant model is flagging some near-term risks for stocks. Nevertheless, as long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors with a 12-month horizon to bail on equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Commodity producers are a natural choice. Banks could also gain from an uptick in inflation. Chart 20 shows the remarkably strong correlation between the performance of US banks relative to the S&P 500 and the 10-year Treasury yield. Higher bond yields would boost bank net interest margins, leading to higher profits. Banks are also very cheap and have started to see their earnings estimates rise faster not only relative to the broader market but even relative to tech stocks (Chart 21). Chart 20Bank Shares Are A Buy (I) Bank Shares Are A Buy (I) Bank Shares Are A Buy (I) Fixed-income investors should keep duration risk low. They should also favor inflation-protected securities over nominal bonds. Chart 21Bank Shares Are A Buy (II) 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Looking further out, the secular bull market in stocks will end when inflation rises to a high enough level that even the Fed cannot ignore. That day will arrive, but probably not for another two years.   Peter Berezin Chief Global Strategist pberezin@bcaresearch.com   Footnotes 1  Globalization is often cited as a potential reason behind low inflation in advanced economies, including the US. However, a number of empirical studies have found that globalization did not play a major role. In general, domestic economic conditions are seen as the main factor in the inflation process. Please see Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, “Some Simple Tests of the Globalization and Inflation Hypothesis,” Board of Governors of the Federal Reserve System (International Finance Discussion Papers No. 891) (April 2007); Laurence M. Ball, “Has Globalization Changed Inflation?” National Bureau of Economic Research Working Paper Series 12687 (November 2006), and associated blog post “Has Globalization Changed Inflation?” National Bureau of Economic Research,  (June 2007); Janet. L. Yellen, 'Panel discussion of William R. White “Globalisation and the Determinants of Domestic Inflation”,' Presentation to the Banque de France International Symposium on Globalisation, Inflation and Monetary Policy (March 2008); Fabio Milani, “Global Slack And Domestic Inflation Rates: A Structural Investigation For G-7 Countries,” Journal of Macroeconomics, (32:4) (2010); and and Lei Lv, Zhixin Liu, and Yingying Xu, “Technological progress, globalization and low-inflation: Evidence from the United States,” PLoS ONE, (14:4), (April 2019).   Global Investment Strategy View Matrix 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Special Trade Recommendations 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again Current MacroQuant Model Scores 1970s-Style Inflation: Yes, It Could Happen Again 1970s-Style Inflation: Yes, It Could Happen Again

Global equity valuations are at a level where they are very sensitive to changes in the discount rate. Chart 1 shows that the cyclically-adjusted earnings yield on the S&P 500 is slightly below its 2000 low. Equity investors have thus far taken comfort from the fact that US bond yields have been depressed, and taking into consideration low bond yields the US equity market is not as bubbly as it was in the 2000s. Chart 1Rising US Bond Yields Threatens US Equity Valuations Rising US Bond Yields Threatens US Equity Valuations Rising US Bond Yields Threatens US Equity Valuations However, the fact that the US equity market’s valuations after accounting for the level of interest rates are not as expensive as they were in 2000 does not mean share prices cannot experience a meaningful shakeout. Notably, there is a lot of speculation and euphoria among investors, reminiscent of the late 1990s (please refer to Charts 24-26 below). Critically, when equity multiples are very elevated and bond yields are extremely low, the sensitivity of multiples to interest rates is most pronounced. Hence, rising US Treasury yields could result in a setback in share prices. All in all, our themes for now are as follows: Chart 2A Full-Fledged Mania In Asian TMT Stocks A Full-Fledged Mania In Asian TMT Stocks A Full-Fledged Mania In Asian TMT Stocks Enormous US fiscal and monetary stimulus, strong economic growth and supply bottlenecks will push up the US core inflation rate. As a result, the ongoing sell-off in long-term US bond yields will continue. EM and DM credit spreads are currently very tight and credit spreads might not be able to compress further to offset the rise in US Treasury yields. Hence, rising US Treasury yields will trigger higher corporate and EM sovereign bond yields. In brief, rising EM bond yields is the key risk to EM share prices. Charts 5 and 6 below illustrate these points. Given that the US trade-weighted dollar is extremely oversold, rising US Treasury yields will likely trigger a countertrend rally in the greenback. This will cause a shakeout in EM currencies, fixed-income markets and commodities prices. Historically, the greenback has not had a stable relationship with US Treasury yields – they were both positively and negatively correlated in different periods. In such an environment, DM growth stocks will underperform DM value stocks. We have less conviction in growth/value performance in the EM space. The reason lies in the speculative frenzy taking place in Chinese new economy stocks trading in Hong Kong as well as tech share prices in Korea and Taiwan. As Chart 2 reveals, the Hang Seng Tech index and EM TMT stocks have been rising exponentially. Visibility is very low. The timing of a reversal of this equity euphoria is impossible to predict. Outside these TMT stocks, the relative performance of EM equities has been rather underwhelming, as is illustrated in Charts 71-73. Notably, the economic recovery in EM ex-China, Korea and Taiwan has been much weaker than those in DM and North Asian economies (please refer to Charts 63 and 66). This will continue as many of these nations are lagging in vaccine rollouts and their fiscal and monetary support has been much smaller. In addition, peak stimulus in China means that the mainland’s construction and infrastructure investment will slow meaningfully in H2 2021. This is another risk to EM economies supplying to China. Weighing pros and cons, we continue to recommend a neutral allocation to EM in a global equity portfolio. The same is true for EM credit (sovereign and corporate) within a global credit portfolio. For local bonds, inflation in EM – including China – is still very low and will likely stay depressed. As a result, we continue recommending receiving 10-year swap rates in Mexico, Colombia, Russia, Malaysia, India and China. Investors should use a rebound in the US dollar  to transition from receiving rates to being long on cash bonds. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Yellow Flags For Share Prices Rising US corporate bond yields pose a risk to the equity rally. Interestingly, New Zealand’s stock market has begun correcting. Often but not always, this development heralds a pullback in EM share prices (albeit for unknown reasons). Chart 3Yellow Flags For Share Prices Yellow Flags For Share Prices Yellow Flags For Share Prices Chart 4Yellow Flags For Share Prices Yellow Flags For Share Prices Yellow Flags For Share Prices Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields Historically, rising EM corporate USD bond yields led to a selloff in EM share prices. If rising US Treasury yields begin pushing up EM sovereign and corporate bonds yields, which is quite likely, the EM equity rally will be jeopardized. Chart 5Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields Chart 6Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields Beware Of Potential Rise In EM Sovereign And Corporate USD Bond Yields EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery So far, the EM equity index has snubbed the rollover in China’s credit impulse and plummeting gold prices in non-US dollar currencies. The ongoing EM corporate earnings recovery has justified the rally in of share prices. However, much  of the good news has already been priced in. Chart 7EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery Chart 8EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery Chart 9EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery EM Equities Are Ignoring Many Warning Signs Due To Profit Recovery   Investors Are Super Bullish European investors are very bullish on EM equities and European growth. From a contrarian perspective, this does not always herald a bear market but suggests that odds of a meaningful shakeout are non-trivial. Chart 10Investors Are Super Bullish Investors Are Super Bullish Investors Are Super Bullish Chart 11Investors Are Super Bullish Investors Are Super Bullish Investors Are Super Bullish Investor Growth Expectations Are Super High Our proxy for global growth expectations as well as EM net EPS revisions are elevated. Similarly, analysts’ EM 12-month forward EPS growth differential vs. US are the widest since 2001. Chart 12Investor Growth Expectations Are Super High Investor Growth Expectations Are Super High Investor Growth Expectations Are Super High Chart 13Investor Growth Expectations Are Super High Investor Growth Expectations Are Super High Investor Growth Expectations Are Super High US Inflation And Rates US core goods inflation has been rising due to strong US household demand and supply bottlenecks. When the economy fully reopens, US core service inflation will rise as pent-up demand for services is unleashed. This will push up US bond yields regardless of the Fed’s rhetoric. Chart 14US Inflation And Rates US Inflation And Rates US Inflation And Rates Chart 15US Inflation And Rates US Inflation And Rates US Inflation And Rates   Chart 16US Inflation And Rates US Inflation And Rates US Inflation And Rates Look Out For Cracks In EM High-Yield Bond Space A rise in US TIPS and nominal yields will likely send shockwaves through EM risk assets and commodities that have greatly benefited from the plunge in TIPS yields. Watch out for cracks in the EM high-yield bond space. Chart 17Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Chart 18Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Chart 19Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Chart 20Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space Look Out For Cracks In EM High-Yield Bond Space   EM Currencies Are Not Yet Expensive But Are Overbought Although cyclically and for some countries structurally speaking EM currencies have more upside and their appreciation path will not be without major setbacks. In fact, several key currencies like MXN and ZAR are facing an important technical resistance. Investors should not chase them higher but accumulate them on a relapse. Chart 21EM Currencies Are Not Yet Expensive But Are Overbought EM Currencies Are Not Yet Expensive But Are Overbought EM Currencies Are Not Yet Expensive But Are Overbought Chart 23EM Currencies Are Not Yet Expensive But Are Overbought EM Currencies Are Not Yet Expensive But Are Overbought EM Currencies Are Not Yet Expensive But Are Overbought Chart 22EM Currencies Are Not Yet Expensive But Are Overbought EM Currencies Are Not Yet Expensive But Are Overbought EM Currencies Are Not Yet Expensive But Are Overbought   Equity Market Euphoria Is Running Wild Certain measures of stock market activity – like the call-put ratio, trading volumes and margin loans –  reveal engulfing speculative behavior not only in the US but also in other markets like Korea. Chart 24Equity Market Euphoria Is Running Wild Equity Market Euphoria Is Running Wild Equity Market Euphoria Is Running Wild Chart 25Equity Market Euphoria Is Running Wild Equity Market Euphoria Is Running Wild Equity Market Euphoria Is Running Wild Chart 26Equity Market Euphoria Is Running Wild Equity Market Euphoria Is Running Wild Equity Market Euphoria Is Running Wild   A Mania Can Run Further And Longer Than Rational Analysis Can Envision The IPO boom is not as expansive as it was at its 2000 and 2007 peaks and there is some US dollar cash left to be put to work. Visibility is very low. Chart 27A Mania Can Run Further And Longer Than Rational Analysis Can Envision A Mania Can Run Further And Longer Than Rational Analysis Can Envision A Mania Can Run Further And Longer Than Rational Analysis Can Envision Chart 28A Mania Can Run Further And Longer Than Rational Analysis Can Envision A Mania Can Run Further And Longer Than Rational Analysis Can Envision A Mania Can Run Further And Longer Than Rational Analysis Can Envision Chart 29A Mania Can Run Further And Longer Than Rational Analysis Can Envision A Mania Can Run Further And Longer Than Rational Analysis Can Envision A Mania Can Run Further And Longer Than Rational Analysis Can Envision   Steep Equity Volatility Curves A steep equity volatility curve heralds a correction. Chart 30Steep Equity Volatility Curves Steep Equity Volatility Curves Steep Equity Volatility Curves Chart 31Steep Equity Volatility Curves Steep Equity Volatility Curves Steep Equity Volatility Curves Chart 32Steep Equity Volatility Curves Steep Equity Volatility Curves Steep Equity Volatility Curves Chart 33Steep Equity Volatility Curves Steep Equity Volatility Curves Steep Equity Volatility Curves   Volatilities Across FX, Bonds And Commodities Oil volatility has been and remains in a bull market – making higher lows. Currency volatility remains elevated while US bond volatility is still very low and is bound to rise. Chart 34Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Chart 35Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Chart 36Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Chart 37Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities   Chart 38Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Chart 39Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities Volatilities Across FX, Bonds and Commodities   Cyclicals Vs. Defensives And Growth Vs. Value Performance Global cyclical stocks’ relative performance versus defensive stocks might be due for a pause. Growth will underperform value in DM due to rising bond yields. We are less convinced about the growth/value performance in the EM equity space due to the mania occurring in EM TMT stocks. Chart 40Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Chart 41Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Chart 42Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Chart 43Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance Cyclicals Vs. Defensives And Growth Vs. Value Performance   Profiles Of Various Global Equity Indexes Many global equity indexes excluding US or TMT have either not broken out or have done so only marginally. Chart 44Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Chart 45Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Chart 46Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Chart 47Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes Profiles Of Various Global Equity Indexes   EM ex-TMT Equity Performance Has Been Unimpressive Excluding TMT stocks, EM equity indexes have not broken above their previous highs. It has been a mania in TMT stocks that has boosted the EM overall equity index. Chart 48EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive Chart 49EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive Chart 50EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive Chart 51EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive EM ex-TMT Equity Performance Has Been Unimpressive   A Mania In Chinese Stocks, Especially In TMT Stocks Chinese offshore stocks ex-TMT and onshore equal-weighted and small caps have done rather poorly. The latest euphoria in Hong Kong-listed Chinese stocks has been due to an increased quota for mainland investors to buy offshore stocks. This has led to massive southbound outflows and has propelled Chinese stock trading in Hong Kong. Chart 52A Mania In Chinese Stocks, Especially In TMT Stocks A Mania In Chinese Stocks, Especially In TMT Stocks A Mania In Chinese Stocks, Especially In TMT Stocks Chart 53A Mania In Chinese Stocks, Especially In TMT Stocks A Mania In Chinese Stocks, Especially In TMT Stocks A Mania In Chinese Stocks, Especially In TMT Stocks   Chart 54A Mania In Chinese Stocks, Especially In TMT Stocks A Mania In Chinese Stocks, Especially In TMT Stocks A Mania In Chinese Stocks, Especially In TMT Stocks The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 Rollover in credit and fiscal stimulus in Q4 2020 entails weak growth in H2 2021 in segments leveraged to stimulus. Chart 55The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 Chart 56The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021   Chart 57The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 Chart 58The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021 The Chinese Economy: Peak Stimulus = Weak Growth In H2 2021   Commodity Prices The end of commodities restocking in China, weaker demand from mainland construction in H2 and elevated investor net long positions in commodities constitute the basis for a setback in commodities prices this year. Nevertheless, such a pullback will occur only if the USD rebounds and global equity prices sell off. Chart 59Commodity Prices Commodity Prices Commodity Prices Chart 60Commodity Prices Commodity Prices Commodity Prices Chart 61Commodity Prices Commodity Prices Commodity Prices Chart 62Commodity Prices Commodity Prices Commodity Prices   The Recovery In EM ex-North Asia Has Been Very Subdued The economic recovery in EM ex-China, Korea and Taiwan has been much weaker than those in DM and North Asian economies. Chart 63The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued Chart 64The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued Chart 65The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued Chart 66The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued The Recovery In EM ex-North Asia Has Been Very Subdued   The Recovery In EM ex-North Asia Will Continue To Lag EM ex-North Asia’s economic underperformance will continue as many of these nations are lagging in vaccine rollouts and their fiscal and monetary support has been much smaller. Besides, their banks are reluctant to lend due to high NPLs. Chart 67The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag Chart 68The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag Chart 69The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag Chart 70The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag The Recovery In EM ex-North Asia Will Continue To Lag   EM ex-TMT Equity Performance Has Been Underwhelming A slow recovery in EM ex-TMT industries explains why EM equity performance outside TMT stocks has been underwhelming. Chart 71EM ex-TMT Equity Performance Has Been Underwhelming EM ex-TMT Equity Performance Has Been Underwhelming EM ex-TMT Equity Performance Has Been Underwhelming Chart 72EM ex-TMT Equity Performance Has Been Underwhelming EM ex-TMT Equity Performance Has Been Underwhelming EM ex-TMT Equity Performance Has Been Underwhelming Chart 73EM ex-TMT Equity Performance Has Been Underwhelming EM ex-TMT Equity Performance Has Been Underwhelming EM ex-TMT Equity Performance Has Been Underwhelming   Footnotes

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