Monetary

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Table 2Global Spread Products In Our Analysis An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The decade-long US equity market outperformance versus the rest of the world could be nearing its end. We are upgrading EM stocks from underweight to neutral within a global equity portfolio. We reiterate the change in our US dollar outlook from bullish to bearish. The concentration risk in EM (specifically in North Asia) mega-cap stocks, poor fundamentals in EM outside North Asia, and a potential flare-up in US-China tensions are the reasons why we are reluctant to be overweight EM stocks. Feature We recommended the short EM equities / long S&P 500 position in late 2010,1 and have reiterated this strategy consistently over the past decade. Since its inception, this trade has produced a 193% gain with extremely low volatility (Chart 1). We recommend taking profits on this position for the reasons elaborated in this report. Chart 1Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Chart 2Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Consistently, we are upgrading EM stocks from underweight to neutral within a global equity portfolio. Our decade-long equity sector theme – introduced in our June 8, 2010 report2 – has been to underweight resources and overweight technology and healthcare (Chart 2). This sector strategy has been one of the reasons for underweighting EM and favoring the US market in a global equity portfolio over the past decade. Going forward, the risk-reward of this sector strategy is no longer attractive. Regarding EM absolute performance, we recommend that absolute-return investors remain on standby for a correction before going long the EM equity benchmark. The End Of US Equity Outperformance The decade-long US equity market outperformance versus the rest of the world could be nearing its end.It is widely known that this decade’s US equity outperformance was largely due to FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft). The FAANGM rally meets many of the criteria for a bubble, as we elaborated in our July 16 report. Our FAANGM equity index – an equal-weighted average of the six stocks – has increased almost 20-fold in real (inflation-adjusted) terms since January 2010 (Chart 3). Chart 3Each Decade = One Mania Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index through the 1990s, or of Walt Disney. through the 1960s, and it well exceeds other bubbles, as illustrated on Chart 3. All price indexes are shown in real (inflation-adjusted) terms. FAANGM stocks have greatly benefited from the recent “work from home” and other societal shifts and have been outperforming through the March financial carnage. It has made them unassailable in the eyes of investors. Yet, even great companies have a fair price, and considerable price overshoots will not be sustainable in the long term. We sense that a growing number of investors deem the US FAANGM and EM mega-cap stocks to be invincible. When some stocks are regarded as unbeatable, their top is not far. Therefore, it is highly unlikely that the FAANGM will outperform in the next selloff. Rather, the odds are that they will underperform because these stocks are extremely expensive, overbought, over-hyped and over-owned. The decade-long US equity market outperformance versus the rest of the world could be nearing its end. Apart from technology and FAANGM, US equities are facing a mediocre profit outlook. As long as the pandemic is not contained, America’s consumer and business confidence will remain lackluster, and, as a result, a recovery in their spending will be subdued. Chart 4US Stocks Are Not Cheap After Removing Market-Cap Bias Notably, the broad US equity market is also expensive. The equal-weighted US equity index is trading at a 12-month forward P/E ratio of 21 (Chart 4, top panel). The risks associated with domestic politics are rising in the US. Social, political and economic divisions have been magnified by both the pandemic and the economic downtrend. Social and political tensions will likely flare up around the November elections. Our colleagues from the Geopolitical team argue that a contested election is possible and could lead to a crisis of presidential legitimacy in the US. Finally, the US equity market cap has reached 58% of the global market cap, the highest on record. Gravity forces are likely to kick in sooner than later, capping US equity outperformance. Bottom Line: The tailwinds supporting the US equity outperformance are fading. We are booking gains on the short EM stocks / long S&P 500 strategy. Consistently, we are also closing the short EM banks / long US banks and short Chinese banks / long US banks positions. They have produced a 75% gain and an 11% loss, respectively. Downgrading The US Dollar Outlook = Upgrading The EM View We had been bullish on the US dollar and bearish on EM currencies since early 2011 (Chart 5, top panel), but on July 9 made a major change in our currency strategy: we switched our shorts in EM currencies away from the US dollar to against an equal-weighted basket of the euro, Swiss franc and the yen. Since then, the EM ex-China equal-weighted currency index has rebounded versus the US dollar, but has depreciated against the basket of the euro, CHF and JPY (Chart 5, bottom panel). Chart 5EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens While the US dollar could rebound in the short term, especially versus EM currencies, any rebound will likely prove to be short-lived. From now on, the strategy for the greenback should be selling into strength. Here is why: As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate. A central bank that is behind the inflation curve is bearish for a nation’s currency. The main reason for turning negative on the US dollar structurally is the rising determination by the Federal Reserve to stay behind the inflation curve in the years to come. This strategy will instigate an inflation outbreak. Falling real interest rates have caused a plunge in the US dollar, as well as a surge in precious metal prices, in recent weeks. In fact, risk-on currencies have lately underperformed safe-haven currencies, such as the CHF and JPY (Chart 6). This market move confirms that the dollar’s recent plunge is due to fears of its debasement, not to robust growth in the world economy and in EM/China. As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate.    Colossal debt monetization. The Fed is undertaking an immense monetization of public and private debt. The current situation, involving the Fed’s purchases of securities, is different from the one following the Lehman crisis. Back in 2008-2014, the Fed’s QE program did not produce an exponential rise in money supply. The US broad money supply (M2) was rising at a single-digit rate between 2009 and 2014 (Chart 7). Presently, US M2 growth has exploded to 24% from a year ago. Chart 6Risk-On Currencies Are Underperforming Safe-Heaven Ones Chart 7Helicopter' Money in the US The pace of US broad money growth is much higher than that of many advanced and developing economies. Chart 8 shows new money creation as a share of GDP across various economies. It demonstrates that Japan and the US are now experiencing the quickest rate of new money creation in the world.   In short, even though debt monetization is occurring in many advanced and EM economies, the US is doing it on an unprecedented scale. Chart 8Money Creation As % Of GDP In 2Q2020 “Helicopter” money will eventually lift inflation. The latest surge in the US money supply has only partially offset the collapse in its velocity. Consequently, America’s nominal GDP has plunged. This stems from the following identity: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumers’ and businesses’ willingness to spend. At that point, rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP. Meantime, the pandemic will probably reduce potential output. The outcome of higher nominal spending and reduced potential productive capacity will be higher inflation. In sum, US inflation will rise well above 2% in the coming years. Yet, the Fed will stay put amid rising inflation. The upshot will be a structural downtrend in the US dollar. Whilst there are many arguments against rising inflation, we are leaning toward the view that US inflation will begin rising as of next year. We will elaborate on this inflation outlook in our future reports.     Rising political and social uncertainty in the US will weigh on the greenback. The failure by the US authorities to contain the spread of the pandemic will continue fueling political and social upheavals. This could culminate in a harshly contested presidential election and a reduction in the US dollar’s allure for foreign investors.    Portfolio inflows into the US will turn into outflows. The stellar performance of US equities attracted portfolio inflows into the US over the last 10 years. These capital inflows, in turn, boosted the greenback. But these dynamics are about to be reversed. Chart 9The US's Net International Investment Position Is At A Record Low The top panel of Chart 9 shows that the US’s net international investment position in equities is at its lowest point since 1986. This means that foreign ownership of US stocks exceeds US resident ownership of foreign equities by a record amount. This reflects the fact that investors have by a large margin favored the US versus other bourses. As American share prices outperformed their international peers, both domestic and foreign investors have poured more capital into US equities. As the US relative equity performance reverses, equity capital will flow out of the US, thus dragging down the US dollar. Chart 10 shows that the trade-weighted dollar tracks the relative performance of the S&P500 versus the global equity benchmark in local currency terms. Regarding debt securities, the US’s net international investment position has widened to  - US$8.5 trillion (Chart 9, bottom panel). Not all fixed-income investors hedge currency risk. As the dollar slides, there will be growing pressure on foreign fixed-income investors to hedge their dollar exposure or sell US and buy non-US debt securities. Chart 10A Top In The US$ = The End Of The US Equity Outperformance? Bottom Line: Immense public debt monetization leading to higher inflation down the road and the Fed falling behind the curve, will produce a lasting and considerable downtrend in the US dollar in the coming years. Why Not Overweight EM Stocks? There are a number of reasons why – for now – we are only upgrading EM equities to neutral, rather than to overweight within a global equity portfolio, and why we are still reluctant to recommend buying EM stocks for absolute-return investors:   Concentration risk in EM mega-cap stocks. As US FAANGM share prices come under selling pressure, contagion will spill over to EM mega-cap stocks. The latter have been responsible for a large share of gains in the EM equity index and, conversely, their pullback will considerably impact the EM benchmark’s performance. The top six companies combined account for about 24% of the MSCI EM equity market cap. To compare, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) also account for 24% of the S&P 500 market cap. Hence, the concentration risk in EM equity space is as high as in the US. Geopolitical risk. A potential flare up in in geopolitical tensions will weigh on Chinese, South Korean and Taiwanese stocks. Given that they make up about 65% of the MSCI EM index equity market cap, the EM benchmark will suffer in absolute terms and be unlikely to outperform the global equity index. Faced with decreased approval in regard to his handling of the pandemic, and to a lesser extent, the economy and other social issues, President Trump could well resort to geopolitics to “rally Americans behind the flag.” He may, for example, ramp up tensions with China in an attempt to make geopolitics and China the focal points of the forthcoming presidential election. China will certainly retaliate. The South China Sea, Taiwan, technology transfers, treatment of multinational companies in both China and the US, as well as North Korea, could be focal points of a confrontation. This will weigh on business confidence in Asia and on capital spending. In our opinion, markets are vulnerable to such geopolitical risks. Poor domestic fundamentals in EM outside China, Korea and Taiwan. Fundamental backdrops remain inferior in many EM economies outside the North Asian ones. The number of new infections continues to rise in India, Indonesia, The Philippines, Brazil, Mexico, Colombia and Peru. Many EM economies will only slowly return to normalcy. In certain countries, banking systems were already in poor health, and things have gotten much worse after the crash in economic activity. As to the positives for EM, they are as follows: Rising Chinese demand will boost EM exports to China and help revive their growth. EM equity valuations are very appealing versus the S&P 500 (Chart 11). The bottom panel of Chart 11 shows that EM’s cyclically-adjusted P/E ratio relative to that in the US is over one standard deviation below its mean. Based on the 12-month forward P/E ratio for an equal-weighted index, EM stocks are cheaper than US ones (please refer to Chart 4 on page 4).  EM currencies are also cheap (Chart 12). While they might experience a short-term setback, as a global risk-off phase takes place, EM exchange rates have probably seen their lows versus the US dollar. Chart 11EM Stocks Offer Value Versus The S&P 500 Chart 12EM Currencies Are Cheap The US dollar’s weakness will mitigate risks for EM issuers of US dollar bonds and, thereby, induce more flows into EM sovereign and corporate credit markets. In short, EM local currency bonds will assuredly benefit from the US dollar’s slide. We have been neutral on both EM local currency bonds and EM sovereign and corporate credit, and are waiting for a correction before upgrading to overweight. In nutshell, little or no stress in EM fixed-income markets bodes well for EM share prices. Bottom Line: Risks to EM equity relative performance are presently balanced. A neutral allocation is warranted for now. EM relative equity performance versus DM is only slightly above its recent low (Chart 13, top panel). It is, therefore, a good juncture to move the EM equity allocation from underweight to neutral. In addition, both the EM equal-weighted and small-cap equity indexes are not yet signaling a broad-based and sustainable outperformance (Chart 13, middle and bottom panels). Chart 13EM Relative Equity Performance Is In A Bottom-Out Phase Some FAQs Question: Wouldn’t the US dollar rally if global stocks sell off? The greenback will likely attempt to rebound from current oversold levels when and as a global risk-off phase sets in. EM high-beta currencies could experience a non-trivial setback but will remain above their March lows. Yet, any rebound in the US dollar versus European currencies and the Japanese yen will be fleeting and moderate. On July 9, in anticipation of US dollar weakness, we booked profits on the short EM currencies/long US dollar strategy and recommended shorting several EM currencies versus an equal-weighted basket of the euro, CHF and JPY. This strategy remains intact for now. Our short list of EM currencies includes: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Chart 14EM Stocks Have Been Low Beta Question: Aren’t EM stocks high-beta and won’t they underperform if, and as, global stocks sell off? The EM equity index has had a beta lower than one since 2013 (Chart 14). Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Within the DM equity space, the US will likely underperform both Europe and Japan in common currency terms. Question: Which equity markets do you favor within the EM space? Our current overweights are China, Thailand, Russia, Peru, Pakistan and Mexico. Our underweights are Indonesia, India, Hong Kong, the Philippines, Turkey, South Africa, Chile and Brazil. Question: Which currencies and local currency bond markets do you recommend overweighting for dedicated EM managers? We recommended going long the Czech koruna versus the US dollar last week. Other currencies that we favor within the EM space are SGD, TWD, THB, MXN and RUB. As for local currency bonds or swap rates, our top picks are Mexico, Russia, Korea, India, China, Malaysia, Thailand, Peru, Ukraine and Pakistan. As always, the list of country recommendations for equities, fixed-income and currencies is available at the end of our reports (please refer to pages 14-15) or on the website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Please see Emerging Markets Strategy Weekly Reports "Inflation, Overheating And The Stampede Into Bonds," dated November 30, 2010, and "Emerging Markets In 2011: Not The Best Play In Town," dated December 14, 2010. 