Inflation/Deflation
This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run. We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Bygones will no longer be bygones for the Fed when it comes to inflation, … : It has yet to define the parameters of its new approach, but the Fed is promising a sizable break with the past by adopting an average inflation target. … and it’s getting out of the business of pre-emptively tightening in response to a too-tight labor market: The Fed will still intervene to combat the effects of underemployment, but it’s done with trying to cool off a labor market that appears to be too strong. The dovish bias should be good for equities … : Over the last 60 years, large-cap US equities have performed considerably better when monetary policy is easy than they have when it is tight. … and it just might help workers: Tightening to prevent hot labor markets from getting too hot had the effect of making labor market strength self-limiting, circumscribing unions’ bargaining power. If the Fed follows its new plans, workers might benefit at bondholders’ expense. Feature At the Kansas City Fed’s annual Jackson Hole conference at the end of last month, Chair Powell took the opportunity to highlight the results of the Fed’s extended policy review. Though the announcement was short on details, the adjustments to the Fed’s longer-run aims should translate into a more accommodative monetary policy stance over the next several years. Promises made when inflation is moribund may be hard to keep when it begins to perk up, so it’s not written in stone that the Fed will stick to its guns when the backdrop changes, but the shifts in its approach could have meaningful impacts for investors and workers. For nearly five years, it's been the Fed's policy to lament past inflation shortfalls; ... From Inflation Targeting To Average Inflation Targeting1 The Fed may be approaching its 107th birthday, but it is still a relatively new institution practicing a relatively new discipline, and its policy goals and the ways it attempts to carry them out regularly shift. Congress gave the Fed its “dual mandate” in 1977 in a bill that spelled out three aims, “maximum employment, stable prices, and moderate long-term interest rates,” though the third has receded to the point of disappearing amidst a four-decade bond bull market. The dual mandate only entered common parlance in the mid-‘90s and the Federal Reserve Board did not explicitly mention “maximum employment” in its policy directives until 2010, after the FOMC first cited it in a post-meeting statement (itself a fairly new invention).2 ... going forward, it's pledging to do something to make up for them. The Fed only introduced an explicit inflation target in January 2012, a concept pioneered by the Reserve Bank of New Zealand in 1990. (It did so in its inaugural statement of longer-run goals and policy strategy, which it has since reviewed annually and adjusted as necessary.)3 When it first introduced an inflation target, the Fed said it was doing so to “help keep longer-term inflation expectations firmly anchored, thereby fostering price stability ... and enhancing [its] ability to promote maximum employment.” Long-run inflation expectations have fallen well below the bottom end of the 2.3-2.5% range consistent with the Fed’s 2% target (Chart 1). Describing its target as “symmetric,” which it began doing in January 2016 to make it clear that persistent shortfalls would be as unwelcome as persistent overshoots, has not helped. Inflation expectations ground higher for the first two symmetric years but ultimately backslid below their January 2016 level as measured inflation showed no signs of recovering. Chart 1Falling Short The Fed is therefore upping the ante, going beyond expressing its concern about inflation shortfalls to pledging that they will be made up for in the future under a new strategy that condones corrective overshoots. It expressed its new intentions as follows: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.4 [Emphasis added] In other words, the Fed’s inflation target will no longer be fixed at 2%, and it will no longer be set in a purely forward-looking vacuum. Its target could now float above 2% for lengthy periods, depending on the recent history of realized inflation data. In meeting the price stability element of its mandate going forward, the Fed will be managing to something much more like a price level target than an annual inflation target. The upshot is that bygones will no longer be bygones when it comes to inflation undershoots; instead of forgetting past shortfalls, the Fed will actively seek to remediate them. The remediation aspect is a profound change, and it will presumably lead to greater policy accommodation over periods that have been preceded by inflation shortfalls. The Fed has apparently made this change to provoke a resetting of inflation expectations more in line with its aims, but long-run inflation expectations are principally a function of long-run trends in realized inflation. The 5-year/5-year forward CPI swap rate correlates much more closely with the 8-year rate of change in CPI inflation (Chart 2, top panel) than it does with the 1-year rate of change (Chart 2, bottom panel). Headline year-over-year inflation readings will therefore most likely have to exceed 2% for an extended stretch before long-term TIPS breakevens sustainably return to the target range our fixed income strategists judge to be compatible with an annualized 2% target. Chart 2Long-Run Inflation Expectations Are A Function Of Actual Long-Run Inflation A New Take On The Full Employment Mandate The Fed also put some distance from the Phillips Curve framework that many investors had come to view with outright disdain.5 The Phillips Curve’s initial assertion that the unemployment rate and inflation were inversely related was debunked in the stagflationary ‘70s, but the view that too-low unemployment could presage inflation remains embedded in mainstream economic models. Chair Powell has repeatedly questioned that premise, as inflation remained persistently below target even after the unemployment rate had fallen a full percentage point below estimates of its natural rate. The Fed’s new statement formally swears off it, saying that policy will seek “to mitigate shortfalls of employment from [its] assessment of its maximum level,” where it previously aimed to mitigate all deviations from its estimated maximum level [Emphasis added]. The wording change suggests that the Fed has caught up to investors when it comes to being fed up with the Phillips Curve’s false signals. As our fixed income colleagues put it, the Fed had previously viewed a negative unemployment gap (unemployment below its estimate of NAIRU)6 as a signal that inflation was poised to accelerate. That view often led to premature tightening, contributing to the pattern of inflation target shortfalls. The Fed now says it will no longer overreact to signs of labor market overheating, waiting instead for potential wage pressure to show up in the actual inflation data before removing monetary accommodation. Its new one-sided employment reaction function (ease if the labor market is soft, stand pat if it seems to be tight) reinforces the idea that the Fed will have an accommodative bias well into the intermediate term. Equity Market Implications Monetary policy is hardly the only influence on equity prices, and it is not possible to assess its state precisely in real time. It would certainly appear to be easy now that the Fed returned to ZIRP in the blink of an eye after the pandemic spread to the US, but no one can always say with certainty in real time that policy is easy, tight or neutral because no one knows exactly what the neutral rate is at any moment. Using our own in-house estimate of the equilibrium rate (the fed funds rate that neither encourages nor discourages economic activity) to divide the monetary policy cycle into four phases based on the fed funds rate’s level and direction (Chart 3), however, the S&P 500 has exhibited a robust and enduring performance pattern. Chart 3The Fed Funds Rate Cycle Over the 60 years covered by our equilibrium rate estimate, large-cap US equities have surged when policy was easy and run in place when it was tight (Table 1). Adjusted for inflation, they have posted juicy real returns when policy was easy but sapped investors’ wealth when policy was tight (Table 2). The significant return spread across easy and tight settings suggests that the state of monetary policy is an important contributor to equity returns and that our equilibrium estimate must be in the ballpark. Our practical takeaway is that investors should have a bias to overweight stocks in balanced portfolios when Fed policy is accommodative. That bias can be overridden by other factors, but we have found it to be a reliable starting point. The Fed's new one-sided employment reaction function (ease when employment falls below its estimated maximum level, but do nothing when it exceeds it) reinforces the accommodative leanings of average inflation targeting. Table 1A 9-Percentage-Point Nominal Return Gap ... Table 2... And An 11-Percentage-Point Real Return Gap Labor Market Implications To translate the natural-rate-of-unemployment concept into a graph-friendly format, let the unemployment gap equal the quantity (u – u*), where u is the reported unemployment rate and u* is NAIRU, as estimated by the Congressional Budget Office. When the unemployment gap is negative (u < u*), employment exceeds its maximum level and the labor market is tight. When the unemployment gap is positive (u > u*), employment falls short of its maximum level and the supply of labor exceeds the demand for it. An emphasis on promoting full employment over price stability favors labor over fixed income investors. The Phillips Curve’s shortcomings and the difficulty of accurately estimating the natural rate of unemployment in real time notwithstanding, wage growth is stronger when the labor market is tight and the unemployment gap is a good general proxy for the balance between labor supply and demand. Nominal and real earnings have grown faster when the unemployment rate has broken through NAIRU since the average hourly earnings series began to be compiled in 1964 (Chart 4). Broadly speaking, a negative unemployment gap is good for labor while a positive gap is bad for it. Chart 4Wages Rise More In Tight Labor Markets From the perspective of the Fed’s dual mandate, then, labor benefits when the Fed places greater emphasis on promoting full employment and suffers it emphasizes price stability. Many factors have been cited as contributors to unions’ struggles over the last four decades,7 but monetary policy is not typically one of them. We would argue that it has played an underappreciated role, as unions’ golden years of the ‘50s, ‘60s and ‘70s coincided with the Fed’s hands-off approach to tight labor markets and their demise coincided with the Fed’s shift to leaning against them (Chart 5). From 1950 until Paul Volcker became Fed chair, the unemployment gap was negative in two out of every three quarters; since Volcker took over, it’s been negative in just one of three (Table 3). Chart 540 Years Of Removing The Punch Bowl Before Labor's Party Gets Going Table 3The Volcker Divide When it comes to a hot labor market, workers’ gains are bond owners’ losses. Prioritizing full employment over price stability works to the benefit of labor and debtors and to the detriment of capital and creditors. We can’t know the strength of the Fed’s new employment commitment until it’s tested by events, but if we take it at its word, four decades of policy that have favored bond owners are at risk of reversing. We reiterate our fixed income underweight over the tactical and cyclical timeframes. The equity impact is more nuanced. Compensation is far and away the largest component of corporate expenses and a policy to intervene only to mitigate employment shortfalls will compress profit margins. Tighter margins, however, should be offset by increased revenues as consumers have more money to spend. The shift in the Fed’s strategy is broadly labor-positive and capital-negative, but the ill effects for capital will be mostly borne by creditors and easy monetary policy has historically given equities a sizable boost. We reiterate our tactical equity equalweight and cyclical overweight. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The discussion of the Fed’s revised approach to achieving its price stability mandate, and the following section’s discussion of its full employment mandate, borrow heavily from our Global Fixed Income and US Bond Strategy colleagues’ joint September 1, 2020 Special Report, "A New Dawn For US Monetary Policy," available at usbs.bcaresearch.com. Those interested in a fuller discussion of the policy changes, and their implications for the bond market, are encouraged to review the original report. 2 Steelman, Aaron, "The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea." Richmond Fed Economic Brief, December 2011, No. 11-12. Accessed September 1, 2020. 3 "Federal Reserve issues FOMC statement of longer-run goals and policy strategy," January 25, 2012. 4https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 5 Please see the February 26, 2019 US Investment Strategy Special Report, "The Phillips Curve: Science Or Superstition?," available at usis.bcaresearch.com. 6 NAIRU stands for non-accelerating inflation rate of unemployment, also known as the natural rate of unemployment. 7 Our Labor Strikes Back series of Special Reports, January 13, 2020 "Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History", January 20, 2020 "Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them", and February 3, 2020 "Labor Strikes Back, Part 3: The Public-Approval Contest", discuss them in full. All available at usis.bcaresearch.com.
Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy. Box 1The Arithmetic Of Debt Sustainability Global Investment Strategy View Matrix Current MacroQuant Model Scores
BCA Research’s Global Investment Strategy service predicts inflation will rise when unemployment rates return to their pre-pandemic level in three or four years. National savings can shrink either because the private sector is spending more or earning less.…
Highlights Achieving 2 percent inflation, whether as a point-target or as an average over time, will continue to be a mission impossible. As central banks continue to push the monetary policy pedal to the metal, it will underpin the valuation of equities and other risk-assets. So long as bond yields do not spike, stock market sell offs will be short-lived rather than an outright bear market. Within bonds, steer towards those where the monetary policy toolbox is not fully depleted, namely US T-bonds. Within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the Swiss franc and the yen. Inflationary fiscal policy, by spiking bond yields, risks collapsing the valuation underpinning of $450 trillion of global risk-assets and catalysing a deflationary bear market. Fractal trade: Euro strength is vulnerable. Feature Chart of the WeekUltra-Low Bond Yields Do Not Create Consumer Price Inflation, They Create Asset Price Inflation Five years ago, we published a Special Report, Mission Impossible: 2% Inflation. We predicted that 2 percent inflation would remain elusive. Or that in the rare economies that it did appear, it would be runaway, rather than a sedate 2 percent. Either way, the 2 percent inflation point-target that had become a quasi-religious commandment for the world’s central banks would be a ‘mission impossible’.1 Our August 2015 report was heterodox and provocative. Some people pushed back, arguing that the all-powerful central banks could pick and hit whatever inflation target they desired. Yet five years on, we have been vindicated. Last week, the Federal Reserve finally threw in the towel on the 2 percent inflation point-target (Chart I-2). Chart I-2"Forecasts For 2 Percent Inflation Were Never Realised On A Sustained Basis" “Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realised on a sustained basis… (hence) our new statement indicates that we will seek to achieve inflation that averages 2 percent over time…”2 We suspect that, just like the Fed, European central banks will soon move their goal posts. Nevertheless, today we are doubling down on our August 2015 prediction. Achieving 2 percent inflation, whether as a point-target or as an average over time, will continue to be a mission impossible (Chart I-3). Chart I-3Mission Impossible: 2 Percent Inflation Price Stability Is A State, Not A Number The current school of central bankers have misunderstood price stability. They have defined it as an over-precise inflation rate: two point zero. Yet most people feel price stability imprecisely and intuitively. A recent IFO paper points out that households’ inflation perceptions are “more in line with the imperfect information view prevailing in social psychology than with the rational actor view assumed in mainstream economics.”3 The human brain cannot distinguish between very low rates of inflation or deflation, a range we just perceive as ‘price stability’. In Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions, Michael Ashton confirms that “it would be challenging for a consumer to distinguish 1 percent inflation from 2 percent inflation – that fine of a gradation in perception would be extremely unusual to find.”4 The human brain cannot distinguish between very low rates of inflation or deflation. As the entire range of ultra-low inflation just feels like one state of price stability, it is impossible for central banks to fine-tune our inflation expectations within that range. Therefore, our behaviour in terms of wage demands and willingness to borrow also stays unchanged. And if our behaviour is unchanged, what is the transmission mechanism to 2 percent inflation – or for that matter, any arbitrarily chosen inflation rate? Hence, inflation targeting can ‘phase-shift’ an economy between the states of price instability and price stability. Most notably, its inception in the 1990s ultimately phase-shifted many advanced economies into the state of price stability (Chart I-4). But once in either state, inflation targeting cannot fine-tune inflation to a desired number such as 2 percent, 4 percent, or 10 percent. Chart I-4Inflation Targeting Phase-Shifted Advanced Economies Into Price Stability A recent NBER paper Inflation Expectations As A Policy Tool? points out that in advanced economies, “the inattention of households and firms to inflation is likely a reflection of policy-makers’ success in stabilizing inflation around a low level for decades. This price stability has reduced the benefit to being informed about aggregate inflation, leading many to rely on readily available price signals.”5 The ultimate proof is that even market-based inflation expectations just track realised inflation. Central Banks Have Gone Backwards In his must-read What’s Wrong With The 2 Percent Inflation Target, the late and great Paul Volcker argued that price stability is “that state in which expected changes in the general price level do not effectively alter business or household decisions. It is ill-advised to define that state with a point target, such as 2 percent, as false precision can lead to dangerous policies.”6 The irony, and tragedy, is that both the Fed and the ECB have gone backwards. Their original definitions of price stability were more correct than their more recent iterations. False precision can lead to dangerous policies. At the Federal Reserve’s July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1 percent. But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1 percent, the zero-bound of interest rates would prevent “real interest rates becoming negative on the rare occasions when required to counter a recession”, an argument that Jay Powell repeated last week. “Expected inflation feeds directly into the general level of interest rates… so if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn.” Meanwhile in Europe, the ECB’s original inflation target of below 2 percent was close to Greenspan’s proposal of 0-1 percent. But in 2003 the ECB changed its inflation target to its current “below but close to 2 percent.” The reason, according to Mario Draghi: “The founding fathers of the ECB thought about the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they must readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2 percent.” Hence, the Fed, ECB and other central banks are targeting inflation at an arbitrary 2 percent to always allow some leeway for negative real rates. The central bank argument can be summarised as: we desperately need you to expect 2 percent inflation. Because otherwise, we won’t be able to help you by cutting real interest rates in a downturn. Yet this argument is facile, as it takes no account of the true science of inflation expectation formation (Chart I-5 and Chart I-6). And it is dangerous, as it takes no account of the financial and economic risks of pushing the monetary policy pedal to the metal. Chart I-5Inflation Expectations Just Track Realised Inflation Chart I-6Inflation Expectations Just Track Realised Inflation Beware The Twists In The Inflation Story Now we come to a couple of twists in the story. When bond yields become ultra-low, their impact on consumer price inflation breaks down – because the economy is already in the state of price stability – but the impact on stock market inflation increases exponentially (Chart of the Week). We refer readers to previous reports in which we have detailed this dynamic.7 The good twist is that as central banks continue to push the monetary policy pedal to the metal, it will underpin the valuation of equities and other risk-assets. So long as bond yields do not spike, stock market sell offs will be short-lived rather than an outright bear market. Remarkably, this has held true even this year in the worst economic downturn since the Depression. The current school of central bankers have misunderstood price stability. Within bonds, steer towards those where the monetary policy toolbox is not fully depleted, namely US T-bonds (Chart I-7 and Chart I-8). Conversely, within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the Swiss franc and the yen. Chart I-7Steer Towards Bonds Where Monetary Policy Is Not Fully Depleted... Chart I-8...Namely US ##br##T-Bonds Finally, given that any economy can ultimately phase-shift to price instability, when should we worry about inflation in advanced economies? Not yet. To expand the broad money supply, somebody must borrow and spend money. If policymakers really want to create rampant inflation, that somebody is the government. It must borrow and spend money at will, with the central bank creating the money. In other words, the central bank loses its independence and government spending goes vertical. So far, we are not remotely close to this situation because government spending has barely replaced the lost incomes and livelihoods of the pandemic. Indeed, things could get worse once the current income replacement schemes end. Yet, in theory at least, government spending could ultimately go vertical. This would lead to the final bad twist. As bond yields spiked in response, the entire valuation support of global risk-assets would collapse, catalysing a devastating bear market. Given that the $450 trillion worth of global risk-assets (including real estate) is five times the size of the $90 trillion global economy, we reach an important conclusion. The road to inflation, if ever taken, goes via deflation. Fractal Trading System* This week we note that the recent strength in EUR/USD is vulnerable to a countertrend pullback. However, as we are already exposed to this via the correlated position in long USD/PLN, there is no new trade. The rolling 1-year win ratio now stands at 59 percent. Chart I-9EUR/USD When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘Mission Impossible: 2% Inflation’, dated August 20, 2015, available at eis.bcaresearch.com. 2 Please see New Economic Challenges and the Fed's Monetary Policy Review, August 27, 2020 available at https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm 3 Please see Households’ Inflation Perceptions and Expectations: Survey Evidence from New Zealand, IFO Working Paper, February 2018 available at https://www.ifo.de/DocDL/wp-2018-255-hayo-neumeier-inflation-perceptions-expectations.pdf 4 Please see Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions by Michael Ashton, National Association for Business Economics available at https://link.springer.com/content/pdf/10.1057/be.2011.35.pdf 5 Please see Inflation Expectations As A Policy Tool? NBER, May 28th, 2018 available at http://conference.nber.org/conf_papers/f117592.pdf 6 Please see https://www.bloomberg.com/opinion/articles/2018-10-24/what-s-wrong-with-the-2-percent-inflation-target 7 Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’, dated October 25, 2018, available at eis.bcaresearch.com. 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
BCA Research’s Global Fixed Income Strategy & US Bond Strategy service highlights that the official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past. The most…
Highlights Portfolio Strategy Softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. A firming macro backdrop, the USD’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Recent Changes Downgrade the S&P hypermarkets index to underweight, today. This move also pushes our S&P consumer staples sector to a modest below benchmark allocation. Table 1 Feature In our March 23 Weekly Report, when we identified 20 reasons to start buying equities, we published a cycle-on-cycle profile (Chart 1, top panel) of how the SPX performs following a greater than 20% drawdown. History suggested that, on average, new all-time highs would emerge sometime in early 2022! Unfortunately, this assessment proved offside as the S&P 500 made fresh all-time closing highs last week, less than five months from the March 23 trough. Chart 1Overstretched Nevertheless, comparing the current unprecedented SPX rebound with the historical recessionary profile remains instructive as it highlights how excessively stretched equities currently appear. The bottom panel of Chart 1 warns that the SPX is vulnerable to a snapback, were the SPX to return to the historical mean or median recovery profile. Likely rising (geo)political risks could serve as a near-term catalyst for a healthy pullback. Importantly, all of the SPX’s return since the March lows is due to the multiple expansion and then some, as forward EPS have taken a beating (not shown). Equities are long duration assets and given the drubbing in the discount rate, the forward P/E multiple has done all the heavy lifting. Chart 2 puts some historical context to the S&P 500 forward P/E going back to 1979 using I/B/E/S data. Empirical data supports finance theory and shows that the 40-year bull market in bond prices has caused a structural upshift to the SPX forward P/E. Chart 2Moving In Opposite Directions While low rates explain the near all-time highs in the SPX forward P/E, looking ahead we doubt that the SPX multiple can expand much further if we assume that the easy assist from ZIRP is behind us and will not repeat; i.e. the Fed will refrain from wrecking the US banking system by exploring NIRP. In contrast, our analysis suggests that a selloff in the bond market is the missing ingredient that will ignite a massive rotation out of growth stocks and into value and propel deep cyclicals versus defensives to uncharted territory. More specifically, the rallies in copper prices, crude oil and the CRB Raw Industrials index need confirmation from the bond market that they are demand, rather than supply driven. This backdrop will also shift equity returns within deep cyclicals away from a handful of tech stocks and toward other beaten down high operating leverage sectors (i.e. energy, industrials and materials) as we posited in our recent August 3 Special Report “Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives”. Zooming out and observing how investors have moved capital from one asset class to the next in the aftermath of QE5 is in order (Chart 3). First, the SPX enjoyed a V-shaped recovery from the March 23 lows. Then in early-May, as we first posited in our May 11 Weekly Report, the big EURUSD up-move was set in motion and investors started piling into short USD positions taking cue from the Fed’s QE5 that was directly targeting the US dollar with liquidity swaps. The debasing of the dollar served as a global reflator. Now the final piece of the QE5 puzzle is the bond market. Chart 3 highlights that in order for QE to work, counterintuitively a selloff in the bond market would confirm that the economy is healing and is ready to start standing on its own two feet. The jury is still out. With regard to the Fed’s remaining bullets, yield curve control (YCC) is one unorthodox tool that the FOMC could choose to deploy in the coming years. On that front, turning back in time and drawing parallels with the 1940s is instructive. In 1942 the Fed, at the behest of the Treasury, pegged long-term interest rates at 2.5% and ballooned its balance sheet in order to finance the government’s expenditures during WWII. The Fed surrendered its independence, and this YCC unwarrantedly stayed in place until 1951 when in the midst of the Korean War, the Treasury-Federal Reserve Accord finally ended the peg of government long-dated bond interest rates.1 Chart 3Bonds Yields Are Left To Rally Chart 4WWII-Like Starting Point Chart 4 shows the ebbs and flows of the US government’s total debt-to-GDP ratio and fiscal deficit as a percentage of output since 1940. While the debt-to-GDP profile fell from 1945 onward owing partially to a tight fiscal ship that the US subsequently ran, it troughed when the US floated the greenback. Since then, the US has been fiscally irresponsible running large budget deficits and the debt-to-GDP ratio has never looked back and very recently went parabolic (top panel, Chart 4). Charts 5 & 6 take a closer look at some macro variables in the 1940s and Charts 7 & 8 compare them to today. Chart 5The… Chart 6…1940s… First, YCC did not prevent the late-1948 recession (Chart 5, shaded areas). Crudely put, monetary stimulus is not a panacea for boom/bust cycles. Second, M2 growth was climbing at a 30%/annum rate, the money multiplier was on a secular advance and money velocity was surging especially in the first half of the 1940s (Chart 6). As a result and as expected, YCC caused three significant inflationary jumps (bottom panel, Chart 6) that aided the US government in bringing down the massive debt-to-GDP ratio (i.e. inflating its way out of a debt trap) that it had accumulated via large deficits in the front half of the 1940s (top panel, Chart 5). Third, interest rates were a coiled spring and once the Treasury-Fed Accord was signed, they exploded higher (fourth panel, Chart 5). Finally, equities fared well during the first three years of YCC until the end of WWII, but then suffered an outsized setback until mid-1949, before recovering and taking out the 1945 highs in 1951 (bottom panel, Chart 5). Chart 7...Compared With… Chart 8…Today Were the Fed to embark on YCC in the near-future in order to monetize the US government’s deficits, there are a few parallels to draw with the 1940s especially given that the starting point of debt-to-GDP is similar to the WWII figure (top panel, Chart 4). The Fed would likely lose its independence. This would be a paradigm shift. The Fed would crowd out fixed income investors, and flood the market with US dollars. M2 money stock would continue to surge. Few investors will be chasing US dollar assets including equities. The path of least resistance would be significantly lower for the US dollar as foreign investors would flee. This debt monetization along with a depreciating currency and swelling money supply would result in inflation rearing its ugly head, especially given that import prices would soar. What is difficult to envision is how the economy would perform during an inflationary impulse. Our sense is that the risk of stagflation would rise significantly, especially given the current inverse correlation between M2 growth and the velocity of money.2 In the stagflationary 1970s, any liquidity injections via higher M2 growth failed to translate into rising money velocity. Importantly, the “Nixon shock” effectively ended the Bretton Woods system and floated the US dollar causing a 40% devaluation from peak-to-trough (Chart 9). Tack on the oil related supply shock and stagflation reigned supreme in the 1970s, owing to cost-push inflation. Chart 9Dollar The Reflator In contrast during the 1940s, demand-pull inflation hit the economy rather hard, as the US was retooling its industrial base to win WWII alongside its allies. Also the US dollar was linked to gold since the Gold Reserve Act of 1934 and ten years later the Bretton Woods international monetary agreement ushered in the era of fixed exchange rates, which is a big difference from the 1970s.3 As a reminder, from a political perspective venturing down the inflation avenue is the least painful way of dealing with a debt burden, rather than pursuing tight fiscal policy which is synonymous with political suicide. From an equity perspective, owning commodity-levered sectors and other hard asset-linked equities including REITs would make sense as we highlighted in our recent inflation Special Report. Health care stocks would also shine in case of an inflationary spurt according to empirical evidence that we highlighted in the same Special Report. On the flip side, our inflation Special Report also revealed that shedding telecom services and utilities would be wise and most importantly avoiding technology stocks. Tech stocks are disinflationary beneficiaries as they are mired in constant deflation and have built business models not only to withstand, but also to thrive in deflation. Inflation is a tech killer as these growth stocks suffer when the discount rate spikes and causes valuations to move from a premium to a discount. Nevertheless, deflation/disinflation is more likely in the coming 12-to-18 months, whereas inflation is at least two-to-three years away as we mentioned in our recent inflation Special Report. This week we continue to augment our cyclicals versus defensives portfolio bent and take our defensive exposure down a notch by downgrading consumer staples to a modest below benchmark allocation via a downgrade in the S&P hypermarkets index. Downgrade Hypermarkets To Underweight… Last summer we upgraded the S&P hypermarkets index to overweight as we were preparing the portfolio to withstand a recessionary shock given that the yield curve had inverted. Fast forward to the March carnage in the equity markets and this defensive move served our portfolio well. However, we did not want to overstay our welcome and set a stop in order to exit this position that was triggered in late-March netting our portfolio 26% in relative gains. More recently, we have been adding cyclical exposure to the portfolio and lightening up on defensives and as a continuation of this shift we are now compelled to downgrade the S&P hypermarkets to underweight. The economy is reopening and thus it no longer pays to seek refuge in safe haven hypermarket equities. In fact most of the macro indicators we track suggest the recession is over that will sustain severe downward pressure on relative share prices. Chart 10 shows that the ISM manufacturing new orders subcomponent has slingshot from below 30 to north of 60, junk spreads are probing all-time lows, consumer confidence has troughed and small and medium enterprises hiring intentions are on the mend. Moreover, the extraordinary fiscal expansion has brought spending forward and PCE is all but certain to skyrocket when the Q3 GDP figures get released in late-October, signaling that the easy money has been made in Big Box retailers (top panel, Chart 11). Similarly, discretionary spending should pick up the slack from staple-related purchases, further dampening the need to own hypermarket shares (middle & bottom panels, Chart 11). Chart 10Rebounding Macro Chart 11Returning to Normality On the operating front, while WMT is making strides in its online presence and offering mix, non-store retail sales are on a tear dominated by King AMZN (as a reminder we are overweight the S&P internet retail index). This is a secular trend and should continue unabated and in a relative sense continue to weigh on hypermarket profitability (bottom panel, Chart 12). Finally, a significant tailwind is turning into a severe headwind for this industry: import price inflation. The US dollar has reversed course and it is in a freefall. Historically, the greenback has been an excellent leading indicator of import price inflation and the current message is grim for hypermarket razor thin profit margins (import prices shown inverted, Chart 13). Chart 12Amazonification Is On Track Chart 13Currency Headwinds Adding it all up, softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. Bottom Line: Trim the S&P hypermarkets index to underweight. The ticker symbols for the stocks in this index are: BLBG S5HYPC – WMT, COST. …Which Pushes Consumer Staples To A Below Benchmark Allocation The downgrade in the S&P hypermarkets index tilts our S&P consumer staples sector to a modest below benchmark allocation. Countercyclical consumer staples stocks served their purpose and provided the support to our portfolio in the front half of the year when we needed them most. Now that the economic reopening is gaining steam and the government, the health care system and society are all ready to effectively deal with a flare up in the pandemic, the allure of defensive positioning has diminished. In other words, COVID-19 is currently a known known risk versus an unknown unknown risk early in the year, and defending against it now is more successful. Moreover, according to our mid-April research on what sectors investors should avoid during recessionary recoveries, consumer staples stocks trail the SPX on average by 660bps one year following the SPX trough. The current macro backdrop corroborates this analysis and underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also consumer confidence is making an effort to trough (ISM manufacturing and consumer confidence shown inverted, Chart 14). Meanwhile, financial market variables emit a similarly bearish signal for safe haven staples stocks. Following a brief spike in the bond-to-stock ratio (BSR), the BSR has recently resumed its downdraft (top panel, Chart 15). Volatility has all but collapsed since soaring to over 80 in March, as the Fed has orchestrated a quashing of all asset class volatilities (middle panel, Chart 15). Lastly, the pairwise correlation between stocks in the S&P 500 has also nosedived bringing some semblance of normality back into equity markets (bottom panel, Chart 15). All three of these financial market variables will continue to exert downward pressure on relative share prices. Chart 14V-shaped Recovery… Chart 15...Across The Board On the US dollar front, while consumer goods manufacturers get a P&L translation gain from a depreciating currency, their export exposure is on par with the SPX and does not provide a relative advantage. In marked contrast, empirical evidence shows that relative profitability moves in tandem with the greenback and the USD recent weakness will undercut consumer staples profitability (bottom panel, Chart 16), especially via climbing input cost inflation. In sum, a firming macro backdrop, the US dollar’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Bottom Line: Downgrade the S&P consumer staples index to underweight. Chart 16Mind the Gap Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Footnotes 1 https://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/background 2 The velocity of money “is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.” Source: Federal Reserve Bank of St. Louis. 3 Our colleagues from The Bank Credit Analyst recently illustrated how a strong dollar is good for the US economy on a medium term basis. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020 Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth
Highlights Nominal Yields: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yields: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. US Economy: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Feature Chart 1Reflation Pushes Real Yields Lower Market movements during the past couple of months are consistent with an environment of economic reflation. Equities and commodity prices are up, the US dollar is down, spread product has outperformed Treasuries and TIPS breakeven inflation rates have widened. This “reflation trade” is the result of global economic recovery and highly accommodative Fed policy, the latter being particularly important. In fact, Fed policy has been so accommodative that bonds are the one asset class that has so far bucked the broader reflationary trend. Nominal Treasury yields dipped during the past few weeks, as rising inflation expectations were more than offset by plunging real yields (Chart 1). Our base case expectation is that, broadly speaking, the reflation trade will continue. Global economic growth will improve during the next 6-12 months and Fed policy will remain highly accommodative. In this week’s report we consider how to position for that outcome in US rates markets. In the process, we provide trade recommendations for the nominal, real and inflation compensation curves. We also consider the main risk to our reflationary view: The possibility that further US fiscal stimulus is too little or arrives too late. Positioning For Reflation Chart 2More Downside In Short-Maturity Real Yields Back in April, we explained how the Fed’s zero-lower-bound interest rate policy can lead to unusual movements in bond markets, particularly in how real bond yields respond to broader market trends.1 The importance of the zero lower bound is easily seen through the lens of the Fisher Equation – the equation that connects nominal yields, real yields and inflation expectations. Real Yield = Nominal Yield – Inflation Expectations If the Fed is expected to hold the nominal short rate steady for a long period of time, then nominal bond yields won’t move around very much in response to the economy. Necessarily, this means that increases in inflation expectations must be matched by falling real yields. Chart 1 shows how this has played out for 10-year yields, but the dynamic is even more pronounced at the short-end of the curve where the Fed has greater control over nominal rate expectations (Chart 2). With these relationships in mind, we consider the outlooks for the nominal, inflation compensation and real yield curves. Nominal Treasury Curve Chart 3Fed Guidance Has Crushed Nominal Rate Vol As is alluded to above, fed funds rate expectations drive nominal Treasury yields. Treasury yields rise when the market revises its rate expectations up and fall when the market revises its expectations down. But what happens when the Fed signals that the funds rate will stay pinned at its current level, even as inflationary pressures mount? What happens is that nominal bond yields become increasingly insensitive to fluctuations in economic data and rate volatility plunges (Chart 3). Not surprisingly, this decline in rate volatility has been more pronounced at the front-end of the curve than at the long-end (Chart 3, bottom panel). This is because the Fed’s rate guidance exerts more influence over short maturities. The market might be very confident that the fed funds rate will stay at its current level for the next year or two, but it will be less confident about rate expectations five or ten years down the road. The conclusion we draw is that the Fed’s dovish rate guidance will prevent a large increase in nominal bond yields, even as the reflation trade rolls on. But at some point, rising inflation expectations will cause the market to price-in policy firming at the long-end of the curve and long-maturity nominal Treasury yields will move somewhat higher. Historically, nominal bond yields usually move in the same direction as TIPS breakeven inflation rates (Chart 4). Chart 4Nominal Yields And Inflation Expectations Are Positively Correlated While this base case outlook calls for flat-to-slightly higher Treasury yields, we recommend keeping portfolio duration close to benchmark on a 6-12 month investment horizon. The reason for this caution is that significant downside risks to our base case economic scenario remain (see section “Avoiding Deflation” below). Chart 5Bullets Trade Expensive When Rates Are Pinned At Zero Instead, we recommend positioning for the continuation of the reflation trade via duration-neutral yield curve steepeners. The nominal yield curve will respond to global economic recovery by steepening because the market will price-in eventual policy tightening at the long-end of the curve before it prices-in near-term policy tightening at the front-end of the curve. Specifically, we suggest buying the 5-year bullet and shorting a duration-neutral barbell consisting of the 2-year and 10-year notes. This trade is designed to profit from steepening of the 2/10 yield curve.2 The one problem with our proposed trade is that it is not cheap. The 5-year bullet yield is below the 2/10 barbell yield and the 5-year bullet trades as expensive on our yield curve model (Chart 5). However, we note that the 5-year looked much more expensive at the height of the last zero-lower-bound episode in 2012. In today’s similar environment, we anticipate a return to similar valuation levels. Bottom Line: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation Curve Chart 6Adaptive Expectations Model Almost by definition, the continuation of the reflation trade means that the cost of inflation compensation will rise (i.e. TIPS breakeven inflation rates will move higher), and we remain positioned for that outcome. However, at least according to our Adaptive Expectations Model, the inflation component of bond yields could have a more difficult time rising going forward. Our model, which is based on several different measures of realized inflation, shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value (Chart 6). In other words, further upside from here is contingent upon rising inflation. Fortunately, rising inflation seems likely during the next few months. Month-over-month headline CPI bottomed in April (Chart 7), the oil price is trending up (Chart 7, panel 2) and core inflation has undershot relative to the trimmed mean (Chart 7, panel 3). All of this suggests that our model’s fair value will move higher during the next few months. Chart 7Inflation Has Bottomed But beyond the near-term snapback that we anticipate, a wide output gap in the United States will prevent inflation from entering a sustainable uptrend as we head into 2021. After all, our Pipeline Inflation Indicator remains deep in deflationary territory (Chart 7, bottom panel). At some point near the end of this year, we anticipate getting an opportunity to move tactically underweight TIPS versus nominal Treasuries, once breakevens start to look expensive on our model. Our Adaptive Expectations Model shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value. A higher conviction long-run trade relates to the slope of the inflation curve. At present, the 10-year CPI swap rate remains somewhat above the 2-year rate, but we eventually expect this slope to invert (Chart 8). With the Fed explicitly targeting a temporary overshoot of its 2% inflation target, it would make sense for the cost of short-maturity inflation protection to trade above the cost of long-maturity inflation protection. This would mark a significant break from historical trends, but this is also true of the Fed’s new policy approach. Chart 8Inflation Curve Will Invert Bottom Line: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yield Curve Chart 9Buy Real Yield Curve Steepeners At the beginning of this report we noted that the combination of stable nominal rate expectations and rising inflation expectations has led to a steep decline in real Treasury yields. This decline has been more severe at the short-end of the curve, which has resulted in real yield curve steepening (Chart 9). At the long-end of the curve, the outlook for the level of real yields is highly uncertain, even under the assumption that the reflation trade continues. If 10-year nominal rate expectations hold steady, then continued reflation will lead to a further decline in the 10-year real yield. However, as discussed above, long-dated nominal rate expectations will eventually follow inflation expectations higher. If that adjustment to long-dated rate expectations outpaces the increase in expected inflation compensation, then the 10-year real yield will move up as well. The outlook for the short-end of the curve is more certain. Two-year nominal rate expectations are unlikely to budge anytime soon. This means that the continuation of the reflation trade will send the cost of 2-year inflation protection higher and the 2-year real yield lower. For this reason, we would rather take a position in real yield curve steepeners than an outright position on the level of real yields. In fact, as long as the reflation trade continues, the real yield curve should steepen whether the absolute level of real yields is rising or falling. It is only in a renewed deflation scare where we would expect the real yield curve to flatten, as occurred back in March. As long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Bottom Line: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Avoiding Deflation The first part of this report talked about how to position in rates markets assuming that the global economic recovery remains on track and that the so-called reflation trade continues. While this is our base case scenario, it is by no means a certainty. In fact, this view is contingent upon continued US fiscal stimulus that is sufficient to sustain household income and prevent a snowballing of foreclosures and bankruptcies. March’s CARES act did a more-than-admirable job supporting household income. In fact, disposable household income rose 7.2% in the four month period between March and June compared to the four months that preceded the COVID recession (Chart 10). This is a far greater increase than what was seen in the first four months of the 2008 recession (dashed line in Chart 10, panel 2), despite the fact that the hit to wage compensation has been worse (dashed line in Chart 10, bottom panel). Chart 11A confirms that, without the CARES act, the hit to disposable income would have been substantial. Chart 10Income Well Supported... So Far Chart 11ADisposable Personal Income Growth And Its Drivers I The problem is that the main income supporting provisions of the CARES act have either been paid out or have expired. Chart 11B shows the impact on disposable income of the CARES act’s different provisions. The two most important were: The Economic Impact Payments: The one-time $1200 stimulus checks. The Pandemic Unemployment Compensation Payments: The extra $600 per week that was added to unemployment benefits. Chart 11BDisposable Personal Income Growth And Its Drivers II The Economic Impact Payments have all been delivered, and the Pandemic Unemployment Compensation Payments expired at the end of July. Based on the information that has been released about the ongoing negotiations over a follow-up stimulus bill, we expect that a compromise deal will be large enough to keep disposable income at or above pre-recession levels.3 However, a compromise is proving difficult. Congress’ foot dragging prompted President Trump to announce several executive orders of questionable legality in an attempt to deliver some stimulus. However, even if the executive orders are followed, the boost to household income will be meager without another bill. The President’s executive order to extend the extra unemployment benefits appropriates only $44 billion from the Disaster Relief Fund and asks states to contribute the rest. Many states will be unable to contribute anything, and an extra $44 billion amounts to only 8% of the income support provided by the CARES act. State & local government aid must be addressed in the new stimulus bill. The other urgent area that must be addressed in a follow-up stimulus bill is aid for state & local governments. State & local government spending fell 5.6% (annualized) in the second quarter, as governments have been forced to impose harsh austerity in the face of collapsing tax revenues (Chart 12). This is one area where the Democrats and Republicans are still far apart. The Center on Budget and Policy Priorities estimates that states need $555 billion to close COVID-related budget shortfalls.4 The Democrats’ initial proposal contained $1.13 trillion for states, the Republicans’ initial offer left out state & local government aid altogether. Chart 12State & Local Governments Need A Bailout Bottom Line: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Based on the numbers that have been floated, that deal will contain sufficient income support to keep households afloat and the recovery on track. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 To understand why this trade profits in an environment of yield curve steepening please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 In their initial proposals, House Democrats offered $435 billion in Economic Impact Payments and $437 billion for expanded unemployment benefits. The Senate Republicans offered $300 billion for Economic Impact Payments and $110 billion for expanded unemployment benefits. For context, the CARES act authorized $293 billion for Economic Impact Payments and $268 billion for expanded unemployment benefits. For more details on the ongoing budget negotiations please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War”, dated July 31, 2020, available at gps.bcaresearch.com 4 https://www.cbpp.org/research/state-budget-and-tax/states-continue-to-face-large-shortfalls-due-to-covid-19-effects Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification