Policy

Highlights Chart 1Back To Fair Value Back To Fair Value Back To Fair Value February was a terrible month for the bond market. In fact, the Bloomberg Barclays Treasury Master Index returned -1.8%, its worst month since November 2016. The 5-year/5-year forward Treasury yield rose 37 bps. At 2.19%, it is now fairly valued for the first time since 2019, at least according to survey estimates of the long-run neutral fed funds rates (Chart 1). We outlined a checklist for increasing portfolio duration in our Webcast two weeks ago. So far, only two of the five items on our list have been checked. In particular, dollar sentiment and cyclical economic indicators continue to point toward higher yields, even though the market is now priced for a rate hike cycle that is slightly more hawkish than the Fed’s median forecast from December. We anxiously await this month’s revisions to the Fed’s interest rate forecasts. If the Fed’s forecasts remain unchanged from December, then we may get an opportunity to add some duration back into our recommended portfolio. Stay tuned. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 65 basis points in February, bringing year-to-date excess returns up to +68 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. Though Treasury yields have risen in recent weeks, this does not yet pose a risk for credit spreads. The 5-year/ 5-year forward TIPS breakeven inflation rate remains below 2%. We won’t be concerned about restrictive monetary policy pushing credit spreads wider until it reaches a range of 2.3% to 2.5%. Despite the positive macro backdrop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 2nd percentile (Chart 2). This means that the breakeven spread has only been tighter 2% of the time since 1995. The same measure shows that Baa-rated bonds have only been more expensive 3% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better value outside of the investment grade corporate space.1 Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration. We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration. Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Stay Bearish On Bonds Stay Bearish On Bonds Table 3BCorporate Sector Risk Vs. Reward* Stay Bearish On Bonds Stay Bearish On Bonds High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 115 basis points in February, bringing year-to-date excess returns up to +178 bps. Ba-rated credits outperformed duration-matched Treasuries by 111 bps on the month, besting B-rated bonds which outperformed by only 104 bps. The Caa-rated credit tier delivered 138 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.3% for the next 12 months (panel 3). This represents a steep drop from the 8.3% default rate observed during the most recent 12-month period. However, only 2 defaults occurred in January, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 26 basis points in February, dragging year-to-date excess returns down to -2 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 6 bps in February, but it remains low relative to the recent pace of mortgage refinancings (Chart 4). The MBS option-adjusted spread (OAS) tightened 1 bp on the month to 24 bps. This is considerably below the 57 bps offered by Aa-rated corporate bonds and the 42 bps offered by Agency CMBS. It is only slightly above the 22 bps offered by Aaa-rated consumer ABS. The plummeting primary mortgage spread was a key reason for the elevated refi activity seen during the past year. However, the spread has now recovered back to more typical levels (bottom panel). The implication is that further increases in Treasury yields will likely be matched by higher mortgage rates. This means that mortgage refinancings are likely close to a peak. A drop in refi activity would be a positive development for MBS returns, but we aren’t yet ready to turn bullish on the sector. First, relative OAS valuation favors Aa-rated corporates and Agency CMBS over MBS. Second, the gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2) meaning that we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service has shown that a considerable majority of households will remain current on their loans once the forbearance period ends, causing the delinquency rate to fall back down.3  Government-Related: Neutral Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 3 basis points in February, dragging year-to-date excess returns down to +21 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in February, dragging year-to-date excess returns down to -116 bps. Foreign Agencies outperformed the Treasury benchmark by 31 bps on the month, bringing year-to-date excess returns up to +25 bps. Local Authority bonds outperformed by 63 bps in February, bringing year-to-date excess returns up to +203 bps. Domestic Agency bonds outperformed by 1 bp, bringing year-to-date excess returns up to +16 bps. Supranationals underperformed by 2 bps, dragging year-to-date excess returns down to +5 bps. We recently took a detailed look at valuation for USD-denominated Emerging Market (EM) Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 6 basis points in February, dragging year-to-date excess returns down to +102 bps (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past few months and Aaa-rated Munis now look expensive compared to Treasuries, with the exception of the short-end of the curve (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel), the same goes for Revenue bonds in the 8-12 year maturity bucket (panel 3). Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate above 0.3%. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 1% and 10%, respectively. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in January. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury yields moved up dramatically in February, with the curve steepening out to the 7-year maturity point and flattening thereafter. The 2/10 Treasury slope steepened 30 bps on the month to reach 130 bps. The 5/30 slope, meanwhile, held steady at 142 bps. Slopes across the entire yield curve traded directionally with yields for the bulk of February. That is, until last Thursday when a surge in bond yields occurred alongside flattening beyond the 5-year maturity point. As a result, the 2/5/10 butterfly spread spiked (Chart 7), moving into positive territory for the first time in a while (panel 4). This curve behavior raises an interesting question. Was last week’s sharp underperformance in the belly a one-off move driven by convexity selling and other technical factors, as many have suggested?5 Or, are we now close enough to a potential Fed liftoff date that we should expect some segments of the yield curve to flatten on days when yields rise? We will be watching the correlations between different yield curve segments and the overall level of yields closely during the next few weeks, but as of today, we think it’s premature to declare that the 5/10 slope has transitioned into a regime where it flattens on days when yields move higher. That being the case, we expect further increases in bond yields to coincide with a falling 2/5/10 butterfly spread, and we retain our recommended position long the 5-year bullet and short a duration-matched 2/10 barbell. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 39 basis points in February, bringing year-to-date excess returns up to +183 bps. The 10-year TIPS breakeven inflation rate rose 2 bps on the month to hit 2.17%. The 5-year/5-year forward TIPS breakeven inflation rate fell 15 bps in February to reach 1.91%. February’s TIPS outperformance was concentrated at the front-end of the curve, as investors started to price-in the possibility of higher inflation during the next year or two that eventually subsides. It’s interesting to note that, despite last month’s surge in bond yields, the 5-year/5-year forward TIPS breakeven inflation rate fell, moving further away from the Fed’s 2.3% to 2.5% target range in the process (Chart 8). The Fed will continue to strive for an accommodative policy stance at least until this target is met. Last month’s price action caused our recommended positions in inflation curve flatteners and real yield curve steepeners to perform very well, but we think further gains are possible in the coming months. The 2/10 CPI swap slope has only just dipped into negative territory (panel 4). With the Fed officially targeting a temporary overshoot of its 2% inflation target, this slope should remain inverted for some time yet. With the Fed also continuing to exert more control over short-dated nominal yields than over long-term ones, short-maturity real yields will continue to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in February, bringing year-to-date excess returns up to +20 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +13 bps. Non-Aaa ABS outperformed by 9 bps on the month, bringing year-to-date excess returns up to +58 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent, and now another round of checks is pushing the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfall to pay down debt (bottom panel). Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in February, bringing year-to-date excess returns up to +87 bps. Aaa Non-Agency CMBS underperformed Treasuries by 5 bps in February, dragging year-to-date excess returns down to +37 bps. Meanwhile, non-Aaa CMBS outperformed by 75 bps, bringing year-to-date excess returns up to +262 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus won’t be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 11 basis points in February, bringing year-to-date excess returns up to +39 bps. The average index option-adjusted spread tightened 3 bps on the month to reach 42 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of February 26TH, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of February 26TH, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 39 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 39 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Stay Bearish On Bonds Stay Bearish On Bonds Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of February 26th, 2021) Stay Bearish On Bonds Stay Bearish On Bonds Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a look at alternatives to investment grade corporates please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 https://www.bloomberg.com/news/articles/2021-02-25/convexity-hedging-haunts-markets-already-reeling-from-bond-rout?sref=Ij5V3tFi Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

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

Highlights US Treasuries: The uptrend in US Treasury yields has more room to run. However, the primary driver is starting to shift from increased inflation expectations to higher real yields amid greater confidence on the cyclical US economic outlook. Fed Outlook: It is still too soon to expect the Fed to begin signaling a move to turn less accommodative. However, rising realized US inflation amid dwindling spare economic capacity will make the Fed more nervous about its ultra-dovish policy stance in the second half of 2021. This will trigger a repricing of the future path of US interest rates embedded in the Treasury curve, but a Taper Tantrum repeat will be avoided. US Duration: Maintain below-benchmark US duration exposure, with the 10-year Treasury yield likely to soon test the 1.5% level. Feature Chart 1A Cyclical Rise In Global Bond Yields A Cyclical Rise In Global Bond Yields A Cyclical Rise In Global Bond Yields The selloff in global government bond markets that began in the final few months of 2020 has gained momentum over the past few weeks. The benchmark 10-year US Treasury yield now sits at 1.37%, up 45bps so far in 2021, while the 30-year Treasury yield is at a six-year high of 2.22%. Yields are on the move in other countries, as well, with longer-maturity yields moving higher in the UK, Canada, Australia, New Zealand – even Germany, where the 30yr is now back in positive yield territory at 0.20%, a 34bp increase over the past month alone. The main reason for this move higher in yields can be summed up in one word: “optimism”. Economic growth expectations are improving according to investor surveys like the global ZEW, which is a reliable leading indicator of global bond yields (Chart 1). Falling global COVID-19 case numbers with rising vaccination rates, combined with very large US fiscal stimulus measures proposed by the Biden administration, have given investors hope that a return to some form of pre-pandemic economic normalcy can be achieved later this year. That means faster global growth and a risk of higher inflation, both of which must be reflected in higher bond yields. With the 10-year US Treasury yield now already in the middle of our 2021 year-end target range of 1.25-1.5%, and the macro backdrop remaining bond-bearish, we think it is timely to discuss the possibility that our yield target is too conservative Good Cyclical News Is Bad News For Treasuries The more recent move higher in US Treasury yields is notable because it has not been all about higher inflation breakevens, as has been the case since yields bottomed in mid-2020; real yields are finally starting to inch higher. The 30-year TIPS yield now sits in positive territory at +0.09%, ending a period of negative real yields dating back to the pandemic-induced market shock of last spring (Chart 2). Real yields across the rest of the TIPS curve are also starting to stir, even at the 2-year point, yet remain negative. Thus, the price action has supported one of US Bond Strategy’s Key Views for 2021 that the real yield curve will steepen.1 This uptick in US real yields has occurred alongside a string of positive developments on the US economy, suggesting that improved growth prospects – and what that means for future US inflation and Fed policy - are the key driver. Improving US domestic demand US economic data is not only showing resilience but gaining positive momentum. The preliminary US Markit composite PMI (combining both manufacturing and services industries) for February rose to the highest level in six years (Chart 3). Retail sales in January rose by an eye-popping 5.3% versus the month prior, due in no small part to the impact of government stimulus checks issued in the December pandemic relief package. The Conference Board measure of consumer confidence also picked up in January. The improving trend in US data so far in 2021 is pointing to some potentially big GDP numbers – the New York Fed’s “Nowcast” is calling for Q1 real GDP growth of 8.3%. Chart 2US Real Yields Starting Are Stirring US Real Yields Starting Are Stirring US Real Yields Starting Are Stirring Chart 3US Growing Faster Than Lockdown-Stricken Europe US Growing Faster Than Lockdown-Stricken Europe US Growing Faster Than Lockdown-Stricken Europe Vaccine rollout success After a sloppy start to the COVID-19 vaccination program in the US, the numbers are starting to improve with 19% of the US population having received at least one dose (Chart 4). Numbers of new cases and hospitalizations due to the virus have been collapsing as well, a sign that new lockdowns can be avoided, particularly in the larger US coastal cities. The vaccination numbers are even higher in the UK, where Prime Minister Boris Johnson this week revealed an ambitious plan to fully reopen the UK economy by June. While the pace of inoculation has been far slower within the euro area and other developed countries like Canada, developments in the US and UK are a hopeful sign that the vaccines can help free the world economy from the shackles of COVID-19. Chart 4The US & UK Leading The Way On The Vaccine Rollout Optimism Reigns Supreme Optimism Reigns Supreme Even more fiscal stimulus Our US political strategists expect the Biden Administration’s $1.9 trillion pandemic relief package (the “American Rescue Plan”) to be passed by the US Senate in mid-March via a simple majority through a reconciliation bill.2 A second bill is likely to be passed this autumn or next spring with a much larger number, potentially up to $8 trillion worth of spending on infrastructure, health care, child care and green projects over the next ten years (Chart 5). These are big numbers for a $21 trillion US economy that will increasingly need less stimulus as lockdowns ease. Chart 5Biden’s Agenda AFTER The American Rescue Plan Optimism Reigns Supreme Optimism Reigns Supreme Chart 6Welcome Back, Inflation? Welcome Back, Inflation? Welcome Back, Inflation? Chart 7Price Pressures From US Manufacturing Bottlenecks Price Pressures From US Manufacturing Bottlenecks Price Pressures From US Manufacturing Bottlenecks The combined impact of fiscal stimulus, accommodative monetary policy, easy financial conditions and fewer pandemic related economic restrictions has the potential to boost US economic growth quite sharply this year. If US GDP growth follows the Bloomberg consensus forecasts, the US output gap will be fully closed by Q1/2022 (Chart 6).That would be a much faster elimination of the spare capacity created by the 2020 recession compared to the post-2009 experience, raising the risk of upside inflation surprises later this year and in 2022. Signs of growing inflation pressures will make many FOMC members increasingly uncomfortable, even under the Fed’s new Average Inflation Targeting strategy where inflation overshoots will be more tolerated. Already, there are signs of sharply increased price pressures in the US economy stemming from factory bottlenecks (Chart 7). US manufacturers have had to deal with pandemic-induced disruptions to supply chains, in addition to the unexpectedly fast recovery of US consumer demand from last year’s recession that left companies short of inventory.3 The ISM Manufacturing Prices Paid index hit a 10-year high in January, fueled by surging commodity prices, which is already showing up in some inflation data. The US Producer Price Index for finished goods jumped 1.3% in January – the largest monthly surge since 2009 – boosting the annual inflation rate to 1.7% from 0.8% the prior month. Chart 8A Boost To US Inflation Coming Soon From Base Effects A Boost To US Inflation Coming Soon From Base Effects A Boost To US Inflation Coming Soon From Base Effects Chart 9Additional Upside US Inflation Risks Additional Upside US Inflation Risks Additional Upside US Inflation Risks Chart 10US Shelter Inflation Set To Bottom Out US Shelter Inflation Set To Bottom Out US Shelter Inflation Set To Bottom Out A pickup in US annual inflation rates over the next few months was already essentially a done deal because of base effect comparisons versus the collapse in inflation during the 2020 COVID-19 recession (Chart 8). Additional inflation pressures stemming from factory bottlenecks could provide an additional lift to realized inflation rates. When looking at the main components of the US inflation data, there is scope for a broad-based pickup that goes beyond simple base effect moves. Core Goods CPI inflation is now rising at a 1.7% year-over-year rate, the highest since 2012, with more to come based on the acceleration of growth in US non-oil import prices (Chart 9). Core Services CPI inflation has plunged during the pandemic and is now growing at a 0.5% annual rate. As the US economy reopens from pandemic restrictions, services inflation should begin to recover and add to the rising trend of goods inflation. This will especially be true if the Shelter component of US inflation also begins to recover in response to a tightening demand/supply balance for US housing (Chart 10). Bottom Line: US Treasury yields are rising in response to positive upward momentum in US economic growth, the likelihood of some pickup in inflation over the next 6-12 months and, most importantly, shifting expectations that the Fed will turn less dovish later this year. Evaluating The Fed’s Next Moves Fed officials have continued to signal that they are not yet ready to consider any change to monetary policy settings or forward guidance on future rate moves. In his semi-annual testimony before US Congress this week, Fed Chair Jerome Powell reiterated that the pace of the Fed’s asset purchases would only begin to slow once “substantial progress” has been made towards the Fed’s inflation and unemployment objectives. Powell also stuck to his previous messaging that the Fed would “continue to clearly communicate our assessment of progress toward our goals well in advance of any change in the pace of purchases”.4 According to the New York Fed’s Primary Dealer and Market Participant surveys for January, however, the Fed is not expected to stay silent on the topic of tapering for much longer. According to the surveys, the Fed is expected to begin tapering its purchases of Treasuries and Agency MBS in the first quarter of 2022 (Chart 11). A full tapering to zero (net of rollovers of maturing debt) is expected by the first quarter of 2023. Clearly, bond traders and asset managers believe that US growth and inflation dynamics will both improve over the course of this year such that the Fed will have little choice but to begin the signaling of tapering sometime before the end of 2021. Chart 11Fed Surveys Expect A Full QE Tapering In 2022 Optimism Reigns Supreme Optimism Reigns Supreme The Fed has been a bit more transparent on the conditions that must be in place before rate hikes would begin. Labor market conditions must be consistent with full employment, while headline PCE inflation must reach at least 2% and be “on track” to moderately exceed that target for some time. On that front, markets believe these conditions will all be met by early 2023, based on pricing in the US overnight index swap (OIS) curve. The first 25bp rate hike is now priced to occur in February 2023 (Chart 12). This is a big shift from the start of the year, when Fed “liftoff” was expected to occur in October 2023. Thus, in a span of just six weeks, interest rate markets have pulled forward the timing of the first Fed rate hike by eight months. Liftoff would occur almost immediately after the Fed was done fully tapering asset purchases, based on the timetable laid out in the New York Fed surveys, although Fed officials have noted that rate hikes could begin before tapering is complete. Chart 12Pulling Forward The Timing Of Future Fed Rate Hikes Pulling Forward The Timing Of Future Fed Rate Hikes Pulling Forward The Timing Of Future Fed Rate Hikes In our view, the timetable laid out in the New York Fed surveys and in the US OIS curve is not only plausible but probable. If the US economy does indeed print the 4-5% real GDP consensus growth forecasts during the second half of this year, with realized inflation approaching 2% as outlined above, then it will be very difficult for the Fed to justify the need to maintain the current pace of asset purchases. The Fed will want to avoid another 2013 Taper Tantrum by signaling less QE well in advance, to avoid triggering a spike in Treasury yields that could upset equity and credit markets or cause an unwelcome appreciation of the US dollar. However, the New York Fed surveys indicate that the bond market is well prepared for a 2022 taper, so the Fed only has to meet those expectations to prevent an unruly move in the Treasury market. That means the Fed will likely signal tapering toward the end of this year. Chart 13Markets Expect A Negative Real Fed Funds Rate Optimism Reigns Supreme Optimism Reigns Supreme The Fed can maintain caution on signaling the timing of the first rate hike once tapering begins, based on how rapidly the US unemployment rate falls towards the Fed’s estimate of full employment. The median projection from the FOMC’s latest Summary of Economic Projections is for the US unemployment rate to fall to 4.2% in 2022 and 3.7% in 2023, compared to the median longer-run estimate of 4.1%. Thus, if the Fed sticks to current guidance on the employment conditions that must be in place before rate hikes can begin, then liftoff would occur sometime in late 2022 or early 2023 – not far off current market pricing – as long as US inflation is at or above the Fed’s 2% target at the same time. Once the Fed begins rate hikes, the pace of the hikes relative to inflation will determine how high real bond yields can rise. The 10-year TIPS yield has become highly correlated over the past few years to the level of the real fed funds rate (Chart 13). The current forward pricing in US OIS and CPI swap curves indicates that the markets are priced for a negative real fed funds rate until at least 2030. That is highly dovish pricing that will be revised higher once the Fed begins tapering and the market begins to debate the timing and pace of the Fed’s next rate hike cycle. Thus, it is highly unlikely that real Treasury yields will stay as low as implied by the forward curves over the next few years. Bottom Line: It is still too soon to expect the Fed to begin signaling a move to turn less accommodative. However, rising realized US inflation amid dwindling spare economic capacity will make the Fed more nervous about its ultra-dovish policy stance in the second half of 2021. This will trigger a repricing of the future path of US interest rates embedded in the Treasury curve, but a Taper Tantrum repeat will be avoided. How High Can Treasury Yields Go In The Current Move? Our preferred financial market-based cyclical bond indicators are still trending in a direction pointing to higher Treasury yields (Chart 14). The ratio of the industrial commodity prices (copper, most notably) to the price of gold, the relative equity market performance of US cyclicals (excluding technology) to defensives, and the total return of a basket of emerging market currencies are all consistent with a 10-year US Treasury yield above 1.5%. With regards to other valuation measures, the 5-year/5-year Treasury forward rate is already at or close to the top of the range of the longer-run fed funds rate projection from the New York Fed surveys (Chart 15). We have used that range to provide guidance as to how high Treasury yields can go during the current bond bear market. On this basis, longer maturity yields do not have much more upside unless survey respondents start to revise up their fed fund rate expectations, something that could easily happen if inflation surprises to the upside in the back-half of the year. Chart 14Cyclical Indicators Support Rising UST Yields Cyclical Indicators Support Rising UST Yields Cyclical Indicators Support Rising UST Yields Chart 15A Rapid Move Higher In UST Forward Rates A Rapid Move Higher In UST Forward Rates A Rapid Move Higher In UST Forward Rates Chart 16This UST Selloff Not Yet Stretched This UST Selloff Not Yet Stretched This UST Selloff Not Yet Stretched Finally, the rising uptrend in longer-maturity Treasury yields is not overly stretched from a technical perspective (Chart 16). The 10-year yield is currently 55bps above its 200-day moving average, but yields got as high as 80-90bps above the moving average during the previous cyclical troughs in 2013 and 2016. The survey of fixed income client duration positioning from JP Morgan shows that bond investors are running duration exposure below benchmarks, but not yet at the bearish extremes seen in 2011, 2014 and 2017. A similar message can be seen in the Market Vane Treasury Sentiment indicator, which has been falling but remains well above recent cyclical lows. Summing it all up, it appears that the 1.5% ceiling of our 2021 10-year Treasury yield target range may prove to be too low. A move 20-30bps above that is quite possible, although those levels would only be sustainable if the Fed alters the forward guidance to pull forward the timing of rate hikes. We view that as a risk for 2022, not 2021. Bottom Line: Maintain below-benchmark US duration exposure, with the 10-year Treasury yield likely to soon test the 1.5% level.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "2011 Key Views: US Fixed Income", dated December 15, 2020, available at usbs.bcaresearch.com. 2 Please see BCA Research US Political Strategy Weekly Report, "Don’t Forget Biden’s Health Care Policy", dated February 17, 2021, available at usps.bcaresearch.com. 3https://www.wsj.com/articles/consumer-demand-snaps-back-factories-cant-keep-up-11614019305?page=1 4https://www.federalreserve.gov/newsevents/testimony/powell20210223a.htm Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Optimism Reigns Supreme Optimism Reigns Supreme Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Health care remains a top priority of the Democratic Party even though it is flying under the radar at the moment. Health care embodies the shift from small government to big government. While the 2021 budget reconciliation will hit Big Pharma and expand Medicaid, the 2022 reconciliation will seek a public health insurance option and Medicare role in price negotiations. If forced to choose between health care and climate change priorities, Democrats will choose health care. It is a bigger vote-winner. Stay short managed health care relative to the S&P 500. Go long health care facilities and equipment relative to the rest of the health sector. Feature The US Senate acquitted former President Donald Trump on a vote of 57-43 on February 13. No one was hanged.1 The trial was not economically or financially significant except insofar as it underscored peak US political polarization, US distraction from the global stage, and the extent of divisions within the Republican Party. Equity market volatility melted away as stocks surged higher on the generally positive backdrop of COVID vaccines and stimulus.   Seven Republicans joined Democrats in voting to convict the former president of “incitement to insurrection.” Trump’s performance was worse than Bill Clinton’s but better than Andrew Johnson’s, though neither Clinton nor Johnson saw defections from their own party (Chart 1). The Republicans’ internal differences are serious enough to hobble them in the 2022 or 2024 elections but it is too soon to draw any hard conclusions. The Democratic agenda is also capable of bringing Republicans back together. Meanwhile the maximum of seven Republican defectors shows that it will be extremely difficult for Democrats to get 10 Republicans to join them in passing any controversial legislation in the Senate (Table 1). Hence the filibuster will remain in jeopardy over the long run if not in the short run. Also, in 2022, the Democrats have a chance to pick up seats in Pennsylvania and North Carolina. Chart 1Trump’s Acquittal And Historic Impeachment Results Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table 1The Seven Senate Republicans Who Defected From Trump Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s Agenda After The American Rescue Plan Democrats are plowing forward with the first of two budget reconciliation bills, which enables them to pass legislation with a simple majority in the Senate. They hope to pass President Biden’s $1.9 trillion American Rescue Plan by mid-March, when unemployment benefits expire under the Consolidated Appropriations Act of 2020. The final sum might be a bit less than this headline number. The second budget reconciliation bill, for fiscal year 2022, will be passed in the autumn or next spring and will contain anywhere from $4 trillion to $8 trillion worth of additional spending on health care, child care, infrastructure, and green projects over a ten-year period (Chart 2). This number will be watered down in negotiation as the pandemic subsides and the aura of crisis dies down, reducing the willingness of moderate Democrats to vote for anything controversial. But investors should not doubt Biden’s agenda at this stage. If there is anything we know about the reconciliation process it is that the ruling party will get what it wants. Investors should plan accordingly: the output gap will be closed sooner than expected and inflationary pressures will build faster than expected, even though it will take a while for the labor market to heal. Chart 2Biden’s Agenda AFTER The American Rescue Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy This policy combination of “loose fiscal, loose monetary” policy continues to drive stocks higher (and the dollar lower) despite the misgivings we noted about underrated geopolitical risks (Chart 3). A critical question is when the Fed will normalize monetary policy. This is not an apolitical question. Fed chair Jerome Powell’s term ends in February of 2022. He may contemplate tapering asset purchases prior to that date, causing troubles in the equity market, but actual tapering is more likely to occur in 2022, in the view of our US Bond Strategist Ryan Swift. Powell would only taper in 2022 if he is forced to do so by an ironclad policy consensus precipitated by robust inflation and possibly financial instability concerns. This timing gives President Biden an opportunity to nominate an ultra-dovish Fed chair. Rate hikes are entirely possible in 2022 but our political bias implies they are unlikely before 2023 (unless an ironclad consensus develops that they are necessary). Even in 2023, an ultra-dove will be reluctant to hike, depending on the context. And rate hikes are virtually off limits in 2024, at least until after the November election. This political timeline reinforces the view that the Fed will not be hiking anytime soon and investors should prepare for inflation risks to surprise to the upside over the coming years. Chart 3"Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination The Senate parliamentarian has not yet ruled whether a federal minimum wage hike to $15 per hour can be included in the bill. Biden has accepted it may be cut but his party will push it through if possible. Last week we found that a higher minimum wage would not have a dramatic macroeconomic impact. Still, wages will rise in the coming years due to the cumulative effect of the Democratic Party’s policies. Higher wages, taxes, and regulatory hurdles will cut into corporate profits. But the passage of a higher minimum wage today would not in itself be a negative catalyst for equities. Rather, we would expect the rally to take a breather once the first reconciliation bill is finished (next week or in the coming weeks), since it will bring wage hikes, rate hikes, and tax hikes more clearly into view on the investment horizon.  Unlike minimum wages, there is little controversy over whether budget reconciliation can be used to change the health care system. This was done in 2010 as the second critical part to President Barack Obama’s Affordable Care Act (Obamacare). Hence Biden is highly likely to get his health agenda passed, which is largely an agenda of entrenching and expanding Obamacare. That is, as long as he prioritizes health care above other structural reforms like climate change. We think he will. In the rest of this report we look at Biden’s health care policy and the implications for US financial markets. Biden’s Health Care Policy Health care has been a top priority of the Democrats since 1992 yet they have repeatedly lost control of the agenda due to surprise Republican victories in 2000 and 2016. Republicans expanded Medicare under Bush but then failed to repeal and replace Obamacare under Trump. Now Democrats have only the narrowest of majorities in the House and Senate and will push hard to solidify and build on Obamacare. There is a low chance that they will leave this issue unsettled under the Biden administration. If new obstacles arise, more political capital will be spent to secure health care reform at the expense of other policies on the agenda. COVID-19 reinforces the Democrats’ focus on health care. The US has seen around 1,500 deaths per million people, making it one of the worst performers amid the crisis, comparable to the UK and Italy (Chart 4). Yet COVID is only the latest in a line of US public health failings and it is important to put COVID into perspective. For example, among US adults aged 25-44 years old, all-cause excess mortality from March to July last year was about 11,899 more than expected. By contrast, during the same period in 2018, there were 10,347 unintentional deaths due to opioids (Chart 5).2 In other words, the COVID crisis last year was comparable to the opioid crisis in magnitude, at least for middle-aged people. Obviously COVID has taken a terrible toll and is a more deadly disease for the old and the sick. The point is that the public’s wrath over poor public health and the US government’s ineffectiveness is well established. A pandemic was foreseeable, and foreseen, yet not prepared for, and it came on top of the opioid crisis and the debate about 30 million Americans who lack health insurance. The Biden administration has the intention and the capability to address these issues. Chart 4US Handling Of COVID-19 Left Much To Be Desired Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy   Chart 5Opioid Crisis Versus COVID Crisis Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy  The structural problem is well-known: The US spends more than other countries on health care but achieves worse results (Charts 6A & 6B). When workers get fired they lose health care, as insurance is tied to employment. Those whose employers do not provide health care or who are unemployed count among the ranks of the roughly 30 million uninsured. This number has fallen from its peak at 47 million in 2010 when Obamacare was enacted but has crept upward again since Trump’s attempt to dismantle that law and the lockdowns of 2020 (Chart 7). This is a driver of popular discontent that has proven again and again to generate votes, including in key swing states. Chart 6AThe US Spends More On Health Care … Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 6B… But Sees Worse Avoidable Mortality Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 7Rising Number Of Uninsured Even Pre-COVID Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy A range of public opinion polling over many years shows that health care is a close second or third to the economy and jobs in voter priorities. Voters care more about COVID and health care than they do about climate change and the environment (Chart 8, first panel). Chart 8Public Opinion On Biden’s Priorities: Jobs, Health, Then Climate Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Another important takeaway from this opinion polling is that voters could not care less about budget deficits. Big spending solutions are all the rage (Chart 8, second panel). The Biden administration is prioritizing economic recovery and the pandemic response but will also pursue its health care reforms. If this policy requires a tradeoff with infrastructure and renewables, we would expect health care to get the greater attention.  Over the long run Obamacare can be replaced but not repealed. The law is getting more popular over time and entitlements get harder to repeal over time. Slightly more than half of voters have a favorable view of the law and only 34% have an unfavorable view. Only 29%of voters want to repeal or scale back the law while about 62% want to build on it or keep it as it is (Chart 9). Underscoring this polling is the fact that the law was modeled on a Republican plan and even Trump adopted several of the most popular provisions: requiring insurance coverage for patients with preexisting conditions and slapping caps on pharmaceutical prices through import and pricing schemes. The Supreme Court has ruled Obamacare constitutional and is not expected to change that ruling this spring. It could object to the individual mandate – the most controversial part of Obamacare that required each person to pay a tax penalty if they did not purchase health insurance. But if parts of the law are stricken, Democrats have the votes to patch it up or provide an alternative.  Chart 9Obamacare Has Grown On American Public Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden simultaneously shows that Democrats rejected the most popular alternative to Obamacare – “Medicare for All,” or single-payer government-provided health care – at least for the current presidential cycle. Medicare for All was co-sponsored by Vice President Kamala Harris and is still a long-term goal of the progressive wing of the Democratic Party. However, voters do not like the proposal when asked about its practical consequences (Chart 10). In the Democratic primary, only Senators Bernie Sanders and Elizabeth Warren argued for wholesale revolution in US health care that would see private insurance cease to exist and 176 million voters moved onto a public health system. Sanders’s plan would have cost an estimated $31 trillion, increasing the budget deficit by $13 trillion over 10 years, and would have encouraged the overuse of medical services due to the absence of a co-pay or fixed cost. This idea will not vanish but the Biden administration’s likely success in expanding Obamacare will lead the party to focus on other things (e.g. climate change). Chart 10Insufficient Public Demand For Government-Provided Health Care (For Now) Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s big proposal is to add a public insurance option that would exist alongside current private insurance options. This idea was originally part of Obamacare but was removed during negotiations – precisely because the Democrats eschewed the use of budget reconciliation (again, not a constraint this time).3 The Biden plan is estimated to cost $2.25 trillion over 10 years and includes larger subsidies, the ability of workers to choose whether they want their employer-provided plan or the public option, automatic enrollment, a lower age of eligibility for Medicare (from 65 to 60), drug price caps, and various other provisions (Table 2). Table 2Biden’s Health Care Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Medicare, a giant consumer, would be able to negotiate drug prices directly with companies to drive down the price. Tax hikes on high-income earners and capital gains would pay for Biden’s policy.  With public backing and full Democratic control of Congress, there is little that can stop Biden from achieving this health care policy, other than a change in direction from his party, which we do not expect. The first budget reconciliation only contains small parts of the Biden agenda, such as incentives for states to expand Medicaid under Obamacare and a reduction in Medicaid rebates for drug manufacturers.4 The second budget reconciliation process will have to cover health care and tax hikes. But the consensus view is that the second reconciliation will focus on infrastructure and green energy. This is a conflict of priorities that will have to be resolved. The research above suggests it will be resolved in favor of health care. This would leave the regular budget process as the means to advance infrastructure and green projects. Macro Impact Of Biden’s Health Care Policy The great health care debate over the past decade reflected the broad post-Cold War debate in the US over the role of government in the economy. It centered on whether government involvement should increase to expand health insurance coverage. Although private US health care spending accounts for 31% of total health care spending, and is thus larger than either Medicare (21%) or Medicaid (16%), the government has control of 44% of spending when all of its functions are added together. This share is set to increase now that the debate has been decided in favor of Big Government (at least for now). Future administrations might carve out more space for private choice and competition in health care but a permanent step-up in government involvement and regulation has occurred given the above points about Obamacare’s irrevocability. What are the macro consequences of such a change?   The imposition of Obamacare may have contributed to the sluggish economic recovery in the wake of the Great Recession but the case is hard to examine objectively because the tax penalties only took effect in 2015-16 and then a new administration ceased implementation in 2017. In 2015 the Congressional Budget Office estimated that repealing Obamacare would increase the budget deficit by $353 billion over a ten year period but that it would also increase GDP by an average of 0.7% per year during the latter end of full implementation, thus boosting revenues and producing a net $137 billion increase in the budget deficit over ten years.5 In other words, Obamacare marginally tightened fiscal policy and encouraged some workers to cut their hours or stop working due to expanded subsidies, tax credits, and Medicaid eligibility.6 Repealing it would have reduced the tax burden on corporations and reduced the subsidy benefits to households but possibly with a slight boost to growth (Chart 11). Going forward, Biden’s policies are adjustments rather than a total overhaul but they would ostensibly add $2.25 trillion in spending and $1.4 trillion in revenue, resulting in a negative impact on the budget deficit (fiscal loosening) of $850 billion. The implication is that Biden’s plan would increase rather than decrease aggregate demand, albeit marginally in an era of already gigantic deficits. It would also remove some labor supply and eventually drag on GDP growth. Yet the impact of these effects is still uncertain given the general context of loose fiscal and loose monetary policy, the reduction in the number of uninsured people, and the potentially positive second-order effects of this increase in the social safety net for low-income families with high marginal propensities to consume. The bottom line is that the macro effects of Biden’s health plan will not be known for many years but the headline effect in the short run is an incremental addition to an already extremely loose fiscal policy setting.  Chart 11Macro Effects Of Obamacare Repeal Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy The negative effects will largely fall on high-income earners, capital gains earners, and corporations who will provide the revenue to pay for the plan. The private health insurance industry faced an existential threat from the Sanders plan but it still faces a loss of customers and earnings from the Biden plan. The major difference between Obamacare and Bidencare is that Obamacare forced insurance companies to provide a basic insurance option to the public but did not offer a public option to compete with them. Therefore their customer base increased albeit at a lower profit. Whereas Biden’s plan will create a public competitor that will siphon off customers from private insurance. Biden proposed giving workers this choice anytime but in the presidential debates suggested there would be limits. Either way private insurers stand to lose customers over time. This is not a major political constraint given that Big Insurance gets little sympathy from the public but it will have a negative impact on innovation and productivity in the health sector. Meanwhile Medicare would reimburse hospitals, clinics, and drug providers less for their services and goods. This would weigh on the profitability of small and private medical outfits and favor large and public providers that receive government subsidies and can stomach higher costs. It would also take a toll on Big Pharma and biotech sectors which have operated in a lucrative environment of low taxes, low regulation, and sizable pricing power. The US government has enormous negotiating power in the market, especially over home care, hospitals, nursing homes, and prescription drugs. Private and public investment are roughly evenly split, with public money dominating health care research and private money dominating structures and equipment. The government accounts for about 40% of total drug spending and both political parties believe this influence should be used to keep costs down, as public opinion is increasingly dissatisfied with high drug costs.7 There is a lot more to be said about the US health care system. A risk of Biden’s health reform is that it will increase the demand for health services without arranging for consummate increases in supply. In this sense it is inflationary. Investment Takeaways Health care stocks and each of the health care sub-sectors – pharmaceuticals, biotech, managed health care, facilities, and equipment – underperformed the S&P500 index amid the passage of Obamacare from March 23 to November 20, 2010. Within the sector, managed health care (health insurance) and biotech suffered most when the legislation first hit while facilities and equipment suffered most over the whole legislative episode. Once the law took full effect in 2014-15, equipment and managed health care outperformed, facilities were flat, and pharma and biotech underperformed. A look at the performance of the health care sector relative to the S&P 500 over the past 13 years shows that the sector rallied on President Obama’s victories in 2008, fell during the passage of Obamacare, staged a recovery that continued through the Supreme Court’s decision to uphold the new law in June of 2012, and then dropped off (Chart 12 A). Health stocks benefited from the global macro backdrop from 2011-15. After 2015, when Obamacare took full effect, the business cycle entered its later stage, and populism emerged (with Sanders threatening a government takeover and Trump firing up the cyclical economy), health care stocks underperformed the market. Chart 12AHealth Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Subsequent rallies have occurred, notably on the outbreak of COVID-19, but have not been sustainable. When Republicans failed to repeal Obamacare, when various crises gave defensive plays a tailwind, when Biden won the Democratic nomination over Sanders or Warren, and when the pandemic arose, the sector surged, often due to risk aversion in financial markets. In the end the negative trend reasserted itself as the combination of rising risk sentiment and policy headwinds outweighed the underlying demographic tailwind for earnings as society aged. Since the Democratic sweep of government in the 2020 elections the sector is testing new lows in relative performance. Pharmaceuticals charted a similar course to the overall health sector but never regained their pre-Obamacare peak in relative performance. They have underperformed again and again since the rise of Bernie Sanders and are today touching new lows (Chart 12B). Chart 12BBig Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga A closer look at the sector since the 2020 election and especially the Democratic victory in the Senate shows that it continues to underperform the broad market. Facilities are the most resilient, pharma and biotech are trying to find a bottom, and equipment and managed health care have sold off. Relative to the health care sector, equipment and facilities are the outperformers but, again, pharma and biotech are trying to bottom (Chart 13). These results make sense as Biden’s biggest policy impact will be to stimulate demand for health care facilities and equipment while constraining profits for Big Insurance and Big Pharma via the public insurance option and allowing Medicare to negotiate drug prices. Thus equipment and facilities benefit from the political environment, pharma and biotech should be monitored to see if they break down to new lows on the passage of legislation, and managed health care gets the short end of the stick. Our US Equity Strategy service is neutral on the sector as a whole, overweight equipment, and underweight pharma. Chart 13Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Putting it all together, health care stocks are good candidates for a short-term, tactical bounce when the exuberant stock rally suffers a correction but they are not yet candidates for strategic investments. They are not likely to find a bottom until Biden’s policies are passed, or the pro-cyclical macro backdrop has changed. Biden’s policies are high priority for his party and face low legislative and political hurdles to passage, yet will have a huge impact on the relevant industries – undercutting the private health insurance customer base and capping the profits of America’s drug makers. These changes will have long-term ramifications so they are not likely to be fully discounted yet. Previously health care firms had huge pricing power – they could charge whatever they wanted while they did not face the full might of the government in setting prices – but going forward that will change. Biotech and pharma have large profit margins that are exposed to this policy shift so they are exposed to further downside – we would not be bottom-feeders. Moreover pharmaceuticals make up 28% of the health sector while biotech makes up 13%, so that these sectors will weigh down the whole sector. One would think that health care would outperform during a global pandemic – and most sectors did see a big bounce during the height of the COVID-19 outbreak. But the pandemic has created the impetus for a stimulus splurge that has fired up the cyclical parts of the economy. It has also underscored the industry’s public role and undercut its profit-making capabilities, not least by producing a Democratic sweep bent on improving US health outcomes – at the expense of US health industry profits. In sum, from a tactical point of view, health care stocks are well-positioned for a near-term rally in relative performance but from a strategic point of view they continue to face policy headwinds and should be underweighted relative to the broad S&P 500. Tactically, stay short the managed health care sub-sector relative to the S&P 500 (Chart 14). Strategically, go long health care facilities and equipment relative to the health care sector. Chart 14Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1BPolitical Capital: Household And Business Sentiment Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1CPolitical Capital: The Economy And Markets Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A2Political Risk Matrix Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A3Biden’s Cabinet Position Appointments Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy           Footnotes 1     During the election crisis [of 1876], Kentucky Democrat Henry Watterson urged that “a hundred thousand petitioners” and “ten thousand unarmed Kentuckians” go to Washington to see that justice was done. Years later, when he was sitting next to [Ulysses S.] Grant at a dinner party, Watterson told him, “I have a bone to pick with you.” “Well, what is it?” asked Grant. “You remember in 1876,” said Watterson, “when it was said I was coming to Washington at the head of a regiment, and you said you would hang me if I came.” “Oh, no,” cried Grant, “I never said that.” “I am glad to hear it,” smiled Watterson. “I like you better than ever.” “But,” added Grant drily, “I would, if you had come.” See Paul F. Boller, Jr, Presidential Campaigns: From George Washington To George W. Bush (Oxford: Oxford University Press, 2004 [1984]), p. 141. 2     See Jeremy Samuel Faust, Harlan M. Krumholz, and Chengan Du, “All-Cause Excess Mortality and COVID-19-Related Mortality Among US Adults Aged 25-44 Years, March-July 2020,” Journal of the American Medical Association, December 16, 2020, jamanetwork.com. 3    The death of Senator Edward Kennedy forced the Democrats to use reconciliation for the second part of President Obama’s health care reform, the Healthcare and Education Reconciliation Act of 2010.  4    Currently the Medicaid rebate cap is set at 100% of the cost of making a drug. Other provisions would include a boost for rural health care services (a partial reallocation of headline COVID relief funds) and an expansion of Obamacare tax credits and subsidies for unemployed workers to keep their former employer-provided insurance. These are mainly COVID relief measures rather than aspects of Biden’s long-term health agenda. See Julie Rovner, “KHN’s ‘What the Health?’: All About Budget Reconciliation,” Kaiser Family Foundation, February 11, 2021, khn.org; see also Nick Hut, “A look at some of the healthcare-specific provisions in the pending COVID-19 relief legislation,” Healthcare Financial Management Association, February 10, 2021, hfma.org. 5    For the CBO’s original report on repeal, see “Budgetary and Economic Effects of Repealing the Affordable Care Act,” Congressional Budget Office, June 19, 2015, cbo.gov. More recently see Paul N. Van de Water, “Affordable Care Act Still Reduces Deficits, Despite Tax Repeals,” Center for Budget and Policy Priorities, January 9, 2020, cbpp.org. 6    See BCA Global Investment Strategy, “The Fed’s Dilemma,” May 12, 2017 and “Four Key Questions On The 2018 Global Growth Outlook,” January 5, 2018, bcaresearch.com. Regarding the debate around Obamacare, promoters highlight the recovery in US growth and jobs – including full-time jobs and small-business jobs – by 2015. Critics say the recovery would have been stronger if not for the law. See e.g. Casey B. Mulligan, “Has Obamacare Been Good for the Economy?” Manhattan Institute, Issues Brief, June 27, 2016, manhattan-institute.org; Cathy Schoen, “The Affordable Care Act and the U.S. Economy: A Five-Year Perspective,” Commonwealth Fund, February 2016, commonwealthfund.org. 7     Republican Senator Chuck Grassley co-sponsored a bill with his Democratic counterpart Ron Wyden of Oregon that would penalize drug companies that raised drug prices faster than inflation. In a separate bill with Senator Amy Klobuchar of Minnesota, he also proposed to prevent big name drug companies from paying generic drug-makers to delay the introduction of generics to the market. These bills were not debated on the main floor because then-Senate Majority Leader Mitch McConnell was unenthused about them but they exemplify the bipartisan consensus on government intervention to push down drug prices.

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (today at 10:00 AM EST, 3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist  

Highlights This week, we present the second edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand. Feature The data on lending standards during the last quarter of 2020 are decidedly mixed. Credit standards for business loans continued to tighten in most countries (Chart 1). On the positive side, the pace of that tightening slowed, or is expected to slow, going into 2021. Importantly, the survey data for consumer loan demand in many countries paints a more optimistic picture for household spending than consumer confidence indices. In sum, the lending surveys indicate that the panoply of global fiscal and monetary stimulus measures introduced over the past year to help offset the financial shock of the pandemic have passed through, to some degree, into easier credit standards. This should help sustain the current trends of rising global bond yields and narrowing corporate credit spreads. Chart 1Mixed Data On Lending Standards Mixed Data On Lending Standards Mixed Data On Lending Standards An Overview Of Global Credit Condition Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, the net percent of domestic respondents to the Fed’s Senior Loan Officer survey that tightened standards for commercial and industrial (C&I) loans (measured as an average of small, middle-market, and large firms) fell significantly in Q4/2020 (Chart 3). The key issue, both for lenders that tightened and eased standards, was the economic outlook, with those that eased taking a more sanguine view and vice-versa. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions Chart 4Corporate Borrowing Costs Are Driving Easy Financial Conditions Corporate Borrowing Costs Are Driving Easy Financial Conditions Corporate Borrowing Costs Are Driving Easy Financial Conditions The ad-hoc questions, asked in every instalment of the survey, discussed the outlook for 2021. On this front, US lenders expect easier lending standards over the course of the year, driven by an increase in risk tolerance and expected improvement in the credit quality of their loan portfolios. There was a marked improvement in demand for C&I loans in Q4/2020 although, on net, a small number of lenders still reported weaker demand over Q4/2020. Those that reported stronger loan demand cited financing for mergers and acquisitions as the biggest driver. Meanwhile, lenders reporting weaker demand primarily cited decreased fixed asset investment. However, the reasons for weaker demand were not all bad—many cited a reduced need for precautionary cash and liquidity. Over 2021, the outlook is quite bullish, with demand expected to hit all-time highs in net balance terms. The picture on the consumer side was buoyant in Q4 and that trend is expected to continue in 2021. A net +7% of banks increased credit limits on credit cards, while a moderately smaller share charged a narrower spread over cost of funds. However, in a trend we will continue to note for other regions in this report, there is a seeming divergence between consumer lending behavior and the sentiment numbers. This indicates a pent-up ability to spend that will likely be realized in full as pandemic restrictions begin to lift. After the economic outlook, increased competition from other banks and non-bank lenders was another leading factor behind easing standards. This is in line with our view that plummeting corporate borrowing costs are the primary driver of easy financial conditions in the US (Chart 4). We have shown that credit standards lead the US high-yield default rate by a one-year period; easier credit standards will further improve the default outlook, creating a virtuous cycle for as long as the Fed maintains monetary support. Euro Area In the euro area, lending standards continued to tighten at a faster pace in Q4/2020 even though that number had been expected to fall (Chart 5). The key reason was a worsening in risk perceptions due to continued uncertainty about the recovery. Persistently low risk tolerance also contributed to the tightening of standards. The tightening was somewhat worse for small and medium-sized enterprises than for large enterprises, and was also more pronounced in longer-term loans. This pessimistic outlook on credit standards is in line with an elevated high-yield default rate that has not shown signs of rolling over as it has in the US. Going into Q1/2021, standards are expected to continue tightening, albeit at a slightly slower rate. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions Chart 6Credit Standards For Major Euro Area Economies Credit Standards For Major Euro Area Economies Credit Standards For Major Euro Area Economies Business credit demand was grim as well, weakening at a faster pace in Q4. This was driven by falling demand for fixed investments. Chart 7ECB Support Will Bring Down The Italy-Germany Spread ECB Support Will Bring Down The Italy-Germany Spread ECB Support Will Bring Down The Italy-Germany Spread Inventory and working capital financing needs, which spiked dramatically in Q2/2020 due to acute liquidity needs, continued to contribute positively to loan demand - albeit to a much lesser extent than previous quarters as firms had already built up significant liquidity buffers. The decline in credit demand was also significantly larger for longer-term financing. Taken together with fixed investment demand, which has been in significant and persistent decline since Q1/2020, this is an extremely troubling trend for the euro area economy, confirming the ECB’s fears that the capital stock destruction wreaked by Covid-19 has permanently lowered potential long-term growth. After staging a tentative recovery in Q3/2020, consumer credit demand once again weakened in Q4/2020, attributable to declining consumer confidence and spending on durable goods as renewed pandemic lockdowns swept through Europe. However, low interest rates did contribute slightly to lifting credit demand on the margin. The divergence between consumer credit and confidence is not as dramatic in the euro area as in other regions. With demand expected to pick up in Q1, any narrowing in this gap is largely dependent on whether the EU can recover from what is already being called a botched vaccine rollout. Looking individually at the four major euro area economies, standards continued to tighten at a slow pace in Germany while remaining flat in Italy (Chart 6). Standards tightened more slowly in Spain due to an improvement in risk perceptions but tightened at a faster pace in France for the very same reason. Elevated risk perceptions in France could reflect concern about high debt levels among French firms. Going forward, firms expect the pace of tightening to slow in France and Spain, while picking up in Germany. Meanwhile, standards are expected to tighten outright in Italy in Q1/2021. Bank lending, however, continues to grow at the strongest pace since the 2008 financial crisis, reflecting the extent of the extraordinary pandemic-related measures (Chart 7). The ECB’s cheap bank funding through LTROs is helping support loan growth in the more fragile economies of Italy and Spain. In the face of this, investors should fade concern about an expected tightening in credit conditions in Italy that could drive up the risk premia on Italian government bonds. UK Chart 8UK Credit Conditions UK Credit Conditions UK Credit Conditions In the UK, overall corporate credit standards remained mostly unchanged, with corporate credit availability deteriorating very slightly (Chart 8). The increased reticence to lend to small businesses is justified by small business default rates, which saw the worst developments since Q2/2020. The demand side, meanwhile, has been volatile. The massive demand spike in Q2/2020 to meet liquidity needs was followed by a commensurate decline in the following quarter. The picture now appears to be stabilizing, with demand recovering to a stable level and expected to grow moderately in Q1/2021. Household credit demand strengthened, while credit standards for secured and unsecured loans to consumers eased in last quarter of 2020. While the recovery in consumer confidence has been muted, expect the divergence between credit demand and sentiment to fade as the UK moves towards lifting restrictions and households look to satisfy pent-up demand. The two predominant narratives of Q4/2020 in the UK were positive developments on the vaccine and the Brexit deal, both contributing to a massive reduction in uncertainty. This is reflected in the survey data, with lenders reporting that the economic outlook and improving risk appetites will contribute to easier credit standards in Q1/2021. The UK is currently leading developed market peers in terms of cumulative vaccinations per capita. In addition, Prime Minister Johnson will be unveiling next week a roadmap out of lockdown, another positive sign for the heavily services-weighted economy. Japan Chart 9Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions After decades of perma-QE and ultra-low rates, the Japanese credit market behaves in a contrary way to most other markets. In Q2/2020 at the height of the pandemic, while other lenders were tightening standards, Japanese lenders were actually easing standards (Chart 9). Since then, there has been a significant drop in the number of firms reporting easier standards. More importantly, none of the firms in the Q4/2020 survey reported tightening, meaning that borrowing conditions have not changed significantly since the massive liquidity injection in response to the pandemic. So, it appears that demand is the primary driver of the Japanese credit market. On balance, firms reported weaker demand for loans in Q4, citing decreased fixed investment, an increase in internally generated funds, and availability of funding from other sources. As we discussed in our last Credit Conditions chartbook,2 business lending demand in Japan is typically countercyclical, meaning that firms usually seek funds for precautionary or restructuring reasons. Going into Q1, survey respondents expect an increase in loan demand, which is in line with the recent deterioration in business sentiment. On the consumer side, loan demand rebounded strongly in Q4. Leading factors were an increase in housing investment and consumption. As in the UK, there has been a divergence between consumer credit demand and sentiment which will likely resolve as the recent resurgence in Covid-19 cases is brought under control. Canada & New Zealand In Canada, business lending standards eased slightly in Q4/2020, coinciding with a rebound in business confidence (Chart 10). As in other developed markets, the recovery was driven by vaccine optimism and hopes of reopening in 2021. The more important story for the Bank of Canada (BoC), however, is the overheating housing market. As we discussed last week in a Special Report published jointly with our colleagues at BCA Research Foreign Exchange Strategy,3 ultra-low rates have helped fuel another upturn in the Canadian housing market, with housing the most affordable it has been in five years, according to the BoC’s indicator. The strength in the housing market was supported by easing standards on mortgage lending, indicating that monetary and regulatory measures to bolster the market have seen quick and efficient pass-through. Although we expect the BoC to remain relatively dovish, a frothy housing market, and the resulting financial stability issues, are a key risk to that view. In New Zealand, fewer lenders reported a tightening in business loan standards, while standards for residential mortgages continued to tighten at an unchanged pace from the previous survey (Chart 11). Decreased risk tolerance and worsening risk perceptions were the key factors behind reduced credit availability; these were partly offset by changes in regulation and a falling cost of funds. Standards are expected to ease, and business loan demand is expected to pick up remarkably, by the end of Q1/2021. Chart 10Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions Chart 11New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions On the consumer side, while standards for residential mortgages continued to tighten at an unchanged pace during the survey period, they are expected to ease going forward. As in Canada, house prices are at the forefront of the monetary policy discussion in New Zealand, which means that the expected easing in standards might actually pose a problem for the Reserve Bank of New Zealand. Meanwhile, although consumer loan demand did weaken over the survey period, it is expected to stage a recovery this quarter. This view is bolstered by a strong recovery in consumer confidence, which is working its way up to pre-pandemic levels.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2020/2020-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. 2 Please see BCA Research Global Fixed Income Strategy Report, "Introducing The GFIS Global Credit Conditions Chartbook", dated September 8, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Foreign Exchange Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Highlights The Biden administration’s budget reconciliation bill will close the output gap, so markets will have to start thinking about upcoming tax hikes, rising wages, and eventual Fed interest rate hikes. Biden’s lax immigration policies will not have a major negative impact on wage growth. A doubling of the minimum wage, which could still make it into one of two budget reconciliation bills, would include a measure to index the post-2026 minimum wage to the average rate of wage rises. Biden’s industrial policy and support of labor unions would also increase wages. Stay long Treasury inflation-protected securities versus duration-matched Treasuries and long value stocks over growth stocks.  Feature The Senate and House of Representatives passed a concurrent resolution on the budget for FY2021, the first step in the budget reconciliation process that will enable Democratic leadership to pass President Joe Biden’s $1.9 trillion American Rescue Plan with only a simple majority in the Senate. The budget resolution is a fantasy that the ruling party uses to bypass the Senate filibuster, as was the case under George W. Bush, Barack Obama, and Donald Trump. The latest such resolution claims that the budget deficit will be smaller, not larger, after the Biden rescue plan than what is currently projected by the Congressional Budget Office (Chart 1). It envisions the entire $1.9 trillion being spent in 2021 and then a huge drop in expenditures in 2022. A fiscal cliff ahead of the 2022 midterm election will not occur. Instead the second budget reconciliation maneuver, for FY2022, will increase spending levels once again with infrastructure and green projects, as per Biden’s campaign platform. Chart 1Democrats Pass Budget Resolution Biden Opens The Border Biden Opens The Border The FY2021 budget resolution does not contain any tax increases, “revenue offsets,” to keep the budget in line because the COVID relief is emergency spending that is one-off, not recurring. The FY2022, however, will aim partially to repeal President Trump’s tax cuts. As such financial markets will continue to “buy the rumor” of additional fiscal spending for now but they will also sell the news given that the next reconciliation bill will push up inflation expectations even further, hasten the Federal Reserve’s policy normalization, and include tax hikes. And the current buy-the-rumor phase could be interrupted anyway by Biden’s immediate foreign policy challenges. Larry Summers And The Output Gap Democrats will err on the larger side of the $1.9 trillion stimulus because they regret erring on the smaller side back in 2009. But it is still possible for the price tag to be knocked down to around $1.5 trillion given that the economy is recovering and several moderate Democrats will balk at the enormous size. After all, $900 billion passed at the end of the year is not yet spent. Biden has already compromised by raising the eligibility requirements for households to receive $1,400 stimulus checks. Larry Summers, a frequent guest at the annual BCA conference and a veteran of the Clinton and Obama White Houses, has stirred up a firestorm over the past month by warning that too much federal money spent on short-term cash handouts today would crowd out the administration’s political capital and the amount of deficit spending that is available for long-term, productivity-enhancing investments. Summers warned that the current proposed stimulus is three times larger than required to fill the output gap. Chart 2 shows the output gap from 2009-12 and projected from 2021-24 alongside the size of the relevant stimulus packages to illustrate his point. Treasury Secretary Janet Yellen defended the $1.9 trillion price tag – like Summers, she is not normally one to worry about overheating the economy, but unlike Summers, she is now an administration official. She predicted that this size of package would bring the economy back to full employment by next year. The Congressional Budget Office, based on earlier congressional actions, had predicted employment would not return to its pre-COVID level until around 2024. The administration will look to Yellen now and in future to make the call on when enough stimulus is enough. With inflation expectations recovering rapidly, the Fed could be forced to hike rates as early as late 2022, though we think 2023 is more likely given our methodological bias as political analysts. This means the scope for overheating is quite large – a point reinforced by the comparison with the economic recovery back in 2009 (Chart 3). Summers’s criticism is not remiss and could come back to haunt the administration.1 When inflation picks up, the Fed will have to allow an overshoot according to its new policy of targeting average inflation. But once it is assured, it will have to start hiking rates. And once it starts hiking rates it could trigger a recession. Plus, even if we set recession risks aside, Summers’s critical point is that too much stimulus today will reduce the political and budgetary scope for Biden’s long-term agenda, which includes what will likely be his second major bill focused on infrastructure and renewables. The reconciliation process makes it highly likely that Democrats will drive through this initiative through the Senate but not if moderate Senate Democrats balk in the face of rising budget deficits and inflation. Chart 2How Much Is Too Much Stimulus? Biden Opens The Border Biden Opens The Border Our base case still holds that Democrats will pass both reconciliation bills over the next roughly 12 months but investors should keep Summers’s warning in mind. Chart 3Recovery Is Ahead Of The Previous Cycle Recovery Is Ahead Of The Previous Cycle Recovery Is Ahead Of The Previous Cycle There are tailwinds for Biden’s agenda. First, his political capital is moderate-to-strong and likely to strengthen over the coming year. It will get bumped up by improving economic conditions, including most recently a marked decline in bankruptcy filings from Q3 to Q4. Our updated Political Capital Index is shown in the  Appendix. Second, concern about budget deficits has eroded, as Republican fiscal largesse showed under Trump – the pandemic and atmosphere of crisis greatly reinforce this point. Third, divisions in the Republican Party have produced as many as five moderates who could assist Biden in winning close legislative votes – even beyond the relatively easy passage of the American Rescue Plan in his honeymoon period. This Republican Party split is the only significance of President Trump’s second impeachment. Trump’s legal woes will continue after he is acquitted in the Senate. The deeper Republicans are divided over Trump’s legacy the harder time they will have recovering in the 2022 midterms, where opposition parties are normally favored. But the Biden administration’s leftward agenda will bring Republicans together, especially once the country moves out of the crisis. One of the biggest battles looms over the southern border. Bottom Line: The $1.9 trillion American Rescue Plan will more than close the output gap and yet it is only one of two budget reconciliation bills that the Biden administration will seek to pass over the next 12 months. There are still domestic and international factors that could impede the recovery, not least China’s policy tightening, but the risk of excessively short-term stimulus at the expense of long-term public investment is clear. Republicans Will Regroup Over Immigration To Summers’s warning about Biden’s legislative window of opportunity, recall that President Trump never achieved his signature 2016 policy promise – to build a wall on the border with Mexico – because congressional Republicans led him to prioritize repealing and replacing the Affordable Care Act (which failed) and passing the Tax Cut and Jobs Act (which succeeded). There was no political capital left for a major legislative push on the border and immigration. Immigration is one of the areas where Biden has a major incentive to push his policies aggressively. Immigrants tend to skew Democratic in their party affiliations. Americans increasingly believe immigration should be increased, a trend that accelerated after Trump’s election on an avowedly anti-immigration platform (Chart 4, top panel). Today 34% believe it should be increased in addition to 36% who are comfortable with the current level. Meanwhile the number who believe it should be decreased has fallen to 28%, down from 34%-38% around the time of Trump’s election. An anti-immigration candidate may be able to win within the Republican Party (especially under the specific circumstances of 2015-16) but he or she will have trouble winning general elections. Trump himself discarded the topic in the 2020 race. For Democrats, immigration is also probably the single most effective way to drive a wedge between the populist and establishment factions of the Republican Party. For example, establishment Republican presidents oversaw huge infusions of foreigners into US society, the 1986 Immigration and Reform Control Act, which granted amnesty to three million illegal immigrants, and the 1990 Immigration Act, which increased the quota of legal immigrants. By contrast Trump rose to power by attacking the bipartisan consensus on “open borders.” As long as a substantial cohort of Republicans defends immigration on free market principles, and upholds the corporate interest in having plentiful availability of lower wage seasonal and specialized workers, the party will be divided. The above points explain why the Biden administration will pursue immigration reform more intently than public opinion would leave one to believe. Polls show that voters want to focus on the economic recovery, the pandemic response, and social and civil rights policies more than immigration. There is no question that Biden is prioritizing the pandemic, the economy, and health care (Chart 4, bottom panel). But the Democratic Party has a strategic interest in expanding immigration so Biden will continue to plow forward with executive orders and comprehensive immigration reform in Congress. The US does need immigration reform – to ensure the flow is orderly. President Trump’s “wall” proposal did not come out of nowhere. Like the “Know Nothing Party” that emerged in the 1840s and rose to prominence in the 1850s, the Trump movement arose amid a historic increase in the foreign-born share of the population (Chart 5). But Trump’s policies hardly made a dent in the flow of legal immigrants into the US. Now Biden will reverse them and encourage more incomers. Therefore immigration will persist as a bone of contention in the 2020s. Granted, immigration has amply attested positive effects on the economy – including most clearly by lifting the US’s fertility rate so that it does not suffer from as rapid of an aging process as other developed countries. Indeed, voters are primarily concerned about illegal, not legal, immigration. Still, Republicans will struggle to walk the line between tighter immigration policies and appealing to an audience beyond “old white folks.” This suggests the Biden administration has room to run. Chart 4Public Not Too Concerned About Immigration Public Not Too Concerned About Immigration Public Not Too Concerned About Immigration Chart 5Historically Large Foreign-Born Population Biden Opens The Border Biden Opens The Border It helps Biden that the post-World War II and post-Cold War booms in legal immigration are relatively measured when compared to the overall population. The inflow of migrants was around 0.3% in 2019, very far from its post-war peak of 0.7% per year (Chart 6). Thus the Biden administration will not be overly concerned about being too progressive on this issue. Chart 6Boom In Legal Immigration Less Impressive Relative To Population Biden Opens The Border Biden Opens The Border Chart 7Detainees On The Mexican Border Biden Opens The Border Biden Opens The Border Illegal immigration is the biggest factor motivating periodic public backlashes such as in 2016. Southwestern border apprehensions – the only credible way to measure the unauthorized flow of people over the Mexican border – spiked under President Obama as well as President Trump, though US agents detained nowhere near the numbers witnessed in the 1980s and 1990s (Chart 7). The stock of illegal immigrants in the US ranges from 10-11 million and has remained flat, or fallen slightly, since the financial crisis of 2008. The weakening of the US economy, in the context of tighter border security, reduced incentives to make the difficult journey (Chart 8). The fact that President Obama and Trump increased detentions suggests that the demand to get into the country recovered over the course of the last business cycle. Based on President Biden’s voting record in the Senate and statements during the 2020 campaign, he is not an ultra-dove on the border – but his party has moved to the left on the issue. This is clear from his rivals’ positions in the Democratic primary election. Even his Vice President Kamala Harris, who was not the most radical on stage, supported decriminalizing illegal border crossings and downgrading Immigration and Customs Enforcement. Still, until Democrats repeal the filibuster in the Senate, they will not have a chance of passing comprehensive immigration reform with Republicans unless they accept stronger enforcement provisions. Biden voted for the 2006 Secure Fence Act but more recently has emphasized high-tech upgrades to better monitor crossovers. Harris also accepted high-tech security funding that did not involve building a wall. Even with these compromises, it will still be a stretch to find 10 Republicans willing to cross the aisle on this issue while Trump and his faction remain active to punish them in primary elections. Chart 8Estimate Of Total Illegal Immigrants Biden Opens The Border Biden Opens The Border The demand to enter the US will revive once the pandemic is over. The big surge in illegal border crossings in the 1980s-90s coincided with a period in which US economic growth and wellbeing far outpaced that of Mexico and Central America (Chart 9). The gap in GDP per capita is the crudest possible measure and does not reflect the dramatic differences in quality of life that drive people to relocate. Nevertheless, the gap remains drastic, especially with Mexico. Chart 9The Grass Is Greener On The Other Side Biden Opens The Border Biden Opens The Border The gap in current economic activity, such as manufacturing PMIs, between the US and Mexico is as wide as ever. Even as manufacturing contracts in Mexico, the demand for workers in US service industries is soaring (Chart 10). Moreover the US economic revival will be super-charged by the gargantuan fiscal stimulus of 2020-21 whereas Mexican government support for the economy is comparatively austere (Chart 11) Chart 10Super-Charged US Recovery Opens Big Gap With Mexico Super-Charged US Recovery Opens Big Gap With Mexico Super-Charged US Recovery Opens Big Gap With Mexico Chart 11Less Government Support In Mexico Than US Less Government Support In Mexico Than US Less Government Support In Mexico Than US Bottom Line: Biden is opening up the borders at a time of economic disparity between the US and Latin America that will lead to an influx of immigration. This is positive for US labor force growth and productivity but it will be hard to pass a long-term solution through Congress. The Republican Party is deeply divided on the issue today but it is likely to become a rallying cry as numbers of newcomers increase and as Trump-style populism remains an active force within the party. Immigration, Wages, And The Minimum Wage   The macroeconomic and market impact of easier border and immigration controls boils down to the impact on wages. There is a vast literature on this subject and we will not pretend to be comprehensive. We will merely make a few observations. The foreign-to-native-born wage differential has narrowed substantially over the past twenty years. The discount to hire immigrants has shrunk from 24% to 15% (Chart 12). This is a reflection of the high demand for immigrant labor and especially the increase in high-skilled workers alongside the booming tech, legal, financial, personal care, and health care industries in the United States – the fastest growing sectors for foreign-born workers since 2003. Earnings growth for foreign workers is more cyclical than for native workers and has been rising faster in recent decades (Chart 13). Chart 12Immigrants Command A Higher Price Than They Used To Biden Opens The Border Biden Opens The Border Chart 13Immigrant Wages Grow In Boom Times Biden Opens The Border Biden Opens The Border Immigrants work the lowest-wage jobs and hence there is some correlation between the share of foreign-born workers in any given industry and the hourly wage, just as there was at the turn of the century (Chart 14). But it does not follow that an increase in immigration suppresses wages as a whole. Chart 15 shows that, over the last business cycle at least, a change in the foreign worker share of a given industry does not correlate with a change in wage growth. Of course, it stands to reason that increasing the supply of labor decreases the price. But not if demand is growing sufficiently to raise the price for all workers. As we have seen, since migrants are willing to undertake long and dangerous journeys for work, they are likely to go where the demand is strong and the price is right – and the flow drops when the jobs dry up. Chart 14Immigrants Work The Lowest Wage Jobs Biden Opens The Border Biden Opens The Border Chart 15More Immigration Not Necessarily A Pay Cut Biden Opens The Border Biden Opens The Border Academics debate the impact on wages. There could be a negative impact, especially for low-skilled native workers, but the aggregate effect is small. One study showed that wages for native workers fell by three percent cumulatively over the 20-year period from 1980-2000 due to immigration.2  This is not dramatic. We can test the connection between immigration and wage growth informally by plotting the growth of southwest border detentions and legal permanent residence admissions alongside that of real wages. There is no clear relationship either way (Chart 16). The same is true if we test it with real median wages – the surge in border apprehensions under President Trump coincided with a boom in wages across the spectrum.  Chart 16Border Influx Does Not Suppress Wages Border Influx Does Not Suppress Wages Border Influx Does Not Suppress Wages Thus we cannot rule out the possibility that the Biden administration’s relaxation of border controls will have a dampening effect on wages over the long run but we cannot endorse it either. Chances are that the rollout of COVID-19 vaccines and government spending will continue to power a recovery that tightens the labor market and lifts wages for most workers.   What about the administration’s simultaneous policy of doubling the federal minimum wage to $15 per hour by the year 2026 – and indexing wage growth after that date to the median hourly wage? The minimum wage hike might yet make it into the budget reconciliation bill under negotiation – but Biden has already signaled it can be delayed. There is a growing fear about the negative impact on small businesses struggling during the pandemic. The Congressional Budget Office estimates that anywhere from 1 million to 2.7 million jobs could be lost in 2025 if the wage hike were implemented now and businesses would pay $333 billion.3 But the proposal will return when the second budget reconciliation bill is up for consideration unless the Senate parliamentarian rules it out, in which case its passage becomes much less likely. Only about 2% of workers are paid at or below the current minimum wage of $7.25 per hour so a minimum wage hike but the CBO estimates that 10 percent of workers would be below the proposed wage level by 2025 (Chart 17). The states with higher proportions of minimum wage workers will be the ones most affected and are mostly in the south, including South Carolina, Mississippi, Kentucky, and Texas, though there are a few in the north such as New Hampshire and Pennsylvania (Chart 18). Chart 17Most Workers Earn More Than Minimum Wage Biden Opens The Border Biden Opens The Border Chart 18Minimum Wage Workers By State Biden Opens The Border Biden Opens The Border Previous minimum wage hikes did not prevent the economy from reaching full employment – nor did they lead to a lasting pickup in overall wage growth. But indexation to overall wage growth would mark a big change in favor of an eventual wage-price spiral. It cannot be ruled out given that the reconciliation option might be available to Democrats, though it would not take effect till 2026. Bottom Line: There is no firm link between immigration growth and wage growth. Increased immigration flows often coincide with higher incomes and wages as growth and productivity improve. Meanwhile a change in the minimum wage will have a limited impact from a macro point of view alone but a bigger impact if it is indexed to wage growth after 2026, which is possible. In the coming years the much greater impact of Biden’s policies will stem from the massive infusion of fiscal spending he is likely to pass through Congress, which will close the output gap quickly and put upward pressure on wages.    Investment Takeaways Easier immigration and a higher minimum wage are not the only Biden policies that will affect wages. One of the biggest developments since Biden took office is his confirmation that he will maintain a tougher trade policy than his predecessors, excluding Trump. Biden won the election among Midwestern blue collar voters at least partly by stealing Trump’s thunder on trade and globalization. Since taking office he has issued a “Buy American” executive order and declared that he will maintain “extreme” competition with China. His cabinet appointees – notably Antony Blinken at the State Department and Janet Yellen at the Treasury – have given words of warning to China over trade as well. Geopolitical risk is one reason we are cutting back on our participation in the market’s exuberance at the moment, given that critical foreign policy stances are likely to be tested early in Biden’s term. But there is also a long-term implication of the Democrats’ marginal increase in protectionism.   It was the overall policy context of hyper-globalization that led to sluggish wage growth in the United States over the previous forty years. A major factor was the decline of manufacturing and unionization as a result of a lack of competitiveness in the US as global production came online. The erosion in manufacturing jobs only stopped in recent years (Chart 19). Popular support for unions has risen to levels last seen in the late 1970s and 1990s since the Great Recession – under Trump even Republicans talked up unions. Chart 19Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Biden’s policies outlined above are reminiscent of the “third way” Democrats in the 1990s – particularly Bill Clinton, who oversaw an increase in the minimum wage and a surge in both legal and illegal immigration. But on trade Biden is shaping up to be more like Trump than Clinton, albeit directing his protectionism more at China than other trade partners. His spending bills will also use fiscal spending to promote industrial policy. Meanwhile labor protections will go up and unionization will at least stem its multi-decade decline.    For the stock market the risk of higher wages looms mostly due to the super-charging of the economy with stimulus. But shoring up domestic manufacturing, unions, labor perks and protections, and possibly indexing the minimum wage will contribute to faster wage growth and – to corporations – higher employment costs (Chart 20). This is a headwind to the corporate earnings outlook. But like the Biden administration’s tax hikes it is not yet affecting the market’s overall bullishness – and may not until the first reconciliation bill passes and the narrative shifts from stimulus to structural reform. Investors may soon find out that they will be dealing with higher wages, higher taxes, higher inflation, and a higher cost of capital. Chart 20Higher Wages, Lower Corporate Profits Higher Wages, Lower Corporate Profits Higher Wages, Lower Corporate Profits Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Biden Opens The Border Biden Opens The Border Table A1BPolitical Capital: Household And Business Sentiment Biden Opens The Border Biden Opens The Border Table A1CPolitical Capital: The Economy And Markets Biden Opens The Border Biden Opens The Border Table A2Political Risk Matrix Biden Opens The Border Biden Opens The Border Table A3Biden’s Cabinet Position Appointments Biden Opens The Border Biden Opens The Border     Footnotes 1     See BCA Global Investment Strategy, “Fiscal Stimulus: How Much Is Too Much?” January 8, 2021, bcaresearch.com. 2     George J. Borjas and Stephen J. Trejo, “The Evolution of the Mexican-Born Workforce in the United States,” in Borjas, ed, Mexican Immigration to the United States (Chicago: Chicago University Press, 2005), pp.13-55.     3    See “The Budgetary Effects of the Raise the Wage Act of 2021,” Congressional Budget Office, February 2021, cbo.gov.  

Highlights Duration: Long-maturity Treasury yields are closing in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Ba Versus Baa Corporates: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Feature Chart 1Uptrend Intact Uptrend Intact Uptrend Intact Bond yields moved higher last week, maintaining their post-August uptrend despite a brief lull in the second half of January (Chart 1). The 30-year yield even touched 1.97%, its highest level since last February. Given the sharp up-move, the first section of this week’s report considers whether bond yields look stretched. More broadly, we discuss several factors that will help us decide when to increase portfolio duration. How Much Higher Can Yields Rise? We have maintained a recommended below-benchmark duration stance since October and have been targeting a range of 2% to 2.25% for the 5-year/5-year forward Treasury yield.1 That target range is based on median estimates of the long-run equilibrium fed funds rate from the New York Fed’s surveys of market participants and primary dealers (Chart 2). The rationale is that in an environment of global economic recovery where the Fed is expected to eventually lift the funds rate back to equilibrium, long-dated forward yields should reflect expectations of that long-run equilibrium. At present, the 5-year/5-year forward Treasury yield is 1.97% meaning that there is between 3 bps and 28 bps of upside before our target is met. Chart 2Almost At Target Almost At Target Almost At Target A 5-year/5-year forward Treasury yield between 2% and 2.25% would not automatically trigger an increase in our recommended portfolio duration, but it would mean that further increases in yields would need to be justified by upward revisions to survey estimates of the long-run equilibrium fed funds rate. In a similar vein, the 5-year/5-year forward TIPS breakeven inflation rate has risen considerably in recent months, but at 2.15%, it remains below the 2.3% to 2.5% range that the Fed would consider “well anchored” (Chart 2, bottom panel). In other words, there is still some running room for reflationary economic outcomes to be priced into bond yields. Cyclical Growth Indicators Treasury yields may be encroaching on the lower bounds of our target ranges, but cyclical economic indicators suggest further increases ahead. The CRB Raw Industrials / Gold ratio remains in a solid uptrend, and encouragingly, it is being driven by a surging CRB index and not just a falling gold price (Chart 3). Separately, the outperformance of cyclical equity sectors over defensives has moderated in recent weeks, but not yet by enough to warrant reversing our duration call (Chart 3, bottom panel). Chart 3Cyclical Bond Indicators Cyclical Bond Indicators Cyclical Bond Indicators Value Indicators Chart 4Bond Valuation Indicators Bond Valuation Indicators Bond Valuation Indicators While cyclical indicators point to further bond weakness ahead, a couple valuation measures show yields starting to look stretched. Two survey-derived estimates of the 10-year zero-coupon term premium have moved up sharply. The estimate derived from the New York Fed’s Survey of Market Participants has jumped into positive territory and the estimate derived from the Survey of Primary Dealers is close behind (Chart 4). These surveys ask respondents to estimate what they think the fed funds rate will average over the next ten years. By comparing the median survey response to the current spot 10-year Treasury yield we get a measure of how much term premium the median investor expects to earn. These term premium estimates have typically been negative during the past few years, though they did rise to about +50 bps before Treasury yields peaked in 2018. In other words, a positive term premium estimate, on its own, is no reason to extend duration. All it tells us is that if the median investor is correct about the future path of the fed funds rate, then there is more money to be made at the long-end of the curve than in cash. This doesn’t rule out investors revising their funds rate expectations higher, or the term premium becoming even more stretched. Another related bond valuation indicator is the difference between the market’s expected path for the fed funds rate and the path projected by the FOMC (Chart 4, bottom panel). Here we see that, for the first time since 2014, the market is priced for a faster pace of tightening over the next two years than the median FOMC participant anticipates. Again, this is not a decisive signal to buy bonds. The FOMC could revise its funds rate projections higher when it meets next month. However, the longer that market pricing remains more hawkish than the Fed, the stronger the case to increase duration becomes. The Dollar Chart 5Dollar Still Supports Higher Yields Dollar Still Supports Higher Yields Dollar Still Supports Higher Yields Finally, we should note that the trade-weighted dollar appreciated last week as bond yields rose (Chart 5). A stronger dollar certainly supports the case for extending duration, the only question is whether the dollar has strengthened enough to dent US economic growth and pull US yields back down. Our sense is that we haven’t reached that breaking point yet, but we could if US real yields continue to rise relative to real yields in the rest of the world (Chart 5, panels 2 & 3). We think of the relationship between US bond yields and the dollar as a feedback loop. A weaker dollar supports economic reflation, which eventually sends yields higher. However, once higher US yields de-couple too far from yields in the rest of the world, the dollar appreciates. A stronger dollar impairs the economic outlook and sends US yields back down, the dollar then depreciates and the cycle repeats. At present, we appear to be in the stage of the feedback loop where US yields are rising relative to the rest of the world, putting upward pressure on the dollar. However, we don’t think the dollar is yet strong enough to prevent US yields from climbing. Dollar bullish sentiment, for example, remains below 50% suggesting that most investors remain dollar bears. A sub-50 reading on this index also tends to coincide with rising US Treasury yields (Chart 5, bottom panel). A move above 50 in the dollar sentiment index would be another signal that the bond bear market is becoming stretched. Bottom Line: Long-maturity Treasury yields are closing-in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Comparing Baa- And Ba-Rated Corporate Bonds Chart 6The Ba Index OAS Is Unusually High The Ba Index OAS Is Unusually High The Ba Index OAS Is Unusually High We have previously written that the macro environment is extremely positive for credit risk and we recommend moving down in quality within corporate bonds. We have also pointed out that the incremental spread pick-up earned from moving out of Baa-rated bonds and into Ba-rated bonds is elevated compared to typical historical levels. As such, the Ba-rated credit tier looks like the sweet spot for corporate bond allocation from a risk/reward perspective.2 In this week’s report we delve a little deeper into the relative valuation between Baa- and Ba-rated bonds. First, we note the difference between the average option-adjusted spread (OAS) of the Ba index and the average OAS of the Baa index. The Ba index OAS is 126 bps above the Baa index OAS, a level that looks high compared to recent years (Chart 6). One problem with this simple comparison of index OAS is that the average duration of the Ba index is much lower than the average duration of the Baa index (Chart 6, bottom panel). However, after doing our best to match the duration between the two indexes, we still find that Ba offers an attractive yield advantage, particularly compared to levels seen in 2017 and 2018 (Chart 6, panel 2). Going back to our simple OAS differential, we conducted a small study looking at calendar year excess returns between 1989 and 2020. Our results show that the differential between the Default-Adjusted Ba OAS and the Baa OAS does a good job predicting relative excess returns between the two sectors (Table 1).3 The Default-Adjusted Ba OAS is the Ba index OAS at the beginning of the calendar year minus realized Ba default losses that occurred during the year in question. We also use the Baa index OAS from the beginning of the year, but don’t make any adjustments for Baa default losses. Table 1Annual Excess Return Differential & Relative Spreads: Ba Corporates Over Baa Corporates Ba-Rated Bonds Look Best Ba-Rated Bonds Look Best Our results show that Ba excess returns outpaced Baa excess returns in every calendar year for which the Adjusted Ba/Baa OAS differential exceeds 100 bps. The raw Ba/Baa OAS differential is currently 126 bps. This means that we should be very confident that Ba-rated bonds will outperform Baa-rated bonds in 2021, as long as Ba default losses come in below 0.26%. This seems likely. For context, Ba default losses came in at 0.09% in 2020, despite the 12-month default rate spiking to almost 9%. Fallen Angels Another interesting issue to consider when looking at the intersection between the Baa and Ba credit tiers is the presence of fallen angels – bonds that were initially rated investment grade but have been downgraded to junk. The 2020 default cycle coincided with a huge spike in ratings downgrades and the number of outstanding fallen angels jumped dramatically (Chart 7). Not only that, but fallen angels also performed exceptionally well in 2020. Fallen angels outperformed duration-matched Treasuries by 800 bps in 2020 compared to 431 bps for the Ba-rated index, -10 bps for the Baa-rated index and -13 bps for the B-rated index (Chart 7, bottom panel). All that outperformance has compressed fallen angel valuations a lot. The incremental spread pick-up in fallen angels over duration-matched Baa-rated bonds is 201 bps, about one standard deviation below its post-2010 average (Chart 8). Fallen angels look even worse compared to the Ba index, offering only a 30 bps spread advantage (Chart 8, panel 2). Chart 7Fallen Angels Dominated In 2020 Fallen Angels Dominated In 2020 Fallen Angels Dominated In 2020 Chart 8Fallen Angels No Longer Look Cheap Fallen Angels No Longer Look Cheap Fallen Angels No Longer Look Cheap Bottom Line: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes.   Labor Market Update Chart 9Employment Growth Has Slowed Employment Growth Has Slowed Employment Growth Has Slowed Last week’s January employment report was a disappointment with nonfarm payrolls growing only 49k after having contracted by 227k in December (Chart 9).   Two weeks ago, we calculated the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 4.5% by certain future dates.4 In our view, an unemployment rate of 4.5% would meet the Fed’s definition of maximum employment, making it an important pre-condition for monetary tightening. Revising our calculations to incorporate January’s report, a 4.5% unemployment rate by the end of 2021 still looks like a long shot. Nonfarm payroll growth would have to average between +328k and +705k per month to meet that target, depending on the path of the participation rate (Table 2). That said, we still view a 4.5% unemployment rate by the end of 2022 as achievable. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% ##br##By The Given Date Ba-Rated Bonds Look Best Ba-Rated Bonds Look Best Yes, even that will require average monthly payroll growth of between +210k and +411k, but we are likely to see a re-opening of certain shuttered sectors – Leisure & Hospitality, for example – during that timeframe. When it occurs, this re-opening will lead to a surge in employment growth that will push average monthly payroll growth dramatically higher. Notice that almost 40% of the 9.9 million drop in overall employment since February 2020 has come from the Leisure & Hospitality sector (Chart 10). Chart 10Waiting For The Post-COVID Snapback Waiting For The Post-COVID Snapback Waiting For The Post-COVID Snapback Bottom Line: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Excess returns are calculated relative to duration-matched Treasury securities in all cases. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification