Inflation/Deflation
Highlights Don’t trust market inflation expectations or real interest rates. When inflation is near-zero, think in nominal terms not in real terms. New structural recommendation: Underweight inflation protected bonds versus conventional bonds. For the time being stay overweight stocks versus bonds, but sell stocks if the 10-year T-bond yield rises by 0.3 percent. We address four concerns about inflation raised by clients. Fractal trade: short copper versus gold. Don’t Trust Market Inflation Expectations Or Real Interest Rates Are the markets any good at predicting inflation? No, they are not (Chart of the Week). Both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds have been lousy predictors of inflation.1 We can forgive that. What we cannot forgive is how these markets derive their inflation forecasts. Chart of the Week AThe Markets Are Lousy At Predicting Inflation Chart of the Week BThe Markets Are Lousy At Predicting Inflation Expected inflation in the UK just tracks the commodity price index (Chart I-2), and expected inflation in the US just tracks the oil price (Chart I-3 and Chart I-4). This link between expected inflation and the level of commodity prices is absurd, for three reasons: Chart I-2UK Bond Markets' Expected Inflation Just Tracks Commodity Prices Chart I-3US Bond Markets' Expected Inflation Just Tracks The Oil Price Chart I-4US Inflation Swaps' Expected Inflation Just Tracks The Oil Price Inflation measures a change in a price. Therefore, inflation expectations should not track the price level of anything. Even if expected inflation is incorrectly tracking a price level, a lower price today will increase the scope for future inflation, and vice-versa. Hence, any relationship with the current price level should be an inverse relationship, not a positive relationship. Most absurd of all, how can the level of commodity prices today conceivably forecast the inflation rate five years ahead through 2026-31, as the inflation forwards seem to be suggesting? There are two important takeaways from the absurdity of inflation expectations. First, it follows that the market’s estimates of the real interest rate must also be lousy, and taken with a huge dose of salt. The market’s estimates of the real interest rate must be taken with a huge dose of salt. Second, as the market’s inflation expectations just track commodity prices, the relative performance of UK index-linked gilts versus conventional gilts just tracks commodity prices too (Chart I-5); and the performance of US TIPS versus T-bonds just tracks the oil price. Nothing more and nothing less (Chart I-6). As we expect the structural bear market in commodities has much further to run, the structural recommendation for bond investors is: Chart I-5UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices Chart I-6US TIPS Vs. T-Bonds = The Oil Price Underweight inflation protected bonds versus conventional bonds. When Inflation Is Near-Zero, Think In Nominal Terms Not In Real Terms If the market is lousy at predicting long-term inflation, then it might also be lousy at predicting the long-term nominal return on equities. After all, shouldn’t prospective inflation impact the prospective 10-year nominal return on equities? The surprising answer is no. The prospective 10-year nominal return on the stock market depends only on the stock market’s starting valuation. The 10-year nominal return on the stock market does not depend on prospective inflation, it depends only on the stock market’s starting valuation. The same relationship between the stock market’s starting valuation and prospective nominal return applied in the high-inflation 1970s and 1980s as it did in the low-inflation 2000s (Chart I-7). Chart I-7The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The reason is that the stock market’s 10-year nominal return has two components: the income through the 10 years, and the terminal value at the end of the 10 years. When inflation is high, the income component is larger, but the terminal value component is smaller – because in an inflationary environment the market will demand a higher subsequent return, requiring a lower price. When inflation is low, the opposite is true: lower income, but higher terminal value. These effects cancel out, so the result is a prospective nominal return that is independent of prospective inflation. Crucially, the required prospective return on equities in excess of bonds is also established in nominal terms. This is because the bond yield’s lower limit is nominal, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. Witness Swiss bonds this year. As the riskiness of equities and bonds converges, the required prospective nominal return on equities collapses towards the ultra-low bond yields. The upshot is that both the prospective return on equities and the required prospective return on equities should always be calculated in nominal terms, never in real terms. Right now, the high valuation of the aggregate stock market means a very low prospective nominal return, and this valuation is hypersensitive to ultra-low bond yields (Chart I-8 and Chart I-9). Chart I-8The Stock Market Is Priced To Generate A Feeble Long-Term Return Chart I-9AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Chart I-9BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time For the time being stay overweight stocks versus bonds, but as we warned two weeks ago, Sell Stocks If The Bond Yield Rises By 0.3 Percent. Four Concerns About Inflation Raised By Clients In this section, which is in question and answer format, we will address four concerns about long-term inflation that our clients have raised. 1, Isn’t the unprecedent fiscal stimulus in 2020 setting us up for inflation down the road? No, not in itself. Understand that the unprecedented stimulus is in response to unprecedented shocks to incomes that have come from the rolling waves of the pandemic. As incomes disappeared, governments provided income-substitution. As and when incomes reappear, governments will withdraw the income-substitution. Indeed, the UK government tried to withdraw its income-substitution (furlough) scheme prematurely and had to backtrack when the virus resurged. This illustrates that the unprecedented fiscal stimulus is a much-needed stabiliser of the economy, rather than a source of inflation. 2. But if governments want a bit of inflation, they can get it, can’t they? No. Understand that inflation is a non-linear system with two states, price stability and price instability. You can shift between these two states, but you cannot get a ‘little bit of inflation’ in a controlled fashion, or hit an arbitrary inflation target like 2 percent, 3 percent, or 5 percent. This is something that we have been arguing for years, and it is comforting that some great thinkers – like (the late) Paul Volker and William White – fully support our non-linear system thesis. You cannot get a ‘little bit of inflation’ in a controlled fashion. Any government can take its economy into the state of price instability if it so chooses. Witness Turkey and Argentina. But price stability is the much better state to be in. Given that developed economies have expended decades of blood, sweat, and tears to reach the state of price stability, we think that it would be a monumental policy error to embark on the road to price instability (Chart I-10). Chart I-10Inflation Is A Non-Linear System With Two States, Price Stability And Price Instability 3. But doesn’t rampant Argentina-type inflation bail out the heavily indebted? No, not necessarily. It will only bail you out if your debt is a one-off lump sum payment in the distant future. If your debt requires ongoing refinancing, then inflation will not bail you out, because the refinancing interest rate could rise in line with, or even faster than, the inflation rate. Therefore, those highly indebted governments, firms, and households that need to refinance their debts would not benefit from rampant inflation. 4. In which case, isn’t the solution to let inflation rip while keeping interest rates depressed – so-called ‘financial repression?’ No. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of equities and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the required prospective nominal return would surge as a compensation for the higher inflation. The result being an almighty crash in stock and real estate markets. Given that the near $500 trillion combined worth of such markets dwarfs the $90 trillion global economy, the impact of such a crash would make this year’s pandemic feel like a waltz in the park. Fractal Trading System* This week’s recommended trade is short copper versus gold, given that the spectacular relative outperformance is showing fragility in both its 65-day and 130-day fractal structures. The profit target and symmetrical stop-loss is set at 10 percent. Chart I-11Copper Vs. Gold In other trades, long RUB/CZK reached the end of its holding period with a marginal partial loss. The rolling 12-month win ratio now stands at 53 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights Inflation Breakeven Trades: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, as breakevens in both countries are no longer below the fair values implied by our models. We are initiating a new trade this week, going long French 10-year inflation-linked bonds versus French nominal OATs, as French breakevens remain below fair value. Yield Curve Butterfly Trades: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Cross-Country Spread Trades: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months. Feature Dear Client, Next week, we will be jointly publishing our semi-annual Central Bank Monitor Chartbook along with our colleagues at BCA Research Foreign Exchange Strategy. You will receive that report a few days later than usual on Friday, December 11. We will return to our regular publishing schedule on Tuesday, December 15 with our 2021 Key Views report outlining our main investment themes and ideas for the upcoming year. Best Regards, Rob Robis As we enter the final weeks of an incredibly eventful and (unfortunately) all too memorable 2020, our attention now turns to investment ideas for the coming New Year. This week, all BCA Research clients will receive the 2021 Outlook report, detailing the key themes and recommendations from all our strategists. We will follow that up with our own 2021 Global Fixed Income Strategy outlook report later this month. The waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio. In addition, the waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio (Table 1). Several of our suggested trades have generated a solid profit (like inflation breakeven wideners) but have now outlived their original rationale. Others, like some of our yield curve trades in Europe, have not gone as we expected and should therefore be closed out. Table 1Changes To Our Tactical Overlay Portfolio As a reminder to our regular readers, our Tactical Overlay is a portfolio of individual trade ideas within the global fixed income space with an investment horizon of six months or less. These differ from our more typical strategic (6-12 month) recommendations that also populate our model bond portfolio. Ideas for our Tactical Overlay trades often stem from our fair value models, but can also be plays on events that we expect will be market relevant on a near-term basis, like central bank meetings. All recommended trades are implemented using specific securities, rather than generic Bloomberg tickers or bond indices. This allows for a more transparent process where clients can follow along with the performance of our trades. Evaluating Our Tactical Inflation-Linked Breakeven Trades We currently have two open tactical trade recommendations involving inflation-linked bonds: Long 10-year Italian inflation-linked bonds vs short 10-year Italian bond futures Long 10-year Canadian inflation-linked bonds vs short 10-year Canadian bond futures We initiated both of these trades back in June of this year, as well as an additional trade involving US TIPS, based on the output of our inflation breakeven fair value framework. In our models, we regress 10-year inflation breakevens on the annual rate of change of oil prices in local currency terms and a multi-year moving average of realized headline inflation.1 At the time of our mid-year report, inflation breakevens were too low on our models in the majority of developed market countries with inflation-linked bonds – a lingering after-effect of the COVID-19 shock to global growth in the second quarter of 2020 (Chart 1). Since then, 10-year inflation breakevens have caught up to fair value in the US, Germany, Italy and Canada, and have even moved above fair value in the UK and Australia. Chart 1A Big Shift In Inflation Breakeven Valuations In June, we also entered into a US 10-year TIPS breakeven widening trade, but we took profits on the trade once US breakevens returned back to our model fair value estimate in September. We now see a similar situation in Canada (Chart 2) and Italy (Chart 3) where breakevens have converged to our model-implied fair value. Chart 2Canadian 10-Year Inflation Breakeven Model A move above fair value is possible, but could be harder to achieve with the Canadian dollar and euro steadily trending higher which could weigh on the market’s view on future inflation in Canada and Italy. We are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. Thus, we are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. The Italian returns were boosted considerably by the long side of this trade, as we entered the position when the 10-year real yield was +1.05% and which has since collapsed to -0.05% on the back of the massive rally in Italian bonds. One place where breakevens still look attractively cheap, trading close to one standard deviation below our model fair value, is in France (Chart 4). This contrasts with the breakevens in Italy and Germany that have fully converged to fair value. Thus, we are entering a new trade this week, going long the on-the-run 10yr French inflation-linked bond (OATi) and shorting French bond futures (Euro-OATs). The hedge ratio used for this trade to keep both legs duration matched, given the much shorter duration of the OATi relative to nominal French bonds, is 0.49 (see the Tactical Overlay table on page 17 for specific details on the securities used in the trade). Chart 3Italian 10-Year Inflation Breakeven Model Chart 4French 10-Year Inflation Breakeven Model Bottom Line: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, while initiating a new breakeven widening position in France, based on the output of our breakeven fair value models. Evaluating Our Yield Curve/Butterfly Spread Trades Back in July, we initiated a series of yield curve butterfly spread trades in the US, UK, Italy and France.2 Butterfly spreads compare the yield of a single bond (bullets) to that of a duration-neutral combination of bonds with shorter and longer maturities relative to the bullet (barbells). Our valuation models produce fair value estimates of various butterfly combinations based on the relation of the butterfly spreads to the slope of the yield curve. We then combine those valuations with our own macro views on the future slope of yield curves to come up with potential value-based curve trades.3 We now evaluate our four existing curve trades in turn. Long UK 3/20 Barbell vs. 10-Year Bullet Our original rationale for entering this trade was two-fold. Firstly, this position was the most attractive butterfly combination in terms of the standardized deviation of the spread from its model-implied fair value. Secondly, there was a relatively low correlation between nominal UK bond yields and inflation breakevens--meaning that we could see a rise in long-dated inflation expectations that did not also push up nominal bond yields by a proportional amount. This made the trade consistent with our overall macro view back in July that the Gilt curve would flatten (the same rationale applies to the other two long barbell versus short bullet trades, or “flatteners”, in France and Italy that we discuss below). Unfortunately, our rationale did not play out as expected (Chart 5). Instead of reverting to fair value, the butterfly spread was mostly flat while the bullet grew more expensive relative to the barbell, driven by a rise in the model fair value. This in turn was due to significant steepening in the underlying 3/20 curve, contrary to our expectations. We also saw a significant overall upward shift in the overall UK Gilt curve, which generated losses on our long barbell position (which has a higher interest rate convexity) that overwhelmed the profits on our short bullet position. Going forward, there are good technical and strategic reasons to exit this trade. The butterfly spread is not yet at levels where it tends to mean-revert (second panel). In addition, Joe Biden’s US election victory has also increased the odds of a Brexit deal, which would put bear-steepening pressure on the UK Gilt