2Please see Emerging Markets Strategy Special Report "How To Play Emerging Market Growth In The Coming Decade," dated June 8, 2010   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The Fed’s emergency lending facilities have successfully stabilized markets … : Credit spreads have tightened dramatically since March and liquidity has been restored to the US Treasury market. … at very little cost to the central bank: Just the announcement of Fed lending facilities has been enough to push spreads lower in most cases. The facilities themselves have seen very little actual uptake. The only cost borne by the Fed has been a dramatic expansion of its balance sheet due to purchases of Treasury securities. We still want to “buy what the Fed is buying”: In US fixed income, we want to favor those sectors that are eligible for Fed support. This includes corporate bonds rated Ba and higher, municipal bonds and Aaa-rated securitizations. Keep portfolio duration at neutral: The Fed will be much more cautious about raising interest rates than in the past, and could wait until inflation is above its target before lifting off zero. Feature Back in April, we published a detailed explainer of the extraordinary actions taken by the Federal Reserve to combat the pandemic-induced recession.1 This week, we re-visit that Special Report to assess what the Fed has accomplished during the past three months and to speculate about what lies ahead. Overall, the Fed’s response has been highly effective. Stability was restored to financial markets almost immediately after the most dramatic policy interventions were announced, and it turns out that the announcements themselves did most of the work. The ultimate usage of the Fed’s Section 13(3) emergency lending facilities has been extremely low relative to their stated maximum capacities (Table 1). If you are the Fed, it is apparently enough to marshal overwhelming force and announce your willingness to deploy it. Like the ECB demonstrated in the fraught Eurozone summer of 2012, a bazooka can restore order without being fired.2 Table 1Usage Of The 2020 Federal Reserve Emergency Lending Facilities The only possible cost borne by the Fed has been an explosion in the size of its balance sheet, mostly attributable to purchases of Treasury securities. The ultimate usage of the Fed’s facilities has been extremely low relative to their stated maximum capacities. This report looks at how the Fed’s actions have influenced (and will influence) interest rates, Treasury market liquidity, the corporate bond market and other fixed income spread products. It also considers the potential impact of the size of the Fed’s balance sheet on the economy and financial markets. Interest Rates The Fed dropped the funds rate to a range of 0% to 0.25% on March 15, and since then it has aggressively signaled that rates will stay pinned at the zero-lower-bound for a long time. Investors quickly took this message on board (Chart 1). The median estimate from the New York Fed’s Survey of Market Participants has the funds rate holding steady at least through the end of 2022. Meanwhile, the overnight index swap curve isn’t pricing-in a rate hike until 2024. Chart 1The Fed And Market Agree: No Hikes Through 2022 Chart 2Better Signaling From The Fed The market adjusted much more quickly to the Fed’s zero interest rate policy this year than it did during the last zero-lower-bound episode (Chart 2). The MOVE index of Treasury yield volatility has already plunged to below 50. It took several years for it to reach those levels after the Fed cut rates to zero at the end of 2008. Similarly, the yield curve is much flatter today than it was during the last zero-lower-bound episode. This partly reflects the market’s expectation that rates will stay at zero for longer and partly the downward revisions to estimates of the long-run neutral fed funds rate that have occurred during the past few years. The bottom line is that the Fed has successfully achieved its goal on interest rate policy. The funds rate is at its effective lower bound and the entire term structure is priced for it to stay there for a very long time. There are two main reasons for this success. First, the Fed’s forward guidance has been more dovish this year than at any point during the last zero-lower-bound episode, with many FOMC participants calling for the Fed to target a temporary overshoot of the 2% inflation target. Second, the market is more skeptical about inflation ever returning to that target, as evidenced by much lower long-dated inflation expectations (Chart 2, bottom panel). What’s Next? The Fed has already made it clear that it won’t pursue negative interest rates. With those off the table, the next step will be for the Fed to make its forward rate guidance more explicit. In all likelihood this will involve the return of some form of the Evans Rule that was in place between 2012 and 2014. The Evans Rule was a commitment to not lift rates at least until the unemployment rate moved below 6.5% or inflation moved above 2.5%.3 The new version of the Evans Rule will be much more dovish. In a recent speech, Governor Lael Brainard favorably cited research suggesting that the Fed should refrain from liftoff until inflation reaches the 2% target.4 That may very well be the rule that ends up becoming official Fed guidance. If the Fed wants to strengthen its commitment to low rates even more, it could follow the Reserve Bank of Australia’s lead and implement a Yield Curve Control policy. This policy would involve setting caps for Treasury yields out to a 2-year or 3-year maturity. The Fed would pledge to buy as many securities as necessary to enforce the caps and would only lift the caps when the criteria of its new Evans Rule are met. While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. For the time being, there is no rush for the Fed to deliver more explicit forward guidance and/or Yield Curve Control. As we noted above, bond yields are already pricing-in an extremely lengthy period of zero rates. But these policies will become more important as the economic recovery progresses and market participants start to speculate about an eventual exit from the zero bound. Explicit forward guidance and/or Yield Curve Control would then prevent a premature rise in bond yields and tightening of financial conditions. With all that in mind, we would not be surprised to see more explicit (Evans Rule-style) forward guidance rolled out at some point this year, but unless bonds sell off significantly beforehand, it probably won’t have an immediate impact on yields. The same is true for Yield Curve Control, though the odds of that being announced this year are lower as it is a tool with which the Fed is less comfortable. Treasury Market Liquidity Chart 3When Treasury Market Liquidity Evaporated As the COVID-19 crisis flared in March, there were several tense days when liquidity in the US Treasury market evaporated. Bond yields jumped even as the equity market plunged (Chart 3). Meanwhile, liquidity markers showed that it had become much more difficult to transact in US Treasuries. Treasury Bid/Ask spreads widened dramatically and the iShares 20+ Year Treasury ETF (TLT) traded at a huge discount to its net asset value (Chart 3, panel 3). During the past four months, researchers have identified hedge fund selling of Treasuries to meet margin calls and foreign bank selling of Treasuries to meet demands for US dollar funding as the proximate causes of March’s Treasury rout. However, it is clearly a failure of market structure that the Treasury market was unable to accommodate that selling pressure without liquidity disappearing. In a recent paper from The Brookings Institution, Darrell Duffie explains why the Treasury market was unable to maintain its liquidity during this tumultuous period.5 Essentially, he argues that it is the combination of rising Treasury supply and post-2008 regulations imposed on dealer banks that has led to an environment where there is a large and growing amount of Treasury supply, but where dealers have less balance sheet capacity to intermediate trading. To illustrate, Chart 4 shows the ratio between the outstanding supply of Treasury securities and the quantity of Treasury inventories for which primary dealers obtained financing. Quite obviously, the dealers’ intermediation activities have not kept pace with the expanding size of the market. Chart 4Primary Dealers Have Not Kept Up With Treasury Issuance What’s Next? Without changes to Treasury market structure or bank capital requirements (Duffie recommends abandoning the system of competing dealer banks altogether and moving all Treasury trades through one central clearinghouse), we are likely to see more episodes like March where a spate of Treasury selling leads to an evaporation of market liquidity. When that happens, the Fed will be forced to step in and buy Treasuries, as it did in March (Chart 3, bottom panel). The goal of that intervention is simply to remove enough supply from the market so that the remaining trading volume can be handled by the dealers. As this pattern repeats itself over time, it will cause the Fed’s presence in the Treasury market to grow. Bottom Line: Unless structural changes are made to the Treasury market or bank capital regulations are rolled back, we should expect more episodes of Treasury market illiquidity like we saw in March. We should also expect the Fed to respond to those episodes with aggressive Treasury purchases, and for the Fed’s presence in the Treasury market to grow over time. Corporate Bonds The Fed’s intervention in the corporate bond market consists of three lending facilities: The Secondary Market Corporate Credit Facility (SMCCF) where the Fed purchases investment grade corporate bonds and recent Ba-rated fallen angels in the secondary market. This facility also purchases investment grade and high-yield ETFs. The Primary Market Corporate Credit Facility (PMCCF) where the Fed buys new issuance from investment grade-rated issuers (and recent fallen angels) in the primary market. The Main Street Lending Facility (MSLF) where the Fed purchases loans off of bank balance sheets. The loans must be made to small or medium-sized firms with Debt-to-EBITDA ratios below 6.0. Chart 5Corporate Issuance Surged Following The Fed's Announcements As mentioned above, these facilities have barely been tapped. As of July 1, the Fed had purchased $1.5 billion of corporate bonds and just under $8 billion of ETFs through the SMCCF, while the PMCCF had not been used at all. However, the impact of the Fed’s promise to back-stop such a large portion of the corporate debt market has been immense. Corporate bond issuance surged following the announcement of the Fed’s facilities, and set monthly post-2008 records in March, April and May (Chart 5). The effect on corporate bond spreads has been just as dramatic. Spreads peaked on March 23, the day that the SMCCF and PMCCF were announced, and have tightened significantly since then. Further underscoring the importance of the SMCCF, PMCCF and MSLF announcements is that those segments of the corporate bond market most likely to have access to the Fed’s lending facilities have seen the most spread compression. Recall that investment grade issuers and recent fallen angels have access to the SMCCF and PMCCF, while the MSLF will benefit most issuers rated Ba or higher. Some B-rated issuers are able to tap the MSLF, but not the majority. Issuers rated Caa or below are much less likely to benefit from any of the Fed’s programs. Table 2 shows how the impact of the Fed’s facilities has played out across the different corporate credit tiers. It shows each credit tier’s option-adjusted spread and 12-month breakeven spread as of March 23 and today. It also shows the percentile rank of those spreads since 2010 (100% indicating the widest spread since 2010 and 0% indicating the tightest). While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. The B-rated and below credit tiers are particularly cheap, with 12-month breakeven spreads all above their 80th percentiles since 2010. Table 2The Fed's Impact On Corporate Spreads Chart 6Spread Curve Back To Normal The market impact of the Fed’s corporate lending facilities is also apparent across the corporate bond term structure. In March, the investment grade corporate bond spread slope inverted, as 1-5 year maturity corporate bond spreads widened relative to spreads of securities with more than 5 years to maturity (Chart 6).6 The Fed concentrated its lending facilities on securities with less than 5 years to maturity, and it has successfully re-steepened the corporate spread curve. But the Fed’s corporate lending facilities are not all powerful. As Chair Powell likes to say: “the Fed has lending powers, not spending powers”. So while the promise of Fed lending is a big help, it still means that troubled firms will have to increase their debt loads to survive the economic downturn. Those firms that take on debt may still see their credit ratings downgraded as their balance sheet health deteriorates. Indeed, this is exactly what has happened. Ratings downgrades have jumped during the past few months, as have defaults (Chart 7). There has also been a spike in the number of fallen angels – firms downgraded out of investment grade – but not as big a jump as was seen during the last recession (Chart 7, panel 2). The Fed’s emergency lending facilities have likely prevented some downgrades, but not all. Chart 7Fed Can't Prevent Downgrades What’s Next? The Fed’s lending facilities are responsible for a huge portion of the spread compression we’ve seen since late March. That said, it is a potential problem for corporate bonds that those facilities are scheduled to expire at the end of September. Our sense is that the expiry date will be extended, and that the facilities will only be wound down after a significant period of time where they see zero usage. At that point, the Fed should be able to halt the facilities without unduly impacting markets. In terms of investment implications, we think that the Fed’s back-stop will continue to be the most important driver of corporate bond spreads during the next few months. This means we would avoid chasing the attractive valuations in bonds rated B & below, and would continue to focus our corporate bond exposure on bonds rated Ba and above. We make an exception to our “buy what the Fed is buying” rule when it comes to positioning across the corporate bond term structure. Here, we are inclined to grab the extra spread offered by longer-maturity securities even though Fed secondary market purchases are concentrated at the front-end. Our rationale is that the Fed’s secondary market purchases are already low and will likely decline as time goes on. Meanwhile, if firms with long-maturity debt outstanding need help they can still access the PMCCF if needed.  Other Fed Lending Facilities & Fixed Income Sectors Outside of the three programs geared toward the corporate bond market, the Fed also rolled out emergency lending facilities meant to back-stop: money market mutual funds (MMLF), the commercial paper market (CPFF), the asset-backed securities market (TALF), the municipal bond market (MLF) and the federal government’s new Paycheck Protection Program (PPPLF). Once again, the announcement effect did most of the work for all of these facilities and the Fed managed to quickly restore stability to each targeted market without doing much actual lending. For starters, the MMLF successfully halted a flight out of prime money market funds with a relatively modest $53 billion in loans (Chart 8). The CPFF caused the commercial paper/T-bill spread to normalize with only $4 billion of lending, and the LIBOR/OIS spread also tightened soon after the Fed rolled out its facilities (Chart 8, bottom panel). The Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. In the asset-backed securities market, the Fed decided that only Aaa-rated securitizations are eligible for TALF. With that in mind, Aaa-rated consumer ABS and CMBS spreads have tightened considerably since TALF’s announcement (Chart 9). Non-Aaa consumer ABS spreads have tightened modestly despite the lack of Fed support. This is because fiscal stimulus has, so far, kept households flush with cash and prevented a wave of consumer bankruptcies. Non-Aaa CMBS, on the other hand, have struggled due to lack of Fed support and a sharp increase in commercial real estate delinquencies. Chart 8Stability Restored Chart 9Consumer ABS & CMBS Spreads Tightened Considerably...   The announcement of the MLF also successfully led to compression in municipal bond spreads (Chart 10), though the Aaa muni curve still trades cheap relative to Treasuries. Like the other facilities, the MLF has seen very low take-up. In this instance, low MLF usage results from its expensive pricing. Municipal governments can access loans through the MLF for a period of up to three years at a cost of 3-year OIS plus a fixed spread that varies depending on the municipality’s credit rating. However, current market pricing is well below the MLF rate for all credit tiers (Chart 10, bottom 2 panels). This means that the MLF provides a nice back-stop in case muni spreads widen again, but it is not currently an effective means of getting cash to struggling state & local governments. Chart 10...As Have Municipal Bond Spreads Finally, the PPPLF is a facility that purchases loans made through the Paycheck Protection Program (PPP) off of bank balance sheets. Essentially, it is an insurance policy designed to make sure that banks have the necessary balance sheet capacity to deliver all of the PPP loans authorized by Congress. It has achieved this goal with relatively little usage. Banks have doled out more than $500 billon of PPP loans and the Fed has purchased only $68 billion. What’s Next? As with the corporate lending facilities discussed above, there is a risk surrounding the scheduled expiry of these other lending facilities at the end of September. Once again, we see the Fed being very cautious in this regard. All facilities will be extended until they have seen long periods of no usage. In the near-term, we think it’s possible that the Fed will make MLF loans cheaper. They will likely feel intense pressure to do so if Congress fails to pass sufficient stimulus to state & local governments in the next bailout package. In terms of investment strategy, we want to stick with what has worked so far. We are overweight Aaa consumer ABS and Aaa CMBS due to the TALF back-stop. We are also overweight municipal bonds, especially in the Aaa-rated space where yields are attractive versus Treasuries and the risk of default is low. We would also advise taking some extra risk in non-Aaa consumer ABS. These securities have no TALF back-stop, but we expect Congress to deliver enough government stimulus to keep the underlying borrowers solvent. The Size Of The Fed’s Balance Sheet As this report has made clear, the Fed’s emergency lending facilities have accomplished a lot during the past four months with the Fed taking very little actual risk onto its balance sheet. But while its usage of the emergency lending facilities has been low, the Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. To restore stability to the Treasury and MBS markets, the Fed avidly bought Treasuries and agency MBS from mid-March to mid-April, ballooning the size of its balance sheet by $2 trillion in just five weeks. Tacked onto the QE programs undertaken to battle the GFC, the Fed’s balance sheet expansion has been massive, and it is roughly six times larger as a share of GDP than it was in the three decades preceding the subprime crisis (Chart 11). Chart 11Massive Expansion Of The Fed's Balance Sheet Investors and citizens may ask what that balance sheet expansion has achieved so far, and what it’s likely to achieve going forward. Are there unintended consequences that haven’t yet made their presence felt? What constitutes a normalized Fed balance sheet, and when will the Fed be able to get back to it? The immediate consequence many investors attribute to the balance sheet expansion is higher stock prices (Chart 12). Fans of the balance sheet/equities link are undeterred by the decoupling after 2015, arguing that standing pat/tapering the balance sheet by 15% helped precipitate its vicious sell-off in the fourth quarter of 2018. It probably has not escaped their notice that the spectacular bounce from March’s lows has occurred alongside a 70% balance sheet expansion. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. We don’t think there is much to the observed relationship, however. Correlation is not causation and we have a hard time seeing how the Fed’s purchases of Treasuries, agencies and agency MBS flowed into the equity market. While the Fed’s pre-pandemic QE purchases turbo-charged the size of the monetary base, it only gently expanded the money supply, because the banks that sold securities to the Fed largely handed the proceeds right back to it as deposits (Chart 13). The net effect mainly filled the Fed’s vaults with the new money it had conjured up via its open-market operations. Chart 12Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Chart 13Only A Modest Expansion Of Money Supply   Banks were not the only counterparties to the Fed’s QE purchases, of course. Fixed income mutual funds, insurance companies and pension funds must also have trimmed their holdings to accommodate the Fed. They were likely obligated by prospectus mandates or regulatory oversight to redeploy the proceeds into other bonds. Surely some unconstrained investors turned QE cash into new equity investments, but the larger QE effect on financial markets was likely to narrow credit spreads as dedicated fixed income investors redeployed their proceeds further out the risk curve. Tighter spreads helped reduce corporations’ cost of servicing newly issued debt, boosting corporate profits at the margin, but we think it’s a stretch to say QE drove the equity rally. What’s Next? Chart 14Wave Of Bank Deposits The picture is slightly different today, with the money supply popping amidst frenzied corporate borrowing. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. The largest banks were inundated with deposits in the second quarter (Chart 14), possibly driven by corporations stashing their issuance proceeds in cash just as banks previously stashed their QE proceeds in excess reserves. With households actively paying down their debt and businesses having already pre-funded two or three years of cash needs, the deposits may not be lent out, hemming in the money multiplier and limiting the self-reinforcing magic of fractional-reserve banking. Liquidity that is being hoarded is not available to drive up equity multiples, so we don’t expect the Fed’s new balance sheet expansion will directly boost stock prices any more than we think it did post-crisis. Indirectly, we think it does contribute to economic growth and risk asset appreciation because we view QE and other extraordinary easing measures as a signal that zero interest rate policy will remain in place for a long time. The importance of that signal, and the possibility that nineteen months of tapering at the start of Jay Powell’s term as Fed chair did promote volatility and increased equities’ vulnerability to a sharp downdraft, may well keep the Fed from attempting to normalize the balance sheet any time soon. An outsized Fed balance sheet may well be the new normal, and it may well breed unintended consequences, but we don’t think that kiting stock prices will be one of them. Ryan Swift US Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com   Footnotes 1 Please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usis.bcaresearch.com and usbs.bcaresearch.com 2 The Outright Monetary Transactions facility at the heart of ECB President Mario Draghi’s “whatever it takes” pledge was never actually used. The ECB did eventually purchase government securities through a separate facility. But this didn’t occur until 2015, after sovereign bond yields had already fallen. 3 This explicit forward guidance was the brainchild of Chicago Fed President Charles Evans. It was official Fed forward guidance between December 2012 and March 2014. 4 https://www.federalreserve.gov/newsevents/speech/brainard20200714a.htm 5 https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf 6 This inversion of the corporate spread curve is typical during default cycles. For more details on this dynamic please see US Bond Strategy Special Report, “On The Term Structure Of Credit Spreads”, dated July 10, 2013, available at usbs.bcaresearch.com

Highlights Monetary Policy: Central bankers worldwide are promising to keeping policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, tolerating a rise in inflation just as many of the secular forces that have dampened global inflation are fading. Bond Strategy: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy. Feature “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” – Fed Chairman Jerome Powell Central bankers have emptied their bags of tricks in recent months, providing extreme monetary policy accommodation to fight the deflationary impacts of the COVID-19 recession. 0% policy interest rates, large-scale asset purchases and liquidity support programs have all been implemented in some form by the major developed market central banks. Even more extreme options like yield curve control have been contemplated in the US and implemented in Australia. Perhaps the most important tool used by policymakers, however, is the most simple of all – dovish forward guidance on future interest rate moves. The Fed, European Central Bank (ECB), Bank of Japan (BoJ) and others are now committing to keep rates at current levels for at least the next two years. Additional “state-based” guidance, tying future rate hikes only to a sustainable return of inflation back to policymaker targets, is the likely next step, with the Bank of Canada already making that connection at last week’s policy meeting. Given how difficult it has been for central banks to reach those targets, policy rates can now potentially stay lower for much longer. Interest rate markets have already discounted such an outcome, with overnight index swap (OIS) curves pricing in no change in policy rates in the US, Europe, UK, Japan, Canada or Australia until at least mid-2022 and only very mild increases afterward (Chart of the Week). It remains to be seen if policymakers will actually follow through on their promises to sit on their hands and do nothing for that long, even as global growth and inflation continue what will likely be an extended and choppy recovery from the deep COVID-19 recession. Chart of the WeekAggressive Forward Guidance Is Working However, if central bankers are truly serious about keeping interest rates low even if inflation picks up, in an attempt to “catch up” from previous undershoots of inflation targets, that has major implications for global bond investors – in particular, raising the value of maintaining core holdings of inflation-linked bonds in fixed-income portfolios. The First Step To Higher Inflation: Stop Talking About Rate Hikes Central bankers are increasingly using the same arguments, and even the same language, to justify their current hyper-accommodative policy stance. Here are some examples, taken from speeches and policy meetings that took place last week: ECB President Christine Lagarde: “We expect interest rates to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon and such convergence has been consistently reflected in underlying inflation dynamics.” Federal Reserve Governor Lael Brainard: “Looking ahead, it likely will be appropriate to shift the focus of monetary policy from stabilization to accommodation by supporting a full recovery in employment and a sustained return of inflation to its 2 percent objective […] policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence.” Bank of Canada Governor Tiff Macklem: "As the economy moves from reopening to recuperation, it will continue to require extraordinary monetary policy support. The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.” Chart 2Global Growth Expectations Have Rebounded We could have switched the names on those three quotes and the message would be the same. Policy rates will stay at current levels until inflation has sustainably returned to the 2% target. Raising rates on the back of a forecast of higher inflation, driven by an expectation of lower unemployment, will not be enough this time for policymakers that have been repeatedly burned by their belief in the Phillips Curve. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. The latest data from the ZEW survey of economic and financial market sentiment, that was published last week and covers the period to mid-July, shows this shift in expectations. On the economy, the current conditions indices for the euro area, US, UK and Japan have stopped falling, while the expectations data have all soared to the highest levels seen since 2015 (Chart 2). The ZEW also poses questions on expectations for interest rates and inflation, and there the answers are more interesting for bond investors. The net balances on expectations for long-term interest rates have bottomed out for the US, euro area and UK, as have expectations for inflation over the next twelve months (Chart 3). At the same time, expectations for short-term interest rates have lagged the moves seen in the other two series, with the net balances hovering around zero for all four countries. One possible interpretation of this data is that a greater number of the financial professionals who take part in the ZEW survey are starting to “get the hint” about central bankers’ dovish messages, expecting higher inflation and bond yields but with no change in short-term policy rates. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. We see similar pricing in inflation-linked bond markets. While nominal bond yields have stayed stable, the mix between inflation expectations and real bond yields has shifted. Breakevens on 10-year bonds have been slowly climbing across the major developed markets since the end of March, while real yields have fallen roughly the same amount as breakevens have widened (Chart 4). Chart 3Global Inflation Expectations Are Drifting Higher Chart 4Inflation Breakevens & Real Yields: Mirror Images This is a relatively unusual development in the global inflation-linked bond universe. More often, breakevens and real yields move in the same direction. Inflation expectations tend to rise when economic growth is improving, which also puts upward pressure on real bond yields – often in tandem with markets pricing in higher policy rates at the short end of yield curves. That is not the case today. The latest fall in real bond yields may simply be markets pricing in slower potential economic growth, and lower equilibrium real interest rates, in a world where the COVID-19 pandemic is likely to leave lasting scars. That would be consistent with Bloomberg growth and inflation forecasts for the major developed economies, which expect unemployment rates to remain above pre-COVID levels in 2022, with inflation rates struggling to reach 2% (Chart 5). Chart 5The Consensus Expects A Slow Global Recovery In a recent report, we presented some basic Taylor Rule estimates of the “appropriate” level of policy rates for the US, euro area, UK, Japan, Canada and Australia after the collapse in growth seen in response to the COVID-19 lockdowns. We used the most basic formulation of the Taylor Rule that put equal weight on deviations of headline inflation from central bank target levels, and deviations of unemployment from full-employment NAIRU measures. Chart 6Taylor Rules Suggest Rates Will Need To Head Higher Given the surge in unemployment and collapse in inflation due to the COVID-19 recession, Taylor Rule estimates were calling for negative nominal interest rates across the developed economies (Chart 6). The estimates were most severe in the US, where a fed funds rate of -3.8% is deemed “appropriate” with an unemployment rate of 11% and headline CPI inflation at 0.6%. When the Bloomberg consensus forecasts for the next two years are put into the Taylor Rule, a rising path for interest rates is projected but with rates remaining below pre-COVID levels. However, if policymakers stick to their current pledge to keep rates on hold for longer to ensure that inflation not only returns to 2%, but also stays there without the help from very easy monetary policy, then the implication is that a “below-appropriate” interest rate will be maintained for an extended period. Interest rate markets have already come to that conclusion. 5-year OIS rates, 5-years forward are trading between 0% and 1% across the developed economies – levels that are below the neutral interest rate estimates we are using in our Taylor Rule forecasts (Chart 7). Chart 7Markets Priced For An Extended Period Of Below-Neutral Rates With interest rates already at or near the zero bound, any rise in inflation from current levels also near 0% will result in real policy rates turning negative if central banks do nothing. This would be consistent with the messages sent by the ZEW survey, and global inflation linked bond markets where real yields are falling deeper into negative territory. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility. This is especially true for the likes of the Fed, which has a well-established history of turning hawkish at the first sign of rising inflation pressures. The Fed has already hinted that it is considering shifting its policy strategy to allow overshoots of inflation after periods of undershooting the 2% target. Other central banks, like the ECB, have announced similar reviews of their inflation targets and strategy. Such a move to tolerate higher levels of inflation is a logical response to a global pandemic and deep global recession, coming on the heels of several years of low inflation. The timing may actually be ideal to run more dovish policies to boost inflation, with many of the structural factors that have helped restrain global inflation starting to turn in a more inflationary direction. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility.  Bottom Line: Central bankers worldwide are promising to keep policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, becoming more tolerant of faster inflation. Potential Reasons Why Inflation Could Return Central bankers are talking a good game right now, pledging not to turn too hawkish, too soon and allowing inflation to move back above policy targets. It remains to be seen if they would actually follow through and do nothing if realized inflation rates were to start climbing back to 2% or even higher. It is unlikely that policymakers will be facing that choice anytime soon. The COVID-19 pandemic is showing no signs of slowing in the US and large emerging market countries, global growth remains fragile and heavily reliant on monetary and fiscal policy support, and inflation rates worldwide are currently closer to 0% than 2%. Yet at the same time, there are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. Demographics Chart 8Demographics Have Turned Less Disinflationary BCA Research Global Investment Strategy has noted that the global demographic trends that helped restrain inflation in recent decades are shifting.1 The ratio of the number of global workers to the number of global consumers – the global support ratio - peaked back in 2013 and is now steadily falling (Chart 8). There are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. A rising support ratio implies there are more people producing through work than consuming which, on the margin, is disinflationary. Now, with baby boomers leaving the labor force in droves and becoming consumers in retirement (especially consuming services like health care), the support ratio is falling and becoming a potentially more inflationary force. Globalization Chart 9Globalization Has Turned Less Disinflationary One of the biggest disinflationary forces of the past quarter-century has been the rapid increase in global trade. As trade barriers fell and global supply chains expanded, companies were able to lower their costs of production. This allowed companies to widen profit margins without resorting to large price increases, helping to dampen overall inflation rates. Now, with global populism and protectionism on the rise, trade as a share of global GDP is declining (Chart 9). The COVID-19 pandemic will likely exacerbate this trend as more companies bring production closer to home, reversing the disinflationary impact of global supply chains, on the margin. A Strong US Dollar The relentless rise of the US dollar in recent years has exerted a major disinflationary headwind to the world economy, with a large share of global traded goods and commodities priced in dollars. Now, with the greenback finally showing signs of rolling over on a more sustainable basis (Chart 10), fueled by less favorable interest rate differentials and signs of improving global growth, the dollar is slowly becoming a more inflationary force. Chart 10USD Weakness Would Be Inflationary Chart 11Structural Reasons Why Policy Rates Need To Stay Low Of course, these factors are slow moving and will not necessarily result in an immediate increase in global inflation. Yet the trends now in place are more inflationary, on the margin, than has been the case for many years. Coming at a time when global productivity growth is anemic, the potential for an inflationary spark from overly easy monetary policies should not be ignored. Especially given the very high levels of private and public debt in the developed world, which puts more pressure on policymakers to choose inflation as a way to reduce debt burdens (Chart 11).   Investment Implication – Stay Overweight Inflation-Linked Bonds Central bankers are now signaling a desire to keep interest rates lower for longer, both to provide stimulus for virus-stricken economies and to boost weak inflation. Coming at a time when secular disinflationary forces are losing potency, this raises the risk of a protracted period of negative real policy rates as inflation rises and policymakers do little to stop it pre-emptively. Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Chart 12Maintain A Core Overweight In Inflation-Linked Bonds Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Inflation breakevens are more likely to creep upward than soar higher in the near term given the lingering economic threat from the COVID-19 pandemic. Yet inflation-linked bonds are likely to outperform nominal government debt over the next few years – if central bankers stay true to their word and keep rates unchanged while welcoming a pickup in inflation. The experience of the years following the 2008 financial crisis, when global policy rates were kept near 0% and central banks expanded balance sheets through quantitative easing, may be a template to follow. Global inflation linked bonds, as an asset class, steadily outperformed nominal government bonds from 2012-2016, shown in Chart 12 on a rolling 3-year annualized basis using benchmark indices from Bloomberg Barclays. A similar extended period of outperformance is not out of the question over the next few years, with central banks ramping up asset purchases once again and promising to keep policy easy until inflation returns. Bottom Line: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy where our models show that breakevens are most undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Investment Strategy "Third Quarter 2020 Strategy Outlook, Navigating The Second Wave", dated June 30, 2020, available at gis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, US Investment Strategy will take the first of two summer breaks next week, so there will be no publication on July 13th. We will return on July 20th with the latest installment of our Big Bank Beige Book, reviewing the five largest banks’ second quarter earnings calls. Best regards, Doug Peta   Highlights Bottom-up S&P 500 earnings expectations for 2021 are probably high: I/B/E/S expectations incorporating periods six or seven quarters away are little more than extrapolations and investors shouldn’t get hung up on them. The higher corporate income tax rates that would follow a Democratic sweep are a bigger concern. Policymakers have decisively won the early rounds of their bout with the pandemic’s economic effects, … : Transfer payments pushed April and May personal income well above its February level, and households have accordingly stayed current on their rent and other financial obligations. … and they will win the fight provided Congress doesn’t tire, … : Volatility may rise amidst the back and forth of negotiations, but Republican Senators cannot risk allowing aid to elapse three months before the election. … but what’s good for the economy in the long run may come at the expense of active managers’ performance: Value investors can’t catch a break, and all stock pickers will have to contend with a policy backdrop that challenges their established modus operandi.   Feature We have not traveled any farther for work than the kitchen table in three and a half months. Renewing our expiring passport could take a year, and the clock is ticking on our ability to fly domestically on a driver’s license from the persona non grata state of New York. Unless the administration or the electorate has a change of heart, the REAL ID rules may prevent us from seeing a client in person until well into 2021. At least the construction at LaGuardia may be finished by then. Even if we’re not seeing clients face to face, however, communication continues. Several topics have come up repeatedly in virtual discussions and we devote this week’s report to examining them. Our overriding impression is that global investors have been surprised by risk assets’ resilience and are skeptical that it can be sustained. We share the surprise and some measure of the skepticism, though we are more constructive than most BCA clients because of our conviction that policymakers can bridge the economic gap created by the pandemic and the commercially restrictive measures undertaken to combat it. Yes, Estimates Are Too High (But It’s Mainly An Election Story) Q: Consensus S&P 500 earnings estimates for next year are in line with actual 2019 earnings, yet 2019 was the tenth full year of an expansion and we’re likely to begin 2021 with an unemployment rate close to 10%. Isn’t there something wrong with this picture? We agree that consensus estimates for 2021 S&P 500 earnings are too high. It seems unlikely on its face that 2021 earnings, currently estimated at $163, will match 2018 ($162) and 2019 ($163) when the public health and economic backdrops are so uncertain. An additional 14% of EPS growth in 2022 seems like a pipe dream. We put very little stock in consensus estimates more than two quarters into the future, however, because analysts put very little effort into producing them. They focus on the current quarter and the following quarter; estimates beyond that range are nothing more than simple extrapolation. Investors familiar with sell-side analysts’ processes presumably don’t look beyond near two-quarter estimates themselves. We therefore doubt that the equity market is hanging on stated 2021 estimates and will be at risk when they are eventually revised down. We simply conclude that the S&P 500’s forward four-quarter earnings multiple of 24 is somewhat more elevated than it appears to the naked eye. Stocks are not cheap, and investors have probably gotten somewhat complacent. Equities have little margin for safety now and are therefore vulnerable to a near-term decline. Valuation is a notoriously poor timing tool, however, and we are content to remain neutral on equities over the tactical zero-to-three-month timeframe. A much stronger case against the earnings outlook for 2021 and beyond comes from the president’s flagging re-election prospects. Our Geopolitical Strategy service continues to estimate Joe Biden’s probability of winning the election at 65%. The virtual betting market PredictIt places Biden’s odds at 62%, and has had him as the favorite since May 30th. It is too simplistic to say that a Democratic president, backed by majorities in both houses of Congress,1 would be bad for the economy, but a Biden victory would introduce two profit headwinds. First, reversing half of the decline in the top marginal corporate tax rate, as the Biden campaign has proposed, would directly strike at the earnings stream available to common shareholders. Precisely quantifying that drop is not easy. S&P 500 constituents’ effective tax rates vary widely, with only a small proportion paying the statutory rate, and they do not disclose the federal component of their tax bill. We make the simple back-of-the-envelope assumption that the maximum net earnings impact of the cut in the top marginal rate from 35% to 21%, beginning in 2018, was 21.5%, as .79 (1-.21) is 21.5% greater than .65 (1-.35). Similarly, the maximum net earnings impact of hiking the top marginal rate to 28% from 21%, beginning in 2021, would be -9%, as .72 (1-.28) is nearly 9% less than .79 (1-.21). Equities seem to be ignoring the negative profit margin consequences of an increasingly likely Democratic sweep. Chart 1The Tax Cut Materially Boosted Median S&P 500 Earnings The change in effective tax rates before and after the 2018 tax cuts was about half of our maximum ballpark estimate. In the two years before the rate cut, excluding 4Q17 and its myriad one-time adjustments, the median effective tax rate for S&P 500 constituents was around 28%; in the two subsequent years, excluding 1Q18, the median rate has hovered near 20% (Chart 1). The change suggests that the tax cuts have boosted median S&P 500 earnings by about 11%.2 In addition to raising taxes, a Biden administration would be considerably more friendly to labor than the Trump administration. A soft labor market in which full employment is at least a few years away argues against broad wage gains, but companies that have benefitted from a complaisant National Labor Relations Board for the last four years could face a rude awakening. If Biden wins, we wager that McDonald’s workers will be unionized before next summer,3 a scenario that McDonald’s stock clearly does not anticipate (Chart 2). Chart 2For McDonald's, A Biden Win Means An NLRB Reversal Bottom Line: A Democratic sweep would weigh on earnings via higher corporate income tax rates and revived advocacy for labor at executive branch departments like the NLRB. Considering these incremental drags, it is unlikely that S&P 500 earnings will match their 2019 levels in 2021. Policymakers Versus The Virus: The Fight So Far Chart 3D.C. Is Keeping Households Afloat ... Q: Your constructive cyclical take depends on policymakers’ ability to offset the pandemic’s economic consequences. How do the data say that’s going so far? The data say that it’s going swimmingly. Thanks to generous transfer payments from the federal government, personal income in April and May comfortably surpassed February’s pre-pandemic peak (Chart 3). Households have not spent much of their windfall (Chart 4), choosing instead to squirrel it away, driving the savings rate to 32% in April and 23% in May. The mountain of savings will make it easy for households to service their debt (Chart 5), which they have been paying down. Chart 4... And They're Saving The Money, ... Chart 5... Much To Their Creditors' Relief The apartment REITs will not likely disclose June rent collection data before their earnings calls, but the National Multifamily Housing Council rent tracker shows that June collections have built on May’s month-over-month improvement. Through June 27th, June collections are tracking ahead of April and May collections and are barely off of last year’s pace (Table 1). Table 1Apartment Tenants Are Paying Their Rent Table 2Consumer Borrowers Are Making Their Payments TransUnion’s monthly consumer loan delinquency data for May reinforce the conclusion that policymakers are achieving their goal of preventing a default spiral. Auto loan delinquencies rose sharply in May, but delinquencies in all other personal loan categories fell on a month-over-month basis (Table 2). Mortgage delinquencies are below their year-ago level, while credit cards and other personal loans have risen only slightly from a low base. Auto loan delinquencies are up appreciably from May 2019, but TransUnion’s data show that the true rot is concentrated in loans made by independent lenders. Their 60-day delinquencies rose to 7.2% in May from 4.5% in April, while bank (0.62%) and credit union delinquencies (0.51%) eased slightly in May. Bottom Line: Extremely generous income assistance has helped households amass formidable cash reserves. The aid has allowed households to pay their rent and service their debt, shielding landlords, banks and many specialty lenders from pressure. Policymakers Versus The Virus: Going The Distance Q: What might cause the Fed to waver in its resolution to help the economy battle the virus? Will the Senate block future stimulus efforts? Nothing will cause the Fed to waver in its resolution to shield the economy from the virus; investors can take Chair Powell’s pledge to do whatever it takes for as long as it takes to the bank. Capitol Hill’s commitment is much less certain and public posturing during Senate negotiations could stoke market volatility. Elected officials reliably respond to career incentives, however, and those incentives will keep recalcitrant Senate Republicans from blocking another round of fiscal largesse. Investors need not worry that Republicans in the Senate will pull the rug out from under the economy and markets – doing so would wreck their own political fortunes. The Republicans’ election prospects have been sliding for a month. Four months is an eternity in a campaign, and they have ample time to reverse their fortunes. But if Republican Senators were to obstruct the passage of the next aid bill, they would be signing their own death warrant. They simply cannot cut off ailing households’ lifeline, or strip municipalities of essential services, as the campaign enters the homestretch. Any individual Senator would be imperiling his/her own quest for influence, and the party’s majority status and relevance, if s/he were to cast one of the votes that blocked a new spending round, and it would be folly to do so over a minor matter like principle. Policymakers Versus Active Managers Q: If valuations no longer matter, how do we show our clients that we’re adding value? It chagrined us to acknowledge on a call last week that equity valuations have been greatly deemphasized in our base case scenario. That scenario calls for overweighting equities in balanced portfolios over a twelve-month timeframe on the view that the flood of emergency stimulus will linger in the system long after it’s needed, stoking aggregate demand and pushing up the prices of cyclically exposed assets. Provided that policymakers succeed in limiting defaults and bankruptcies, thus preventing a pernicious chain reaction from taking hold, we are willing to overlook elevated valuations. Massive accommodation makes active managers' jobs harder because there's no telling who's swimming naked when policymakers won't let the tide go out. Those valuations are supported arithmetically by discount rates which appear as if they will remain very low for an extended period as long as investors don’t become nervous and demand a higher equity risk premium, diluting the impact of nominally lower interest rates. Our base case is that they won’t, but there is no doubt that equity investors’ margin of safety is quite thin. We cannot use the term margin of safety without thinking of Benjamin Graham, and it gives us a pang to think that his disciples may face another few years of wandering in the wilderness. Value investing is predicated on making distinctions between individual companies, as is security analysis more generally. A rising tide lifts all boats, however, and the massive stimulus efforts that have been unleashed in all the major economies (Chart 6) have the effect of obliterating differences between companies. That potentially limits the value that skilled active managers can add to an investment portfolio via a focus on traditional bottom-up metrics. Chart 6All Together Now Our solution is to try to focus on the varying impact top-down factors will have on different companies and sub-industry groups. We are overweight the SIFI banks because we view them as the biggest beneficiary of policymakers’ attempt to suppress defaults and their rock-bottom valuations stand in sharp contrast with the rest of the market. We echo our fixed income strategists’ recommendations to buy the bonds the Fed is buying. We also think that positioning portfolios for regulatory changes that might ensue in 2021 and beyond could be a rich source of alpha if a blue wave really is poised to strike the US on the first Tuesday in November.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com     Footnotes 1 Our geopolitical team expects the Democrats to take the Senate if they win the White House. PredictIt markets imply that Democrats have a 61% probability of winning a Senate majority. 2After-tax earnings before the tax cut were 72 cents on the dollar (1-28%) = .72. After the tax cut, they rose to 80 cents (1-20%) = .80. 80 is 11.11% greater than 72. 3Please see the NLRB/McDonald’s discussion on pp.7-9 of the February 3, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 3: The Public-Approval Contest,” available at usis.bcaresearch.com.

Highlights Global Growth & Inflation: An increasing number of growth indicators worldwide are tracing out a “v”-shaped pattern from the COVID-19 recession. However, high unemployment and a lack of inflationary pressure will ensure that global monetary policies remain highly stimulative for some time. Duration:  Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield). Feature Today marks the midway point of what has already become one the most eventful years of our lifetimes. Investors have had to process multiple massive shocks: a global pandemic; a historically deep worldwide recession; and in the US, nationwide social unrest and a now politically vulnerable president.  Yet despite the severe economic shock and persistent uncertainties, financial market performance over the entire first six months of the year has not been terrible. The S&P 500 index is only down -5.5% year-to-date, while the NASDAQ index is up +10.5% over the same period. Meanwhile, the Barclays Global Aggregate benchmark fixed income index is up +3.9% so far in 2020 (in hedged US dollar terms).  In light of the magnitude of losses suffered by global equity and credit markets in February and March, those are impressive year-to-date returns. CHART OF THE WEEKA Tug Of War Falling government bond yields, driven lower by an aggressive easing of global monetary policies through rate cuts and quantitative easing (QE), have played a major role in driving the recovery in risk assets. With the number of global COVID-19 cases now accelerating rapidly once again, however, the odds are increasing that investors become more reluctant to drive equity and credit valuations even higher (Chart of the Week). At the halfway point of the calendar year, this is a good time to review our most trusted indicators, and current investment recommendations, for global government debt and corporate credit. Duration Allocation: A Non-Inflationary Growth Recovery – But With Higher Inflation Expectations Our current recommended overall global duration stance is NEUTRAL. Global growth has started to recover from the sharp COVID-19 recession.  Survey data like manufacturing and services purchasing managers indices (PMIs) have rapidly rebounded from the huge March/April drops, although most PMIs remain below the 50 level suggesting accelerating economic growth (Chart 2). While there is less timely “hard data” available due to reporting lags, there are signs of improvement in critical measures like US durable goods orders, which soared +15.8% in May after falling by similar amounts in both March and April.  Global realized inflation data remains very weak, however, with headline CPI flirting with deflation in most major develop economies.  Combined with still very high levels of unemployment, which will take years to return anywhere close to pre-COVID levels, the backdrop will keep central banks highly dovish for a long time. The US Federal Reserve has already signaled that the fed funds rate will remain near 0% until the end of 2022, while the Bank of Japan has said no rate hikes will happen before 2023 at the earliest. Our Global Duration Indicator, comprised of three elements - our global leading economic indicator and its diffusion index, along with the global ZEW measure of economic expectations - has already returned to pre-COVID levels (Chart 3).  This leading, directional indicator of bond yields suggests that the downward pressure on yields seen over the first half of 2020 is over.   Chart 2Growth, But Not Inflation, Is Recovering Chart 3Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 However, it is far too soon to expect a big bond selloff, with nominal government bond yields now pulled in opposing directions by their real yield and inflation expectations components. As we discussed in last week’s report, our models for market-based inflation expectations indicate that breakevens derived from inflation-linked bonds are too low.1 Hyper-easy monetary policies from the Fed, ECB and other major central banks will help lift inflation expectations, especially with oil prices likely to continue rising over the next 12-18 months according to BCA’s commodity strategists.  Chart 4Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves The rise in inflation breakevens already seen over the past three months in places like the US, Canada and Australia – combined with dovish forward guidance on future interest rates that has kept shorter-maturity bond yields anchored -  should have resulted in a bearish steepening of government bond yield curves.  Yet the differences between 10-year and 2-year yields across the major developed markets have gone sideways since the beginning of April, even as 10-year inflation breakevens have increased (Chart 4). This has also kept the overall level of nominal 10-year yields nearly unchanged over the same period; for example, the 10-year US Treasury yield is now at 0.64% compared to the 0.58% closing level seen back on April 1. An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.  That is exactly what has happened when looking at the actual real yield on 10-year inflation-linked bonds in the US, euro area, Canada, Japan, the UK and Australia. Using the US as an example, the 10-year inflation breakeven has increased +44bps since April 1, while the 10-year real yield has declined by -38bps. The decline in global real bond yields has coincided with the major central banks aggressively easing monetary policy, including large-scale purchases of government bonds.  This occurred even in countries that had not engaged in major QE programs before, like Australia and Canada. The sizes involved for the new QE purchases have been massive, given the significant increase in the size of central bank balance sheets in absolute terms and relative to GDP (Chart 5).  An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.   Chart 5Global QE Is Helping Drive Real Bond Yields Lower It is possible that the decline in real yields is due to other factors besides QE purchases, like markets pricing in structurally slower economic growth (and lower neutral interest rates) following the severe COVID-19 recession.  Or perhaps it is more fundamentally economic in nature, reflecting a surge in domestic savings at a time of falling investment spending.  The key takeaway for investors is that rising inflation expectations do not necessarily have to translate into higher nominal bond yields if the markets do not expect central banks to signal a need to tighten monetary policy in the near future, which would push real bond yields higher. For this reason, we continue to prefer structural allocations to inflation-linked bonds out of nominal government debt, rather than maintaining below-benchmark duration exposure in fixed income portfolios.  That is a position that benefits from both higher inflation breakevens and lower real yields, while still having the benefit of maintaining a neutral level of safe-haven duration exposure given the lingering uncertainties over the accelerating global spread of COVID-19. At the specific country level, we recommend overweighting inflation-linked bonds over nominals in the US, Italy and Canada where breakevens appear most cheap on our models. Bottom Line: Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit Allocation: Keep Buying What The Central Banks Are Buying Our current recommended overall stance on global corporate credit is NEUTRAL. The same reflationary arguments underlying our recommended inflation-linked bond positions also help support our views on global corporate debt.  Aggressively easy monetary policies, combined with some recovery in global economic growth, will help minimize the risk premium on corporate debt.  Yield-starved investors will continue to have no choice but to look to corporate bond markets for income over the next 6-12 months. The same reflationary arguments under-lying our recommended inflation-linked bond positions also help support our views on global corporate debt.   The combined growth rate of the balance sheets for the major central banks (the Fed, ECB, Bank of Japan and Bank of England) has been a reliable leading indicator of excess returns for global investment grade and high-yield debt since the 2008 financial crisis (Chart 6). With that combined balance sheet now expanding at a 34% year-over-year pace after the ramp up of global QE, this suggests continued support for global corporate outperformance versus government bonds over the next year. Corporate debt is also benefitting from direct central bank purchases by the Fed, ECB and Bank of England. Unsurprisingly, the 2020 peak in US investment grade and high-yield corporate spreads occurred on March 20, literally the last trading day before the Fed announced its corporate bond purchase programs (Chart 7).  Chart 6Global QE Will Continue To Support Risk Assets Chart 7The Fed Has Removed The 'Left Tail' Risk Of US Credit   The Fed’s announced plan for its corporate bond buying was to have it focused on shorter maturity (1-5 year) investment grade credit.  Later, the Fed allowed the programs to buy high-yield ETFs while also allowing “fallen angel” debt of investment grade credits downgrade to junk to be held within the programs.  Since that announcement in late March, risk premiums for US corporate debt across all credit tiers and maturities have narrowed.  However, the limits of that broad-based spread tightening may have now been reached, as some of the dislocations in US corporate bond markets created by the global market rout in February and early March have now been corrected.  Chart 8Relative US Corporate Spread Relationships Have Normalized For example, the spread on the Bloomberg Barclays 1-5 year US investment grade index – a proxy for the universe of bonds the Fed is buying – has moved from a level 25bps above that of the 5-10 year US investment grade index, seen before the Fed announced its purchase programs, to 53bps below the longer maturity index (Chart 8, top panel). This is a more normal “slope” for that spread maturity curve relationship, in line with levels seen over the past decade. This suggests that additional spread tightening in US investment grade corporates may be more widespread across all maturities, even with the Fed still focusing its own purchases on shorter-maturity bonds. A similar dynamic is evident in the US high-yield universe.  The spread between the riskier B-rated and Caa-rated credit tiers to Ba-rated names has narrowed since late March to the lower bound of a rising trend channel in place since mid-2018 (bottom panel).  The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19. The implication going forward is that additional outperformance of lower-rated US junk bonds will be difficult to achieve. The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19.  European corporate debt has also been witnessing similar trends to those seen in the US.  Euro area investment grade corporate spreads have tightened alongside US spreads since the March 20 peak, but that trend has now stabilized given the recent uptick in market volatility measures like the VIX and VStoxx index (Chart 9).  The spread tightening in euro area high yield has also stalled, with spreads seeing a slight uptick alongside the recent increase in market volatility (Chart 10). Chart 9Global IG Spread Tightening Has Stalled Chart 10Have Global HY Spreads Bottomed? Given the renewed uncertainty over the accelerating number of global COVID-19 cases, hitting large US population areas in the US southern states and across the emerging economies, it will be difficult for global market volatility and credit spreads to return to even the recent lows, much less the pre-COVID levels. Thus, we continue to recommend a “selective” approach to global corporate bond allocations, based on valuations, while maintaining a neutral exposure to credit versus government bonds. Our preferred method for evaluating the attractiveness of credit spreads is to look at 12-month breakeven spreads, or the amount of spread widening that would make corporate bond returns equal to duration-matched government debt over a one-year horizon.  We compare those breakeven spreads to their own history to determine if the current level of credit spreads offer value, while adjusting for the underlying spread volatility backdrop. In the US, the 12-month breakeven spread for investment grade corporates is now less attractive than was the case back in March, now sitting at the long-run median level (Chart 11, top panel). The 12-month breakeven for US high-yield is much more attractive, sitting near the highest readings dating back to the mid-1990s (bottom panel).  Of course, this approach only looks at spreads relative to their volatility and does not incorporate credit risk, which is an obvious risk after the recent collapse in US economic growth. In other words, high-yield needs to offer very high 12-month breakeven spreads to be attractive in the current environment. In the euro area, 12-month breakevens for high-yield are only at long-run median levels, while the breakevens for investment grade are a bit more attractive sitting at the 65th percentile of its own history (Chart 12). Chart 11US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults Chart 12European Corporate Breakeven Spreads: Now At Median Levels Importantly, 12-month breakeven spreads in both the US and euro area, for investment grade and high-yield, have not fallen into the lower quartile rankings, even after the sharp tightening of spreads since late March. This is a sign the current rally in global corporates has more room to run, strictly from a spread compression perspective.  For high-yield credit, however, the risk of default losses coming after a short, but intense, recession must be factored into any assessment of valuation. Chart 13Default-Adjusted HY Spreads In The US & Europe Are Unattractive Looking at default-adjusted spreads – spread in excess of realized and expected credit losses – shows that the current level of junk spreads on both sides of the Atlantic offers little-to-no compensation for credit losses (Chart 13).  Default-adjusted spreads are already well below long-run median levels, but if a typical 10-12% recessionary default rate is applied, expected credit losses over the next twelve months will exceed the current level of spreads, thus ensuring negative excess returns on allocations to junk bonds versus government bonds. Tying it all together, our valuation metrics for corporates suggest the following recommended allocations: Overweight US investment grade corporates, but focused on the 1-5 year maturity range that is supported by Fed purchases Overweight US Ba-rated high-yield (also eligible for Fed holdings), while underweighting lower-rated B- and Caa-rated junk Neutral allocation to euro area investment grade Underweight euro area high-yield across all credit tiers This allocation is in line with our current allocations within our model bond portfolio, which are on pages 13-14. Bottom Line: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1  Please see BCA Research Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations”, dated June 23, 2020, available at gfis.bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Money Supply Drivers: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. Money Supply Impact: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Bank Bonds: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. Feature The COVID-19 recession and associated policy response have led to unprecedented moves in a number of economic indicators. In this week’s report we focus on one such move that is particularly difficult to square with the rest of the economic landscape, at least judging by the large volume of client questions we’ve received on the topic. The move in question: Broad money supply growth (M1 & M2) is faster today than at any time since the mid-1940s (Chart 1). This week, we look at what has driven money growth to such heights and consider what it might mean for bond investors. We also update our call to overweight subordinate bank bonds based on last week’s release of the Fed’s bank stress tests. Chart 1Massive Money Growth! Money Supply Drivers The US economy’s broad money supply is more or less the sum total of all the money sitting in bank deposits at any point in time. More specifically, the M1 measure includes currency in circulation, demand deposits and traveler’s checks. The M2 measure includes all of M1 plus savings accounts, time deposits and retail money market funds. Fed asset purchases and bank lending are the two drivers of money supply growth. There are two ways for these broad money supply measures to grow. First, the Fed can purchase securities from the private market. Second, banks can lend money to the private sector. We consider both of these drivers in turn. The Federal Reserve’s Contribution To Money Growth The Fed influences the money supply by changing the amount of reserves in the banking system. To see how this works, Table 1 shows recent balance sheets for both the Fed and the aggregate US banking system. Table 1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System The largest line items on the Fed’s balance sheet are the securities it owns (on the asset side) and the reserves it supplies to the banking system (on the liability side). The Treasury Department’s General Account has also become a sizeable liability for the Fed during the past couple of months (see Box). Box 1: The Large Treasury General Account Is Not Stimulus Waiting To Be Deployed The Treasury General Account (TGA), aka the Treasury Department’s cash account at the Fed, has skyrocketed during the past couple of months and now totals $1.6 trillion (Chart 3). This has prompted more than a few client questions, mostly asking whether this large amount of money represents fiscal stimulus that is waiting to be deployed. Chart 3Treasury Holds A Huge Cash Buffer It does not. Any new fiscal stimulus must be authorized by Congress and with most of the funds from the CARES act having already been paid out, any further fiscal stimulus is contingent upon Congress passing a follow-up bill. So why is the TGA balance so large? The Treasury Department’s job is to finance the federal government’s deficit by issuing bonds. To do this, it must make estimates about what tax revenues and government spending will be in the future. To avoid a situation where it has not issued enough bonds to finance the deficit, it will typically err on the side of caution and issue some extra bonds, holding the proceeds in cash in its account at the Fed. Due to the heightened uncertainty of the current macro environment, it recently decided to target a larger-than-usual cash balance of $800 billion. It even overshot that target during the past couple of months, likely because tax revenues came in higher than expected. Going forward, heightened uncertainty about federal deficit projections will ensure that the Treasury continues to hold an elevated cash balance. However, it will probably try to bring the TGA balance down a bit in the second half of the year, closer to its stated $800 billion target. It will accomplish this by simply issuing fewer T-bills in the second half of the year. This will have the result of increasing the broad money supply through the same mechanism as Fed asset purchases. That is, any drawdown in the TGA increases the amount of reserves supplied on the liability side of the Fed’s balance sheet. When the Fed buys a Treasury security it removes that security from the private market and replaces it with cash in the form of a bank reserve. Those bank reserves are a liability for the Fed, but appear on the asset side of the banking sector’s aggregate balance sheet. Please note that the amount of reserves supplied on the Fed’s balance sheet in Table 1 doesn’t exactly match the amount of reserves shown on the banking sector’s balance sheet. This is only because the numbers were recorded on different days. Turning to the banking sector’s balance sheet, we see that when the amount of reserves increases there are only a few different things that can occur to keep the balance sheet in balance. Banks can accommodate the increase in reserves by reducing the amount of loans or securities they hold. Alternatively, banks can raise capital, borrow in private debt markets or show an increase in deposits. When banks accommodate the increase in reserves by raising deposits, the money supply rises. Charts 2A and 2B show the change in the main items on the aggregate banking system balance sheet since the end of February. First, we see that banks did not reduce their other asset holdings in response to the sharp increase in reserves. Neither did they raise capital or debt. Rather, deposit growth accommodated the entire increase in bank reserves. Chart 2AChange In Commercial Bank Assets: February 26 To June 17, 2020 Chart 2BChange In Commercial Bank Liabilities & Capital: February 26 To June 17, 2020 In fact, deposits have grown by about $2 trillion since February compared to reserve growth of $1.4 trillion. Roughly, we can say that Fed asset purchases are responsible for 70% of the growth in the money supply since then. The remaining 30% is attributable to the second driver of the money supply: bank lending. Bank Lending’s Contribution To Money Growth Looking again at Table 1, we see that an increase in bank loans must also lead to an increase in deposits, unless the bank raises debt and/or capital instead. Further, Chart 2A shows that increased bank lending since February accounts for about 30% of the growth in deposits. However, we expect bank loan growth to moderate in the coming months, easing some of the upward pressure on the money supply. This year's increase in bank loan growth has been driven entirely by C&I loans. A look at bank loan growth by category shows that this year’s increase has been driven entirely by Commercial & Industrial (C&I) loans (Chart 4). Growth in other major loan categories – commercial real estate, residential real estate and consumer – has flagged. Further, the increase in C&I lending has been mostly due to firms drawing on existing credit lines. Chart 4A Spike In C&I Lending The Fed’s Senior Loan Officer Survey for the first quarter of 2020 showed a small increase in C&I loan demand. But the survey also asked about potential reasons for the demand uptick (Chart 5). When faced with that question, 95% of respondents reported that “precautionary demand for cash” was a “very important” reason for increased C&I loan demand in Q1. 71% of respondents also pointed to a lack of internally generated funds as a “very important” reason. Importantly, no respondents reported increased C&I loan demand due to investment needs or M&A activity. Chart 5Possible Reasons For Greater C&I Loan Demand In Q1 2020 The distinction is important. Greater investment needs and M&A activity would suggest an improving economic back-drop, and would imply a more sustainable increase in bank lending. In contrast, there is a limit to how much firms can tap existing credit lines for immediate cash needs, and this activity should taper off during the next few months. Bottom Line: About 70% of the unprecedented increase in broad money supply is the result of the Fed’s asset purchase activity. The remaining 30% is due to an uptick in C&I loan growth, almost all of which is from nonfinancial firms tapping existing credit lines, an activity that will taper off in the coming months. The Implications Of Rapid Money Growth According to some theory and popular thought, there are three possible channels through which rapid money growth could impact the economy and financial markets: Fast money growth could lead to stronger economic growth in the future. Fast money growth could lead to rising inflationary pressures. A larger money supply could suggest that there are more funds available to deploy in financial markets. As such, it could lead to price appreciation in risky financial assets. We are inclined to downplay the importance of M1 and M2 as indicators in all three of these areas, for reasons discussed below. The Money Supply’s Impact On Economic Growth In the past, measures of the broad money supply (M1 and M2) did a good job of forecasting economic growth and were tracked closely (and at times targeted) by the Federal Reserve. But as the banking and monetary systems evolved, M1 and M2 became less important. As Fed Chairman Alan Greenspan explained in 1996:1 At different times in our history a varying set of simple indicators seemed successfully to summarize the state of monetary policy and its relationship to the economy. Thus, during the decades of the 1970s and 1980s, trends in money supply, first M1, then M2, were useful guides. […] Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy. Chairman Greenspan’s insight is backed up by the empirical data (Chart 6). Real M2 growth was an excellent leading indicator of economic growth until the early 1990s. The relationship has broken down since then, and in fact, the only reliable trend in Real M2 since the 1990s is that it tends to spike during recessions. Chart 6Broad Money Growth Has Been A Poor Indicator For Economic Activity Since The 1990s The Conference Board also noticed this trend and removed Real M2 from its Leading Economic Indicator in 2012. According to the Conference Board, Real M2 ceased to function as a leading economic indicator because (i) the Fed began targeting interest rates instead of monetary aggregates and (ii) the creation of interest-bearing checking accounts and money market funds increased safe haven demand for M2. The latter helps explain why money growth has surged during the last three recessions. All in all, broad money growth is now a poor indicator for GDP. The Money Supply’s Impact On Inflation Another popular theory is that money growth is a leading indicator of inflation. This stems from the following identity, aka the Equation of Exchange: MV = PY Where: M = money supply, V = velocity of money, P = price level and Y = real output The identity holds, but is of little practical value, mainly because there is no good way to measure (or model) velocity (V) without relying on money growth and nominal GDP (P*Y). This means that an increase in the money supply doesn’t necessarily tell us anything about inflation, because we have no idea how velocity will respond. In fact, many commentators have observed that the stronger empirical correlation is actually between money velocity (PY/M) and core inflation (Chart 7). When nominal GDP growth exceeds money growth, core inflation tends to rise 18 months later. However, this relationship also holds if we remove money supply from the equation entirely (Chart 7, bottom panel). What we’re actually observing is that core inflation tends to lag economic growth by about 18 months. Chart 7Inflation Lags Economic Growth, Not Broad Money Growth Since we’ve already seen that money supply does a poor job forecasting economic growth, it’s clear that indicators such as M1 and M2 don’t improve our ability to forecast inflation, and in fact probably only confuse the picture. The Money Supply’s Impact On Financial Markets BCA’s US Bond Strategy definitely subscribes to the notion that the stance of monetary policy is one of the most important drivers of financial market performance. If the Fed keeps interest rates low and signals to the market that rates will stay low for a long time, then we would expect investors to chase greater returns in riskier assets, driving up the prices of corporate bonds and equities. That being said, the appropriate way to measure the stance of monetary policy is with interest rates. Money supply measures like M1 and M2 are not helpful guides for risk asset performance. We have already seen that an increase in the money supply can only arise via (i) greater bank lending or (ii) the Fed’s purchase of securities and injection of reserves into the banking system. Both of these things are likely to occur when interest rates are low and monetary policy is accommodative. Low interest rates boost loan demand, and large-scale Fed asset purchases are more likely to occur when interest rates are already at the zero-lower-bound. We would argue that it is, in fact, low interest rates that influence both money growth and financial asset prices. The drivers of money supply growth – bank lending and Fed asset purchases – don’t offer any new information beyond what the interest rate already tells us. On loan growth, both loan demand and risk asset price appreciation are functions of low interest rates. In fact, financial markets will respond more quickly to changes in interest rates than will bank lending: Stock prices are included in the Conference Board’s Leading Economic Indicator, while C&I bank lending is included in the Lagging Economic Indicator.2 This means that, practically, any money supply growth that is driven by bank lending is not useful as an indicator for financial asset prices. What about money growth that is driven by Fed asset purchases? Here, we need to distinguish between the signaling impact of Fed asset purchases and any other potential impact that purchases might have on asset prices. In the first half of 2019, financial markets responded to the Fed's dovish interest rate policy, not to its shrinking balance sheet. Though the data are difficult to parse, our reading is that the only meaningful impact of Fed purchases on financial asset prices is through what the purchase announcements signal to markets about the future path of interest rates. To test this theory, we need to search for periods when the Fed’s signaling about its future interest rate policy diverges from its balance sheet policy. That is, we need to find periods when the balance sheet is shrinking and Fed rate guidance is becoming more dovish, or periods when the balance sheet is growing and rate policy is becoming more hawkish. Unfortunately, we can only identify one such period and that is the first half of 2019 when the Fed was simultaneously shrinking its balance sheet and signaling to markets that interest rate policy was becoming more dovish (Chart 8A). During that period, financial markets responded to the more dovish interest rate policy and not to the shrinking of the Fed’s balance sheet (Chart 8B). Bond yields fell, the dollar weakened and both corporate bonds and equities delivered strong returns. Chart 8ARates Policy Trumps Balance Sheet Part I Chart 8BRates Policy Trumps Balance Sheet Part II Bottom Line: We don’t find broad money supply measures (M1 and M2) to be useful indicators of economic growth, inflation or financial asset performance. Subordinate Bank Bonds: Still In The Sweet Spot Chart 9Still In The Sweet Spot Two months ago we made the case for owning subordinate bank bonds.3 The premise for this call is that subordinate bank bonds are a high-quality cyclical sector, exactly the sweet spot of the investment grade corporate bond market that we want to own in the current environment. We expect that extraordinary Fed support for the market will cause investment grade corporate bond spreads to tighten during the next 6-12 months. In that environment we want to focus on cyclical (or “high beta”) bond sectors, ones that outperform the index during periods of spread tightening. However, we also recognize that the Fed’s emergency lending facilities will not prevent a surge in ratings downgrades. Therefore, the sweet spot we want to own is cyclical bonds that are unlikely to be downgraded. High-quality Baa-rated securities, like subordinate bank bonds, fit the bill nicely. Chart 9 shows that the subordinate bank bond index has a duration-times-spread ratio above 1.0.4 This confirms that the sector will trade cyclically relative to the corporate benchmark. We also see that subordinate bank bonds have outperformed both the overall corporate index and other Baa-rated bonds since the start of the year (Chart 9, panel 2). Further, subordinate bank bonds offer a spread pick-up versus the corporate index in both option-adjusted spread terms (Chart 9, panel 3) and 12-month breakeven spread terms (Chart 9, bottom panel).   What Did We Learn From The Stress Tests? Last week the Fed released the results of its 2020 bank stress tests. Results for individual banks were released for a “severely adverse scenario”, the details of which had been publicly available since February. However, because of concern that the “severely adverse scenario” wasn’t dire enough to capture the potential fallout from the pandemic, the Fed also stress tested three COVID-specific scenarios and released results only for the banking system in aggregate. The three scenarios are: A ‘V’-shaped recovery, where economic growth recovers in Q3 and Q4 of this year after contracting significantly in the first half. A ‘U’-shaped recovery, where the growth pick-up in the second half of 2020 is much milder. A ‘W’-shaped recovery, where economic growth recovers in Q3 but then dips again near the end of the year. Table 2 shows a few key assumptions of the three scenarios along with how the actual economy is tracking. It seems that, absent the re-imposition of lock-down measures, the economy is tracking to be in a slightly better place than in any of the three scenarios. Note that the unemployment rate has already peaked below 15%, lower than assumed by any of the three scenarios. Table 2Three Stress Test Scenarios* Chart 10Banks Have Huge Capital Buffers Chart 10 shows the Common Equity Tier 1 Capital Ratio for the aggregate banking sector, and the dashed horizontal lines show how far it would fall in the three different COVID scenarios. The results show that the ‘V’-shaped scenario is manageable for the banking system, but a significant number of banks would run into trouble in the ‘U’ and ‘W’ shaped scenarios.   The good news for bank credit quality is that, based on how the economy is tracking and the prospects for further fiscal stimulus, the worst ‘U’ and ‘W’ shaped scenarios will probably be avoided. Further, the Fed has already suspended share buybacks and capped dividend payouts. It will also re-run the stress tests later this year. Another round of stress tests this year is credit positive, as it will encourage banks to strengthen their capital buffers during the next few months. Bottom Line: After viewing the results of the Fed’s stress tests, we still think the odds of bank ratings downgrades this year are low. Investors should stay overweight subordinate bank bonds. 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 3Performance Since March 23 Announcement Of Emergency Fed Facilities Footnotes 1 https://www.federalreserve.gov/BOARDDOCS/SPEECHES/19961205.htm 2 https://www.conference-board.org/data/bci/index.cfm?id=2160 3 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 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights When retail investors invest aggressively and central banks buy assets en masse, economic fundamentals take the back seat and momentum becomes king. Global risk assets are at a fork in the road: either they will relapse meaningfully as they have run well ahead of fundamentals or a budding mania will push global share prices to fresh new highs.   A budding mania is the basis behind our strategy of chasing momentum from this point on. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Feature Chart I-1Make It Or Break It Moment For US Dollar Global share prices have reached a point where they are no longer oversold. In turn, the trade-weighted US dollar has worked out its overbought conditions and is sitting on major defensive lines (Chart I-1). If the dollar relapses below its technical resistances, it will enter a bear market. Consistently, EM risk assets will enter a bull market. The trajectory of EM risk assets and currencies in the coming months will ultimately depend on what happens to the ongoing global FOMO (fear-of-missing-out) rally. We refer to it as a FOMO rally because both the DM and EM equity rallies have been taking place despite deteriorating corporate profit expectations, as we documented in our June 4 report. Why The FOMO Rally May Still Have Legs There are a number of reasons why this FOMO-driven rally could persist: Chart I-2Helicopter Money In The US First, the Federal Reserve is explicitly targeting higher asset prices, and to achieve this goal it is deploying its “nuclear” arsenal – printing money and monetizing public debt, lending to the private sector as well as buying corporate bonds. US broad money growth is at an all-time high (Chart I-2). Consequently, the risk of a full-blown equity bubble formation in the US cannot be ruled out. If this occurs, all EM risk assets will rally along with the S&P 500. US policymakers are throwing everything into the system to keep financial asset prices inflated. It seems that after any day that the S&P 500 sells off, the Fed or the US administration comes up with some sort of new measure to support the economy and asset prices. Historically, investors have placed a lot of weight on the Fed’s actions. Aggressive measures by the Fed have recently led investors to purchase stocks and corporate bonds, irrespective of the condition of the underlying economy. As a result, share prices worldwide have decoupled from corporate profit expectations (Chart I-3A and I-3B). If US policymakers succeed in lifting US share prices further, every investor will likely chase the rally and the US equity market will become a full-scale bubble. Chart I-3AGlobal Stocks Are Pricing In A Lot Of Good News Chart I-3BSurging EM Share Prices Amid Plunging Forward EPS Chart I-4Retail Investors Have Driven Up Trading Volumes At some point, the bubble will start cracking even if corporate earnings find their way back to a recovery path. When equities make up a large share of investors’ assets, any trigger could lead to marginal sellers outnumbering marginal buyers. As we discuss below, there are plenty of risks that could result in a trigger. Both retail and institutional investors are very averse to losses, and when the market begins to slide, investors will sell their shares simultaneously. The market will plunge. The Fed will be forced to buy stocks to avert the negative impact of falling share prices on the economy. In a nutshell, US equities and corporate bonds have become extremely dependent on the Fed. This might be good news in the short and medium term. Nevertheless, it is negative for the US in the long run. Second, when retail investors rush into the market and actively trade, fundamentals take the back seat. This is what has been occurring since March. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks. This is illustrated by the surge in turnover volumes on the Nasdaq as well as in Southwest Airline, Norwegian Cruise Lines and Chesapeake Energy stocks (Chart I-4). Yet the impact of their actions is not limited to these stocks. Stocks are fungible. When retail investors purchase shares of near-bankrupt companies at elevated prices (at higher than fundamentals warrant), institutional investors sell those stocks and move capital to other companies. In aggregate, the stock market index rises.  The ongoing retail investor mania is not solely a US phenomenon. It has become prevalent in many other countries. There are anecdotes that Japanese retail investors have been actively trading Jasdaq stocks, while Korean, Taiwanese and Filipino retail investors have been buying local shares en masse.1  The top panel of Chart I-5 illustrates that Korean individual investors have been accumulating stocks while foreigners have been selling out. In Taiwan, the share of individual investors in equity trading has been rising at the expense of domestic institutional investors (Chart I-5, bottom panel). Retail investors do not do much fundamental analysis, and it should not come as a surprise that share prices have decoupled from their fundamentals (profits) and have gained despite lingering massive risks. Retail investors appear to be especially attracted to crushed or near-bankrupt US stocks as well as popular tech stocks.  Third, the mania phase – the last and most speculative stage – in bubble formation typically lasts between nine and 18 months. This is based on the duration of the mania phase in the Nikkei (1989), the NASDAQ (1999-2000), oil (2008) and Chinese A shares (2014-‘15) (Chart I-6). The retail investor-driven equity mania began in March and is now three months old. If the duration of previous manias is any guide, the current rally could last another six months at least. Chart I-5Strong Retail Buying Is Also Evident In Korea And Taiwan Chart I-6How Long Mania Phase Lasted During Previous Bubbles? Chart I-7China A-Share Bubble: A Divergence Between Stocks And EPS The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. Chart I-7 demonstrates that Chinese A-share prices skyrocketed in H1 2015, despite a deteriorating corporate profit picture. It lasted for a while and ended with a bust without any policy tightening taking place. Finally, retail investors are not quick to give up when they lose money. Having acquired a taste for capital gains over the past few months, retail investors will likely become even more aggressive and will keep buying the dips. In such a scenario, institutional and professional investors may be forced to capitulate and chase risk assets higher. We are at a fork in the road: either retail investors will begin reducing their equity holdings soon, or institutional and professional investors will capitulate and start buying en masse. In the first scenario, stocks will tumble as retail investors rapidly head for the exits. The latter scenario on the other hand will push share prices considerably higher. This is the basis behind our strategy of chasing momentum from this point on. Bottom Line: All financial market manias eventually crash. However, if the market breaks out, the rally could endure for several months. Not chasing the rally will be very painful for portfolio managers. This is why even though we believe the current global equity rally has been a FOMO-driven mania, we recommend to play it if EM share prices break above, and the broad-trade weighted dollar relapses below, current levels. Plenty Of (Disregarded) Risks Chart I-8Number Of New Inflections Is Rising In Large EM Countries Even though global risk assets have been rallying, the global investment landscape remains poor, with plenty of risks. In particular: Geopolitical tensions are bound to rise between the US and China. Taiwan and its semiconductor sector are at the epicenter of the US-China technological and geopolitical standoffs. Timing any escalation is tricky, but Taiwanese stocks are not pricing in these risks. Further, odds are high that North Korea will test a strategic weapon, which will undermine the credibility of President Trump’s foreign policy. This is negative for the KOSPI and the Korean won. An escalation in US-China tensions encompassing technology, Hong Kong, Taiwan and the Koreas is negative for equity markets in China, South Korea and Taiwan alike. Together they account for about 60% of the EM MSCI equity benchmark market cap. Moreover, the China-India skirmish is a risk for Indian stocks. The number of new Covid-19 infections is rising in the majority of EM countries excluding China, Korea and Taiwan as demonstrated in Chart I-8. It will be hard to ameliorate consumer and business confidence and thereby boost spending in these countries amid a worsening trend in the global pandemic. Indeed, a second wave of the coronavirus now hitting Beijing is evidence that even the very efficient Chinese system is not able to prevent pockets of renewed infection outbreaks. This risk still looms large over many advanced and developing nations after the first wave subsides. The post-lockdown natural snapback in economic activity is creating a mirage of a V-shaped recovery. Like any mirage, it can last and drive markets for a while. However, it will eventually fade. When that happens, misalignments in financial markets will be ironed out rather abruptly. A snapback in economic activity around the world is natural following the unwinding of strict lockdowns. Nevertheless, the level of business activity remains very low. Going forward, persistent social distancing, the threat of a second wave and an initial substantial income drawdown will cap the speed of recovery in household and business spending around the world. In our February 20 report titled EM: Growing Risk Of A Breakdown, we contended that the most likely trajectory for Chinese growth is the one demonstrated in Chart I-9. It assumed the plunge in business activity would be succeeded by a rather sharp snap-back due to pent-up demand. However, this snapback would likely be followed by weaker growth in the following months. This is also our roadmap for the business cycles of many DM and EM economies. Even though on May 28 we upgraded our economic outlook for Chinese growth from negative to mildly positive, near-term risks for China-related plays remain. Consistent with the trajectory described above, the Chinese economy has been coming back to life, aided in large part by significant credit and fiscal stimulus (Chart I-10, top and middle panel). Traditional infrastructure investment has accelerated strongly (Chart I-10, bottom panel). Chart I-9Our Roadmap For China’s Business Cycle Chart I-10China: Money/Credit And Infrastructure Are Accelerating   Consequently, mainland demand for commodities has been very robust and raw materials prices have rallied. However, it remains to be seen if the recent strength in commodities purchases can be maintained going forward. A couple of our indicators and market price signals are also suggesting that caution is warranted in the near term with respect to China-related plays. First, our indicators for marginal propensity to spend among households and enterprises continue to deteriorate, even when May data points are included (Chart I-11). These indicators have been good pointers for consumer discretionary spending and business investment/demand for industrial metals, as illustrated in Chart I-11. Chart I-11Marginal Propensity To Spend Is Falling For Consumers And Enterprises Chart I-12Copper: Shanghai/London Premium And Prices   Second, the copper price premium in Shanghai over London has been a good coincident indicator for copper prices and has recently been flagging short-term risks to copper prices (Chart I-12). A rising Shanghai/London copper premium implies more robust demand in China, while a declining premium signals weaker copper demand in the mainland. Finally, share prices of property developers, industrials and materials in the onshore market have failed to advance much (Chart I-13). This fact does not corroborate that there is a strong recovery occurring in China’s broad capital spending outside infrastructure. Chart I-13Chinese Stocks Do Not Corroborate A Strong Recovery A similar message stems from the investable universe of Chinese stocks. We are using the sector indexes from the onshore market because they are less hyped by the global FOMO rally, and the number of companies included in these onshore sector indexes is larger than in the investable indexes. Bank share prices have done even worse (Chart I-13, bottom panel). Overall, near-term risks to China-plays remain and we are looking for a better entry point in the weeks and months ahead. The trend-setting US equity market is expensive, as we corroborated in our report on EM and US equity valuations a month ago. The forward P/E ratio stands at 22, using analysts’ 12-month forward EPS expectations that we believe are still optimistic. Global financial market correlations are presently high, and domestic conditions in EM ex-China, Korea and Taiwan are rather grim. If the S&P 500 relapses for whatever reason, there is little chance EM risk assets will avoid selling off. Bottom Line: Risks are abundant and fundamentals (profits, valuations, geopolitical risks, the ongoing pandemic) do not justify higher share prices. However, if a FOMO-driven rush into stocks persists, financial markets will continue ignoring fundamentals. Investment Strategy: Momentum Is Now King When retail investors invest aggressively and central banks buy assets en masse, it is not the time for fundamental analysis. Indeed, momentum becomes king. Investors should adjust their strategy based on momentum in global stocks and the broad trade-weighted US dollar in the coming weeks. Our composite momentum indicator for global share prices has risen to zero from extremely oversold levels (Chart I-14). Chart I-14Global Share Prices Are At A Critical Juncture If global and EM share prices break meaningfully above their 200-day moving averages and the US dollar breaks materially below its 200-day moving average (see Chart I-1 on page 1), our advice will be for investors to chase the rally. Even if DM and EM share prices break out, the odds are that EM stocks will continue underperforming DM ones. Hence, we continue to underweight EM in a global equity portfolio. The basis is that North Asian equity markets (China, Korea and Taiwan) are at risk of a heightened geopolitical confrontation between the US and China, as per our discussion above. Meanwhile, the remainder of EM is struggling with the pandemic. Hence, EM will continue to underperform, even if global share prices rise a lot. The current equity mania resembles the one in China’s A-share market in 2014-‘15 in two aspects: (1) it is driven by retail investors and (2) it is occurring amid very underwhelming corporate profits. That said, if global stocks and commodities prices break out and the greenback breaks down, we will close our remaining short positions in EM currencies and upgrade our stance on EM fixed-income markets from neutral to bullish. We have been receiving rates in Mexico, Colombia, Russia, India, China, Korea, Pakistan, Ukraine and Egypt, but have been reluctant to take on currency risk. Also, we upgraded our stance on EM credit markets to neutral on June 4. We will likely upgrade EM local currency bonds and EM credit markets further to “buy” if the above-mentioned breakouts transpire. Upgrade Chinese, Downgrade Korean Stocks Chart I-15DRAM And Korean Tech Stocks We are moving China from neutral to overweight and downgrading Korea from overweight to neutral relative to the EM equity benchmark. Regarding Korean equities, the risks are as follows: First, rising threats of North Korea testing a strategic weapon is negative for South Korea’s equities and currency. Second, DRAM prices and volumes are dropping. Chart I-15 shows that the DRAM revenue proxy is falling, a bad omen for Korean tech stocks that derive a lot of operating profits from DRAM sales.  Finally, the Korean bourse is heavy in old-economy stocks, which will experience a slow recovery in their profits from very low levels amid the enduring global trade downturn.  The reasons to upgrade Chinese investable stocks relative to the EM equity benchmark include: As we discussed above, the medium-term growth outlook for China is mildly positive due to the credit and fiscal stimulus Beijing has unleashed. The outlook for domestic demand is worse in many other developing economies. The credit and money bubble in China will inflate further and will pose a major challenge in the years ahead. That said, another round of major credit/money expansion will likely stabilize the system in the medium term. If the FOMO-driven mania continues, FAANG stocks will likely outperform, which will spread to similar stocks around the world. The Chinese investable index includes Alibaba, Tencent and other new economy stocks that will likely outperform the EM benchmark. If global markets correct and EM currencies drop, the Chinese RMB will appreciate relative to most EM exchange rates. This will help China’s equity performance relative to other EM bourses. Finally, if US-China tensions escalate and EM markets sell off, Chinese authorities will support share prices by deploying the national team and other government proxies to buy Chinese stocks. This will help the broad universe of Chinese stocks to outperform the EM benchmark. Chart I-16Long Chinese Investable / Short Korean Equities Bottom Line: We are upgrading Chinese stocks from neutral to overweight and downgrading the Korean bourse from overweight to neutral within an EM equity portfolio. Market-neutral investors should consider the following trade: long Chinese / short Korean equities (Chart I-16).   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   1     Please see the following articles: Coronavirus spawns new generation of Japanese stock pickers Stuck at Home, More Filipinos Try Luck at Stock Investing   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights High-Yield: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. Fed/Treasuries: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitizations: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. Feature In case it wasn’t already obvious that the Fed will continue to act as a tailwind behind risky asset prices, Chair Powell made it abundantly clear at last week’s FOMC press conference. When asked about the risk of bubbles in financial markets, Powell’s response was to focus on the millions of unemployed workers and imply that it would be a dereliction of the Fed’s duties if it were to hold back on monetary stimulus because it thought asset prices were too high. Ironically, this strong statement of market support came the day before the S&P 500 fell 6% in a single session. Nonetheless, with the Fed providing such aggressive forward guidance on top of direct intervention in certain segments of the fixed income market, it behooves us to consider whether our recommended portfolio allocation is insufficiently aggressive. The Strong Performance Of Low-Rated Junk Chart 1Lower-Rated Junk Bonds Playing Catch-Up Within the high-yield corporate bond market we have been advising an overweight allocation to Ba-rated bonds but an underweight allocation to bonds rated B and below. The reasoning is that Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold.1 This positioning worked well throughout April and the first half of May, but lower-rated junk bonds have started to play catch-up during the past month (Chart 1). High-Yield Index Fundamentals To get a sense of whether we should extend our overweight recommendation to the B and below credit tiers, let’s first perform a valuation exercise on the entire high-yield index. In this exercise we consider current spread levels relative to likely economic outcomes. We set aside any impact from direct Fed intervention for the time being. Our analysis revolves around the High-Yield Default-Adjusted Spread (Chart 2). This valuation measure takes the junk index spread and subtracts default losses realized during the subsequent 12 month period. The spread’s historical average is around 250 bps, but it has occasionally dipped below zero during periods when default losses swamp the compensation offered by the index. Chart 2High-Yield Index Assessment: Default-Adjusted Spread The Default-Adjusted Spread also lines up very closely with 12-month excess returns (Chart 2, panel 2). A simple linear regression model of 12-month excess returns versus the Default-Adjusted Spread gives an R2 of 53% and tells us that the threshold between positive and negative excess returns is a Default-Adjusted Spread of 187 bps. That is, if the Default-Adjusted Spread is above 187 bps we should expect high-yield to outperform Treasuries, if it is below 187 bps we should expect high-yield to underperform. With that in mind, we can apply some quick figures to the current context. The High-Yield index option-adjusted spread is 611 bps. If we assume a default rate of 10% and recovery rate of 25% for the next 12 months, we get expected default losses of 750 bps and a Default-Adjusted Spread of -139 bps. We should expect Treasuries to outperform junk bonds in that scenario. Ba-rated bonds are largely eligible for the Fed’s emergency lending facilities while lower-rated junk bonds are mostly left out in the cold. We can also perform the same sort of analysis in reverse. If we target a Default-Adjusted Spread of 187 bps – the spread that is consistent with high-yield performing in line with Treasuries – and we also assume a recovery rate of 25%, then the current index spread gives us an implied 12-month default rate of 5.7% (Chart 2, bottom panel). That is, we should expect high-yield to outperform Treasuries during the next 12 months if the default rate comes in below 5.7%, and underperform if it is above 5.7%. There are a couple assumptions used in the above analysis that require clarification. First, we relied on a simple linear regression model to get the result that a Default-Adjusted Spread of 187 bps is consistent with junk bonds breaking even with Treasuries. This is not an entirely accurate depiction of the historical record. Table 1 shows a more complete picture of the historical linkage between the Default-Adjusted Spread and 12-month high-yield excess returns. Here, we see that junk bonds have actually outperformed duration-matched Treasuries 81% of the time when the Default-Adjusted Spread is between 150 bps and 200 bps, and 72% of the time when it is between 100 bps and 150 bps. Relative junk bond losses only become more likely than gains when the Default-Adjusted Spread is below 100 bps. Table 1The Default-Adjusted Spread & High-Yield Excess Returns Second, we assumed a 25% recovery rate when we calculated our implied default rate of 5.7%. This is low compared to the historical average, but we would argue that a low recovery rate assumption is appropriate in the current environment. We analyzed the main economic drivers of default and recovery rates in a recent Special Report and found that the recovery rate observed during an economic downturn is primarily driven by corporate balance sheet leverage heading into that downturn.2 Corporate balance sheets were carrying a lot of debt heading into the current recession, meaning that we should expect a lower-than-normal recovery rate. In fact, the current trailing 12-month recovery rate is 22%, below our assumed level. Table 2 shows what the Default-Adjusted Spread will be for the next 12 months under different default and recovery rate assumptions. We think that 25% is a reasonable recovery rate assumption and expect that the default rate will be somewhere between 9% and 12% during the next 12 months. At present, Moody’s baseline 12-month default rate forecast is 11.6%. Table 2Default-Adjusted Spread (BPs) Given Different Assumptions For Default And Recovery Rates Clearly, junk spreads do not offer adequate compensation for default losses in the economic environment we anticipate. This logic also extends to the individual B and Caa/C credit tiers when we look at them in isolation. A Focus On B-Rated & Below Junk Bonds Charts 3A and 3B show the historical linkage between Default-Adjusted Spreads and excess returns for those specific credit tiers, with forecasts plugged in for “mild”, “moderate” and “severe” default scenarios. All three scenarios use a recovery rate of 25%. The assumed default rate is 6% in the “mild” scenario, 9% in the “moderate” scenario and 12% in the “severe” scenario. Default-adjusted compensation is unattractive in all three cases. Chart 3AB-Rated Default-Adjusted Spread Chart 3BCaa/C-Rated Default-Adjusted Spread Bottom Line: Our analysis of current junk spread levels relative to likely economic outcomes leaves us inclined to maintain our current recommended positioning: Overweight Ba-rated bonds, underweight bonds rated B & below. The Fed’s support for the Ba credit tier will significantly limit default losses for those bonds, making current spread levels attractive. However, absent Fed intervention, junk spreads are already far too tight. Investors should avoid bonds rated B & below where issuers generally don’t benefit from the Fed’s emergency programs. No Rush For More Explicit Forward Guidance In addition to Chair Powell’s strong statement of support for risky assets, last week’s FOMC meeting brought us the committee’s updated interest rate projections. With only two exceptions, those projections revealed that all Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. There had been some expectation that the Fed might provide more explicit forward guidance for the funds rate. Something along the lines of the “Evans Rule” that was used during the last zero-lower-bound episode. For example, the Fed could pledge to not increase rates until the unemployment rate is below some specified threshold or inflation is above some specified threshold. Fed policymakers expect to keep the fed funds rate at its current level at least until the end of 2022. This sort of forward guidance would be useful if the Fed needed to convince markets about its commitment to keeping rates pinned near zero, but the market has already internalized that message. Notice in Chart 4 that expectations priced into the overnight index swap curve show no rate hikes through the end of 2022. The same goes for the median estimate from the New York Fed’s April 2020 Survey of Market Participants. Chart 4Fed Policymakers And Market Participants Agree: No Hikes Until 2023 More explicit forward rate guidance will likely be required in the future, when the market starts to price-in the eventual return of rate hikes. But for the time being, the Fed will probably be content to stay the course. Treasury Positioning The combination of the Fed’s strong commitment to zero interest rates and the risks to the 6-12 month economic outlook that we detailed in last week’s report make us inclined to maintain our recommended “At Benchmark” portfolio duration stance.3 However, we also recognize that yields are more likely to rise than fall in the coming months as the US economy re-opens and the economic data trend higher. For this reason, we advise holding several tactical overlay trades that will profit from rising bond yields: overweight TIPS versus nominal Treasuries, duration-neutral nominal curve steepeners, real yield curve steepeners. On TIPS, May’s CPI report showed a third consecutive month-over-month decline but the drop was far less severe than what was seen in March and April (Chart 5). This is a preliminary indication that we could already be passed the trough in inflation. The fact that trimmed mean CPI has not followed the core measure lower during the past few months is further evidence that inflation may not fall much more from its current level (Chart 5, bottom panel). If inflation has indeed bottomed, then our recommendation to favor TIPS over nominal Treasuries looks very good. We calculate that the current 1-year TIPS breakeven inflation rate is 0.1%, slightly below trailing 12-month headline CPI inflation (Chart 5, panel 2). Along the nominal Treasury curve, we continue to recommend favoring the 5-year bullet over a duration-matched 2/10 barbell. This position will profit from continued 2/10 yield curve steepening (Chart 6). We also recommend steepeners along the real yield curve. The real 2/10 slope has already steepened a lot (Chart 6, bottom panel), but has more room to run given that the 2-year cost of inflation compensation remains well below the 10-year cost (Chart 6, panel 3). Chart 5Is The Trough In Inflation Already##br## Behind Us? Chart 6Keep Steepeners Along Both The Nominal And Real Yield Curves Bottom Line: There is no urgency for the Fed to provide more explicit forward rate guidance. The market has already taken on board the expectation that the funds rate will stay pinned at zero at least through the end of 2022. Investors should keep portfolio duration near benchmark but add tactical overlay positions: long TIPS versus nominal Treasuries, and steepeners along both the nominal and real yield curves. Securitized Products Update Take Some Non-Aaa Risk In Consumer ABS, But Not In CMBS Since the Fed rolled out its emergency lending facilities in late-March, our spread product strategy has been to favor sectors that offer attractive spreads and that benefit from Fed support. This has meant owning Aaa-rated consumer ABS and CMBS, which are eligible for the Fed’s Term Asset-Backed Securities Loan Facility (TALF), and avoiding non-Aaa securitizations, which don’t qualify for Fed support. How has this worked out? Aaa-rated ABS and CMBS have both performed well since spreads peaked on March 23 (Chart 7). Within ABS, Aaa issues have beaten Treasuries by 390 bps since March 23 compared to 290 bps for non-Aaa securities. In CMBS, non-Aaa securities have lagged, losing 470 bps versus Treasuries since March 23 compared to gains of 810 bps for Aaa CMBS. As Chart 7 makes plain, no segments of either market have regained all of the ground that was lost during March’s blow-up. Chart 7Opportunities In Non-Aaa Consumer ABS, But Not In CMBS Going forward, we think it is wise to re-consider our strategy when it comes to consumer ABS. Specifically, we think investors should dip into non-Aaa ABS where we see potential for strong returns, even in the absence of Fed support. The reason for our optimism is that consumer credit losses will probably turn out to be significantly lower than many had feared in March. During the past two months, we learned that federal government stimulus actually caused real personal income to rise by 9% since February. Also, consumers have generally been able to keep up with their debt payments.4  According to data from TransUnion, the percentage of credit card and mortgage loans that are more than 30 days past due actually declined in April compared to March. For auto loans it only increased by 7 bps (Table 3). Further, the data show that households paid off significantly more of their credit card balances than usual in April, presumably because they received an influx of cash from the government but had fewer spending opportunities due to the quarantine. Table 3No Spike In Consumer Credit Delinquencies There remains a risk that Congress will delay passing further stimulus measures to keep consumers flush during the next few months. But we think enough stimulus will be delivered to prevent a significant default spike in credit cards and auto loans. Investors should add some exposure to non-Aaa consumer ABS. CMBS is a different story. The commercial real estate market is particularly challenged by the current environment. The office and retail sectors in particular were already facing structural headwinds from remote working and online shopping, respectively. The pandemic has accelerated the adoption of those trends. Not surprisingly, May’s CMBS delinquency rate saw its largest jump since 2017 and more delinquencies are certainly on the way (Chart 8). Chart 8Challenging Environment For CMBS Investors should continue to avoid non-Aaa CMBS. Continue To Avoid Agency MBS We have been advising an underweight allocation to Agency MBS because, even though the securities benefit from support through the Fed’s direct MBS purchases, value has been insufficiently attractive. That is starting to change. Agency MBS spreads widened considerably during the past month and are now very close to Aa-rated corporate bond spreads. They are also greater than Agency CMBS and Aaa ABS spreads (Chart 9). However, despite improving valuations, we remain concerned about risks in the MBS sector. Notice in the top 2 panels of Chart 9 that the MBS option-adjusted spread (OAS) has returned to 2012 levels, but the nominal spread (which is not adjusted for expected prepayment losses) remains quite low. This means that the prepayment loss assumption embedded in the current index OAS is much lower than it was in 2012. Is this reasonable? We estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. In part, yes it is. Even with mortgage rates at all-time lows, we estimate that 63% of the conventional 30-year MBS index is eligible for refinancing. This is lower than what was seen in 2012 (Chart 10). However, we would also argue that mortgage rates have room to fall further Chart 9Agency MBS Spreads Have Widened Chart 10Prepayment Risk Is Elevated Despite having fallen to all-time lows, this year’s decline in the 30-year mortgage rate has been much smaller than what was seen in Treasury or MBS yields (Chart 10, bottom 3 panels). The 30-year mortgage rate could drop by another 50 bps and it would only restore typical primary and secondary mortgage spread levels. We estimate that a further 50 bps drop in the mortgage rate would increase the refinanceable share of the MBS index from 63% to 74% (horizontal dashed line in the second panel of Chart 10). This is below 2012 levels, but still leads us to the conclusion that the current index OAS understates the risk of prepayment losses. In summary, the Agency MBS OAS is starting to look more attractive but we are concerned that it embeds an overly optimistic prepayment loss assumption. Investors should maintain underweight allocations to Agency MBS. Bottom Line: We recommend that investors continue to overweight Aaa-rated consumer ABS and CMBS, as both sectors offer attractive spreads and benefit from TALF. Despite the lack of Fed support, adding some non-Aaa consumer ABS exposure also makes sense. Investors should continue to avoid Agency MBS, where value has improved but prepayment risk remains high. 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 Footnotes 1 For more details on the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 4 For more details on the outlook for the US consumer please see US Investment Strategy Weekly Report, “So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)”, dated June 8, 2020, available at usis.bcaresearch.com   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Equities hit an air pocket last week after making another recovery high: Investors seemed to reassess the economy’s direction following official forecasts that ranged from sober to grim. “Whatever we can, and for as long as it takes”: The FOMC’s outlook may have dampened investors’ mood now, but it contained the promise of an extended period of easy policy. Further fiscal help is on the way: The White House supports additional spending and some new Republican proposals offered a hint of what the next phase of fiscal relief might look like. Bank stocks quailed at the prospect of lower rates: The SIFI banks sold off sharply as investors feared that falling rates and a flatter yield curve would crimp net interest margins. We are undeterred from our bullish stance on the group. Feature Coming into last week, the gap between the effervescence of the stock market and the gloom of the pandemic-stricken economy was Topic A for investors and the financial media. We have interpreted the gap as a vote of confidence for policymakers. The Fed and Congress have thrown nearly everything they have at shielding the economy from the virus’ depredations and investors have concluded that they’ll succeed, bidding equities higher and corporate bond spreads tighter (Chart 1). Chart 1Spreads Are Back To The Middle Of Their Post-GFC Range ... Through last Monday, the benchmark Bloomberg Barclays Investment Grade and High Yield Corporate Bond Indexes had generated total returns of 17% and 24%, respectively, since their March 20-23 lows, while the S&P 500 was up 45% peak-to-trough on a total return basis. Equities’ torrid run had the S&P in the black year-to-date and within just 5% of its mid-February peak (Chart 2). Given that the economic projections have only worsened since late March, and the virus toll has been worse than the consensus expected, policy has had to shoulder the entire load. Chart 2... And Equities Made It All The Way Back To Their 2019 Close In the monetary sphere, the Fed swiftly cut the fed funds rate to zero, purchased Treasuries and agency MBS at a faster rate than it did during the global financial crisis, revived several GFC initiatives and announced it would lend money directly to investment-grade-rated corporations1 for the first time. The medley of measures quickly gained traction. Though the new issuance market initially seized up upon the arrival of the pandemic, record amounts of corporate bonds were issued in both March and April. All-out stimulus efforts from Congress and the Fed have produced a remarkable market turnaround. From the fiscal side, Congress passed several measures to speed aid to vulnerable parts of the economy, crowned by the CARES Act. As we detailed last week,2 its expansion of state unemployment insurance benefits has made two-thirds of the unemployed eligible to earn more than they did at their jobs. Bolstering unemployment insurance and sending direct $1,200 payments to nearly two-thirds of taxpayers has allowed households to service their debt and pay their rent, preventing wider contagion. Although several fiscal hawks cited May’s way-better-than-expected employment situation report as evidence that Congress can relax its fiscal efforts, we expect that another phase of assistance will follow by the end of July. The potential vulnerability in financial markets stems from the prevailing certainty that policymakers have already won. But things could still go wrong, as highlighted by last week’s bracing economic projections from the OECD and the Fed. US financial markets are generally unaware of the OECD’s semi-annual outlooks, but this one’s probability assessments were striking: it sees a 50-50 chance that an infection second wave will require new lockdowns before the end of the year. The Fed Has The Economy’s Back … Chart 3Take All This ZIRP And Call Me In 2023 “At the Federal Reserve, we are strongly committed to using our tools to do whatever we can, and for as long as it takes, to provide some relief and stability, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.” As Chair Powell stated at the beginning of his prepared remarks, whatever it takes was the theme of last week’s FOMC meeting press conference. He made it very clear that the Fed intends to err to the side of providing too much accommodation as it confronts the highly uncertain environment. Asked how long the Fed would stick with zero interest rates if the economy surprises to the upside, he said, “we’re not even thinking about thinking about raising rates.” The first Summary of Economic Projections (SEP) since December validated his statement. Every voter projected that the fed funds rate will remain at its current near-zero level for all of 2020 and 2021, and only two voters foresaw rate hikes in 2022 (Chart 3). After Powell described the new round of QE purchases as a necessary measure to support the smooth functioning of financial markets and ensure credit access, a reporter asked if they were still needed, given how market disruptions have dissipated amidst the recovery rally. He replied that the FOMC did not want to take anything for granted and risk prematurely withdrawing its support. As he said in his prepared remarks, “We will continue to use [our emergency lending] powers forcefully, proactively, and aggressively until we are confident that we are solidly on the road to recovery.” The Fed is not even thinking about thinking about raising rates. Powell’s pledges to keep applying the Fed’s full range of tools to support the economy went to the heart of our rationale for overweighting equities over the cyclical timeframe: the Fed will maintain hyper-accommodative policy settings even after they’re no longer necessary. Every rose has its thorn, however, and the Fed would not be on an emergency footing if conditions weren’t dire. Though Powell and the committee expect a recovery to take hold over the next two quarters, the median SEP participant expects the unemployment rate to exceed 9% at the end of this year and does not see GDP returning to its 2019 level until the second half of 2022. The glum projections dampened investors’ enthusiasm and halted equities’ upward march. … And Congress Eventually Will, Too In testimony before a Senate committee on Wednesday, Treasury Secretary Mnuchin touted the budding recovery but made it clear that the administration wants additional stimulus measures. “I definitely think we are going to need … to put more money into the economy,” he said. He expressed a preference for programs that get people back to work and voiced concern that the first round of enhanced unemployment benefits may encourage people to stay out of work, but left the door open to some form of extension. He also indicated that the administration would consider another round of direct payments to taxpayers. Unemployment benefits well in excess of median wages may not be extended beyond July 31st but Republican senators and representatives have begun to put forth appealing alternative proposals like a temporary $450 weekly bonus or an additional two weeks of the existing $600 supplement for those returning to work. The bottom line is that events are validating our geopolitical strategists’ view that another fiscal stimulus package is inevitable. Senate holdouts caught between the House’s and the White House’s desire for more aid will be unable to thwart another round. Banks And The Yield Curve Just a week ago, when the animal spirits sap was rising and a range of indicators suggested that growth may be bottoming, the 10-year Treasury yield surged 26 basis points (bps) in six sessions, from 0.65% to 0.91%, and the 2s/10s segment of the curve steepened by 20 bps. Bank stocks surged, and the SIFIs gained an average of 22% (Table 1). Then the 10-year yield reversed field, tumbling 25 bps in just three sessions from Tuesday to Thursday, and the curve flattened by 23 bps. The SIFI rally evaporated across the three midweek sessions, and the group fell 18% to end the nine-day round trip 30 bps from where it began. Table 1Back So Soon? The violent back and forth reinforced the conventional wisdom that banks are joined at the hip with long yields and the slope of the curve. If the 10-year doesn’t go anywhere, the thinking goes, and the curve doesn’t steepen, bank stocks can’t make any significant headway. We beg to differ. The link from the curve to bank earnings runs through net interest margin (NIM), the difference between the banks’ weighted-average lending yield and cost of funds. It makes perfect sense that NIM would expand and contract as the yield curve steepens and flattens, and it did into the early nineties. But by then banks had learned the lesson of the savings and loan debacle – borrowing short and lending long can be fatal if inflation and/or the Fed drive short rates much higher – and they became fastidious about matching the duration of their assets and liabilities. In the new duration-matched regime, NIM has become insensitive to the slope of the curve (Chart 4). With the NIM link broken, the yield curve has no influence on bank earnings (Chart 5). There is no doubt that banks regularly trade with long yields, but any link with the yield curve is easily severed (Chart 6) by earnings surprises. If the policy outlook doesn’t change between now and mid-July, we expect the SIFI banks will get a boost from smaller than expected loan-loss reserve builds. Taking our cue from the way monetary and fiscal largess will hold down defaults, we reiterate our overweight on the SIFI banks. Chart 4There's No Empirical Relationship Between Bank NIM And The Yield Curve, ... Chart 5... Or Bank Net Income And The Yield Curve Chart 6Bank Stocks' Relative Performance Is Not A Function Of The Yield Curve Investment Implications A client asked us last week how investors who have built up cash holdings over the last few months should approach re-entering the equity market. Patiently, we replied, in line with the qualms we’ve had about the magnitude and speed of the rally from the March lows. We are only neutral equities over the tactical 0-to-3-month horizon because the S&P 500’s forward P/E multiple is elevated (Chart 7) and investors don’t seem to be assigning a high enough probability to the possibility that the virus, Congress, or geopolitics could create a bump in the road. We are still looking for a double-digit correction. Our SIFI banks thesis doesn't require a steeper curve or higher long yields; it'll work as long as loan-loss reserve builds fall short of investors' fears. Chart 7Stocks Are Expensive Table 2Downside Insurance Is Awfully Expensive We suggested that the client get 15-20% of the desired allocation deployed that day (Thursday, fortuitously) and parcel the rest out at lower limits all the way down to 2,875 (10% below the recent peak around 3,200) or some lower target like 2,700 or 2,800. With the revival in the VIX, we also suggested considering writing out-of-the-money put options on the SPY ETF. As of Thursday’s close, an investor could be compensated handsomely for agreeing to get hit down another 6.7% (280) or 10% (270) any time between now and the third Friday of July (Table 2). Writing puts is a way to get paid to wait to deploy capital, and with the VIX in the 40s, an investor can earn 20-30% annualized on the notional amount of capital s/he is committing by writing the option.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Corporations downgraded to junk ("fallen angels") after the lending facility was announced subsequently became eligible to participate. 2 Please see the June 8, 2020 US Investment Strategy Weekly Report, "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)", available at usis.bcaresearch.com.