curve. With that in mind, we are closing our Long UK 3/20 Barbell vs. 10-Year Bullet for a loss of -0.17%. Long France 2/30 Barbell vs. 5-Year Bullet Our rationale for entering this flattener was the same as in the UK. However, we fared quite a bit better here. The underlying 2/30 curve did flatten, as we expected, however, the butterfly spread itself moved further away from fair value, with the bullet component becoming relatively more expensive (Chart 6). So, as with the UK, the returns on this trade can be largely explained by the relative outperformance of the barbell component due to its higher convexity. In France, however, the effect worked to our favor as the yield curve shifted downwards significantly. The positive returns on the long French 30-year OAT component, where yields have been nearly slashed in half since July, dominated the other parts of the trade - even with the 30-year bond only being a small piece (11%) of the duration-weighted barbell Chart 5UK 3/10/20 Spread Fair Value Model Chart 6France 2/5/30 Spread Fair Value Model Although we did make profits on the flattener, it turned into a convexity bet that was not our original intention. Seeing as our underlying logic did not work out as expected, we are not comfortable remaining in this position. Thus, we are closing our France butterfly trade for a profit of 0.56%. Long Italy 5/30 Barbell vs. 10-Year Bullet As with the UK and France, we entered this trade based on its attractive model-based valuation and the relatively low correlation between inflation breakevens and nominal yields in France. Our expectation of flattening in the underlying 5/30 curve did not bear out as it remained mostly flat (Chart 7). We did see some reversion in the butterfly spread towards our model-implied fair value, which helped us make profits on our trade. Again, we cannot ignore the effect of convexity when looking at the outperformance of the barbell component. Yields fell dramatically across the Italian curve in one of the clearest examples of the yield-chasing behavior we have been describing this year.4 As Italian yields continue their race to the bottom, supported by ECB asset purchases and perceptions of more fiscal co-operation between the countries of Europe, there is a chance that this trade will continue to perform by virtue of its exposure to the long end of the Italian curve. However, as our original bias towards curve flattening did not play out, we prefer to maintain our exposure to Italian government debt via an overweight allocation in our model bond portfolio instead. We therefore close our Long Italy 5/30 Barbell vs. 10-Year Bullet for a profit of 0.83% Long US 7-Year Bullet vs. 5/10 Barbell The US was the only region where we initiated a “steepener” trade, with a long bullet versus short barbell combination that does well when the yield curve steepens. We chose this particular 5/7/10 butterfly as it was the most attractive steepener available based on our model-implied valuation that also fit our fundamental macro bias back in July towards US Treasury curve steepening – a view that we still hold today. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Our rationale for initiating the trade was borne out, with the underlying 5/10 Treasury curve steepening and the butterfly spread tightening towards fair value (Chart 8). Our trade was supported by a continued rebound in long-dated US inflation expectations as well as the US election result, the most bond-bearish event of the year. Chart 7Italy 5/10/30 Spread Fair Value Model Chart 8US 5/7/10 Spread Fair Value Model Going forward, we see good reasons to maintain this trade. The butterfly spread, after briefly reaching expensive levels, is back to being attractively valued. Even if the residual were to dip back below zero, it would still have room to become more expensive, shoring up our trade. This trade also remains the most attractive of all the steepener trades on a model-implied valuation basis, removing any incentive to rotate towards another part of the curve. The odds favor more reflationary Treasury curve steepening after the US election. President-elect Biden has a stated goal of more fiscal stimulus, while his selection of Janet Yellen as Treasury Secretary signaling increased cooperation between monetary and fiscal authorities. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Bottom Line: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Evaluating Our Cross-Country Yield Spread Trades We currently have two recommended trades involving plays on the spread between government bonds: Long 5-year New Zealand government bonds versus short 5-year UK Gilts, currency-hedged into GBP We initiated this trade on August 25, and to date the trade is severely underwater with a total return of -1.8%.5 That loss comes from the long New Zealand leg of the trade, as the 5-year NZ bond yield has increased by 34bps from our entry level. Chart 9A Rapid Shift Upward In NZ Rate Expectations The rationale for this trade was based on our assessment of the relative probability of the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) moving to a negative interest rate policy. Both central banks hinted strongly at such a move throughout the summer months as part of their efforts to support pandemic-stricken economies. Our view back in late August was that it was more likely that the RBNZ would choose negative rates, as New Zealand had far lower inflation expectations than the UK and, unlike the British pound, the New Zealand dollar was not undervalued. This trade was initially profitable, but all that changed rapidly during the month of November. The RBNZ disappointed investor expectations on a move to negative rates at the November 11 monetary policy meeting. The central bank elected instead to increase the size of its existing quantitative easing program, while giving no hint that negative rates were coming soon. The response was a sharp move higher in both New Zealand bond yields and the New Zealand dollar (Chart 9). There was an even more violent adjustment in yields and the currency last week, after New Zealand Finance Minister Grant Robertson wrote a letter to RBNZ Governor Adrian Orr asking the central bank to change its policy remit to include controlling New Zealand house price inflation. Markets interpreted this blatant political pressure on the central bank as the end of any hopes of negative rates in New Zealand, with bond yields and the currency spiking higher once again. House prices have surged after the RBNZ aggressively cut interest rates earlier this year, with a rapidly rising share of new mortgages having higher loan-to-value ratios (Chart 10). House price inflation is now running at 19.8%, and Finance Minister Robertson did cite deteriorating housing affordability and inequality as the basis for his letter to the RBNZ. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. This shatters the underlying rationale for our long New Zealand/short UK yield spread trade (Chart 11). Chart 10RBNZ-Fueled Boom In House Prices Thus, we are choosing to cut our losses and close out our recommended trade. Long 10-year German Bunds versus short 10-year US Treasuries Chart 11Time To Cut Our Losses On The NZ-UK Trade We initiated this recommendation on October 27, and to date the trade is running a small loss of -0.17%.6 The rationale behind the trade was two-fold: Our valuation model for the 10-year UST-Bund yield spread showed that the spread was far below fair value; We turned more bearish on US Treasuries just before the US presidential election, downgrading our recommended allocation to underweight while also upgrading more defensive Germany – with its low yield-beta to US Treasuries - to overweight. The trade initially performed well, driven by faster growth and inflation in the US versus the euro area (Chart 12). The Treasury selloff has stalled of late, but we view this as more a consolidative pause than a near-term peak in yields. Chart 12Fundamentals Justify A Wider UST-Bund Spread With our Treasury-Bund valuation model still showing that the spread is too tight, and with the spread not looking overly stretched versus its 200-day moving average (Chart 13), we are keeping our US versus Germany trade in our Tactical Overlay portfolio. Chart 13Valuation & Momentum Point To A Wider UST-Bund Spread Bottom Line: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, " How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Yield Curve Trades: Netting Returns With Butterflies", dated July 7, 2020, available at gfis.bcaresearch.com. 3 Readers looking for more detailed background on butterfly trades and our yield curve modelling framework should refer to the July 7, 2020 Strategy Report where we initiated these trades. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rates Club", dated August 26, 2020, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Global Bond Implications Of Rising Treasury Yields", dated October 27, 2020 available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Dear Client, Instead of our regular report next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. We will be back the week after with the GIS quarterly Strategy Outlook, where we will explore the major investment themes and views we see playing out in 2021. Best regards, Peter Berezin, Chief Global Strategist Highlights While a vaccine, ironically, could dampen economic activity in the near term, it will pave the way for faster growth in the medium-to-long term. Inflation is unlikely to rise much over the next two-to-three years. However, it could gallop higher later this decade as unemployment falls below pre-pandemic levels and policymakers keep both monetary and fiscal policy accommodative. Many of the structural factors that have depressed inflation are going into reverse: Baby boomers are leaving the labor force, globalization is on the back foot, and social cohesion is fraying. The lackluster pace of productivity growth suggests that innovation is not occurring as fast as many people think. Rather, what seems to be happening is that the nature of innovation is changing in ways that are a lot more favorable to Wall Street than Main Street. Monopoly power has grown, especially in the tech sector. This has had a deflationary effect in the past but could take a more inflationary tone in the future. Investors should remain overweight stocks for the next 12 months, while shifting equity allocation away from growth companies towards value companies and away from the US towards the rest of the world. The Waiting Game This week brought some further good news on the pandemic front. The number of reported daily cases continues to trend lower in Europe. The 7-day average has now fallen by 30% from its November 8th peak (Chart 1). In the US, there are faint indications that the number of new cases is stabilizing, especially in the hard-hit Midwest (Chart 2). Chart 1Covid Cases In Europe: Past The Worst Chart 2Covid Cases In The US: Approaching The Peak Of The Third Wave? Nevertheless, it is too early to breathe a sigh of relief. As with other coronaviruses, SARS-CoV-2 spreads more easily in colder temperatures. Moreover, this week is Thanksgiving in the US, and with the holiday season approaching in the wider world, there will be more opportunities for the virus to propagate. Chart 3The US May Have To Follow Europe In Tightening Lockdown Measures Despite the cresting in new cases, the absolute number of confirmed daily infections remains extremely high. The 7-day average currently stands at about 175,000 in the US. Adjusting for the typical three-week lag between new cases and deaths, the case-fatality rate is approximately 1.8%. The CDC estimates the “true” fatality rate is 0.7%.1 This implies that for every one person who tests positive for Covid-19, 1.5 people go undetected. Thus, around 450,000 Americans are catching Covid every day. That is 3.2 million per week or about 1% of the US population. Other estimates from the CDC suggest that the true number of new infections may now be even greater, perhaps as high as 11 million per week.2 Unlike in Europe, where governments have implemented a series of stringent lockdown measures, the US has taken a more relaxed approach (Chart 3). If the number of new infections fails to fall much from current levels, more US states will have to tighten social distancing rules. The availability of vaccines will pave the way for stronger growth in the medium-to-long term. Ironically however, as we pointed out two weeks ago, vaccine optimism could dampen economic activity in the near term. With the light clearly visible at the end of the tunnel, more people may choose to hunker down to avoid being infected. After all, how frustrating would it be to contract the virus just a few months before one can be vaccinated? It is like being the last guy shot on the battlefield in a war that is drawing to an end. The Outlook For Inflation Could inflation make a comeback once a vaccine is widely available? The pandemic put significant downward pressure on prices in a number of areas, particularly air transport, accommodation, apparel, and gasoline. While prices in some categories, such as used cars, meats and eggs, and certain toiletries did rise briskly, the net effect was still a substantial decline in overall inflation (Chart 4). Chart 4The Impact Of Covid On US Inflation Core PCE inflation stood at 1.4% in October, well below the Fed’s target. As Chart 5 illustrates, core inflation is below central bank targets in most other economies as well. A bounce back in prices in the most pandemic-afflicted sectors should lift inflation over the next six months. Our US bond strategists expect core PCE inflation to peak at 2¼% in the second quarter of next year, before falling back below 2% by the end of 2021. Chart 5Core Inflation Below Central Bank Targets Chart 6Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Ignoring the temporary oscillations in inflation due to base effects, a more sustained increase in inflation would require that labor market slack be fully absorbed. In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the major economies would fall back to its full employment level by around 2025 (Chart 6). While a vaccine will expedite the healing of labor markets, it is probable that unemployment will remain too high to generate an overheated economy for the next three years. What about beyond then? The fact that long-term bond yields are so low today implies that most investors think that inflation will remain subdued for many years to come (Chart 7). This is confirmed by CPI swaps, which in some countries go out as far as 50 years. For the most part, they are all trading at levels below official central bank inflation targets (Chart 8). Chart 7Long-Term Bond Yields Are Depressed... Chart 8… As Are Long-Term Inflation Expectations Heading Towards The Kink Is inflation really dead, or is it just dormant? We think it is the latter. Contrary to the claim that the Phillips curve has become defunct, Chart 9 shows that the wage version of the Phillips curve – which compares wage growth with the unemployment rate – is very much alive and well. What is true is that rising wage growth has failed to translate into higher price inflation in most economies since the early 1980s. However, this may have simply been due to happenstance: Every time the global economy was starting to heat up to the point that a price-wage spiral could develop, something would happen to break it. In 2019, the unemployment rate in the G7 hit a 46-year low. Perhaps inflation would have accelerated this year had it not been for the pandemic? Likewise, inflation might have risen in 2008 had it not been for the financial crisis, and in 2001 had it not been for the dotcom bust. Chart 9Is The Phillips Curve Really Dead? Chart 10Inflation Reached The ''Kink'' In 1966 Rather than being defunct, the price-version of the Phillips curve may turn out to be kinked at a very low level of the unemployment rate. Such was the case during the 1960s (Chart 10). US core inflation remained steady at around 1.5% in the first half of that decade, even as the unemployment rate drifted lower and lower. In 1966, with the unemployment rate nearly two percentage points below NAIRU, inflation blasted off, doubling to more than 3% within a span of six months. Core inflation would go on to increase to 6% by 1969, setting the stage for the stagflationary 1970s. A Less Deflationary Structural Backdrop Many pundits argue that the structural backdrop for inflation is vastly different today than it was during the 1960s, making any comparison with that decade next to worthless. They point out that unions had a lot more power back then, global supply chains were underdeveloped, and rapid population growth was creating more demand for goods and services than the economy could supply. We have addressed these arguments in the past and will not belabor the point this week other than to note that all three of these structural forces are now in retreat.3 Chart 11The Heyday Of Globalization Is Behind Us Granted, unions are not as powerful as they were in the 1960s. However, public policy is still moving in a more worker-friendly direction. Witness the fact that Florida voters, despite handing the state to President Trump, voted 61%-to-39% to raise the state minimum wage in increments from $8.56 an hour to $15 by 2026. Joe Biden has also pledged to hike the federal minimum wage to $15 from its current level of $7.25. Meanwhile, globalization is on the back foot, with the ratio of trade-to-output moving sideways for more than a decade (Chart 11). At the same time, baby boomers are departing the labor force en masse. Rather than remaining net savers, these retiring workers will become dissavers. This means that the global savings glut, which has suppressed interest rates and inflation, could begin to dry up. Perhaps most ominously, social stability is at risk of breaking down. Homicides in the US have risen by nearly 30% so far this year compared to the same period a year ago.4 Historically, the institutionalization rate has tracked the homicide rate quite closely (Chart 12). As was the case in the 1960s, a lot of the well-meaning discussion about criminal justice reform today could turn out to be counterproductive. Perhaps it was just a coincidence, but it is worth remembering that inflation exploded in the 1960s at exactly the same time that the murder rate shot up (Chart 13). Chart 12Dramatic Drop In Institutionalization Rate During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Chart 13Social Unrest Can Fuel Inflation The Role Of Innovation Technological innovation has been routinely cited as a driver of falling inflation. In many ways, this is rather odd. Economic theory states that faster innovation should lead to higher real income. 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. Moreover, the fixation on technology as a deflationary force is a bit strange considering that measured productivity growth has been exceptionally weak in most advanced economies over the past 15 years – weaker, in fact, than it was in the 1970s (Chart 14). Chart 14US Productivity Has Been Exceptionally Weak Over The Past Ten Years How, then, does one explain why tech stocks have fared so well? One often-heard answer is that productivity growth is mismeasured. We examined this argument carefully in our report entitled Weak Productivity Growth: Don't Blame The Statisticians, concluding that this does not appear to be the case. A more plausible answer is that while the pace of innovation has not sped up, the nature of innovation has changed dramatically in ways that have helped Wall Street a lot more than Main Street. The True Nature Of Corporate Profits Standard economics textbooks regard profit as a return on capital. This implies that if the price of capital goes down, firms should respond by increasing investment spending in order to further boost profits. In practice, that has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. While business investment did rise in 2018, this was all due to a rebound in energy spending. Outside of the oil and mining sector, business investment grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 15). Likewise, neither falling interest rates nor rising stock prices – two factors that should produce a lower cost of capital – have done much to buoy investment spending in recent years. Chart 15Overall Capex In 2017-2019 Was Boosted By The Oil And Mining Sector Chart 16A Winner-Takes-All Economy Why did the standard economic relationship between investment and the cost of capital break down? The answer is that the traditional approach does not take into account what has become an increasingly important driver of corporate profits: monopoly power. A recent study by Grullon, Larkin, and Michaely found that market concentration has increased in 75% of all US industries since 1997.5 Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times that of the median firm, a massive increase from the historic average of two times (Chart 16). The dispersion in performance has been particularly stark within the tech sector. According to BCA Research’s proprietary Equity Analyzer, the shares of “value tech” companies – that is, companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales – have not only lagged the shares of other tech companies, but they have also lagged the shares of similarly valued financial companies (Chart 17). This underscores the point that the outperformance of growth stocks over the past 12 years has not just been a story about technology. Rather, it has primarily been a story about some tech companies doing much better than other tech companies. Chart 17Value Tech Lagged Value Financials The Winner-Take-All Economy What explains the bifurcation in performance within the tech sector? Two reasons come to mind. First, tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. The role played by winner-take-all markets explains how a handful of companies were able to become mega-cap tech titans. Chart 18 and Chart 19 show that increased monopoly power, as reflected in rising profit margins and higher relative P/E ratios, has played a greater role in driving tech share outperformance since the mid-1990s than faster revenue growth. Chart 18Decomposing Tech Outperformance (I) Chart 19Decomposing Tech Outperformance (II) Reaching Adulthood History suggests that monopolists tend to experience an initial rapid growth phase in which they capture ever-more market share, followed by a mature phase where they effectively function as utilities – cranking out stable cash flows to shareholders without experiencing much further growth. While it is impossible to say how far along most of today’s tech leaders are in this cycle, it does appear that the period of rapid growth for many of them may be drawing to a close. As it is, close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. The shift away from “growth status” towards “utility status” for some tech monopolists could prompt investors to trim the valuation premium they assign to these stocks. In addition, it could lead to increased regulation by governments to ensure that monopoly power is not abused. This could further depress valuations. Monopolies And Inflation What about the implications for inflation? Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output could depress selling prices, thus leading to lower profit margins. As my colleague Mathieu Savary has emphasized,6 this implies that rising market power could simultaneously increase profits while reducing investment in new capacity. At least initially, this could be deflationary in two ways: First, lower investment spending will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. This helps explain why falling real interest rates and rising profits have failed to trigger an investment boom. Further down the road, the impact of monopoly power on inflation could turn on its head. Less investment spending will curb potential GDP growth, making it easier for economies to run up against capacity constraints. Low real interest rates could also induce governments to run larger budget deficits, boosting aggregate demand in the process. Finally, an economy where monopoly power runs unchecked will eventually spur a populist backlash, leading to reflationary policies that favor workers over business oligarchs. Investment Conclusions Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 20). Given the likelihood that economic growth could surprise on the downside in the near term, equities are vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Chart 20A Lot Of Bullishness Chart 21European Banks: A Low Bar For Success Equity investors should shift their allocation away from growth stocks towards value stocks and away from the US towards the rest of the world. We like European banks in particular. They currently trade at 0.6-times tangible book value and 7.2-times 2019 earnings. Earnings estimates for 2021 have been slashed but should rebound on the expectation of a vaccine-driven growth recovery later next year (Chart 21). Faster growth should produce a modest steepening in yield curves, boosting net interest margins in the process. Faster growth should also lead to stronger credit demand while reducing bad loans. Looking further out, this week’s report argues that inflation could accelerate meaningfully once unemployment returns to pre-pandemic levels in about two-to-three years. The departure of baby boomers from the labor market, sluggish productivity growth, fraying social cohesion, and a backlash against monopoly power could all push up inflation. These forces could also create a more challenging environment for stocks, particularly today’s mega-cap tech names. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. 2 Please see “Covid live updates: CDC estimates only eighth of infections counted,” NBC News Live Blog, November 25, 2020; and “The Latest: South Korea has most daily cases in 8 months,” Associated Press, November 26, 2020. 3 Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” October 25, 2019; Special Reports “1970s-Style Inflation: Could It Happen Again? (Part 1),” and “1970s-Style Inflation: Could It Happen Again? (Part 2),”dated August 10 and 24, 2018; and Weekly Report, “Is The Phillips Curve Dead Or Dormant?” dated September 22, 2017. 4 Please see this Twitter thread on the latest data from the 100 largest US cities by Patrick Sharkey, Professor of Sociology and Public Affairs at Princeton University. 5 Gustavo Grullon, Yelena Larkin, and Roni Michaely, “Are US Industries Becoming More Concentrated?” Oxford Academic, Review of Finance (23:4), July 2019. 6 Please see The Bank Credit Analyst Special Report, “The Productivity Puzzle: Competition Is The Missing Ingredient,” dated June 27, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
I will be co-hosting a webcast with our Chief Geopolitical Strategist, Matt Gertken, in which we will discuss arguably the two biggest topics of the moment. The US Election Result, And The Pandemic: What Happens Next? on Friday November 6 at 8.00AM EST (1.00PM GMT, 2.00PM CET, 9.00PM HKT). Also, in lieu of the next strategy report, I will be presenting the quarterly webcast on Thursday November 12 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join both webcasts. Highlights Productivity growth will continue to outperform in the US versus Europe through 2021. Equity investors should tilt towards viable small companies and businesses with operations in the US rather than in Europe. Higher productivity growth in the US means that this cycle’s low in US versus euro area core CPI inflation is unlikely to be reached until deep into 2021, at the earliest. Remain structurally overweight long-dated US bonds versus long-dated core European bonds. Structurally favour European currencies versus the dollar. Investors who cannot tolerate volatility should own CHF/USD. Investors who can tolerate volatility should own the more undervalued SEK/USD. Fractal trade: Underweight Australian construction. Feature If the economic difference between the US and Europe could be encapsulated in one picture, then the Chart of the Week would be that picture. In the US, you can hire and fire workers very easily. In Europe, you cannot. This means that in good times, the US can create millions of jobs, Europe much less so. The flip side is that in bad times, the US can destroy millions of jobs, Europe much less so. Chart of the WeekThe US Can Hire And Fire Workers. Europe Much Less So After the dot com bust of 2000, employment fell by 2 percent in the US, but did not fall at all in France. After the global financial crisis of 2008, employment fell by 6 percent in the US, but by just 1.5 percent in France. After the pandemic recession of this year, US employment has rebounded strongly, yet is still down by 7 percent. In contrast, employment in France is down by just 3 percent. After A Recession, Productivity Surges In The US, But Not In Europe If an economy can shed millions of jobs in a recession, then it is easier to restructure the economy with a new labour-saving technology or strategy that substitutes for the labour input permanently. In which case – to paraphrase Ernest Hemingway – the economy’s productivity growth comes gradually, and then suddenly. The suddenly tends to be immediately after a recession. In Europe, where the economy cannot easily shed workers in a recession, such a sudden post-recession productivity boom never happens. In the US, it always does. For example, at the start of the Great Depression a substantial part of the US automobile industry was still based on skilled craftsmanship. These smaller, less productive craft-production plants were the ones that shut down permanently, while plants that had adopted labour-saving mass production had the competitive advantage that enabled them to survive. The result was a major restructuring of the auto productive structure. Another simple example is the ‘typing pool’ which was a ubiquitous feature of the office environment until the late 1990s. Following the 2000 downturn, these typing jobs became extinct, to be replaced by the wholesale roll-out of Microsoft Word. Productivity growth will continue to outperform in the US versus Europe through 2021. After the 2000 downturn, productivity surged by 9 percent in the US, but rose by just 2 percent in France. After the 2008 recession, productivity increased by 5 percent in the US, but did not increase at all in France. And after this year’s recession, productivity is already up by 4 percent in the US, while it is down by 1 percent in France1 (Chart I-2). Chart I-2After Recessions, Productivity Surges In The US But Not In Europe If history is any guide, productivity growth will continue to outperform in the US versus Europe through 2021. One conclusion is that equity investors should tilt towards viable small companies and businesses with operations in the US rather than in Europe. A Surge In Productivity Means Lower Inflation Yet the flip side of the post-recession productivity boom is rising unemployment. After the 2000 downturn, the number of permanently unemployed US workers continued to rise until September 2003, two years after the trough in economic activity. After the 2008 recession, permanent unemployment continued to rise until February 2010, almost a year after the economy had bottomed (Chart I-3). Chart I-3US Permanent Unemployment Peaks Well After The Economy Bottoms Therefore, optimistically assuming the pandemic trough in the economy occurred in the second quarter of 2020, the rise in the number of permanently unemployed US workers is likely to continue through the winter. In fact, it could last much longer because, compared to the global financial crisis, the pandemic is wreaking much more structural havoc on the way that we live, work, and interact. This means that compared to a common-or-garden recession, many more jobs are now economically unviable. Worse, if a resurgent pandemic causes a double-dip recession, then the peak in structural unemployment will be pushed back even further. Higher structural unemployment depresses rent inflation. Higher structural unemployment hurts the security and growth of wages. Therefore, as we pointed out in last week’s Special Report, The Real Risk Is Real Estate, one major consequence is that it depresses housing rent inflation (Chart I-4). It also depresses owner equivalent rent (OER) inflation – the imputed costs that homeowners notionally pay ‘to consume’ their home – because OER inflation closely tracks actual rent inflation (Chart I-5). Chart I-4Higher US Permanent Unemployment Depresses Rent Inflation Chart I-5Owner Equivalent Rent Inflation Tracks Actual Rent Inflation This is important for European investors, because another big difference between the US and Europe is the treatment of owner-occupied housing costs in the consumer price index (CPI). The US includes OER in its inflation rate, whereas Europe does not. The result is that shelter – the sum of OER and actual rents – carries a 42 percent weighting in the US core CPI, compared with just a 13 percent weighting in the euro area core CPI. Hence, US core CPI inflation closely tracks rent inflation (Chart I-6). Meaning that US core CPI inflation reaches its cycle low only after the number of permanently unemployed workers reaches its peak. This holds true both in absolute terms, and in relative terms versus euro area core CPI inflation. After the 2000 downturn, both the absolute and relative inflation cycle lows were not reached until late 2003. After the 2008 recession, the inflation lows were not reached until late 2010 (Chart I-7 and Chart I-8). Chart I-6US Core CPI Inflation Tracks ##br##Rent Inflation Chart I-7Only After Permanent Unemployment Peaks Does US Core Inflation Bottom, Both In Absolute Terms... Chart I-8...And Relative To Euro Area Core CPI Inflation On this basis, this cycle’s low in US versus euro area core CPI inflation is unlikely to be reached until deep into 2021, even on the most optimistic assumptions. Some Investment Conclusions From an investment perspective, US versus euro area core CPI inflation is important because it drives relative bond yields. As the spread between relative inflation rates compresses, the spread between long-dated bond yields also compresses (Chart I-9). Chart I-9When US And Euro Area Core CPI Inflation Rates Converge, So Do US And Euro Area Bond Yields One conclusion is to remain overweight long-dated US bonds versus long-dated core European bonds. Our preferred expression is to stay overweight a 50:50 portfolio of higher yielding US T-bonds and Spanish Bonos versus a 50:50 portfolio of near-zero yielding German Bunds and French OATs. In this strategic position, any price moves in the aftermath of the US election result are just short-term noise. A second conclusion is that the likely yield spread compression between US and European long-dated bond yields will structurally favour European currencies versus the dollar. Though an important caveat is that the dollar will retain its haven qualities during periods of market stress, because many haven assets and markets are denominated in the greenback. Remain overweight long-dated US bonds versus long-dated core European bonds. Therefore, investors who cannot tolerate volatility should own Europe’s haven currency, the Swiss franc versus the dollar. Investors who can tolerate volatility should own the more undervalued Swedish krona versus the dollar. Fractal Trading System* This week’s recommended trade is to underweight the Australian construction sector versus the market. One way to implement this is to short an equally-weighted basket of James Hardie, Lendlease, and Boral versus the market. Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short MSCI Finland versus MSCI Switzerland achieved its 7 percent profit target. But long 30-year T-bond versus French 30-year OAT reached its 3.2 percent stop-loss just before the T-bond’s strong post-election rally. The rolling 1-year win ratio now stands at 53 percent. Chart I-10Australia: Construction Materials Vs. Market 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 Productivity is defined here as real GDP per employed person, and productivity growth is quoted for the periods q1 2002 through q4 2003, q2 2008 through q4 2010, and q4 2019 through q3 2020. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations
Highlights COVID-19 In Europe: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. ECB: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. European Bond Strategy: Stay overweight core European government debt, particularly versus US Treasuries. Remain overweight Italian and Spanish government bonds, as well, which remain supported by both ECB asset purchases and perceptions of increases European fiscal integration. Stay cautious on euro area corporate debt, however, as the renewed recession risk comes at a time when yields and spreads offer poor protection from future credit downgrades and defaults. Feature Chart of the WeekA Bad Time For A Second Wave Today’s long anticipated US election will be the focus for investors in the coming days (and, potentially, weeks) as all votes are counted. We have discussed our views on the potential bond market impact of the election - bearish for US Treasuries with both Joe Biden and Donald Trump promising big fiscal stimulus in 2021 – in our previous two reports. We will provide an update of those views as soon as we get clarity on the election result. This week, we discuss a new concern for jittery markets - the explosion of new COVID-19 cases in Europe that has already led to governments imposing aggressive lockdown measures. The timing of the new viral surge could not be worse for the euro area economy, which had recovered smartly from the massive lockdown-related demand shock this past spring. Real GDP for the entire euro area exploded higher at a 12.7% rate in Q3/2020, a big rebound from the 11.8% drop in Q2. Yet the second wave of coronavirus is starting to weigh on the more domestically focused service sectors most vulnerable to lockdowns and declining consumer confidence (Chart of the Week). From the perspective of European fixed income strategy, the imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. This will support the performance of euro area government bond markets, both in absolute terms and especially versus US Treasuries where yields are drifting higher and should continue to do so after the US election. Another Deflationary Shock To Europe From The Virus The surge in COVID-19 cases has hit the euro area hard and fast. France has seen the most stunning increase, with a population-adjusted daily increase of 596 new cases per million, a nearly six-fold increase in just two months (Chart 2). Importantly, this second wave has so far been nowhere near as lethal as the first wave. The “case fatality ratio” – confirmed deaths as a percentage of confirmed cases – is down in the low single digits for the largest euro area countries (bottom panel). The imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. Even with this second wave being less deadly, governments are taking no chances. France and Germany announced national lockdowns last week for at least the month of November, and Italy and Spain have put new restrictions on activity as well. The new lockdowns are already denting consumer confidence across the euro area and this trend will continue as people choose to spend less time outside of their homes to avoid infection. If the case numbers do not begin to stabilize and the lockdown measures extend into December or beyond, governments will likely be forced to consider new fiscal stimulus measures. According to the latest IMF Fiscal Monitor, the largest euro area economies are projected to have a negative “fiscal thrust” – the change in the cyclically-adjusted primary budget balance as a share of potential GDP – in 2021 of at least -3% of GDP (Chart 3). Chart 22nd Wave Of European Coronavirus Is Far Less Lethal Chart 3A Big European Fiscal Drag Coming Next Year In the case of Italy, the fiscal thrust is expected to be a whopping -6.6% of GDP. The main cause is reduced government spending as the massive temporary stimulus measures to fight the 2020 COVID-19 recessions roll off. Chart 4The ECB Has A Deflation Problem A fresh set of lockdowns will result in a need for more government support measures for unemployed workers, especially those in service-related industries like hospitality and tourism most exposed to lost business as consumers stay home. This poses a serious problem in countries like Spain and Italy that saw a rise in unemployment during the first lockdown but have seen no reversal since (Chart 4). More elevated unemployment rates suggest a lack of inflationary pressure, a point confirmed by recent inflation data. Overall headline HICP inflation fell to -0.3% in September, while core inflation is now a mere +0.4%. Headline HICP inflation rates are now below 0% in the largest euro area economies (Germany, France, Italy and Spain), while core HICP inflation in Italy fell to -0.3% in September. The collapse in oil prices earlier in 2020 has been the main cause of the negative headline inflation prints in the euro area, but is not the only source of weak inflation. According to a decomposition of inflation presented in the Bank of Italy’s October 2020 Economic Bulletin, a falling contribution from services inflation was responsible for about one-third of the entire decline in euro area headline HICP inflation since January (Chart 5). This comes from the part of the euro area economy most exposed to COVID-19 restrictions, highlighting the deflationary risk of the second wave. Chart 5Euro Area Deflation Is Mostly, But Not Only, Driven By Oil Simply put, the second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Policymakers need to spring into action to help provide support for the euro area economy during this time, starting with the ECB. The second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Bottom Line: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. The ECB Will Deliver New Stimulus In December At last week’s policy meeting, ECB President Christine Lagarde announced that the Governing Council would reassess its monetary policy stance at the December meeting, when a new set of economic projections would be presented that factored in the negative impact of the second COVID-19 wave. Lagarde was very candid about the expected outcome of that next meeting, when she stated that the ECB would “recalibrate its instruments” based on the new economic forecasts. Chart 6European Banks Are Tigthening Lending Standards In our view, the ECB’s next policy options can only realistically focus on three options: Cutting policy rates deeper into negative territory Increasing the size, or altering the composition of its bond-buying programs Altering the terms of its current Targeted Long-Term Refinancing Operations (TLTROs) We view a rate cut as a low probability outcome. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. According to the ECB’s latest Bank Lending Survey, euro area banks tightened credit conditions in Q3/2020 (Chart 6). Worsening perceptions of risk and a deteriorating economic outlook were cited as the main reasons for tightening lending standards. The tightening was most severe in Spain, but Italy also saw a big swing away from the easing standards seen in the Q2/2020 survey. Within the details of the Q3/2020 survey, the demand for loans from companies was expected to improve in Q4/2020. The demand for housing and consumer credit increased due to favorable borrowing conditions and a softening in negative contribution from consumer sentiment. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. The ECB’s bond buying programs – the Asset Purchase Program (APP) and the Pandemic Emergency Purchase Program (PEPP) – were deemed to have a positive impact on bank liquidity and financing but a negative impact on profitability. Chart 7Low Interest Rates Are Crushing European Bank Stocks Therein lies the problem of the ECB’s negative interest rate policy and large-scale bond buying – it has lowered borrowing costs for euro area governments, consumers and businesses, but has crushed the profits of Europe’s banks. That can be seen when looking at the ongoing miserable performance of euro area bank stocks, which continue to plumb new lows. The relative performance of euro area banks versus the broad equity market benchmark index tracks the slope of government bond yield curves quite closely in the major euro area economies (Chart 7), highlighting the link between the level of euro area interest rates and bank profits. In Chart 8A, we show the Tier 1 capital ratio, as well as the non-performing loan (NPL) ratio for the five largest banks in Germany, France, Italy, Spain and the Netherlands. The message from the chart is clear – European banks remain well capitalized, with double-digit Tier 1 capital ratios well in excess of regulatory minimums, and have a relatively low share of assets that are non-performing. This is especially true in Italy, where the NPL ratio has collapsed from a high of 20% to 7% over the past five years. In Chart 8B, we present the return on equity and return on asset ratios for the same banks presented in the previous chart. Most large euro area banks suffer from a very low return on assets, not materially above 0%, reflecting the non-existent interest rates banks earn on their government bond holdings as well as the low rates on their loan books. Chart 8AEuropean Banks: The Good News Chart 8BEuropean Banks: The Bad News So given the fragile state of euro area bank health, and with banks already tightening lending standards in anticipation of slower economic activity because of second wave lockdowns, we can rule out a policy interest rate cut as an option to ease policy in December. This leaves only two other easing options, both associated with an expansion of the ECB’s balance sheet – more asset purchases of sovereign bonds and encouraging bank lending through cheap funding via TLTROs (Chart 9). The impact of either policy in offsetting slowing growth is debatable. Government bond yields are already miniscule, if not outright negative, across the euro area and do not represent a hindrance to increased government spending. The ECB can tweak some of the terms of the existing TLTRO programs, like maturity or the price of funding, but that may not encourage new lending if both borrowers and lenders fear a double-dip recession because of the second wave. The pressure is on the ECB to do something to stem the decline in euro area inflation. Nonetheless, the pressure is on the ECB to do something to stem the decline in euro area inflation. While real interest rates are still negative, they are increasingly becoming less so as inflation expectations continue to drift lower. The 5-year/5-year forward EUR CPI swap rate is now down to 1.1%, and was last trading near the ECB’s inflation target of just under 2% in 2013-14 (Chart 10). Unsurprisingly, the rising real rate backdrop has helped boost the value of the euro, especially versus the US dollar, which has suffered under the weight of falling real US interest rates this year. Chart 9The ECB Can Only Expand Its Balance Sheet In the end, greater fiscal stimulus will be the only option available to get Europe through the second wave. All the ECB can do is provide a backdrop of loose monetary policy that supports easy financial conditions, so that any stimulus will have the maximum effect on growth. Chart 10Deflation Is Pushing Up Real Rates In Europe Bottom Line: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. Stay Overweight European Government Bonds, But Stay Cautious On Euro Area Credit With the ECB set to deliver some form of easing in December, core European bond yields are likely to remain stable over at least the next six months. The ECB has shown no reservations about expanding its balance sheet via bond purchases when needed. A surge of buying similar in size to that of the first COVID-19 wave is not out of the question if Europe faces a double-dip second wave recession (Chart 11). Chart 11Stay Overweight Core European Government Bonds Chart 12Italian BTPs Are Preferable To Euro Area Corporate Credit In an environment where we see US Treasury yields having more upside on the back of post-election fiscal stimulus, this makes the likes of German bunds and French OATs good “defensive” lower-beta plays to replace high-beta US Treasury exposure in global USD-hedged bond portfolios. We also like core Europe as a pure spread trade versus Treasuries, as we see scope for the UST-Bund spread to widen further – a tactical trade we initiated last week (see our Tactical Overlay table on page 15). We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying. We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying (Chart 12). The ECB has already been purchasing a greater share of Italy in the PEPP, allowing significant deviations from the Capital Key weights that limit purchases in the older APP. ECB President Lagarde noted last week that those deviations will continue over the life of the PEPP, which should help support further declines in Italian bond yields over at least the next six months. We are maintaining a relatively cautious stance on European credit, however, even with the ECB likely to make a move in December. The renewed recession risk from the second wave comes at a time when low yields and spreads for euro area corporate bonds offer poor protection from future credit downgrades and defaults. We continue to prefer owning US corporate credit, both investment grade and high-yield, versus US equivalents in USD-hedged bond portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Chart 2.... As Do Betting Markets Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures. Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Chart 7Democratic Districts Have Fared Better Over The Past Decade Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3 As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4 There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers. What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Chart 5Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9). Chart 7Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future. The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21). Chart 21The Present Value Of Earnings: A Scenario Analysis Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield Imagine having to decide whether to place your money either in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50% (Chart 24). Chart 24 (I)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 24 (II)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves Chart 27USD Remains Overvalued Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul. Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa. Chart 37High-Yielding Bond Markets Are The Most Cyclical In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020. 2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020. 3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores